JPMorgan Is Facing Federal Probe

Sept. 4 (Bloomberg) — JPMorgan Chase & Co. will stop selling interest-rate swaps to government borrowers in the $2.6 trillion U.S. municipal bond market roiled by an antitrust probe and the near bankruptcy of Alabama’s most-populous county.

At least seven former JPMorgan bankers are under scrutiny in a Justice Department criminal investigation of whether banks conspired to overcharge local governments on swaps and other derivatives. The bank also is embroiled in negotiations over how to resolve a debt crisis with Jefferson County, Alabama, where the county’s former adviser says a group of firms led by JPMorgan, the third-largest U.S. bank by assets, overcharged it by as much as $100 million for financing a new sewer system.

Banks marketed unregulated derivatives as a way for municipalities to save money. The financing, which local officials across the country have said they didn’t understand, backfired this year as fallout from the global credit crisis caused borrowing costs to rise more than fourfold in some cases to as high as 20 percent. Now, Jefferson County can’t afford its monthly payments and JPMorgan may be left holding defaulted debt.

“The risk/return profile of this business is such that the returns no longer justify the level of resources we have allocated to it,” Matt Zames, JPMorgan’s head of rates, foreign exchange and municipal bonds, said yesterday in a memo to employees, a copy of which was obtained by Bloomberg News.

Pennsylvania Suit

By stopping sales of derivatives in public finance, JPMorgan also may be trying to protect its reputation, said Christopher “Kit” Taylor, who ran the Alexandria, Virginia-based Municipal Securities Rulemaking Board, a self-regulatory group created by Congress to oversee the market, from 1978 to 2007.

“It cuts down on all the bad publicity,” he said.

JPMorgan was sued last week by the Erie, Pennsylvania, school district over undisclosed fees it reaped on swaps, and is among those named in civil antitrust suits pending in U.S. court.

The New York-based bank has also disclosed that the Securities and Exchange Commission may sue the bank in connection with an investigation of derivatives.

JPMorgan said in the memo it would stop selling interest- rate derivatives to local governments, though it will continue to market the products to non-profit customers such as hospitals. Derivatives are contracts whose value is derived from tradeable securities or linked to future changes in lending costs.

The bank also will trim the number of its regional investment banking offices to 10 from 19, affecting about 15 people, some of whom may be relocated.

Private Contracts

The specter of lawsuits has tarnished what was a thriving market for the municipal-finance departments on Wall Street.

Sales of derivatives to cities, towns and school districts boomed over the past decade, providing banks with a new source of fees as it earned less from arranging sales of tax-exempt bonds used to build schools, roads and other public works.

Underwriting fees on municipal bonds sold through negotiated agreement, which make up about 80 percent of the market, declined to $5.40 per $1,000 bonds last year from $7.23 in 1998, according to Thomson Reuters data.

States, counties and cities routinely ask suppliers to compete for the right to sell police cars, computers and ambulances; they don’t do that with public finance. About 80 percent of debt sold by municipalities today is arranged without competitive bidding. That’s up from 27 percent in 1974, according to data from Bloomberg and Thomson Reuters.

In these noncompetitive financings, known as negotiated deals, a municipality talks privately with a bank about public financing and negotiates an interest rate and price with the bank. In a competitive deal, the issuer posts a public notice asking banks to put in bids and awards bond work to the bidder who offers the lowest costs.

Payments Swapped

Interest-rate swaps, contracts in which two parties agree to exchange interest payments based on an underlying bond, also are usually awarded without competitive bidding. Fees — which the banks make by adjusting the interest rates up and down –are frequently not disclosed to the buyer.

“All financial products as they go through the maturation cycle become less profitable and muni swaps have gone through a maturation cycle,” said Peter Shapiro, managing director of Swap Financial Group, a South Orange, New Jersey-based financial adviser to state and local governments. “That’s happened at the same time as the fed criminal investigation has moved ahead and a series of civil suits have multiplied.”

Jefferson County paid more than $100 million in fees for interest-rate swaps it purchased from JPMorgan and other banks, paying about $50 million above prevailing prices for 11 of the contracts it bought between 2002 and 2004, according to an August 2005 Bloomberg Markets article. None of the fees were disclosed to officials, records show.

Fees on Deals

Porter, White & Co., the Birmingham-based financial advisory firm later hired by the county to analyze all 17 of its swap agreements, said the banks raked in as much as $100 million in excessive fees on the deals.

School districts in Pennsylvania also were unaware of the fees they were charged on derivative deals, according to a February article by Bloomberg Markets, and the advisers they hired never told them.

The derivatives were typically paired with debt, such as auction-rate securities, whose interest rates fluctuate weekly or monthly. Under the swap, the borrower would pay a fixed rate and received a rate that varied, which was supposed to match the floating rate on its bonds.

The strategy worked as long as top-rated insurers agreed to guarantee the bonds against default and banks acted as buyers of last resort for investors who wanted to sell when rates were reset.

Debt Dumped

When guarantors’ credit ratings came under pressure this year because of losses on subprime mortgage-linked securities, investors dumped insured debt, while dealers of auction-rate bonds suddenly stopped buying unwanted securities. Borrowers faced interest costs of more than 20 percent, and, to refinance into fixed-rate debt, they paid fees to banks to break their swap contracts.

