Merrill Lynch Says It Told Citron of Risk : Bankruptcy: Documents show warnings dating to 1992. Firm contends the records should absolve it of culpability in crisis.

By JEFF BRAZIL

Jan. 11, 1995 12 AM PT

TIMES STAFF WRITER

COSTA MESA —

Offering the most detailed defense yet of its role in Orange County government’s financial collapse, Merrill Lynch & Co. on Tuesday disclosed that the firm repeatedly warned former Treasurer Robert L. Citron that his investment tactics were risky and twice offered to buy back most of the diciest offerings in the county’s ill-fated investment portfolio.

Seeking to counter public perceptions that it was in part responsible for Citron’s failed strategy, officials of the giant Wall Street brokerage released internal documents that the firm contends should absolve it of any culpability in what has become the largest municipal bankruptcy filing in U.S. history.

Since 1992, the documents indicate, Merrill Lynch officials had been admonishing Citron about the risky nature of the county’s $7.5-billion portfolio and suggesting that he reassess his longstanding strategy of betting that interest rates would remain low or fall.

Merrill officials acknowledged Tuesday that the firm continued to sell to Citron the same type of risky investments it was advising him to unload, even as the county fell deeper into financial trouble.

“As a broker-dealer, our role was to provide him with products--when he wanted, what he wanted,” said Paul W. Critchlow, Merrill’s senior vice president for marketing and communications.

But asked whether the firm’s concerns should have prompted it to reconsider its sales of the securities that eventually contributed to the fund’s collapse last month, Critchlow said: “Well, that’s a legitimate question.”

Tuesday’s disclosures came as state and federal investigations of Merrill’s role in the financial crisis continue. The county is preparing a lawsuit against Merrill Lynch alleging fraud and securities violations.

Merrill Lynch has emerged as a major figure in the financial debacle. The firm both underwrote and marketed many of the bonds Orange County floated in recent years, and also sold Citron many of the investment pool’s riskiest investments. Its dealings with Orange County generated millions in fees and commissions annually.

Citron’s attorney, David Wiechert, has said that Merrill Lynch supported Citron’s strategy of investing in financial instruments whose values would rise as interest rates fell, supplying the Orange County treasurer with company reports predicting that interest rates would continue to fall even as they were beginning to climb.

Citron, Wiechert said, depended heavily on the advice of Charles I. Clough Jr., Merrill’s chief investment strategist, and veteran Merrill broker Michael G. Stamenson, who had worked closely with Citron for years.

But beginning in October, 1992, according to the Merrill Lynch documents, an analysis of the county’s portfolio by the firm red-flagged the high degree of leverage that Citron was using, and the amount of derivatives the investment pool contained.

In a letter to Citron dated Oct. 14, 1992, Stamenson cautioned that Citron’s use of reverse repurchase agreements to enhance his interest earnings exposed the county to greater risk if interest rates should rise.

“We suggest that Orange County constantly review the volatility in the existing portfolio,” Stamenson wrote.

In essence, Citron was arranging for short-term loans, which he might have to renew at higher interest rates, to purchase long term bonds and notes that could not be cashed in for the full face value for years to come. That left the county vulnerable to the interest rate increases eventually imposed by the Federal Reserve Board in 1994.

By March, 1993, the firm said its concerns about the health of the portfolio had grown to such an extent that it offered to buy back all of the derivative securities it had sold to the county. By Citron’s own estimate at the time, Merrill had sold the county 95% of all the derivatives in the portfolio.

Citron rejected Merrill’s offer, according to an April 26, 1993, letter from the ex-treasurer to Stamenson.

“Although there may be an alleged interest rate risk in these type of securities,” Citron wrote, “we believe because of future low interest rates that the securities that we now own may be even more valuable than they are today.”

In the same letter, Citron pointed out that it was Merrill Lynch that had prompted him to purchase such a high number of derivatives to begin with.

“In fact, Mike,” Citron said, “it was only after extensive consultation with highly placed Merrill Lynch officials by conference call, in person, and in writing well over a year ago that we felt secure in investing an even larger percentage of our portfolio in derivative securities.”

In June, 1993, Stamenson replied to Citron by letter, cautioning Citron not to base his investment strategy “exclusively on Merrill interest rate projections.” The letter suggests that Merrill’s offer to repurchase all the derivatives it had sold Citron still stood.

