"JPMorgan Faces Charges Over Derivatives Sales to Alabama County
By Martin Z. Braun and William Selway
May 8 (Bloomberg) -- JPMorgan Chase & Co. said yesterday it’s facing charges that it violated federal securities laws over bond and interest-rate swap sales that helped push Alabama’s most populous county to the brink of bankruptcy.
Potential action by the U.S. Securities and Exchange Commission comes as Birmingham, Alabama’s mayor awaits trial this summer on bribery and money laundering charges in connection with the deals while he was president of the Jefferson County Commission.
At least seven former JPMorgan bankers are under scrutiny in a Justice Department criminal antitrust investigation of the sale of unregulated derivatives to local governments across the U.S., federal regulatory records show.
“The bigger the amount of money, the more temptation there is for corruption,” said Christopher “Kit” Taylor, executive director of the Municipal Securities Rulemaking Board from 1978 to 2007.
JPMorgan may be the first bank to be challenged by federal regulators for the practice of selling municipalities interest- rate swaps, a technique marketed as a way for cash-strapped cities and towns to save on their financing. The transactions have also provided Wall Street banks with fees 10 times larger than what they get for municipal bond sales.
The complex contracts, which local officials across the U.S. have said they don’t understand, backfired last year as fallout from the global credit crunch caused municipal borrowing costs to rise more than fourfold.
No location has been hit harder by its derivative deals than Jefferson County, which for more than a year has been unable to pay the soaring cost of its sewer bond deals with JPMorgan in 2002 and 2003.
The SEC’s move toward sanctioning JPMorgan comes four years after Bloomberg News reported that the New York-based bank overcharged the county by at least $45 million on derivative contracts. All of the transactions were tied to debt that financed construction of the county’s sewers.
Those public financings have pushed the county toward insolvency, threatening it with bankruptcy. They’re also threatening to cost local residents, as the rate for their sewer bills has more than tripled to cover borrowing costs.
JPMorgan spokesman Brian Marchiony declined to comment. The bank said in a regulatory filing yesterday that it is “engaged in discussions” with the SEC to reach a resolution before the agency files a civil complaint.
JPMorgan Closes Unit
JPMorgan said in September that it decided to close the unit that sold interest-rate swaps to government borrowers.
JPMorgan’s role in selling interest-rate derivatives to cities and towns has led to a nationwide federal investigation of the bank. Prosecutors are trying to determine whether it conspired with financial advisers to overcharge customers.
The bank sold swap contracts to school districts and other borrowers desperate to raise cash. In Butler, Pennsylvania, JPMorgan convinced a cash-strapped school district in 2003 to sell it an option on an interest-rate swap, a so-called swaption, for $730,000.
The district later said it had been duped by the bank. Last year it repaid JPMorgan seven times what it had received to get out of the deal. Erie, Pennsylvania’s school district sold a similar contract to the bank in 2003.
“You have severe building needs, you have serious academic needs,” James Barker, superintendent of the Erie school district, said in a Nov. 2007 interview. “It’s very hard to ignore the fact that the bank says it will give you cash.”
Three years after JPMorgan paid the Erie schools $750,000, interest rates went the wrong way and the district paid the bank $2.9 million to cancel the contract.
“That was like a sucker punch,” Barker said. “It’s not about the district and the superintendent. It’s about resources being sucked out of the classroom. If it’s happening here, it’s happening in other places.”
In 2002 and 2003, relying on JPMorgan’s advice, Jefferson County refinanced $3 billion of sewer bonds with floating-rate debt and interest-rate swaps, public records show.
The bank had told county commissioners that the deals would cut the locality’s borrowing costs. In a swap, parties agree to exchange interest payments based on an underlying bond. The two sides pay each other amounts based on different rates, which vary based on a financial index.
In 2008, the insurers guaranteeing Jefferson County’s bonds lost their top credit ratings, after suffering subprime mortgage related losses. As a result, the yields on the bonds surged more than three-fold in one month to 10 percent.
The swaps compounded the increased borrowing costs because under the agreements the variable rates the banks paid the county declined.
Since then, Jefferson County’s annual sewer debt payment surged to $460 million, more than twice the $190 million it collects in revenue. The county couldn’t refinance the bonds without paying hundreds of millions of dollars in fees to get out of the swaps, and it didn’t have the money to do that.
JPMorgan is now in negotiations to prevent Jefferson County from filing the biggest municipal bankruptcy since Orange County, California defaulted in 1994.
The Jefferson County transactions have also forced losses on the bank. Jefferson County owes JPMorgan more than $600 million for the swaps and the bank has so far not forced the county to pay.
The unregulated world of derivatives, which provided Wall Street banks with enormous fees, was ripe for corruption, said Taylor, the MSRB’s former executive director.
“Until you get strong ethical rules put in place nationwide, you’re asking for problems,” he said.
A December federal indictment of former Jefferson County Commission President Larry Langford alleged that JPMorgan paid an Alabama banker and former chairman of Alabama’s Democratic Party to get involved in the sewer financing deals. JPMorgan gave William Blount, a long-time friend of Langford, almost $3 million to arrange the swaps associated with the county’s sewer refinancing, the indictment said.
Bear Stearns Cos. paid Blount $2.4 million while Goldman Sachs Group Inc. paid him $300,000 after Langford told JPMorgan to include the firm as a condition of a $1.1 billion swap agreement in 2003, the indictment said. The banks weren’t charged.
Blount helped Langford get a $50,000 loan and paid for jewelry, a Rolex watch and expensive clothing from Ermenegildo Zegna SpA and Salvatore Ferragamo SpA, the indictment said.
Langford, Blount and Blount’s associate Albert LaPierre, who was allegedly paid $219,500 by Blount for his help, have all pleaded not guilty. In response to a parallel civil complaint filed by the SEC, the men have argued that the agency doesn’t have jurisdiction over swaps.
Given the scope of the case so far, it’s not surprising that the SEC would consider charges against JPMorgan, said Jim White, a former financial adviser to Jefferson County. The county hired White after it had agreed to do the swap deals.
“If you know all that, and you’ve read the indictment, then you wouldn’t be surprised,” White said yesterday.
The Justice Department investigation of JPMorgan is looking at transactions across the country.
In Pennsylvania, two school districts sued JPMorgan last year, alleging the bank colluded with a financial adviser to reap excessive, undisclosed fees on derivative deals. The lawsuits were dismissed by a federal judge, who said the transactions weren’t covered by securities laws.
The Erie City School District sued JPMorgan and a Pennsylvania financial adviser in federal court alleging they colluded to reap more than $1 million in excessive fees on a derivative deal.
Erie’s school board, which said it had “rudimentary, laymen’s understanding of the derivatives market,” met in September 2003 with JPMorgan banker David DiCarlo. DiCarlo told the board that the district could make $750,000 by selling a swaption, or an option on an interest-rate swap, according to an audiotape of a board meeting.
DiCarlo told the board he didn’t know how much JPMorgan would make on the deal. Pottstown, Pennsylvania-based Investment Management Advisory Group, which had been recommended to advise the district by DiCarlo, told board members that the district was getting a fair price for the contract, the tape shows.
The district ended up paying JPMorgan $1 million in fees for the $750,000 it had received upfront, according to data compiled by Bloomberg.