The agonies of Jefferson County, Alabama, which got itself into a too-clever-by-half funding arrangement that put the county on the verge of bankruptcy, have faded from the public eye. However, the type of transaction that caused so much woe, a swaption to supposedly lower financing costs, has been the subject of SEC and Justice Department investigations for some time. The focus has moved to JP Morgan based on its role n the ill-fated Jefferson County deal and other municipal transactions.
The Bloomberg story provides some detail on the swaption itself, and if the reporting is accurate, this looks like an a deal almost certain to have turned out badly for the county. This is not at all uncommon for OTC derivatives, where even if the transaction in theory has merit, the fees charged are so high as to make the deal uneconomical to the client. But clients almost universally lack the skills to properly model the deal to figure this out. Most deals don’t blow up as spectacularly as this one did, so most clients never figure out they were had.
The U.S. Justice Department is investigating a derivative trade between the state of Alabama and JPMorgan Chase & Co. as part of a nationwide criminal probe.
The Justice Department subpoenaed documents about a so- called swaption, or an option on an interest-rate swap, between JPMorgan and the state’s school construction authority, according to a federal lawsuit filed by the state, which is trying to void the 2002 deal. The agency is investigating whether banks and advisers conspired to overcharge governments on the contracts.
“Although the authority does not seek by this action to avoid payment of any legitimate obligation, the pendency of at least two separate governmental inquiries implicating the validity of the transaction heightens the necessity for a judicial determination of the parties’ rights,” the complaint, filed yesterday in federal court in Montgomery, Alabama, said.
U.S. prosecutors and the Securities and Exchange Commission have searched for almost two years for evidence of rigged bidding and price fixing by banks in the $2.7 trillion municipal bond market. They have focused on derivatives, such as interest-rate swaps tied to bonds, and contracts to invest bond-sale proceeds.
The SEC has also sought information from the Bethlehem Area School District in Pennsylvania about its swap transactions with JPMorgan, while two other school districts in that state have sued the bank for allegedly conspiring to shortchange them on swaption deals like the one in Alabama.
Prosecutors have informed at least five former JPMorgan derivative bankers that they’re targets of a grand jury investigation, according to the Financial Industry Regulatory Authority. Finra is the largest self-regulator for securities firms doing business in the U.S…
Alabama’s Public School and College Authority, which sells bonds for public schools, colleges and universities, alleges the deal doesn’t comply with state law because it wasn’t a “legitimate hedging transaction.”
In March 2002, the agency received $12.6 million upfront from JPMorgan in return for selling the swaption. That gave the bank the right to force the state into $710.2 million of interest-rate swaps on four series of bonds between 2008 and 2011. The swaps called for the state to pay a fixed rate and receive a percentage of the London interbank offered rate.
JPMorgan pitched the deal as a way to protect against the risk of rising interest rates and refinance old debt at a lower cost, the complaint said.
In June, JPMorgan told the state it would exercise its option on Nov. 1 on a series of bonds issued in 1998.
That would have required the state to issue floating-rate bonds, a type of security whose interest rates have jumped more than 10 percent because of the U.S. credit crisis. The state also could have terminated the deal at a cost that wasn’t disclosed in the complaint.
Alabama alleges the swaption wasn’t documented in accordance with state law, which requires a governmental body to certify the swap was entered into for the purpose of hedging.
State law also says governments can issue refunding debt only at a lower cost than the old debt. The cost of issuing variable-rate bonds, including a fixed-rate payment to JPMorgan, would exceed the amount payable under the 1998 bonds, the complaint said.
The $2.2 million Alabama received for the swaption on the 1998 bonds was less than 1 percent of the amount outstanding, the complaint said.
The deal was also structured so that JPMorgan would receive more than $66 million, 50 percent of the fixed-rate payments due from the state, within two years after the swaption was exercised.
“By structuring APSCA’s fixed-rate payments in this manner, JPMorgan’s exercise of the swaption was for all intents and purposes a certainty, since by doing so it would receive what amounts to a $66 million loan from APSCA with effectively no rate of return or implied interest rate,” the complaint said.