Since so many people read my post on Harrisburg (thank you), I figured that I might as well explain how Jefferson County’s problems evolved. I consider this story to be old news. As with Harrisburg, however, some people mistakenly characterise Jefferson County’s financial problems as a canary in the coalmine for the municipal bond market, which suggests that they still have no idea what transpired there (or how long Jefferson County has been in financial distress). Portraying Jefferson County as a typical municipal credit is akin to portraying Enron as a typical corporate credit. With Jefferson County, various financial firms – but primarily JP Morgan – exploited an existing culture of corruption and made taxpayers the victims of one of the largest frauds in the history of the financial markets.
(For the record, most of the information that I have pieced together in this post derives from a series of complaints filed by the Securities and Exchange Commission against deal participants, see here and here – which I feel fairly confident in citing, since substantially all of the information is based on email correspondence, taped phone conversations, and the testimony of bank employees – and from this timeline of events prepared by the Bond Buyer.)
Back in 1996, Jefferson County entered into a consent decree with the federal Environmental Protection Agency to make extensive improvements to its sewer system. The county financed the improvements through several bond offerings. The project was originally estimated to cost around $1.5 billion, but its scope eventually climbed to $3 billion. (Sewer rates quadrupled over four years in order to pay for the project.)
In 2002, the FBI launched an investigation into the county’s construction program, which resulted in the conviction of 21 people, including contractors, county commissioners, and county employees. The convictions were mainly related to construction firms bribing local officials to obtain business.
The practice of bribery did not disappear with those convictions, unfortunately. According to the SEC, in March 2002, Charles LeCroy, then managing director for JP Morgan Securities’ southeast regional office in Orlando, Florida, sent a series of emails to his superiors discussing how one of the firm’s competitors (three guesses who) had successfully scored new municipal underwriting and swap business by enlisting the paid support of the politically connected principals and employees of local broker-dealers. LeCroy’s superiors endorsed this strategy, and he provided them with estimates (in emails, no less) of what the going rate for paying these folks off would be.
In their first experiment with Jefferson County, LeCroy and Douglas MacFaddin, managing director of JP Morgan’s municipal derivatives unit, focused their efforts on two commissioners, and mostly on Commissioner Jeff Germany. These commissioners had not been reelected and wanted to execute a $1.8 billion debt refinancing before they left office in November in order to direct payments to people who had supported their campaigns – specifically through Gardnyr Michael and ABI Capital, two local broker-dealers.
(As an aside, I am often amused by the progressive bias toward using smaller firms rather than megabanks. It was the good old boys at the smaller firms that JP Morgan and other banks used to gain access to local officials in this and other frauds, and the people at those smaller firms had already been deeply entrenched in corrupt schemes with public officials for decades. In fact, as you will see, these smaller firms played the megabanks off of each other, which only increased the cost of the schemes to taxpayers.)
The county ended up issuing the bonds in three series: 2002-B, 2002-C, and 2002-D. The 2002-C series was the largest component of the transaction, and was the only series that involved auction rate securities and (theoretically offsetting) interest rate swaps. Although the county had selected Gardnyr Michael and ABI Capital to serve as co-underwriters on the 2002-B and 2002-D series, they were not eligible to work on 2002-C because Alabama state law imposes net capital requirements on counterparties to swap contracts, which the two firms did not meet.
The state’s capital requirements for swap counterparties are significant because JP Morgan’s strategy for producing the funds to pay off these firms (in exchange for the firms persuading county commissioners to hire JP Morgan) was to incorporate the cost of the payments into the interest rates on the county’s swap agreements. JP Morgan essentially structured the transaction so that county taxpayers would be the ones paying to bribe their own officials. To pass the funds on to Gardnyr Michael and ABI Capital, JP Morgan had to devise some role for the firms in a transaction that it would have been illegal for them to participate in.
Humorously, the firms had sent invoices to JP Morgan for their work as “co-managers on the Jefferson County, Alabama swap,” language that would have made anyone who had ever worked with swaps believe something was amiss (or question whether the local bankers even knew what an interest rate swap was). After much debate captured in taped phone conversations (“we probably should not say the firms advised us on the swap or structuring…”), they settled on writing something to the effect of “Jeff Germany told us to pay them” on the invoices. (When in doubt, say it wasn’t you.) JP Morgan ended up wiring $250,000 each to the local firms, who provided no actual services to the county, equivalent to one-third of JP Morgan’s $1.5 million underwriting fee on the deal. (Because the cost was being passed on to the county, the JP Morgan bankers were mostly indifferent to how much the firms were being paid.) Those firms turned around and wired a large portion of the fees to some of Germany’s campaign contributors.
