When Wall Street Takes Advantage of the Public Sector

Andrew Clavell called it, back in February:

Let’s assume you work at a Pennsylvania school board… The more complex the structured product, the more opportunity for agents to extract fees at your expense… If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t.

OK, so he got the state wrong. But the NYT has an astonishing tale today of what happened to a school board in Whitefish Bay, Wisconsin. They were persuaded by an investment banker, who hailed from a local shop called Stifel Nicolaus, to invest in a leveraged synthetic CDO. It was a high-risk, low-return instrument:

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.

Why on earth would they take such a deal? Well, the investment banker, for one, was highly incentivized: his firm made about $1.2 million on the deal.

In the same story, we learn about a peculiar debt instrument issued by New York’s own Metropolitan Transportation Authority, which seems to be some kind of floating-rate note with an embedded put option, not to the MTA, but to the underwriter:

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…

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.

This is a crazy premium. There was a total of $200 million of the bonds in question; if the debt service on those bonds rose by $12 million a year, that would mean Depfa was charging a whopping 600 basis points extra in interest payments when it took possession of the bonds. Again, what bond issuer would ever agree to such a thing?

The NYT story never says what these bonds were called, or exactly how the "buyer of last resort" facility was structured, so any more information on that front would be very welcome. But what’s very clear is that public-sector issuers and investors were taken for a ride by Wall Street. Which I guess is nothing new, but it’s not going to help the banks one bit now that they’re turning to the public fisc for bailouts.

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