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CPS did lose money in derivatives deal with Lehman Brothers... Did CPS officials lie to public about risky investment losses?

Top officials of the Chicago Board of Education, including the Board's treasurer and the Board's budget director, either misled or deliberately lied to the public on August 18, when they denied that Chicago's public schools had lost in excess of one million dollars because of risky derivatives trading through the now bankrupt Lehman Brothers in the years since 2007.

Chicago Board of Education treasurer David Bryant (above at microphone) told the August 18, 2009, hearing at Marshall High School that the Board had not suffered losses because of risky derivatives trading through the now-bankrupt Lehman Brothers bank. Bryant's appearance at the second day of the hearing was the result of questions raised by Whitney Young High School teacher Jay Rehak (standing above with hands on chin) at the August 17 budget hearing at Amundsen High School the previous day. Based on a footnote in the Board's "Comprehensive Annual Financial Report" (CAFR) for fiscal 2008 (the 2007-2008 school year), Rehak had asked how much money was lost dues to investments in derivatives through Lehman brothers in the years prior to now. CPS budget director Christine Herzog said that she would get an answer to Rehak's question, and the following day Bryant spoke at the second of the three budget hearings. Substance photo by George N. Schmidt.After being asked about the Board's dealings with Lehman Brothers during the recent hearings on the Board's proposed 2009 - 2010 budget, CPS officials tried to deny that the Board had suffered losses because of risky derivatives trading through the now bankrupt investment bank, Lehman Brothers, beginning some time in the middle years of this decade. Although the proposed budget noted a serious drop in what the Board calls "investment income", CPS said the drop was due to general market forces and not because of risky investments.

Less than two weeks after a Chicago teacher charged that the Chicago Board of Education had lost millions of dollars in derivatives deals with the now bankrupt Lehman Brothers investment bank, a CPS filing in bankruptcy court reveals that at least some of the charges were true.

CPS quietly enters the Lehman bankruptcy litigation

Above, the first page of the 15-page motion filed by the Chicago Board of Education on August 27 in the U.S. Bankruptcy Court (Southern District New York) handling the Lehman bankruptcy. The complaint filed by CPS by the Board's outside attorneys reveals more about CPS involvement in derivatives beginning in 2003 than was ever put on the public record by the Chicago Board of Education. Although complex financial matters have been regularly discussed by the Board in its executive sessions, since July 1, 1995, the Board of Education has kept secret all of the minutes from their closed sessions, in violation of the Open Meetings Act and the Freedom of Information Act, so that the public has had no information regarding some of the most expensive and complex financial decisions made by the third largest school system in the USA. Substance caption and photo by George N. Schmidt.On August 27, 2009, attorneys for the Chicago Board of Education filed a 15-page brief in U.S. Bankruptcy Court in New York, asking that the Board be freed from $1.2 million that it owes Lehman Brothers as a result of the risky deals the Board entered into in 2007. Lehman is claiming that CPS owes that money because of the nature of the contracts the two parties had in the years before the Lehman bankruptcy shook the financial world and became one of the precipitating causes of the world-wide recession.

Yet as late as August 18, 2009, CPS officials categorically denied that they had lost any money in derivatives trading, either with Lehman or any other entity.

Chicago Board of Education financial officials tried to refute the charges made by Jay Rehak, a Whitney Young High School teacher and candidate for trustee of the Chicago Teachers Pension Fund, at the August 17, 2009 hearings at Amundsen High School on the Board of Education's $6.8 billion proposed budget. [See below on this Home Page: "Budget hearing: Teacher demands to know how much CPS lost in speculative investments in derivatives between early 2008 and today..." reporting on the Amundsen High School hearing and particularly the question raised by Jay Rehak. Substance was the only news organization to cover all three days of the budget hearings from August 17 to August 19].

Holding a copy of the Chicago Board of Education's Comprehensive Annual Financial Report (CAFR) for Fiscal 2008, Whitney Young High School teacher Jay Rehak (above) reads a lengthy question for CPS budget officials at the first of three budget hearings. The hearing was held at Amundsen High School on Monday, August 17, 2009. Rehak was referring to a footnote in the CAFR that noted CPS losses in derivative investments and asked how great the losses were. CPS officials told him they would get back to him with their answers. Substance photo by George N. Schmidt.The day after Rehak raised the issue, citing a footnote in the CPS "Comprehensive Annual Financial Report" for Fiscal 2008 (the 2007-2008 school year), CPS sent its treasurer to the second of three hearings on the proposed budget. The treasurer told the hearing on August 18, 2009, that CPS did not lose any money through derivatives investments through Lehman Brothers, which went bankrupt nearly one year ago, leading to much of the financial collapse of the global economy.

