Jefferson County Alabama is back in the news with a Fraud probe involving JPMorgan. The background for this story can be found in my April 12 post: Jefferson County Death Spiral Swaps.

The Largest U.S. Municipal Bankruptcy Looms in Alabama. What caused this mess is an interest rate swap Jefferson County officials entered into when they financed a $3.2 billion sewer cleanup. The strategy backfired, demonstrating the speculative, risky nature of swaps.

On May 22 Bloomberg reported JPMorgan Swap Deals Spur Probe as Default Stalks Alabama County.

Like homeowners who took out mortgages they couldn’t afford and didn’t understand, Jefferson County officials rejected fixed- rate debt and borrowed instead at rates that varied with the market.

The county paid banks $120 million in fees — six times the prevailing rate — for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt.

hat means local officials now have to pay to banks money that otherwise might have been used to build schools, hospitals or public housing.

Meanwhile, the U.S. Securities and Exchange Commission and the Justice Department are now investigating bankers and officials involved in Jefferson County’s swap agreements.

Bankers who worked for New York-based Bear Stearns Cos. and JPMorgan when Jefferson County bought its swaps have been told they might face criminal charges under an antitrust investigation of the municipal derivatives industry, according to records filed with the Financial Industry Regulatory Authority Inc.

On April 30, the SEC sued Larry Langford, the former county commission president and now Birmingham’s mayor, for fraud in allegedly accepting $156,000 from a local banker while refinancing the sewer debt. Langford denies any wrongdoing. JPMorgan spokesman Brian Marchiony declined to comment for this article.

The Federal Bureau of Investigation has raided financial advisers in California, Minnesota and Pennsylvania to get files. In January 2007, Charlotte, North Carolina-based Bank of America Corp. agreed to cooperate with federal prosecutors in exchange for leniency. Bank of America spokeswoman Shirley Norton declined to comment.

Jefferson County — which weathered the U.S. Civil War in the 1860s and racial strife in the 1960s — is now scrambling to avert what would be the biggest municipal bankruptcy in the nation’s history, measured by outstanding bonds.

Secret Swap Fees

JPMorgan, Bank of America, Bear Stearns, and Lehman Brothers Holdings Inc. charged Jefferson County about $50 million above prevailing prices for 11 of the interest-rate swaps the county bought between 2001 and 2004. None of the fees were disclosed to the commissioners, records show.

Porter, White & Co., the Birmingham-based financial advisory firm later hired by the county to analyze its swaps, said the banks raked in as much as $100 million in excessive fees on all 17 of its swaps.

At least four JPMorgan bankers who worked for the bank at the time Jefferson County deals were done, including Douglas MacFaddin, the former head of municipal derivative sales, have been told by the U.S. Attorney’s office that they could face criminal charges, records show. MacFaddin, who was fired in March, couldn’t be reached for comment.

“In Jefferson County’s case, the people who were allegedly doing the price fixing were right at the center of the scandal,” says Christopher “Kit” Taylor, who ran the Municipal Securities Rulemaking Board, the public finance regulator in the U.S., from 1978 to 2007.

Jefferson County could use the federal probe of the banks that financed the sewer debt as leverage to stop the firms from demanding more money, Taylor says. So far, the county has won agreements with JPMorgan and the other banks to keep from being forced to buy back as much as $847 million of unwanted bonds or pay up the $277 million it owes on its swaps.

The banks might be worried that Jefferson County, if pressed, could walk away from the derivatives trades on the grounds that they were signed in what might have been fraudulent deals written by the banks, Taylor says. That threat could be enough for the county to bide its time as it works for a solution.

Some Jefferson County residents have taken to joking about the mess local officials and banks have dumped on them. Greer, the chaplain, is selling what he calls look-alike bonds, for $2.50. He says they should be used as toilet paper. He’s also distributed bumper stickers saying “Wipe Out Sewer Debt.”

Clear Case Of Fraud

I am not an attorney but the facts presented suggest there is a clear case of fraud. Jefferson County should walk away from those deals and/or sue JPMorgan for fraud and antitrust violations.

JPMorgan for its part would be smart to absolve Jefferson County of those deals because there is no way for it to win. Even if JPMorgan won a lawsuit vs. Jefferson County, the county could simply declare bankruptcy.

Mike “Mish” Shedlock
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