[Marxism] How did we get suckered into this?

[Louis Proyect]

NY Times, November 2, 2008
The Reckoning
 From Midwest to M.T.A., Pain From Global Gamble
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 Kenosha, Wis., school board

On a snowy day two years ago, the school board in Whitefish Bay, 
Wis., gathered to discuss a looming problem: how to plug a gaping 
hole in the teachers' retirement plan.

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, New York subway officials were also being 
wooed by bankers. Officials were told that just as home buyers had 
embraced adjustable-rate loans, New York could save money by 
borrowing at lower interest rates that changed every day.

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 New York's transportation system are among the many 
players in a financial fiasco that has ricocheted globally.

The Wisconsin schools are on the brink of losing their money, 
confronting educators with possible budget cuts. Interest rates for 
New York's subways are skyrocketing and contributing to budget woes 
that have transportation officials considering higher fares and 
delaying long-planned track repairs.

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 Kenosha, Wis., one of the districts that 
invested in Mr. Noack's deal. "If millions of dollars are gone, what 
happens to my retirement? Or the construction paper and pencils and 
supplies we need to teach?"

The trail through Wisconsin, New York and Europe illustrates how this 
financial crisis has moved around the world so fast, why it is so 
hard to tame, and why cities, schools and many other institutions 
will probably struggle for years.

"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 Whitefish Bay district. 
"This is something I'll regret until the day I die."

Selling Risk

Whitefish Bay's school district did not intend to become a hedge 
fund. It and four nearby districts were just trying to finance 
retirement obligations that were growing as health care costs rose.

Mr. Noack, the local representative of Stifel, Nicolaus & Company, a 
St. Louis investment bank, 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.

Mr. Noack told the Whitefish Bay board that investing in the global 
economy carried few risks, according to the tape.

"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 
Milwaukee suburb.

Soon, Whitefish Bay and the four other districts borrowed $165 
million from Depfa and contributed $35 million of their own money to 
purchase three C.D.O.'s sold by the Royal Bank of Canada, which had a 
relationship with Mr. Noack's company.

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 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 C.D.O.'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.

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 Kenosha school board who spent 13 years 
on Wall Street. "We had all our questions answered satisfactorily by 
Dave Noack, so I wasn't worried."

Wisconsin schools were not the only ones to jump into such 
complicated financial products. More than $1.2 trillion of C.D.O.'s 
have been sold to buyers of all kinds since 2005 — including many 
cities and government agencies — an increase of 270 percent from the 
four previous years combined, according to Thomson Reuters.

"Selling these products to municipalities was pretty widespread," 
said Janet Tavakoli, a finance industry consultant in Chicago. "They 
tend to be less sophisticated. So bankers sell them products stuffed 
with junk."

 From the Wisconsin deal, the Royal Bank of Canada received promises 
of payments totaling about $11.2 million, according to documents. 
Stifel Nicolaus made about $1.2 million. Mr. Noack's total salary was 
about $300,000 a year, according to someone with knowledge of his 
finances. And Depfa received interest on its loans.

In separate statements, the Royal Bank of Canada and Stifel Nicolaus 
said board members signed documents indicating they understood the 
investments' risks. Both companies said they were not financial 
advisers to the boards but merely sold them products or services. 
Stifel Nicolaus said its relationship with the boards ended in 2007. 
Mr. Noack now works for a rival firm.

"Everyone knew New York guys were making tons of money on these kinds 
of deals," said Mr. Hujik, of the school board. "It wasn't 
implausible that we could make money, too."

A Bank Goes Global

By the time Depfa financed the Wisconsin schools' investment, it had 
already become an emblem of the new global economy. It was founded 86 
years ago as a sleepy German lender, and for most of its history had 
focused on its home market.

But in 2002 a new chief executive, Gerhard Bruckermann, moved Depfa 
to the freewheeling financial center of Dublin to take advantage of 
low corporate taxes. He soon pushed the company into São Paulo, 
Mumbai, Warsaw, Hong Kong, Dallas, New York, Tokyo and elsewhere. 
Depfa became one of Europe's most profitable banks and was famous for 
lavish events and large paychecks. In 2006, top executives took home 
the equivalent of $33 million at today's exchange rates.

Mr. Bruckermann was a gregarious leader who joked that he hoped to 
make all employees into millionaires. He divided his time between a 
London home and a vast farm in Spain, where he grew exotic medicinal 
plants. And his success fueled an arrogance, former colleagues say.

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 United States.

Some of Mr. Bruckermann's employees grew concerned about deals like 
one struck in 2005 with the Metropolitan Transportation Authority of 
New York, the agency overseeing the city and suburban subways, buses 
and trains.

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 New York, jumped 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 
Germany's biggest lenders, Hypo Real Estate, to purchase Depfa for 
$7.8 billion. Mr. Bruckermann's cut was more than $150 million. He 
left the company to grow oranges on his Spanish estate.

The Risks Turn Bad

Last March the delicate web tying Wisconsin, Dublin and Manhattan 
became an anchor dragging everyone down.

Mr. Yde, the director of business services for the Whitefish Bay 
district, began receiving troubling messages indicating the 
district's investments were declining. Worried, he started coming 
into his office at dawn, before the hallways of Whitefish Bay High 
School filled with students.

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 
London and New York. Each person referred him to someone else.

Then notices arrived saying that the bonds insured by Whitefish Bay's 
C.D.O.'s were defaulting. It became increasingly likely that the 
district's money would be seized to pay off other bondholders. Most, 
if not all, of the $200 million would probably be lost.

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 Wisconsin 
schools were unlikely to be repaid. Additionally, bonds all over the 
world were declining in value, exposing the company to the 
possibility they would have to make good on their pledges as a buyer 
of last resort. And Depfa was still borrowing billions each month to 
cover its short-term loans. By autumn, the short-term debt of the 
bank and its parent company, Hypo, totaled $81 billion.

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 Germany, where officials worried that 
Depfa's sudden need for cash would drag down its parent company and 
set off a chain reaction at other banks. The German government and 
private banks extended $64 billion in credit to Hypo to stop it from imploding.

"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 New York transportation authority's repayment obligation 
could eventually balloon by about $12 million a year on the Depfa loans alone.

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 New York's use of 
variable bonds.

"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 California, Connecticut, Illinois and South Dakota. 
Officials in Florida, Massachusetts and Montana have cut budgets 
because of C.D.O.'s or similar risky bets.

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 Canada and Stifel Nicolaus alleging misrepresentations. Board 
members hope they will prevail and schools and retirement plans will 
emerge unscathed. The companies dispute the lawsuit's claims. Mr. 
Noack is not named as a defendant and is cooperating with the school boards.

In Mrs. Velvikis's classroom at Grewenow Elementary in Kenosha, 
students have recently completed a lesson in which each first grader 
contributed a vegetable to a common vat of "stone soup." The project 
— based on a children's book — teaches the benefits of working 
together. The schools have learned that when everyone works together, 
they can also all starve.

"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."