The Looting of America: How Wall St. (RBC Canada) Fleeced
Millions from Wisconsin Schools
The Wisconsin school officials bought three different
bondlike CDO financial instruments from the Royal Bank of Canada:
1. Tribune Series 30--$25 million,
2. Sentinel Series 1--$60 Million, and
3. Sentinel Series 2-- $115 Million.
With a little Wall Street magic, a big payoff seemed like a
sure thing.
The Canadian bank received $11.2 million in up-front fees.
(That's right, the bank was, in effect, buying insurance,
yet the school districts were paying the bank up-front fees for the
honor of insuring the bank's junk debt.)
The investment sales company took $1.2 million in
commissions.
We don't know precisely how much Depfa got for the loans,
but it was substantial.
The Looting of America: How Wall Street [Canada's Royal
Bank] Fleeced Millions from Wisconsin Schools
<http://www.alternet.org/workplace/140208/the_looting_of_america%3A_how_wall
_street_fleeced_millions_from_wisconsin_schools/>
By Les Leopold, Chelsea Green Publishing
Posted on June 3, 2009, Printed on June 3, 2009
http://www.alternet.org/story/140208/ Wall Street investment houses went after the $100 billion
saved in school-district trust funds like Whitefish Bay's, and made a
killing.
The following is an excerpt from Les
Leopold's new book, "The Looting of America
<http://www.amazon.com/Looting-America-Destroyed-Pensions-Prosperity/dp/1603
582053> " (Chelsea Green, 2009).
The Hooking of Whitefish Bay
The great economic crash of 2008 tore right through
Whitefish Bay, Wisconsin, population 13,500-though you'd never guess it from
looking around town.
Located just a few miles north of Milwaukee, this golden
village exudes the hopeful self-confidence of the early 1960s. Whitefish
Bay's stately mansions offer breathtaking views of Lake Michigan from cliffs
that rise a hundred feet above the shoreline. As you head inland on its
tree-lined streets, the houses slowly shrink back into sturdy, middle-class
neighborhoods. The stores on Silver Spring Drive, its main shopping strip,
have survived despite fierce competition from the nearby Bayshore Mall (a
self-contained ultramodern shopping village with faux streets, a faux town
square, and real condos). Whitefish Bay also supports an art deco movie
theater that serves meals while you watch the show, and a top-notch
supermarket, fish market, and bakery. Nothing is out of place-except you, if
you happen to be brown or black. Whitefish Bay is 94 percent white and only
1 percent black. There's a reason the town's unfortunate moniker is White
Folks Bay.
Yet this white-collar town voted for Obama-and has always
voted for its schools, which are considered among the best in the state. Its
residents' deep pockets supply the school system with all the extras: In
2007, $700,000 in donations provided "opportunities, services and facilities
for students." The investment has paid off. An average of 94 percent of
Whitefish Bay's high school graduates go on to college immediately. And the
school dropout rate is less than half of 1 percent.
The school district takes its fiscal responsibilities
seriously. It has set up a trust fund to pay benefits, primarily health
insurance, for retired school employees. When these benefits (called "Other
Post-Employment Benefits" or OPEB) were originally negotiated, the expense
was modest. But then health care costs exploded. What's more, accounting
rules now require that school districts amortize these costs and post them
on their books as a liability each year. Whitefish Bay, like many other
school districts, became worried about how to meet these liabilities.
Whitefish Bay is a town full of financially sophisticated
residents, including its school managers. They sought to pump up the OPEB
trust fund quickly so they could keep their promises to retirees. As
responsible guardians of the town's resources, they looked for the highest
rate of return at a minimal risk to the fund's principal. As Shaun Yde, the
school district's director of business services, put it, the goal was to
"guarantee a secure future for our employees without increasing the burden
on our taxpayers or decreasing the funds available to our students to fund
their education."
Meanwhile, Wall Street investment houses had set their
sights on school-district trust funds like Whitefish Bay's. They hoped to
persuade districts to stop stashing this money-valued at well above $100
billion nationwide in 2006-in treasury bonds and federally insured
certificates of deposit (CDs). Wall Street's "innovative" securities could
provide higher returns-not to mention more lucrative fees for the investment
firms.
So an old-fashioned financial romance began: Supply (Wall
Street's hottest financial products) met Demand (school districts seeking to
build up their OPEB trust funds). It looked like a perfect match.
In the Milwaukee area, Supply was represented by Stifel
Nicolaus & Company, a venerable, 108-year-old financial firm, which promised
to put "the welfare of clients and community first" as it pursued
"excellence and a desire to exceed clients' expectations . . ."
As a national firm based in St. Louis, Stifel Nicolaus was
fortunate to be represented in Milwaukee by David W. Noack. According to the
New York Times, "He had been advising Wisconsin school boards for two
decades, helping them borrow for new gymnasiums and classrooms. His father
had taught at an area high school for 47 years. All six of his children
attended Milwaukee schools." School boards repeatedly referred to him as
their "financial advisor"-a label he never refuted.
