Merrill Executives Saw O.C.’s Disaster Coming
The Merrill Lynch & Co. executive who helped pioneer the complex investments that contributed to Orange County’s financial downfall predicted with uncanny accuracy that the county’s investment policies, if left unchanged, were headed toward disaster fully 21 months before the pool collapsed, according to an internal company memo released Thursday.
Those concerns were never completely revealed to county officials other than longtime Treasurer-Tax Collector Robert L. Citron, who largely ignored them, nor to the many investors.
The executive, William S. Broeksmit, bluntly warned his superiors that the pool “barely meets” Merrill Lynch borrowing limits and was attracting “hot” money from investors--funds invested solely to reap the huge returns generated by Citron’s dangerous strategy of heavily borrowing against public funds to gamble that interest rates would fall.
That hot money, Broeksmit warned, would just as quickly be withdrawn by the investors if the pool’s rates of return fell, forcing the county to quickly liquidate billions in assets to pay the withdrawals. “The potential adverse consequences for Orange County in the event of a substantial increase in interest rates and the flight of hot money,” Broeksmit warned, “compel us” to encourage the county to change its strategy.
“I believe we should go on record recommending the sale of the entire portfolio,” Broeksmit wrote, referring to the county’s $2.8 billion in risky securities.
Merrill Lynch officials would not allow Broeksmit to be interviewed but they say he later admitted he was mistaken about the pool’s vulnerability to immediate withdrawals, that investors had to give Citron at least 30 days notice before cashing out. They also said most of Broeksmit’s recommendations were followed.
Broeksmit’s memo was released Thursday at the request of a special state Senate committee investigating the Orange County bankruptcy. They are among 32,000 Merrill documents assembled in the county’s lawsuit against the company in U.S. Bankruptcy Court. The county blames Merrill Lynch and others for the $1.7 billion lost in the pool and seeks $2.5 billion from the brokerage.
“From the date of [Broeksmit’s] memo until the day of the bankruptcy, the treasurer bought about $11.9 billion of securities from Merrill Lynch,” said Merrill spokesman Paul Critchlow, 75% of them ordinary fixed-rate investments.
Broeksmit’s three-page memo, written Feb. 24, 1993, to Edson V. Mitchell, a director of Merrill’s fixed-income group, was one of several that reveal how executives in the brokerage firm questioned Merrill’s involvement with Citron and the pool, and shared their concerns liberally in the company.
Citron pleaded guilty April 27 to six counts of securities fraud and misappropriation of funds, and faces up to 14 years in prison and a $10-million fine. He is cooperating with investigators from the Orange County district attorney’s office, the U.S. attorney and the U.S. Securities and Exchange Commission.
The memos make clear that Merrill had concerns about Citron’s investment strategy in early 1992.
A “file” memo written Feb. 11, 1992, describes a meeting four days earlier between Citron and three Merrill executives, including Daniel T. Napoli, Merrill’s global risk manager. The memo described Citron’s “sophistication” in the way he bought and sold securities to increase the yield in his investments, and his success for many years. “This came at a fortuitous time as the lack of tax receipts have necessitated a more aggressive investment philosophy.”
But the executives apparently left that meeting with serious questions about the depth of Merrill’s exposure in Orange County. Merrill soon began examining Citron’s investments more closely.
On July 10, 1992, for example, executives began writing that “it would be worthwhile for us to a develop a portfolio analysis for Orange County.” By August, 1992, risk managers had determined that Citron’s heavy borrowing to achieve even greater returns had made his holdings extremely sensitive to interest rate changes.
In October, 1992, Merrill salesman Michael G. Stamenson wrote Citron urging him to “constantly review the volatility” in his portfolio.
As reflected in the memos, Merrill’s communication with Citron appeared to have little effect on him. He continued to borrow heavily and leverage the portfolio to riskier heights, eventually prompting Broeksmit to write his memo.
The county’s investments in derivatives, Broeksmit wrote, “has experienced fantastic appreciation” and “now would be an excellent time for it to lighten up on its interest rate exposure.”
Likening the investment pool to a bank, Broeksmit wrote that it was difficult to determine how much of it consisted of “core cash”--the amount of county taxes and investor deposits that change little from year to year. But by 1993, he wrote, the amount of commingled funds in the pool had started to creep up steadily from $2.5 billion in 1990, to $2.75 billion in 1991, to $3.6 billion in 1992. But by February, 1993, it suddenly shot up to $5.5 billion.
“While I’m not an expert in public finance, it would seem to me the dramatic growth of the commingled fund has been driven by the extraordinary yields being offered,” Broeksmit wrote.
In addition to offering to buy back Citron’s risky securities and declining to sell him more until the pool’s overall risk had been reduced, Broeksmit encouraged greater disclosure in Orange County by providing the treasurer with information for his annual report on the pool to supervisors and investors.
On April 1, 1993, Stamenson passed Merrill’s suggestions on to Citron for his annual report. “If rates were to rise, it is reasonable to expect that the overall performance of the portfolio will decline,” Merrill suggested--and Citron included it in the annual report.
At a meeting Thursday in Sacramento with Scott Johnson, the Senate panel counsel, two Merrill Lynch lawyers implied that a wider a circle of officials in Orange County knew the dangers of Citron’s investment strategy far earlier than has been disclosed.
“They left us with the impression that there were others at the county who must have known about the risks involved, and that there are county memos that reflect that,” Johnson said.
One memo, marked confidential and dated May 13, 1993, is addressed to then-County Administrative Officer Ernie Schneider by Auditor-Controller Steve E. Lewis, with copies sent to Harriet M. Wieder, then chairman of the Board of Supervisors, and Citron.
“It is my understanding that the treasurer has discussed the techniques with you and your staff and you understand and believe the involved risk is acceptable and appropriate for the county general fund,” Lewis wrote.
” . . . Because of the county’s current high rate of return, I believe it extremely important that you thoroughly understand the related risk and find it acceptable.”
