The Incredible Story Of The Jefferson County Bankruptcy -- One Of The Greatest Financial Ripoffs Of All Time, Bond Girl, Self-Evident, 10/23/11
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 characterize 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 math, 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 funneling 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 skeptical 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 license 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.
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