In 2006, Mr. Noack, an avuncular, low-key salesman (he
preferred to be called a banker), urged the Whitefish school board and
others in Wisconsin to buy securities that offered higher returns than
treasury notes but were just about as safe. He had recently attended a
two-hour training session on these new financial products, so he was
confident when he assured the officials that they were "safe double-A,
triple-A-type investments." None of the investments included subprime debt,
he said. And the deal conformed to state statutes, so the district would be
erring on the conservative side. In fact, Noack said, the risk was so low
that there would have to be "15 Enrons" before the district would be
affected. For the schools to lose their investment, "out of the top eight
hundred companies in the world, one hundred would have to go under."
As in many romances, one party seduces and the other is
seduced. Noack certainly came across as a caring, considerate suitor. He
started his sales drive by inviting area school administrators and board
members to tea, "with food and beverage provided by Stifel Nicolaus," making
the gathering seem more like a PTA fund-raiser than a high-powered
investment pitch. He merely wanted to introduce the local officials to these
new "AA-AAA" investments, as the invitation pointed out.
In a series of video- and audiotapes recorded by the Kenosha
school board-which later joined forces with Whitefish Bay and three other
nearby school districts to invest with Noack-you could discern a pattern to
his pitch.
First he would stress the enormity of the
financial problems the school districts faced in meeting their long-term
retiree liabilities. For example, during a seventeen-minute spiel recorded
on July 24, 2006, he reminded school board members that, based on Stifel's
actuarial computations, the district had an $80-million post-retiree
liability. (In an "updated" Stifel study presented a year later, the
estimate rose to $240 million.) In fact, Noack spent much more time
describing the extent of the liability and how the district would have to
account for it than he did explaining his proposed multimillion dollar
investments and loans. Not to worry. He said that he had "spent the past
four years" developing investment solutions for such liability problems.
Next Noack stressed that he was not about to
take unacceptable risks with the schools' money. His recommended investments
were extremely conservative, his approach cautious. As he put it in the July
meeting, "our program ... is using the trust to a certain degree [and] a
small portion of the district's contribution, investing the money, making
the spread in double-A, triple-A investments and funding a little bit at a
time over a long period of time ... and what we make is as risk-free as we
can get. . . ."
He also nudged the school district along
with a bit of peer-group pressure, describing how other Wisconsin districts
were working with him on similar investments. There was power in numbers, he
told them. By working together with other districts, they would "increase
their purchasing power," a phrase he repeated many times.
Noack made it seem as if the districts'
collective "purchasing power" had banks and investment houses lining up to
compete for their business, offering them the lowest-cost loans and highest
rates of return. He was soon going to be "bidding out" the districts'
packages and he was sure he was going to get them the best rates.
To take the edge off the enormity of the
investment Noack was pushing, he ended his pitch by asking the school board
to pass resolutions to "authorize but not obligate" its financial committee
or officials to make the investment if and when the rates seemed favorable.
He never asked the boards to make a final commitment then and there.
Instead, he conveyed the sense that even after the vote, they weren't
committed to anything.
But the seduced are rarely passive. In this affair, several
key board members helped the process along. On the Kenosha videotapes, for
example, one board member, Mark Hujik, a hulking, ex-Wall Street player who
now owns a Wisconsin financial advisory service, repeatedly sealed the
deals. The self-confident Hujik never asked a question he didn't already
know the answer to. He made sure everyone knew that he knew the ins and outs
of finance. At a key meeting before Kenosha signed on to its first deal, he
stressed that the tens of millions in loans the board would be taking out
were "moral" but not "contractual" obligations on behalf of the town. He
implied that if things went wrong, the town really wasn't on the hook for
$28.5 million in loans. (Unfortunately, he didn't mention that the town
could still be successfully sued and see its debt ratings plummet if it
defaulted on its "moral" financial obligations. And when a town's debt
rating falls, it faces higher interest rates for all its other borrowing
needs, assuming anyone will ever lend to it again.)
Together, Hujik and Noack wooed the parties with intimate
bankerspeak that conveyed confidence and expertise. They whispered financial
sweet nothings: LIBOR rates, basis points, spreads, mark to market, cost of
issuance, static and managed investments, arbitrage, tranches, letters of
credit, collateralization ratios, and standby-note purchase agreements.
After a while the board members started using the same language. Words like
"million" and "dollars" disappeared from their vocabulary; instead they
referred familiarly to "twenty" and "thirty" (as in thirty million dollars).
Perhaps the slang and technical lingo distracted the officials from the
risky nature of their financial decisions. They whispered financial sweet
nothings: LIBOR rates, basis points, spreads, mark to market, cost of
issuance, static and managed investments, arbitrage, tranches, letters of
credit, collateralization ratios, and standby-note purchase agreements.