Rehak's actual question is worth quoting in full at this point, for those who don't want to read down to the previous article at SubstanceNews:

CPS Budget Director Christina Herzog (above right) presided over the three nights of hearings on the Proposed Budget 2009 - 2010 for the Chicago Board of Education. She is shown above responding to the questions raised by Jay Rehak about the drop in CPS investment revenues from last year to the new budget year. Substance photo by George N. Schmidt."Prior to reading the proposed CPS budget for the 2010 fiscal year," Rehak began, "I read through the last comprehensive Annual Financial Report (CAFR). That report is available to the public, although it doesn't come out until about six months after the end of each fiscal year. So the most recent one was released in December 2008 or January 2009, but only covers the period through June 30, 2008. The audited Comprehensive Annual Financial Report of the Chicago Public Schools for FY 2008 noted that as of June 30th, 2008, CPS had $95 million invested in derivatives through Lehman Brothers..."

Rehak tried to get the Chicago Board of Education's budget officials to be precise at the hearing, but learned, as did others, that almost all questions were answered with a phrase remininscent of Arne Duncan's "We'll get back to you on that..." During the seven years he was Chief Executive Officer of CPS, Duncan gave that answer whenever he wanted to avoid giving a specific answer to a question and seemed worried he'd be caught in a lie in public. The experience at Substance was that Duncan would never give an answer once he had promised "I'll get back to you on that..."

Rehak was very precise in his question and in stating his worry on August 17.

"According to the most recent CAFR," Rehak continued, "CPS also had $90 million in derivatives invested through Goldman Sachs, $100 million invested in derivatives through Bank of America, and $162 million invested in derivates through Royal Bank of Canada. In total, CPS, as of June 30, 2008, through those four entities, had $457 million invested in highly speculative derivatives. Well, we all know what happened to Lehman Brothers a couple of months later, although it’s unclear what happened to all our money. Anyway, I note that as of June 30th, 2008 the CPS Comprehensive Annual Financial Report stated that aggregate $457 million invested in derivatives had lost $63 million of their value. But that still leaves $397 million in highly speculative derivatives unaccounted for. I mention this now because on .pdf page 49 of the 'Proposed Budget for 2009 - 2010' (the budget we're discussing here tonight), CPS notes a large decline in investment earnings..."

In his remarks, Rehak was referring to the admission in the CPS financial statements that income from CPS investments had dropped greatly between the beginning of the 2009 fiscal year on July 1, 2008 and the end of the fiscal year on June 30, 2009. In all previous years, CPS investment income had been considerable. The reason for this is that CPS invests money it received from tax collections in August and March during the period between when CPS gets the money and CPS has to spent the money. In addition, CPS also has generated reserves during the previous five years which never dropped below $400 million, despite annual claims that CPS was facing a 'deficit.'

Treasurer come to Marshall

According to an article posted on line at The Wall Street Journal, at 5:00 p.m. on August 28, however, it turns out that CPS did lose money with Lehman Brothers.

"It’s back-to-school time, and Lehman Brothers Holdings Inc. is celebrating by seeking to force the Chicago Board of Education to pay it about $1.2 million under a soured derivatives deal," the Wall Street's Journal Patrick Fitzgerald repoted on August 28, 2009. "The Chicago school board isn’t too happy about that. It says Lehman defaulted on the derivatives deal — an interest rate swap tied to variable rate bonds issued by the board — when it filed for bankruptcy protection in September 2008. Lehman hasn’t made any payments to the board since the bankruptcy filing but is demanding the board pay up. And that has the board steamed..."

While CPS officials tried to talk around the question of how much CPS had invested in risky investments and the nature of those investments, some of the information is now coming out in the Lehman bankruptcy. The public information, however, is not coming out because of any attempt at transparency by members of the Chicago Board of Education or CPS financial officials.

