From "MISH"this story the Erie City School District in Pennsylvania.
In an "offer too good to be true", and was, David DiCarlo, an Erie-based JPMorgan Chase banker, talked Barker and the school district into a credit default swap. The swap gave the school district an upfront $750,000 and a huge nightmare down the road. Let's pick up the rest of the story from Bloomberg.
What New York-based JPMorgan Chase didn't tell them, the transcript shows, was that the bank would get more in fees than the school district would get in cash: $1 million. The complex deal, which placed taxpayer money at risk, was linked to four variables involving interest rates. Three years later, as interest rate benchmarks went the wrong way for the school district, the Erie board paid $2.9 million to JPMorgan to get out of the deal, which officials now say they didn't understand.
JPMorgan's Chief Executive Officer Jamie Dimon declined to say if he thought the bank's fee disclosure was proper and whether the bank acted in a fair, responsible and moral manner in Erie. Banker DiCarlo declined to comment.
My Comment: Declining to comment is a comment. Jamie Dimon has to know the fees in question are not fair and that JPMorgan dot act in a "moral manner" to the school districts. However, morals and legality are two different things. At the heart of the issue will be a legal requirement to disclose fees. This will no doubt be settled in court.
The Pennsylvania deals show that school districts routinely lose when making derivative deals. They pay fees to banks that are as much as five times higher than typical rates and overpay advisers by as much as 10-fold. That means banks often underpay schools on upfront amounts, as JPMorgan Chase did in Erie, public records show. And school officials aren't always well served by their supposedly independent advisers, whose fees are paid by the banks selling the deals -- only if the sale is made.
My Comment: This opens up still another legal attack. If the so called independent advisers represented the brokerage houses and/or proper disclosures were not made, both the brokerage houses and the independent advisers are going to find themselves in court.
Christopher Cox, chairman of the U.S. Securities and Exchange Commission, says he's concerned that municipalities are taking on more risk than in the past when they raised money primarily from bond sales.
"It's a serious issue, not only in Pennsylvania but across the country," says Cox, 55, who has headed the SEC since 2005. "That is what we have seen repeatedly. More often than not, the municipalities aren't configured to have financial sophisticates in charge of these offerings -- and the result is that the firms are the only ones who know what's going on."
The banks that arrange these deals create the swap contracts before pitching them to schools. Using software programs designed for valuing swaps, they calculate prices for which they can sell them after a school signs a contract. That's how the banks make money. For example, if a bank agrees to pay a district $800,000 in a deal it valued at $2 million, it could reap $1.2 million for itself and middlemen.
"They load it off instantly," says Taylor, who's now on the advisory board of Rockwater Municipal Advisors LLC, an Irvine, California-based investment firm.
Banks hedge their risk in derivative deals by making trades to cover possible losses to school districts. The banks make their money from fees, regardless of interest rate movements.
The reason Erie and other districts don't know how much the bank makes from a deal is because banks don't tell them, the records show.
My Comment: These kinds of deals and the fees they generate are now dead in the water. Regardless of the litigation outcome, such predatory practices will stop. Together with collapsing leveraged buyouts (LBOs), and with commercial real estate headed into the sewer, what's obvious is that profits at the brokerage houses has peaked this cycle.
While the SEC doesn't regulate derivatives, it has authority to oversee how banks conduct transactions. SEC Chairman Cox says all financial firms should tell clients what their fees are before signing any deals.
"Brokers and advisers should disclose their compensation and conflicts of interest to their customers, and to the extent that they are regulated by the SEC, they must," he says.
Cox also says school district officials have a responsibility to the public and to bond investors to ensure their advisers are actually independent and acting in the best interests of taxpayers. "To the extent that municipalities are participating in transactions they are not qualified for, there is an obligation to get good independent advice," he says.
My Comment: What Cox seems to be saying is that both parties are at fault. There is plenty of ground here for future litigation.
In many cases, the banks repeatedly sell more derivatives to replace old ones. In Bethlehem, Pennsylvania, JPMorgan and Morgan Stanley sold the school district eight swaps on just two bond issues, records show.
"It sure looks a lot like churning," Yang [head of research at financial advisory firm Andrew Kalotay Associates Inc.] says. Churning is a term used to describe how stockbrokers or insurance agents sometimes continually sell and resell the same or similar products to clients in order to make more in fees. "Doing more than one swap against a single bond issuance definitely benefited the swap adviser and bank, but probably not the school district."
Other Pennsylvania school districts are paying banks excessive fees. Bethlehem, 50 miles north of Philadelphia, is also a former steel-making center. With a population of 72,000, the city has maintained its historic buildings.
So far, the [Bethlehem] district has taken in about $900,000 from the deals, Bloomberg data show. That compares with $3 million in transaction fees. Lestrange and Access made $630,000 each for arranging the swaps, according to school district records. New York-based Morgan Stanley made $840,000 and JPMorgan received fees totaling $900,000, Bloomberg data show.
Lestrange and Access earned a fee 10 times more than the Easton Area School District, Bethlehem's neighbor, paid its adviser on a comparable interest-rate swap in 2004.
The rates the banks charged Bethlehem were twice the average for comparable swaps deals. In this kind of swap, in which both sides pay floating interest rates, a bank calculates its fees by subtracting an amount from the rate it will pay.
"It's obscene," says Peter Shapiro, managing director of South Orange, New Jersey-based adviser Swap Financial Group, who doesn't advise Pennsylvania school districts. "What is going on in Pennsylvania?"
Hornet's Nest Recap
* Merrill Lynch, Citigroup, and others clearly sold products not suitable for retail customers to retail customers. However, these companies are likely to maintain they did so in "good faith".
* Fees and risks were not properly disclosed. The issue of undisclosed fees may prove to be extremely fertile ground for litigation.
* Inappropriate relationships by so called "independent advisers" will come under legal scrutiny.
* There will be grounds for lawsuits for recommendations that amount to "churning".
* A mammoth wave of lawsuits against Bear Stearns (BSC), Merrill Lync (MER), Citigroup (C), Lehman (LEH), Morgan Stanley (MS), Goldman Sachs (GC), JPMorgan (JPM) and others is likely on the way.
* By agreeing to reimburse Springfield, Merrill Lynch may have inadvertently opened the door for more litigation.
Merrill Lynch, Citigroup and other got caught up in their own CDO Ponzi schemes once the pool of greater fools ran out. A hornet's nest of litigation is now on the way. Legal bees will be buzzing over this for a long, long time.
Mike "Mish" Shedlock
globaleconomicanalysis.blogspot.com |
