Last year, as panic raged through the municipal bond market that cities and possibly even states might default on their debt under the burdens of massive government expenditures, particularly in the form of unfunded liabilities posed by public pension funds, J.P. Morgan (JPM) went out and studied whether the problem was indeed as acute as some had feared.

The result wasn’t something J.P. Morgan, the largest underwriter of municipal debt, wanted to brag about, at least in public, according to people with direct knowledge of the matter. The study, completed in March 2011, showed that problem with pension funds was indeed real: States and big cities had amassed trillions of dollars of unfunded liabilities for their public pension systems.

At the same time, these municipalities were failing to properly account for their exploding pension costs, and the only way out of the mess involved public officials making some politically difficult decisions, including raising taxes significantly, slashing budgets, and demanding that public workers pay a portion of their retirement benefits.

Without these measures, many of the nation’s largest cities and states just couldn’t afford the fiscal time bomb of their mounting pension costs.

Inside J.P. Morgan the study was heralded as both groundbreaking and dangerous; an email sent to the firm’s municipal bond banking department called the study “unlike any analysis that has been presented before” that would provide a “better understanding of what all the noise is on pensions.”

But people in senior management worried that the study’s stark analysis about the looming threat of unfunded pensions to state and local finances -- and its recommendation on how to fix the problem -- would offend the firm’s municipal bond clients, namely those cities and states that tap J.P. Morgan to underwrite their bonds.

With that, the firm decided that it would keep the study largely under wraps, according to people with direct knowledge of the matter. Only its best hedge fund clients and large institutional investors would receive the report. The cities and states at the heart of the analysis wouldn’t be informed, nor would most public investors.

What's more, J.P. Morgan didn’t include the report’s findings about rising pension costs -- one of the risk factors for any municipal bond -- in the disclosure documents of the state and city bond deals, according to people with direct knowledge of the matter. A review by the FOX Business Network of some these disclosure documents for bond deals underwritten by J.P. Morgan shows that, despite language involving unfunded pensions, the results of the study were not included.

That decision to hold back the study from broad public distribution was a “business decision,” according to an executive at the firm. “We didn’t want the public theatrics” where J.P. Morgan would be at the center of a debate over a looming national crisis, this executive said.

Another executive with knowledge of the report said “the firm was worried about offending municipal issuer clients and then losing business.”

Business considerations aside, failure to broadly disseminate the study, including adding its findings in disclosure documents that accompany municipal-bond offerings, could also pose a regulatory problem for the big bank at a difficult time. Regulators are cracking down on faulty disclosures in muni-bond deals with the SEC launching a sweeping examination into whether underwriters are properly disclosing risks to bond deals, including pension-fund obligations.

Meanwhile, J.P. Morgan is under fire over whether it properly disclosed risk-taking in its London office that manages the bank’s $375 billion internal portfolio. This risk taking eventually led to a $2 billion to $5 billion trading loss. That loss and the disclosures made by the firm of the trading activity are the focus of several major regulatory investigations and Senate Banking Committee hearings today in Washington.

A J.P. Morgan spokeswoman said the bank was under no legal obligation either to make the 2011 pension fund study public, or include its findings in municipal-bond disclosure documents. The spokeswoman, Kristen Lemkau, said the firm gave the study to 100 investor clients, many of them large institutions who buy municipal debt, as well as some hedge funds. She said the US Treasury has used some of the study’s findings in its own analysis.

“Problems involving public pensions funds aren’t exactly a secret,” she added.

But Peter Henning, a professor of business law at Wayne State University, said that at the very least, J.P. Morgan had an obligation “to alert its municipal clients” about any issues it had concerning unfunded pension liabilities, particularly if the issuer’s description of the liability differed from evidence in the J.P. Morgan report.

“One of the fundamental duties of the underwriter is to make sure disclosure is good,” Henning said.

Under the SEC’s anti-fraud regulations, underwriters are required to make a “reasonable investigation” of how an issuer represents various risks, including pension fund obligations, "until satisfied that the correct disclosure has been made." In conducting this investigation, the underwriter must consider any work done by its research department which “may have substantive knowledge about the issuer and should be consulted in performing its investigation.”

Yet, J.P. Morgan didn’t include its pension fund analysis in bond deal disclosure materials that are made to investors, known as the deal’s “official statement,” according to current and former executives at the firm. Case in point: a $469 million bond issue by Massachusetts in May of last year, two months after the pension report was published.

