Joseph Ambrosini says the deal looked so easy. JPMorgan Chase & Co. bankers told him there was really no risk. All he had to do was sign a public financing contract, and the bank would give $280,000 to his school district in New Castle, Pennsylvania.
By William Selway and Martin Z. Braun
“They basically said, unless the world goes under the sea, we’d be in good shape,” says Ambrosini, the district’s business manager.
In September, Ambrosini says, his 3,400-student district went underwater. On Sept. 25, the week after Lehman Brothers Holdings Inc. collapsed, the New Castle Area School District’s interest rate on $9.7 million of financing arranged by JPMorgan hit 10.6 percent, more than doubling since the month began, as investors demanded skyrocketing returns for municipal debt.
While JPMorgan has been relatively unscathed by the subprime crisis that hit Bear Stearns Cos., Merrill Lynch & Co., Lehman and other Wall Street firms, a little-known part of the largest bank in the U.S. made a tidy profit peddling a different kind of corrosive debt to hundreds of counties and school districts earlier this decade.
As the credit crunch froze lending globally, causing stock markets to plunge, local officials who say they trusted JPMorgan faced a crisis of their own. Wall Street’s drive for profits over the past decade has backfired on towns, cities and counties that borrow in the $2.7 trillion municipal bond market.
Financings arranged by JPMorgan and other banks are forcing hundreds of public agencies to spend billions of dollars they don’t have to pay for increased interest payments and penalties.
These come in municipal bond and derivative deals that have turned poisonous. Unlike JPMorgan, which has benefited from federal bailouts, the towns and schools the bank has financed have received no help from Washington.
In the midst of the Wall Street collapse, JPMorgan and Jamie Dimon, its chief executive officer, have stood as pillars. The bank helped the Federal Reserve bail out a tumbling Bear Stearns in March, as the U.S. Treasury pledged $29 billion to Dimon’s firm to cover losses.
In October, JPMorgan took over failing Washington Mutual Inc., the largest savings and loan institution in the U.S., with $188 billion in deposits.
Behind the glow of favorable publicity in which JPMorgan has basked, its municipal derivatives unit has operated in obscurity. The financings it arranged have sparked lawsuits from local governments alleging fraud.
The muni derivatives unit has become snarled in the largest-ever criminal investigation of public finance by the Department of Justice.
Prosecutors have informed at least five former JPMorgan derivative bankers that they’re targets in an investigation of whether banks conspired to overcharge local governments, according to the Financial Industry Regulatory Authority, or Finra, the largest self-regulator for securities firms doing business in the U.S.
The Securities and Exchange Commission is conducting a civil probe of the deals.
On Sept. 3, JPMorgan shut down its unit selling debt derivatives to municipalities because the risks outweighed the profit. Even so, localities are still on the hook for explosive contracts arranged by the bank.
“The legacy of this is going to resonate in state and local governments for years,” says Christopher Taylor, who ran the Municipal Securities Rulemaking Board, the industry’s regulator, from 1978 to 2007.
`Clean it Up’
“The culture started before Jamie Dimon got there,” Taylor says. “The question is, Is he going to clean it up once and for all? Because it stands in contrast to the rest of JPMorgan’s public image.”
The bank declined to make Dimon or any other executives available to comment for this story.
JPMorgan lured municipalities into derivative deals by offering upfront cash payments in exchange for a pledge by the local government to agree to enter interest-rate swaps with the bank at a future date.
In these deals, which were rarely put out for public competitive bidding, the bank said its clients would come out ahead if interest rates increased in the future.
JPMorgan and competitors routinely didn’t disclose their fees for these contracts, public records show. In some cases, the bank made more money than it paid out. In Erie, Pennsylvania, JPMorgan gave the school district $755,000 upfront and collected $1.2 million in fees.
How Fees Are Hidden[/h3]
The bank was able to lock in its income by selling a mirror-image swap contract on the open market for the higher amount. The transactions involved derivatives, which are unregulated contracts tied to the value of securities, indexes or interest rates.
The deals JPMorgan arranged used floating-rate bonds and interest-rate swaps. The swaps required a municipality and the bank to exchange payments as frequently as every month. The amounts that changed hands were based on various global lending rates.
Some deals also gave JPMorgan the power over decisions about taxpayer funds by allowing the bank to decide whether an agency would enter a swap in the future.
Jefferson County on Brink[/h3]
The bonds were backed by AAA-rated insurance companies and worked well for several years because Wall Street had easy access to cash. By the end of 2007, mortgage losses were undermining insurance company credit ratings and money flows began to tighten.
