|How JPMorgan Made Jefferson County Toxic
| August 12, 2011
JPMorgan Chase & Co. (JPM)’s Charles LeCroy said the key to landing bond deals in Jefferson County, Alabama, was finding out whom to pay off. In one example, that meant a $2.6 million payment to Bill Blount, a local banker and longtime friend of County Commissioner Larry Langford.
“It’s a lot of money, but in the end it’s worth it on a billion-dollar deal,” LeCroy told a colleague in 2003, according to a complaint filed by the Securities and Exchange Commission.
That’s because in the $2.9-trillion market for state and local government debt, where 80 percent of all financings are negotiated in private, conflicts of interest prevail. While Langford and Blount are in jail, LeCroy is fighting an SEC action. JPMorgan, which provided most of the toxic debt that devastated Jefferson County, has suffered no loss of business as the nation’s third-largest underwriter of municipal bonds, according to data compiled by Bloomberg.
Just 21 months ago, JPMorgan agreed to a $722 million SEC settlement to end a case over secret payments to friends of Jefferson County commissioners. The financings arranged by JPMorgan, a package of floating-rate debt and derivatives, exposed taxpayers to the 2008 credit crisis and dealt a blow that may lead the county to approve the biggest U.S. municipal bankruptcy as soon as today.
“As an outsider looking in, it just certainly appears to me that JPMorgan ravaged this county,” said Robert Brooks, a finance professor at the University of Alabama in Tuscaloosa and the author of a textbook on derivatives. “They convinced Jefferson County to pursue a strategy they never would have followed to generate a lot of fees.”
Jefferson County’s financing shows how Wall Street peddled complex bond-and-derivative deals that backfired on taxpayers, from small Pennsylvania school districts to California’s state government. Banks may have charged $20 billion in hidden fees on the derivatives alone, Andrew Kalotay, a New York-based financial consultant who specializes in such agreements, told an SEC hearing in Jefferson County last month. The agreements allowed lenders to earn fees that were rarely, if ever, disclosed, while exposing municipalities to unexpected increases in borrowing costs.
Yet while JPMorgan’s deals denuded Jefferson County, the company has emerged with its municipal-debt underwriting business unscathed. During the past two years, public officials from California to Massachusetts hired the New York-based bank to arrange $64.7 billion of bond offerings, making it the third- largest underwriter in the market for state and local securities, according to Bloomberg data.
“The issuers need the bankers,” said Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics, which assesses banks. “Morgan’s a big house and they’re very aggressive and they’re out there looking for business everywhere. So people tend to forget.”
Last month, without admitting or denying wrongdoing, JPMorgan agreed to pay $211 million in a separate settlement with state and federal regulators over charges that its municipal-derivatives unit participated in an industry-wide scheme to fix prices and overcharge local governments on investment contracts. The bank blamed former employees and said it has increased oversight of its public finance business.
In a motion to dismiss a lawsuit by Jefferson County, JPMorgan said the county was inappropriately attempting to lay blame for the debt crisis at the bank’s feet.
“The simple fact is that the county took on too much debt and vastly underestimated the cost of building out its sewer system,” lawyers for JPMorgan argued. “These problems were only exacerbated by the county’s poor management of its sewer system and the current credit crisis.”
JPMorgan spokesman Justin Perras declined to comment for this story and said Chief Executive Officer Jamie Dimon, who joined JPMorgan after the Jefferson County deals were done, wasn’t available for an interview. William B. Harrison Jr., the bank’s CEO at the time it sold the contracts, didn’t return phone calls seeking comment.
The county’s collapse has loomed over the municipal bond market for more than three years and inspired provisions in the Dodd-Frank law seeking to protect localities from complex financial trades involving derivatives. Officials are asking JPMorgan and other creditors to forgive about $1 billion of the bonds or may decide as soon as today to file for bankruptcy protection to escape the debts.
In Jefferson County, JPMorgan pitched a money-saving plan that converted almost all the county’s $3 billion of sewer- system debt into floating-rate securities coupled with derivatives. The deals comprised the largest transactions in municipal swaps and auction-rate bonds, a form of floating-rate borrowing, in the bank’s history, according to the SEC.
