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Originally Posted by Skydaemon
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That was a good, informative read. There was some more on JPM and the Jefferson County dilemma yesterday.
JPMorgan Swap With Alabama Drawn Into Criminal Probe (Update2)
By Martin Z. Braun
Oct. 29 (Bloomberg) -- The U.S. Justice Department is investigating a derivative trade between the state of Alabama and JPMorgan Chase & Co. as part of a nationwide criminal probe.
The Justice Department subpoenaed documents about a so- called swaption, or an option on an interest-rate swap, between JPMorgan and the state's school construction authority, according to a federal lawsuit filed by the state, which is trying to void the 2002 deal. The agency is investigating whether banks and advisers conspired to overcharge governments on the contracts.
``Although the authority does not seek by this action to avoid payment of any legitimate obligation, the pendency of at least two separate governmental inquiries implicating the validity of the transaction heightens the necessity for a judicial determination of the parties' rights,'' the complaint, filed yesterday in federal court in Montgomery, Alabama, said.
U.S. prosecutors and the Securities and Exchange Commission have searched for almost two years for evidence of rigged bidding and price fixing by banks in the $2.7 trillion municipal bond market. They have focused on derivatives, such as interest-rate swaps tied to bonds, and contracts to invest bond-sale proceeds.
The SEC has also sought information from the Bethlehem Area School District in Pennsylvania about its swap transactions with JPMorgan, while two other school districts in that state have sued the bank for allegedly conspiring to shortchange them on swaption deals like the one in Alabama.
Antitrust Investigation
Prosecutors have informed at least five former JPMorgan derivative bankers that they're targets of a grand jury investigation, according to the Financial Industry Regulatory Authority. Finra is the largest self-regulator for securities firms doing business in the U.S.
JPMorgan, in its annual report filed with the SEC on Feb. 29, said the inquiries focus on ``possible antitrust and securities violations,'' mostly between 2001 and 2006.
The federal subpoenas for documents regarding Alabama's swap deal with JPMorgan were reported earlier by the Birmingham News.
JPMorgan spokesman Brian Marchiony didn't immediately return a call seeking comment. Alabama's finance director, James Main, who received the Justice Department subpoena, also didn't return a call.
Alabama's Public School and College Authority, which sells bonds for public schools, colleges and universities, alleges the deal doesn't comply with state law because it wasn't a ``legitimate hedging transaction.''
$12.6 Million Upfront
In March 2002, the agency received $12.6 million upfront from JPMorgan in return for selling the swaption. That gave the bank the right to force the state into $710.2 million of interest-rate swaps on four series of bonds between 2008 and 2011. The swaps called for the state to pay a fixed rate and receive a percentage of the London interbank offered rate.
JPMorgan pitched the deal as a way to protect against the risk of rising interest rates and refinance old debt at a lower cost, the complaint said.
In June, JPMorgan told the state it would exercise its option on Nov. 1 on a series of bonds issued in 1998.
That would have required the state to issue floating-rate bonds, a type of security whose interest rates have jumped more than 10 percent because of the U.S. credit crisis. The state also could have terminated the deal at a cost that wasn't disclosed in the complaint.
Legal Question
Alabama alleges the swaption wasn't documented in accordance with state law, which requires a governmental body to certify the swap was entered into for the purpose of hedging.
State law also says governments can issue refunding debt only at a lower cost than the old debt. The cost of issuing variable-rate bonds, including a fixed-rate payment to JPMorgan, would exceed the amount payable under the 1998 bonds, the complaint said.
The $2.2 million Alabama received for the swaption on the 1998 bonds was less than 1 percent of the amount outstanding, the complaint said.
The deal was also structured so that JPMorgan would receive more than $66 million, 50 percent of the fixed-rate payments due from the state, within two years after the swaption was exercised.
``By structuring APSCA's fixed-rate payments in this manner, JPMorgan's exercise of the swaption was for all intents and purposes a certainty, since by doing so it would receive what amounts to a $66 million loan from APSCA with effectively no rate of return or implied interest rate,'' the complaint said.
Loans Not Allowed
The state authority can't legally make loans, the complaint said.
Swap Financial Group LLC of South Orange, New Jersey, advised Alabama on the swaption. Peter Shapiro, managing director at Swap Financial, didn't immediately return a call.
Douglas MacFaddin, JPMorgan's former head of municipal derivatives sales, signed the swap documents with Alabama.
MacFaddin, who worked at JPMorgan for 14 years, was fired by the New York-based bank in March after revealing he was a target of the municipal derivatives investigation.
Alabama has agreed to repay JPMorgan the $12.6 million it received from the bank with interest, the complaint said.
The case is Alabama Public School and College Authority v. JPMorgan Chase Bank, 2:08-cv-00863-WKW-CSC, U.S. District Court, Middle District of Alabama.
Municipal insolvency
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