The Looting of America: How Wall Street Fleeced Millions from Wisconsin Schools

By Les Leopold, Chelsea Green Publishing. Posted June 3, 2009.

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.

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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).

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