Kids, can you count to 15 Enrons? | FT Alphaville

Kids, can you count to 15 Enrons?

Fresh out of the SEC on Wednesday morning, a depressing allegation of fraud that hints at the absurdity of the working definition of “fiduciary duty” when it comes to municipalities.

In a complaint filed in federal court in Milwaukee, the SEC alleges that Stifel and Senior Vice President David W. Noack created a proprietary program to help the school districts fund retiree benefits by investing in notes linked to the performance of synthetic collateralized debt obligations (CDOs). The school districts established trusts that invested $200 million in three transactions from June to December 2006, paid for largely with borrowed funds. According to the SEC’s complaint, Stifel and Noack misrepresented the risk of the investments and failed to disclose material facts to the school districts. In the end, the investments were a complete failure, but generated significant fees for Stifel and Noack.

The complaint details how Stifel and Noack sold the school districts synthetic CDOs that were linked to the performance of over 100 credit default swaps on corporate bonds. The districts invested a total of $200m in the products, of which $198.7m was borrowed money — a highly leveraged situation for anyone, never mind a municipality. In the end the districts “lost tens of millions of dollars” as a result of alleged malpractice by Stifel and Noack.

The SEC allege that Stifel and Noack used “a series of falsehoods and misrepresentations” to “materially mislead” the districts regarding the safety of the synthetic CDOs. “They represented that 30 of the 105 companies in the portfolio would have to go bankrupt, and that 100 of the top 800 companies in the world would have to go under,” according to the complaint. In fact it took much fewer defaults (around six depending on the size) to register a loss.

In December 2010 the SEC announced that following the Dodd-Frank Act it would be requiring all municipal advisers to register with the Commission. These reforms, along with those proposed by the Municipal Rulemaking Board, should at the very least increase the amount of disclosure required by both sides of muni deals.

However, it remains to be seen whether they do enough to overcome the asymmetry of information and expertise between many munis and their advisers. And with more direct lending to munis than ever before, it’s two steps forward and one step back on the transparency front, too.

There needs to be a way of stopping nonsense like this allegation of “advice” from Noack at a school board meeting in 2006:

“And it gives added comfort that, you know, it takes 15 defaults for us to start losing money and we have somebody watching over every company, every day, for seven years, and if it starts to look like it’s going that way, they get out of it. The only way – the real – you need 15 Enrons. You need something to happen that big overnight.”

Related links:
The municipal middle man misses out again – FT Alphaville