Jefferson County, Alabama, has filed for Chapter 9 bankruptcy protection after failing to reach a final agreement on terms with creditors to settle a $3.14 billion sewer-system bond debt. The Chapter 9 filing, which is the 11th by a municipality this year, is the largest municipal bankruptcy in American history, far surpassing Orange County, California’s default on its $1.7 billion debt in 1994. While the bankruptcy filing will certainly damage Jefferson County’s financial condition, investors are hopeful that it will not significantly harm an already skittish municipal bond market.
Jefferson County’s Financial Woes
The seeds for Jefferson County’s financial collapse were sown when the County was ordered to rebuild a crippled sewer system that had been leeching raw sewage into nearby rivers. In response, County officials approved a series of complex financial contracts designed to save the County money by swapping the variable interest rates the County was paying on its sewer debt with a fixed interest rate that was lower than traditional bonds. Pursuant to the new contracts, the County’s sewer debt carried interest rates that periodically reset at auction, and were thereby designed to save the County money by using short-term interest rates on debt that did not mature for decades.
Following the unprecedented sub-prime mortgage meltdown in 2008, however, municipal lending rates skyrocketed, banks began hoarding capital, and the market froze for auction-rate bonds, forcing Jefferson County to pay penalty interest rates. Then, when insurers of Jefferson County’s bonds suffered a dip in their credit ratings, investors dumped Jefferson’s sewer bonds on banks that had agreed to serve as buyers of last resort. These sales triggered contractual requirements for the County to pay off its debt in four years rather than the expected 30 or 40 years.
Bankruptcy: The Only Option?
To compound its already perilous debt crisis, Jefferson County lost a significant source of revenue when an occupational tax was struck down in court. Alabama’s Legislature balked at allowing the County to institute any new taxes, forcing Jefferson County to make drastic cuts to reduce its budget. Prior to its bankruptcy filing, Jefferson County faced another $40 million in cuts and the specter of slashing the budget to include only constitutionally mandated programs.
While County officials have attempted to negotiate with creditors, their efforts have been stymied by local lawmakers who refuse to agree to any settlement. Despite creditors’ willingness to accept a significant amount less on the obligations owed to them, Alabama lawmakers have resisted suggestions designed to help the County avoid bankruptcy. Delegates have rejected calls to set up an independent sewer authority to issue new debt, and have rejected calls to raise sewage usage fees to help repay bond obligations, which lawmakers argue would further burden struggling taxpayers.
Chapter 9 Overview
The use of Chapter 9 of the bankruptcy code, which governs municipal bankruptcy, affords municipalities more leverage when dealing with creditors than is available outside of the Chapter 9 context. The automatic stay grants a municipality “breathing room” from ongoing litigations and efforts by creditors to collect any debts, thereby allowing the municipality time to formulate a plan to reorganize its debt and re-allocate its resources. It also allows a municipality to propose a plan that does not have the support of all of its creditors and “cram-down” the plan on the dissenting creditors if the plan otherwise satisfies all of the requirements of Chapter 9.
Yet, Jefferson County’s bankruptcy will not be without its challenges. Chapter 9 does not divorce the County’s credit problems from an arduous political process. At court, the County must convince the judge that the plan satisfies the requirements of the bankruptcy code, including that the plan is “in the best interests of creditors and is feasible”. If Jefferson County is unable to gain the consent of the necessary creditors to reduce or restructure the obligations without additional revenue and decides that the only path to emergence from Chapter 9 is to impose or raise a tax or monetary levy, the imposition of such tax or monetary levy would require voter approval or a special session of the Legislature. Thus, it remains possible, given lawmakers’ earlier reluctance to tax the populace, that Jefferson County’s bankruptcy plan may languish in the court for a time.
How Will Jefferson County’s Bankruptcy Affect the Bond Market?
Although Jefferson County’s bankruptcy filing will have a significant impact on the municipality’s bonds, experts predict that there will be little impact on the broader municipal bond market. When municipalities declare bankruptcy, most classify the event as a “one-off,” attributable to a unique set of circumstances associated with that particular municipality. Jefferson County’s financial problems occurred primarily due to sewage issues, while Orange County suffered from speculative investments gone wrong. As a result, market observers view Jefferson County’s default as an isolated incident rather than as a symptom of systemic problems in the municipal bond market.
Moreover, investors were not surprised by Jefferson County’s bankruptcy filing. The County’s problems had become apparent over the preceding years – so much so, that when the news of the County’s bankruptcy became official, the market was not caught unaware. Even the rest of Alabama should be largely insulated from Jefferson County’s default. Experts predict that while some may seek to limit their exposure to the bankruptcy by avoiding Alabama securities entirely, investor interest in Alabama debt during the past three years has been relatively consistent, indicating that collateral damage from the bankruptcy likely will be limited.
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Forrest Hainline III
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