

In 2007, the school raised $1B, and instead of issuing bonds, it let the bankers who'd been courting it talk it into issuing a floating-rate bond that it swapped into a fixed-rate issue.

It was the largest auction-rate security issued by any Illinois school board — it was a larger issue than the state of California's. And it lost them $100 million.

Few Illinois government entities took advantage of the new, um, flexibility, but the Chicago Public Schools did in a big way, issuing $1 billion of auction rate securities by 2007 and swapping them into fixed rates. That amount of auction-rate securities issuance was not only more than any other school district in Illinois issued, it was more than was sold by the state of California. Crisis followers no doubt recall that the auction-rate securities market promised investors that the instruments were almost as liquid as money-market funds, and they could get cash back in weekly auction. The reality was that there was not enough investor buying at auctions. Dealers were supporting the auctions and carrying more and more inventory. When the monoline insurers were facing downgrades, which would have left the investment banks with losses (most issues were guaranteed by monolines), dealers dumped their inventories and quit supporting the market. The deals had clauses so that if the investor was unable to get his money back at a weekly auction, the issuer, here meaning Chicago Public Schools, would have to pay a much higher interest rate.

And that's before you get to the swap losses.

The story shows a not-surprising backstory: bankers were actively soliciting the Chicago Public Schools with proposals involving auction-rate securities, the hot product of the day. CPS hired a politically connected former banker to evaluate the deals. Any regular reader of this site no doubt has figured out that it takes a high level of expertise to evaluate derivatives, and that's well beyond the skill level of most "bankers". The open question here. Even so, in this case the analysis was so slipshod that it raises the question of whether the advisor ever intended to do anything more than provide a paper trial supporting going ahead with the deal.