Securing a second transaction through the same means proved to be a little more complicated for JP Morgan’s bankers because Goldman Sachs had already beat them to establishing a relationship with the new crop of county commissioners. In November 2002, a fellow named Larry Langford took over as president of the Jefferson County Commission. Langford was explicit in his intention to direct as much of the county’s business to Blount Parrish, a local broker-dealer owned by Langford’s long-time friend and supporter, William Blount, which had not received any of the county’s business since 1997. (Incidentally, in 1998, when Langford was mayor of the city of Fairfield, Blount Parrish served as underwriter on bonds used to finance a new theme park. The park was mismanaged, did not generate as much revenue as projected, defaulted on its debt, and was placed into receivership by bondholders. One has to love the masses for consistently electing such people to public office, when disaster follows them wherever they go.)
Both JP Morgan and Goldman Sachs had been pitching new bond offerings and swap arrangements to the county. Blount Parrish had wanted to participate in any new offering, but like Gardnyr Michael and ABI Capital, did not meet the state’s net capital requirements for that kind of transaction. Blount suggested that Langford hire Goldman Sachs to underwrite a new 2003-B deal because Blount already had a “consulting” agreement with Goldman. Another broker-dealer, Rice Financial Products, had likewise been pitching offerings to the county through a local “consultant” that was also good friends with Blount.
To ensure that JP Morgan won the county’s business, LeCroy and MacFaddin cut a deal with Langford to pay the whole bunch off. (As I said before, since the JP Morgan bankers were confident no one would check their swap maths, there really was not much of a ceiling on the cost they would pass on to taxpayers.) Pursuant to their negotiations, LeCroy and MacFaddin paid Goldman Sachs $3 million and Rice Financial $1.4 million. Goldman Sachs turned around and paid Blount Parrish $300,000. Goldman Sachs and Rice Financial, having far more CYA expertise than the local bankers JP Morgan had previously worked with, did not try to insert themselves into the county’s transactions. Instead, JP Morgan entered into a swap with the county (at an inflated cost to the county), and Goldman and Rice entered into separate corresponding swaps with JP Morgan. That was how the money was passed from one firm to another. Just to be clear, the net effect of this transaction was that Jefferson County taxpayers ended up paying Goldman and Rice not to do business with the county.
(Humorously, Goldman sent a CYA letter to Langford, explaining that the firm was passing on “consulting” fees to Blount Parrish, and recommending that Langford disclose the payment to the county’s bond counsel on the transaction, so that the bond counsel could decide whether or not the payments should be included in the bonds’ offering documents. I’m sure Langford’s reaction in reading the letter was something like, “Goodness. How could we have forgotten to tell our bond counsel that this transaction was a massive fraud? We should rectify that immediately.”)
As you have likely surmised, Langford was not funelling money to Blount out of the goodness of his heart. Around the time Langford took office, he was stressing out about the $70,000 in credit card debt he had amassed buying rockstar duds. He confessed as much to his friends Blount and Albert LaPierre, a lobbyist. LaPierre told Langford to apply for a loan at Colonial Bank in Birmingham, which he did. Why Colonial Bank? Blount’s girlfriend at the time was the chief credit officer for the bank. She approved Langford for an unsecured, six-month, $50,000 loan, despite his less-than-desirable credit.
When the loan was due in January 2003, Langford asked LaPierre to pay off the loan. Blount had his girlfriend approve a $50,000 loan for LaPierre, which was used to pay off Langford’s debt. Blount eventually repaid the loan on Langford’s behalf. Blount tried to get Colonial Bank to offer Langford another $75,000 loan, as Langford continued to live large on his credit cards, but Colonial turned him down. Blount then provided the money for Langford himself, using LaPierre’s lobbying firm as a conduit. On a separate occasion, Blount funneled money through LaPierre’s lobbying firm to Langford so that Langford could pay close to $30,000 in taxes to the IRS. Blount’s payments on Langford’s behalf were sandwiched in between two large bond offerings, for which Blount’s firm served as co-underwriter.
By the time the second major bond offering was being contemplated, JP Morgan’s bankers were getting a little exasperated by Blount’s demands. Much to their relief, Goldman had taken itself out of the picture (“we’ve got a lot more latitude dealing with [Blount] than with Goldman Sachs”), but Blount, who understood that he had Langford wrapped around his little finger, was demanding 15% of JP Morgan’s fees on the next swap agreement. JP Morgan ended up paying Blount Parrish $2.6 million on the transaction. JP Morgan also paid $150,000 each to their old friends Gardnyr Michael and ABI Capital, who had hired a friend of Commissioner Sheila Smoot as a “consultant” so that they could stay in the game. (They also paid $1,122 to send another commissioner to New York for a spa trip, among other gifts – very generous people. A judge would eventually sentence her to 3 years’ probation, 200 hours community service, and to pay a $20,000 fine.) Again, all of these payments were built into the county’s cost on the swaps.
