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

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

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.

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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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