After a while the board members started using the same language. Words like
"million" and "dollars" disappeared from their vocabulary; instead they
referred familiarly to "twenty" and "thirty" (as in thirty million dollars).
Like any romance, at first everything seemed simple. There
was so much trust. As one Kenosha board member said to more experienced
members before a key authorization vote: "I'm not a financial person. So if
you say it should be done, I will follow your lead."
Listening to seven taped meetings, it's hard not to notice
the school officials' consistent deference to Noack and their inability to
ask him basic or troubling questions. No one wanted to seem dumb, though
nearly all decidedly were not "financial persons." The district officials
never asked questions such as: "How will the rate of return compare to
government-guaranteed securities?" Or, "If Wall Street goes into a slump,
how much could we lose?" Unless you're Woody Allen, you don't talk about the
prospect of breaking up at the beginning of a romance. When the votes were
taken, no one dissented. Demand and Supply consummated their relationship.
To the Wisconsin school districts, the deal seemed safe.
They would pool their money to increase their "purchasing power." They would
borrow more money ("leverage," as the big boys call it) and invest it in
something called a "synthetic CDO" for seven years. In a handout he gave to
the boards on July 24, 2006, Noack illustrated how their trust fund for
retirees' benefits could accumulate almost $9 million in seven years by
borrowing and investing $80 million. These CDOs would pay them over 1
percent more than what it would cost to borrow the money. The more the
schools borrowed, the more they would make. It was practically free money.
What was not to like?
The complexity of the deal alone should have given the
investors pause. Their newly purchased "Floating Rate Credit Linked Secured
Notes" were a lot more complicated than federally insured CDs or treasury
notes. In fact they were more convoluted than anything any of them had ever
bought or sold, individually or collectively. But Noack had done his job
well by making the purchases seem straightforward and prudent.
According to court documents, by the time Noack was through,
the five school districts had put up $37.3 million of their own funds (most
of it raised through their towns' general-obligation bonds) and borrowed
$165 million more from Depfa, an aggressive Irish bank owned by a much
larger German bank. The net investment after fees [$12.3-million] was $200
million. With that money, the school officials bought three different
bondlike CDO financial instruments from the Royal Bank of Canada-Tribune
Series 30, Sentinel Series 1, and Sentinel Series 2. With a little Wall
Street magic, a big payoff seemed like a sure thing.
But what if Wall Street took a tumble and the value of the
school boards' investments fell below the value of their loans? The school
officials didn't even ask the question, but Noack already had the answer:
"If we stick to all investment-grade companies, you still got to have ten
percent . . . go under. You're talking, I would assume, and I'm not an
economist, but that's a depression."
The districts seemed oblivious to risk, even after securing
disappointing returns on their first investments. There was a huge gap
between the rates Noack had expected to lock in and what they finally got.
The entire point of investing in CDOs was to get a rate of return that was
substantially higher than what it would cost to borrow the money. The
difference is called "the spread." Every quarter of a year you were supposed
to collect what you'd earned through the spread and reinvest it. Noack had
predicted that the CDOs would yield the school districts about 1.5 percent
above what it would cost to borrow the money.
1. In the first purchase, Tribune Series 30 for $25 million, the spread
was 1.02 percent.
2. However, on the next CDO purchase, Sentinel 1 for $60 million, the
spread was only 0.67 percent.
3. In their final deal, Sentinel 2 for $115 million, the spread was
0.82 percent.
The idea was that after the seven years the
districts could redeem their CDOs, like bonds, and have enough money to pay
off the Depfa loan as well as the general-obligation bonds taken out by the
town. Of course, this assumed that the CDOs would be safe and sound for
seven years.
Unfortunately the CDOs were not the secure investment Noack
had thought they would be. According to the New York Times' analysis:
If just 6 percent of the bonds ... went bad, the Wisconsin
educators could lose all their money. If none of the bonds defaulted, the
schools would receive about $1.8 million a year after paying off their own
debt. By comparison, the CDO's offered only a modestly better return than a
$35 million investment in ultra-safe Treasury bonds, which would have paid
about $1.5 million a year, with virtually no risk.
But this comparison missed the true alchemy of the deal, and
its great attraction to the local school officials. Buying a safe treasury
bond would have required the schools to put up $35 million from their
general-obligation borrowing-money they would have to pay back and on which
they would have to pay interest to the bondholders. In fact, if the
districts had made such an investment, they would have had to pay more in
interest than the treasury bonds would have yielded. That investment would
make little sense.
The CDO deal was complex but it seemed to have enormous
advantages: Not only would it supposedly produce $1.8 million a year in
revenues, it would also pay for all the interest on the general-obligation
bonds, as well as the debt itself, at the end of the seven years. That is,
returns from the CDOs would cover the $165 million in loans from Depfa and
the $35 million of collateral the schools put up through the
general-obligation bonds. All in all, the deal was supposed to generate $1.8
million a year, free and clear. Now that's fantasy finance.
