Muni swaps

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See also bond insurance, Build America bond, derivatives, municipal securities, municipal bankruptcy and Municipal Securities Rulemaking Board.


2010 efforts to reform muni swap oversight


Of immediate concern for many market participants is the regulatory reform legislation that passed the House earlier this month as well as separate draft legislation that the Senate Banking Committee is reworking.

The Senate legislation would be significant for the muni market in part because it would prohibit states and localities that have discretionary investments of less than $50 million, excluding bond proceeds, from being considered “eligible contract participants” in derivatives transactions. Derivatives deals with non-ECPs would have to be exchange-traded, which probably would not be feasible for state and local governments because they would be required to meet daily margining requirements.

The House bill contains a different provision. While it contains the $50 million threshold of discretionary investments, it would allow governments to be ECPs if their counterparty is a bank or broker-dealer. That would mean that virtually all municipalities could engage in derivatives transactions.

In its current form, the Senate bill would have the effect of shutting down the OTC swaps market for governmental issuers, according to Sam Gruer, managing director at Cityview Capital Solutions LLC in Millburn, N.J. Gruer contends the legislation’s definition of “discretionary investments” would exclude states and localities’ general funds, which generally are earmarked for specific projects and operations and not set aside like a university endowment that is designed to grow over time.

As a result, very few, if any, municipalities would meet the sophistication threshold, he said, adding that if Dodd’s intention is to keep states and localities out of the OTC derivatives market, the proposal works.

“But even if that’s the intent, many municipalities are already in the market and if nothing else they need a clear exit strategy so that existing trades can be unwound within existing parameters, or be restructured if and when they need or choose to do so,” he added.

One market participant who asked not to be named said Congress has a natural impulse when it encounters a situation where constituents have suffered losses to make it so that those losses become illegal in the future.

Though many municipalities have, on net, saved money with derivatives, he said some issuers, such as Jefferson County, have lost “spectacularly,” which has led many lawmakers to try to overregulate.

But market participants said that the $50 million of “discretionary investments” threshold for determining eligible contract participants is misguided. Peter Shapiro, managing director at Swap Financial Group in South Orange, N.J., said it stems from a misunderstanding that derivatives are investments when in fact they are overwhelmingly hedges on debt, and have nothing to do with investing.

Meanwhile, the Securities Industry and Financial Markets Association is drafting a proposed framework for OTC derivatives used in the muni market, said Michael Decker, managing director and co-head of SIFMA’s municipal securities division here.

Other market participants note that the federal effort to address the sophistication of municipalities that engage in swaps comes amid the Justice Department and SEC’s parallel criminal and civil probes of anti-competitive practices related to municipal swaps and investment contracts. Jeffrey Blumenfeld, of counsel at Kutak Rock LLP in Philadelphia, said the probes also are likely to have a regulatory consequence at the state level, perhaps mirroring new rules in Tennessee that require issuers to have at least $50 million of outstanding debt before they can enter into interest rate swaps. Earlier this week, the Delaware River Port Authority of Pennsylvania and New Jersey agreed to ban its use of swaps and to consider terminating current agreements.

“The biggest consequence is going to be protecting public money in the future by restricting issuers, based on size or type, from participating in these kinds of trades,” Blumenfeld said. “And the pendulum may swing too far because the hardest part of any legislation of this type is knowing where to draw the line.”..."

California’s Lockyer seeks curbs on ‘naked’ swaps

California Treasurer Bill Lockyer said the U.S. and international financial regulators should limit trading of municipal credit-default swaps to help prevent speculative, or “naked,” trading of the derivatives.

Lockyer, a Democrat, said absent an outright ban on speculative trading of credit default swaps -- the trading of debt-insurance contracts by investors who don’t own the securities -- regulators should adopt capital-margin requirements in order to reduce leverage and prevent abuses.

“The municipal CDS market, when used by bondholders to hedge risk, can benefit issuers by increasing demand for bonds,” Lockyer said today in a statement. “But naked trading of CDS by investors who don’t own California bonds poses a potential danger to taxpayers.”

Lockyer in April asked six banks -- Bank of America Merrill Lynch, Barclays Plc, Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley -- to describe the extent to which they market the default contracts and asked them to explain how trading in the instruments affects interest costs on the state’s bonds. California is the largest issuer of U.S. municipal debt and is the lowest-rated among the 50 states. The treasurer earlier sought a ban on speculative trading.

Betting Against State

In May, Lockyer asked the banks to say whether they bet against the state with credit default swaps and how much swaps are sold to investors who don’t own the debt. He’s said he was concerned that speculative trading could boost borrowing costs if the transactions create an unjustifiably negative perception of California’s risk of default.

“Unchecked speculation opens the door to market manipulation that could artificially inflate perceived credit risk and increase taxpayers’ borrowing costs on bonds,” Lockyer said today. “Reducing leverage opportunities will make it harder for speculators to game the system and hurt taxpayers.”

Moody’s Investors Service grades California debt at A1, its fifth-highest rating. Standard & Poor’s gives it an A-, its seventh-highest.

Underwriters traded $27 bln CDS of Calif. debt

Six top underwriters of California debt have since 2007 completed over $27.5 billion of credit default swap trades on the state's general obligation bonds, the California Treasurer's office said on Thursday.

The disclosure marked the latest step in Treasurer Bill Lockyer's inquiry into whether it is appropriate for the six banks that underwrite the state's debt to also sell credit default swaps on it.

Lockyer is concerned the twin functions puts the banks in a position whereby they may bet against the state's low credit rating and inflate the cost for California to issue debt.

The finding results from a letter sent last month by Lockyer to Bank of America Merrill Lynch (BAC.N), Barclays (BARC.L), Citigroup (C.N), Goldman Sachs (GS.N), JP Morgan (JPM.N) and Morgan Stanley (MS.N) expressing concern spreads on California CDS are mispricing the state's credit risk and inflating interest costs.

Lockyer says the state's low credit rating a poor gauge of California's credit-worthiness since it has never defaulted on a debt service payment and is very unlikely to do so despite the state's budget problems.

California paid the six banks a combined $215 million bond underwriting fees and commission, a statement by Lockyer's office said.

CDS are used to hedge against default risk or to speculate on credit quality. The contracts were widely blamed for adding to fears about financial firms such as Lehman Brothers before it failed in 2008.

Lockyer's office in its statement said the treasurer believes the CDS trading's effect on bond prices is "not significant enough to cause concern at this time." The statement underscored "at this time."

"The data suggest the banks themselves, during the period covered, did not bet against the credit quality of California GO bonds," the statement said.

"The low net face value of the banks CDS positions, on the surface, indicates the absence of any conscious decision to 'short' California GOs via the CDS market," the statement added.

The statement said Lockyer will seek more information to clarify any "proprietary" trading by the six banks of California CDS and on any CDS plays on the state's debt by bank clients that do not have California credit exposure.

Lockyer will also require the 86 firms in California's bond underwriter pool to file quarterly reports providing detailed information on their CDS market activity.

Oversight of California CDS trading will be crucial if Build America bonds (BABs) become a "permanent part of the municipal landscape," the statement by Lockyer's office said.

Created in the U.S. economic stimulus plan last year, BABs offer issuers a federal rebate equal to 35 percent of interest costs. The BABs program has proven popular with investors and President Barack Obama recently signed a law extending it past its ending date in December.

"BABs are taxable, and they are more akin to corporate bonds than traditional tax-exempt municipal bonds. CDS play a much more prominent role in the corporate bond market. The six banks agreed CDS likely will gain significance in the municipal bond market if the BABs program lives beyond its current 2010 sunset date," the statement said.

CA Treasurer requests swap activity details from underwriters

Dear Mr. Blankfein:

I write to request information about your firm's market activities related to credit default swaps on municipal bonds in general, and State of California general obligation (GO) bonds specifically.

The State never has defaulted on a debt service payment in its history. Small wonder.

The State's GO bonds are backed by the full faith and credit, and taxing power, ofthe eighth largest economy on the planet. Under the state Constitution, debt service has second call on General Fund revenues, right behind schools. To provide a picture ofthis protection's strength, consider:

The Governor's revised 2009110 budget projects General Fund revenues at $88.1 billion and schools spending at $41.8 billion. GO debt service has first call on the remaining $46.3 billion. GO debt service for FY 2009110 is projected at $5.2 billion. In other words, we have debt service coverage of more than 8 times.

There's more. GO debt service payments are continuously appropriated. In plain English, that means debt service gets paid even if the State has no budget.

Your firm is fully aware of all this, because it sells California GO bonds. Frequently, your firm manages those bond sales.

