The American banker couldn't even pronounce the name of his German client when he appeared for the interview on the morning of Sept. 20, 2012: Kommunale Wasserwerke Leipzig, quite a tongue twister for a Wall Street man. But it wouldn't make much difference, he reasoned, because hardly anyone in America was likely to have heard of it before.

By the afternoon of the next day, after undergoing 12 hours of questioning by the American financial regulatory agency, the Securities and Exchange Commission (SEC), John Simon* knew he was mistaken. SEC enforcement division lawyer Andrew H. Feller was in fact very well informed, after having read through emails and call logs, and he knew whom Simon had met in New York, London and South Africa. The SEC attorney could even pronounce the name of the city of Leipzig's water utility relatively well.

Feller had spent two years investigating the methods Simon had used to develop risky deals involving water treatment plants in the eastern German state of Saxony for UBS, a major Swiss bank. In the end, Leipzig faced potential losses of €300 million ($400 million), joining the ranks of many German municipalities that had lost vast sums of money in complex Wall Street deals.

There had already been a number of court cases to examine the ways in which local politicians in Germany had been led astray in global financial markets. The SEC investigation now outlined a more comprehensive picture and shed light on the dubious role played by the banks. When the SEC in Washington concludes its investigation, known by its file No. 11728, it will likely lead to a reassessment of the actions of German cities before and during the financial crisis.

Were City Managers Duped?

Until now, it was widely felt that local politicians and the managers of their municipal operations often had only themselves to blame. With a mixture of naïveté and greed, they had bought financial products of which they understood neither the names nor the risks they were taking by making those investments.

It is now emerging that international bankers developed aggressive strategies to dispose of toxic securities by selling them to German municipalities. It appears the banks deliberately targeted inexperienced provincial managers and sold them bad deals from which only the banks could profit.

Internal bank documents and court records show that shortly before the financial crisis began, UBS apparently sold securities to the city of Leipzig for which the risks were almost impossible to calculate, earning a sizeable profit in the process. "The supposed transaction only served the purposes of banks and criminal racketeers and is null and void, as far as we are concerned," says current Leipzig Mayor Burkhard Jung, a member of the center-left Social Democratic Party (SPD).

It was too late by the time city managers realized that in order to insure their sewage treatment plants, they were to be liable for the mortgage-backed securities of American banks.

Much is at stake. If the SEC can prove that the bankers acted fraudulently, other investment banks could also face consequences resulting from past deals. In Berlin, J.P. Morgan is claiming €155 million from a similar deal with the city's public transport authority. In the case of the Leipzig water utility, UBS will likely be slapped with substantial fines. Leipzig, on the other hand, will probably not be ordered to pay the €300 million the Swiss bank has sought to recover in a lawsuit filed against the city.

A City Discovers Turbo-Capitalism

The story began in the late 1990s, when local politicians and the managers of municipal operations discovered turbo-capitalism, along with its seemingly endless possibilities for increasing wealth. Cross-border leasing was the magic word.

In the transactions, cities sold their infrastructure to US financial investors, who then leased the facilities back to the municipal governments. It was purely an accounting transaction that promised to benefit everyone involved, or at least it seemed that way. The investors benefited by reducing their US tax liability, and they passed on a portion of these savings to the municipalities in the form of "cash value benefits."

Leipzig was a particularly avid participant in the game. First city officials sold off the convention center, followed by the city's streetcars. Sewage networks and sewage treatment plants were also targeted for sale to American investors.

Moving More than Water

Klaus Heininger was especially fascinated by this business model. The head of Kommunale Wasserwerke Leipzig (KWL) had moved to Leipzig from Bavaria. Self-confident, risk-taking managers like Heininger were in great demand there at the time. But soon Heininger realized that the classic business of managing the city's water supply was no longer sufficiently attractive. "We move more than water," was his motto.

Starting in 2000, he began moving hundreds of millions of euros back and forth. Banks, trusts and offshore companies around the world became involved in the business of selling and leasing back Leipzig's sewage networks and wastewater treatment plants. The deal went through and initially provided Leipzig with €22 million in revenues.