Hujik certainly had bought into the dream. "Everyone knew
New York guys were making tons of money on these kinds of deals," he said.
"It wasn't implausible that we could make money, too."
The Wisconsin officials didn't see that their quest for this
pot of gold had created two insidious problems.
First, town elders were now ensnarled in a
series of complicated financial transactions that yielded considerable fees
for bankers and brokers. The districts paid fees to issue their
general-obligation bonds; they paid fees to service those payments; they
paid fees to borrow the funds to buy their CDOs; they paid fees to buy their
CDOs, and they paid fees to collect the loan payments and to distribute the
CDO payments. Someone would be getting rich off all this, but it wasn't the
five Wisconsin school districts.
Second, when little fish try to swim with
big fish, they better be prepared for risk-lots of it. No one on either side
of the deal, at least on the local level, had read the fine print. They
couldn't have, since the detailed documents-the "drawdown prospectuses"-were
delivered weeks after the securities were purchased. They wouldn't have
understood them anyway. In this romance between Supply and Demand, everyone
was in over their heads. The "experts" in the room (on both sides) sounded
cautious, confident, and knowledgeable. But in truth, Noack had no idea what
he really was selling, and school district officials like Hujik and Yde had
no idea what they really were buying. It is likely that both parties truly
believed they were handling the equivalent of a mutual fund made up of
highly rated corporate bonds. They weren't.
It's hard to blame the Wisconsinites for not understanding
the transaction: They were dealing with one of the most complex derivatives
ever designed-a synthetic collateralized debt obligation, which is a
combination of two other derivatives: a collateralized debt obligation (CDO)
and a credit default swap (CDS). This is the kind of security that Federal
Reserve chairman Ben Bernanke called "exotic and opaque." Investment guru
Warren Buffet called it a "financial weapon of mass destruction." In other
words, one of the most dazzling-and dangerous-illusions in all of fantasy
finance.
As we'll see, these investments were truly mysterious in
their design and in their execution. One of the most "exotic" features was
that these securities didn't give the buyer ownership of anything tangible
at all. The buyer received no stake in a corporation, as they would have
with a stock or bond. Instead, the school districts, without realizing it,
had become part of the trillion-dollar financial insurance industry. (It was
not called insurance, however, since insurance is, by law, heavily
regulated.) In fact, they had put up their millions, and had borrowed
millions more, to insure $20 billion worth of debt held (or bet upon) by the
Royal Bank of Canada. And that debt included some very nasty stuff: home
equity loans, leases, residential mortgage loans, commercial mortgage loans,
auto finance receivables, credit card receivables, and other debt
obligations. Technically, Mr. Noack may have been correct when he said that
the schools didn't own any subprime debt. They didn't own anything. Instead,
they had agreed to insure junk debt. The revenue they hoped to receive each
quarter was like receiving insurance premiums from the Royal Bank of Canada,
which was covering its bets on the junk debt.
What's more, although the synthetic CDOs had been rated AA,
as Noack had touted, those ratings were bogus. The CDOs were drawn from a
vast pool of junk debt that had been chopped up into slices based on risk.
The top slices had the least risk and the bottom slices had the most risk.
Unbeknownst to both Noack and the school districts, the districts' $200
million of borrowed money was used to insure a slice near the bottom of the
barrel! They would be on the hook for paying out claims if the default rate
hit about 6 percent, a number it is fast approaching. Neither savvy Dave
Noack, nor confident Mark Hujik, nor concerned Shawn Yde appeared to have
any understanding of this frightening reality.
But the big fish-the CDO creators and peddlers at the top
levels-knew what they were doing. The Canadian bank received $11.2 million
in up-front fees. (That's right, the bank was, in effect, buying insurance,
yet the school districts were paying the bank up-front fees for the honor of
insuring the bank's junk debt.) The investment sales company took $1.2
million in commissions. We don't know precisely how much Depfa got for the
loans, but it was substantial.
Whitefish Bay and the other school districts got something
substantial too: nearly all of the risk. The school districts are about to
lose all of their initial $37.3 million. They will also lose another $165
million of the money they'd borrowed from Depfa. As soon as the default rate
is reached, $200 million will go to pay insurance claims to the Royal Bank
of Canada. And the schools still will owe the full $165-million Depfa loan,
and they will still owe on the bonds they had issued to raise much of their
$37.3 million in collateral. The risk of reaching total default currently is
so high that Kenosha's entire piece of the CDO investment ($35.6 million)
was valued at only $925,000, as of January 29, 2009-a decline in value of
$36,575,000. Now the school districts are paying hefty fees not just to
bankers but also to lawyers, as they sue to unwind the deal and recover
damages.
