NEWS ANALYSIS : County Fund Fiasco Sows Dissension on Wall Street

Orange County’s financial disaster is causing deep fissures on Wall Street, isolating giant Merrill Lynch & Co.--the county’s principal financier--and shining a bright and unwanted light on the brokerage industry’s sales, marketing and lobbying practices.

In particular, the county’s bankruptcy is likely to expose many of the contradictions inherent in brokerages’ hawking last year of “derivative” bond securities that represented a high-risk bet on falling interest rates--at a time when many brokerage executives appeared convinced that rates were bottoming.

Even the workout of the county’s loss-ridden bond portfolio presents a threat to Wall Street in that it creates potentially awkward choices for Merrill Lynch rival Salomon Bros., which the county has picked to sort out the portfolio.

Salomon could be asked by county officials to detail whether certain transactions either were ill-advised or simply wrong for the county fund. But any evidence to that end could indict Wall Street sales practices in general.

“If Salomon turns on Merrill for what they did, they (Salomon) might also have to admit that they were peddling some of this Kool-Aid themselves” to their own clients, one bond trader said.

The stakes now clearly are highest for Merrill Lynch, which enjoyed a close relationship with former county Treasurer Robert L. Citron--selling him billions of dollars in securities, and underwriting nearly one-fifth of all county and county agency bond offerings since 1990--and which from the beginning of the crisis sought to rally the rest of Wall Street to the county fund’s defense.

In reconstructing the days leading up to last Tuesday’s bankruptcy filing, brokerage executives say the industry at first appeared united in trying to halt the county’s downward spiral.

Because major brokerages had more than $13 billion in loans outstanding to the $18.5-billion fund, it was thought to be in the interest of all players to help the county over its liquidity crisis. That crisis had been sparked by the rising cost of the fund’s short-term loans, while its long-term bond portfolio was falling in value.

In an attempt to avoid triggering a debacle, brokerages Smith Barney and Nomura Securities are believed to have agreed to roll over relatively small loan amounts that came due in the days preceding the bankruptcy filing, even though they were well aware of Citron’s cash crunch.

“Virtually all of us took Merrill’s tack on this--that it could be worked out,” said one brokerage executive who spoke on condition of anonymity.

Citron, this executive said, had tried to mollify Wall Street by even suggesting that he could borrow from the state to pay his bills if necessary, even though Gov. Pete Wilson’s office has maintained all along that the state was not in a position to supply cash.

By last Monday, worries were mounting on Wall Street that the fund’s losses were bigger than the $1.5 billion Citron had indicated. Worse for the brokerage community, it awoke Monday to learn that Citron--the fund’s mastermind--had resigned.

Merrill Lynch, which had $2.1 billion in loans outstanding to the county fund, continued to insist last Monday that it had no plans to cut off credit to the fund. But the fund’s biggest creditor, brokerage CS First Boston Corp., was beginning to waver.

For reasons still unclear except perhaps for the sheer size of its $2.6-billion loan to the county fund, CS First Boston pulled the plug Tuesday after the county said it was unable to make $1.2 billion in payments that fell due.

By seizing and selling the county-owned bonds it held as collateral for its loan, CS First Boston precipitated the bankruptcy filing. Within 24 hours, nearly every other brokerage with loans to the county fund also called them in, seized the collateral securities and sold them.

By Friday, the county reported that collateral bonds worth $11.4 billion had been liquidated, and that the only major brokerage creditor remaining was Merrill Lynch. Outraged county authorities have sued one of the brokerages, Nomura Securities, demanding the return of the bonds, and have said all of the other sellers will be sued as well.

Privately, Merrill Lynch has been lashing out at its rivals for turning on the county, tying itself even more closely to the county’s declining fortunes. Although many Wall Street attorneys insist that bankruptcy rules permit the liquidation of collateral securities, Merrill’s attorneys apparently are taking the opposite view.

One Merrill Lynch official said privately that “they’d (the other brokerages) better not spend any extra proceeds from the bond sales because they could be giving it back.”

Some analysts say Merrill’s increasing distance from its peers over the Orange County case reminds them of now-defunct junk bond giant Drexel Burnham Lambert’s rapid isolation after the junk market collapsed in 1989. And investors are plainly worried about Merrill’s ties to the county: The brokerage’s stock price has tumbled 16% since mid-November.

