December 8, 2023

High & Low Finance: Portent of Peril for Muni Bondholders

Large municipal bond disasters have been rare, but I suspect there will be more. The Jefferson County bankruptcy may serve as a precedent for forcing bondholders to take losses in bankruptcy. Despite lots of legal protections, loans to municipal governments can be just like loans to people and companies: if the borrower truly can’t afford to pay what was promised, it won’t be paid.

Jefferson County’s problems involve corrupt politicians and bad luck, but they also include a longstanding reluctance to face facts about the county’s sewer system — and a bond market that failed to face the facts about the county and kept lending money long after it was prudent to do so.

The corruption involved was breathtaking. More than 20 people, including politicians, contractors and influence peddlers, have been convicted. JPMorgan escaped criminal charges, but the Securities and Exchange Commission penalized it for paying bribes through local middlemen.

That corruption was important and no doubt raised the financing costs for the county. But the basic financial decisions about the structure of the county’s debt were different only in scale from what many other municipalities did.

The disaster provides an example of how derivative securities can be oversold. Not all risks can be hedged, and certainly not at acceptable costs, but that is something Wall Street salesmen tend to overlook when they make their pitches. When such contracts are written, you can be sure that the Wall Street firm will make sure it will come out O.K., even if that increases the risk that the customer will not.

The county’s sewer debt used to be long-term, fixed-rate debt. The county would have been better off if that had not changed. But Wall Street persuaded it, and a lot of other municipalities, that such debt was too costly. The county could save some money by issuing what the salesmen called synthetic fixed-rate debt.

And what is that? The county issued long-term variable-rate debt, where the interest payments would fluctuate based on short-term market rates. Just doing that would have left the county at risk if interest rates surged, so JPMorgan also entered into an interest rate swap. That provided that the county would pay a long-term rate to JPMorgan, which would pay a short-term rate to the county.

The net cost of that was a little lower than the cost of fixed-rate debt would have been.

There was an important catch: the swap payments were not based on what the county actually had to pay. They were based instead on indexes that might, or might not, move in the same way that rates moved on the county’s actual debt. It was not really “fixed rate,” the title notwithstanding.

Another risk, probably never considered, was that the monoline insurance companies, which routinely guaranteed munis for a fee, would collapse.

Those risks were not necessarily large, and if Jefferson County had not structured 90 percent of its debt that way — rather than the 10 or 20 percent some advisers recommend — they might not have become crucial. But in the credit crisis, a lot happened that had not been expected.

Jefferson County issued two types of variable-rate debt, both of which blew up.

The largest was auction-rate debt. That debt paid rates that were set every week at auctions. The risk to investors was that an auction could fail and they would be stuck with the bonds. If that happened, the county would pay a penalty rate, often twice the London Interbank Offered Rate, known as Libor.

When auctions began to fail, that penalty rate was not enough to attract investors, but it was high enough to raise the financing costs for the county significantly. The interest rate swap did not protect it because it was based on an index, not on the actual cost the county was paying. Suddenly the “fixed rate” went up.

Floyd Norris comments on finance and the economy at

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Foxconn Begins Bribery Investigation

The company said last week that an internal investigation had uncovered possible wrongdoing in the supply chain and that those findings had been shared with the authorities in China.

The announcement is the latest setback for Foxconn, which produces a growing share of the world’s smartphones, laptop computers and other electronics.

“We can confirm that we are working with law enforcement officials whom we brought in to work with our own internal audit team as part of an investigation into allegations against a number of Foxconn employees related to illegal payments from supply chain partners,” Foxconn said in a statement e-mailed to the news media.

“Since the matter is under investigation, we are not able to comment further,” Foxconn said. “However, we can say that the integrity of our employees is something we take very seriously and any employees found guilty of any illegal actions or violations of our company’s Code of Conduct will be prosecuted to the fullest extent of the law. We are also carrying out a full review of our policies and practices to identify steps we can take to strengthen such measures to further mitigate against such actions.”

Foxconn, which is based in Taiwan but has production facilities throughout China, did not offer details about the nature of the investigation or how the problem was uncovered. But last week, the Taiwan edition of Next Magazine reported that a Foxconn executive in the coastal Chinese city of Shenzhen had been detained by the police on bribery allegations.

In its report, Next magazine said an executive at Foxconn’s operation in Shenzhen had been detained after being accused of asking for bribes from suppliers, and that two executives overseeing the company’s production of Apple products had left their positions in recent months.

Foxconn is considered one of the world’s most reliable suppliers of electronics. But the company’s image has been tarnished in recent years by labor strikes, accusations of poor working and safety conditions, and a spate of worker suicides at some of its Chinese factories.