"This is something I'll regret until the day I die," said
Shawn Yde of the Whitefish Bay schools.
He's not alone. As National Public Radio and the New York
Times reported in a joint article, "Wisconsin schools were not the only ones
to jump into such complicated financial products. More than $1.2 trillion of
CDOs have been sold to buyers of all kinds since 2005-including many cities
and government agencies. . . ."
Did these public agencies deserve any protections? A prudent
rule might be to forbid investment houses to peddle such risky securities
within a thousand yards of a school district. But there are no rules, since
these "exotic and opaque" financial securities are still entirely
unregulated. (When the Kenosha Teachers Association discovered that the
securities peddled to the school districts were identical to those that sunk
AIG, it requested that the Federal Reserve remove them from the school
districts just as they have done for AIG-an eminently fair and reasonable
request in my opinion. See chapter 8 for more on AIG.)
Whitefish Bay, Kenosha, and the other three districts made
missteps and miscalculations. They were naive. As Mark Hujik candidly said,
they saw a pot of gold on Wall Street and wanted their piece. But they were
had. We all were. We know that something has gone terribly wrong not just in
Whitefish Bay but with our entire economy. There's a connection between the
junk that was peddled to the "Wisconsin Five" and the crash of the global
financial system. In fact, if we can understand exactly what David Noack
sold to Whitefish Bay and why, we will also understand how the economy
collapsed, and what needs to change to prevent this from happening again.
Our trail will lead to an examination of financial booms and
busts, including the Great Depression. And those of us with strong stomachs
will also learn more than we ever wanted to know about CDOs, CDOs-squared,
synthetic CDOs, and credit default swaps-those exotic instruments that
swamped Whitefish Bay.
Along the way, we will see how bankers, traders, and
salespeople pocketed hundreds of millions of dollars by selling risk all
over the world as if it were a collection of predictable Swiss watches. And
we'll puzzle over why Alan Greenspan, Robert Rubin, and Ben Bernanke fought
so hard to keep these dangerous financial instruments unregulated.
We'll tackle the "logic" of free marketeers who claim that
the meltdown is the fault of low-income homebuyers who got in over their
heads. We'll also marvel at how, in response to the financial meltdown,
former treasury secretary Paulson and friends blew open the U.S. Treasury
vault so that Wall Street could walk off with a trillion dollars . . . and
counting.
And once we've put all the puzzle pieces together, we'll use
our new understanding to formulate reforms that might protect us from the
fantasy-finance fiasco that is harming not just Wisconsin and the rest of
America, but the whole world.
Les Leopold is the executive director of the Labor Institute
and Public Health Institute in New York, and author of The Looting of
America
<http://www.amazon.com/Looting-America-Destroyed-Pensions-Prosperity/dp/1603
582053> (Chelsea Green Publishing, 2009).
Canada's Royal Bank SOLD Leveraged C.D.O.'s to U.S. School
Boards !!
<http://www.nytimes.com/>
November 2, 2008
The Reckoning
From Midwest to M.T.A., Pain From Global Gamble
<http://www.nytimes.com/2008/11/02/business/02global.html?ref=business>
By CHARLES DUHIGG
<http://topics.nytimes.com/top/reference/timestopics/people/d/charles_duhigg
/index.html?inline=nyt-per> and CARTER DOUGHERTY
"People come up to me in the grocery store and say, 'How did
we get suckered into this?' "
- Marc Hujik, of the Kenosha, Wis., school board
On a snowy day two years ago, the school board in Whitefish
Bay, Wis., gathered to discuss a looming problem: how to plug a gaping hole
in the teachers' retirement plan.
It turned to David W. Noack, a trusted local investment
banker, who proposed that the district borrow from overseas and use the
money for a complex investment that offered big profits.
"Every three months you're going to get a payment," he
promised, according to a tape of the meeting. But would it be risky? "There
would need to be 15 Enrons" for the district to lose money, he said.
The board and four other nearby districts ultimately
invested $200 million in the deal, most of it borrowed from an Irish bank.
Without realizing it, the schools were imitating hedge funds.
Half a continent away, New York subway officials were also
being wooed by bankers. Officials were told that just as home buyers had
embraced adjustable-rate loans, New York could save money by borrowing at
lower interest rates that changed every day.
For some of the deals, the officials were encouraged to rely
on the same Irish bank as the Wisconsin
<http://topics.nytimes.com/top/news/national/usstatesterritoriesandpossessio
ns/wisconsin/index.html?inline=nyt-geo> schools.
During the go-go investing years, school districts, transit
agencies and other government entities were quick to jump into the global
economy, hoping for fast gains to cover growing pension costs and budgets
without raising taxes. Deals were arranged by armies of persuasive
financiers who received big paydays.