On Saturday, The Times reported that Merrill Lynch had lobbied extensively since 1987 in the state Legislature for laws that expanded county investment funds’ ability to purchase more complex securities.

That is likely to accentuate what are already the biggest issues dogging Merrill and all of Wall Street as the county’s case is dissected by regulators: Did Merrill and other brokerages sell the fund high-risk derivative securities that were unsuitable for it, and did they essentially take advantage of what now appears to be a dangerous and outlandish bet by Citron that interest rates would continue falling?

As interest rates reached 20- to 30-year lows in late summer, 1993, Citron was insisting to county supervisors that he saw no possibility of rates rising significantly for at least three years.

But on Wall Street, many brokerage officials saw higher interest rates as an inevitability in 1994, and were planning accordingly. They also were advising many of their clients along the same lines.

In a deal now viewed as a landmark, Morgan Stanley & Co. and Merrill Lynch in summer, 1993, helped Walt Disney Co. sell fixed-rate bonds maturing in 100 years--a sign that Disney, among other savvy corporations, believed that interest rates had reached depths that might not be seen again for a generation or more.

Meanwhile, in arranging billions of dollars of derivative-bond transactions in 1993, Wall Street essentially had to talk out of both sides of its mouth.

For clients such as Citron, who believed that interest rates would keep falling, commission-hungry brokerage salespeople naturally touted the high-octane returns that certain derivatives would provide if that bet were correct.

But to create such a derivative, a brokerage had to find another client who was willing to take the opposite side of the bet--that interest rates would rise. That client would have gotten the same glowing pitch from brokerage salespeople, only touting the opposite scenario on rates.

Wall Street’s defense, of course, is that it is nothing more than a facilitator, arranging transactions for independent investors who have a right to choose which interest-rate scenario to believe.

Indeed, Merrill Lynch can argue that even within its own executive ranks there has been and continues to be dissension over interest rates’ direction: Chief economist Donald Straszheim is expecting rates to fall, while Thomas Sowanick, head of taxable bonds at the firm, is predicting another surge in rates in 1995.

Even so, Merrill overall appears to have made the right call on interest rates as far as its own capital is concerned. Unlike some other major brokerages that have lost hundreds of millions of dollars betting on lower rates, Merrill’s earnings in the first nine months of this year were off just 10% from 1993’s record pace.

In his third-quarter report to shareholders, Merrill Chairman Daniel P. Tully credited a “well-diversified revenue base” and “effective cost and risk management” for protecting the company’s earnings.

Yet by helping the Orange County fund massively leverage its bet on falling interest rates--with little apparent regard to risk management--Merrill and other brokerages that functioned as advisers and securities sellers to the county may be at least partly liable for the fund’s demise, some brokerage industry observers worry.

In what may have set a dangerous precedent for Wall Street, Bankers Trust New York Corp., one of the biggest underwriters of derivatives, recently agreed to settle a lawsuit with client Gibson Greetings by absorbing most of the losses Gibson incurred on derivative investments--investments that Gibson contended it should not have made and did not understand.

What’s more, dozens of mutual fund companies this year have swallowed derivative-related losses in some of their funds, effectively sending a message to shareholders that fund management erred--and that shareholders should not have to pay the price for those errors.

For its part, Merrill Lynch has continued to state that it never acted improperly, and that Orange County was a sophisticated investor capable of making complex investment decisions.

At least one of Merrill’s peer firms saw things differently.

The current issue of Grant’s Municipal Bond Observer newsletter in New York reprints a letter Citron sent to brokerage Goldman, Sachs & Co. in October, 1993--just as interest rates were turning up.

In the letter, Citron lambastes Goldman officials in New York, charging that while the firm’s San Francisco office wanted to do business with Orange County, that office “has encountered many objections from your New York office and its legal counsel . . . because they don’t understand the type of investment strategies that we are using.”

In a line that now seems prophetic, Citron caustically wrote that Goldman should not seek to do any business with the county if the firm was uncomfortable with his use of leverage, because “any major malfunction of the (county) treasury could have an affect (sic) on county finances.”