Apple has strongly defended its partner against allegations of poor working conditions and Foxconn executives have responded in the past year by upgrading its management, work standards and production facilities.

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India’s Widening Iron Ore Scandal Hurts Stocks

As a result of a government investigative report issued late last week, several stocks have lost value — including shares of Adani Enterprises, the biggest piece of a mining, port and power plant empire built by the billionaire Gautam S. Adani, India’s sixth-wealthiest person.

Adani Enterprises has denied wrongdoing. But it and several other big Indian companies are facing tough questions from investors and policy makers.

The 466-page report, by a former Indian Supreme Court justice who is now a public ombudsman, contends public officials and companies cheated the government of Karnataka state out of billions of dollars in royalty, tax and other payments from a lucrative domestic and foreign trade in iron ore. The ore is an important raw material for steel that has been in great demand in fast growing China and India.

“Huge bribes were paid,” said the report, written by Santosh Hegde, the former justice. “Mafia type operations were the routine practices of the day.”

Analysts say Mr. Hegde’s findings provide evidence of corruption in important parts of the Indian economy, including land and natural resources, that are still tightly controlled by politicians and corporate executives — even as other sectors, including consumer goods, banking and information technology, have become more competitive and open.

Procedurally, it is unclear what will happen next. Mr. Hegde does not have the power to prosecute the companies and individuals he accuses in his report. That is up to Karnataka’s government, which has previously played down concerns about mining, or to the judicial system.

India’s Supreme Court on Friday temporarily suspended all iron ore mining in Bellary, the region that was the main focus of the inquiry. The court in recent years has often led the charge to prosecute officials accused of corruption, and anticorruption advocates hope that it will do so in this case.

The scandal forced the chief minister of Karnataka state to resign on Sunday, although he has denied wrongdoing.

Shares of Adani Enterprises were down nearly 23 percent on Thursday and Friday, but they regained almost 9 percent on Monday.

The stock of another company implicated in the report, JSW Steel, fell more than 10 percent late last week. JSW’s shares dropped by an additional 10.3 percent on Monday, after Citigroup downgraded the stock and put a sell rating on it.

A big break in the investigation occurred early last year. Anticorruption agents raided the offices of Adani Enterprises, which operated an iron ore terminal at the Indian port of Belekeri, on the Arabian Sea, and discovered a document that appeared to be an illicit payroll.

A computer file from 2008 listed payoffs that Adani Enterprises was suspected of making to government officials. The port director, for instance, was paid 50,000 rupees ($1,100) per ship that set sail from the port, the file said. A customs official got 100,000 rupees every three months and 0.50 rupee per ton of iron ore shipped, it said. Police inspectors received 14,000 rupees every month, and local politicians were paid “once in a while,” the file said. The report was issued as Indians increasingly questioned the growing wealth and power amassed by a small elite group. In a separate corruption scandal, government auditors estimated that officials may have cost the federal government $40 billion by giving telecommunications licenses to favored companies rather than auctioning them.

The mining scandal in Karnataka state, which is also home to the technology hub Bangalore, has been brewing for several years. In 2008, Mr. Hegde, who is the state’s lokayukta or ombudsman, produced a report on problems of illegal mining in the state’s Bellary region.

In his latest report Mr. Hegde said the situation had only worsened since then, as the companies had sought to avoid paying royalties to the state and export duties to the federal government, and as companies had mined in forests that were supposed to be protected under conservation laws.

But the government in Karnataka state, which is controlled by the Bhartiya Janata Party, did little to control the mining, much of which was in the hands of three businessmen brothers, the Reddys, who are powerful members of the party.

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Afghans Arrest Two Officials Over Kabul Bank Collapse

According to Rahmatullah Nazari, the deputy attorney general, authorities arrested Sherkhan Farnood, the former chairman of Kabul Bank, and Khalilulah Frozi, its former chief executive officer, on Wednesday in connection with what Mr. Nazari said was $900 million in fraudulent loans to bank officers and insiders, many of them politically well connected.

Mr. Nazari declined to specify what charges have been brought against the two but said they were being held at the Kabul Detention Center for further investigation.

He said further arrests were expected in connection with the case, both among Kabul Bank figures and Central Bank officials.

These were the first arrests in the Kabul Bank affair since exposure of the bank’s huge losses last August. The move is likely to be welcomed by Afghanistan’s international backers, which have held up some aid to Afghanistan until government action is taken on Kabul Bank.

Some $900 million in loans were made to insiders with little or no collateral and even no repayment plan in what auditors have described as effectively a massive Ponzi scheme. Among loan recipients was Mahmoud Karzai, the brother of President Hamid Karzai, and Haseen Fahim, brother of First Vice President Muhammad Fahim.