Nowhere have JPMorgan’s derivative deals wreaked more havoc than in Jefferson County, Alabama, home of Birmingham, the state’s largest city. A combination of soaring rates on its bonds and interest-rate swaps is threatening the county with the biggest municipal bankruptcy since Orange County, California’s default in 1994.
Jefferson County said it couldn’t make its $84 million interest payment on Oct. 1. JPMorgan and other creditors gave it a month to come up with a plan to rework its debts.
In April, the county’s financial adviser approached the Fed and the Treasury in Washington to explain its dilemma. On Oct. 6, Alabama Governor Bob Riley asked the Treasury for financial help for Jefferson County. Washington turned down the request.
`At Least a Conversation’
County Commissioner Shelia Smoot says that if the U.S. government was willing to rescue Wall Street, it should have responded to requests for help from a county on the brink of bankruptcy.
“If they’re bailing out some of the very people who got us in this mess, I think at least we could get a conversation,” she says.
JPMorgan and other banks have turned away from traditional, competitively bid, fixed-rate municipal bond sales in the past decade.
Fees banks collected for selling bonds that build roads, schools and hospitals dropped 25 percent to $5.27 for every $1,000 of debt in 2007 from 1998, as fixed-rate bonds became like commodities dropping in sales value. Banks found they could charge 10 times as much for selling municipal derivatives, public records show.
“The Street was driven into this stuff because the cash products weren’t profitable,” says Christopher Whalen, a former Bear Stearns bond trader who’s now managing director of research firm Institutional Risk Analytics. “You’ve got to find new participants or the game shrinks.”
If local authorities had stayed with old-fashioned, fixed-rate municipal bonds for financing, they wouldn’t be facing the rate blasts hitting them today. But banks realized that plain-vanilla municipal bond sales didn’t make them enough money, says Steve Kohlhagen, former head of debt derivatives at Wachovia Corp.
“It just wasn’t a very profitable business, but the derivatives part was,” says Kohlhagen, who retired in 2002. “So we kept a minor presence in bonds. The reason was the derivatives.”
JPMorgan was the sixth-largest municipal bond underwriter in 1985, with Citicorp and Merrill Lynch at the top of the list, according to data compiled by Thomson Reuters. JPMorgan managed to gain on its New York-based rivals by developing new methods of public finance.
Using derivatives, JPMorgan pitched a host of deals whose names alone are indecipherable. For Philadelphia International Airport, the bank sold something called a “path-dependent knock-out swaption.”
JPMorgan also sold interest-rate swap options, which are also known as swaptions, to school districts. When JPMorgan exercises those options, municipalities must issue floating- rate bonds and enter into interest-rate swaps with the bank.
The contracts allowed borrowers to tap money market funds to secure short-term rates on bonds that wouldn’t mature for decades. The derivatives were meant to protect them against soaring rates.
For the arrangements to work, banks would have to find buyers of municipal debt as often as every day. That included the so-called auction-rate bond market, which for decades ran smoothly with a surplus of buyers.
When the credit crunch hit in the second half of 2007, demand for such sales withered away. That sent the market for variable-rate municipal debt and derivative contracts into a frenzy.
High and Dry[/h3]
When banks couldn’t find buyers for auction-rate bonds, they stopped purchasing them themselves, so municipalities were left high and dry, stuck with spiking interest rates. The turmoil later rippled through the market for other variable- rate bonds as investors demanded high yields for them, too.
That increased interest rates each month for cities and towns.
Municipalities were stung again when the swap contracts, which were written to protect against rising rates, didn’t work.
Since the second half of 2007, lending rates have declined, causing the payments banks made to municipalities to drop.
On Aug. 14, JPMorgan settled with regulators, agreeing to buy back $3 billion of auction-rate bonds to settle industrywide investigations of whether banks misled investors about the risks of the auction bonds. That action didn’t help Jefferson County. JPMorgan neither admitted nor denied wrongdoing.
“A lot of people are getting killed; they’re getting crushed,” says Steve Goldfield, a financial adviser at Public Resources Advisory Group in Media, Pennsylvania, which was hired by a school district now suing JPMorgan.
“Nobody is talking about the impact on the debt side to taxpayers, how much school districts are going to pay in extra interest expense because of this blowup,” he says.
The seeds of JPMorgan’s municipal derivative deals were planted in the late 1980s. In 1987, the Fed relaxed provisions of the Glass-Steagall Act, the Depression-era legislation that prevented commercial banks from underwriting corporate securities and many types of local bonds.
