7 Towns, Burned by the Financial Crisis, Sue Citigroup Over Investment Losses

VIK, Norway -- The 2,800 residents of this pristine village isolated on a narrow finger of the gleaming Sognefjord are embarrassed, angry, and eager to get their money back. So are the townspeople of Bremanger, Hattfjelldal and Hemnes, not to mention those of Kvinesdal, Narvik and Rana.

The seven small communities, lodged deep in a timeless Norwegian landscape of fiords and snow-clad mountains, somehow got caught up in the go-go markets of big, distant cities such as London and New York. At the time, it seemed like an easy way for the towns to get rich. But when the global financial crisis struck, they ended up getting burned by big-time investments beyond their ability to manage or even understand.

Along with what remains of their bankrupt brokerage firm in Oslo, the faraway Norwegian capital, the seven towns brought suit in New York on Aug. 10 against Citigroup, demanding $200 million in reparations from the U.S. banking giant. High-rolling Citigroup salesmen, they charged, lured unsophisticated Norwegian town councils into an investment scheme so complicated that nobody could fathom it and so risky that, when worldwide markets went wobbly, the little towns lost millions as suddenly as a salmon leaps from the fiord's chilly waters to gobble down a fly.

The improbable voyage of Citigroup's arcane investment model -- from frantic trading rooms in New York and London to tranquil waterside villages such as Vik, where townspeople see no need to lock their doors -- suggests some of the reasons the international financial system exploded almost a year ago: the unchallenged spread of greed, recklessness and, above all, faith that churning around those millions would somehow bring endless profits for all.

"The small communities who went to the market all hoped to get rich," a chastened member of Vik's city council, Morten Oystein Holmberg, said in an interview at his home overlooking the gentle rapids of the Vikja River bubbling toward the Sognefjord. "As politicians, now we know we are not entitled to gamble with citizens' money. That's my conclusion."

The collapse of the seven towns' investments, which had become chillingly clear by May 2008 and was irreversible by the time the crisis rippled around the world last fall, left a lot of debris in its wake.

Terra, the Norwegian securities firm that was the go-between with Citigroup, was forced into bankruptcy. Its residual interests are being represented by a prominent Oslo lawyer, Jon Skjorshammer, whose Selmer & Co. law firm brought the suit against Citigroup in U.S. District Court for the Southern District of New York.

"The only ones who made money from these investments were the issuer and the broker," Skjorshammer said in his sleek offices overlooking an Oslo boat slip. "And now the lawyers," he added, chuckling softly.

A London-based Citigroup spokesman, Adam Castellani, said the bank rejects any responsibility for the towns' losses because, in its portrayal to Terra, the risks were clearly pointed out. "As Citi has maintained throughout, we are confident that the risks of investing in the notes were described in the materials provided to Terra Securities," Castellani said in a statement. "We intend to vigorously defend our position."

Local governments around the world lost big money on complex investments. Alabama's largest county is verging on insolvency after paying tens of millions of dollars to J.P. Morgan Chase and other banks for what amounted to losing bets on interest rates. More than 20 Massachusetts cities and towns bought long-term bonds described as ultra-safe from the Swiss bank UBS and then watched the values drop.

In the little Norwegian towns, mayors and council members are struggling to make up the losses. The national government had to change the law to give them more time to balance their budgets. One of the biggest losses was to their reputations. National newspapers portrayed them as country bumpkins who got rolled by slicks from the big city.

But there were more practical losses as well. Streetlights were turned off during the dark Arctic night in far-northern Narvik. Town halls in several communities lowered the temperature to cut back on heating bills during the frigid Norwegian winter. Here in Vik, the budget was scaled back so much that some of the elderly were sleeping in hallways at the local retirement home and there was no money to put water in the town swimming pool.

Kurt Arne, in the town economic bureau, said 10 city employees were let go to shave the municipal payroll. "In every service, we've had to look for cuts," he lamented.

Carl Andre Riiber, who owns and manages the Hopstock Hotel here, said he was particularly incensed by the need to enact a special property tax to make up the market losses. The hike will cost him nearly $10,000 this year, he said, and nobody knows when, or whether, it will be repealed.

"If it had been losses in an ordinary investment, maybe we could understand it," he said. "But this was no ordinary investment." The lesson for city councilmen, he added, should be: "There is no such thing as a free lunch."

In some ways, the little Norwegian towns already had been given a free lunch. All seven had hydroelectric plants, taking advantage of the many streams flowing into fiords. As a result, their finances were unusually healthy.

But then, from Oslo, came the siren call of even bigger money to be made by investing in international financial markets. The message was carried by representatives of Terra Securities, an investment firm owned partially by Terra Group, a union of 78 Norwegian savings banks.

As unlikely as it may seem, Vik and its sister towns proved receptive, and they had money to invest. As far back as 2001, they had found a loophole in Norway's cautious municipal finances law that allowed them to pull in a large amount of cash without waiting for annual electricity revenue to flow.

Since electricity prices tended to be volatile, the towns sold future supplies -- in effect millions of dollars borrowed on revenue anticipated from electricity sales over the coming decade. With that money, they made a first round of investments through Terra in 2005.

These investments, some of them funds based on bundled subprime mortgage loans, turned out to be losers, although not on a huge scale. Then, in the spring of 2007, according to Selmer lawyers and town officials, Terra representatives came up with a proposal to turn things around, a novel financial note linked to a "tender option bond." This, they said, was portrayed as a low-risk investment, tied to municipal bonds but cleverly insulated by several layers of funds to hedge against further losses.

In fact, as events showed before the end of the year, the risks were high -- far higher than people in Vik or its sister towns understood. It was unclear whether those risks were ever communicated. Some town council members suggested that Terra Securities, in translating the Citigroup material into Norwegian, may have left out the parts that raised doubts. But Holmberg said the decisions were not made on the basis of careful analysis of the fine print.

The fact is, he explained, Vik and the other towns had been working with Terra representatives for several years and felt inclined to accept their advice. It was like buying a Volvo: You don't inspect the new car carefully; you rely on Volvo's reputation.

"This is a kind of paradise," he said, gesturing at the view from his deck, waterfalls plunging in thin white ribbons from surrounding mountains. "I won't call it naive. Maybe it's trust. Yes, it's trust."

Holmberg described one meeting, held in the local church, at which Terra representatives pitched the new investment. He raised his hand, he recalled, to ask how such a note could be counted on to unfailingly go up when financial markets have always gone down as well as up.

"The Terra representative looked at me and said, 'You must not believe in our financial system,' " Holmberg recalled. Skjorshammer said, however, that the Terra brokers probably did not understand the scheme themselves. Citigroup's oral and written descriptions inadequately portrayed the risk, he charged, and used a faulty mathematical demonstration to prove how one fund would hedge against losses by the other. Moreover, he said, the way the instrument was constructed called on the Norwegian towns to provide additional funds if Citigroup's tactics lost money, in effect insuring Citigroup against losses of its own.

To a gray-haired bus driver who pulled out of Vik the other day on a trip to the ferry slip, the village had no business getting involved with fancy investments so far from home.

"They thought they were going to make a lot of money, but they didn't," he said of the occupants of city hall just across from the bus stop. "It was wrong. It was too much for a little place like this."

© 2009 The Washington Post Company

http://www.washingtonpost.com/wp-dyn/content/article/2009/08/24/AR2009082403165_pf.html