Credit default swaps (CDS) amount to insurance against default. Yet, despite the security-plus backing of California GOs, and our spotless record of paying our debt on time and in full, market participants actively buy and sell credit default swaps (CDS) on our bonds. In fact, my office has information that indicates CDS on the State's GO bonds may rank No.1 in dollar value among all municipal issuers. We also have information that indicates your firm, which sells California GO bonds, may participate in the municipal CDS market.

Data reported in the news media and other sources show that the prices, or spreads, on California CDS wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan, Croatia, Bulgaria and Thailand. The perception of risk could adversely affect the price of our bonds when we go to market. That makes the CDS market important to our taxpayers. That is why I want to fully understand the municipal CDS market in general, the market for California CDS, and your firm's role in these markets.

I have no preconceived notions about the effect of CDS trading on California GO bond prices, or about your firm's activities in the California CDS market. I do, however, worry about firms selling our bonds, on one hand, and trading CDS on our bonds, or otherwise participating in that market, on the other. I also firmly believe taxpayers have a right to know this information.

Please provide responses to the enclosed questions by the close of business on April 12,2010.

Thank you in advance for your cooperation.


"-It's easy to forget amid the sea of scandal and outrage that has roiled the municipal bond market this year, but interest-rate swaps aren't bad for everybody.

The most common interest-rate swaps, where bond issuers agree to pay a bank a fixed interest rate in return for the bank covering payments on variable-rate bonds, were big winners for some prudent players in the municipal-bond market.

Take, for example, San Francisco International Airport, or SFO. The airport's head of capital finance, Kevin Kone, said swaps have allowed SFO to cut its debt service to 44% of operating costs from 50% in the last six years.

That, in turn, has driven down the airport's cost per passenger boarding a plane by 31% to $13.48, and allowed it to attract new, low-cost carriers. "It has served the airport well," Kone said. "It has been a way to create certainty in a less certain environment."

That is the theory, anyway. Interest-rate swaps are a way to lock in low rates by exchanging cheap, but risky, variable rate interest payments for a substantially reduced fixed rate.

Of course, that's not always the case. Reduced costs come with a myriad of new risks, as bond issuers from Harvard University to Jefferson County, Ala., have discovered the hard way. From the most sophisticated borrowers to the least, even the simplest swaps have proven a tricky financing problem, and one that can leave taxpayers out hundreds of millions of dollars. Given that reality, it may be useful to look at what SFO did right.

The first lesson, according to Kone, is avoid bankers baring leading-edge financial engineering. Kone said that at the height of the financial boom, investment banks were pitching municipalities "hot and heavy" on new contracts that would cut their cost of capital. While the airport saw the advantages of some contracts, they drew a firm line in the sand: understandability.

"If we ... can't understand it, (we) shouldn't be approving it," Kone said.

As a result, the airport chose only the plainest of "plain vanilla" swaps. Under the contracts they issue variable-rate bonds, and the bank pays the interest on those bonds in return for a steady fixed-rate interest payment.

From the bank's perspective, the contract is a speculative bet that interest rates will remain below the fixed rate - 3.95% in the contracts SFO has coming into effect in February with Goldman Sachs Group Inc. (GS) and the Irish bank DePfa Bank PLC. But for SFO, it locks in low interest rates on long-term debt.

The second lesson is to recognize that even if it saves you some money, a swap agreement adds players, and risks, to a debt offering. SFO took the time to hold public hearings that outline all of the various risks a swap exposed them to, including the risk that the bank they entered into the agreement with could fail, leaving them exposed. They also resolved that because of those risks, they would only enter into swaps that saved the airport significant amounts of money.

"If you enter into a swap where you save a dollar, you're only saving a dollar but you got a ton of risk," Kone said. "The amount of money you save...needs to be commensurate with what you think is worth the risk."

Incidentally, Kone doesn't think the risks are worth the payoff right now, since the credit crisis has considerably driven up the cost of swaps. He said the swaps going into effect in February will be the airport's last for the foreseeable future.

Bid rigging in muni swaps

A unit of General Electric Co. and a former subsidiary of Belgian bank Dexia SA were the two unnamed companies that allegedly conspired with a financial adviser charged by the U.S. with rigging auctions on municipal investment transactions, people familiar with the matter said.

Trinity Funding Co., owned by General Electric Capital Corp., and Financial Security Assurance Holdings Ltd. were two of four unidentified companies in the Oct. 29 indictment of CDR Financial Products Inc., its founder, David Rubin, and two executives, according to the people, who spoke on the condition of anonymity because they weren’t authorized to do so publicly. Trinity and FSA weren’t charged.

Two of the unidentified companies paid CDR to win agreements from local governments that hired Rubin’s adviser firm from 2002 to 2004, disguising kickbacks by paying his company to broker swaps with two unnamed financial institutions, according to the indictment. The indictment, brought in federal court in Manhattan, was the first resulting from a more than three-year investigation of the municipal bond industry.

“The CDR defendants and co-conspirators engaged in an ongoing scheme to defraud municipalities,” according to the indictment.

Brussels-based Dexia completed the sale of FSA’s bond- insurance business in July to Assured Guaranty Ltd. of Hamilton, Bermuda, while retaining its outstanding investment contracts. FSA, based in New York, was the biggest insurer of U.S. municipal bonds in 2007 and 2008.

Bidding Agent

CDR was hired by local governments to conduct auctions for investments purchased with bond proceeds until the money was needed to pay for construction projects. The government alleges that the conspiracy to steer deals to favored firms with sham auctions allowed companies to pay lower returns on the investments at taxpayers’ expense.

Since 2000, CDR has served as bidding agent or investment consultant on more than 1,000 transactions worth more than $25 billion, according to the Los Angeles-based firm.

The indictment, brought in federal court in Manhattan, was the first resulting from a more than three-year investigation of the municipal bond industry. CDR’s clients included the state of New Jersey, city of Philadelphia, and Jefferson County, Alabama, which last week sued JPMorgan Chase & Co. and the former president of the county commission, alleging they engineered a more than $3 billion sewer-debt refinancing to generate hundreds of millions in fees and interest payments.

Largest Lender

FSA spokeswoman Betsy Castenir in New York declined to comment in an e-mail. Ned Reynolds, a spokesman for GE Capital in Stamford, Connecticut, declined to comment in an e-mail. Francine Marx, a Dexia attorney, didn’t return a phone call to her New York office seeking comment. Justice Department spokeswoman Laura Sweeney in Washington, D.C., declined to comment in a call.

Dexia, the largest lender to local governments in France and Belgium, has agreed to indemnify Assured Guaranty and its affiliates against liability arising from the federal investigation and civil antitrust class action suits, according to a Nov. 16 corporate filing by the Bermuda-based insurer.

Rubin and CDR executives Stewart Wolmark and Evan Zarefsky have pleaded not guilty.

“We submit that the allegations brought by the Department of Justice are without merit and in fact, a total fiction based on a lack of understanding of the municipal reinvestment market,” CDR, which was founded in 1986, said in a statement on its Web site. “We believe that our position is fully supportable and that after a thorough review of the government’s case, CDR will be vindicated.”

Two Dozen

At least two dozen banks, brokers and insurance companies have been subpoenaed during the federal investigation. Former bankers with JPMorgan, Bear Stearns Cos. and Goldman Sachs Group Inc. have been notified that they may face prosecution, according to broker-registration records filed with the Financial Industry Regulatory Authority.

The U.S. Securities and Exchange Commission, which is also conducting an investigation into bid-rigging of municipal investment contracts, has notified at least seven firms, including GE Capital and FSA, that they face civil lawsuits in a parallel investigation, according to corporate filings.

Both GE and FSA have disclosed receiving so-called Wells notices from the SEC, giving them an opportunity to say why regulators shouldn’t bring a civil action. GE said in a filing last year that the investigation related to bidding by former employees and that the firm disagreed with the SEC’s recommendation to file suit.

Provider A

Zurich-based UBS AG and Bank of America Corp. have also received Wells notices, according to company filings. Charlotte, North Carolina-based Bank of America is cooperating with the Justice Department in exchange for leniency, the bank said in a February 2007 press release.

The government’s charges against CDR center on its involvement with two unidentified firms. One, called Provider B, is a group of financial-services companies that is part of a corporation with headquarters in Connecticut, according to the federal indictment. The state is home to General Electric Co. The second, Provider A, is a “group of financial-services companies located -- or controlled by those -- in Manhattan,” the indictment said.

FSA’s involvement with CDR-run auctions corresponds with at least two examples mentioned in the federal indictment, according to public records obtained through open-records law requests.

Water Agency

One of the transactions mentioned in the indictment involves an unidentified state water authority that used CDR on Oct. 23, 2003, to solicit bids for a contract to invest bond proceeds. FSA won a bid on that date for three such contracts with the West Virginia Water Development Authority after being solicited by CDR, according to documents obtained from the authority under a public-records request.