The decision, which followed requests from Bankers Trust Corp., Citicorp and JPMorgan, allowed all banks — not just securities firms — to expand their sales of public debt.
Turning to Derivatives[/h3]
JPMorgan seized the opportunity. It turned to its strength: derivatives, says Peter Shapiro, managing director at Swap Financial Group LLC, a South Orange, New Jersey-based financial adviser.
“More than anybody else, they used derivatives to go from nowhere as an underwriter in 1987 into the group of leaders,” Shapiro says.
The most common derivative JPMorgan sold to municipalities was the interest-rate swap, in which two parties agree to exchange periodic payments based on two different interest rates, one fixed and the other floating.
Municipalities liked the deals because they could get cash upfront.
“They were able to create very appealing products for municipal issuers on what is known as the exotic side of the market,” Shapiro says.
In 2000, J.P. Morgan & Co. and Chase Manhattan Corp. merged. Douglas MacFaddin, the head of Chase’s municipal derivatives group, took over from Ajay Nagpal, who had headed J.P. Morgan’s desk. MacFaddin joined with former Chase bankers Samuel Gruer, James Hertz and Hugh Nickola.
The Justice Department told Gruer, Hertz and MacFaddin beginning in November 2007 that they were targets in the criminal investigation of the municipal derivatives market, according to Finra.
JPMorgan fired MacFaddin and Hertz after learning of the probe, federal records show. Nickola wasn’t named as a target and still works at JPMorgan. Gruer, who joined Deutsche Bank AG in 2006, denies wrongdoing, records show.
MacFaddin, Nickola and Hertz didn’t return requests for comment. Gruer declined to comment.
MacFaddin, 47, a graduate of Union College in Schenectady, New York, took J.P. Morgan’s emphasis on exotic derivatives and merged it with Chase’s goal of doing many deals quickly, Shapiro says.
Just as lenders that offered subprime mortgages relied on an army of local brokers to sign up less-than-creditworthy borrowers, JPMorgan developed ties with local municipal bond firms, advisers and lawyers to land deals.
JPMorgan gave these firms work in return for promoting the bank to elected officials, Charles LeCroy, JPMorgan’s top revenue producer in public finance, told an outside lawyer for the bank in 2004, according to court filings in Philadelphia.
In 2005, LeCroy, 54, and JPMorgan banker Anthony Snell pleaded guilty in Philadelphia to charges of filing false invoices in connection with swap and bond deals steeped in corruption.
LeCroy was sentenced to three months in jail. Snell was sentenced to 90 days of house arrest and fined $15,000. Philadelphia Treasurer Corey Kemp was found guilty after a trial in Federal District Court in Philadelphia in 2005 and is serving 10 years in prison.
`A Lot of Stroke’
In Philadelphia, JPMorgan turned to bond lawyer Ron White, a confidant and fundraiser for then-Mayor John Street.
“He carries a lot of stroke with the city,” LeCroy wrote of White to a fellow JPMorgan banker in a December 2001 e-mail.
All of the deals that JPMorgan and White discussed involved derivatives, LeCroy said during an SEC administrative hearing in December 2006. JPMorgan agreed to train White so he could become the lawyer on Philadelphia’s interest-rate-swap deals, LeCroy told investigators.
In 2002, LeCroy held a meeting between White and MacFaddin, who outlined what White would have to do, according to court records.
JPMorgan also agreed to contribute to White’s charities. It gave $70,000 to a foundation for youth leadership and $20,000 for a minority scholarship fund in White’s name at his alma mater, Wesleyan University in Middletown, Connecticut.
$50,000 for Nothing[/h3]
JPMorgan also paid White $50,000 in a Mobile, Alabama, public finance transaction in which he played no role, court records show.
On Feb. 19, 2003, White told Kemp that JPMorgan was pushing swaps to generate fees, not because they were in the city’s interest, according to a tape recording by the Federal Bureau of Investigation.
“You know, they don’t watch your back,” White said. “They’re about getting fees and getting the most fees they can get. If there was an issue between whether to do a bond deal or a swap, they gonna take the swap, even though it may not be the best thing.” White died of cancer before the trial.
Richard Metcalfe, head of policy for the International Swaps and Derivatives Association Inc., says swaps help to manage risk.
“While an interest-rate swap will hedge against movements in interest rates, it is simply not designed to address other forms of risk,” he says.
