OK, while stuck in traffic today I read what was about a nine page article on the FBI probe of JP Morgan’s fee structure for certain swaps on municipal debt. It’s a great article, but I know most of you won’t find yourself trapped in a tin can for an extended period of time with nothing to do but read financial articles on your phone so I am going to attempt to summarize it.
Basically, after the feds relaxed Glass-Steagall in 1987, and continuing through the early half of this decade, JP Morgan realized they could make a hell of a lot more money if they were to sell exotic instruments to municipalities instead of taking trivial commissions on weaksauce issuance of boring old municipal bonds.
JPM, more than any other brokerage, issued these deals. And, supposedly, the deals weren’t competitive, JPM failed to declare their fees and took the authority to decide whether or not agencies would enter future swaps, with taxpayer funds. The end result is that a lot of municipalities that bought into these floating-rate bonds and interest-rate swaps are in a lot of trouble. Some examples:
- Jefferson County/Birmingham, Alabama – you can read all about this one in this week’s Fortune mag – missed an $84 million interest payment on Oct 1. JPM and company gave the county a month to rework. Clock’s ticking. $2.2 bn of their debt was underwritten by JPM.
- Philadelphia International Airport issued $6.5 million in floating rate bonds on which they have recently been paying anywhere from 7-10% interest, buffetted by a swap on which JPM is paying them a measly 1.8%.
Several Pennsylvania school districts have similar sordid tales, of bad deals for the municipality and massive fees paid to JPM for the setup, many of which are under investigation for being 10 times normal. You’re probably wondering by now – why didn’t these counties hire a financial adviser who would be able to tell them these deals would blow up in their face? Oh, they did, but the handful of advisers competent to discuss these things were on JPM’s payroll:
Local officials didn’t recognize the conflicts of interest created by the relationships between the advisers and the banks. Banks routinely pay these advisers and often refer them to government issuers.
In Erie, JPMorgan recommended Pottstown, Pennsylvania- based IMAGE to be the school district’s independent financial adviser. During a Sept. 4, 2003, meeting of the Erie City School District’s board, JPMorgan banker David DiCarlo praised the firm.
“There’s only probably three or four firms in the world that do these things, and IMAGE is probably the premier firm,” DiCarlo said, according to a transcript of the meeting… IMAGE never disclosed JPMorgan’s fee. Neither did the bank. In a written statement, IMAGE said it could only estimate the bank’s fees, which it described as normal for the industry.
No one knew what JPM stood to make, and it’s debatable they knew what they were getting into at all. An exchange from the Erie school board that would be laughable if it weren’t so sad:
Erie school board member Eva Tucker asked DiCarlo how much JPMorgan would make in the deal.
“Everybody has asked, and it is a reasonable question, what does JPMorgan, what do we get on this transaction?” DiCarlo said, according to minutes of a school board meeting.
“I can’t quantify that to you,” he said. “What this transaction is, is a financial transaction that is put into a huge hedge fund that JPMorgan controls. There’s a trillion dollars of investments in that hedge fund. There’s some other issuer in Tokyo or somewhere else who’s got an opposite bet and they’re going to offset each other.”
Exotic instruments, indeed. The other side of this swap is held in a foreign land! The land of PROFITS!
I don’t feel like going on and on about the investigation because I get tired of typing “alleged” over and over again and hell, I don’t know how to price out swaptions or slap fees on a deal, and many of the people reading this are going to know much better than I do. (You can read all about the investigation in the Bloomberg article linked above.) All I can tell is that, taxpayers, you’ll be eating the crow from this mess for a while, in the form of higher sewer rates, higher airport taxes, and, one wonders, in the form of your children attending what is soon going to be known as J.P. Morgan Elementary School. Hey, at least the math classes will probably be pretty solid there.