The story began in 2006, when five Wisconsin school districts – Kenosha Unified School District, Kimberly Area School District, School District of Waukesha, West Allis-West Milwaukee School District and Whitefish Bay School District – went looking for investment advice to shore up its teachers’ retirement plans. David Noack, a local investment banker with Stifel, Nicolaus & Company, had the perfect solution. It involved hedge funds and investments in complex collateralized debt obligations (CDOs).
According to Noack, the investment was simple, safe, even conservative. There was no way anyone could lose. The school districts’ board members knew very little about CDOs; they did know Noack, however. He had been a trusted advisor to them for years.
The five Wisconsin school districts ultimately took Noack’s advice and borrowed $200 million from the Depfa Bank of Ireland. In addition, they invested some $35 million of their own money to purchase three CDOs sold by the Royal Bank of Canada (RBC), which also had a relationship with Noack. Under the arrangement, the Wisconsin school districts would receive the spread between the interest rate they were paying on their loan from Depfa and the interest rate received from their CDO investments, according to a Nov. 8 article in the St. Louis Business Journal. The spread itself was lucrative: “several million dollars” over the seven-year life of the investment.
Everything worked – for awhile. Then, the districts began to notice something was off. Bonds are expected to deliver consistent, steady returns, yet the value of the districts’ investment kept fluctuating wildly.
The school districts found their answer after hiring a lawyer. They discovered the AA/AAA-rated corporate bonds that had been touted by Noack and Stifel, Nicolaus & Company at the beginning of their deal didn’t exist. Instead, the “safe” investment described to them consisted of synthetic CDOs that purchased high-risk subprime mortgage-backed securities and other toxic investments.
In addition to the CDOs, the districts learned that another part of their investment consisted of a credit default swap. Unbeknownst to them, they were in the insurance business, responsible for guaranteeing about $20 billion on a pool of corporate bonds. If the bonds did OK, so did their investment. However, if just a handful of companies in that CDO pool were to default, the school districts could lose all of their money.
The inevitable happened. Lehman Brothers, American Insurance Corporation (AIG), Washington Mutual, Fannie Mae and Freddie Mac all were part of the districts’ CDO pool. So far, the Wisconsin school districts’ $200 million investments have lost $150 million of their value.
The districts are now suing Stifel, Nicolaus & Company and the Royal Bank of Canada. In addition to fraud, negligence and breach of contract, the districts allege that both firms intentionally misrepresented the CDOs and the credit default swap as safe, low-risk investments.
Meanwhile, the people and the companies responsible for orchestrating the deal for the school districts – David Noack, Stifel, Nicolaus & Company and the Royal Bank of Scotland – have raked in millions of dollars in fees for their services.