About 90 minutes before bids were due, Wolmark, CDR’s chief financial officer, spoke to an unnamed employee of Provider A about paying a kickback, according to the Oct. 29 indictment.

A half-hour after the deadline, Zarefsky of CDR gave the employee information about the bids submitted by other firms and suggested that Provider A lower the interest rate on one of the agreements to a specific number, according to the indictment.

Eleven days after the company won the bids, an unnamed financial institution paid a $4,500 kickback to CDR, disguised as a fee to compensate the firm for acting as a broker in arranging swaps between the institution and Provider A, according to the indictment. CDR received another $4,500 payment, the indictment said.

No ‘Discussion’

The West Virginia Water Development Authority was subpoenaed by the Justice Department on April 13, according to a copy of the subpoena obtained under a public-records request.

Chris Jarrett, the authority’s executive director in Charleston, said in an interview that he didn’t know if his agency was the one referred to in the CDR indictment.

“I have not had any discussion with the Justice Department,” Jarrett said.

The indictment also describes CDR’s work for a municipal port authority in September 2002. About an hour before bids were due on Sept. 26, 2002, Wolmark called an official with Provider A to discuss kickbacks that would be masked as fees on a separate transaction, according to the U.S. charges.

At the time bids were due, Wolmark gave the official information about other bids and agreed on the secret fees CDR would receive, according to the indictment. On Oct. 15, CDR signed a certification that bidders weren’t told about other submissions, the indictment said.

Oakland Port

The dates correspond to CDR’s work for Oakland, California’s port. On Sept. 26, 2002, FSA won the bidding to invest the proceeds of a $120 million bond issue, records show. On Oct. 15, CDR signed the broker’s certificate with the agency, according to a copy.

The agency was subpoenaed by the Justice Department, said Douglas Waring, deputy executive director of the port for finance. He said he doesn’t know whether the agency is the one mentioned in the indictment.

“If it is, there’s no way I would know that,” he said.

The case is U.S. v. Rubin/Chambers, Dunhill Insurance Services, Inc., et al, 09-CR-01058, U.S. District Court for the Southern District of New York (Manhattan).

"The massive class action lawsuit which was tossed out earlier in the year, is moving forward again. This is at the same time as the criminal investigation into CDR and could spell serious trouble into the 2.8 trillion dollar muni-bond industry, the fact that there was an informant who appears to have detailed the information as well as taped some of the players could blow the lid off the whole scam.

WASHINGTON — Court documents filed in class action and other lawsuits by issuers’ lawyers who were briefed by attorneys at Bank of America — the one firm that is cooperating with the Justice Department’s antitrust probe in return for indemnity from criminal charges — present a disturbing picture of alleged widespread collusion between dozens of firms involved with municipal investment contracts and derivatives.

Relying largely on information from a confidential witness at Bank of America called CW, the lawsuits provide something of a play-by-play primer on routines among certain firms in the reinvestment and derivatives business. The winners of bids for the contracts in the sector were determined in advance, traders used verbal cues to rig bids, some firms intentionally submitted losing bids, and several firms received “last looks” that allowed them to compare competing bids and alter their own to win.

The suits also rely in part on extensive audiotapes that B of A made available to the Justice Department. The issuer attorneys did not have access to the tapes but received detailed descriptions of some of their contents from the bank’s attorneys.

In addition, one of the suits notes that Charles Anderson, the former field operations manager for the Internal Revenue Service’ tax-exempt bond office, said: “I have listened to tape recordings of bankers talking to each other saying, 'This law firm or lawyer will go along, they know what’s going on, they’ll give us an opinion.’ It might take a little time to unwind it all, but I think we’ve only seen the tip of the iceberg.”

The class action lawsuit that Baltimore and other issuers filed against dozens of firms, and five separate suits filed against many of the same firms by Los Angeles and other issuers in California, are pending before the United States District Court for the Southern District of New York in Manhattan. They allege that a significant portion of the industry was involved in bid-rigging and anti-competitive behavior that led to last week’s federal indictment of Beverly Hills, Calif.-based CDR Financial Products Inc., its founder David Rubin, and a current and a former employee at the firm.

According to reports, pay for play was so endemic that top executives were angry if it bid winners weren't pre-ordained:

The “unlawful pre-selection practice” was so widespread that Phillip Murphy, the former managing director of B of A’s muni derivatives department, “expressed dissatisfaction if the CW did not know who would win a trade before it was bid.” The collusive practices continued after Murphy left the bank to become a principal at Winters & Co. in 2002, the Hausfeld suit said.

The cw is the confidential wittness who apparently got in pretty damn deep:

The CW, who discovered the alleged collusive conduct after he joined Bank of America’s muni derivatives trading desk in April of 1999, “learned that his was a business about doing favors, generating referrals for brokers, and getting favors in return,” according to the Hausfeld and Cotchett suits. He got his job on the recommendation of executives from IMAGE, the firm he was assigned to work with by Murphy and Douglas Campbell, a former sales team manager at B of A. He also closely worked with Martin Stallone, a managing director at IMAGE.

The CW and other members of the bank’s trading desk used various verbal cues to rig bids, the suits said. One approach used by the CW was to ask if the bank’s bid was “a good fit,” according to the Hausfeld suit. But the conspirators allegedly used several additional code phrases to communicate their desire to be pre-selected as the winner of a particular auction, including: “We really want this deal” or “We want to get in on this rate,” or “I can do better, I want this bid.”

The code word “axe” was also allegedly commonly used to refer to a contract provider’s interest in winning a deal.Firms allegedly also put in sham bids that they knew would not win for business they did not want.

I would assume the sham bids were part of the conspiracy to provide a veneer of competitvness even though key players would have known ahead of time who was going to win what. Perhaps this is a bit of cliche, but this informatnt who went undercover, recorded conversations, detailed secret deals sounds like a scene right out of the movies.

Bid rigging suit by municipalities

Wall Street must be wondering whether the returns on selling derivatives to municipalities (and say, Greece) are really worth the headache.

In the latest development in the saga of investment banks v munis in re derivatives, a judge ruled on Thursday that a dozen financial institutions will have to defend themselves against allegations of bid rigging and price fixing in the market for municipal derivatives.

(The original action, brought in August 2009, included more than 40 corporate defendants, court filings show. Goldman Sachs, for those wondering, was not named in the case.)

The defendants read like a who’s who of the Street: Wells Fargo, JP Morgan Chase and Morgan Stanley are among those that will face a pre-trial conference on April 30. Even Bear Stearns — RIP — made an appearance. Representing Europe: UBS, NatWest, SocGen and Natixis.

The plaintiffs include the City of Baltimore, the University of Mississippi Medical Center and the Bucks County Water & Sewer Authority.

As for the conduct alleged:

This action involves allegations of a conspiracy “to fix, maintain or stabilize the price of, and to rig bids and allocate customers and markets for” municipal derivatives sold in the United States and its territories

Named Defendants combined and conspired to allocate customers and fix and stabilize the prices of municipal derivatives, including the interest rates paid to issuers on such derivatives. The [complaint] alleges that individuals employed by Named Defendants knowingly acted as conduits for communication of pricing and bidding information among Named Defendants, with the knowledge and consent of Named Defendants. Further, Named Plaintiffs allege that Named Defendants shared profits from winning bids, provided secret compensation to losing bidders and paid kickbacks to co-conspirators.

Not good, and especially so when two of the defendants named — JP Morgan and UBS — are already facing trial in Italy on charges related to a 2005 deal involving Milan and a €1.7bn bond issue.

Muni swaps approx $300 billion annually

New Jersey taxpayers are being saddled with a bill of about $657,000 a month from Bank of Montreal for an interest-rate swap approved by state officials and linked to bonds that were never sold.

The 11th-largest U.S. state by population, which is cutting expenses to close a $1 billion budget deficit, will pay Canada’s oldest lender $23.5 million. The sum, about the same as the salaries for 113 teachers over three years, will allow it to avoid a $50 million penalty for canceling the contract, which was tied to planned sales of school-construction bonds.

The interest rate swap, an agreement between borrowers to exchange fixed and variable-rate payments on a set amount of debt, was arranged in 2004 to protect taxpayers against rising borrowing costs. The strategy backfired after officials decided against issuing the securities.

“This is a classic case of a strategic error,” said Robert Brooks, a finance professor at the University of Alabama- Tuscaloosa and author of a book on derivatives. “It’s arrogant to believe that you have such a command of the future that you know with certainty what is going to happen.”

