Some Wisconsin school districts are reeling after a risky financial investment produced disastrous consequences–including severe injury to school operating budgets and teacher retirement funds.

Two years ago, school board members across Wisconsin tried to help save teachers’ retirement plans by borrowing money from a European bank in an investment that reportedly promised big profits.

Now, these five Wisconsin school districts–Kenosha, Kimberly, Waukesha, West Allis-West Milwaukee, and Whitefish Bay–are suing the investment firm of Stifel, Nicolaus & Co. Inc., as well as the Royal Bank of Canada, in Milwaukee County Circuit Court over their $200 million loss. The districts say the investment firm did not fully disclose the risks involved.

Most of the $200 million was borrowed from an Irish bank called Depfa.

Depfa–a Dublin-based lender acquired last year by Hypo Real Estate of Germany–underwrote a package of municipal bonds that were then downgraded by ratings agencies, meaning Depfa was deemed less credit worthy. Because of this status, Depfa had to buy back the bonds, which would have created immediate liquidity problems at Hypo itself.

The German government has now agreed to approve Hypo’s request for a 15 billion euro bailout, or $19.6 billion, meant to guarantee its debt until it receives a larger bailout in a few weeks.

The credit line is a guarantee on the company’s short-term lending activity, which is strained by the credit crunch, and aims to support Hypo until it gets more rescue funds agreed to in early October.

But even with Hypo’s bailout, and with much of the world’s economy in turmoil, the Wisconsin schools are on the "brink of losing their money, confronting educators with possible budget cuts"–as well as the loss of educators’ retirement funds, reports the New York Times.

"I am really worried," Becky Velvikis, a first-grade teacher at Grewenow Elementary School in Kenosha, Wis., told the Times. "If millions of dollars are gone, what happens to my retirement? Or the construction paper and pencils and supplies we need to teach?"

The problem started when David W. Noack, a local investment banker, proposed that the district of Whitefish Bay invest overseas–but what the district didn’t know is that this investment was imitating hedge funds.

"They were buying something that school boards should never actually be buying. It’s called synthetic CDO [collateralized debt obligation]. Basically, they sold insurance on a big collection of bonds, which put them on the hook if anything went bad–but they didn’t know that," said New York Times reporter Charles Duhigg during an interview with National Public Radio.

"Unfortunately, what we thought we bought and what we bought are two separate things," said Kenosha school board member Marc Hujik. "And the information we were provided prior, when we asked questions and received answers, wasn’t necessarily reality or truth."

"I don’t think any of us envisioned that this would become a wholesale slaughter that it eventually did become," said Herb Jacobs, former managing director of Depfa in New York.

All five districts in total borrowed the $165 million from Depfa and contributed $35 million of their own money to purchase three CDOs sold by the Royal Bank of Canada. These "synthetic CDOs" committed the school boards to paying off other bondholders if corporations failed to honor their debts.

According to the deal, if just 6 percent of the bond issues 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.

However, according to the Times, last March Whitefish Bay began receiving notices saying that the bonds insured by its CDOs were defaulting. The district’s money would be seized to pay off other bondholders, and most of the $200 million would be lost.

Soon, other districts started receiving similar notices, and officials began to consider the need to dip into school funds–which would mean course cuts in art and drama, less classroom maintenance, and forgoing replacing teachers who retire.

The Wisconsin districts hope they’ll win their suit, leaving their retirement plans intact.

"You know, I would have to say that the villain is probably ignorance and the exuberance that drew cities and school districts and regular people into this big economic global system when they didn’t really understand how it worked," said Duhigg.

Unfortunately, Wisconsin school districts are a few of the many businesses and organizations that have been burned by Depfa and the international market crisis. The Metro Transit Authority in New York has endured severe financial loss, and affordable housing projects in Colorado and California and a bridge project in Vancouver are also at risk.

Links:

New York Times story on Depfa losses

National Public Radio

Wisconsin Department of Public Instruction

Wisconsin Association of School Boards

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