Jefferson County’s Crisis Underscores Credit Market Risks

September 1, 2008 Updated: September 2, 2008

Twelve years ago, Alabama’s Jefferson County—which includes Birmingham, its most populous city—took over its towns’ sanitation sewer operations in an effort to upgrade infrastructure. Today, the project is on hold and the county is close to default on $3.2 billion in debt.

Jefferson County’s near bankruptcy serves as a sobering reminder of how far-reaching today’s credit market problems are. The county’s sewer debt alone will cost each person in the region nearly $5,000, based on 2000 census figures.

According to Birmingham News, the county in 2002 and 2003 refinanced most of its sewer-related debt into auction rate securities, which are highly complex credit derivatives that reset interest rates at monthly intervals. In addition to auction rate securities, county commissioners also refinanced the debt into variable rate bonds and risky interest rate swap arrangements.

Back in 2003, county leadership and its Wall Street advisors were prudent in issuing auction rate securities, as interest rates were low and the securities were free from costly maintenance and other fees of traditional loans.

However, as subprime homeowners defaulted, the United States plunged into a credit illiquidity crisis. Banks and investors were unable to sell many loans and bond holdings. In turn, market interest rates ballooned, which pulled up the interest rates attached to Jefferson’s auction rate securities and variable rate bonds.

Recent problems encountered by “Monoline” insurers further hurt Jefferson Country’s ability to pay. In the past, small municipalities were unable to obtain cheap financing options unless their debt was guaranteed by an outside insurance agency, known as a “Monoline” insurer. Such insurance companies, which owned high credit ratings, wrapped muni bonds to help municipalities obtain lower interest rates.

The problem lies in that “Monolines” were also major players in the mortgage debt insurance business. As the U.S. mortgage crisis worsened, their survival was at stake, and bonds insured by “Monolines” no longer looked so secure.

Two of the largest “Monoline” insurers guaranteed Jefferson’s debt—XL Capital Assurance Inc. and Financial Guaranty Insurance Co. Its insurers’ woes caused Jefferson’s variable interest rate to jump to more than 10 percent earlier this year. That translates to $320 million in annual interest payments alone.

According to reports, Jefferson County’s sewer system only generated $190 million in revenues last year. Factoring in costs to run the sewage system, residual profit became insufficient to repay the interest.

As of July 18, Moody’s Investor Services, a leading bond rating agency, gave Jefferson County a credit rating of “Caa3.” Such ratings put Jefferson debt into “junk bond” territory at severe risk of default. Moody’s currently lists Jefferson’s bonds on possible further downgrade review.

Temporary Truce

Negotiations between county officials and its creditors, most notably Bank of America Corp. and JPMorgan Chase & Co., have been intense during the last month.

On Friday, Alabama Governor Bob Riley announced a plan to restructure the debt into fixed-rate instruments. In a released statement, Riley said that Jefferson’s creditors will refrain from taking legal action for at least 30 days.

“The County presented a proposal that provides for a restructure of the existing bond debt at lower, fixed interest rates over a longer term,” Riley said on Friday, Aug. 29. “Creditors received the proposal and agreed to respond next week.”

“In the meantime, the County will be presented with a proposal from the creditors to forbear until September 30 at no cost to the County,” he said in the written statement. “The tone of the meeting was positive and constructive and I remain willing to facilitate further progress towards a solution.”

Creditors allowed the county to delay all interest payments at no cost until Sept. 30.

County commissioners told lawyers last week to file for bankruptcy protection should talks falter. If Jefferson County declares bankruptcy, it would become the largest municipality default in U.S. history.