The payments, which work out to $21,892 a day for three years, show how elected and appointed officials failed taxpayers by agreeing to financial strategies they didn’t fully understand. New Jersey spent $21.3 million in 2008 to exit three contracts signed when James Florio and James McGreevey were governors. The state’s transportation trust fund is giving almost $1 million a month to a Goldman Sachs Group Inc. partnership in an agreement linked to bonds that were redeemed.

Penalties and Losses

New Jersey isn’t alone. Borrowers from Massachusetts to California are struggling with billions of dollars in swap penalties and losses at the same time that budget deficits expand to an estimated $350 billion in 2010 and 2011, according to the Washington, D.C.-based Center on Budget and Policy Priorities.

The derivatives, mostly interest-rate swaps used to exchange fixed payments for variable rates, have grown to as much as $300 billion annually, the Alexandria, Virginia-based Municipal Securities Rulemaking Board said in an April report, citing information from market participants.

Derivatives have created “unprecedented financial stress” for some of the 500 municipal issuers that sold variable-rate debt and purchased swaps from banks to lock in borrowing costs, according to an October report by Moody’s Investors Service. The biggest users of the arrangements are Pennsylvania, California, Texas and Tennessee.

The U.S. Justice Department and Securities and Exchange Commission are investigating whether Wall Street banks conspired with brokers to rig bids on the contracts.

Forward-Starting Agreement

Jefferson County, Alabama, is on the edge of bankruptcy mostly because of a $3 billion sewer project in which fixed-rate bonds were refinanced into floating-rate securities hedged with interest-rate swaps. Larry Langford, the former Democratic mayor of Birmingham, was convicted of federal corruption charges Oct. 29 for accepting bribes in exchange for giving underwriting contracts to a banker friend while he was county commission president.

New Jersey’s 2004 school-bond swap with Bank of Montreal was linked to a $250 million bond originally scheduled to be sold in 2007. The so-called forward-starting agreement was one of 15 such contracts the state set up to help finance construction.

The issue was deferred to 2009 because the school program wasn’t borrowing fast enough to use swaps coming due in 2007, according to treasury spokesman Tom Bell.

Fixed Rate

Under its contract, New Jersey agreed to pay the bank a fixed rate of about 4.6 percent, or $967,000 a month, on the $250 million principal. In return, it would receive unspecified variable-rate payments based on a percentage of the one-month London interbank offered rate, according to Treasury Department spokesman Tom Vincz.

The one-month rate was 0.23 percent on Dec. 3, down from 1.9 percent when the Bank of Montreal swap was set up, according to the British Bankers Association One-Month Libor U.S. Dollar Index. Libor is a benchmark for the cost of loans between banks.

In pushing the swap off to 2009, New Jersey agreed to a 9 basis-point reduction in its fixed interest rate and the bank changed the floating-rate formula to a lower percentage of Libor. A basis point is 0.01 percentage point.

When the revamped agreement took effect on Nov. 1, the state faced payments of $833,000 a month, Vincz said in an e- mail. Treasury officials allowed the bank to suspend floating- rate payments while lowering New Jersey’s fixed-rate cost to 3.1 percent, or $656,770 monthly, through November 2012.

Typical School

The cost would cover the $23.6 million price of a typical elementary school, according to New Jersey Schools Development Authority reports. It would also pay 113 teachers’ salaries for three years, based on data reported by the state Teachers Pension and Annuity Fund.

“It is obscene,” New Jersey Governor-elect Christopher Christie said at a Nov. 16 news conference in Trenton, referring to financial strategies such as swaps pursued largely during McGreevey’s term from 2001 to 2004. “It is extraordinary to me that someone could do that much damage in less than three years.”

McGreevey, who resigned in 2004 after saying he was gay, didn’t respond to phone messages left at his home and the office of his partner, Mark O’Donnell, at real-estate developer Kushner Cos. in New York City. The former governor also didn’t return a message left at the Episcopal All Saints Parish in Hoboken, New Jersey, where he serves as an assistant while seeking a Master of Divinity degree at Manhattan’s General Theological Seminary.

$3.4 Billion

John McCormac, Christie’s transition team economic development and growth adviser who served as state treasurer when most of New Jersey’s swaps were arranged, hung up when asked about them on Nov. 11.

“OK, thanks for calling,” McCormac, mayor of Woodbridge Township, said before disconnecting.

New Jersey refinanced $3.4 billion of debt tied to derivatives last year, according to a report from the state Treasury Department’s Office of Public Finance.

The renegotiated swap lets New Jersey avoid a termination fee, estimated at $50 million in an Oct. 31 state report. It will allow the original swap to be reinstated if officials want to sell school-construction bonds in 2012, Vincz said in the Nov. 16 e-mail.

Diligent Work

“We are working diligently to manage and reduce the cost of the swap portfolio this administration inherited,” he said. “This temporary solution limits swap costs for a three-year period, after which time the state will retain the option of applying the original terms with a future borrowing as a hedge against rising interest rates.”

“We are not in a position to comment, out of an obligation of confidentiality to the client,” Kim Hanson, a spokeswoman for Bank of Montreal, said in a phone interview.

Peter Nissen, a financial adviser in Marlboro, New Jersey, who worked on the swap while at Public Financial Management, the state’s Harrisburg, Pennsylvania-based adviser, declined to comment.

Marty Margolis, managing director at PFM, said in a phone interview that Nissen worked independently on the contract and hasn’t been associated with the company for more than two years.

“That swap was done by someone who hasn’t worked for the company for several years,” Margolis said. “I know nothing about it.”

Except for two deals to stem losses from existing derivative contracts, New Jersey has entered into no new swaps since Governor Jon Corzine, the former co-chairman of Goldman Sachs, took office in 2006, according to Vincz. Christie, a former U.S. prosecutor, defeated Corzine last month and is to be sworn in Jan. 19.

UBS Contract

New Jersey paid $21.3 million last year to end three derivative contracts connected to bonds for business-incentive grants, the River Line Light Rail project from Trenton to Camden and the New Jersey Sports and Exposition Authority. On Nov. 18, the Delaware River Port Authority, a bistate agency that runs toll bridges and a rail line to Pennsylvania, agreed to give Zurich-based UBS AG $111 million if the authority can’t issue variable-rate debt to make use of an existing swap by February.

The state Transportation Trust Fund Authority is paying almost $1 million monthly to Goldman Sachs Mitsui Marine Derivative Products L.P., a partnership of the New York-based bank and Japan’s Mitsui Sumitomo Insurance Group Holdings Inc., under a swap agreement made during McGreevey’s administration in 2003. The derivatives were linked to $345 million in auction- rate bonds sold to finance road and rail projects.

Fixed-Rate Debt

While New Jersey replaced the debt with fixed-rate securities in 2008, the derivative payments aren’t scheduled to expire until 2019. The state plans to sell $150 million in variable-rate bonds on Dec. 7 to make use of part of the swap.

The state treasury “should continue to aggressively manage the termination, conversion and management of swaps that this administration inherited, while dealing with the realities of the most difficult credit conditions in history,” Corzine’s former spokesman, Steve Sigmund, said in an e-mail on Oct. 22.

New Jersey passed up borrowing costs of 4.6 percent to 4.9 percent when it opted to issue variable-rate bonds tied to swaps during McGreevey’s tenure, a 2008 state analysis shows. The net interest cost on the debt was about 4 percent while the original derivative agreements were in effect, according to the report.

Revenue Bonds

The yield on 25-year fixed-rate revenue bonds is now 4.98 percent, up from a yearly low of 4.69 percent in early October, according to a Bond Buyer Index.

Derivatives can save taxpayers money over longer periods if they’re managed properly, said Peter Shapiro, managing director of Swap Financial Group LLC, in South Orange, New Jersey, an adviser to companies and governments.

“Will municipal officers ever take for granted that floating-rate bonds will be dull, boring and predictable means of finance?” he said in a phone interview. “No, and they probably never should have.”

Goldman Sachs and New Jersey swaps

"- New Jersey taxpayers are sending almost $1 million a month to a partnership run by Goldman Sachs Group Inc. for protection against rising interest costs on bonds that the state redeemed more than a year ago.

The most-densely populated U.S. state is making the payments under an agreement made during the administration of former Governor James E. McGreevey in 2003, when New Jersey’s Transportation Trust Fund Authority sold $345 million in auction-rate bonds whose yields fluctuated with short-term interest costs. The agency finances road and rail projects.

“This vividly shows the risk of entering into interest- rate swap agreements,” said Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board in Alexandria, Virginia. “The world’s got to see what stupidity even the sophisticated investors like the transportation fund can get into.”

While New Jersey replaced the debt with fixed-rate securities in 2008 after the $330 billion auction-rate bond market froze, the swap -- in which two parties typically exchange fixed payments for ones based on floating interest rates -- isn’t scheduled to expire until 2019.

