ORANGE COUNTY IN BANKRUPTCY : Merrill Reportedly Ignored Own Warnings on Citron Investments : Brokerage: Concerns about risk reached firm’s top levels in 1991, Wall Street Journal says. But bondholders weren’t told.

Strong warnings from three departments within Merrill Lynch & Co. that Orange County’s investment strategy was dangerous and getting more so were ignored by others in the firm who continued to encourage the risky borrowing and interest-rate gambling by former County Treasurer-Tax Collector Robert L. Citron, according to a published report Wednesday.

The new disclosures portray the investment giant as a company at war with itself over its contradictory involvement in Orange County’s finances.

Merrill’s concerns reached all the way to its 17-man executive committee nearly three years before $1.7 billion in trading losses plunged the county into bankruptcy.

On Feb. 6, 1992, for example, Daniel T. Napoli, senior vice president for risk management and an executive committee member, made an unprecedented personal visit to Citron to caution the treasurer about so heavily borrowing against public funds to boost his investment earnings.

“You have 10 times the leverage in your portfolio that we allow in ours,” Napoli warned Citron on Feb. 6, 1992, a Merrill Lynch spokesman quoted Napoli as saying.

The revelations, contained in internal Merrill Lynch documents, were reported Wednesday by the Wall Street Journal. Merrill Lynch, in a news release, dismissed the Journal’s disclosures as “nonsense.”

“This article misrepresents selected internal documents, misstates statistics, and relies on anonymous sources in distorting the basic facts of how Merrill Lynch determined to conduct its relationship with the Orange County Treasurer’s Office,” the statement said.

A Merrill Lynch spokesman said he had reviewed the memos cited by the newspaper but refused to release them.

In addition to Napoli’s risk management analysis, the Wall Street Journal reported that Gary Rupert, the head of Merrill’s “repurchase” desk complained in a Feb. 26, 1992, memo that the firm “is pushing the high end of a prudent target range with respect to any client” in selling Orange County risky securities while loaning large amounts of money to the county.

As a result of Rupert’s complaint, Merrill began charging the county a higher interest rate on borrowed funds.

“What do you do in a situation where you are in so deep?” Thomas Akin, a now retired Merrill manager was quoted by the newspaper as saying. “You don’t agree with it, but you can’t walk away.”

Reached at his Tiburon home in Northern California, Akin referred calls to Merrill’s spokesmen.

According to the Wall Street Journal account, Merrill’s concerns about Orange County surfaced in early 1992, eight months earlier than the firm has previously said.

Napoli, who reported directly to Merrill Chief Executive Daniel P. Tully, had his risk-management group closely analyze Citron’s portfolio in July, 1992. On Aug. 17, 1992, that analysis showed Citron’s pool, with $4 billion in derivatives and $2.5 billion in loans, had become supersensitive to interest rate fluctuations. The higher interest rates rose, the less the pool earned.

This information was critical to Citron, who attracted investors seeking to supplement the taxes of their cities, school districts or other agencies with extra interest income. Nearly three years before the pool collapsed, Merrill’s analysts realized, a sudden drop in Citron’s yields could start a run on the investment pool.

Armed with data detailing just how precarious the pool’s footing was, Napoli told Michael G. Stamenson, the salesman who sold Citron most of his investments, to share Merrill’s detailed findings with the treasurer.

The next month, as Merrill has previously disclosed, Stamenson wrote Citron, saying the firm’s research showed “substantially more price volatility” and that the county “should constantly review the volatility.”

At the time, Citron firmly believed that interest rates would remain low for several years, and he structured his investments accordingly to maximize yields.

But Stamenson’s warning letter to Citron, according to the Wall Street Journal, failed to discuss a $1.4-billion limit on borrowing by the county that Merrill had imposed on Citron, or that Orange County’s cost of borrowing would increase significantly and the pool’s earnings would plummet if interest rates rose.

Merrill spokesman Tim Gilles( disagreed with the newspaper’s account, saying that Stamenson fully disclosed all of the concerns raised by Napoli.

“There were no omissions in Mr. Stamenson’s letter,” Gilles said. “It fully covered the analysis that had been done.”

In a second, 3 1/2-page response to the Wall Street Journal article, Merrill Lynch noted that Stamenson’s letter “had been preceded and was followed by numerous oral discussions . . . where these issues were discussed in greater detail.”

Months after Stamenson’s 1992 letter, the newspaper reported, William Broeksmit, who helped design many of the firm’s complex derivative securities, formally criticized the firm in meetings for continuing to help the county leverage the pool. The county’s borrowings, according to the newspaper, had increased 2.6 times since Napoli’s meeting, as the pool swelled to $12 billion, with $6.5 billion in loans from Merrill and other firms.

“What particularly concerns me is the difficulty we have in determining” how many of the pool’s investors would be willing to ride out a sharp drop in yields, Broeksmit wrote in a memo cited by the newspaper, adding that in the event of such a dip, “hot money will flee . . . with adverse consequences for Orange County.”

Broeksmit recommended buying back $2.8 billion of the county’s derivatives.

“This is exactly the course of action Merrill Lynch adopted,” the firm said in its statement.

In its $3-billion lawsuit against Merrill Lynch in U.S. Bankruptcy Court, the county charged that the brokerage firm “abused the trust and confidence which the county placed in it by permitting and encouraging Citron to invest public funds in volatile financial instruments.”

Merrill Lynch, the suit alleges, implemented an elaborate “investment scheme,” selling Citron exotic debt obligations to further an investment strategy that ultimately caused the county’s collapse.

The firm denies the charges. But citing the legal action, it declined to allow executives mentioned in the article to talk to reporters.

Industry observers, meanwhile, said the state and federal regulators investigating Merrill’s dealings with the county may find the newspaper’s disclosures of interest.

Robert Lamb, a municipal bond expert at New York University, said, “In any firm there’s going to be discussions about what to do. This shows that their risk management supervisor went out there and spent time with the county. I don’t know if its clear how far they are expected to go when the warnings have been repeated. It could raise questions as to whether they could have done more.”

And Sam Gruenbaum, a Los Angeles lawyer and former enforcement agent with the U.S. Securities and Exchange Commission, said, “The question is whether facts evaluated during some of those internal wranglings at Merrill should have been disclosed to bond investors. You’ve got to ask yourself--have all the material pluses and minuses been addressed?”

Richard Lehmann, president of the Bond Investors Assn., a trade group representing bondholders, said, “It’s clear that Merrill disclosed to Citron that he was skating on thin ice. The issue is whether Merrill had an obligation to go over his head and tell others.

“It’s also clear that more about these memos and this whole issue should have been told to bondholders.”