Slowly the story comes out

Only Substance covered the three days of hearings on the Board's proposed 2009-2010 budget, and one of the many questions at those hearings concerned the Board's dealings with Lehman brothers beginning in 2006 or 2007. CPS denied losing money via deals with Lehman, while preparing litigation to stop the loss of money from its Lehman Brothers deals. CPS budget director Christine Herzog told Substance that she would provide Substance with the complete stenographic transcript of the three days of budget hearings. Substance reporters emphasized that the transcripts were necessary because of the complexity of some of the questions that were being raised and the fact that the answers to most of those questions were answered with a "We'll get back to you on that."

The transcript of the budget hearings were supposed to be available by the time of the Board of Education meeting on August 26, 2009, but as of August 30, 2009, CPS had not provided the transcripts to Substance, and it appeared to Substance that the transcripts were not available to members of the Board of Education at the time they voted, unanimously and without debate, to approve the same confused budget that he been the subject of the three days of budget hearings.

“'Their failure to perform excuses our failure to perform,” said Jeff J. Friedman, a partner at Katten Muchin Rosenman LLP who represents the school board,' according to the Journal report.

"Under the deal, the board made semiannual payments to Lehman at fixed rate while the bank maid monthly variable rate payments to the school board," the Journal reported, "allowing the board to hedge its exposure to interest rate fluctuations and to control its borrowing costs. Lehman wants the school board to pay it the so-called cure costs so it can transfer the contract to a third party."

"The school board is asking the bankruptcy judge overseeing Lehman’s case for a ruling declaring that it owes Lehman nothing. It also wants Judge James Peck of the U.S. Bankruptcy Court in Manhattan to block Lehman from transferring the swap agreement," the Journal concluded.

The latest court filing

The 15-page brief filed in U.S. Bankruptcy Court (Southern District, New York) on behalf of CPS basically argues that CPS doesn't owe the Lehman creditors the money it would have owed Lehman under the CPS derivatives investments. According to the court record, CPS began investing in derivatives and issuing various contracts involving its bonds in 2003. According to paragraph 24 of the CPS brief, "The parties performed their respective obligations under the Swap Agreement from December 3, 2003, when the agreement was entered, up to and including September 1, 2008. On September 1, 2008, the School Board made its semiannual payment due to LBSF [Lehman Brothers] of approximately $1,656,061.68." {Why this is called an "approximation" is not indicated in the filing].

Although knowledge of the problems at Lehman Brothers was common among Wall Street insiders more than a year before the company finally collapsed in the largest bankruptcy in world history, CPS continued to deal with Lehman Brothers until the end. The end came on September 14 and September 15, 2008, when Lehman Brothers directors voted to file for Chapter 11 bankruptcy (the directors voted on September 14; the filing was on September 15). Although Lehman Brothers went into bankruptcy with more than a trillion dollars in debt because of a series of risky investments, the most notorious of which were in so-called "derivatives," Lehman also had world wide properties, including real estate that it had borrowed to acquire around the world during the time the executives of Lehman (led by CEO Richard Fuld) tried to bring Lehman into the biggest of the Wall Street "Big Leagues" in competition with investment banks like Goldman Sachs and Bank of America.

The Lehman Chapter 11 filling immediately wiped out the corporation's common stock owners, but the complex legalities involving other investors are now playing out in bankruptcy court as secured creditors try to identify and recover as much money as they can on their investments. The question of whether the Chicago Board of Education owes money under one of its contracts is the subject of the recent court filing. IF CPS owes that money, then that money has to be paid and it becomes part of the money available for settling with secured creditors.

How much else did CPS have in risky investment?

The question raised by Jay Rehak on the first day of the budget hearings did not simply ask about Lehman Brothers, but about the major banks whose investment policies had created their own financial problems (requiring the massive federal bailouts under TARP), and also the total losses.

One of the many things ignored by the members of the Chicago Board of Education at the time the Board voted on August 26, 2009, to approve the "Proposed Budget for the School Year 2009 - 2010" was the loss CPS took during the previous year in investments. Despite the widespread belief that "all" investments lost money during the tumultuous past 12 months, the fact is that many did not. As was noted in the financial reporting at the time, those who speculated in stocks and real estate (the most notorious example being Lehman Brothers and AIG) lost enormously when the real estate bubble burst.

