CHICAGO - Wisconsin's Waukesha School District could face a downgrade in its A1 credit from Moody's Investors Service as it grapples with the fiscal strain of dealing with a faltering investment in a complex transaction that involved collateralized debt obligations and a credit default swap.

Waukesha is one of five districts that invested in the CDOs. All are weighing litigation against the financial firms they believe misrepresented the safety of the complex investment transaction intended to help fund a portion of their other post-employment benefit liabilities.

The districts believe their $200 million investment has lost as much as $120 million of its value based on a legal review they commissioned of the two-year-old transaction, according to a joint statement from the districts.

Moody's recently revised its outlook on the credit and the district's $16 million of general obligation unlimited-tax debt to negative from stable after analysts received information on the lost value of the investment.

Moody's last reviewed and affirmed the credit just a month ago, but analysts received more detailed information about the struggling OPEB trust fund investment since that review, sparking analysts' concerns that "the district's financial operations could become increasingly pressured over the near-term."

To address its OPEB liability, the district established a trust in 2006 and issued $50 million of asset-backed notes and $15.7 million of anticipation notes, the proceeds of which were invested in CDOs. The district at the time anticipated that its investment earnings would cover interest on the debts and generate sufficient additional revenue to fund the OPEB liability. The district's OPEB liability as of July 2007 was $145.5 million, with an unfunded actuarial accrued liability of $86 million

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 57%, leaving a $21 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. The investment's interest earnings, however, are continuing to generate enough to cover the interest due on the asset-backed notes, the ratings report said.

"Should the district choose to appropriate funds in its fiscal 2009-2010 budget, and possibly beyond, monies would likely come from the issuance of long-term debt payable from operating funds which are subject to revenue caps and are already pressured. Conversely, if the district does not appropriate funds it would demonstrate a failure in its willingness to pay, which is a key credit rating component," the agency's report states.

The anticipation notes are secured by a pledge to issue long-term general obligation debt prior to their maturity in 2011. The district had hoped to repay the notes with interest earnings from the investment though at this time such revenues are likely to fall short.

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.

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 since have learned that the collateralized debt obligations they invested in included more risky triple-B rated securities, including subprime mortgages.

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