Cover Story November 18, 2009, 8:10PM EST

Wall Street Plays Hardball

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Detroit's public transportation system is also feeling the pinch. Because of budget restraints, bus routes have been canceled and equipment hasn't been fixed. On a cold day in early November, a group of students stood shivering as they awaited the No. 30 bus. The bus comes only once an hour now, compared with every 45 minutes a year ago. Longtime driver Linda Martin, whose bus broke down five times in the past year, helped organize a demonstration in August. Months later, the 56-year-old grandmother of eight was among 113 transportation workers laid off. "These are hardworking people, juggling three jobs sometimes," she says. "If they lose their income, there's a ripple effect throughout the whole community."

Of course, many of the municipal-finance investments blowing up now were fairly standard contracts that clearly spelled out the pitfalls. "Municipalities knew the risks," says James S. Normile, a New York partner at law firm Winston Strawn. "They just didn't think they were going to happen."

But some public entities, lacking the financial expertise, proved to be willing buyers for Wall Street's more dubious ideas. Consider the plight of Hoosier Energy Rural Electric Cooperative. In 2002 a group of attorneys and investment bankers presented the tiny nonprofit utility, indirectly owned by its 800,000 mostly rural customers, with a quick way to earn some money. Hoosier Energy leased a power plant near the Wabash River in Sullivan County, Ind., to John Hancock Financial Services. Hancock then turned around and leased it back. As a result, the utility netted $20 million while Hancock planned to reap tax benefits on the facility. The bankers and lawyers, meanwhile, made $12 million. The transaction was part of a broader trend: Over the past decade dozens of utilities, transportation agencies, and other public nonprofit entities struck so-called leaseback deals to collect cash on their assets.

Around the same time the Hoosier agreement was finalized, the IRS began cracking down on leaseback deals. The federal agency in a memorandum called them a "sham" that lacked any business purpose beyond tax evasion and amounted to a circular exchange of assets and cash. Legally speaking, a transaction that merely reaps tax rewards and has no other economic purpose is often considered an abusive tax shelter. Although the IRS hasn't ruled on Hancock's tax breaks, U.S. District Court Judge David F. Hamilton concluded in an opinion last fall that they looked "abusive." Hancock says it believes it's entitled to the tax benefits.

Vulnerable Public Transportation

Now Hancock is exploiting a technicality in the 3,000-page pact with Hoosier that could allow the financial firm to wiggle out of the contract and collect a fat fee. Even though Hoosier has continued to make all of its payments, it fell into technical default after Ambac Financial Group (ABK), which backed the transaction, suffered a credit-rating downgrade. Having not found a suitable replacement, Hoosier faces a $120 million penalty, a sum that could exhaust its cash and credit lines. "It's a huge challenge for us," says Donna L. Snyder, Hoosier's vice-president for finance. "We're a small not-for-profit."

Hoosier may have to pay up soon. In September the Seventh Circuit Court of Appeals ruled the utility had to find a new guarantor this year or pay Hancock the money. If the latter happens, residents could face higher electricity rates. Already, Hoosier has hiked rates 3% because of the uncertainty of the deal. In the meantime the utility is conserving cash by postponing environmental upgrades to its coal plants and putting off payments to other power companies in the co-op. Says Jonathan Chiel, John Hancock's general counsel: "We've acted reasonably, and we believe no party to the transaction should seek to gain an unfair advantage."

Public transportation systems around the nation could be vulnerable to leaseback blowups. Moody's Investors Service (MCO) estimates that 25 big municipal transportation authorities entered into deals similar to Hoosier's. The fallout could be more than just financial. In recent years the Washington Metropolitan Area Transit Authority tied up a third of its subway fleet—almost 300 cars, some 30 years old—in a series of pacts with investors, some of which required keeping the same equipment running until 2014. To avoid violating the terms, the transit authority rejected a 2006 recommendation by the National Transportation Safety Board (NTSB) to replace or retrofit older cars. The NTSB warned at the time that in the event of a crash the old cars posed a higher risk of injury to passengers than newer models. One of the old cars was involved in a wreck in June that killed nine people. A spokeswoman for the transit authority said it lacks the funds to replace the cars.

Even public institutions that entered into relatively common investments are getting hurt. Many chased risky deals only in the later years of the credit boom and now are paying hefty fees on those underwater assets.

In 2006 the Teacher Retirement System of Texas hired T. Britton Harris IV to overhaul the $100 billion pension fund. The portfolio, one of the 20 largest pension funds, was still recovering from the dot-com bust earlier in the decade. Harris, a veteran of investment firm Bridgewater Associates and the Verizon Communications (VZ) employee pension plan, told board members: "My approach has never been incrementalist."

True to his word, Harris revamped the pension fund. For years, Texas Teachers had focused on stocks and bonds, relying on in-house managers to invest the money. The new investment officer proposed a huge shift into risky investments that promised better returns, including private equity and real estate. In April 2008—right after the fall of Bear Stearns—Wall Street chiefs flocked to Austin to seal their investment deals with the pension fund. Harris even hosted a dinner at a local steakhouse for Morgan Stanley's (MS) John Mack, Lehman Brothers' Richard Fuld, and Laurence Fink of BlackRock (BLK). "Being novices, there's a certain level of trust with decision-makers," says Tim Lee, executive director of the Texas Retired Teachers Assn. The pension fund's target stake in alternatives swelled to 29%, from 8%.

Then the crash came. Texas Teachers recently reported that its new private equity and real estate investments had dropped by 15% and 33%, respectively, in the first nine months of the year. Among the clunkers: Colony Capital VIII, a fund that invested in the buyout of Station Casinos, a Las Vegas casino operator that later went belly-up, and Neverland Ranch, the estate of the late Michael Jackson. It likely will take a while for the portfolio of alternative investments to recover.

Wall Street, though, will keep collecting its share. Private equity firms and hedge funds typically charge a hefty 1% to 2% fee on the total pool of assets under management even if their strategy loses money. On Texas Teachers' $13.5 billion portfolio, that amount to tens of millions a year. The fund says it remains committed to alternative investments. "We are long-term and very liquid," says Harris. "This should be a time when the investments we make should prove rewarding."

Many of the million-plus educators who rely on the pension fund for their retirement benefits are worried about their financial fate. The fund's obligations exceeded its assets by $22 billion this year. To make up the difference, the fund's board asked Texas legislators this summer to increase contributions both from taxpayers and active teachers, but lawmakers rejected the proposal. That means retired teachers, who haven't seen a cost-of-living increase since 2001, aren't likely to get a bump anytime soon. Says Bill Barnes, a retired school principal from Fort Worth: "The whole question is: Where's the money going to come from?"

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Muni Mayhem

In its ongoing coverage of the crisis in Jefferson County, Ala., Bloomberg reported on Nov. 13 that the municipality sued JPMorgan Chase (JPM) and a former city official. The county alleges that the bank and ex-official refinanced $3 billion of debt to generate fees and interest payments: "This is a suit…against those who have brought the county and its citizens to the brink of financial disaster while lining their own pockets."JPMorgan says the claims are "meritless."

To read the full article go to http://bx.businessweek.com/municipal-bonds--/reference/.

Francis is a correspondent in BusinessWeek's Washington bureau. Levisohn is a staff editor at BusinessWeek covering finance and personal finance. Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau. Follow him on Twitter @chrispalmeri . Silver-Greenberg is a reporter for BusinessWeek.com.