The state paid $940,000 under the agreement last month and a total of $11.4 million since the auction-rate bonds were redeemed. The expenditures come as the fund reaches its borrowing limit and Governor Jon Corzine, Goldman’s former chairman who was a U.S. senator when the contract was signed, seeks $400 million in budget reductions as tax receipts fall.

Bond’s Life

“The state has made it clear that true interest costs are measured over the life of bonds,” the New Jersey Treasurer’s office said in an e-mailed statement from spokesman Tom Vincz. “As this swap is applied as it was intended to be applied, with TTFA variable-rate bonds, true interests costs are projected to be below the average true interest costs for TTFA bonds,” the statement said, referring to the Transportation Trust Fund Authority by its acronym.

“Unfortunately, Bloomberg misleadingly measured these costs over a brief window in time, which captured only the influences of the worst credit conditions in U.S. history.”

Harvard Swaps

Municipalities and universities across the U.S. have paid hundreds of millions to terminate swaps on variable-rate debt after interest costs, instead of climbing, fell to record lows in the worst credit crisis since the Great Depression. Harvard University last week disclosed it had given $497.6 million to investment banks to exit such agreements following similar terminations by New York’s Metropolitan Transportation Authority and the Oakland, California-based Bay Area Toll Authority.

In New Jersey, the 3.6 percent fixed rate the trust fund is paying on the swap has pushed the cost to taxpayers of the original $345 million borrowing to 7.8 percent, the most the authority has paid since it was formed in 1985, according to records posted on its Web site.

John McCormac, the Mayor of Woodbridge, N.J., state treasurer at the time of the 2003 deal, declined to discuss the issue in a telephone conversation today.

“I have no recollection of anything,” he said. “Ask the treasurer.”

Corzine spokesman Robert Corrales referred an inquiry today to the treasurer’s office for comment, and Goldman Sachs spokesman Michael DuVally referred to an earlier statement in which the bank said it is working with the state.

Inheriting Swaps

“This administration inherited a large swap portfolio and has worked over the last several years to terminate, reverse and prudently manage the derivatives to the benefit of the taxpayer,” the treasurer’s statement said. “This administration has initiated only two new swaps, which have been used to reverse pre-existing swaps and protect taxpayers from potential financial risks.”

Payments on the swaps without underlying variable-rate bonds are draining money from a dwindling account that may not be able to support new projects because the $895 million in annual gasoline taxes and toll revenue dedicated to the transportation trust fund will be needed to pay debt service on $10.3 billion in debt. To help prop up spending, officials have suggested raising New Jersey’s 14.5 cents-a-gallon gasoline levy, the fourth- lowest among U.S. states, according to research by the Tax Foundation, a Washington, D.C.-based research organization.

Pulaski Skyway

New Jersey’s contract with Goldman Sachs Mitsui Marine Derivative Products L.P., a partnership of the bank and Japan’s Mitsui Sumitomo Insurance Group Holdings Inc., allows the state to terminate the deal without penalty after 2011. Canceling before then would require a payment estimated at $37.6 million on Sept. 30, according to state records.

The state’s payments on the swap in the past year have exceeded the $10 million budgeted to maintain the 76-year-old Pulaski Skyway, the 3-mile (4.8 kilometers) elevated road from Newark to Jersey City.

“I’m sure there’s an explanation,” Corzine, 62, said during a brief interview as he left a contractors’ convention in New Brunswick, New Jersey, on Oct. 14. “They don’t just send money out.”

“We believe treasury should continue to aggressively manage the termination, conversion and management of swaps that this administration inherited, while dealing with the realities of the most difficult credit conditions in history,” Corzine’s spokesman Steve Sigmund said in an e-mail.

Cost Reduction

“Through careful planning and prudent decision-making, we continue to seek out and find ways to reduce or minimize public finance costs supported by the budget and New Jersey taxpayers,” the treasury statement said.

Corzine, a Democrat, is the only U.S. governor seeking re- election this year and tied in this month’s Quinnipiac poll with Republican Christopher Christie, 47, a former federal prosecutor. Each had about 40 percent, with a 2.8 percentage- point margin of error.

New Jersey couldn’t reach acceptable terms when it tried to issue variable-rate bonds last year to replace the failed auction-rate securities hedged by the Goldman swap, the Office of Public Finance said in a three-page response to questions about the transaction. It is unfair to judge the ultimate performance of the 16-year agreement until it concludes in 2019, the agency said in the statement.

“Cherry-picking one date in time for a net payment or net receipt of swap payment does not accurately or objectively reflect the true economics of the contract,” the office said in the e-mailed statement.

Making Adjustment

Goldman Sachs is working with officials to make adjustments in light of “changes in market conditions that have made the transaction less attractive,” spokesman Michael DuVally said in an e-mail. “The economics and risks involved in this transaction were fully understood when the authority decided to enter into this swap six years ago.”

Acacia Financial Group Inc., the Marlton, N.J.-based adviser on the fixed-rate bonds that replaced the auction securities, referred questions to the Office of Public Finance.

“Decisions were made to proceed with the swap,” Vivian Altman, the trust fund’s adviser on the original debt issue in 2003, said in a phone interview.

“I can’t speak to what discussions they had internally,” she said. “I would have no way of knowing. I just have no idea of what information they had been provided.”

New Jersey, which Moody’s Investors Service called “one of the largest users of swaps in the municipal market,” has 28 such contracts outstanding on $4.4 billion worth of debt, according to a monthly valuation report.

Trust Fund Agreement

The trust fund agreement was made three years before Corzine became governor. Auction-rate obligations involved in the transaction were supposed to allow borrowers to realize short-term interest rates on long-term debt by offering the bonds for periodic resale. The market froze after banks that historically volunteered to buy unwanted securities stopped doing so during the global credit crisis.

Kevin Willens, a managing director of Goldman and currently a director of the MSRB, which sets standards for banks and securities firms in the $2.8 trillion municipal market, presented the swaps proposal on the bank’s behalf, authority minutes show.

Charts “described the success rates of swaps,” according to the minutes. Willens was not an MSRB director at the time.

$9.9 Million

New Jersey saved $9.9 million from 2003 to 2008 by issuing the auction-rate bonds instead of fixed-cost debt, the Office of Public Finance said in a report last year.

The trust fund paid $4.5 million in penalty interest payments when the auction-rate market collapsed and some borrowers’ costs soared. After it failed to put together a sale of a different type of variable-rate bonds, New Jersey then issued 11-year, fixed-rate notes yielding 4.18 percent in August 2008, according to the Office of Public Finance.

Refinancing the bonds cost $2.1 million, reducing the authority’s savings on the transaction to $3.3 million, state records show.

Since then, the fund has paid almost four times that amount on a contract that hedges nothing.

For New Jersey, the swap became “a tool for no purpose,” former regulator Taylor said.

Roundtable Discussion with Former MSRB Executive Director Christopher "Kit" Taylor and Municipal Market Advisors CEO Thomas Doe.

BofA, UBS, JPMorgan sued over sales of derivatives

" Bank of America Corp., UBS AG, JPMorgan Chase & Co. and other banks were sued by a California public utility over claims they rigged sales of municipal derivatives and shared illegal profits through kickbacks.

The lawsuit, filed by the Sacramento Municipal Utility District, is based on federal and state antitrust claims. It alleges Charlotte, North Carolina-based Bank of America and more than a dozen other banks conspired to pre-select winners of municipal derivative auctions, coordinated their pricing, and accepted kickbacks disguised as fees from co-conspirators.

The allegations resemble those made by a U.S. grand jury in New York last month, according to the lawsuit filed Nov. 12 in federal court in Sacramento. CDR Financial Products Inc. founder David Rubin and two employees of the Beverly Hills, California- based company were indicted for allegedly accepting kickbacks on investments sold to local governments. CDR is also named as a defendant in the Sacramento case.

The banks engaged in “allocating customers and markets for municipal derivatives, rigging the bidding process by which municipal bond issuers acquire municipal derivatives, and conspiring to manipulate the terms that issuers received,” according to the lawsuit.

The charges against Rubin and the CDR employees were the first to result from a more than three-year investigation into bid-rigging in the municipal bond market. The probe is continuing and has already drawn in some two dozen banks, insurers and local government advisers.

Derivatives are unregulated financial instruments linked to stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather.

Shirley Norton, a Bank of America spokeswoman, didn’t immediately return a call seeking comment after regular business hours yesterday.

The case is Sacramento Municipal Utility District v. Bank of America, 09-01810, U.S. District Court, Eastern District of California (Sacramento)."

Alabama county sues JP Morgan over swaps deals

"Alabama's most populous county filed suit Friday blaming Wall Street powerhouse JPMorgan Chase and others for the financial disaster that brought it to the brink of what would be the largest municipal bankruptcy in U.S. history.

