JPMorgan Slinks Away From Swaps

This post first appeared on Minyanville.

Savvy mortgage-backed securities traders weren’t the only ones that blew up the Wall Street lab during the credit boom.

Their colleagues at the other end of the trading floor -- equally adept at turning low yielding, safe debt into risk-laden toxic waste -- made big bucks peddling complex interest rate derivatives to municipalities. Now government officials are crying foul and claiming bankers duped them into making investments they didn’t fully comprehend.

Ignorance, in fact, is nothing approaching bliss.

Alabama’s Jefferson County is on the brink of bankruptcy after financial “advisors” at JPMorgan (JPM) convinced it to refinance more than $3 billion of fixed rate debt into adjustable rate bonds, using interest rate swaps as a hedge against higher rates. According to Bloomberg, the bureaucrats now claim they didn’t understand the arrangement, relying instead on their bankers who pocketed a cool $100 million in fees for arranging the transactions.

Interest rate swaps (are supposed to) allow debt issuers to offset the risk of variable rate bonds increasing in cost if interest rates should rise. The swap, coupled with the variable rate bond, is designed to smooth out any interest expenses in the event rates start moving in the wrong direction - namely up.

In the case of ill-fated Jefferson County, not only did rates move against it, but the swaps that were supposed to act as hedges backfired. When fears bond insurers Ambac (ABK) and MBIA (MBI) wouldn’t be able to make good on their obligations rocked the once-placid municipal bond market earlier this year, yields on Jefferson County’s bonds spiked from 3% to as high as 10%. Meanwhile, roiling credit markets meant the swaps, purchased for the very purpose of protecting against higher rates, didn’t do their job.

Now the Justice Department is investigating whether JPMorgan and other Wall Street banks gouged Jefferson County and other unsophisticated administrators on fees, jamming them into complex debt arrangements that hadn’t been properly stress tested.

JPMorgan announced today that it’s exiting the business altogether, claiming selling interest rate swaps to government borrowers is no longer a reliable revenue center. That could stem, in part, from the fact the financial services company may be on the hook for billions in defaulted debt if it can’t successfully keep Jefferson County from becoming the largest municipal bankruptcy since Orange County, California went bust in 1994.

The business of concocting and selling complex structured finance transactions is in shambles. Models didn’t properly account for the sort of comeuppance the credit markets have experienced in the past 12 months, as multi-standard deviation events are occurring with alarming frequency.

In all likelihood, similar to the mortgage business that’s reverting back to its boring, low- yielding roots, the love affair between municipalities and Wall Street will take years to mend.