But now, hundreds of cities and government agencies are
facing economic turmoil. Far from being isolated examples, the Wisconsin
schools and New York's transportation system are among the many players in a
financial fiasco that has ricocheted globally.
The Wisconsin schools are on the brink of losing their
money, confronting educators with possible budget cuts. Interest rates for
New York's subways are skyrocketing and contributing to budget woes that
have transportation officials considering higher fares and delaying
long-planned track repairs.
The bank at the center of the saga, named Depfa, is now in
trouble, threatening the stability of its parent company in Munich and
forcing German officials to intervene with a multibillion-dollar bailout to
stop a chain reaction that could freeze Germany's economic system.
"I am really worried," said Becky Velvikis, a first-grade
teacher at Grewenow Elementary in Kenosha, Wis., one of the districts that
invested in Mr. Noack's deal. "If millions of dollars are gone, what happens
to my retirement? Or the construction paper and pencils and supplies we need
to teach?"
The trail through Wisconsin, New York and Europe illustrates
how this financial crisis
<http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisi
s/index.html?inline=nyt-classifier> has moved around the world so fast, why
it is so hard to tame, and why cities, schools and many other institutions
will probably struggle for years.
Ashley Gilbertson for The New York Times
IN WISCONSIN "This is something I'll regret
until the day I die," said Shawn Yde of the Whitefish Bay schools.
"The local papers and radio shows call us idiots, and now
when I go home, my kids ask me, 'Dad, did you do something wrong?' " said
Shawn Yde, the director of business services in the Whitefish Bay district.
"This is something I'll regret until the day I die."
The Royal Bank of Canada
<http://topics.nytimes.com/top/news/business/companies/royal-bank-of-canada/
index.html?inline=nyt-org> Was Selling Risk
Whitefish Bay's school district did not intend to become a
hedge fund. It and four nearby districts were just trying to finance
retirement obligations that were growing as health care costs rose.
Mr. Noack, the local representative of Stifel, Nicolaus &
Company, a St. Louis investment bank, had been advising Wisconsin school
boards for two decades, helping them borrow for new gymnasiums and
classrooms. His father had taught at an area high school for 47 years. All
six of his children attended Milwaukee schools.
Mr. Noack told the Whitefish Bay board that investing in the
global economy carried few risks, according to the tape.
"What's the best investment? It's called a collateralized
debt obligation," or a C.D.O., Mr. Noack said. He described it as a
collection of bonds from 105 of the most reputable companies that would pay
the school board a small return every quarter.
"We're being very conservative," Mr. Noack told the board,
composed of lawyers, salesmen and a homemaker who lived in the affluent
Milwaukee suburb.
Soon, Whitefish Bay and the four other districts borrowed
$165 million from Depfa and contributed $35 million of their own money to
purchase three C.D.O.'s sold by the Royal Bank of Canada
<http://topics.nytimes.com/top/news/business/companies/royal-bank-of-canada/
index.html?inline=nyt-org> , which had a relationship with Mr. Noack's
company.
But Mr. Noack's explanation of a C.D.O. was very wrong. Mr.
Noack, who through his lawyer declined to comment, had attended only a
two-hour training session on C.D.O.'s, he told a friend.
The schools' $200 million was actually used as collateral
for a complicated form of insurance guaranteeing about $20 billion of
corporate bonds. That investment - known as a synthetic C.D.O. - committed
the boards to paying off other bondholders if corporations failed to honor
their debts.
If just 6 percent of the bonds insured went bad, the
Wisconsin educators could lose all their money. If none of the bonds
defaulted, the schools would receive about $1.8 million a year after paying
off their own debt. By comparison, the C.D.O.'s offered only a modestly
better return than a $35 million investment in ultra-safe Treasury bonds,
which would have paid about $1.5 million a year, with virtually no risk.
The boards, as part of their deal, received thick packets of
documents.
"I've never read the prospectus," said Marc Hujik, a local
financial adviser and a member of the Kenosha school board who spent 13
years on Wall Street. "We had all our questions answered satisfactorily by
Dave Noack, so I wasn't worried."
Wisconsin schools were not the only ones to jump into such
complicated financial products. More than $1.2 trillion of C.D.O.'s have
been sold to buyers of all kinds since 2005 - including many cities and
government agencies - an increase of 270 percent from the four previous
years combined, according to Thomson Reuters.
"Selling these products to municipalities was pretty
widespread," said Janet Tavakoli, a finance industry consultant in Chicago.
"They tend to be less sophisticated. So bankers sell them products stuffed
with junk."
From the Wisconsin deal, the Royal Bank of Canada received
promises of payments totaling about $11.2 million, according to documents.
Stifel Nicolaus made about $1.2 million. Mr. Noack's total salary was about
$300,000 a year, according to someone with knowledge of his finances. And
Depfa received interest on its loans.
