CHICAGO — Depfa Bank Plc has formally demanded repayment of its $165 million loan to five Wisconsin school districts, calling on them to make good on their moral obligation pledge to repay the funds used to establish trusts to help pay other post-employment benefit liabilities.
The bank also seized the meager $5.3 million that remained in the trusts yesterday. The actions mark the latest development in the ongoing saga of the districts’ $200 million gamble in a complex investment scheme that involved collateralized debt obligations and a credit default swap.
Depfa’s action, however, now forces each district’s hand. Each board must now decide whether to stand behind its moral obligation pledge and appropriate the funds in the next budget.
The districts have sued the firms that proposed and structured the trusts — Stifel, Nicolaus & Co., James Zemlyak, an executive vice president at the firm, and the Royal Bank of Canada Europe Ltd. — alleging they fraudulently misrepresented the safety of the investments. The firms counter that the districts were aware of the risks.
The districts have pushed Depfa to join them, but the bank is not interested in becoming a party to the litigation, instead pressing the districts to sit down and restructure the terms and conditions of the original agreements.
“We’ve been very frustrated with the lack of progress with the school districts and decided in light of the current budgeting process that now is the time to act,” John Reilly, a managing director and branch manager at Depfa, said in an interview yesterday along with Jane Russell, a managing director who was involved in the original loan agreements. “The bank has always been willing to restructure the transactions and give the districts some breathing room.”
The five districts involved are the Kenosha Unified School District, the Kimberly Area School District, the Waukesha School District, the West Allis/West Milwaukee School District, and the Whitefish Bay School District. They invested the $200 million to help cover their collective $432 million of unfunded OPEB liabilities.
An attorney for the districts said he could not predict how the districts’ boards will react.
“We are certainly not surprised by their decision to seize the funds. As far as their decision to call their loans, the business managers of the districts will follow the process under the moral obligation agreement to present a line item to the boards,” said C.J. Krawczyk, a partner at Kravit Hovel & Krawczyk, which is representing the districts in their lawsuit. “The districts believe the best way for Depfa to get paid is for the districts to prevail in the lawsuit, it is for the benefit of Depfa.”
The districts thought the investments were safe in 2006 when they entered into the transactions. The districts believed the investments were made in highly rated securities that were not exposed to subprime or other market risks.
When the subprime real estate market collapsed and the value of other structured securities fell, the value of the trusts dwindled. The trusts went into default in December 2007. The market’s ongoing problems and the recession further cut into the value of the trusts that held just $5.3 million yesterday when Depfa sought to withdraw the funds as permitted under its agreements with the districts.
Under the original deals, the districts established the trusts which in turn issued a combined $165 million of post employment benefit trust notes and they made a combined $35 million equity contribution to fund the investment in three CDOs. Depfa purchased the notes.
Under the trust agreements with Depfa, the districts’ trusts were required to make quarterly interest payments with the principal due in various bullet maturities in 2013. The districts paid an interest rate of the London Interbank Offered Rate plus 18 basis points. The trusts were current on all interest payments.
The districts expected to benefit financially by capturing the spread between the low rate it paid on the notes and the higher rate of return it expected on its investments, which was originally expected to be roughly Libor plus 100 basis points. The districts put up their moral obligation pledge to cure any deficiency in value of the trusts should the worth of its assets fall below 101% of the principal amount of the notes.
The moral obligation contribution agreement states that the districts may become contingently obligated, subject to appropriation of sufficient funds, to contribute money to the trust from time to time.
The value of the collateral in the trusts fell below 101% in December 2007, triggering a default, at which point the districts had 30 days to cure. The districts did not take any action. The interest rate on the notes also increases to a default rate of Libor plus 93 basis points. Depfa has had the right to seize the funds since the districts’ failed to cure the default, bank officials said.
Depfa had not taken any action until March 9 when the bank sent each of the districts a default acceleration notice and a request for contribution notice under the moral obligation contribution agreement. A total of $154.8 million is due after the seizure of the $5.3 million. The principal was also previously reduced by a separate agreement entered into with one of the districts that issued general obligation notes to repay a portion of the trust notes.
Reilly and Russell said the bank’s sole role in the transaction was as buyer of the notes and it’s not responsible for the structure of the trust or how it performed. Stifel approached the bank — widely known as a buyer of taxable municipal pension bond obligations — about purchasing the notes in early 2006. The first transaction closed in June 2006.
The bank was attracted to the deal because of the moral obligation pledge. The transaction’s debt structure was unique — although municipalities had begun establishing trusts to fund their OPEB liabilities — and the bank has not entered into any other similar transactions.
Depfa has informed Wisconsin state debt manager Frank Hoadley of its actions. Hoadley could not be reached to comment yesterday.
Though the notes were not marketed as traditional bonds, the districts stand to damage both their ratings and their market access if they fail to meet the pledge, according to market participants. “It’s a unique transaction but as an investor you have to be very careful in buying the debt of any issuer that walks away from a moral obligation pledge,” said Matt Fabian, a managing director at Municipal Market Advisors. “The moral obligation is a time honored tradition.”
Moody’s Investors Service last year lowered the ratings of two of the five districts, all of which had been placed on negative watch over the risk posed by the dwindling investments, and warned of future action if the districts failed to meet their moral obligation pledge. Moody’s analysts could be reached yesterday for comment.
“Moody’s notes that if the district does not appropriate funds when, or if, called upon it would demonstrate a failure in its willingness to pay, which would place downward pressure on the district’s credit rating,” analysts wrote in the individual reports.
