Records Show Brokerage Knew of O.C. Risks

For two years before Orange County went bankrupt, Merrill Lynch & Co. officials sharply disagreed among themselves about whether to let the county’s treasurer, Robert L. Citron, continue a strategy of betting on the movement of U.S. interest rates, according to sworn testimony released this week.

But despite the debate that raged within the investment company as to whether the strategy could prove disastrous, the firm’s profit-oriented sales staff, in the end, prevailed over the firm’s risk analysts, who were responsible for safeguarding the company’s investments.

Even Merrill’s top salesman, Michael G. Stamenson, believed it was not the firm’s responsibility to police the county’s portfolio--as this exchange between Stamenson and Orange County attorney James W. Mercer Jr. illustrated:

Mercer: Is it fair to say you didn’t perceive your responsibility to be that of a policeman?

Stamenson: I carry no badge, sir.

The testimony, taken in the county’s recently settled lawsuit against Merrill, shows that options that might have averted the bankruptcy were considered by the firm, but none were pursued.

At one point, some Merrill officials questioned the wisdom of granting Citron credit, but they ended up extending his credit line by $900 million.

Orange County settled its civil fraud lawsuit against Merrill last month for $420 million. After that announcement, The Times and other news organizations sought the release of depositions and exhibits compiled in the massive lawsuit.

The testimony shows for the first time how Merrill executives actually viewed Citron’s $21-billion investment pool, whose value plummeted in the fall of 1994 as interest rates continued to spiral upward.

Eighteen months before the bankruptcy in December 1994, Merrill Lynch executives attempting to minimize the firm’s financial and legal risks wanted Citron to reveal his unorthodox investment strategy to county supervisors and all 200 cities, schools and special districts in the investment pool he managed.

But no such warning was issued.

Instead, Merrill Lynch sales staff and other officials quietly helped the treasurer rewrite his annual report to supervisors issued at the end of 1993, which contained more subtle warnings.

In his deposition, Thomas Akin, former managing director of Merrill’s San Francisco office, was asked whether a warning was issued.

“I don’t believe so, no,” he said, adding, “Things just moved slower than you’d like them to from all regards.”

Citron, too, recalled that Merrill risk managers wanted him to make a special midyear presentation because they were concerned “that they may have a liability . . . if the type of securities they were selling to Orange County failed,” Citron testified.

Merrill Lynch recognized the importance of keeping a watchful eye on investments by having Daniel T. Napoli, global risk manager for the firm, report to the firm’s chief executive officer. But there was a natural tension between sales professionals seeking lucrative commissions and fees and those cautioning prudence.

In November 1992, top Merrill officials discussed what the firm should do about Citron, whose pool faced the danger of a run on the bank by investors should interest rates suddenly rise.

Merrill decided to require that all dangerously volatile securities be reviewed by risk managers before sales became final.

It is not clear why, but in Orange County’s case, that task was transferred a year later to sales staff in Chicago.

John Breit, the risk manager who held the job of reviewing the sales, testified that he had trouble getting answers about the pool from Stamenson.

“My best recollection is that Mike was reluctant to bother Citron with too many requests and that there were just difficulties in finding everything I wanted to know,” Breit said.

Merrill spokesman Bill Halldin acknowledged Thursday that company executives debated what to do about Orange County’s investment pool. He said the firm paid close attention to the warnings issued by its risk managers and twice tried to buy back the entire portfolio of so-called derivative securities from Citron “at a profit to the county.”

“There were disagreements, but after meetings a consensus was reached and Merrill Lynch management aggressively moved to implement recommendations,” Halldin said.

Until the bankruptcy, Citron was such a big revenue producer for Merrill that officials were acutely sensitive about what they could even discuss with him, lest they make him unhappy and risk losing Orange County’s business.

“The big discussion around the office was how much can we tell Mr. Citron what to do,” according to Akin, Stamenson’s boss.

Even though executives met several times to discuss what they considered Citron’s foolhardy strategy, Akin said he was never instructed to tell Stamenson to chart a less risky path for the treasurer.

“The best of my recollection was that we did make an effort to sell securities to Orange County that would reduce leverage in the portfolio,” Akin said, adding, “I believe that point had been discussed quite extensively.”

But at the time of the pool’s collapse, Citron, with Merrill’s help, had leveraged the pool’s $7.5 billion in assets, borrowing and investing another $14 billion.

And the testimony indicates that when Citron wanted credit to make more investments, he got it.

Had Merrill’s risk managers insisted that Citron disclose his risky strategy in mid-1993, county supervisors might have been compelled to take actions to prevent a collapse.

Asked why the firm didn’t just tell the board itself, Richard M. Fuscone, managing director of Merrill’s fixed-income securities group, testified that would have been “an extraordinary event” that would have unnecessarily alarmed the Board of Supervisors.

For his part, Citron testified that he adamantly opposed the idea of Merrill Lynch officials talking directly to the Board of Supervisors about the risks he was running.

Citing a previously disclosed tape-recorded conversation with Stamenson, Citron recalled he told the Merrill salesman that he wouldn’t permit such a direct meeting because “when Merrill Lynch sold me these securities, they . . . said they were suitable for my portfolio and that they were an excellent investment . . . they made very high returns.”

Citron continued, “And Mr. Stamenson’s reply to that statement . . . was, ‘Bob, I knew you would say that, and I agree with you completely.’ ”

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Times staff writers Davan Maharaj, Ray F. Herndon, Lorenza Munoz and Jean O. Pasco contributed to this report.