JP Morgan Under Criminal Investigation for Jefferson County, Other Swaps

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.

From Bloomberg:

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.

Print Friendly, PDF & Email


  1. Anonymous

    Satyajit Das is going to have to come out with multiple editions of his great book
    Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives

  2. macndub

    I’m getting easily confused in my old age, Yves. How does the cash flow, here? If the muni pays fixed and receives Libor on exercise, why would the muni now have to issue floating rate bonds?

    Anyway, despite the details, I can’t see how writing an option could ever lower risk.

  3. bg

    By 1935 the US government was prosecuting Andrew Mellon, the former treasury secretary for using then legal tax deductions in 1931. The legal theory was that he made investments in tax free bonds because they were tax deductable. Thus the investments were entirely for tax avoidance.

    Perhaps JPM is a cartel of criminals. Perhaps we are reaching a point where we could convict Mother Theresa if only she invested in a derivative.

    I am not so sure the governments hands are clean, and JPM makes a clean target.

  4. patrick neid

    Without trying to ascertain guilt or innocence what I am prepared to say is welcome to the future.

    When large sums of money disappear the only thing you can be certain of is that lawyers will appear.

    To date with 12 trillion evaporating worldwide I think “lawyering” will be the next bubble.

  5. The Pragmatic Progressive

    As a former muni bond lawyer, I believe that it’s probably safe to say that the number of lawsuits like this is only limited by the number of lawyer-hours available to be deployed in filing them…

  6. Anonymous

    Funny that Prince Kasahri denied Jefferson County a bailout the other day, and now the Feds are all over a Goldman rival. interesting for sure

  7. Anonymous

    the intersection of municipal finance and derivatives is one of the scummiest corners on the capital markets map. easy way to avoid this going forward is to hang a few bankers — after clawing back their bonuses and those of their managers, all the way to the top.

  8. Anonymous

    whatever happened to caveat emptor? The deal seems to give JPM much more (all?) of the benefit but nobody put a gun to the heads of this county. This looks a lot like a subprime pitch to me – hey, we’ll give you $12m now to help out your county and we’ll just worry about your obligations later…I don’t see what this muni body is doing entering into a contract it doesn’t understand, the rule on swaptions, as I understand it is you have to take a position on interest rates. If you’re not equipped to do the models than stay out and find a different bank to lend you money. JPM could obviously pressure the county in different ways, but still – caveat emptor, I have to return to.

  9. john bougearel

    These securities that JP Morgan sold to state muni’s, public school systems and other state related agencies occurred throughout the country over the past decade.

    These securities also bore significant and undesirable risks to short-term interest rates, and were sold as a way to participate in obtaining cheaper financing rates as the fed funds rate plunged to 1%.

    There was no exit strategy for when rates began to go back up. To decompose the risks, rather than seek out a fixed rate, they sold them interest rates swaps to protect them against adverse interest rate swings only served to keep them in a financing strategy that had lost its viability.

    What these muni’s were sold was a pig-in-a-poke. But JPM generated a lot of fees from selling these new insurance products they called swaps (I mean pig)

    Snake oil salesmen. They should be taken out behind the barn and shot.

  10. john bougearel

    Another footnote:

    State laws precluded states, state municipalities, and school districts from investing in these new financial innovations.

    Only after intense lobbying by banks were these state laws repealed in the first half of this decade

  11. Anonymous

    as to ‘caveat emptor,’ what’s wrong with hanging a few thieves? we put tons of young men behind bars for stealing much less. you’re not going soft on crime, are you?

  12. Anonymous

    “JPM could obviously pressure the county in different ways, but still – caveat emptor, I have to return to.”

    are you also in favor of lower taxes and more efficient govt? if so you are going to have to choose between the slick scoundrels at the big banks and the dumb municipal managers who regularly get taken to the cleaners by the former. it’s your tax money too, mr. c. emptor….

  13. Anonymous

    macndub, you’re RIGHT! Typical of complicated stories like this, even Bloomberg is reporting it WRONG. writing a swaption is no risk reducer! Also receiving fixed is nothing to fear if you originally feared rates going UP!

  14. Anonymous

    What JP Morgan did to the Bethleham school district was unconscionable.

    The district needed money so JP Morgan bought a swaption off them for around $750k. JPM then proceeded to immediately turn around and sell that same derivative for its market price of $2 million. After paying around 250k in fees, JPM made an easy million. It would later cost the school district $2.9m to get out of the deal.