J.P. Morgan was the lead underwriter of the deal, but the disclosure documents didn’t include the report’s dire findings, including the possibility that under one scenario the state must cut spending by 20.1% to fully fund its pensions over the next two decades, raise taxes dramatically or a combination of both.

Lemkau wouldn’t deny that the firm failed to include the report’s findings in its official statements, but said that the firm’s disclosures were proper.

Disclosure is certainly something that the firm will be dealing with today as the Senate Banking Committee hearings on the firm’s “London Whale’ trading loss. The hearings will feature the testimony of J.P. Morgan chief executive Jamie Dimon, one of the most reputable executives in banking. Dimon will likely be asked whether the bank disclosed the $2 billion to $5 billion trading loss in a timely fashion to investors, or whether he improperly downplayed press reports about the big risks taken by a group of traders in London who were responsible for the losses.

Dimon himself initially described those reports as a “tempest in a teapot,” and he has since apologized, but the Securities and Exchange Commission is examining the matter, including whether J.P. Morgan properly disclosed the incident.

Disclosure -- or lack of it -- by states and cities was clearly at the heart of last year’s pension report, titled “US State and local pensions; Off-balance sheet liabilities and the municipal bond market.”

At the time, investors had been bailing out of municipal bonds and states and cities were being forced to pay higher interest rates to entice bond buyers after analyst Meredith Whitney predicted a wave of municipal defaults related in large part to the inability of local governments to cut spending, particularly in the area of contractual obligations to meet the pension fund needs of public workers.

The J.P. Morgan study, labeled “strictly confidential” and authored by a trio of analysts in its municipal markets strategy group, didn’t go so far as Whitney in predicting waves of municipal-bond defaults. But its findings, focused on the hot-button topic of whether state and local governments will be able to meet their pension obligations, were nonetheless ominous.

The accounting rules used by most state and local governments allow public officials to significantly understate the true costs to fully fund their public pension funds, the report said. This so called unfunded liability “is roughly five times larger than the amount reported on public balance sheets,” according to the report obtained by the FOX Business Network.

Under the accounting rules used by most states and municipalities, less than $1 trillion in unfunded liabilities exist. But the real number, the report stated, is closer to $3.9 trillion because governments are not “setting aside sufficient assets to prefund these benefits.”

The solution, J.P. Morgan said, is pretty straightforward, though difficult for cash-strapped cities and states burdened by the after effects of the financial crisis with lower tax revenues and bloated governments: Fairly significant tax increases, drastic benefit cuts or a combination of both depending on the state or city.

Despite Whitney’s warning, the report suggested that the risk of wide-spread municipal defaults might not be something that investors should worry about in the immediate future.

Credit rating downgrades and higher costs associated with debt sales would be the more immediate problem as investors factor in the true costs of pensions over time, the study stated.

Even so, given the size and scope of the pension problem, defaults could not be dismissed if drastic action is not taken soon, the report said. The report stated that the risk of default is “greater for municipalities than for states.”

But that’s not all. The report also broke down the unfunded obligations on a state-by-state basis, showing what a state might have to do in terms of tax increases and budgets cuts to fully fund its pension system over the next two decades.

Amid strong union opposition, New Jersey governor Chris Christie has made strides in reigning in pension funds costs. But the J.P. Morgan report suggests the Christie still has a long way to go in reforming the system.

Like most Northeast states, New Jersey voters already burdened by high taxes are increasingly uneasy about paying higher taxes to fund government programs, while public sector unions are balking over giving up pension benefits.

To demonstrate some of the difficult decisions that must be made by New Jersey, the report said state lawmakers could raise taxes a modest 0.5 percentage point on personal income, as long as they increase the retirement age by nine years, increase employee contributions to their pensions by a whopping 23%, cut the state budget by 7%, while cutting cost of living adjustments by 2 percentage points.

“The discussion internally was that if this stuff was released it would pose a problem for clients and our relationship with those clients,” said one former executive at J.P. Morgan.

The bigger question may be if by keeping such analysis from investors, J.P. Morgan violated the law. “When it comes down to it it’s the issuer’s official statement,” said Bill Daly, director of government affairs for the National Association of Bond Lawyers. 

“But for JPMorgan it’s a judgment call. If the firm knew the municipality had a problem and it wasn’t disclosed, you can make the case that it should be in the” official statement.

Charles Gasparino joined FOX Business Network (FBN) in February 2010 as Senior Correspondent.