ORANGE COUNTY IN BANKRUPTCY : Treasurer’s Office Didn’t Warn Investors : Disclosure: April ’94 letter was high on prospects, although Merrill Lynch had predicted rate increase.

Only two months after Merrill Lynch & Co. cautioned the treasurer’s office about the county investment fund’s vulnerability to rising interest rates, Assistant Treasurer Matthew R. Raabe told investors that “all of our advisers” viewed a sharp rise in rates as “extremely unlikely.”

Raabe’s April letter raises questions about whether the treasurer’s office was making full and frank disclosures to investors in the fund--one of the issues currently under investigation by local, state and federal authorities.

But Raabe’s attorney, Terry Bird, said Saturday his client had been doing his best to keep investors accurately informed about the status of the county’s investment pool.

“Obviously, there were people raising questions, and Matt was the doing the best job he could to answer them,” Bird said Saturday. “He provided them with honest answers and wasn’t trying to fool anybody.”

However, in a letter dated April 28 of last year, Raabe told the Tri-Cities Municipal Water District that a rise of 1.5% in short-term interest rates could eliminate any earnings on reverse repurchase agreements--debt-fueled investments on which the county had long depended to pump up the income of its investment fund.

With a rise of 1.5% in rates, Raabe wrote, the county’s borrowing costs would consume all of the interest earned on its reverse repurchase agreements.

“If rates continued to rise even further, we may need to liquidate some securities,” Raabe said in the letter. “However, we do have several strategies in mind that would counter such an occurrence.”

Those two sentences in Raabe’s letter, however, prompted water district General Manager Peter J. Oeth to gradually withdraw the district’s $4.2 million out of the county investment pool, Oeth said Saturday.

By the end of September, Oeth, a former business consultant specializing in interest rates, reduced the district’s investment to $1.2 million because he disagreed with forecasts that interest rates would not rise.

Oeth said he had written Raabe requesting detailed financial information after questions surfaced about the soundness of the county’s investment strategies during last spring’s race for the treasurer-tax collector’s office.

He said he received Raabe’s letter in response--the only such correspondence between the two--and found it “very communicative” about the county’s investment policies.

But Oeth said he was disturbed that Raabe’s letter failed to mention the high degree to which the county had leveraged its funds to maximize its returns. The county’s $7.8-billion fund had been leveraged nearly three times its value before the county ran into a cash crunch and filed for bankruptcy Dec. 6.

Had Raabe mentioned the risky leveraging strategy, Oeth said, the district would have withdrawn all of the money immediately.

“You don’t just bet the farm, which is what the county was doing,” he said.

In April, Raabe signaled that all of the county’s financial advisers viewed sharply rising rates as “extremely unlikely,” but Merrill Lynch two weeks earlier had issued a report forecasting a 1.4% rise in short-term rates by the end of 1995.

Merrill Lynch, Orange County’s chief broker, already had warned in a February report that “interest rates going forward are more of a question mark than at any point in the past several years.” Noting rate increases engineered by the Federal Reserve Board, the firm added, “Historically, the first Fed tightening has led to numerous others.”

In reports during the fall, Merrill sharply raised its forecasts for short-term rates.

But Bird said Saturday that Merrill Lynch offered “recommendations”--not warnings--about the possibility of escalating interest rates. Merrill Lynch’s continued selling and underwriting of bonds during this same period undercuts the investment firm’s claims it issued credible early warnings, Bird said.

“They didn’t come in here and flash red lights and say, ‘You are in big trouble,’ ” Bird said. “They can’t have it both ways.”

Bird countered Merrill Lynch is now “rewriting history” to avoid legal trouble. The county is suing Merrill Lynch, blaming the Wall Street giant, which handled much of the county’s bond business, for the financial collapse.

Raabe’s assurance that the county had a strategy for dealing with rising rates also came shortly after then-Treasurer-Tax Collector Robert L. Citron received a Merrill Lynch proposal for lessening the investment fund’s exposure to higher interest rates. While he followed some of Merrill’s proposals, Citron also continued to purchase some securities that depended on falling rates for their success.

At the time, Merrill Lynch warned Citron that for every 1% increase in rates, the county’s fund would lose $270 million. More than $2 billion in fund losses propelled the county last December into the nation’s largest municipal bankruptcy.

Citron may have received conflicting forecasts from Merrill Lynch analysts. A week after the firm’s February report, Citron had breakfast with Merrill’s chief investment strategist, Charles I. Clough Jr., and veteran Merrill broker Michael G. Stamenson, who had worked closely with Citron for years. Citron’s attorney has said that Clough then advised Citron that high interest rates were “not sustainable.”

Merrill Lynch has acknowledged that Clough was the most “optimistic” of the firm’s analysts on the subject of interest rates, but the brokerage said that Citron was provided with forecasts from other Merrill analysts who were more bearish.

Times staff writer Jeff Brazil contributed to this report.