Here is an example of changing weights and measures....
JPMorgan Swap Deals Spur Probe as Default Stalks Alabama County
By William Selway and Martin Z. Braun
May 22 (Bloomberg) -- As nighttime temperatures plunged in Birmingham, Alabama, last October, Dora Bonner had a choice: either pay the gas bill so she could heat the home she shares with four grandchildren, or send the Birmingham Water Works a $250 check for her water and sewer bill.
Bonner, who is 73 and lives on Social Security, decided to keep the house from freezing.
``I couldn't afford the water, so they shut it off,'' she says.
Bonner's sewer bills have risen more than fourfold in the past decade. So have those of others in Jefferson County, which has 659,000 residents and includes Birmingham, the state's largest city.
What's threatening to increase them even more isn't the high cost of treating waste; it's the way county officials chose to finance the $3.2 billion in debt they took on to build a new sewer system. The county relied on advice from a bank, JPMorgan Chase & Co., to arrange its funding, rather than use competitive bidding.
Like homeowners who took out mortgages they couldn't afford and didn't understand, Jefferson County officials rejected fixed- rate debt and borrowed instead at rates that varied with the market.
The county paid banks $120 million in fees -- six times the prevailing rate -- for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt.
Interest Rate Soared
In February, the county's interest rate soared to as much as 10 percent, up from 3 percent just weeks earlier. The swaps have now compounded the risk that Jefferson County will file for bankruptcy as it faces its worst financial crisis since it was founded in 1819.
The same subprime chaos that has felled chief executive officers on Wall Street and forced banks to write off $322 billion has plowed into Jefferson County and other municipalities. That means local officials now have to pay to banks money that otherwise might have been used to build schools, hospitals or public housing.
Meanwhile, the U.S. Securities and Exchange Commission and the Justice Department are now investigating bankers and officials involved in Jefferson County's swap agreements.
Bankers who worked for New York-based Bear Stearns Cos. and JPMorgan when Jefferson County bought its swaps have been told they might face criminal charges under an antitrust investigation of the municipal derivatives industry, according to records filed with the Financial Industry Regulatory Authority Inc.
SEC Sues Mayor
On April 30, the SEC sued Larry Langford, the former county commission president and now Birmingham's mayor, for fraud in allegedly accepting $156,000 from a local banker while refinancing the sewer debt. Langford denies any wrongdoing. JPMorgan spokesman Brian Marchiony declined to comment for this article.
The Federal Bureau of Investigation has raided financial advisers in California, Minnesota and Pennsylvania to get files. In January 2007, Charlotte, North Carolina-based Bank of America Corp. agreed to cooperate with federal prosecutors in exchange for leniency. Bank of America spokeswoman Shirley Norton declined to comment.
Jefferson County -- which weathered the U.S. Civil War in the 1860s and racial strife in the 1960s -- is now scrambling to avert what would be the biggest municipal bankruptcy in the nation's history, measured by outstanding bonds.
``It's going to come back to us, to the people,'' says Bonner, a retired waitress. ``Whether you're poor or you're rich, you're going to end up paying.''
Secret Swap Fees
JPMorgan, Bank of America, Bear Stearns, and Lehman Brothers Holdings Inc. charged Jefferson County about $50 million above prevailing prices for 11 of the interest-rate swaps the county bought between 2001 and 2004. None of the fees were disclosed to the commissioners, records show.
Porter, White & Co., the Birmingham-based financial advisory firm later hired by the county to analyze its swaps, said the banks raked in as much as $100 million in excessive fees on all 17 of its swaps.
The swaps are contracts in which the county and the banks agreed to exchange periodic payments based on the size of the outstanding debt and changes in prevailing lending rates. Swaps are derivatives, which are unregulated financial contracts tied to the underlying value of a security, commodity or index.
Jefferson County's deals started to unravel in January after its bond insurers, Financial Guaranty Insurance Co. and XL Capital Assurance Inc., suffered hundreds of millions of dollars in losses on securities tied to home loans.
Bonds Take Hit
Standard & Poor's downgraded Financial Guaranty's credit rating to AA from AAA on Jan. 31. The next week, Moody's Investors Service cut XL Capital six levels to A3. Moody's then downgraded Financial Guaranty to A3.
