NY Times, November 2, 2008
The Reckoning
From Midwest to M.T.A., Pain From Global Gamble
By CHARLES DUHIGG 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 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.
And 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 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.
"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."
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, 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 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, 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 their loans to the Wisconsin
schools were unlikely to be repaid. Additionally, 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
went bankrupt. Short-term lending markets froze up. Ratings agencies,
including Standard & Poor's, 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, 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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