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Muni Suits Pose New Legal Threat to Banks

Banks face new charges over Alabama municipal bond deals, thanks to the bankruptcy of Jefferson County, and that could spell further trouble.

Bank of America may have settled one big lawsuit in recent days, but the shareholder complaint over the ill-fated Merrill Lynch deal in 2008 isn't the only bit of legal woe the big bank is facing.

In September the U.S. Bankruptcy Court of the Northern District of Alabama agreed to let 140,000 property owners in Jefferson County sue BofA along with JPMorgan Chase, Bank of New York Mellon and others for $1.6 billion in damages.

The lawsuit is still in its infancy; but the idea of property owners suing banks for bond refinancing activities, which they say have resulted in increased taxes and assessments to repay the municipal bonds, could trigger a cascade of similar lawsuits. And for many banks already under pressure to settle lawsuits on a multitude of fronts, the costs could be in the tens of billions.

The case is relatively straightforward. Between 1997 and 2002, Jefferson County raised $2.75 billion through warrants at a fixed rate of 5.25 percent for improving its sewer system. Soon after, a number of banks led by JPMorgan Chase refinanced the warrants, raising the principal amount by $365 million and replacing the fixed rate by a variable rate that would be as high as 18 percent. Swap fees and profits from the refinancing: $170 million.

To hedge against interest rate swings, the banks then sold Jefferson County interest-rate-swap contracts totaling a notional $5.6 billion. The fees on the swaps, according to Bloomberg, were $120 million, or about six times market rates. When interest rates spiked, the county found itself facing total liabilities in excess of $5 billion. The county then filed for bankruptcy in what became the largest municipal bankruptcy in U.S. history.

“The burden of the refinancing, which creates an increased liability of $1.65 billion, falls squarely on the property owners of Jefferson County rather than the county itself, which is merely a conduit for transfer of payments made by the property owners to the bankers,” says Calvin Grigsby, the lead attorney for the Jefferson County property owners.

Adds Rajan Pillai, co-counsel: “As a result of the swap refinancing transactions, which are in flagrant violation of various provisions of law, the property owners will now have to pay three times as much on account of increased sewer charges. And not one penny of the $1.6 billion so collected will go toward improvements or maintenance of the sewer system.”

Similar lawsuits have cropped up elsewhere. In 2009, seven Norwegian municipalities sued Citigroup after losing millions of U.S. dollars on an investment. The towns claimed they borrowed from Norway’s DnB NORD bank to buy structured notes that Citibank said were conservative and linked to a municipal bond arbitrage fund. But soon the towns' original investment was gone and they ended up owing a total of $176 million to DnB. Since the incident, the Norwegian government has barred the sale of similar products to “nonprofessional” investors.

The Jefferson County case might never have happened. The case should normally have been litigated by the county itself. “But the county itself had not fully asserted that these refinancings were in fact highly imprudent transactions,” says Grigsby. Moreover, it was the county that had approved the deal. One county commissioner has since been convicted of bribery in connection with the refinancings.

It was only after a change in the county administration that some officials joined embattled property owners in a class action against the bankers. And it was only after about two years of legal maneuvering by counsel, acting on a pro bono basis, that the case will finally go to trial on the merits in U.S. Bankruptcy Court.

The Jefferson County refinancings already have been the subject of legal scrutiny. In 2009, the SEC issued a cease and desist order against J.P. Morgan Securities based on its offer of settlement. The order referred to $8.2 million in payoffs by J.P. Morgan Securities made to senior county officials and others, and set out other details of corruption and fraud in connection with the 2002 and 2003 refinancing warrants. J.P. Morgan Securities was ordered by the SEC to pay $25 million in fines and $50 million in restitution to the county, and its affiliated bank, JPMorgan Chase, was ordered to forfeit $647 million.

But those fines and forfeitures weren’t the end of the bank’s problems in Alabama.

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