Ten Times as Much[/h3]
In April 2002, Philadelphia International Airport entered into a high-stakes derivative trade with JPMorgan. The airport got $6.5 million; JPMorgan acquired the right to put the bank into an interest-rate swap on $189 million of bonds.
JPMorgan took in $4 million-$4.5 million on the deal in fees, according to LeCroy’s SEC testimony. That was 10 times what the bank earned for underwriting a floating-rate-bond issue for the airport after the bank exercised the option.
The deal has turned out terribly for Philadelphia. In June 2008, the interest rate on the floating-rate bonds the airport issued surged to 7.2 percent from 1.8 percent the week before, after MBIA Inc., the company that guaranteed the bonds, lost its AAA credit rating.
The rate on the debt reached a high of 10 percent on Sept. 23. That wouldn’t be so bad if the floating rates the airport received from JPMorgan matched the increased rate it pays the bond investors, which is what the contract is designed to do.
That hasn’t happened. The average rate the bank paid the airport from June to September was 2.27 percent.
`We’d Rather Not’
Philadelphia officials say they don’t really have the choice of canceling the swap. Based on prices at the end of September, termination would cost Philadelphia about $24.4 million, according to the city. That’s almost $20 million more than what it received in 2002.
“Obviously, the termination payment would be significant,” City Treasurer Rebecca Rhynhart says. “It’s something we’d rather not have to do.”
JPMorgan turned to other politically connected friends to win contracts in Western Pennsylvania in 2003. That year, it bought Cranberry Township-based underwriter RRZ Public Markets Inc., near Pittsburgh.
Greg Zappala, the son of former Pennsylvania Supreme Court Chief Justice Stephen Zappala and the brother of the Allegheny County district attorney, brought his local government clients to the Wall Street bank. Along with them, according to two lawsuits, came windfall profits on derivative deals.
Zappala urged the Butler Area School District, in the countryside 40 miles (64 kilometers) north of Pittsburgh, to take cash out of bonds that couldn’t be refinanced until 2008.
Bank Got More[/h3]
In September 2003, the school district got $730,000 from JPMorgan by selling the bank the option to push the school district into a swap beginning in 2008.
That exchange was more valuable to JPMorgan. The bank made $894,000 at the same time, according to a lawsuit filed by the district in September.
The district alleged that JPMorgan conspired with adviser Investment Management Advisory Group Inc., or IMAGE, to hide the fees and push the district into an unfair trade. As of mid-October, JPMorgan and IMAGE hadn’t filed a court response.
In July, JPMorgan told the school district it would exercise the option on Oct. 1. That would lock the district into potentially huge interest rate increases. So the district paid JPMorgan $5.2 million to walk away, seven times more than the bank paid it in 2003.
Edward Fink, superintendent of the school district, says it’s now clear the risky deal was a mistake.
“The last few months have led us to conclude that swap transactions, although legal for public school districts in Pennsylvania, are inappropriate transactions for public school districts,” he says.
The New Castle school district is learning the same lesson. In September, Ambrosini, the district’s business manager, found that the cash the schools accepted left him exposed to market chaos he never anticipated.
In 2004, JPMorgan banker Michael Lena, one of those under investigation by the Justice Department, made a deal with the district in which the bank gave the schools $280,000 for the option to force the district into interest-rate swaps on $9.7 million of bonds.
`They Assured Me’
It also purchased options on two other district bond issues. Lena didn’t respond to requests for comment.
Ambrosini says JPMorgan’s bankers told him the deal was nearly fail-safe and would allow the schools to collect money that would disappear if interest rates rose.
“They assured me, ‘You’re going to be in great shape,”’ he says.
The credit crisis caused the interest rate to jump on Sept. 25 to 8.75 percent on $9.7 million of bonds he sold in May as JPMorgan called in its option. The swap added another 1.9 percentage points, bringing the district’s interest rate to 10.6 percent.
Phil Conti, vice president of the New Castle school board, says he doesn’t know what to do.
“We’re in a dilemma,” he says. “We’re struggling just to keep our head above water.”
Conflicts of Interest[/h3]
Many municipalities, including Butler County, Jefferson County and Philadelphia, hired financial advisers to analyze prices, fees and interest rates to determine whether swap contracts were fair.
Local officials didn’t recognize the conflicts of interest created by the relationships between the advisers and the banks. Banks routinely pay these advisers and often refer them to government issuers.
In Erie, JPMorgan recommended Pottstown, Pennsylvania- based IMAGE to be the school district’s independent financial adviser. During a Sept. 4, 2003, meeting of the Erie City School District’s board, JPMorgan banker David DiCarlo praised the firm.
