Prosecutors are trying to determine whether it conspired with financial advisers to overcharge customers.

TO BE NOTED: From Bloomberg:

"JPMorgan Faces Charges Over Derivatives Sales to Alabama County

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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.

Soaring Costs

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.

SEC spokesman John Heine declined to comment and Jefferson County Commissioner Jim Carns said he was unaware of any SEC moves against JPMorgan.

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.

‘Sucker Punch’

“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.

Credit Ratings

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.

Bank Losses

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.

Rolex, Jewelry

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.

Collusion Allegation

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.

To contact the reporter on this story: William Selway in San Francisco at wselway@bloomberg.net. Martin Z. Braun in New York at mbraun6@bloomberg.net."

federal subsidy is distorting the market so that issuers are selling bonds at yields that are attractive to taxable buyers

TO BE NOTED: From Bloomberg:

"Taxpayers Lose $281 Million in Build America Bondholder Profits

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By Darrell Preston and Bryan Keogh

May 4 (Bloomberg) -- State and local public finance officials from New Jersey to California rewarded investors with $281 million of instant profits by selling debt through the government’s Build America bond program.

That’s how much prices of the five biggest bonds have risen in total since the first sales almost three weeks ago, according to Municipal Securities Rulemaking Board price data compiled by Bloomberg. About $7.6 billion of the debt, whose interest costs are partly subsidized by the U.S. government, has been issued.

Local officials say the federal subsidy has saved money compared with tax-exempt bonds. The rising prices of the securities and simultaneous decline in yields relative to benchmark rates shows municipalities would have saved another $1.32 billion in interest over the life of the bonds had they sold at current levels. The yields on $1.38 billion of debt sold by the New Jersey Turnpike Authority tumbled to 6.69 percent from 7.41 percent within a day of its April 20 offering.

“Some of these may have been good deals for the issuers, but could they have been even better?” said Ben Watkins, Florida’s director of bond sales. “They could have had much tighter pricing.”

New Jersey Turnpike spokesman Joseph Orlando declined to comment, referring questions to Dennis Enright, the authority’s financial adviser. Enright, president of NW Capital in Jersey City, New Jersey, called the sale “very successful.”

Buyers Rewarded

California’s $3 billion of Build America bonds sold April 20 and due in 2039 rose 2.3 percent, rewarding buyers with $68 million of profits and pushing yields down to 7.25 percent from 7.43 percent, Bloomberg data show. The state’s $2 billion of 25- year debt climbed 1.6 percent, or $32 million.

The New York Metropolitan Transportation Authority’s $750 million of debt, issued the same day, surged 6.8 percent, driving the yield down to 6.8 percent from 7.34 percent.

Build America bonds are part of President Barack Obama’s American Recovery and Reinvestment Act passed earlier this year to create jobs building roads, schools and infrastructure. The government pays a 35 percent subsidy on the interest rates that can cut coupons below those in the tax-exempt market.

The bonds are exempt from local taxes in the state of issue, though not from federal taxes. Strategists at Barclays Capital in New York predict the market may grow to as much as $150 billion over the next two years.

Relative Yields

Investors are snapping up Build America bonds because they offer the same yields as companies with lower ratings.

The New York Metropolitan Transportation Authority, ranked AA by Standard & Poor’s, paid 7.336 percent interest for its 30- year Build America bonds. At the same time, corporate bonds with the same maturity and rating yielded 6.10 percent to 6.19 percent, according to a Moody’s index. MTA bonds paid a yield higher than the 6.78 percent average for companies with A ratings from Moody’s, index data show.

The best opportunity for investors “is to get involved early” because “that’s where you’re going to get the cheap offerings,” said Scott Minerd, chief executive officer of New York-based Guggenheim Partners Asset Management Inc., which oversees about $30 billion. Minerd made the comments at the Milken Institute Global Conference in Beverly Hills, California, last week.

Municipal governments have been hit by the double whammy of rising borrowing costs and the recession since credit markets seized up in August 2007. Spending will likely exceed revenue in 34 states, the National Conference of State Legislatures said April 14.

Borrowing Costs

The cost of borrowing in the long-term tax-exempt municipal bond market has exceeded that of the U.S. government, with top- rated 30-year municipal bonds yielding 4.67 percent on April 30, compared with 4.09 percent for Treasuries of the same maturity. Muni rates have historically been less than Treasuries because of the tax exemption.

California’s bonds pay yields of 7.43 percent, the equivalent of about 4.83 percent after the 35 percent subsidy. Yields on California tax-exempt bonds were about 5.05 percent to 5.35 percent when the new securities were sold. Corporate bonds with similar ratings to California yielded 6.73 percent at the time, Moody’s data show.

“The federal subsidy is distorting the market so that issuers are selling bonds at yields that are attractive to taxable buyers,” said Evan Rourke, a money manager in New York for Eaton Vance Investment Co. “There was a certain amount of price discovery going on.”

Call Provisions

Savings on Build America bonds may be overstated because the securities include terms that make it unprofitable to refinance them if interest rates fall, limiting the municipality’s flexibility.

