No Alarms Sounded in 1993-94 Audit Report : Investments: On eve of county bankruptcy, controller gave no warning of the looming crisis.

One day before the county declared bankruptcy, Auditor-Controller Steve E. Lewis’ office was preparing a draft financial report to the Board of Supervisors that gave no hint of the impending crisis.

Although Lewis had been warned a month earlier by then-Assistant Treasurer Matthew Raabe that the county’s investment pool was in serious trouble, just two cautionary sentences are devoted to the pool in a nine-page transmittal letter summarizing the 1993-1994 financial report.

In one instance, Lewis’ letter simply noted that the rapid interest rate increases in late 1994 had reduced the effectiveness of the county’s investment strategy, and that “interest earnings are likely to be much lower over the next several years.”

The financial report itself notes that as of Dec. 1, 1994, the county’s investment pool had “experienced market decline”--which a careful reader could calculate as a $1-billion drop from June 30 to Dec. 1. It then states reassuringly, however, that “county management had informed investors and brokers” of the decline and believed “it had not resulted in any permanent loss of principal.”

While Lewis prides himself on having criticized former Treasurer-Tax Collector Robert L. Citron and questioned Citron’s investments in audits addressed privately to county supervisors, the Dec. 5 draft of the one major report his office prepares for public consumption makes no mention of the risky investments or the improper fund transfers that have since come to light.

The draft report said the county’s “economic uncertainty fund,” where Citron’s office deposited interest earnings improperly skimmed from the accounts of other pool investors, had been fed “primarily . . . (by) property tax penalties.”

Lewis said the draft report, which contains financial data audited by the accounting firm KPMG Peat Marwick, was not a final version. The report was due to be released Dec. 15, he said.

“It was never issued and it would have all had to be changed,” said Lewis, who is elected countywide to a four-year term like the supervisors. “Those figures and numbers and explanations and all weren’t as of that (Dec. 5) date.”

Lewis said that the transmittal letter accompanying the financial report had been compiled from information supplied by many departments, and that once he spoke with Raabe, “we knew we had to disclose there was a problem with the treasury.”

But Lewis said that while Peat Marwick, the county’s independent auditor, had not submitted its final opinion letter to be included with the financial report, the firm had told him “there were no problems” with the financial report as it existed in early December.

“When were we told ‘no problems’? Up until the bankruptcy,” Lewis said. “They would definitely have problems with the numbers now.”

Several high-ranking sources working to unravel the county bankruptcy have said that Peat Marwick was “within hours” of giving the draft report its stamp of approval.

John R. Miller, one of Peat Marwick’s directors, denied that Peat Marwick had been about to approve the report. “Our audit test work was not substantially complete when the county instructed us to stop our work,” said Miller, who heads the firm’s government audit division. “The suggestion that we were essentially ready to issue our auditors’ report on the county’s financial statements is unequivocally false.”

The firm was told by county officials to cease work once the bankruptcy petition was filed.

County supervisors and other highly placed county officials said that by Dec. 5--10 days before the report was due--both Lewis’ office and Peat Marwick should have highlighted greater problems than the financial report identified, and spotted the investment fund’s extreme vulnerability to the interest rate hikes that caused its collapse.

“They couldn’t have been operating in a vacuum, given the very significant disclosures that began in November,” said Supervisor William G. Steiner, who until recently had been a strong supporter of Lewis.

“The date and the content would certainly raise some questions,” added Supervisor Gaddi H. Vasquez, the board’s chairman.

Steiner and other county officials said the draft raises further questions on the role Lewis played in the county’s bankruptcy and in the improper diversions of funds recently discovered within the county’s investment pool.

Lewis’ office has come under scrutiny by both the district attorney’s office and county supervisors in recent weeks. Two weeks ago, district attorney’s investigators quizzed Lewis, who has worked for the county since 1965, for two hours, and subsequently questioned one of his top assistants.

Last week, outside accountants uncovered evidence suggesting that at least $85 million in interest earnings due other pool investors was skimmed into the county’s economic uncertainty fund.

Lewis’ office handles all cash transfers between accounts in the investment pool, and he said he was directed by the supervisors to shift what were called “extraordinary interest earnings” into the uncertainty fund.

But in the draft 1993-94 financial report that was being audited by Peat Marwick, the source of the money in the uncertainty fund consisted “primarily of property tax penalties.”

Last Friday, Lewis issued a 5 1/2-page public letter in which he cast himself as the one person who consistently warned supervisors and other county officials that Citron was playing fast and loose with the county’s money. Lewis cited internal audits he had released in 1987 and 1993 that raised questions about Citron, and a letter he wrote to County Administrative Officer Ernie Schneider on June 8, 1994, with copies to the county supervisors.

None of the supervisors remember receiving the documents, although two supervisors found copies of the 1993 audit report in their files.

Oddly, while Lewis’ June 8 letter protested the county’s selling of $320 million worth of pension obligation bonds for the county employee retirement program, the Dec. 5 transmittal letter attached to the financial report lauds the selling of the bonds as having the potential to “save the county significant amounts over the next 14 years.”

One official currently working on the county’s recovery plan criticized Lewis’ vaunted warnings as basically “memos to the file. And they almost feel calculated to establish a paper trail. . . . The kind of things he warned about are things he should have gone up and delivered personally to each of the supervisors.”

