(MONEY Magazine) – Then a municipality mismanages its money, taxpayers and muni bond investors can get crushed. In the case of Orange County, Calif., the pain is intensified by the fact that nobody knows how bad it is going to get. The county filed for bankruptcy in early December, after its highly leveraged $7.8 billion investment fund, which was well stocked with the risky securities known as derivatives, plunged $1.5 billion in value. Total losses will exceed $2 billion. The scary headlines sent municipal bond prices tumbling and raised troubling questions about how taxpayer money gets managed in municipalities across the country.

For Orange County and the other municipalities that also had money in the fund--about 180 local governments and agencies in California--the debacle could mean a loss of more than 26% of their investment. The most seriously hurt will face a shortage of cash to pay teachers, collect garbage, fund capital projects and service debt. Here's what the crunch means to you:

If you invest in municipal bonds: Counterintuitively, now is a good time to buy munis, financial experts say. Muni prices were already reeling from half a dozen interest-rate hikes this year, and in the wake of Orange County's troubles, the selling only intensified. Result: Since the beginning of 1994, 30-year muni bond prices have fallen 20%. James Solloway, research director at Argus Research, says strong local economies make many battered issues look attractive. "There's an opportunity to buy shares that panicky investors are selling," he says.

Still, the Orange County fiasco is a reminder that munis do carry some risk--so investors should be compensated for it. Before you buy individual bonds or bond funds, compare the after-tax returns of munis and taxable government issues. "You want to get at least 0.2 to 0.5 percentage points more with munis than you can get by owning higher-quality Treasury bonds," says Ralph Norton, managing editor of the Bond Fund Advisor ($59 a year; 800-445-5900). That's the case now for investors in the 28% tax bracket or higher.

A second lesson: You increase your risk by buying bonds from only one state. "Putting all your eggs in one basket is not a prudent investment," warns Jim Lynch, editor of Lynch Municipal Bond Advisory ($250 a year; 212-663-5552). His advice: Don't invest more than 50% of your bond portfolio in any one state, and avoid single-state mutual funds altogether.

Also, keep in mind that high credit ratings do not guarantee safety. "The Orange County issues had very high ratings," says David MacEwen, manager of $403 million Benham California Tax-Free Intermediate-Term. You can protect against default by sticking to insured bonds, which typically pay 0.5 to 0.75 percentage points less. But insurance doesn't shield you against losses attributable to rising interest rates or the kind of panic selling now affecting California bonds.

California municipal bond investors: If you're a California investor, don't panic. Some 46% of the long-term bonds affected by Orange County's troubles carried insurance or some other guarantee that interest and principal will be paid, even if the issuer goes bankrupt. So though you may be suffering from a short-term price drop, you figure to get paid in full at maturity. Several single-state California funds, including TransAmerica California Tax-Free Income and Oppenheimer California Tax-Exempt, have at least 5% of their portfolio in Orange County-related bonds that don't carry these protections (see the table). But not all these bonds are equally vulnerable. For example, the Irvine Unified School District and the Orange County Flood Control District kept only their spare cash in the pool.

On the other hand, the cities of Claremont and Irvine, among others, issued bonds known as certificates of participation to finance specific projects. They rely on annual appropriations by the county supervisors, meaning officials can vote to cut the bonds' funding. Most at risk are bonds backed directly by the investment pool itself.

If your bonds are in trouble, resist the temptation to sell. As the nation's 36th wealthiest county, Orange County figures to have the financial wherewithal to make good on its debts in the long run. "We would expect that no bondholder, other than those who try to bail out now, will suffer undue loss," says Richard Lehmann, president of the Bond Investors Association. Our advice: Wait for the market to settle down, then sell and diversify.

Tax-exempt money-market investors: Yes, they got nailed too. A number of big mutual fund companies with money funds invested in Orange paper--including Putnam Investments and Franklin Resources--have poured money into their funds to reassure nervous investors that net asset values won't fall below the standard $1 a share. The moral: Stick to fund companies with deep pockets.

Taxpayers: If you live in California, brace yourself for fewer government services or maybe more taxes, as Orange County and its fellow municipal investors scramble to get by without funds from the investment pool.

Could something this rotten happen where you live? Unfortunately, yes. Municipal investments aren't closely regulated by the Securities and Exchange Commission. And state laws vary greatly: Many do not force fund managers to price their portfolios daily or to follow standard accounting practices. "Hundreds, maybe even thousands of municipalities could suffer substantial losses from derivatives," says Robert Lamb, professor of finance and management at New York University, "though not on the order of Orange County's."

If you suspect local elected officials in your town are playing with matches near your tax dollars, call your local treasurer or city council member. Ask whether your government's fund uses derivatives, invests short-term money in long-term securities or uses leverage. If you don't like the answers, tell the mayor--and threaten to vote your convictions. Your city officials might not understand derivatives, but this much they do understand: They derive their power from you.