Alabama County Votes to Declare Biggest Municipal Bankruptcy

Nov. 9 (Bloomberg) -- Jefferson County, Alabama, commissioners voted 4-1 to file the largest U.S. municipal bankruptcy after reaching an impasse over concessions with holders of $3.14 billion of bonds.

JPMorgan Chase & Co., which arranged most of the debt to fund a sewer renovation, will likely take the biggest loss.

A provisional agreement with creditors that commissioners approved in September included $1.1 billion in concessions and called for sewer-rate increases of as much as 8.2 percent for the first three years. The county was unable to get signed commitments from creditors, Commission President David Carrington said today. Terms were changing even last night, he said.

In addition, the county's 25-member legislative delegation was unable to unite behind bills needed to implement the tentative settlement, including ways to generate revenue for a strained general fund.

The vote by officials in Alabama's most populous county occurred about a month after Pennsylvania's capital of Harrisburg sought court protection citing millions in overdue bond payments tied to a trash-to-energy incinerator. A Jefferson filing would eclipse that of California's Orange County in 1994. The action might reignite concerns among investors over defaults in the $2.9 trillion U.S. municipal bond market.


Commanding Attention


"It's going to create attention-grabbing headlines, and the question is how retail investors react," Peter Hayes, a managing director at BlackRock Inc., the world's largest asset manager and the owner of $95.6 billion of municipal bonds, said before today's decision.

The threat of bankruptcy has loomed over the county, home to Birmingham, Alabama's biggest city by population, for more than three years. Commissioners sought to spare residents from ballooning fees needed to pay off the debt that financed a sewer project rife with corruption.

The crisis intensified in March when the state's highest court struck down a tax on wages that generated $70 million annually for the general fund. The county put employees on unpaid leave, closed courthouses and scuttled road repairs after losing the levy that provided about a quarter of its revenue.

A special session of the Legislature is needed to enact several conditions of the prospective deal with creditors. One would set up an independent sewer authority to issue new debt backed by a so-called moral-obligation pledge from the state.


Lawmakers Disagree


Democratic lawmakers in the county's delegation -- any member of which can block a bill -- refused to consider the agreement because of its effect on poor residents, who would have to pay higher fees. Republicans and Democrats also couldn't agree on how to raise revenue to help close a $40 million deficit in the operating budget and replace the overturned tax. County commissioners refused to make more cuts to a budget that is almost $100 million less than last year.

The size of sewer-fee increases has been a sticking point because residents can ill afford higher costs, according to Commissioner George Bowman, who represents one of county's two poorest districts. Almost 70 percent of sewer users are in the two districts with the lowest average incomes, he has said.

Jefferson County's system serves about 478,000 people through 144,000 accounts, according to a June report from John Young, the court-appointed receiver who runs the system.

The county's median household income is about $45,000 a year, according to U.S. Census Bureau data. Many sewer customers reside in Birmingham, where the figure is about $32,000.


Assistance Fund


The average residential wastewater bill is $37.74 a month, according to Young. He has previously proposed setting up a bill-assistance program for low-income customers, funded by $75 million from a settlement paid by JPMorgan, the biggest U.S. bank by assets, after accusations of securities violations related to the sewer bonds.

The $140 million gap between the county and its creditors includes $69 million in interest-rate swap termination fees owed to Lehman Brothers Holdings Inc., $30 million in "contingency" concessions from smaller creditors, and $30 million for a fund to aid sewer customers. The sum also includes $11 million in concessions from Regions Financial Corp.'s Morgan Keegan unit, which has since sold its bonds, Commission President Carrington said.

A bankruptcy would leave banks such as JPMorgan, investors and the bond insurers Financial Guaranty Insurance Co. and Syncora Guarantee Inc. facing hundreds of millions of dollars in losses. It may also burden residents and businesses with higher taxes or sewer bills, which have risen more than fourfold since 1997 as the system's cost ballooned.


Orange County


Municipal bankruptcies are rarer than corporate failures. Jefferson would be the 11th this year. In 2010 there were 13,713 corporate Chapter 11 filings, according to a website maintained by the Administrative Office of the U.S. Courts.

