Advisory Group Calls for Limits on Treasurers

TIMES STAFF WRITERS

Concluding that Orange County's financial fall resulted from a "reckless abuse" of the public trust, a private sector panel Thursday recommended that the Legislature conduct a wholesale revision of state laws governing municipal treasurers.

The 12-member group, which is advising a special Senate committee investigating Orange County's bankruptcy, called for prohibitions on excessive borrowing for investment purposes, criminal penalties for violators and a restriction on the use of derivatives, the complex financial instruments that got former Orange County Treasurer Robert L. Citron into trouble when interest rates climbed last year.

The advisory group--composed of leaders in business, education, labor and finance--suggested that local agencies be considered "unsophisticated investors" in dealing with brokers, putting the onus on Wall Street to make sure municipal investments are sound.

The panel also called for annual audits of county investment funds and the establishment of three-member review committees to help shepherd county investment decisions.

"We do not believe the losses should have occurred or would have occurred if there was appropriate legislation and all parties acted in a responsible manner," said Eli Broad, the advisory board chairman and chief executive of SunAmerica Inc., a Los Angeles-based financial services firm.

The recommendations come as some officials are calling on local agencies to guard against financial disasters by limiting the amount of funds that they borrow for investment purposes and being more vigilant about disclosing risks to investors in municipal securities.

At the same time, various regulatory bodies are weighing whether to place controls on the sales practices of brokers and bankers who market the kind of complex financial packages that have proved troublesome to Orange County and other local governments.

Lawmakers generally applauded the advisory committee's findings, with Senate President Pro Tem Bill Lockyer (D-Hayward) calling the proposals "good ideas presented by credible people."

Sen. Lucy Killea (I-San Diego), who co-chairs the Senate Special Committee on Local Government Investments, said the private sector panel had provided a balanced view that was "very ambitious in scope."

The advisory group unveiled its blueprint shortly before the Senate committee convened its third hearing Thursday to examine the problems that led to the largest municipal bankruptcy filing in U.S. history.

During their morning session, lawmakers grilled representatives of Merrill Lynch, the giant brokerage house that sold Citron many of the interest-sensitive securities that caused the investment fund to collapse in December amid investment losses of $1.69 billion.

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The brokerage, which earned $62.4 million in 1993 and 1994 on its dealings with Orange County, continued to defend itself against allegations that it kept selling Citron inappropriate securities while warning him that the county's investment pool was getting into deeper trouble.

Of particular concern to the Senate committee was Merrill's failure to inform the Orange County Board of Supervisors of the risks, despite warning Citron at least nine times since 1992 and once offering to buy the county's portfolio outright.

Richard M. Fuscone, 43, director of Merrill's fixed income securities group, defended the firm's disclosures in bond offerings for the county and said Merrill encouraged Citron to be more forthcoming with the board about the pool and its exposure to interest rate swings.

"We did persist," Fuscone said in the face of intense questioning. "We had advised the county treasurer that he should disclose more fully or more comprehensively about his strategy, the current market, the risks and rewards of the strategy. And we had suggested that one opportunity to accomplish this was to meet with the board, and we offered our willingness to meet with him (and) with the board to explain the current market environment.

"Mr. Citron declined and had offered to send us a letter verifying his authorization to carry on the business that he was (doing) and the fact that there had been sufficient disclosure to the Board of Supervisors," Fuscone said.

At Merrill's urging, Fuscone said, Citron rewrote parts of his 1993 annual report to the board that described the risks of the investment fund.

Appearing with Fuscone were two bankers who helped underwrite a $600-million bond sale by the county in July: Timothy Romer, an investment banker who joined Merrill Lynch in July, 1989, and who is the son of Colorado Gov. Roy Romer, and Elke Cheveney, a vice president at Merrill Lynch.

Lawmakers grilled the group about whether there had been sufficient disclosure of the condition of the county's investment pool when Merrill underwrote the offering of taxable notes issued solely to reinvest the proceeds in the pool.

Most troubling, committee members said in their questioning, was Merrill's acknowledgment that it knew of the precarious nature of Orange County's fund, and, in a 29-page report, warned Citron of the dangers of his strategy should interest rates rise. Merrill Lynch officials told Citron that each 1% rise in interest rates would shave $270 million off the pool's market value.

But Fuscone replied that what Merrill Lynch sold the county was not a problem. Instead, he insisted, what caused the county trouble was Citron's insistence that interest rates would resume their fall when they were steadily rising.

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"In the course of our relationship with the county, we offered a variety of securities. None of these securities were inherently risky," Fuscone said. "What did have risk was the strategy that Mr. Citron had followed: . . . the bet that interest rates would stay at historically low levels and perhaps fall further."

In testimony during the Senate committee's second hearing Jan. 17, Citron portrayed himself as a financial rube who loyally followed the advice of Merrill Lynch and Michael G. Stamenson, the Merrill broker with whom he dealt most often. Orange County has filed a federal lawsuit against the investment house, alleging that Merrill is responsible for the county's losses in that it should have known that Citron did not have the legal authority to massively leverage the fund, borrowing billions of dollars for his bet on falling interest rates.

Some committee members did not buy Fuscone's explanation Thursday that Merrill Lynch did all it could to warn Citron and the Board of Supervisors about the shakiness of the fund.

"Mr. Fuscone, I'm not convinced," said Sen. John R. Lewis (R-Orange). "It really does sound to me like you were worried enough that you were repeatedly giving Mr. Citron these warnings, but you weren't taking the extra step that was necessary. I've got to tell you that I think your explanation is a dog that just won't hunt."

In other testimony, Douglas Montague, a public finance banker for CS First Boston who helped structure a $110-million pension bond issue now in default, said the bond issue--which the county could be called on to redeem on demand--did not force the county into bankruptcy Dec. 6, as some county officials have claimed.

"It was not the only claim on the pool clearly, and I'm not sure it was the one that broke the camel's back," Montague said.

The committee's afternoon session was dominated by testimony from county officials about whether they should be held accountable for the calamity.

In prepared remarks that were to be his first extensive public comments since being demoted three weeks ago, former County Administrative Officer Ernie Schneider denied any responsibility for the financial collapse. Instead, Schneider pinned the blame for the fiasco on Citron and other county officials, including Auditor-Controller Steve E. Lewis and county counsel Terry C. Andrus, both of whom also testified Thursday.

"Oversight responsibilities were vested with the county auditor, outside auditors doing treasurer audits, Wall Street rating agencies, outside law firm bond counsel, the county counsel, financial advisers, etc.," Schneider's statement read.

"Supervising the treasurer, his investment policy or supervising any other elected agency head was not within my scope of authority," he added.

Schneider acknowledged, however, that his professional experience and lack of financial background made him ill-equipped to understand what Citron was doing.

"The treasurer's annual reports discussed his strategy, but not being a finance expert, I did not understand the workings of complex financial instruments such as derivatives, reverse repurchase agreements, inverse floaters and structured floating rate securities," Schneider said.

Times staff writers Matt Lait and Tracy Weber in Sacramento and Lee Romney in Orange County contributed to this report.

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