The cautionary tale of Jefferson County Alabama

Jefferson County Alabama's sewer authority was once considered among the most sophisticated issuers in municipal finance. Now they are on the brink of Chapter 9. What happened, and can it happen to other municipal issuers?

It all started when investment bankers cooked up a clever way to use derivatives to lower interest expense for municipal issuers. The municipality would sell auction-rate debt, then enter into a pay fixed, receive floating interest rate swap. For tax-exempt issuers, the floating end of the swap is either based on a percentage of LIBOR or the SIFMA Index, which is an index of floating rate municipal debt rates.

The result of these transactions was a synthetic fixed-rate bond. The initial floating liability had been turned into a fixed liability via the derivative transaction. Bankers were able to show that through these machinations, even after hefty fees to the investment bank, the issuer would realize a interest rate savings.

For Jefferson County, those savings were important. They had been ordered by a federal court to make significant upgrades to their sewer system to comply with environmental standards. As a result, there has been a 3-fold increase in sewer rates over the last 10 years. In fact, the sewer system became highly leveraged in an attempt to spread out construction costs over time, which in turn would prevent the pain (and political embarrassment) of even larger rate increases.

Historically, auction rate municipal debt had consistently reset at or very near the SIFMA rate, which in turn was always highly correlated with LIBOR. But the recent liquidity crisis changed all that. Starting in January, auction rate municipals began routinely failing, or at best, resetting at rates considerably higher than the SIFMA or LIBOR indices. In other words, the pay-floating side of the interest rate swap was substantially lower than the actual amount being paid by the sewer system.

Because the sewer system was so leveraged, the extra interest expense was more than their budget could bear. Had they been a stronger credit, the sewer system probably could have refinanced their auction-rate debt with variable rate put bonds. That structure offers investors a weekly put option, and therefore has not suffered the liquidity problems of auction-rate bonds. Or they might have been able to cancel the swap arrangements and refinance their debt as fixed rate. But because of the extreme leverage employed and the rapid deterioration of what balance sheet they had, these options were not viable.

S&P has lowered the Jefferson County Sewer bond rating to CCC, with Moody's currently rating the system at B3. The rating had been A with both agencies as recently as mid-February.

Is bankruptcy in the cards? Probably not. The County, which isn't legally responsible for the sewer bonds, has proposed to redirect sales tax revenue to the extent it is not needed for school construction. It is not clear whether this would be enough to satisfy the sewer systems debt service needs, primarily because of uncertainty surrounding their outstanding swap arrangements.

The sewer system's swap agreements require it to post collateral in the event of a credit rating downgrade. According to the Bond Buyer, that figure is currently $184 million, which the County has yet to post, and is now past due. The swaps counter-parties are unlikely to push the collateral issue too hard, as the bond documents indicate that the swap providers are subordinate to bond investors.

So it seems the most likely outcome will be that banks and the County will work out some sort of restructuring. It would likely involve the County pledging certain revenues, a refinancing of their $869 million in auction rate debt, and some sort of restructuring of their swap arrangements. So bankruptcy cannot be ruled out, but it does seem there are too many interested parties who would rather see another solution.

Could the same thing happen to other issuers? Absolutely. Fortunately for general market municipal investors, the confluence of events leading to Jefferson County's problems are indeed rare. Most of the biggest issuers of ARS are either student loan-related, where max rates are very low, or relatively strong issuers, such as the City of New York, who will be able to refinance without trouble. The problems are most likely to crop up with small issuers, particularly private non-profits (e.g. a hospital or private college), who have entered into onerous swaps. These are issuers with limited resources, and also lack the political support that a sewer system enjoys.

It is a bit worrisome for many municipal investors that an issuer can go from A to CCC in less than 30 days. Gee, maybe bond insurance isn't dead after all.