When a bond insurer takes a ratings hit, so do the bonds it has guaranteed; the insurer effectively lends its high rating to the bond issuer.
That's what happened to about $3 billion of Jefferson County's debt, causing its interest rate to balloon to as high as 10 percent in February and March from 3 percent in January. That helped increase its total monthly debt payments to $23 million from $10 million.
``It happened overnight,'' County Commission President Bettye Fine Collins says. ``It became a situation that worsened every day.''
The turmoil in Jefferson County might be just the beginning of a new, painful chapter in the subprime debacle.
``The Jefferson County crisis could have national implications,'' says U.S. Representative Spencer Bachus, who represents the county and is the top Republican on the House Financial Services Committee. ``Large defaults in the municipal bond market could have a ripple effect on the larger U.S. financial system, again causing systemwide financial stress.''
Bear Stearns Saved
The banks that sold the toxic financing to Jefferson County have themselves fallen victim to the subprime crisis -- none more so than Bear Stearns. The firm, which sold $1.6 billion in swaps to the county, saw its shares plunge 95 percent from Jan. 1 to March 17 before it was bailed out by the Federal Reserve in March.
The Fed negotiated a deal in which JPMorgan bought Bear for $10 a share. JPMorgan had sold $3.2 billion in swaps to Jefferson County.
``It's ironic that the Fed can do corporate welfare for the banks, but they can't bail out a county that was victimized by these banks,'' says Craig Greer, a Catholic chaplain at a Birmingham hospice.
The SEC and Justice Department are probing whether the banks that financed Jefferson County conspired nationwide to fix prices for derivatives, violating the Sherman Antitrust Act, according to target letters sent to bank employees.
Criminal Charges
At least four JPMorgan bankers who worked for the bank at the time Jefferson County deals were done, including Douglas MacFaddin, the former head of municipal derivative sales, have been told by the U.S. Attorney's office that they could face criminal charges, records show. MacFaddin, who was fired in March, couldn't be reached for comment.
``In Jefferson County's case, the people who were allegedly doing the price fixing were right at the center of the scandal,'' says Christopher ``Kit'' Taylor, who ran the Municipal Securities Rulemaking Board, the public finance regulator in the U.S., from 1978 to 2007.
Jefferson County could use the federal probe of the banks that financed the sewer debt as leverage to stop the firms from demanding more money, Taylor says. So far, the county has won agreements with JPMorgan and the other banks to keep from being forced to buy back as much as $847 million of unwanted bonds or pay up the $277 million it owes on its swaps.
Don't Pull Trigger
The banks might be worried that Jefferson County, if pressed, could walk away from the derivatives trades on the grounds that they were signed in what might have been fraudulent deals written by the banks, Taylor says. That threat could be enough for the county to bide its time as it works for a solution.
``The big boys don't want to pull the trigger,'' Taylor says. ``Then they might end up upsetting the whole derivatives apple cart because of what a judge may do in a court case.''
Some Jefferson County residents have taken to joking about the mess local officials and banks have dumped on them. Greer, the chaplain, is selling what he calls look-alike bonds, for $2.50. He says they should be used as toilet paper. He's also distributed bumper stickers saying ``Wipe Out Sewer Debt.''
Not everyone is laughing. Outside a Piggly Wiggly grocery store in western Birmingham, Charles Boyd, a construction supervisor, says it seems like the only thing he does is pay bills.
``It's just not like it used to be,'' Boyd, 67, says. ``It's rough. And I'm working, so when people talk about their sewer bills, I know it's hard. The sewer bill is higher than the water bill. It's ridiculous. It's outrageous.''
Seeds of Crisis
The seeds of Jefferson County's debt crisis were planted in December 1993, when three citizens filed a lawsuit against the county commission, alleging untreated sewage was being discharged into the Black Warrior and Cahaba rivers during heavy rains, in violation of the federal Clean Water Act.
The U.S. Environmental Protection Agency in 1994 joined the taxpayers who filed the complaint. In December 1996, the county settled the case by agreeing to build a sewer system for collecting overflows and cleaning the water.
In 1997, the county began selling bonds to raise money for the project. Most of the bond sales, all done without competitive bidding, were arranged by Charles LeCroy, a banker at St. Petersburg, Florida-based Raymond James & Associates Inc.