“There’s only probably three or four firms in the world that do these things, and IMAGE is probably the premier firm,” DiCarlo said, according to a transcript of the meeting.
As in Butler, IMAGE never disclosed JPMorgan’s fee. Neither did the bank. In a written statement, IMAGE said it could only estimate the bank’s fees, which it described as normal for the industry. The firm denied any conflict of interest.
`I Can’t Quantify That’
Erie school board member Eva Tucker asked DiCarlo how much JPMorgan would make in the deal.
“Everybody has asked, and it is a reasonable question, what does JPMorgan, what do we get on this transaction?” DiCarlo said, according to minutes of a school board meeting.
“I can’t quantify that to you,” he said. “What this transaction is, is a financial transaction that is put into a huge hedge fund that JPMorgan controls. There’s a trillion dollars of investments in that hedge fund. There’s some other issuer in Tokyo or somewhere else who’s got an opposite bet and they’re going to offset each other.”
JPMorgan, which, like other banks, balances the swaps by selling similar derivative deals on the open market, took a fee of $1.23 million, according to data compiled by Bloomberg. That’s almost 10 times the fair rate, according to a lawsuit filed by the school district against JPMorgan and its adviser in federal court.
There had been no court-filed responses as of mid- October. DiCarlo, Zappala and IMAGE didn’t return requests for comment.
$5.4 Billion in Swaps[/h3]
The JPMorgan municipal finance deals that have drawn the most national attention are those in Jefferson County, Alabama. The county, with a population of 660,000, has $5.4 billion in swaps on its books — the most of any county in the U.S.
In “The Banks That Fleeced Alabama” (September 2005), Bloomberg Markets magazine reported that JPMorgan overcharged the county by $45 million on its derivative deals.
The interest rate Jefferson County must pay on its bonds jumped as high as 10 percent in February from about 3 percent two months earlier. The swap agreements drove the county deeper in the hole. It may be forced to file for bankruptcy.
Clarence Arnold, who lives in Birmingham on $738 a month from Social Security, worries that people like him will wind up paying the bill.
“We didn’t get them in this mess,” Arnold, 66, says. “But it doesn’t matter what we do. It’s going to end up in our hands. It always does.”
$100 Million More[/h3]
In 2002 to 2003, Jefferson County refinanced into floating rate bonds almost all of the $3.2 billion of debt it sold to build a sewerage system. The county paid JPMorgan and a group of banks $120.2 million in fees for derivatives that were supposed to protect it from the risk of rising interest rates.
Those fees were about $100 million more than they should have been based on prevailing rates, according to James White, an adviser the county hired in 2007, after the SEC said it was investigating the deals.
JPMorgan and seven other banks in the deals were left holding most of the bonds after credit markets froze in early 2008. The banks asked to get paid back with county tax money or higher sewer fees. Such proposals caused a public outcry.
`We Were Boxed’
“We were boxed in because we couldn’t raise taxes and couldn’t raise rates, which are already too high anyway,” County Commissioner Jim Carns says.
White traveled to Washington in April to tell members of Congress and officials at the Federal Reserve and the Treasury Department about the crisis that was threatening Jefferson County with bankruptcy.
“We were told Jefferson County didn’t have national implications,” he says.
The crisis triggered a seven-month standoff between the county and the banks. In negotiations with the county, banks have sought to be released from any liability in the swap and bond deals, Carns says.
“My constituents do not want to let Wall Street off the hook,” he says. Carns says he opposed the $700 billion Wall Street bailout.
“Motivated by overwhelming greed, Wall Street thrashed around creating financing structures divorced from reality and good sense — and paid lots of people way too much money,” he says.
In Jefferson County, the local consequences may be dire. In Birmingham, one in four people lives below the poverty line, according to the U.S. Census Bureau. Those residents may be forced to bail out the debt mess by paying higher sewer bills.
“The poor people are going to be suffering for it,” retiree Arnold says. It’s not just in Birmingham. Across the country, Wall Street made windfalls peddling risk and the illusion it could be kept under control.
Beverly Schenck, a 71-year-old paralegal who lives in Center Township, Pennsylvania, in the Butler school district, is livid.
“Why wasn’t someone investigating these deals?” she says. “If it looks too good to be true, it is.”
For municipal governments, as for many of the financial institutions themselves, the opaque derivative deals have broken down. And taxpayers are left picking up the pieces.
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