Like homeowners who turned to exotic mortgages, officials refinanced 93 percent of the sewer bonds into securities with adjustable interest rates. They bought interest-rate swaps, in which two parties make periodic payments based on an underlying measure of borrowing costs. The contracts were supposed to offset the floating rates the county paid and give it a fixed rate that was lower than on traditional bonds.
The county paid JPMorgan, Bear Stearns Cos, Bank of America Corp. and Lehman Brothers Holdings Inc. $120 million in fees for swap trades. Those fees were as much as six times the prevailing rate, according to a report by former county financial adviser Porter White & Co. of Birmingham, Alabama.
The money-saving strategy backfired. JPMorgan’s financings unraveled in early 2008 as the subprime mortgage-market meltdown sent ripples through Wall Street, undermining the credit ratings of the companies that insured Jefferson County’s bonds.
Interest Costs Soared
The county’s interest costs soared as investors dumped the bonds. After banks demanded early payoffs, the county defaulted. The swaps exposed the county to hundreds of millions in fees to refinance.
JPMorgan’s Dimon has moved to put the municipal crisis behind him.
In 2008, the bank said it got out of the business of selling interest-rate swaps to state and local governments. In November 2009, it settled with the SEC over allegations that LeCroy and former JPMorgan colleague Douglas MacFaddin funneled $8 million of secret payments to bankers, including Blount, who had ties to Jefferson County politicians.
“It looks like they’ve done the right things to limit the reputational damage,” said Matt Fabian, who tracks the state and local government securities industry for Municipal Market Advisors Inc. in Concord, Massachusetts.
In the Jefferson County case, much of the blame for the collapse has been cast on corrupt politicians.
“It hasn’t hurt them a bit because the whole thing has been sold that they were dealing with corrupt officials,” said Christopher Taylor, the executive director of the Municipal Securities Rulemaking Board from 1978 until 2007. “But the truth of the matter is they were in bed with the issuer.”
Larry Langford, the former commissioner in charge of finance, was found guilty on U.S. criminal charges of accepting bribes from Blount, who pleaded guilty in the case.
LeCroy and MacFaddin, the former head of municipal derivatives for the bank, are fighting SEC civil claims that they failed to disclose payments to Blount and others. JPMorgan fired LeCroy in 2004 and terminated MacFaddin in 2008. No one from JPMorgan is accused of criminal wrongdoing.
MacFaddin and LeCroy have argued that the SEC lacks authority to pursue them under federal anti-fraud statutes because the interest-rate swaps aren’t securities.
Richard Lawler, MacFaddin’s attorney, declined to comment. LeCroy’s lawyer, Lisa Mathewson, also declined to comment.
In Jefferson County, 21 people, including four county commissioners, were convicted or pleaded guilty to charges related to the sewer construction or financing.
Former County commissioner Langford, 63, a longtime friend of Blount’s who was responsible for finance, was convicted of taking $242,000 in bribes in exchange for steering business to Blount. Langford lost an appeal of his convictions, according to a notice posted Aug. 5 by the federal appeals court in Atlanta.
According to the SEC, LeCroy also paid fees to two other local firms to win the support of another former commissioner.
LeCroy joked about the tactics with a fellow JPMorgan banker in 2003. “We have to pick the partners who are going to get free money from us this time,” he said, according to the SEC complaint.
Deals Raised Questions
Bond insurer Syncora Guarantee Inc., which backed about $1 billion of the bonds, said in a lawsuit that JPMorgan knew that the county wouldn’t have enough revenue to pay its debts in a few years but kept a report documenting that secret.
A least one banker at JPMorgan, Charles Giffin, raised internal questions about the risk.
“Do these guys know the risks they are taking (in large doses)?” Giffin wrote in a May 12, 2003, e-mail to a colleague, when asked to prepare materials explaining why the county should buy more derivatives, according to SEC records. “Shouldn’t we be pitching diversification arguments?”