How A School Board In Wisconsin (And The NYC Subway System) Became Accidental Hedge Funds

from the the-obfuscation-of-risk dept

We’ve talked in the past about how one of the causes of the financial crisis was that many banks on Wall Street stopped acting like banks and started acting like hedge funds — despite not really knowing how to do that. That is, they took on much greater risks and higher leverage, without having much of an understanding of how to really hedge that risk. That was fine when all was going well, but when the bubble burst, it started impacting everyone.

Now, in a combined effort between NPR’s Planet Money (I know I’ve said this, but I’ll say it again: if you’re not listening to this every day, you’re missing out, big time) and the NY Times, reports are coming out about how it went well beyond banks turning into hedge funds, to all sorts of other organizations as well. The scary example being described in the first article in this series is how a Wisconsin school board and the NYC subway system, both effectively became hedge funds, lending money out to various banks in exchange for CDOs (collateralized debt obligations). What a CDO is, effectively, is the mashing together of a variety of different debt instruments (loans) that pay out some sort of return. So, you could basically buy some of the return on a whole mess of loans, packaged in all different ways (some amazingly creatively).

If all of those debt instruments that you’re buying into keep on paying, you’re in good shape. If, however, there are defaults, you can be in an awful lot of trouble. However, while everything was going great, defaults weren’t an issue and the folks sold on these CDOs often had no idea how risky they really were. In the article above, for example, the guy who sold the Wisconsin school district on investing $200 million of its pension money in CDOs had only taken a two hour course on them, and greatly downplayed the risks.

And, of course, to make matters even worse, in many cases, the actual risks of such CDOs were hidden through some games, and made worse by either clueless or complicit ratings agencies which rated seriously high risk CDOs as being extremely safe bets. To see a rather graphic (and easily understandable) example of this, I recommend the following Paddy Hirsch video comparing CDOs to pyramids of champagne glasses:

The really scary part was that, effectively, you had numerous less than fully sophisticated investors, dumping hundreds of millions, if not billions, of dollars into incredibly complex investment vehicles that they were being falsely told were extremely safe, when the facts are that they were highly risky. Many pension funds and the like allocate a certain small percentage of their investments into high risk vehicles — but the financial crisis is being caused in part by the realization that a much, much, much larger percentage of their investments actually turned out to be in seriously high risk vehicles, many of which have now defaulted.

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Comments on “How A School Board In Wisconsin (And The NYC Subway System) Became Accidental Hedge Funds”

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11 Comments
J.Locke says:

Frankly im getting tired of this

Too many people running around crying about not knowing what they were getting into (I know many personally). I dont know what kind of idiot invests his money in something he doesnt understand, I also cannot imagine the stupidity of someone who borrows money to invest in something he doesnt understand, and I certainly think that people who borrow and invest OTHER peoples money in things they dont understand are far too stupid to be on this earth with the rest of us. When these munnies start firering the morons that “didnt know” what they were getting into when making these deals, then I will believe someone has actually learned from this. Until then, it just looks like plain ole greedy buyers remorse to me.

purpleslog (user link) says:

5 Districts, not 1

Multiple WI school districts are involved:

http://www.jsonline.com/news/education/29431514.html

Five Wisconsin public school districts have made an investment gamble that could force taxpayers to finance multimillion-dollar bailouts.

The districts – Kenosha, Kimberly Area, Waukesha, West Allis-West Milwaukee and Whitefish Bay – have piled up debt in deals to help fund health insurance and other non-pension benefits for retirees. But as global financial markets have seized up, the districts have been told the value of their investments has fallen so much that they might need to come up with a combined $53 million to avoid default.

Specifically:

• Kenosha might need almost $8 million in additional collateral or risk default on $28.7 million.

• Kimberly might need to put up $1.5 million more or risk default on $4.3 million.

• Waukesha might have to come up with more than $13.3 million in additional money or risk default on $50.5 million in bonds.

• West Allis-West Milwaukee might need to come up with $26.8 million or risk default on $72.4 million in bonds.

• Whitefish Bay might need to come up with $3.8 million or risk default on $9.7 million.

Anonymous Coward says:

Re: 5 Districts, not 1

Five Wisconsin public school districts have made an investment gamble that could force taxpayers to finance multimillion-dollar bailouts.

Risk? What risk is there if you can force the taxpayers to bail you out? None! So why shouldn’t they make risky investments? It’s no skin off their backs when it sinks.

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