Meanwhile in New York, financial managers were developing new ideas to keep the lucrative business with European municipalities going. Simon was one of the hundreds of determined men and women rushing around Wall Street with oversized cardboard cups of coffee in their hands. It was before the crash, when everything seemed possible and even the most absurd-seeming financial products promised to develop into enormous deals. A former business partner referred to Simon as "a cool guy who can sniff out a good deal right away," someone who meant $30 million when he said 30 bucks.

Simon had gone to law school in the early 1990s. Later, working for the investment bank Credit Suisse First Boston, he set up cross-border leasing arrangements with European cities for US investors. He moved to UBS in 2002, where he also worked with municipalities.

But the golden days of cross-border leasing were over. The US government had closed the tax loophole in 2004, thereby obstructing new deals with European cities.

A Bank Unloads Its Risks

Simon and his department developed a new business model, code-named "Matilda." The investment bankers set their sights on existing deals with European customers in order to sell them new financial products: special credit derivatives to supposedly hedge the old lease agreements.

For UBS, this type of transaction had several benefits. For one thing, it provided the bank with substantial commissions and fees. Besides, it enabled UBS to use the products to unload its own risks onto the municipalities.

All Simon needed now were customers onto whom he could palm off a high-risk product that was in fact more of a time bomb than an insurance policy. The UBS manager knew who could help him: two German investment bankers with whom he had set up cross-border leasing arrangements at Credit Suisse First Boston in the past. They had since established a small, discreet company in Switzerland called Value Partners.

On April 10, 2006, Simon wrote his first email about the Matilda project to Value Partners. He wrote that UBS wanted to offer special credit derivatives known as Collateralized Debt Obligations (CDO) within the context of cross-border leasing. The CDOs could serve as an insurance policy if there were problems with the municipal facilities that had been sold and leased back.

The best part of it was that the offer would initially cost the customers nothing and in fact provide them with profits -- as long as they hedged the bank's risks in return.

It didn't take the two Germans long to identify a potential client. In an April 19 email, they wrote to KWL's Heininger, with whom they were familiar from earlier leasing deals. There were ways to "optimize" the existing lease agreements, they explained.

Internal UBS Fears of 'Risk to Our Reputation'

Soon afterwards, Value Partners was able to report positive signals from Leipzig: "Our client is very much money minded -- so please make sure your colleagues are pricing very competitive and fast," one of the emails to Simon reads. Apparently Simon complied, informing his UBS colleagues that if a deal were reached, the client stood to make between "$22 and 28 million" and that "there will likely be a similar fees for the firm." By firm he meant UBS.

Things happened very quickly after that. In early May 2006, Heininger attended a meeting at the UBS branch in London, the center of European investment banking. Simon had flown in from New York for the meeting.

A Witch's Cauldron at UBS

Paul Valota* of the Exotic Desk, as the bank's internal witch's cauldron was known, handled the presentation. Although Valota and his UBS colleagues reportedly mentioned risks, they did so with a highly placating tone, as Heininger recalls today. "The world would end before risks are realized here," the bankers reportedly said.

But things didn't go quite as smoothly as that. First, KWL's attorneys reportedly voiced their concerns about the deal. They argued the financial risks were too great, and in doing so they struck a nerve. The UBS bankers disagreed. For good reasons from their point of view: The financial products were structured in such a way that "UBS" would "benefit the most if the customer suffers losses," Valota wrote to his colleagues.

There was also growing resistance within the bank. The UBS loan auditing division allegedly submitted its veto, saying that it doubted whether the German clients were capable of properly assessing the risks, and feared a "risk to our reputation in the event of losses."

To exert pressure within the bank, Simon allegedly brought in his superiors. The banker responsible for risk products, Simon is said to have told his team soon afterwards, had gotten involved "to 'force' Internal Credit to revise its initial decision and approve the deal."

Bank Auditors Unconvinced

German UBS managers also campaigned for the deal. "According to what I have as background, this should be a suitable transaction," a Frankfurt banker in charge of municipal deals wrote in an email to London. But the Frankfurt team couldn't have gathered much information by that point. Its response was received at 12:58 p.m. on June 7, all of three minutes after the inquiry from London had been sent.