    Now one could say caveat emptor but obviously a school board has no chance at figuring out the risks of something like that. Before the deal was signed, the school board's law firm turned to an outside investment consultancy to advise on the deal. Being far too trusting, the law firm failed to see the conflict of interest in hiring the consultancy that was recommend by JP Morgan. The consultant said the school district should sign the deal and thus the sheep were sheared.

    I'd have trouble sleeping at night knowing I just plundered a struggling school district but apparently those at JPM have no such problems.

    The full story is even more sickening than you could possibly imagine. Refer to this should you ever have a twinge of sympathy for the big banks.

  15. Anonymous

    john bougearel has it correct. It was some perverted type of insurance, with fees paid upfront on the originals and then the secondaries.

    Probably threatened the municipalities rating and used as a selling pressure point.

    Fees the first time around, the second the around, third time……..

  16. Francois

    “whatever happened to caveat emptor? The deal seems to give JPM much more (all?) of the benefit but nobody put a gun to the heads of this county.”

    You think? Like these counties and school districts are swimming in an ocean of cash.

    Do you also think JP Morgan sales reps were, shall we say, upfront about the risks involved? That they didn’t “help” the financial advisor’s that were supposed to work for their clients?

    There are several legitimate reasons why US prosecutors are on these cases. Especially when one considers how difficult they are to successfully prosecute.

  17. Cool Head

    I smell some corruption here. The counties and school boards can’t be that dumb. It may have been “wink, wink, nod, nod” on both sides. Methinks something is really rotten here. Also remember that these deals are now coming out in the open ONLY NOW after the subprime and other messes. Otherwise we may not have come to know of such deals ever. Only some bankers and politicians/bureaucrats would be happily be richer by a few millions.

  18. Yves Smith

    Cool Head,

    The reasons I suspect not is that (admittedly a decade ago) I had some peripheral knowledge of the sales practices of Bankers Trust, which at the time was one of the two biggest players in complex OTC derivatives. They would regularly fleece customers by taking structures that might have made sense and pricing them and/or larding them with fees so that they were a bad deal for the customer.

    And these customers were the Treasury departments of Fortune 500 companies. And when Proctor & Gamble went after them in court, that was basically the end of BT.

    Now you would think P&G would have no case. They are a big sophisticated company, right? Caveat emptor, right? The case never went to trial, but the sales force comments on tape and the (apparent) misrepresentations by the sales force were bad enough that BT was a goner.

    Now, to understand complex derivatives, you do not merely need to have a good grasp of calculus. You need to work enough with calculus (as in daily, a ton), that it is INTUITIVE to you.

    How many people like that do you think are working in city and state government? I'd guess if there were ANY, they'd be on the fund management side, not the fund raising side.

  19. fresno dan

    I think what this shows is that anyone trying to sell you anything should be trusted to the same extent that you would trust a used car salesman.
    I used to think that the guys who ran finance understood complex transactions and could therefore creat value. Now I believe they were just running a casino and all profits were due to the house advantage.

  20. Anonymous

    Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them …

    The products, which are known as power reverse dual currency notes (PRDC), were sold to Japanese households as simple products offering higher yields than regular savings but the bonds were in reality hugely complex structures “with 15 moving parts and multiple points of pain”, derivatives experts at RBS in Tokyo said.

    The products combine exposure to foreign exchange, interest rate differentials and domestic inflation

    Topic: Reform

    the above can go a long way toward a definition of the current crises to educate the public on what has happened to them and how.

    US News media, if they understand it themselves, are useless -indeed, worse than useless because their skill is acting as if they know what they are talking about and people starved for news who watch c-span think they are being educated by congressional hearings that further exploit this absence with sensationalized history, pandering to the public, and more propaganda from witnesses.

    every financial instrument including credit cards, mortgages and bank agreements sold to the public must feature language that can be understood by any high school student with an above B average grade.

    …the old lady

  21. luther

    from the article:

    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.”

    i/o/w this story and the yen story may be 2 sides of the same story.

  22. Anonymous

    madame old lady,

    just got my absentee ballot for new york yesterday. there’s a constitutional amendment in regards to veteran’s affairs on there.

    wait til you get a load of this one…

    say what?

Comments are closed.