For an illustration of the global reach of the credit crisis, consider the plight of Narvik, a Norwegian municipality on the banks of the Ofotfjord.

Located 140 miles north of the Arctic Circle, Narvik goes three straight months without sun during the winter. The town of 18,500 was nevertheless forced to shut off its street lights at night in a draconian response to the fiscal crisis.

The reason, Narvik alleges, is "egregious fraud" by Citigroup, 3,670 miles across the Atlantic Ocean.

Along with a bankrupt securities firm, Narvik is one of seven municipalities in Norway suing Citi for at least $200 million.

The suit, filed in U.S. District Court for the Southern District of New York on Monday, accuses Citi of marketing a doomed municipal arbitrage vehicle as a conservative investment.

The seven municipalities - which have a combined population smaller than Middletown, N.J. - sank more than $115 million worth of Norwegian kroner into notes linked to a Citi fund.

They lost $90 million, according to the suit.

Citi's alleged fraud also forced Terra Securities - the Norwegian firm Citi used to market the investments - into bankruptcy, the suit asserts, wiping out $230 million in enterprise value.

In a statement, Citi called the suit "without merit" and said it intends "to vigorously defend our position."

Citi claims that, through Terra Securities, the company described to the municipalities the risks of investing in TOB arbitrage.

Terra and the municipalities are represented by the New York firm Kasowitz, Benson, Torres & Friedman LLP.

Here is the suit's account of what happened: In early 2007, the municipalities of Narvik, Kvinesdal, Hemnes, Bremanger, Hattfjelldal, Vik and Rana - with a combined population 62,400 - were conscientious small governments with no interest in risky or speculative investments.

In April or May 2007, through Terra Securities, Citi presented to the municipalities what it called a safe, conservative opportunity: tender-option bond arbitrage.

Citi presentedthe standard argument for municipal arbitrage, according to the suit: long-term municipal bond yields are too high relative to short-term municipal bond yields.

Investors can gain low-risk profit by buying long-term munis and borrowing at a short-term muni rate. An arbitrage fund that implements this strategy would collect a higher rate than it paid.

The risk to this strategy is if long-term yields or short-term yields change, disrupting the comfortable profit the fund is earning on the spread of long-term muni rates over short-term rates.

To hedge this risk, the arbitrage fund enters into two derivatives contracts to try and lock in the spread.

One entitles the fund to collect a short-term floating rate, perhaps the three-month London Interbank Offered Rate. This offsets any increase in the rate the fund pays on its short-term borrowing. If it has to pay more on its short-term debt, it also collects more on the derivative.

The other obliges the fund to pay a fixed long-term rate, ideally lower than the rate collected on the long-term munis. That offsets any losses on the long-term bonds. If the long-term bonds decline in value, the fund records gains on the derivative.

As the more than 35 funds in the TOB arbitrage industry found out last year, an insidious flaw lurks in this strategy.

The hedges only work if the rates on the derivatives actually mimic the municipal rates. If the derivative rates behave differently from munis, changes in muni rates could whack the fund with losses not recovered from the hedges. Or worse - the fund could lose money on the arbitrage and on the hedges simultaneously.

According to Citigroup's presentation, the derivatives rates to that point mirrored municipal rates at a correlation of 0.97, a very high ratio. A correlation of 1 means they move by the same magnitude in the same direction all the time.

This was based on the correlation of 30-year Libor to the 30-year rate on the Municipal Market Data yield curve.

The suit alleges Citi utilized hopelessly flawed math to ascertain that figure. The bank measured the correlation in Libor and MMD absolute yields, the suit claims. What matters for the fund is the correlation not of the yields themselves but of the changes in yields. If the rates on long-term munis go up, an arbitrage fund would need its derivative to increase by the same magnitude.

The changes in Libor and MMD yields only correlated at a rate of 0.562 from 1996 to 2006, the suit claims. Further, comparing changes in Libor to changes in Bloomberg's municipal scale instead of MMD's shows a correlation of only 0.27.

Because of the tenuous relationship between the arbitrage itself and the hedges it employed, what Citi marketed as conservative was actually highly risky, the suit claims.

Citi knew the markets were poised to wallop the TOB fund, according to the suit. The bank fobbed the losses onto the municipalities to protect its own balance sheet and its preferred clients, the suit argues.

Further, it claims that Citi duped the municipalities into essentially insuring the fund.

The bank built triggers into the agreement enabling Citi to seize money from a reserve or demand collateral from the municipalities if the fund did poorly.

That made it win-win for Citi: if the fund did well, Citi collected fees; if the fund did poorly, Citi seized the reserve.

The triggers forced some of the municipalities to dump even more cash into their loss-laden investments.

The suit claims the investment losses have been "devastating," with basic services like schools, libraries, and social services suffering.

The seven towns lost more than $1,440 per resident on these investments, based on the reported loss divided by population.

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