This arrangement continued for several other transactions. In the end, the fraudulent payments LeCroy and MacFaddin made to secure the county’s business from 2002 to 2003 totaled $8.2 million. (I think somewhere along the line JP Morgan also made payments to LaPierre, who wasn’t even in the securities business.) Before the refinancing transactions with JP Morgan, over 95% of the county’s debt was in traditional, fixed rate bonds. After the refinancings, 93% was variable rate debt, including $2.1 billion of auction rate securities. The debt was synthetically fixed through $5.6 billion notional of swaps.
Although the Bond Buyer reported in 2004 that the SEC was looking into the county’s bond offerings, the SEC did not begin a formal investigation until 2006 and did not begin issuing subpoenas until 2007. In the meantime, the county restructured three swap agreements with a notional amount of $1.56 billion with Bear Stearns and one swap agreement with a notional amount of $380 million with Bank of America. Blount Parrish received payments under the deals with Bear Stearns. (That’s how insane these people were – they still kept going, even though the SEC was looking into their dealings. I distinctly remember wondering during those years why the SEC was taking so long in nailing these folks. Jefferson County’s story had been a regular feature in industry papers for years.)
The county’s downward spiral began in earnest in 2008 when the auction rate securities market collapsed. As mostly everyone knows, the investment banks serving as auction agents on the bonds had been propping up auctions for months as investors were becoming increasingly sceptical of the liquidity of their holdings, but the banks eventually had to withdraw their support. In January, the credit rating agencies went on a rampage downgrading bond insurers, including FGIC and XL Capital Assurance, which insured Jefferson County’s debt. Jefferson County’s auctions failed, leaving the county paying the penalty interest rates stipulated in bond documents, as much as 10%. (This was happening to all issuers in the ARS market by February. Whether the penalty rate was even remotely affordable depended on how bond documents were drafted and whether the penalty rate was a fixed rate or based on an index plus a spread.) Jefferson County’s VRDO remarketings also failed, which forced the banks providing Jefferson County’s credit facilities to buy back the bonds from investors. As the Fed started lowering interest rates, the payments the county received on its swap agreements decreased, adding to the county’s expenses. S&P cut the sewer bonds’ ratings to junk in February and was followed by Moody’s in March.
JP Morgan and the county’s other creditors entered into a series of forbearance agreements with the county (which allowed payments to be deferred). The county commission, now under the leadership of Bettye Fine Collins (Langford had moved on to become mayor of Birmingham), refused to post collateral on the swaps. The next month, S&P cut the county to D, and the SEC filed securities fraud charges against Langford, Blount, and LaPierre. A federal grand jury began investigating the deals.
Beginning in the spring of 2008, the county began hiring and firing various firms (like Merrill and Citi), who were to advise the commission on its debt restructuring options. (Those firms were soon to have larger problems of their own…) It was at this time that the county began tossing around the idea of filing for Chapter 9 bankruptcy. The state’s pension system had considered purchasing the county’s debt – genius, I know – but only on the condition that the county prepared a bankruptcy filing to force creditors into serious negotiations. The commissioners discussed filing for bankruptcy at pretty much every meeting for the next three years, and they are still discussing it.
In September 2008, the trustee on the bonds declared that the bonds were in default. The bond insurers and trustee filed a lawsuit against the county in federal court requesting that the court appoint a receiver for the sewer system. In November, the judge honored their requests and appointed John Young, president of American Water Services, and John Ames, a lawyer at Greenebaum, Doll & McDonald, as special masters of the sewer system. (Placing an entity in receivership can only happen outside of Chapter 9.) The special masters ultimately recommended that the sewer system increase user rates.
That same month, JP Morgan made the bombshell announcement that the firm would exit the municipal swap business altogether and fire a bunch of employees at regional offices. The firm was getting hit with negative publicity from all sides, due not only to the situation unfolding in Jefferson County, but also the Justice Department’s antitrust probe into municipal derivatives. (Bloomberg reported at the time that the county’s financial adviser had estimated that JP Morgan had overcharged Jefferson County by as much as $100 million for the various sewer refinancings.) The bank said it would continue to provide swaps for some exempt borrowers, such as hospitals.
