CHICAGO - Moody's Investors Service on Friday lowered the ratings of two of five Wisconsin school districts that last year were placed on watch for a possible downgrade over their financial exposures from an investment scheme involving collateralized debt obligations and a credit default swap.

The rating agency removed all five northeast Wisconsin districts from the negative watch list after downgrading two - West Allis/West Milwaukee School District and Waukesha School District - and affirming the credits of the other three.

Moody's downgraded West Allis to A1 from Aa3 and assigned a negative outlook. The move impacts $26.8 million of general obligation unlimited-tax debt. Waukesha's credit was knocked down to A2 from A1 and assigned a negative outlook, affecting $16 million of debt.

The Kimberly Area School District's A1 GO credit on $45.5 million of debt was affirmed and assigned a stable outlook by Moody's. The Whitefish Bay School District received confirmation on its Aa2 rating and was assigned a stable outlook on $2.5 million of debt. The Kenosha Unified School District's A1 rating on $89.7 million of debt was affirmed and assigned a negative outlook.

The action Friday followed the completion of Moody's review of both the complex investment transactions entered into by the five districts to help fund their other post-employment benefit liabilities and the ability of each credit to cope with the financial strain posed by the investment losses. Analysts also met with representatives of four of the five districts. A spokesman for the five did not return calls to comment.

"How much they are on the hook for was a factor, as well as their financial flexibility and how well-suited they are to meet the challenges," said Moody's analyst Ted Damutz. "We looked at what plans they have in place and how, if they have to issue additional debt, it would fit into their credit profile."

The five districts collectively invested about $200 million in the transaction. They now estimate the value has dropped by at least $150 million due to subprime mortgage defaults. The five have filed a lawsuit against Stifel Nicolaus & Co. and the Royal Bank of Canada, alleging that the firms fraudulently misrepresented the safety of the investments.

The districts are awaiting a federal court ruling expected within the next 30 to 60 days on where the litigation will be heard, according to an attorney from Kravit, Hovel & Krawczyk SC, which is representing the districts. The firms being sued want the federal courts to hear the case and the districts want the matter in state court.

The districts contend that the firms violated state securities laws by either knowingly or negligently misrepresenting the transaction. Stifel has countered that the districts signed acknowledgment letters that did discuss the investment risks and included a recommendation that independent advice be sought.

The transactions were entered when the districts decided to establish trusts to help cover their annual required contributions and to move towards fully funding their collective OPEB liabilities of $432 million. Under the terms of the 2006 transactions, the districts' trusts issued asset-backed notes totaling $165 million which are held by Depfa Bank. Those funds and another $35 million were invested in the synthetic CDOs created by RBC Europe.

Under the program, the trusts would receive the spread, or the difference between the interest rate on their loan from Depfa and the interest rate the trusts received on their CDO investments. The districts were told several million dollars would be generated over the seven-year term of the CDO investments. However, CDO defaults have resulted in sharp losses and a deficiency in the trusts' asset ratios.

Under the agreement, the districts put up a moral obligation pledge to cure any deficiency in that asset ratio, which is defined by the value of the investment as compared to the outstanding principal amount on the asset-backed notes. Depfa so far has not demanded any payments.

Moody's dropped West Allis' rating and assigned a negative outlook over concerns that it could not cover with cash on hand its maximum liability of up to $83.3 million, and the additional GO debt would strain the district's budget.

"Given this immense challenge, Moody's believes that if Depfa accelerates termination, the district's financial operations would be subject to severe pressure which would place downward pressure on the district's credit quality, " the agency wrote.

Waukesha's downgrade and negative outlook also was attributed to the district's inability to cover fully a maximum liability of $65.7 million with cash and the need to issue debt.

"The district would likely experience serious deterioration of its reserves and financial operations would become strained," analysts wrote.

In affirming Kenosha's rating and assigning a negative outlook, Moody's said: "The district will experience significant financial challenges should Depfa call upon the district to meet its moral obligation pledge." The district has a total liability of $37.9 million on the investment transaction.

In affirming Kimberly's rating and assigning a stable outlook, Moody's wrote that the district could cover its trust liability of $4.3 million with cash on hand.

"Given the district's sound financial management and a history of prudent budgeting, Moody's believes the district would be able to rebuild its reserves back in line with its rating category relatively quickly," the agency said.

In affirming Whitefish Bay's rating and assigning a stable outlook, Moody's wrote that the district could repay its $9.7 million liability with cash on hand or a debt issue that would still keep the district's debt at a modest level.

"Moody's believes the district would be able to rebuild its reserves back in line with its rating category relatively quickly," the agency said.

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