The attorney general also brought charges this week against the governor of Afghanistan’s Central Bank, Abdul Qadir Fitrat, accusing him of taking millions in bribes to overlook the Kabul Bank fraud. Mr. Fitrat fled to the United States just before those charges were brought, saying he feared for his life because of his own efforts to expose the fraud.

The charges against Mr. Fitrat were brought only after Karzai administration officials, as well as Kabul Bank debtors, reacted furiously to an appearance by Mr. Fitrat at the Afghan Parliament, during which he named the prominent people who he said were resisting repayment of their loans.

“The Central Bank officially requested a special prosecution and a special tribunal to try those who have been implicated in fraud, mismanagement, misuse of funds and embezzlement of hundreds of millions of dollars from Kabul Bank,” Mr. Fitrat said, announcing his resignation last Monday. “To date, there is no information of any credible plan to try and prosecute these suspects. There is concern that the powerful individuals involved in this fraud will go unpunished while the Central Bank and its foreign advisors will ultimately be blamed.”

Until he fled Afghanistan, Mr. Fitrat had expressed confidence that the Central Bank would be able to recover much of the $900 million in loans and interest owed to Kabul Bank. On the orders of the Central Bank under Mr. Fitrat, Kabul Bank, the country’s largest, was broken into two entities, one a receivership to recover the bad loans, and the other consisting of performing loans, deposits and bank branches, which would eventually be sold.

The International Monetary Fund has refused to renew its credit program for Afghanistan pending action on Kabul Bank, which has resulted in the loss of $70 million in incentive funds so far and has blocked other aid programs from many donor countries. The I.M.F. wants Afghanistan to repay the bank’s losses out of its general revenues, rather than from donor money, but the losses potentially equal one year of Afghanistan’s total revenues. The agency has also demanded a forensic audit and legal action.

Western diplomats have said arrests and prosecutions of those responsible for looting the Kabul Bank would be a start toward satisfying concerns of the international backers.

Mr. Frozi and Mr. Farnood, both with their cellphones, were seen in a meeting room at the detention center, with some 15 visitors. They refused to talk to a reporter from The New York Times. “You destroyed the bank, now you want to destroy the detainees,” Mr. Frozi said, referring to coverage of the Kabul Bank crisis last summer. “Please leave me alone. Talk to the attorney general’s office, they’re the ones who did this.”

The two prisoners then turned to playing a game of chess.

Sharifullah Sahak contributed reporting.

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Johnson & Johnson Settles Bribery Complaint

Intriguingly, prosecutors said that Johnson Johnson had provided “significant assistance” in their investigation of others in the industry, resulting in a reduced criminal fine for the health conglomerate. At least a dozen other major drug and device makers are under investigation for similar crimes.

A criminal complaint filed by the Justice Department against a Johnson Johnson subsidiary that makes knee and hip implants quoted internal company e-mails as stating that providing “cash incentives to surgeons is common knowledge in Greece,” and that, were the company to stop paying bribes, “we’d lose 95% of our business by the end of the year.”

In a written statement, the company said that it originally reported its illegal marketing activities to the government in 2007. “We are deeply disappointed by the unacceptable conduct that led to these violations,” said William C. Weldon, the company’s chairman and chief executive.

The case is the latest in a string of criminal investigations into illegal marketing practices by drug and device companies. Again and again, companies have agreed to large-sum settlements in cases involving claims that they bribed doctors in the United States to prescribe or implant medical products in patients who are entirely unaware of their doctors’ financial incentives. With the settlement agreement from Johnson Johnson, prosecutors have now begun penalizing companies in foreign bribery cases as well.

According to statements by the Justice Department and the Securities and Exchange Commission, the payments violated the Foreign Corrupt Practices Act, which outlaws bribes paid to foreign government officials. Since health systems in much of the rest of the world are government-run, doctors are considered government officials.

For Johnson Johnson, the settlement comes at a bad time. The company has issued more than 50 product recalls since the start of last year involving such household brands as Tylenol, Motrin, Rolaids and Benadryl. Last year, it recalled two popular hip implants that a recent study suggested may fail early in close to half of the patients who receive them. The recalls came long after surgeons warned the company that the implants were defective.

Mr. Weldon has denied that the company’s many missteps suggest broader problems in the company’s management or its structure as a set of loosely affiliated subsidiaries. In its statement, Johnson Johnson said that it also “hopes to reach a settlement of a related investigation by the U.K. Serious Fraud Office in several days.” To add insult to injury, the company admitted as part of its deferred prosecution agreement with the government to having paid kickbacks to the Iraqi regime of Saddam Hussein under a United Nations oil-for-food program that investigations have since found was rife with fraud.

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