We’re used to hearing about the disasters visited upon those poor souls who were duped into taking out variable-interest rate mortgages. After an initial period of low interest, rates would subsequently spike, sending mortgage payments through the roof and often leading to bankruptcy or foreclosure.
The same story, writ large, happened to Jefferson County, Alabama, the seat of Birmingham, the largest city in the state. And it’s only just now wrapping up. JP Morgan, a large U.S. investment bank, has agreed to forgive some $842 million in debt. Following a 2009 settlement with the SEC that cost the bank $722 million, the deal will close the book on a long and very costly experiment in municipal financing that involved interest-rate swaps, bribery, and eventually the bankruptcy of Alabama’s largest county. In total, $2.4 billion of debt will be refinanced — JP Morgan takes the largest hit, forgiving about 70% of its $1.2 billion, while hedge funds will collect around 80% of their $842 million.
In the late '90s, the county revamped its sewer system after being accused by the EPA of dumping raw sewage into two rivers in 1996. It decided on a massive, expensive overhaul, which the county then refinanced in 2002 and 2003. These refinancing deals were similar to the floating-rate mortgages many homeowners had prior to the 2008 crisis. When the financial crisis hit, the interest rates on Jefferson County’s sewer debt skyrocketed as investors countrywide dumped municipal bonds. In 2011, a major county tax to cover the costs was declared unconstitutional by the Alabama Supreme Court, forcing a major increase in sewer fees. Jefferson County was eventually forced to declare bankruptcy. In the process, over a dozen county officials were sent to jail for bribery and other charges.
The bank is far from innocent, though. The settlement in 2009, in which the SEC charged JP Morgan with unlawful payments (bribes) in order to secure business with the county, required the bank to pay the enforcement agency $25 million, pay Jefferson County $50 million, and forgive a whopping $647 million in fees. Specifically, former JP Morgan managing directors Charles LeCroy and Douglas MacFaddin were accused of making payments of more than $8 million to close friends of some Jefferson County commissioners. In exchange, the commissioners voted to select JP Morgan as the underwriter of municipal bond offerings to finance the sewer system, and as the affiliated bank for the swaps. In a taped telephone call between LeCroy and MacFaddin, the former is heard telling the commissioners, "Whatever you want — if that's what you need, that's what you get — just tell us how much." The bank then passed on the cost of the bribes to the people of Jefferson County by charging them higher interest rates on the swap transactions.
How did this spin so far out of control? It shouldn’t have come as such a surprise: As early as November 1997, County Commissioner Bettye Fine Collins sent a letter to the Securities and Exchange Commission asking them to investigate the underwriting and subsequent transactions, which ended up raising Jefferson County’s costs while fueling political patronage and cronyism. Even in 2002-2003, some 95% of the county’s liabilities were still fixed-rate obligations. While it was excessive debt, at least it could be planned for. By the end of the refinancing (again engineered by JP Morgan), 93% of the debt was subject to variable rates. Even after this happened, there were still five years to seek help before the crisis of 2008 hit.
Though akin to the crises that befell countless homeowners with floating-rate debt (including many of those with subprime mortgages), the Jefferson County debacle has turned into a sobering lesson for big investment banks, as well — it will end up costing JP Morgan around $2 billion in total. As the saying goes, if you owe the bank $1 million, you can’t sleep at night. If you owe the bank $2 billion, the banker can’t sleep at night.