Other investments, however, did not suffer as much, and those who chose to maintain cash were at least whole when the tumult began to subside. Clearly, the theory that high risk was always a good thing was proven wrong, again. Public officials are not Hedge Fund managers. They are supposed to be especially prudent in their investments. Depending upon the prudence of the investors, some even made money during the 12 months following the Lehman bankruptcy and today. For example, the stocks of most media companies have lost during the previous 12 months. But one company (MEG, Media General) has gone up more than 100 percent since October 2008. Similarly, stock holders in General Motors and Chrysler have been wiped out. But someone who purchased stock in Ford in October 2008 has doubled his money since then.

CPS was under no obligation during the years that Arne Duncan served as CEO to engage in the riskiest of investments — derivatives.

As of the beginning of the 2009 - 2010 school year, however, the recent filings in bankruptcy court in New York only highlight how much risk CPS was taking during the years of the real estate bubble — and how completely lacking in transparency, candor, and basic honesty have been the members of the Chicago Board of Education and their financial officials.

Never underestimate the power of the footnote

While some observers who heard of Jay Rehak's question from August 17 asked why Rehak was making such a big deal about a footnote, experienced financial people knew precisely why. While "full disclosure" and so-called "transparency" are supposedly the order of the day (as well as the law) in complex public financial matters, in the real world the opposite is usually the case, especially when mismanagement or worse (outright fraud) are involved.

Most of the disclosure of problems at corporations like Enron came in the form of brief references, often in footnotes, to the problems. The same became true as Lehman Brothers continued its practices of riskier and riskier investments during the three years prior to the bankruptcy filing. Because publicly traded corporations are required to file a great deal of paperwork with the Securities and Exchange Commission (SEC), they often comply with the letter of the law by relegating the most important matters to footnotes.

In its August 31, 2009, edition, Barron's contains a lengthy article headlined "Watch their language... Some terms in SEC filings can be red flags. We've compiled a list that can help steer investors away from companies where something may be amiss..."

The article lists four phrases that can be searched on line in the lengthy SEC 10K reports that are indicators that further research is necessary. All are obfuscations — from the tautology "unbilled receivables" to the Orwellian "Change in revenue recognition" — are can be utilized in current search engines.

The Barron's story notes that a truly independent board is necessary for a healthy corporation, and that transparency, honesty and candor will pay over time.

The 2009 - 2010 budget passed by the vote of six members of the Chicago Board of Education on August 26, 2009, could be a public sector example of what Barron's is talking about. From a board subservient to Mayor Richard M. Daley to a deliberate policy of keeping the preliminary budget from the public (as reported earlier this month at substancenews.net), the Chciago Board of Education is breaking just about every rule of candor that would be prudent to be followed in the private sector. 



Comments:

August 30, 2009 at 7:19 AM

By: Susan Ohanian

citizen

As I read this excellent coverage, I can't help but think of parallels to the risks CPS takes with students--and then lies about the disastrous results there, too.

August 30, 2009 at 12:02 PM

By: Kugler

Pattern Of Corruption

There is an now becoming an overt pattern of corruption and deceit by public officials (Board employees and members) there needs to be an investigation of the all dealings of the board as it relates to public funds and resources being transferred to private hands.

In just the past few days at least three instances where the Board, on the record made deceptive statements to the public (Dela Cruz, CAO appointments, Investment Losses).

I my view, a government official in their official capacity, making false and misleading statements that involve public funds and resources is a crime, in addition to harm they are causing to the minors in their charge.

August 31, 2009 at 9:44 PM

By: kyle

teacher

If CPS actually held or was trading derivatives there are a couple of good reasons why board members and the treasury department would want to keep that information secret.

That being that derivatives are specifically named and excluded as an investment option by the CPS investment policy. Such investments also seem to be prohibited by Illinois law that governs how public funds are managed and invested.

While I am sure there are loop holes, the spirit of the law and the CPS policy which interprets that law as it pertains to CPS, is most certainly intended to prohibit any investment that may put principle at risk.

In addition to derivatives any CPS investment that lost money likely violates the law and CPS policy.

It is not the purpose of any government agency to put public funds at risk. It would be akin to the US Government saying OOPS...Leahman brothers just lost your social security in the derivative market.

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