November
2, 2008
The Reckoning
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
On a snowy day two years ago, the school board in
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,
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
The
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
The trail through
“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
Selling Risk
Mr. Noack, the local representative of Stifel, Nicolaus & Company, a
Mr. Noack told the
“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
Soon,
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
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
“Selling these products to municipalities was pretty widespread,”
said Janet Tavakoli, a finance industry consultant in
From the Wisconsin deal, the Royal Bank of
In separate statements, the Royal Bank of
“Everyone knew
A Bank Goes Global
By the time Depfa financed the
But in 2002 a new chief executive, Gerhard Bruckermann,
moved Depfa to the freewheeling financial center of
Mr. Bruckermann was a gregarious leader
who joked that he hoped to make all employees into millionaires. He divided his
time between a
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
Some of Mr. Bruckermann’s employees grew
concerned about deals like one struck in 2005 with the Metropolitan
Transportation Authority of
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
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
The Risks Turn Bad
Last March the delicate web tying
Mr. Yde, the director of business
services for the
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
Then notices arrived saying that the bonds insured by
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
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
“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
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
“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
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
In Mrs. Velvikis’s classroom at Grewenow Elementary in
“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.”