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The Fleecing of Alabama: The Bills Come Due

JPMorgan Chase led four banks in selling interest-rate swaps to Jefferson County at six times the going rate. Now, the FBI is investigating the bankers, the SEC has sued a local politician and the county is on the verge of going bust.

By William Selway and Martin Z. Braun Bloomberg Markets July 2008

As nighttime temperatures plunged in Birmingham, Alabama, last October, Dora Bonner had a choice: either pay the gas bill so she could heat the home she shares with four grandchildren, or send the Birmingham Water Works a $250 check for her water and sewer bill.

Bonner, who is 73 and lives on Social Security, decided to keep the house from freezing.

``I couldn't afford the water, so they shut it off,'' she says. Bonner's sewer bills have risen more than fourfold in the past decade. So have those of others in Jefferson County, which has 659,000 residents and includes Birmingham, the state's largest city.

What's threatening to increase them even more isn't the high cost of treating waste; it's the way county officials chose to finance the $3.2 billion in debt they took on to build a new sewer system. The county relied on advice from a bank, JPMorgan Chase & Co., to arrange its funding, rather than use competitive bidding.

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.

Interest Rate Soared

In February, the county's interest rate soared to as much as 10 percent, up from 3 percent just weeks earlier. The swaps have now compounded the risk that Jefferson County will file for bankruptcy as it faces its worst financial crisis since it was founded in 1819.

The same subprime chaos that has felled chief executive officers on Wall Street and forced banks to write off $322 billion has plowed into Jefferson County and other municipalities. That 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.

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.

``It's going to come back to us, to the people,'' says Bonner, a retired waitress. ``Whether you're poor or you're rich, you're going to end up paying.''

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.

The swaps are contracts in which the county and the banks agreed to exchange periodic payments based on the size of the outstanding debt and changes in prevailing lending rates. Swaps are derivatives, which are unregulated financial contracts tied to the underlying value of interest-rate indexes.

Jefferson County's deals started to unravel in January after its bond insurers, Financial Guaranty Insurance Co. and XL Capital Assurance Inc., suffered hundreds of millions of dollars in losses on securities tied to home loans.

Bonds Take Hit

Standard & Poor's downgraded Financial Guaranty's credit rating to AA from AAA on Jan. 31. The next week, Moody's Investors Service cut XL Capital six levels to A3.

When a bond insurer takes a ratings hit, so do the bonds it has guaranteed; the insurer effectively lends its high rating to the bond issuer.

That's what happened to about $3 billion of Jefferson County's debt, causing its interest rate to balloon to as high as 10 percent in February and March from 3 percent in January. That helped increase its total monthly debt payments to $23 million from $10 million.

``It happened overnight,'' County Commission President Bettye Fine Collins says. ``It became a situation that worsened every day.''

The turmoil in Jefferson County might be just the beginning of a new, painful chapter in the subprime debacle.

``The Jefferson County crisis could have national implications,'' says U.S. Representative Spencer Bachus, who represents the county and is the top Republican on the House Financial Services Committee. ``Large defaults in the municipal bond market could have a ripple effect on the larger U.S. financial system, again causing systemwide financial stress.''

Bear Stearns Saved

The banks that sold the toxic financing to Jefferson County have themselves fallen victim to the subprime crisis -- none more so than Bear Stearns. The firm, which sold $1.6 billion in swaps to the county, saw its shares plunge 95 percent from Jan. 1 to March 17 before it was bailed out by the Federal Reserve in March.

The Fed negotiated a deal in which JPMorgan bought Bear for $10 a share. JPMorgan had sold $3.2 billion in swaps to Jefferson County.

``It's ironic that the Fed can do corporate welfare for the banks, but they can't bail out a county that was victimized by these banks,'' says Craig Greer, a Catholic chaplain at a Birmingham hospice.

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