Orange County, which was driven into bankruptcy by $1.7 billion in losses on interest-rate bets, had about $2.2 billion in debt outstanding, according to a June 1995 financial report.

On Aug. 1, Central Falls, Rhode Island's smallest city, sought court protection, citing pension costs it can't afford. The municipality listed almost $21 million in general-obligation debt outstanding.

The fiscal difficulties that drove Jefferson and Central Falls into bankruptcy were largely self-inflicted and have long been recognized by municipal-bond investors, potentially blunting the market effect of Jefferson's step. Even so, the event may increase scrutiny of the market.


Investor Reaction


Investors pulled more than $30 billion from municipal-bond mutual funds from mid-November to June, according to data from Lipper US Fund Flows, as the lingering strains of the recession fueled speculation that defaults would jump. While that hasn't happened, Jefferson's move may reignite those concerns among households, which own about 37 percent of U.S. municipal debt.

Once in bankruptcy, Jefferson must show a federal judge that it can't pay its bills and then draw up a plan for meeting obligations, which the court may reduce. Unlike corporate cases, creditors can't try to seize or sell off county assets, and the court can't appoint a trustee to run the county.

Municipalities have more leverage with creditors under Chapter 9 of the U.S. Bankruptcy Code than corporations have when reorganizing debt in Chapter 11 protection, said Marc Levinson, a lawyer who represented Vallejo, California, when that city went bankrupt. A judge has limited authority to force a municipality to take specific actions, Levinson said.


Limited Court Power


"About the only thing a judge has the power to do is dismiss the case," Levinson said.

Court proceedings may give Jefferson a formal process to rework its debts, a task that has eluded county commissioners, Bentley and former Governor Bob Riley.

The commission's move threatens to expose banks to even steeper losses. Bentley, a Republican, has sought to avert the step, citing its potential effect on the state's credit and image.

The crisis in Alabama arose when investors dumped Jefferson county's bonds as the subprime mortgage-market meltdown sent ripples through Wall Street. Jefferson's floating-rate securities were coupled with interest-rate swaps, a money-saving strategy pitched by banks that backfired. As credit markets convulsed in 2008, the county's interest costs soared. When banks demanded early payoffs of the bonds, the county defaulted.

The debt deals also were rife with political corruption, leading the cost of the sewer project to soar as it was built during the 1990s. Former commission president and Birmingham Mayor Larry Langford, a Democrat, was convicted of accepting bribes in connection with the financing.


Corruption Fallout


Two former JPMorgan bankers are fighting Securities and Exchange Commission charges that they made $8 million in undisclosed payments to friends of commissioners to secure the bank's role in the deals. In 2009, JPMorgan agreed to a $722 million settlement with the SEC.

The financings arranged under Langford converted almost all the county's sewer debt into securities that carried interest rates that periodically reset, a strategy promoted by Wall Street as a way for borrowers to save money using short-term interest rates on debt that didn't mature for decades. The swaps paired with the bonds were meant to hedge against adverse changes in the rates.


Exposed to Crisis


That strategy left the county exposed in 2008, when the credit crisis pushed up municipal lending rates. As banks began hoarding capital, the market froze for auction-rate bonds, a type of security used by Jefferson, and the county had to pay penalty interest rates.

After some bond insurers incurred losses on subprime- related securities, threatening the credit ratings they used to guarantee other Jefferson debts, investors in 2008 dumped the sewer securities on banks that had agreed to act as buyers of last resort. That triggered contractual requirements for the county to pay off $850 million of the debt in four years instead of the 30 or 40 under the original agreements, according to government records.

The demands pushed the county into defaulting. The uncertainty that has reigned since then has led some businesses, politicians and residents to be thankful for any route that would bring the saga to a close.

--Editors: Ted Bunker, Stephen Merelman


To contact the reporters on this story: William Selway in Washington at wselway@bloomberg.net; Martin Braun in New York at mbraun6@bloomberg.net; Margaret Newkirk in Birmingham at mnewkirk@bloomberg.net


To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net

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