CHICAGO — All five southeastern Wisconsin school districts involved in a failed investment scheme tied to funding their non-pension retiree health care trusts are reneging on their moral obligation pledge to repay asset-backed notes issued by the trusts and sold to Depfa Bank Plc.
The schools want to wait until their litigation — alleging fraud against the firms that put together the now-worthless investment in collateralized debt obligations in 2006 — is resolved before repaying Depfa as the bank has demanded under its loan agreements. The Securities and Exchange Commission over the spring launched a probe into the investments, which included credit default swaps.
All five school boards have approved preliminary budgets that do not include note repayment.
Moody’s Investors Service yesterday downgraded Kenosha United School District by one notch to Aa3 with a stable outlook because of its refusal to honor its moral obligation behind $27.7 million of trust notes.
The districts put their moral obligation pledge behind the notes issued by their individual trusts and purchased by Depfa. As the investment faltered, the value of the trusts’ collateral sank, triggering a default in late 2007 that the districts were required under the loan agreements to cure. They did not cure the defaults and in March Depfa demanded repayment.
The districts are required to include an appropriation in their 2011 budgets. All of them did, but the district boards have since voted to strip the line item from the preliminary budgets approved over the last two months.
In a statement, Depfa warned the districts’ action has broader implications.
“Moral obligations have been widely used by municipalities to provide flexibility in financing. Depfa and other lenders have long relied on moral obligations to extend credit to governmental bodies seeking to borrow for public purposes,” said John Reilly, a managing director and branch manager. “The state of Wisconsin and many of its agencies and municipalities have a long history of borrowing with a moral obligation to repay. This situation puts the entire standardized instrument of moral obligations in jeopardy.”
Moody’s last month downgraded Waukesha School District to A1 from Aa3 and assigned a negative outlook after its board adopted a preliminary budget that did not fund repayment of $47.5 million of notes.
The boards of the other three districts — the Kimberly Area School District, the West Allis/West Milwaukee School District and the Whitefish Bay School District — over the last two weeks also have adopted budgets that do not include repayment of the notes.
Whitefish Bay director of business services Shawn Yde stressed that his board’s final decision on repayment of $8.8 million of notes won’t be made until the fall, when a final budget is adopted.
“The board has until Oct. 15 to adopt a final budget,” he said Wednesday, suggesting developments in the litigation could influence the final decision. “We are just starting to get information through the discovery process on the lawsuit.”
White Fish Bay is rated Aa2 by Moody’s but is under review.
Kimberly is currently rated Aa2 by Moody’s but the credit is also under review. The district voted earlier this week to cut the line item in its preliminary budget on repayment of $4.1 million of trust notes.
West Allis-West Milwaukee decided earlier this month to strip the line item repaying $70.8 million of notes in the budget. The district is rated A1 and is also under review.
Analyst Henrietta Chang said Moody’s is considering the fiscal condition of the remaining districts under review along with their failure to meet the obligation as it weighs what action to take. The agency expects to resolve the status of the remaining districts in the coming days.
The five districts invested a total of $200 million — $165 million from the trust notes and $35 million in cash — to help cover their collective $432 million of unfunded other post-employment benefit, or OPEB, liabilities.
The districts believe the litigation will provide some fiscal relief and had hoped to fend off further negative rating actions. The districts are suing Stifel, Nicolaus & Co. and the Royal Bank of Canada Europe Ltd., alleging they fraudulently misrepresented the safety of the investments.
The firms counter that the districts were aware of the risks. The schools have asked Depfa to join them as a party to the lawsuit, but the bank has refused. A status hearing is scheduled in Milwaukee County District Court in September.
The districts contend that they believed they were investing in highly rated securities that were not exposed to subprime or other market risks. When the subprime real estate market collapsed and the value of other structured securities fell, the value of the trusts dwindled. The trusts went into default in December 2007.
The market’s ongoing problems and the recession further cut into the value of the trusts, which held just $5.3 million in March, when Depfa withdrew the funds as permitted under the loan agreements. The districts expected to benefit financially by capturing the spread between the low rate it paid on the notes and the higher rate of return it expected on its investments.
Depfa has pushed the districts to renegotiate the repayment terms of the notes, but they have so far refused. Whitefish Bay’s Shawn Ide said Depfa attempted to intervene in its recent $11 million debt issue through a state trust fund loan from the Wisconsin Board of Commissioners of Public Lands.
The district borrowed $10.2 million under the federal qualified school construction program and another $830,000 under the Build America Bond program. The state board purchased the certificates. Ide said Depfa asked the state to attach a condition to the loan requiring that the district repay the bank. The state issued the loan without any conditions.
Depfa defended the action.
“It was Depfa’s intent to ensure that the board was as well-informed as possible before making its decision and request that the board condition its approval of the loan to Whitefish Bay upon a commitment by the district to satisfy its outstanding obligations to Depfa,” Reilly said. “Whitefish Bay is financially strong and healthy. In fact, Moody’s most recent rating action explicitly stated that the district had the resources to make good on its pledge to Depfa.”
The Kenosha downgrade affects $133.6 million of outstanding general obligation debt. The district benefits from a sizeable tax base with above-average resident wealth levels, and healthy general fund operations. But analysts said the rating also “factors in the district’s decision to tie its moral obligation pledge to the performance of high-risk investments and the board’s decision not to include any amount for the payment of the moral obligation in its preliminary fiscal 2011 budget.”