In separate statements, the Royal Bank of Canada and Stifel
Nicolaus said board members signed documents indicating they understood the
investments' risks. Both companies said they were not financial advisers to
the boards but merely sold them products or services. Stifel Nicolaus said
its relationship with the boards ended in 2007. Mr. Noack now works for a
rival firm.
"Everyone knew New York guys were making tons of money on
these kinds of deals," said Mr. Hujik, of the school board. "It wasn't
implausible that we could make money, too."
A Bank Goes Global
By the time Depfa financed the Wisconsin schools'
investment, it had already become an emblem of the new global economy. It
was founded 86 years ago as a sleepy German lender, and for most of its
history had focused on its home market.
But in 2002 a new chief executive, Gerhard Bruckermann,
moved Depfa to the freewheeling financial center of Dublin to take advantage
of low corporate taxes. He soon pushed the company into São Paulo, Mumbai,
Warsaw, Hong Kong, Dallas, New York, Tokyo and elsewhere. Depfa became one
of Europe's most profitable banks and was famous for lavish events and large
paychecks. In 2006, top executives took home the equivalent of $33 million
at today's exchange rates.
Mr. Bruckermann was a gregarious leader who joked that he
hoped to make all employees into millionaires. He divided his time between a
London home and a vast farm in Spain, where he grew exotic medicinal plants.
And his success fueled an arrogance, former colleagues say.
Mr. Bruckermann once told a trade publication that Depfa,
unlike German banks, understood how to benefit from the global economy.
"With our efforts, we are like the one-eyed man who becomes king in the land
of the blind," he was quoted as saying.
Mr. Bruckermann, who left the bank earlier this year, did
not respond to requests for an interview.
But as Depfa grew, other European banks began competing with
the firm. So executives stretched into riskier deals - the sort that would
eventually send shockwaves across Europe and the United States.
Some of Mr. Bruckermann's employees grew concerned about
deals like one struck in 2005 with the Metropolitan Transportation Authority
<http://topics.nytimes.com/top/reference/timestopics/organizations/m/metropo
litan_transportation_authority/index.html?inline=nyt-org> of New York, the
agency overseeing the city and suburban subways, buses and trains.
For years, municipal agencies like the M.T.A. had raised
money by issuing plain-vanilla bonds with fixed interest rates. But then
bankers began telling officials that there was a way to get cheaper
financing.
Bankers said that cities, like home buyers, could save money
with adjustable-rate loans, where the payments started low and changed over
time. What they did not emphasize was that such payments could eventually
skyrocket. Such borrowing - known as variable-rate bonds - also carried big
fees for Wall Street.
The pitches were very successful. Municipalities issued
twice as many variable-rate bonds last year as they did a decade earlier.
But variable-rate bonds had a hitch: many investors would
purchase them only if a bank like Depfa was hired as a buyer of last resort,
ready to acquire bonds from investors who could find no other buyers. Depfa
collected fees for serving that role, but expected it would rarely have to
honor such pledges.
Mr. Bruckermann's salespeople traveled the world encouraging
officials to sign up for variable-rate loans. And bureaucrats and
politicians, including some in New York, jumped in.
By 2006 Depfa was the largest buyer of last resort in the
world, standing behind $2.9 billion of bonds issued that year alone. It
backed a $200 million bond issued by the M.T.A.
But as Depfa grew, it became more reliant on enormous
short-term loans to finance its operations. Those loans cost less, and thus
helped the bank achieve higher profits, but only when times were good.
Indeed, some employees were worried about that debt.
But Mr. Bruckermann plowed ahead, and it paid off. In 2007,
even as the global economy was softening, Mr. Bruckermann persuaded one of
Germany's biggest lenders, Hypo Real Estate
<http://topics.nytimes.com/top/news/business/companies/hypo_real_estate/inde
x.html?inline=nyt-org> , to purchase Depfa for $7.8 billion. Mr.
Bruckermann's cut was more than $150 million. He left the company to grow
oranges on his Spanish estate.
The Risks Turn Bad
Last March the delicate web tying Wisconsin, Dublin and
Manhattan became an anchor dragging everyone down.
Mr. Yde, the director of business services for the Whitefish
Bay district, began receiving troubling messages indicating the district's
investments were declining. Worried, he started coming into his office at
dawn, before the hallways of Whitefish Bay High School filled with students.
As the sun rose, Mr. Yde searched for explanations by the
light of his computer screen. He Googled "C.D.O.'s." He called bankers in
London and New York. Each person referred him to someone else.
Then notices arrived saying that the bonds insured by
Whitefish Bay's C.D.O.'s were defaulting. It became increasingly likely that
the district's money would be seized to pay off other bondholders. Most, if
not all, of the $200 million would probably be lost.
As other districts received similar notices, panic grew. For
some boards, interest payments on borrowed money were now larger than
revenue from the investments. Officials began quietly warning that they
might have to dip into school funds.
