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Jefferson County $5 Billion Swap Spree Prompts Alabama Derivatives Curbs

Alabama legislators are tightening regulation of derivatives for the state’s largest county, which was nearly bankrupted after a $3 billion sewer-debt refinancing collapsed during the credit crisis.

The State Senate passed a bill by 27-0 yesterday requiring Jefferson County, home to Birmingham, to price interest-rate swaps by competitive bid and disclose all payments made in connection with the contracts. It also calls for the county to hold public hearings before issuing more than $5 million of debt or buying swaps. The legislation, which the House of Representatives passed last month, now moves to Governor Bob Riley for his signature.

“The impact of this legislation on Jefferson County will be to bring more transparency to bond transactions, something we’ve sorely needed,” said Paul DeMarco, a Republican in Alabama’s House of Representatives who sponsored the bill and represents parts of the county, in a phone interview. “Hopefully this will prevent the type of criminal fraud and mismanagement we’ve had in the past.”

The bill’s passage came six days after Larry Langford, the former Democratic president of the county commission, began serving a 15-year sentence for bribery in connection with county bond and swap deals.

Langford was convicted in October for taking more than $200,000 in money, designer clothes and jewelry from an investment banker in exchange for steering more than $7 million in debt and swap fees.

States’ Oversight

Alabama’s action may signal growing momentum by states to boost oversight of swaps, which municipalities employed earlier this decade to lower borrowing costs. States, cities and nonprofits have paid billions of dollars to terminate the private contracts in the wake of the credit crisis. Both financial bills in Congress would regulate the derivatives.

“No one should object to more transparency, more disclosure,” Jefferson County Commission President Bettye Fine Collins said in an e-mailed comment. “The concept is good, and it will be binding.”

Jeff Emerson, a spokesman for Riley, didn’t immediately return a call seeking comment.

Locking in Rate

In an interest-rate swap, counterparties exchange interest payments on a set amount of debt, often with the goal of locking in a fixed rate on a related set of variable-rate bonds.

The contracts turned toxic after central banks lowered lending rates to combat the worst credit crisis since the Great Depression and municipalities were forced to refinance floating- rate bonds underlying the swaps because the debt was insured by companies that lost their top credit ratings.

In October, Tennessee required cities and counties seeking state approval to use swaps to employ a chief financial officer and have an audit committee to monitor the agreements.

Pennsylvania Auditor General Jack Wagner has asked lawmakers to repeal legislation passed in 2003 that allowed school districts and local governments to enter into swaps.

JPMorgan Chase & Co. arranged the $3 billion refinancing of the Jefferson County sewer system in 2002 and 2003, converting the district’s fixed-rate debt -- issued so the sewer system was able to comply with a 1996 federal consent decree -- into floating-rate bonds.

The obligations were paired with more than $5 billion of interest-rate swaps.

2008 Collapse

Jefferson County’s financing collapsed in 2008 when Syncora Guarantee Inc. and Financial Guaranty Insurance Co., the companies guaranteeing the debt, lost their top credit ratings because of losses on unrelated mortgage-backed securities, causing the county’s rates on the sewer debt to soar more than threefold in a month, to 10 percent.

Instead of protecting the county against higher rates, the swaps increased borrowing costs because the variable rates that the banks paid to Jefferson County declined.

The U.S. Securities and Exchange Commission has sued two former JPMorgan bankers for making more than $8 million in undisclosed payments to friends of Jefferson County commissioners to win $5 billion of bond and interest-rate swap business. The payments included almost $3 million to William Blount, a Montgomery, Alabama, investment banker who pleaded guilty to paying bribes to Langford.

The former JPMorgan bankers, Douglas MacFaddin and Charles LeCroy, have asked a federal judge to dismiss the SEC case, arguing that the agency doesn’t have jurisdiction over swaps.

SEC Settlement

In November, JPMorgan agreed to a $722 million settlement with the SEC to end a probe into derivative sales to the county. In addition to paying $50 million, the New York-based bank agreed to cancel $647 million in fees the county faced to unwind the transactions.

JPMorgan, which agreed to settle without admitting or denying that it unlawfully paid politically connected firms, also paid a $25 million penalty that will be placed in a fund to compensate affected investors.

“The power of free markets will protect Jefferson County from future abuses, provided that transactions are done in the light of day with full disclosure of pricing and compensation, rather than in secrecy where bribes and kickbacks are hidden from view,” said James H. White, chairman of Porter, White & Co., a Birmingham-based financial adviser, in an e-mailed comment.

To contact the reporter on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net

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