The Looting of America: 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/
The following is an excerpt
from Les Leopold's new book, "The
Looting of America" (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 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. In
the first purchase, Tribune Series 30 for $25 million, the spread was 1.02
percent. However, on the next CDO purchase, Sentinel 1 for $60 million, the
spread was only 0.67 percent. 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 (Chelsea Green Publishing, 2009).
© 2009 Chelsea Green Publishing All rights
reserved.
View this story online at: http://www.alternet.org/story/140208/