"This is going to have a tremendous financial impact," said
Robert F. Kitchen, a member of the West Allis-West Milwaukee school board.
Officials say some districts may have to cut courses like art and drama,
curtail gym and classroom maintenance, or forgo replacing teachers who
retire.
Problems were emerging elsewhere, as well.
Depfa's executives were realizing that bonds all over the
world were declining in value, exposing the company to the possibility they
would have to make good on their pledges as a buyer of last resort. And
Depfa was still borrowing billions each month to cover its short-term loans.
By autumn, the short-term debt of the bank and its parent company, Hypo,
totaled $81 billion.
Then, in mid-September, the American investment bank Lehman
Brothers
<http://topics.nytimes.com/top/news/business/companies/lehman_brothers_holdi
ngs_inc/index.html?inline=nyt-org> went bankrupt. Short-term lending
markets froze up. Ratings agencies, including Standard & Poor's
<http://topics.nytimes.com/top/news/business/companies/standard_and_poors/in
dex.html?inline=nyt-org> , downgraded Depfa, citing the company's
difficulties borrowing at affordable rates.
That set off a crisis in Germany, where officials worried
that Depfa's sudden need for cash would drag down its parent company and set
off a chain reaction at other banks. The German government and private banks
extended $64 billion in credit to Hypo to stop it from imploding.
"We will not allow the distress of one financial institution
to endanger the entire system," Angela Merkel
<http://topics.nytimes.com/top/reference/timestopics/people/m/angela_merkel/
index.html?inline=nyt-per> , the German chancellor, said at the time.
That crisis spread almost immediately to the M.T.A.
The transportation authority, guided by Gary Dellaverson, a
rumpled, cigarillo-smoking chief financial officer, had $3.75 billion of
variable-rate debt outstanding.
About $200 million of that debt was backed by Depfa. When
the bank was downgraded, investors dumped those transportation bonds,
because of worries they would get stuck with them if Depfa's problems
worsened. Depfa was forced to buy $150 million of them, and bonds worth
billions of dollars issued by other municipalities.
Then came the twist: Depfa's contracts said that if it
bought back bonds, the municipalities had to pay a higher-than-average
interest rate. The New York transportation authority's repayment obligation
could eventually balloon by about $12 million a year on the Depfa loans
alone.
On its own, that cost could be absorbed by the agency. But,
as the economy declined, the M.T.A. had lost hundreds of millions because
tax receipts - which finance part of its budget - were falling. And its
ability to renew its variable-rate bonds at low interest rates was hurt by
the trouble at Depfa and other banks. The transportation authority now faces
a $900 million shortfall, according to officials. It is "fairly
breathtaking," Mr. Dellaverson told the M.T.A.'s finance committee. "This is
not a tolerable long-term position for us to be in."
In a recent interview, Mr. Dellaverson defended New York's
use of variable bonds.
"Variable-rate debt has helped M.T.A. save millions of
dollars, and we've been conservative in issuing it," he said. "But there are
risks, which we work hard to mitigate. Usually it works. But what's
happening today is a total lack of marketplace rationality."
In a statement, the transportation authority said that it
was exploring options to reduce the cost of the Depfa-backed bonds, that its
variable-rate bonds had delivered savings even during the current turmoil
and that the agency had remained within its budget on debt payments this
year.
However, the transportation authority has already announced
it will raise subway and train fares next year because of various fiscal
problems, and may be forced to shrink the work force and reduce some bus
routes. Some analysts say fares will probably rise again in 2010.
The Depfa fallout doesn't end there. Rating agencies have
downgraded the bonds of more than 75 municipal agencies backed by Depfa,
including in California, Connecticut, Illinois and South Dakota. Officials
in Florida, Massachusetts and Montana have cut budgets because of C.D.O.'s
or similar risky bets.
And Hypo, the German company that bought Depfa, last week
asked the German government for financial help for the third time. Depfa has
frozen much of its business, according to Wall Street bankers, and though it
continues to honor its commitments, some wonder for how long.
The Wisconsin school districts have filed suit against the
Royal Bank of Canada and Stifel Nicolaus alleging misrepresentations. Board
members hope they will prevail and schools and retirement plans will emerge
unscathed. The companies dispute the lawsuit's claims. Mr. Noack is not
named as a defendant and is cooperating with the school boards.
In Mrs. Velvikis's classroom at Grewenow Elementary in
Kenosha, students have recently completed a lesson in which each first
grader contributed a vegetable to a common vat of "stone soup." The project
- based on a children's book - teaches the benefits of working together. The
schools have learned that when everyone works together, they can also all
starve.
"Our funding is already so limited," Mrs. Velvikis said. "We
rely on parent donations for some supplies. You hear about all these
millions of dollars that have been lost, and you think, that's got to come
out of somewhere."
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and on the Planet Money blog and podcast at npr.org