CHICAGO - Wisconsin's Kenosha Unified School District No. 1 could face a downgrade of its A1 credit from Moody's Investors Service due to the fiscal strain of dealing with a faltering investment in a complex transaction that involved collateralized debt obligations and a credit default swap.

The move by Moody's to revise its outlook on the credit follows similar action taken about two weeks ago on the outlook for the Waukesha School District's A1 rating. The two are among five southeastern Wisconsin districts that entered into the investment transaction two years ago to help fund a portion of their other post-employment benefit liabilities All five have joined together to hire legal advisers and are considering litigation against the financial firms that floated and executed the deals.

The districts believe their $200 million investment has lost as much as $120 million of its value based on a legal review they commissioned. Moody's action affects nearly $90 million of the district's outstanding general obligation debt. The agency also assigned top marks to the district's $33 million tax and revenue anticipation note sale for cash-flow purposes and $20 million of bond anticipation notes for a school addition.

"Assignment of the negative outlook reflects Moody's belief that the district's credit quality could significantly weaken over the near-term due to its relationship with the Kenosha Unified School District post-employment benefits trust," analysts wrote.

The district established a trust to fund its OPEB liability following a September 2007 actuarial review that determined the district's total OPEB liability to be $243 million. An annual required contribution of $16.3 million would be needed to fully fund the trust.

The district in 2006 issued $37.5 million in asset-backed notes that combined with a $9.5 million "note anticipation note" issued by the district, were invested in collateralized debt obligations. The district had believed the investment earnings would pay interest on both sets of notes.

The district put a moral obligation appropriation pledge behind the asset-backed notes that requires the district to post the amount necessary to cover any deficiency in the trust's asset ratio as defined by the value of the district's CDO investment. The district has until the following budget year to appropriate funds.

The asset ratio has fallen to 24%, leaving a $21.8 million deficiency, and the indenture trustee has requested that the district cover the loss. To date, the district has not acted, which puts the trust in technical default.

"Should the district's exposure prove to materially strain budgetary options, or willingness to honor its obligations perceptibly erode, overall credit quality could face downward pressure," analysts wrote.

The district's note anticipation notes are secured by a pledge to issue long-term general obligation debt prior to the notes' maturity in 2011. The district had hoped that interest earnings from the investment would cover repayment, but that now appears unlikely.

Most of the districts issued some form of taxable debt totaling about $160 million to put towards the transaction that they were told was being used to invest in double-A to triple-A rated debt. The districts commissioned a review of the transaction, learning recently that the collateralized debt obligations they invested in included more risky triple-B rated securities, including subprime mortgages, and included a credit default swap.

The report commissioned by the districts names Stifel, Nicolaus & Co. and former Stifel banker David W. Noack and the Royal Bank of Canada Europe Ltd. as participants in the complex transaction that the districts contend was misrepresented to them. RBC served as the counterparty on the swap that the districts say they were not aware of and Stifel served as the broker and placement agent.

Stifel has countered the allegations of misrepresentation by providing documents they claim show the districts were aware of the investment risk. The districts entered into the transaction as each sought an affordable solution to fund their OPEB liabilities.

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