The suit, filed in state court by Jefferson County, contends JPMorgan Securities Inc., JPMorgan Chase Bank, former Birmingham Mayor Larry Langford and dozens of other defendants were part of a conspiracy to generate huge fees through a series of deals called rate swaps.

The deals were supposed to help the county manage debt from a massive sewer renovation but instead generated huge fees and crippled the county's finances, according to the complaint.

"These transactions provided no value to the county or its citizens and created an inherently flawed financial structure that imploded within just a few years," said the complaint, which seeks an unspecified amount in damages.

The lawsuit also names Montgomery-based investment banker Bill Blount and lobbyist Al LaPierre, both of whom pleaded guilty to bribing Langford in deals that generated $7.1 million in fees for Blount's company, Blount Parrish & Co., which also is a defendant in the case.

The complaint parallels testimony in the recent criminal trial of Langford, who was convicted on 60 counts and removed from office. It also is similar to the federal government's civil complaint against JPMorgan Chase, which agreed to a more than $700 million settlement last week.

JPMorgan Chase issued a statement calling the county's lawsuit "meritless."

"Meanwhile, we continue to work to achieve a responsible restructuring of Jefferson County's financial affairs," it said.

Jefferson County is struggling to avoid filing what would be the largest municipal bankruptcy ever over some $3.2 billion in debt linked to deals dating back seven years. The county's interest payments skyrocketed during the global financial crisis, and it can no longer afford them.

Besides the companies and Langford, the lawsuit names two former JPMorgan Chase executives, Charles LeCroy and Douglas MacFaddin, and numerous unidentified defendants.

The suit contends JPMorgan got the county's business by making payments to Blount Parrish, which had conspired with Langford, who was president of the Jefferson County Commission at the time.

Testimony in Langford's trial showed Blount and LaPierre showered Langford with fancy clothes, checks and loan payments totaling some $236,000. Blount's firm received payments from the rate swaps in return, evidence showed.

The Securities and Exchange Commission sued LeCroy and MacFaddin last week saying the two were involved in the Jefferson County deals. Attorneys for both men denied they had violated securities laws.

Muni swap tear ups

"For banks that built up significant portfolios in the municipal interest rate swap business, it may be time to consider what to do when the customer isn’t always right.

On Friday the Los Angeles City Council directed the city to ask the holders of two $158 million swaps to ease the terms of deals that one official pronounced a “rip-off.” The measure followed advocacy by the Service Employees International Union, which has seized upon the cost of exiting swaps as a central point in a nationwide effort to blame banks for heavily indebted municipalities’ service cuts.

A municipal swaps version of The Huffington Post’s “Move Your Money” campaign, the effort could harm banks’ relationships with local governments and potentially force concessions on some of the more than $200 billion of municipal swaps outstanding, some industry observers said. More broadly, it underscores banks’ weakened political standing, and the threat that poses to their day-to-day business.

“I’m not sure you really want to litigate the swap contract. Municipal finance is a tight community,” said Jeffrey Cohen, an attorney for Patton Boggs who has worked for borrowers and issuers alike.

Though many big banks have exited the municipal swap business — both JPMorgan Chase & Co. and Bank of America Corp. largely shut down new issuance after a series of price-fixing scandals — the outstanding contracts are a tempting bone to pick for municipalities facing job cuts and ratings downgrades.

Distressed public entities have already won concessions on termination fees in Detroit and Jefferson County, Ala. Many believe healthier jurisdictions may already be quietly getting in on the game. If municipalities can issue debt at lower rates, “they’re going to raise whatever defense they’ve got,” Cohen said.

According to several industry observers, substantive grounds for demanding renegotiation are often reed-thin. By swapping variable-rate debt payments for a fixed-interest obligation, a local government bought protection from the risk of rising interest rates, while paying significantly less interest than it would on a comparable fixed-rate municipal bond.

In Los Angeles’ case, that meant that the city entered into a 2006 deal to pay 3.4% a year on $317 million of debt to Bank of New York Mellon Corp. and Dexia SA, receiving the prevailing adjustable rate payment in return. For a couple of years, that was a good deal, producing several million dollars of savings a year. But when the Federal Reserve dropped interest rates to nearly zero during the financial crisis, the city’s 3.4% payment started earning it 0.15% back. Terminating the agreements would require an immediate fee of $29 million..."

Ban local governments from using interest rate swaps?

HARRISBURG, Pa., March 16 /PRNewswire-USNewswire/ -- Auditor General Jack Wagner today joined Sen. Lisa Boscola (D- Lehigh/Monroe/Northampton) and Sen. Patrick Browne (R- Lehigh/Monroe/Northampton) to promote legislation that would ban school districts, local governments and municipal authorities from risking taxpayer money in interest-rate swap agreements. Wagner recently called for legislation banning the use of swaps, after his special investigation determined that 107 of 500 Pennsylvania school districts and 86 local governments had tied up at least $14.9 billion in public debt to swaps. As a result, a sudden movement in interest rates could cost taxpayers hundreds of millions of dollars, said Wagner.

"Swaps are tantamount to gambling with taxpayer money, and they have no place in the public sector," Wagner said at a press conference in the Capitol Media Center. "I commend Sen. Boscola for bringing this problem to the attention of the Department of the Auditor General, and I commend her and Sen. Browne for sponsoring this important taxpayer-focused legislation that implements the recommendations of our report."

Swaps are legal contracts between two parties, such as a school district and an investment bank, that bet on which way interest rates will move. The party that guesses correctly gets paid and the party that guesses incorrectly must pay; the amount of money changing hands is determined by the amount of underlying public debt financed with variable-interest rate bonds "hedged" with swaps, how much the variable rates change, and other factors.

Wagner, who urges the passage of the legislation, has also recommended that school districts, local governments and municipal authorities:

  • Refinance with conventional debt instruments;
  • Assess the financial consequences to taxpayers if they were to suffer the same negative experience with swaps as the Bethlehem * * Area School District and others; and
  • Hire financial advisers through a competitive selection process and periodically evaluate the quality, cost, and independence of the services provided. This recommendation was also included in the legislation discussed at today's press conference.

The Delaware River Port Authority, which operates toll bridges linking metropolitan Philadelphia with New Jersey, faces $199 million in liabilities because of interest-rate swaps that have soured, said Wagner, who became an ex-officio board member several years after DRPA entered into those swaps. At his urging, DRPA recently passed a resolution to ban using swaps in future financial transactions and to begin a process of unwinding its current swaps. Nevertheless, DRPA was required to pay the Swiss investment bank UBS $3.6 million in January and February – the equivalent of six weeks' tolls on the Betsy Ross Bridge – to hedge interest rates on bonds that have not yet been refunded. In addition, DRPA has lost a total of $65 million from swaps that turned sour.

"It's unconscionable that greedy Wall Street bankers are rewarding themselves with excessive bonuses whose profits were derived, in part, by hard-working Pennsylvanians whose elected officials gambled away their tax dollars in risky financial schemes they didn't understand," Wagner said. "Interest-rate swaps have no place in local government and the General Assembly should put a stop to this."

Auditor General Jack Wagner is responsible for ensuring that all state money is spent legally and properly. He is the Commonwealth's elected independent fiscal watchdog, conducting financial audits, performance audits and special investigations. The Department of the Auditor General conducts more than 5,000 audits per year. To learn more about the Department of the Auditor General, taxpayers are encouraged to visit the department's Web site at

Municipalities are best served by simplicity

"A report by Pennsylvania’s auditor general shows what the nation might have looked like if all municipalities had embraced swaps and derivatives as those in the state did.

Two examples show the challenges facing citizen financiers across the nation.

Some Pennsylvania school board officials thought that a synthetic fixed-interest rate, a term used by bankers selling them on a variable-rate bond coupled with a swap, was just as safe as a regular old fixed-rate bond.

“As it turns out,” the report says, “the ‘synthetic fixed-interest rate’ created by the Qualified Interest Rate Management Agreement was only accurate if several variables in the financial markets behaved appropriately.”

The auditor general wrote that the use of the swaps on one issue has already cost one school district $10.2 million more than if it had used fixed-rate bonds, and $15.5 million more than a variable-rate structure.

Then there’s the matter of termination payments, which so many municipalities and other institutions, in Pennsylvania and elsewhere, are making right now to get out of interest rate swaps. One school district superintendent said a termination payment wasn’t a loss; it was the cost of refunding underlying debt.

The auditor general disagreed: Had the district not exposed itself to risk by entering into the swap, it wouldn’t have had to pay $12.3 million to terminate the agreement.