`Cash Cow'
By November 2002, the county had issued $2.9 billion in sewer bonds, with an average rate of 5.25 percent; the cost of building the sewer system doubled from initial projections. Meanwhile, LeCroy had been hired by JPMorgan, taking the county's debt work with him.
``Jefferson County became a cash cow,'' says County Commissioner Shelia Smoot, a Democrat.
In 2002, with municipal bond interest rates near a 34-year low, LeCroy told Jefferson County officials they could save millions of dollars by refinancing their sewer debt. He recommended that the county use a combination of adjustable-rate bonds and interest-rate swaps.
The officials took JPMorgan's advice, and in 2002 and '03 Jefferson County issued $3 billion of adjustable-rate bonds, including $2.2 billion of auction-rate securities, bonds whose interest rates reset at periodic auction sales by banks.
Swaps Seminars
Those bonds provided the banks with about $55 million in fees, county records show. JPMorgan sold Jefferson County $2.7 billion of interest-rate swaps, Bank of America sold the county $373 million in swaps and New York-based Lehman Brothers sold the county $190 million more.
The swaps, if they worked as designed, would allow Jefferson County to pay about 4.2 percent on its debt for 40 years.
Jefferson County was so enthusiastic about its sophisticated debt management techniques that in 2003 and 2004 it held ``Investor Relations'' seminars each year in a Birmingham hotel.
The events were sponsored by 32 banks, advisers, law firms, bond insurers and rating companies, including CDR Financial Products, the county's Beverly Hills, California-based swap adviser, Bear Stearns and JPMorgan. County officials solicited sponsorships, including $27,000 from JPMorgan, $15,000 from Bear Stearns and $10,000 from CDR.
``We have so many little municipalities around here that can't afford to go for any kind of training,'' says Linda Goldblatt, the county's investor relations director. ``We thought it would be a good idea to help get them some idea of what's going on out there.''
`Prudent Financial Management'
Bankers from Bear Stearns and JPMorgan, along with advisers from CDR, led the sessions.
``The worldwide use of privately negotiated derivatives has generated considerable momentum,'' a JPMorgan presentation said. ``The need for prudent financial management continues to drive the wider use of privately negotiated derivatives.''
The phrase privately negotiated is a euphemism bankers use to describe debt deals that are struck without competitive bidding -- as all of Jefferson County's were.
Then JPMorgan banker Matthew Roggenburg quoted Federal Reserve Chairman Alan Greenspan, who lauded derivatives because they create a more flexible and efficient financial system.
``New financial products have enabled risk to be dispersed more effectively to those willing, and presumably able, to bear it,'' Greenspan said in an April 2002 speech. ``Shocks to the overall economic system are accordingly less likely to create cascading credit failure.''
Upfront Cash
In 2004, three months before one of the seminars, Bear Stearns, along with Montgomery, Alabama-based underwriter Blount Parrish & Co. and Mobile, Alabama-based Gardnyr Michael Capital Inc., pitched the county another swap deal, its largest yet.
The county sought to generate millions in upfront cash to hold down sewer bills by agreeing to pay 67 percent of the one-month rate on the London interbank offered rate. In return, the banks would pay the county 56 percent of one-month Libor plus 0.49 percentage point.
In June 2004, the county entered into $1.5 billion of swaps with Bear Stearns on those terms and another $380 million swap with Bank of America on those terms. Jefferson County received $25 million in upfront cash.
The deals also gave Jefferson County the distinction of holding the most interest-rate swaps -- $5.8 billion in all -- of any county in the U.S.
County Commissioner Jim Carns, 67, says the banks used the lack of transparency in derivatives to overcharge Jefferson County.
`Unregulated Market'
``It's easier for mischief to take place in an unregulated market,'' he says. ``You don't have a teacher watching the playground.''
A year after the swaps deals with Jefferson County, JPMorgan's LeCroy ran into legal trouble. He was indicted in June 2004 on federal fraud charges in a municipal finance corruption scandal in Philadelphia. JPMorgan fired him. In January 2005, LeCroy pleaded guilty and was later fined $15,000 and imprisoned for three months. He declined to comment.
The SEC's action against Langford, the former county commission president, hit closer to home. In April, the agency accused Langford in federal court of fraud for failing to disclose he had accepted more than $156,000 from William Blount of Blount Parrish.