Supervisors Steiner and Roger R. Stanton agreed.

“I’m puzzled why he doesn’t communicate with us directly when it has to do with the treasury of Orange County and the residents of Orange County, but he doesn’t have any reluctance to communicate with us directly when it has to do with his own budget, or his own salary,” Stanton said. “I find that rather self-serving.”

Stanton said Lewis had appeared before the board on several occasions when the issues concerned his office. Specifically, Stanton remembered Lewis’ 1994 plea for a salary increase and his complaints in 1993 about a proposed cut in the car allowance and management budget.

One official said that if Lewis had really been concerned about the pool, “he could have withheld his signature” from the vouchers that allowed Citron to transfer investments and monies within the fund. All such transfers must include the signatures of officials in both the treasurer’s and auditor-controller’s offices. Wednesday, Lewis admitted to supervisors that vouchers permitting transfers between funds in the pool were sometimes approved by mid-level managers in his office.

Some county leaders questioned why Lewis and his office had not composed a more alarming account of the county’s finances in his draft year end report, if he already had personal knowledge that the fund was in trouble.

Early in November, Assistant Treasurer Raabe--who was suspended from his duties two weeks ago--went to Lewis with his concerns that Citron continued to make huge leveraged deals while the pool teetered on the verge of collapse.

But a month later, the draft letter to the supervisors contained only one paragraph devoted to investment earnings. Lewis’ letter simply reported that the county had initiated new investment strategies, which included the sale of taxable notes and other “specific investments” during the past two years to build reserves and generate new streams of interest revenue.

The interest rate rises of late 1994, Lewis’ letter said, “will prevent the county from maintaining such an investment strategy, and acquired reserves will likely be exhausted as the county adjusts its budget for the loss of anticipated investment earnings.”

In the financial report itself, the investment section did little to draw attention to the fine print that indicated the fund was hemorrhaging.

The draft report states that “the county did not violate significant legal or contractual provisions for deposits, investments or reverse repurchase agreements during the year ending June 30, 1994, and no losses occurred during the year due to default by counterparties to these transactions.”

A footnote in the section said that as of Dec. 1, 1994, the estimated market value of the county pool was 7% less than the purchase price of its investments, which a column total in a financial statement showed was $22 billion.

The county’s current policy, the footnote read, was to hold investments to maturity, and “management is developing strategies to maintain the needed liquidity to continue with this policy” or “mitigate any loss if it becomes advantageous to sell securities before maturity.”

The report said that “county management . . . believes that the market value decline has not resulted in any permanent loss of principal.”

Lewis stressed Monday that these assertions would “have come from the treasurer”--not his office--”and would be audited by (Peat Marwick). I don’t know if they saw them.”

John Schotz of Saybrook Capital Corp., financial adviser to the creditors’ committee created since the county bankruptcy, said that the information in the notes was blatantly false. “It’s the luckiest thing that ever happened” to Peat Marwick that the firm did not affix its final stamp of approval to the audit, he said.

“They should have done a lot more diligence,” he said. “But I don’t know whether Citron absolutely misrepresented what he had done or if they didn’t ask the right questions.”

Bernie Burke, a partner with Price Waterhouse who examined the report, said the draft report clearly doesn’t “raise red flags” as it should have about the alarming nose dive the market value of the county’s investment pool had taken. “That sucker went south in a hurry, in just a matter of months,” Burke said.

The report shows that the fund had lost $443 million in market value by June 30, 1994, and another $1 billion by Dec. 1.

Lewis said that once he had spoken to Raabe, he knew his office had to start over on the transmittal letter accompanying the financial report. In order to complete the financial report, Lewis said, he had to sign a “representation letter” that everything in the report was accurate.

“Before we can sign, we have to tell (Peat Marwick) everything we know,” Lewis said. “This was such a significant occurrence,” he said, that it required restatement of fund balances.

But Lewis conceded that neither he nor Peat Marwick had come across the problems on their own, and that Peat Marwick was “on the verge” of finishing its annual audit.

In his public letter issued last Friday, Lewis laid a share of blame on the Big Six accounting firm, pointing out that he had asked Peat Marwick to look at the treasurer’s investment program during its 1993 and 1994 audits of the county’s annual financial statements.

Lewis said he specifically asked the accounting firm to investigate whether Citron’s portfolio was “being managed in a safe/fair manner,” whether his investments were “getting more aggressive,” and whether “the liquidity and leveraging of the treasury (was) acceptable.”

Peat Marwick’s Miller disputes that the firm was asked to address any of these issues. He testified last month to a special Senate committee investigating the county’s financial collapse that “KPMG was not asked and did not second-guess the county’s investment strategy.”

Miller also said the firm’s local partners had not been provided with the Dec. 5 draft of the county’s financial statements to sign off on. A firm spokesman said he did not know to what extent other staff members had audited the work.

But the firm’s 1993 audit did not signal any major problems with the treasurer’s office.

The pool collapsed largely because rising interest rates rapidly eroded the value of Citron’s investments in risky, leveraged securities.

The California Board of Accountancy, which regulates accountants and auditors, has said it may look into Peat Marwick’s county audits and is scrutinizing “any firm, auditor or accountant involved in this process.”

Times staff writers Jodi Wilgoren and Michael A. Hiltzik contributed to this story.