Nowhere is that suffering more acute than Jefferson County, which includes Birmingham, Alabama’s largest city. Officials there relied on the advice of JPMorgan in 2002 and 2003 as it refinanced almost all the $3.2 billion of fixed-rate debt that built its sewers into variable-rate bonds coupled with interest- rate swaps.

When the insurers guaranteeing the bonds lost their top credit ratings and the auction-rate market seized up in February, the yield on the bonds jumped as high as 10 percent from about 3 percent in January. At the same time, the swaps tied to the debt, instead of protecting against higher rates, backfired. That pushed the sewer system’s annual debt costs to $460 million, more than twice the $190 million it collects in revenue.

Bankruptcy Talks

JPMorgan is now leading the negotiations to prevent the county from filing the biggest municipal bankruptcy since Orange County, California, in 1994. It is among the banks that are holding Jefferson County bonds under an agreement to act as buyers of last resort, and may suffer losses in the event of default.

JPMorgan, under Chief Executive Officer Jamie Dimon, has weathered the credit-crisis better than many of its rivals, taking $14.3 billion in writedowns, losses and credit provisions since the beginning of 2007.

The company fell 9 percent in New York trading this year, compared with a 33 percent decline for New York-based Citigroup Inc., which reported $55.1 billion in credit losses, and a 46 percent drop for Zurich-based UBS AG, which had $44.2 billion in costs. JPMorgan has raised $9.5 billion in capital to offset the losses, according to Bloomberg data.

Dimon declined comment through spokesman Joseph Evangelisti.

Pennsylvania Deal

JPMorgan’s derivatives sales have also come under scrutiny in Pennsylvania. The Erie City School District on Aug. 29 sued JPMorgan and a Pennsylvania financial adviser in federal court alleging they colluded to reap more than $1 million in excessive fees on a 2003 derivative deal.

The suit alleges JPMorgan conspired with the adviser, Pottstown, Pennsylvania-based Investment Management Advisory Group, to convince the district to sell the bank a derivative known as a swaption, or an option on an interest-rate swap.

Erie’s school board, which only had a “rudimentary, laymen’s understanding of the derivatives market” met in September 2003 with JPMorgan banker David Dicarlo, who told them the district could make $750,000 by selling the swaption, according to the complaint.

Contract Price

DiCarlo told the board he didn’t know how much JPMorgan would make on the deal. Image, which had been recommended to advise the district by DiCarlo, told board members that the district was getting a fair price for the contract. Both statements were false and misleading, the lawsuit alleges. The swaption was worth about $2 million, resulting in fees of more than $1 million at the time, according to a February article in Bloomberg Markets.

Elsewhere in Pennsylvania, in a $55 million interest-rate swap with Bethlehem in 2005, JPMorgan charged the district $900,000 twice the average for comparable swap deals, according to the article.

JPMorgan made $1.23 million on the deal, almost 10 times a fair fee, based on market conditions at the time, the suit alleges. A separate school district, in Butler, Pennsylvania, also asked the SEC to investigate its derivative deal with JPMorgan.

Banking Business

JPMorgan’s exit from municipal interest-rate swaps may harm the firm’s investment banking business because cities and states that solicit bond underwriters want banks with strong derivatives capabilities, said Swap Financial’s Shapiro.

“Historically, derivatives have been one of JPMorgan’s strongest calling cards in the municipal arena,” Shapiro said.

Charles LeCroy, the JPMorgan banker who masterminded Jefferson County’s swaps, pleaded guilty in January 2005 in a federal corruption investigation in Philadelphia into whether city bond business was steered to political supporters of former Mayor John F. Street.

LeCroy and fellow banker Anthony Snell pleaded guilty to charges that they defrauded JPMorgan by arranging a $50,000 payment to bond lawyer and fundraiser Ronald A. White for legal work on a Mobile, Alabama, school district transaction that White didn’t perform.

Higher Fees

According to an interview with Snell by an outside attorney for JPMorgan made public in the case, the bank also sought to get White work on swap transactions because they were more lucrative than typical bond deals.

“Swap deals were more numerous and higher fees available,” Snell said in the interview. “In addition, swap transactions have much more flexibility for payment because there is no requirement, as there is in new money transactions, that the fees be disclosed.”

Taylor, the former municipal bond regulator, said JPMorgan’s exit may be intended to help it deal with charges that may soon emerge from the nearly two-year long investigation by the Justice Department and the SEC.

Federal Probe

Investigators are looking at whether bidding practices for a type of financial agreement, known as a guaranteed investment contract, were rigged. The Internal Revenue Service requires that the contracts, where governments place money raised from bond sales until it is needed for projects, be awarded by competitive bidding from at least three banks.

Federal prosecutors are trying to determine if advisers hired by municipalities to handle the bidding conspired with banks and insurance companies to rig auctions. Authorities are also looking into how banks arranged derivatives for local governments.

“I wonder if they are trying to get ahead of the Justice Department’s decision,” Taylor said. “They want, when that comes out, to say we’re out of that business.”

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.

Last Updated: September 4, 2008 08:48 EDT

Source: Bloomberg

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