Langford steered a portion of the work on every swap and bond deal in 2003 and 2004 to Blount, which was paid more than $6.7 million in fees, according to the complaint. The SEC said in an April 30 press release that it was still investigating. Langford says the SEC's allegations are untrue.
`Political Witch Hunt'
``It was a political witch hunt from day one,'' he says. ``Blount and I have been friends for 30 years. He wouldn't have had to buy no involvement in no bond deal from me.''
Andrew Campbell, a lawyer for Blount, denies any wrongdoing and says the SEC doesn't have jurisdiction over swaps.
The SEC has asked the Jefferson County commissioners to turn over information regarding payments, fees and gifts relating to the county's bond deals and swaps since January 2002, according to Commissioner Collins.
The agency specifically asked for all communications with Bank of America, Bear Stearns, JPMorgan and Lehman Brothers.
Bachus, the Alabama congressman, says the entire controversy would have been avoided if Jefferson County had simply used the kind of financing all municipalities once used: fixed-rate bonds, which through the early 1970s were almost always sold through competitive bidding.
`Knew the Risk'
``On a 30-year issue at a fixed rate, then everybody knew the risk,'' Bachus says. ``Now, with these swaps and these different transactions, the taxpayers, the ratepayers, even the county -- I don't think they understood what they were getting into.''
Some of Jefferson County's commissioners agree. Collins, a Republican and one of the two current members of the five-person board who were there when the deals were struck, says it's now clear that the financing was wrong for the county.
Commissioner Smoot says the commission misplaced its confidence in the bankers and advisers.
``I blame the people who said they were the experts,'' Smoot says. ``The big Wall Street bankers. Where are they now? We trusted them. We asked our folks to trust them. And you know what- -- they violated our trust.''
The interest rate on $2.2 billion of the county's bonds was determined by bond auctions to investors, periodically run by banks. Because of the global debt crisis, investors and banks began pulling money away from the auction-rate-securities market at the start of 2008.
Almost Doubled Rates
When those auctions failed because no one bought the securities, Bank of America and JPMorgan, seeking to shore up their own capital, didn't step in and buy the Alabama debt, as banks that had run such auctions had in the past. That forced Jefferson County to almost double the interest payments on its auction-rate bonds.
Meanwhile, the payments the county received under its swap agreements, which were supposed to cover the interest payments on its floating-rate bonds, went down. The payments were supposed to track the county's bonds, covering any increase to its bills. Instead, they added to them.
``We were already on the razor's edge of what we could afford,'' Commissioner Carns says. ``We're going into the Superbowl with one arm in a cast and another tied behind our backs.''
Cut to Junk
February brought even worse news, Carns says. On Feb. 26, Moody's cut the sewer bonds to Baa3, one step above junk. The downgrade triggered clauses in the county's swap agreements. Bank of America, Bear Stearns, JPMorgan and Lehman Brothers now had the right to cancel the deals -- at a cost of $277 million to the county.
The group of banks left holding almost all of its $847 million of unwanted bonds could also cancel the deals to act as buyers of last resort and force the county to buy the bonds back. On Feb. 29, Standard & Poor's cut the sewer bonds to junk.
``Once we got cut to junk status, we couldn't go any lower without just leaving the scene and turning over a corpse to somebody,'' Carns says.
In March, the county sent its financial advisers from Porter White to meet with JPMorgan, other banks and bond insurers in New York.
They tried to convince the bank to take about $30 million of the revenue from the one-cent sales taxes it collects for a $1 billion school construction bond and add those funds to the $115 million of annual income the county's sewer system can use to pay for the debts.
`We Cannot'
That would still have left the county with at least $100 million less than what it says its annual interest bill would be. The banks and insurers didn't accept the offer. They told the county to find ways to increase sewer revenue, Porter White's President Jim White says.
``We cannot raise sewer rates,'' Commissioner Collins says. ``We've done that and we've done that.''
Birmingham resident Dora Bonner, the grandmother who lost her water, says she feels betrayed by the county's politicians.
``They're not interested in us,'' she says. ``We elect them, then they turn the other way.''
Bonner and other residents are paying for a lesson that Warren Buffett, the world's richest man, wrote about in 2003. Derivatives are like hell, he said: ``Easy to enter and almost impossible to exit.''
