Bond insurers, collateralized debt obligations, Whitefish Bay

Europe’s Toxic Debt Imperils Wisconsin School District’s Finances

November 06, 2008 02:02 PM
by Anne Szustek
The Whitefish Bay, Wis., School District’s buy-up of risky European-based investments has left the Upper Midwest suburb starkly exposed to the troubles of the global economy.

Irish Bank Shakes Up Finances on Shores of Lake Michigan

Some two years ago, the public schools of Whitefish Bay, Wis., an affluent suburb of Milwaukee, pondered how to keep the district’s teachers’ retirement plan in the black.

David W. Noack, an investment banker who had been giving guidance to school boards in Wisconsin for some 20 years, suggested that the Whitefish Bay school board should buy into a series of European investments that he said could only mean steep returns.

“Every three months you’re going to get a payment,” he was recording saying at a school board meeting. The only way it would fail? “There would need to be 15 Enrons,” Noack said.

Or, as in the case of the so-called “toxic debt” now threatening the survival of the teachers’ pension plan, severe distress in the credit markets.

The Whitefish Bay School District and four other local school systems spent $35 million and borrowed an additional $165 million from Irish bank Depfa to buy up synthetic collateralized debt obligations, or synthetic CDOs.

Synthetic CDOs are a form of insurance that guarantees corporate bonds. Should a company default on its debt, the synthetic CDO steps in to cover that loss. “Synthetic CDOs are a modern advance in structured finance that can offer extremely high yields to investors,” according to financial information site Investopedia. “However, investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio.”

And as NPR science reporter David Kestenbaum points out, “Right now, we have a financial hurricane bearing down,” he says.

It turns out that $200 million of the districts’ pooled funds were used to back $20 billion in corporate bonds. If none of the bonds went into default, the school districts would have turned a profit of $1.8 million a year after paying off their own loans.

However, these synthetic CDOs turned out to have toxic debt, and the money the Whitefish Bay School District put up is now going toward covering that debt.

Becky Velvikis, a Kenosha, Wis., first-grade teacher, told The New York Times, “I am really worried. If millions of dollars are gone, what happens to my retirement? Or the construction paper and pencils and supplies we need to teach?”

Depfa, the Irish bank from which the school districts borrowed to buy their synthetic CDOs, was acquired by Germany’s Hypo Real Estate last year, exposing its owner to billions in bad debt.

The German government moved to shore up both Depfa and Hypo, one of the country’s largest banks, with $75 billion in bailout money. In the meantime, the financial woes of Depfa, which lends heavily to governmental bodies around the United States, have left municipal governments strapped for cash.

For example, Depfa’s shaky finances are also threatening the budget of the Metropolitan Transit Authority (MTA), New York City’s public transit system. As investors dumped MTA bonds on the fears that Depfa, which was backing $200 million of the MTA’s $3.75 billion in variable-rate debt, would get into worse financial straits, the MTA “now faces a $900 million shortfall,” writes The New York Times.

The Whitefish Bay School Board is now filing a lawsuit alleging misrepresentation against Royal Bank of Canada and Stifel Nicolaus, the companies that brokered the synthetic CDOs. Both companies maintain that the school board signed documents knowing what it was getting into.

Background: Bond insurers and collateralized debt obligations

Corporate bonds are generally a less volatile investment option than most, given their fixed rate of return. One risk that investors assume when buying corporate bonds is credit fluctuations of the issuing company. The lower a company’s credit rating, the higher the rate of return on the bond—as the investment is that much more risky.

Bond insurers provide diversification for banks’ collateralized debt obligations, or CDOs, many of which have taken a hit during the sub-prime mortgage crisis.

A credit downgrade of bond insurers, who often back consumer investment bonds, means another deficit to be accounted for on banks’ balance sheets.

When a bond insurer’s credit rating drops, it is deemed a riskier investment—and its interest rate rises accordingly. The banks must then pay more in fees to their insurers, making the bond worth slightly less than par value.

Historical Context: New York City on verge of bankruptcy in 1975

New York City was on the verge of bankruptcy in 1975, but stayed solvent after the teacher’s union agreed to put $150 million toward the city’s municipal bonds. The situation was so dire that the city had devised a contingency plan to determine which city services would get paid first: the top three being the police and fire departments, respectively, sanitation and public health, and food and shelter aid programs. Mayor Abraham D. Beame drafted a statement set to be released on Oct. 17, 1975, saying that the City of New York was issued a court order to protect its holdings from creditors. 

Under Chapter 9 bankruptcy, developed during the Great Depression, municipalities are protected from seizure of assets by creditors and are entitled under U.S. bankruptcy law to negotiate repayment terms. In addition, the 10th Amendment effectively grants immunity to municipalities from bankruptcies, as that body of law is federal in scope, yet not part of the Constitution. As municipalities are under the authority of individual states, any law not enumerated in the 27 amendments is at the discretion of the states. 

In reality, when a government goes bankrupt, until the government gets its books in order, public services are cut while taxes and fees go up, as may be the case with the MTA’s likely fare increases. 

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