Blago’s Risky Bet On Derivatives

The Rod Blagojevich pay-to-play scandal may seem like an anachronistically simple big city machine politics scandal next to the ever-widening web of inscrutably interrelated financial scams comprising the on-going financial crisis. But in brokering deals with public coffers, at least, Blago liked “exotic” derivatives as much as the next hedge fund guy.

In January 2004, the Illinois pension obligation program was $36 billion in the hole, the most indebted state pension program in the country. So Blago decided to refinance, taking advantage of the era’s superlow interest rates to float $10 billion in “exotic” new bonds in the country’s biggest pension bond offering on record. Bond Buyer named it the Midwest Deal of the Year at the time — not just for its “complex” pricing but its use of derivatives, which had just been legalized by the state legislature the year earlier. It was the start of a new trend, the trade publication noted:

Since Gov. Rod Blagojevich took office in January 2003 faced with a nearly $5 billion budget deficit, his finance team – which includes former financial advisory professional John Filan and quantitative analyst and investment banker David Abel – has turned to more sophisticated techniques to manage state finances. Supporters have called them creative, while critics have labeled them dangerous.

The deal alone netted investment banks $35 million in fees, including $8 million for the lead underwriter Bear Stearns, which in turn delivered a $809,000 consulting fee to a firm called Springfield Consultants run by lobbyist Robert Kjellander. The fee caused much furor in the Illinois statehouse when Bear Stearns disclosed it in an SEC filing, especially after initial probes launched by the state Inspector General revealed the firm could not produce any evidence that Kjellander, a prominent GOP lobbyist and friend of Karl Rove, had done anything to earn the fee.

The investigation swung into high gear when a hospital president named Pamela Davis got an unsettling phone call at her house from a Bear Stearns executive:

Back in 2003, Davis was trying to get approval for a new medical office building from the Illinois Health Facilities Planning Board. A night or two before a hearing was to be held, Davis recalled, something strange happened. A business acquaintance of hers, Nicholas Hurtgen, then a managing director of the Chicago office of Bear Stearns, called her at home and told her that unless she agreed to use a certain contractor she should pull her building request, because it wasn’t going to be approved.

She ignored the warning and went off to the board hearing, where she was surprised to find that her request was denied. “I was humiliated,” she said. “They were mean. So I walk off, and then a different guy comes up to me and he says, ‘We told you to pull your project. Call me.’ And right then I decided to call the F.B.I.”

The FBI wouldn’t confirm or deny Davis’ story to the New Yorker, but she says she spent seven months secretly recording conversations with Hurtgen and his cronies, eventually filing a sealed federal whistleblower lawsuit alleging that Hurtgen, a former protege of former Wisconsin governor and Bush cabinet member Tommy Thompson, was part of a massive pay-to-play scheme that somehow linked the bond offering to the hospital.

The details are still unclear, but some of that $809,000 allegedly made its way back to Tony Rezko, who in turn split the bounty with three friends — one of whom was Blago, according to last week’s indictment, which refers to Kjellander as a “lobbyist” according to the Chicago Tribune:

Among the earliest and biggest plots in the “Blagojevich Enterprise” was a scheme to direct the sale of billions of dollars in bonds to refinance the state’s pension debt to a company whose lobbyist secretly agreed to kick back hundreds of thousands of dollars to Rezko. Sources with knowledge of the situation identified that company as Bear Stearns and the lobbyist as Robert Kjellander.

Hurtgen pled guilty to charges of extortion and aiding and abetting mail fraud and agreed to cooperate in the investigation in exchange for a light 22.5-month sentence; Kjellander has not been charged and is presumed to be cooperating, as is Rezko, whose sentencing for his conviction of 16 counts of corruption has been postponed pending Blago’s trial.
The exact details of the convoluted arrangement, just one of the many pay-for-play scams uncovered by the six-year-old federal investigation into Chicago municipal corruption, are not completely clear. Whatever the specifics, though, Blago’s is the latest in a long line of indictments of the entire municipal bond business, which is currently the subject of a far-ranging antitrust probe that prompted New Mexico Governor Bill Richardson to withdraw his nomination as commerce secretary over his ties to the shadowy Beverly Hills consulting firm CDR Financial earlier this year.

Philadelphia was the first municipality rocked by the municipal bond scandal, for which its former treasurer Corey Kemp is currently serving 10 years in prison. In 2004, with the $10 billion bond offering coming under fire over a whistleblower lawsuit alleging corruption, the SEC announced it would “take a closer look at potential municipal market ‘pay-to-play’ violations” emerging to see if they “indicated any systemic problem with graft in the municipal industry.” But corporate collusion is as much to blame for scandals like Blago’s as graft, as a story on the CDR investigation in the New York Times explains:

The federal inquiry appears to have started at the I.R.S., which was concerned that the rules for tax-exempt bonds were being trampled.
“We saw this coming and went to the Department of Justice and said, ‘Hey look! It looks as if there’s been price-fixing and bid-rigging on a major scale here,’ ” Charles Anderson, the retired I.R.S. manager, told The Times.

The efforts have broadened into what investigators and lawyers described as a coordinated effort among the federal agencies broken down by jurisdiction.

After all:

“It’s rare to sell a Senate seat, but it’s not rare to sell a bond deal,” Anderson, who retired as manager of tax-exempt bond field operations for the Internal Revenue Service in 2007, told The Times. “Pay-to-play in the municipal bond market is epidemic.”

Thirty investment banks have been subpoenaed in what has become, according to the Times, a coordinated multi-agency probe of municipal finance over corrupt practices experts estimate cost state and local government agencies, pension funds and utilities — and by extension, taxpayers — more than $4 billion a year, or almost as much money as the Illinois pension fund lost between 2004 and 2007 — when Blago proposed another bond issuance — this time worth $16 billion. Hurtgen had been fired by that point, but Bear Stearns was still around, financing another deal that year.

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