Muni bonds are typically sold with options that let borrowers buy back the securities after 10 years. The absence of a call option is worth 0.2 percentage point in yield to investors, according to San Francisco-based De La Rosa & Co., one of the underwriters on California’s bond sale.

Instead, most Build America bonds contain so-called make whole provisions, which require issuers to pay a premium to redeem the securities if interest rates decline. That would protect investors from borrowers paying off the bonds early and having to reinvest the proceeds in lower-yielding debt.

Florida Considers

Florida, which is considering Build America bonds, would have to make sure it gets a low enough rate to sacrifice the right to call the debt in 10 years, Watkins said. Investors “should pay up” for the assurance that they will be able to hold the securities for their full life, he said.

New York is evaluating whether giving up the option is worth the cost, Dominic Colafati, the chief budget examiner who oversees the state’s debt policies, said at a press conference in Albany. He declined to set a savings target the state would require to sell non-callable bonds.

“We are not 100 percent certain” it would be best for the state to give up the option, Colafati said. “We are trying to figure out based on real world experience what we can realistically expect.”

Local governments may not be gaining enough in lower yields for giving up the flexibility, said Andrew Kalotay, chief executive officer of Andrew Kalotay Associates Inc., a New York- based analyst of the value of fixed-rate bonds.

“They’re giving up a lot,” said Kalotay. “I’m not sure they’re getting such a good deal when they give up the call option.”

‘New Flavor’

Borrowers said they were told by their bankers that higher yields were needed to attract buyers to a new market, even though municipalities almost never default.

“We couldn’t sell them unless they were priced the way they were,” California Treasurer Bill Lockyer said in a phone interview. “This is a new flavor of bond.”

California saved between $1.2 billion to $1.7 billion compared with what it would have paid in the tax-exempt market and would have “lost millions of dollars in potential investors,” had it pressured buyers to accept lower yields, Lockyer said. Goldman Sachs Group Inc. and JPMorgan Chase & Co. underwrote the bonds. Spokesmen for the firms declined to comment on the pricing of the securities.

“It’s not like they make up a number, with a dartboard or something, to figure out what the yields should be,” he said. “They match the orders to see where they can make the sale.”

None of California’s underwriters held the bonds in their own account to profit from any potential increase in price in the following days, Lockyer said.

Muni Rally

Municipal bonds have rallied since the first sales of Build America debt, pushing yields on 30-year AAA tax-exempt securities down as much as 0.19 percentage point to a seven- month low of 5 percent, according to Municipal Market Advisors of Concord, Massachusetts. Tax-exempt sales fell about 29 percent to $25.5 billion last month from April 2008, according to Bloomberg data that doesn’t include variable-rate securities.

The New Jersey Turnpike Authority’s $1.38 billion of taxable 7.4 percent bonds due in 2040 gained 9.1 cents to 109.1 cents on the dollar, or $125 million, since the sale. Underwriters led by Morgan Stanley collected $12.7 million in fees.

Enright, the Turnpike’s advisor, called the sale “very successful” because the yield was within 4 percentage points of Treasuries with similar maturities. “Could it have been priced better?” he said. “You never know the answer to that.”

New Jersey general obligation bonds with 30-year maturities traded at yields of about 4.89 percent the week of the state’s Build America bond sale. The taxable securities had a yield of 7.41 percent, or 4.82 percent after the subsidy for an annual difference of 0.07 percent.

“Aggressively” Buying

New York’s Metropolitan Transportation Authority locked in “substantial savings,” said finance director Pat McCoy. The state’s rate on 30-year Build America bonds was 4.88 percent after the subsidy. That compares with an average interest rate of 5 percent on its tax-exempt bonds.

The price of the authority’s Build America bonds rose by 6.8 cents to 106.8 cents on the dollar.

“We understand that is a common dynamic in the taxable market,” McCoy said in an interview. “A couple of investors who received bonds in the allocation were eager to increase their position. They were aggressively going out and seeking to buy bonds.”

McCoy said “small-block trades” pushed up prices after the initial sale. The authority paid its underwriters a fee of about $8.91 per $1,000 of bonds, compared with $5.16 for the sale of tax-exempt debt the same day.

“This is a convention that we seem to be inheriting from the taxable market,” said McCoy.

Virginia Bonds

University of Virginia sold $250 million of 6.2 percent 30- year bonds on April 13. The securities climbed 7.6 cents to 107.3, or by $19.1 million.

Rated AAA by S&P, the school paid about the same yield relative to Treasuries as St. Louis-based Emerson Electric Co., which is ranked five levels lower and sold bonds the same week. Both were priced to yield 2.5 percentage points more than U.S. government debt. The school said it achieved about $2 million a year in interest savings by getting a yield lower than tax- exempt rates.

Yoke San Reynolds, the university’s chief financial officer, didn’t respond to a request for comment.

Some local officials said they haven’t figured out if Build America bonds provide enough savings.

“Among the things we are looking at is how they are priced,” said Nancy Kopp, Maryland’s treasurer, in an interview at the Milken Institute conference in Los Angeles. “My constitutional responsibility is to look out for the taxpayers of my state.”

To contact the reporters on this story: Darrell Preston in Dallas at dpreston@bloomberg.net; Bryan Keogh in New York at Bkeogh4@bloomberg.net"