How It Works

Take that synthetic fixed-interest rate. What the term really means is a fake fixed-interest rate. There’s nothing “fixed” about it. A municipality sells debt whose interest rate changes every week or month. It then enters into a swap with a bank. The municipality pays the bank a fixed rate, and receives a floating rate in return.

The idea here is that the two floating rates will cancel each other out, leaving the municipality with a loan that costs even less than borrowing with a traditional long-term bond.

So let’s say a municipality sells insured, variable-rate debt at 1 percent. It then enters into a swap with a bank, under which it will pay the bank a fixed 3 percent, and receive a variable payment, now also, let us say, 1 percent. The two variable payments (almost always tied to different indexes) cancel each other, and the municipality pays 3 percent at a time when it might have had to pay 4 percent to borrow in the conventional bond market.

The banker on this deal tells the municipal officials that they are “locking in” the long-term rate. “Locking in” was a favorite expression of the bankers putting together these transactions.

Disaster Strikes

So far, so good. But then let’s say the bond insurance company backing the municipality’s variable-rate debt is downgraded. The variable rate shoots up to 2 percent from 1 percent. Then something else happens. As the financial world collapses, governments cut interest rates to nothing. This is reflected in the floating rate the bank pays the municipality.

Now the municipality pays the fixed 3 percent to the bank, and the 2 percent to the holders of its variable-rate bonds, and receives, say, one-quarter of 1 percent from the bank on its swap. The municipality is no longer paying 3 percent to borrow money. It is paying 4.75 percent, and there goes the budget. As the Pennsylvania auditor general pointed out, municipalities rarely budget for financial-instrument catastrophe.

This is a simplified version of what happened across the country in 2008 and 2009.

‘Impenetrably Complex’

As for concealing those swap termination payments in new bond issues designed to refund the old deals, this was going on for years. You could never get issuers or their bankers to say that they had lost a bet on a swap, because they never wanted to treat a swap as a discrete thing. It was part of an endless stream of financings.

The Pennsylvania Auditor General, Jack Wagner, is no fan of swaps. His report concluded that they are “highly risky and impenetrably complex transactions that, quite simply, amount to gambling with public money.” He asked the state to forbid their use, recommended municipalities avoid them “from this day forward,” and advised those who did use them to terminate the things immediately.

Just so nobody would misunderstand, Wagner asked the General Assembly to prohibit the state’s municipalities from using swaps “or any of the specific devices and techniques encompassed therein currently in existence or yet to be invented in connection with the issuance of public debt.”

‘Yet to be Invented’

Got that? I have never seen such language used in a case study involving municipal bonds: “Yet to be invented.” Wagner knows his investment bankers all too well, it seems.

In Pennsylvania, the bankers pushing these products were very successful. The result is that local governments and school districts across the state are faced with higher debt service costs or multimillion-dollar termination payments. Public officials, most of them, didn’t quite understand what they were getting into.

Not all states allow their municipalities to purchase such financial products. Some states are silent on the matter. Others prohibit their use. In 2003, Pennsylvania passed a law authorizing local governments to engage in swaps.

It did so with gusto. Of the 501 school districts in the state, 107 entered into at least one Qualified Interest Rate Management Agreement, the state’s term for swaps and derivatives. Another 86 local governments did the same. Between October 2003 and June 2009, these 193 entities made 626 filings related to $14.9 billion in debt, according to the Wagner report.

Popular in Pennsylvania

To put this into context, Pennsylvania leads the nation in the use of these instruments, according to one rating company’s estimate. Of the 500 issuers Moody’s Investors Service rates that use swaps and variable-rate debt, Pennsylvania accounts for 22 percent (or 110) of them. California and Texas share second place, at 17 percent, with Tennessee third, at 13 percent.

There are lots of lessons to be learned here. The first one is that municipalities are best served by simplicity. Introducing more and more moving parts into bond finance also introduces more risk.

The second lesson is even simpler. You can’t educate the changing cast of citizen financiers in charge of the municipal market to the Wharton or MIT level necessary to understand some of the things Wall Street wants to sell to Main Street.

J.P. Morgan settles SEC charges for Jefferson County, Ala

J.P. Morgan Settles SEC Charges in Jefferson County, Ala. Illegal Payments Scheme

SEC Separately Charges Two Former Managing Directors at Firm


Washington, D.C., Nov. 4, 2009 — The Securities and Exchange Commission today charged J.P. Morgan Securities Inc. and two of its former managing directors for their roles in an unlawful payment scheme that enabled them to win business involving municipal bond offerings and swap agreement transactions with Jefferson County, Ala. This is the SEC's second enforcement action arising from Jefferson County's bond offerings and swap transactions.

Additional Materials:

J.P. Morgan Securities settled the SEC's charges and will pay a penalty of $25 million, make a payment of $50 million to Jefferson County, and forfeit more than $647 million in claimed termination fees.

The SEC alleges that J.P. Morgan Securities and former managing directors Charles LeCroy and Douglas MacFaddin made more than $8 million in undisclosed payments to close friends of certain Jefferson County commissioners. The friends owned or worked at local broker-dealer firms that performed no known services on the transactions. In connection with the payments, the county commissioners voted to select J.P. Morgan Securities as managing underwriter of the bond offerings and its affiliated bank as swap provider for the transactions.

J.P. Morgan Securities did not disclose any of the payments or conflicts of interest in the swap confirmation agreements or bond offering documents, yet passed on the cost of the unlawful payments by charging the county higher interest rates on the swap transactions.

"The transactions were complex but the scheme was simple. Senior J.P. Morgan bankers made unlawful payments to win business and earn fees," said Robert Khuzami, Director of the SEC's Division of Enforcement.

Glenn S. Gordon, Associate Director of the SEC's Miami Regional Office, added, "This self-serving strategy of paying hefty secret fees to local firms with ties to county commissioners assured J.P. Morgan Securities the largest municipal auction rate securities and swap agreement transactions in its history."

The SEC previously charged Birmingham Mayor Larry Langford and two others for undisclosed payments to Langford related to municipal bond offerings and swap agreement transactions that he directed on behalf of Jefferson County while serving as president of the County Commission. On Oct. 28, 2009, Langford was found guilty in a parallel criminal case on 60 counts of bribery, mail fraud, wire fraud and tax evasion. He currently awaits sentencing.

According to the SEC's complaint filed against LeCroy and McFaddin in U.S. District Court for the Northern District of Alabama, the two former managing directors demonstrated in taped telephone conversations that they knew the payments to local firms with ties to county commissioners were designed to obtain business for J.P. Morgan's broker-dealer and affiliated bank. LeCroy and MacFaddin referred to the payments as "payoffs," "giving away free money," and "the price of doing business."

The SEC alleges that the scheme began in July 2002, when LeCroy and MacFaddin solicited Jefferson County on behalf of J.P. Morgan Securities for a $1.4 billion sewer bond deal. LeCroy and MacFaddin knew several county commissioners wanted to complete the transaction before November, when two commissioners would leave office and lose their ability to funnel payments to their supporters' firms. LeCroy later boasted to MacFaddin in a taped telephone conversation about his efforts to persuade the two commissioners to select J.P. Morgan Securities for the deal, beating out a rival firm. LeCroy told MacFaddin that he said to the commissioners, "Whatever you want — if that's what you need, that's what you get — just tell us how much."

J.P. Morgan Securities agreed to settle the SEC's charges without admitting or denying the allegations by paying $50 million to the county for the purpose of assisting displaced county employees, residents and sewer rate payers; forfeiting more than $647 million in termination fees it claims the county owes under the swap transactions; and paying a $25 million penalty that will be placed in a Fair Fund to compensate harmed investors and the county in the municipal bond offerings and the swap transactions. LeCroy and MacFaddin have not agreed to settle the SEC's charges.

The SEC's order instituting settled administrative proceedings against J.P. Morgan Securities finds that it violated Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, Section 15B(c)(1) of the Securities Exchange Act of 1934 and Municipal Securities Rulemaking Board (MSRB) Rule G-17. In addition to the monetary relief described above, the SEC's order censures J.P. Morgan Securities and directs it to cease-and-desist from committing or causing any further violations of the provisions charged.

The SEC charged LeCroy and MacFaddin with violations of Section 17(a) of the Securities Act, Sections 10(b) and 15B(c)(1) of the Exchange Act, and Rule 10b-5 thereunder, and violations of MSRB Rules G-17 and G-20. The SEC's complaint seeks judgments against LeCroy and MacFaddin providing for permanent injunctions and disgorgement with prejudgment interest.

For more information about this enforcement action, contact:

Glenn S. Gordon - Associate Regional Director, SEC's Miami Regional Office, (305) 982-6360

Robert Levenson - Regional Trial Counsel, SEC's Miami Regional Office, (305) 982-6341

"Mayor Larry Langford has a bold vision for Birmingham’s future. But is he a bona fide leader – or a con man, aided and abetted by Wall Street?