Things became much worse for Jefferson County in 2009. A local court struck down the county’s occupational and business licence taxes (ruling that the state legislature had enacted the taxes illegally during the legislative session), a decision that was eventually appealed to and upheld by the Alabama Supreme Court. Those taxes comprised one-third of the county’s general fund budget. The county went into full austerity mode after the ruling, shutting down offices, furloughing employees, and so on.
Shortly thereafter, JP Morgan / Bear Stearns decided to terminate the bank’s interest rate swap agreements with the county, which it would have had the contractual right to do, given the county’s financial position and unwillingness / inability to post collateral. (I am not suggesting that the contracts were legitimate, just saying those are standard terms of swap agreements.) The bank notified the county that it owed JP Morgan approximately $648 million in swap termination payments.
In anticipation of being charged with securities fraud, JP Morgan agreed to settle with the SEC, making a $50 million payment to Jefferson County for the purpose of assisting displaced county employees, residents, and sewer ratepayers; paying a $25 million penalty to the SEC; and agreeing to forfeit the $648 million of swap termination payments. Considering how destructive the transactions proved for the county, the settlement seemed beyond absurd. Securities fraud suits against LeCroy and MacFaddin are still pending. (Incidentally, in 2005, LeCroy was sentenced to three months in jail for wire fraud after an investigation into whether Philadelphia bond business was directed to supporters of Mayor John Street.)
Langford, Blount, and LaPierre ended up being indicted for conspiracy, bribery, and fraud. Blount and LaPierre plead guilty to the charges and were sentenced to 52 and 48 months in prison, respectively. Langford was tried, found guilty, and sentenced to 15 years in prison.
Last month, the county announced that it had reached a settlement agreement with its creditors (JP Morgan is the county’s largest bondholder by far), wherein bondholders would write off $1.09 billion of debt, and the county would restructure the remaining $2.05 billion and enact a series of rate increases (three annual increases of 8.2%, beginning in November, and 3.25% annual rate hikes after 2014).
Unlike Harrisburg, where the state of Pennsylvania moved swiftly to intervene in the city’s financial situation, the state of Alabama has resisted providing any assistance to Jefferson County over the years. Multiple legislative sessions have passed where the Alabama legislature has failed to take action on legislation introduced to help the county restructure its debt or replace the occupational tax revenues it has lost. Part of the problem is that there is a tradition within the Alabama legislature where lawmakers will defer to the local delegation to make decisions on local matters, and the delegation has to be unanimous in its position. (The fact that the legislature has proven to be so dysfunctional in addressing Jefferson County has had a detrimental effect on all municipalities in the state, which have been paying a premium to borrow in the bond market. A number of market analysts have cautioned investors against investing in Alabama debt.)
Given the legislature’s track record, it is difficult to be optimistic about the fate of the county’s settlement with creditors. In order to reduce the county’s interest cost in the debt restructuring, the settlement assumes the debt will be issued with a moral obligation pledge from the state. The legislature would need to approve that provision plus the establishment of a new public corporation to manage the sewer system. So far, it looks like the Alabama delegation is split over supporting the settlement. Some local lawmakers are opposed to the rate increases, which they regard as unjust. (Perhaps they mistakenly believe that filing for bankruptcy would not involve additional costs for local residents?) The county could be forced to file for bankruptcy anyway if legislators draw out their deliberations, because there is not enough liquidity in the county’s general fund to carry the government for much longer. As things stand now, Jefferson County filing for bankruptcy can be avoided. If the county does have to file, it will be entirely due to Alabama policymakers.
On a somewhat-related tangent, Mark Schwartz, attorney for the Harrisburg City Council and resident conspiracy theorist, has pointed to Jefferson County’s bankruptcy threats in defending the council’s decision to file, suggesting that only after Jefferson County threatened to file was the county able to make progress in negotiating with creditors. This is simply untrue. As I pointed out earlier, Jefferson County has been threatening to file for bankruptcy for literally three years now. Jefferson County’s creditors have likely waited until now to settle with Jefferson County because many other things that could have potentially impacted the county’s finances have had to play out (such as the occupational tax case winding its way through the state courts and pending legislation on debt restructuring / new tax revenue). It should also be noted that Jefferson County has some leverage over its largest creditor that Harrisburg does not have, namely that its largest creditor had been charged with securities fraud in the subject debt transactions. Harrisburg’s financial woes, on the other hand, derive entirely from local officials’ stupidity. In the end, the only thing Jefferson County and Harrisburg have in common is their insolvency, which is not particularly instructive when comparing their options.
I hope that all the additional detail on these cases has helped readers understand the limitations of making generalizations about distressed credits and the problem with drawing macro conclusions from isolated events.