“While the decision is yours to make,” Stamenson said, “it was our hope to assist you in bringing the O.C. portfolio in line with a risk profile that is less leveraged and better positioned to perform in the event of unanticipated movements in interest rates.”

Then, on Feb. 23, 1994--19 days after the Federal Reserve Board made the first of six increases in interest rates in 1994--Merrill Lynch officials met with Citron in Orange County and presented him with a 29-page analysis of the county’s fund.

“Interest rates going forward are more of a question mark than at any point in the past several years,” the report warned. It suggested that the Federal Reserve Board’s interest hike may be the first of “numerous others” to come.

Emphasizing the unpredictability of interest rates, Merrill’s presentation also indicated that for each 1% increase in interest rates, the market value of the county’s fund would lose about $270 million. The firm also outlined several strategies Citron could employ if interest rates continued to rise.

In an open letter Tuesday to all its Southern California-based employees, Merrill Lynch Chairman and Chief Executive Officer Daniel P. Tully asserted that high-ranking Merrill officials had also expressed concerns to Citron, primarily via telephone conversations, on at least four other occasions--in February, 1992, November. 1992, January, 1993, and fall, 1993.

Company officials said Tully took the unusual step of writing the letter then releasing it to the public because of the degree of “misinformation” that has been disseminated regarding Merrill’s involvement in the Orange County crisis.

“This misinformation compels us to set out facts and information about our actions that you can use to respond to questions you receive from your clients and others,” Tully wrote. “Once this information is known, it will be quite clear why Merrill Lynch has maintained, with confidence from the outset, that we acted properly and professionally in our relationship with Orange County.”

Citron’s attorney, Wiechert, said: “If Merrill Lynch was taking the position in 1992 and 1993 that the county’s investments were unsuitable, then someone should ask them why at the end of 1993 and the beginning of 1994 they were selling hundreds of millions of dollars of inverse floating derivatives to the county.”

A week after Merrill’s Feb. 23 report was presented to Citron, Wiechert said, Citron had breakfast with Clough and Stamenson in Orange County, and Clough told Citron high interest rates were “not sustainable,” Wiechert said.

Merrill officials, who failed to include the breakfast meeting in their partial recounting of the events leading up to the fiscal disaster, confirmed that the breakfast occurred and acknowledged that Clough probably was the most “optimistic” of the firm’s analysts on the issue of whether interest rates would remain low.

But, they said, Citron was provided with forecasts from Merrill’s other analysts who were more bearish on the future of interest rates and the stability of the bond market.

In any case, Critchlow said, Merrill Lynch officials believe Citron was a sophisticated, “strong willed” investor who was aware of the risks he was taking, and for many years “had been right.”

Of Merrill’s latest disclosure, Orange County Supervisor William G. Steiner said: “It answers some questions, but raises some new ones on their silence on the borrowing of $600 million in June, 1994.”

Steiner was referring to the $600 million the county raised in a Merrill-underwritten issue of taxable notes in July. Sources have said that federal and state regulators were focusing on the transaction to determine if Merrill and the county made full disclosure of potential risks.

“If they really believed there was a problem,” Steiner said, “then why would they feel comfortable with the huge issue?”

Merrill reiterated Tuesday that it had acted properly.

Also Tuesday, the company produced a May, 1985, letter in which Citron, writing about a similar financial disaster in San Jose that also involved Merrill, strongly expressed his belief that brokers should not be blamed for that city’s investment decisions.

Referring to San Jose’s lawsuit against securities firms, including Merrill and others, Citron wrote: “This is a face-saving type of suit in that you have a city treasurer with 23 years experience, an investment officer of 31 years with the city, a city treasurer who has been nationally acclaimed for his professionalism, and the city is saying these two ‘professionals’ didn’t have the experience in knowing what they were investing in and, therefore, were ‘coerced’!!!”

Sources say Orange County has considered making some of the same arguments on behalf of Citron, who, before he resigned in December, had 24 years experience and received numerous awards for his higher-than-average returns in most years.

Responding to criticism of his tactics in an April 22, 1994, article in the Bond Buyer, a trade publication, Citron said: “We’re not Johnny-come-latelies here who all of a sudden thought this up. We feel we are professional managers and know what we are doing.”

Times staff writer Matt Lait contributed to this story.

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