JPMorgan Chase & Co will stop selling interest-rate swaps to government borrowers in the $2.6 trillion US 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. JPMorgan also led a group of banks that charged $120 million in fees for such deals in Jefferson County, Alabama. That was as much as $100 million too high, the county's former adviser said.
Wall Street 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 soar. 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 Municipal Securities Rulemaking Board 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 on swaps, and is among those named in civil antitrust suits pending in US courts.
The New York-based bank also has 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, while continuing to market the products to non-profit customers such as hospitals. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.
Sales of derivatives to cities, towns and school districts provided banks with fees as earnings from arranging sales of tax-exempt bonds used to build schools, roads and other public works declined.
Private Contracts: Underwriting fees on municipal bonds sold through banks chosen ahead of time, which make up about 80 per cent of the market, declined to $5.40 per $1,000 of bonds last year, from $7.23 in 1998, according to Thomson Reuters data.
Interest-rate swaps, contracts in which two parties agree to exchange interest payments based on an underlying bond, are also 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: 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 was disclosed to officials, records show.
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 were also 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.
Strategy Backfires: 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.
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 per cent, 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 while refinancing almost all the $3.2 billion of fixed-rate debt that built sewers into variable-rate bonds coupled with interest-rate swaps.
Costs Spiral: 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 per cent, from about 3 per cent 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.
JPMorgan is now leading the negotiations to prevent the county from filing the biggest municipal bankruptcy since Orange County, California's 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.
Pennsylvania Schools: The company fell 9 per cent in New York trading this year, compared with a 33 per cent decline for New York-based Citigroup Inc., which reported $55.1 billion in credit losses, and a 46 per cent 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 data compiled by Bloomberg. The bank was indicated today at the equivalent of $39.61 in German trading of only 35 shares.
Dimon declined to comment through spokesman Joseph Evangelisti.
JPMorgan's derivatives sales also have 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.
‘Calling Card’: 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.
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 almost 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.''
