Category Archives: State Municipalities

Daniel M. Gallagher, a member of the Securities and Exchange Commission (SEC), is not backing down from recent comments regarding what he called “Armageddon risks” in the municipal bond market.

“I made the comment in the context of credit risk plus interest rate risk being two major factors that maybe investors don’t fully understand,” Gallagher said in an April 23 article by Investment News. “The population of investors in this space means we have to double down on investor education.”

Gallagher made the Armageddon reference last week at a round-table discussion sponsored by the SEC on fixed-income markets. Specifically, Gallagher stated that combining rising rates with the recent California muni bankruptcies could translate into potential “Armageddon.”

What concerns Gallagher, as well as others, is the trend of credit quality in the municipal bond arena, combined with an environment in which rates can only go up and thus drive down the value of existing bonds.

When the small town of Lewisburg, Tennessee, needed help paying the interest on a bond for new sewers, officials thought investment firm Morgan Keegan had the answers. Little did they know that the advice and the poorly conceived municipal bond derivative deal Morgan Keegan came up with eventually would mean millions of dollars in unanticipated costs, leaving Lewisburg and other municipalities like it financially devastated. 

Lewisburg is just one of a number of cities in Tennessee that has found itself burned by municipal bond derivatives and the advice of Memphis-based Morgan Keegan. Today, instead of lower interest rates on its sewer bond, Lewisburg is looking at annual interest payments that have quadrupled to $1 million, according to an April 7 article in the New York Times.

Officials in Lewisburg say when they first entered into the transaction with Morgan Keegan, they never realized the possible ramifications of municipal bond derivatives and the fact that interest rates could skyrocket depending on economic conditions. When the inevitable happened and the economy went south, Lewisburg quickly got a dose of its new reality.

According to the New York Times story, at the time Lewisburg sought the advice of Morgan Keegan, regulations in the municipal bond marketplace were so lax that in Tennessee the investment bank dominated virtually every component of the derivative business. Since 2001, the firm has sold $2 billion worth of municipal bond derivatives to 38 cities and counties.

The predicament facing cities like Lewisburg has led federal regulators to now consider restricting the use of municipal bond derivatives altogether. That news is of little comfort, however, to Lewisburg or Claiborne County, Tennessee, which has been trying to get out of its municipal derivative contract with Morgan Keegan for months. The cost to do so: $3 million, a sum that the already financially strapped county cannot afford.

As for Morgan Keegan, acting in the dual role of investment adviser and underwriter for transactions involving municipal bond derivatives has served it extremely well in Tennessee, with the investment bank raking in millions and millions of dollars in fees.

Municipal bond experts say there is an obvious bias when an investment firm like Morgan Keegan gives advice to municipalities regarding derivatives and then turns around to underwrite the deal itself. Several states, in fact, prohibit a single firm from acting in the role of both adviser and underwriter.

“It’s like the lion being hired to protect the gazelle,” said Robert E. Brooks, a municipal bonds expert and a professor of financial management at the University of Alabama, in the New York Times article. “Who was looking after these little towns?” 

Strangled by the tentacles of toxic subprime mortgages and structured investment vehicles (SIVs), the Florida Local Government Investment Pool (LGIP) is finding itself unable to pull in deposits from once-burned, twice-shy municipalities. 

Florida’s LGIP is used much like a money-market fund by nearly 1,000 school districts, counties and cities in the state Florida. At one time, the fund had $27 billion in assets. Today, the Florida LGIP is down to $5.7 billion after revealing it held billions of dollars worth of below-investment-grade securities. Upon learning that the LGIP had invested in the same kinds of securities responsible for crippling financial institutions and producing $1 trillion of write-downs, investors quickly withdrew more than $13 billion from the fund.

So far, Florida’s LGIP hasn’t lost money. The fund did, however, suspend withdrawals on Nov. 29, 2007, following credit rating downgrades on toxic debt that ultimately reduced its assets by 44%. 

The fund also placed a month’s interest in a reserve account in the event of a future cash shortfall. That move eventually caused a number of municipalities to move their money in rapid fire sequence into banks, Treasuries and private municipal funds. As depositors transferred their assets, another pool for local governments – the Florida Surplus Asset Fund Trust – grew 60% to $255 million in a single year.

The Florida LGIP has since brought in new leadership to shore up its financial and PR issues. Under a reorganization plan created by New York-based BlackRock Inc., the Florida LGIP has eliminated two-thirds of its bad debt, replaced managers and increased oversight. Even those actions, however, appear to be having little impact on restoring investor confidence. 

Mired in debt and still facing the nation’s largest municipal bankruptcy, Jefferson County, Alabama, has made little headway to solving its sewer debt crisis. At the center of controversy are members of the Jefferson County Commission, whom many say have let personal issues take a front seat to finding a solution for the ongoing sewer fiasco.

Problems for Jefferson County began seven years ago, when county commissioners entered into an ill-fated arrangement with Wall Street banks to refinance $3.2 billion worth of bonds for a sewer system overhaul. The deal involved highly complex interest-rate swaps that were supposed to protect Jefferson County from rising interest rates on its sewer bonds. Instead, the county faced double-digit interest rates and calls from creditors for the early repayment of the borrowed money. In the process, Jefferson County commissioners turned over $120 million in fees – six times the prevailing rate – to JP Morgan and other financial institutions.

With bankruptcy looming, Alabama Governor Bob Riley struck a deal with the county’s creditors in September 2008 to restructure the county’s $3.2 billion sewer debt at lower, fixed interest rates over a longer term.

Since then, however, a permanent solution to the county’s sewer issue has yet to emerge. Meanwhile, costs continue to climb.

As reported Feb. 12 in the Birmingham News, Jefferson County’s sewer system generates about $138 million a year from customers after paying for system operations. Under terms of the various deals, Jefferson County finance officials estimate they would owe $577 million in debt service this fiscal year alone. By comparison, the county estimated it would need just $125 million annually to cover debt service at the beginning of 2008.

In addition, the county has paid about $5 million for legal and financial advice since last February. Then there’s the cost to get out of those complex interest-rate swaps that the county used to protect itself against rising interest costs on its sewer debt. That has mushroomed to $608 million from about $180 million in March 2008.

As for Jefferson County residents, they’ve also paid the price for the sewer debacle and the fiscal bungling of elected public officials. Sewer rates have skyrocketed over the past decade in Jefferson County, rising more than four-fold. In late December, county commissioners wisely decided to veto yet another sewer-rate increase that would have gone into effect Jan. 1, 2009, and increased sewer charges by nearly 400%.

Meanwhile, the sewer problem continues. Instead of coming up with solutions, the Jefferson County Commission tried to hire a Washington, D.C. lobbying firm to the tune of $1 million to secure federal bailout dollars to pay down the county’s sewer debt. Perhaps in all their misplaced wisdom, commissioners didn’t hear that President Barack Obama takes a hard line on corporate lobbyists.

As it turns out, the lobbying outfit that commissioners wanted to hire, Book Hill Partners, walked away from the controversial contact last week.

Our securities lawyers are actively involved in advising individual and institutional investors in evaluating their legal options when confronted investment losses. 

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.