CHICAGO - Moody's Investors' Service has placed the ratings of five southeastern Wisconsin school districts on watch for possible downgrade due to concerns over their financial exposure stemming from investments in a complex transaction involving collateralized debt obligations and a credit default swap.
The districts - Kenosha Unified School District, Kimberly Area School District, Waukesha School District, West Allis/West Milwaukee School District, and Whitefish Bay School District - collectively invested about $200 million in the transaction that was tied to funding their other post-employment benefits. They now estimate the value has dropped by at least $150 million.
The five joined together earlier this year to hire legal and financial advisers to review the transaction and recently 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 rating agency had previously assigned negative outlooks to the credits over concerns that the investment losses could pose a severe financial strain to the districts. Their placement on the watch list indicates the likelihood that ratings action is more imminent.
Kenosha is rated A1 with $89.7 million of outstanding GO debt; Waukesha is rated A1 with $15.9 million of general obligation debt; Kimberly is rated A1 with $45.5 million of GO debt; West Allis is rated Aa3 with $23.3 million of GO debt; and Whitefish is rated Aa2 with $2.5 million of debt.
"Moody's is looking to clarify the exposure to the district and its potential impact on the district's credit quality. In addition, the rating action reflects the potential for financial stress that could result from the district's moral obligation pledge on the [OPEB] trust's asset-backed notes," analysts wrote in each of the five reports.
Waukesha issued $50 million in asset-backed notes to partially finance its investment in the synthetic CDO. Kenosha issued $28.4 million, Kimberly issued $4.3 million, West Allis issued $72.4 million, and Whitefish Bay issued $9.7 million.
Under the moral obligation agreement, the districts have pledged to cure any deficiency in the trust's asset ratio which is defined by the value of the investment as compared to the outstanding principal amount on the asset-backed notes.
If called upon to do so, the district has until the following budget year to appropriate funds necessary to cover the shortfall. Moody's reported that as of September, the asset ratio was approximately 24%, representing a $21.8 million deficiency.
The districts collectively faced unfunded OPEB liabilities of $432 million. New Governmental Accounting Standards Board rules require governments to shift from reporting their non pension-related retiree benefits on an annual basis to an accrued one.
The districts decided to establish trusts to help cover their annual required contributions and to move towards fully funding the liability over time as the trusts' holdings grew, believing such a step would positively impact their credit ratings and stabilize operating costs.
Under the terms of the transaction undertaken in 2006, the districts' trusts borrowed $165 million from Depfa Bank which in addition to another $35 million was 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.
The lawsuit contends that the firms violated state securities laws by either knowingly or negligently misrepresenting details of the transaction. The suit further alleges that the firms violated the state's trade and fraud statutes because of their statements about the safety of the transactions and its compliance with state laws. Stifel has countered that it warned the districts' of the investment vehicle's risks.
Moody's said in its reports that it believes that in Wisconsin only the five districts were involved in the CDO investment.