How to Deal with Your District's Bad Debt

By Charles K. Trainor

The current economic climate is challenging. When budgetary demands rise, state aid is reduced, and interest rates are extremely low, school districts may be tempted to abandon their investment policies to increase earnings. Some may reach for opportunities even when they do not fully understand the transaction.

This may have been the case when five Wisconsin districts faced severe financial pressures in 2006. With retirement costs skyrocketing, they wanted a safe investment that would generate enough income to fund retirement benefits.

The districts were presented with a seemingly ideal opportunity. Adding to some cash on hand, they borrowed money from a German bank doing business in Ireland. Next, they purchased $200 million of collateral debt obligation, which is a derivative investment constructed from a portfolio of fixed-income assets.

According to news reports, the investment prospectus was three inches thick. Within that document, the securities were described as “synthetic,” suggesting that reselling the security would be extremely difficult due to the investment’s complex structure. It was also noted that the investment was rated “BBB” by a rating agency, indicating only a medium level of safety.

Board members asked if the investment was safe. The sales representative verbally assured them that the investment would generate the expected quarterly income.

The prospectus was examined carefully only after last year’s financial turmoil erupted, and the true nature of the investment risk was revealed. In September 2008, the districts filed a lawsuit in Milwaukee County Circuit Court against the foreign bank and the local investment broker. At the time the lawsuit was filed, the investment had lost $150 million.

Valuable lessons can be learned from this ill-fated transaction.

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