ORANGE COUNTY IN BANKRUPTCY : Shock of Recognition : San Jose Officials Stunned to See Their Errors Repeated

Former San Jose city officials who weathered that city’s bond fiasco a decade ago find it utterly amazing that Orange County has been brought to its knees by reverse repurchase agreements--the same high-risk investments that nearly bankrupted San Jose.

“It’s stunning to me that this could happen in 1994 in view of that experience,” said Jerry Newfarmer, a Cincinnati-based management consultant who was San Jose’s city manager during the crisis. But, he added, “it’s very easy to get caught up in the psychology that rate of return on investment is a measure of success.”

Had Orange County Treasurer-Tax Collector Robert L. Citron, who resigned under fire Monday, heeded the lessons of a decade ago and focused on portfolio safety and liquidity, Orange County would not be in Bankruptcy Court proceedings, Newfarmer said.

Indeed, in 1984 Citron was one of the staunchest critics when San Jose decided to bail out of its bond portfolio, even though that action helped contain the city’s losses to $60 million and save it from bankruptcy, recalled Les White, who was San Jose assistant city manager at the time.

In the aftermath of the crisis, San Jose sued its auditor and the 13 brokerage firms that it believed had sold city officials “a bill of goods by convincing them these were transactions in which they could not lose money,” said San Jose City Atty. Joan Gallo.

0 One of them was Merrill Lynch, the firm with which Orange County did most of its ill-fated investing. The Merrill broker working with San Jose was Michael Gus Stamenson, with whom Citron conducted his high-risk transactions.

“What the Orange County treasurer has done is absolutely unconscionable,” Newfarmer said Wednesday. “The one thing you do not do with public monies is speculate with them.”

San Jose learned that harsh lesson in 1984. For at least two years before then, San Jose finance officials had followed the advice of prestigious brokerage firms and invested heavily in the reverse repurchase agreements--complex transactions that involve borrowing against a fund’s holdings in the hope of increasing returns as interest rates fall. The strategy basically tied up an increasing proportion of San Jose’s assets in long-term investments. While interest rates cooperated, the city treasurer and the finance director won kudos for achieving high rates of return on long-term bonds.

Then in the fall of 1983, rates took a U-turn, and the city’s investment strategies began to unravel.

While poring over monthly reports, White said he noticed that the city--despite a $325-million portfolio--was reporting zero earnings. Close scrutiny revealed that the city had been shoveling much of its money into the high-risk reverse repos, which had begun to lose money as interest rates rose. The concern was that the city would have no cash to cover its operating expenses.

In late May, 1984, the situation became so dire that, after secret weekend consultations with a bevy of experts, San Jose extricated itself by selling $106 million in bonds, allowing it to raise enough cash to pay off immediate debt. The hasty action held San Jose’s losses to $60 million.

Merrill Lynch settled the San Jose case out of court for $750,000, a pittance compared to the $6.6 million that Paine Webber paid after being found culpable by a San Jose jury. E.F. Hutton, also found guilty, agreed to pay $6 million.

As a result of the debacle, San Jose “put into effect very conservative systems,” Gallo said. “We don’t leverage.”