Now on trial in US District Court in Tuscaloosa, Ala., on 60 counts of money laundering and bribery charges, Mr. Langford is at the center of a spectacular scandal where, prosecutors say, a popular mayor whose motto is “Do something!” gambled a city’s future on a risky Wall Street scheme, all while taking bribes in the form of cash, Rolex watches, and designer clothes.

Langford’s trial is sure to illuminate whether a gung-ho investment atmosphere played into small-time municipal corruption, only to explode into what could become the largest municipal bankruptcy ever, dwarfing the 1994 default of California’s Orange County.

But behind the details of Langford’s personal and political life lies a surprising fact: Across the US, billions of dollars have been lost in similarly risky municipal bond deals, leaving US taxpayers on the hook.

“Bringing justice where fraud has occurred is a very important component to bringing back a culture of trust on which financial markets operate, and that’s why the Larry Langford trial is important,” says Robert Brooks, an economist at the University of Alabama in Tuscaloosa. “If you find transactions being done [by elected officials] with an effort to be opaque … there’s good reason to wonder why.”

Justice Department investigations

The US Justice Department is investigating half a dozen former Wall Street investment bankers and scouring municipal bond deals from Florida to California, looking for more instances where taxpayers were essentially swindled by secretive gambling on the $2.8 trillion municipal bond market.

In the Langford case, “You basically had local officials setting terms, and the banks didn’t have a problem with that,” says Joe Adams, research coordinator at the Public Affairs Research Council of Alabama.

Langford’s alleged scheme involved a new fleet of financial instruments that hundreds of other cities and counties across the US have also utilized.

Those new instruments – which include derivatives and interest-rate swaps – came on the scene as municipal governments started making no-bid agreements with bankers behind closed doors, says Mr. Brooks at the University of Alabama.

As the credit crisis undermined many of those deals, public borrowers began paying billions of dollars to escape the contracts.

Alabama’s unique Constitution, which leaves county government basically unregulated, has created a system “that’s structurally designed for corruption,” says Mr. Adams. But the Langford case may indicate that wherever the new bond financing deals involve collusion and corruption, the results can be dire.

Interest-rate swaps

Specifically, the refinancing that Langford structured for Jefferson County involved interest-rate swaps, which JPMorgan Chase bankers said could reduce the county’s interest costs. (In SEC testimony last year, Langford, who attended Harvard’s Kennedy School of Government in 2000, said he couldn’t tell a bond swap adviser from a rubber band.)

Instead, rates skyrocketed after ratings for the county’s bond insurers fell during last year’s credit crisis. Debt payments for the county’s sewer system ballooned to $460 million a year – twice the annual revenues of the system..."

Alabama bond firm head gets 52 months in sewer case

The former head of a Montgomery, Alabama, securities firm was sentenced to 52 months in prison for paying bribes of cash, clothes and jewelry to the former mayor of Birmingham to get $7.2 million of bond and derivatives business.

William Blount, 57, a former state Democratic party chairman, pleaded guilty last August to conspiracy and bribery. He testified against former mayor Larry Langford, who was convicted in October of taking $235,000 in cash, clothes and jewelry from Blount and go-between Albert LaPierre, while president of the Jefferson County Commission. LaPierre was sentenced today to four years in prison.

“I have many apologies to make,” said Blount, the former chairman of Blount Parrish & Co., in federal court in Tuscaloosa, Alabama. “My intention was to help Jefferson County, and it turned into other things.”

Blount’s sentence was reduced from a maximum 15 years for his cooperation. Blount was ordered to forfeit $1 million and has paid $100,000. Blount and LaPierre were ordered to pay $5.5 million combined in restitution. That amount may be adjusted pending the outcome of a lawsuit Jefferson County has filed against JPMorgan Chase & Co.

Milan charges Deutsche Bank, JPMorgan, UBS with derivatives fraud

Deutsche Bank AG, JPMorgan Chase & Co., UBS AG and Hypo Real Estate Holding AG’s Depfa Bank Plc unit were charged with fraud linked to the sale of derivatives to the City of Milan.

Judge Simone Luerti scheduled the trial of the four firms, 11 bankers and two former city officials for May 6, Prosecutor Alfredo Robledo said after a hearing in Milan today. The banks allegedly misled the city on swaps that adjusted interest payments on 1.7 billion euros ($2.3 billion) of borrowings.

Prosecutors across Italy are probing banks as local and national government agencies face potential losses of 2.5 billion euros on derivatives, lawyers say. The Milan probe may also affect cases as far away as the U.S., where securities firms have faced charges for price-fixing and bid-rigging in the sale of derivatives to municipalities, though not for fraud, according to former regulator Christopher “Kit” Taylor.

“This case could have repercussions over here if the trial showed deliberate intent,” said Taylor, a former executive director of the Municipal Securities Rulemaking Board, the national regulator of the municipal-bond market. “What happened in Europe was the continuation of a pattern in the U.S.”

UBS, JPMorgan and Deutsche Bank officials didn’t have an immediate comment. Officials at Depfa couldn’t immediately be reached.

Economic Advantage

Robledo alleges the London units of the four banks misled Milan on the economic advantage of a financing package that included the swaps and earned 101 million euros in hidden fees.

He also claims the banks violated U.K. securities rules by failing to inform Milan in writing that for the swap deal the city was a counterparty to the lenders rather than a customer. Banks abiding by the rules of the Financial Services Authority are required to shield customers from conflicts of interest and provide them with clear and fair information that isn’t misleading.

The prosecutor, who seized assets from the banks equal to their share of the alleged profit, is claiming JPMorgan charged about 45 million euros in commissions that were hidden from the municipality, while Deutsche Bank made about 25 million euros, Depfa Bank earned 21 million euros and UBS made 10 million euros, court documents show.

“The thesis brought forward by the prosecutor was particularly innovative and aggressive,” said Giampiero Biancolella, an attorney specializing in financial crime who isn’t involved in the case. “The indictments prove the allegations are legitimate, though the charges don’t yet prove the banks are guilty.”

Apulia Probe

In another Italian investigation, magistrates in the region of Apulia are probing Bank of America Corp. and last month requested the company be stopped from doing business with the country’s municipalities for two years amid allegations it misled the municipality on derivatives linked to 870 million euros of bonds. A unit of Dexia SA is also under investigation in the same case.

Separately, Nomura Holdings Inc. bankers are under investigation for alleged fraud relating to derivatives contracts sold to the Italian region of Liguria in 2004, people familiar with the case said last month.

Derivatives are unregulated financial instruments linked to stocks, bonds, loans, currencies and commodities, or related to specific events such as changes in interest rates or the weather.

The allegations have prompted Italian lawmakers to propose new rules restricting the use of derivatives among municipalities by boosting oversight and banning upfront payments. Italy’s Senate Finance Committee on March 11 unanimously approved a proposal on tighter rules that will be used by the finance ministry to shape regulation.

Through swaps, “banks found a way to sell something that is debt without making it look like debt,” said Taylor, who advises a law firm that has sued banks on behalf of residents of Jefferson County, Alabama, which was on the brink of bankruptcy after swaps backfired.

Lehman muni swap index

Lehman Brothers LEH.N on Wednesday will launch a new swap product that will allow investors to bet on U.S. municipal bonds without actually owning them directly.

The new product, called the Lehman Brothers Municipal Index Swap, is a forward-starting agreement allowing investors to take positions on the yield of new five and 10-year swap indexes, the firm said in a primer.

The new swap product is a response to the rapid expansion of municipal structured products in the past few years and increased penetration of foreign investors into the $2.4 trillion U.S. tax-exempt market.

Lehman said further growth of muni derivative products has been hindered by a lack of a reliable high-grade cash market benchmark yield curve. The firm added that there are strict eligibility requirements for inclusion in the indexes.

The new indexes will only include general obligation bonds rated "Aa3," "AA-minus," or higher, excluding insured and prerefunded bonds. Only bonds from deals of $75 million or higher can be included and each issuer cannot represent more than 10 percent of an index.

The new product will be an alternative to swaps based on an index compiled by the Securities Industry and Financial Markets Association (SIFMA), formerly the Bond Market Association (BMA) index.

Muni swaps can be used to either bet on the direction of interest rates in the muni market or hedge exposure to U.S. state and local government debt.

Market participants currently use U.S. Treasuries, London Interbank Offered Rate or SIFMA swaps to hedge their muni bond exposure.

The notional amount of interest rate derivatives outstanding grew almost 14 percent to $285.7 trillion in the second half of the year, according to the International Swaps and Derivatives Association.


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