The biggest news of the day is not Joe Paterno’s firing, Rick Perry’s latest brain fart, or the most recent article planted in the mainstream media by the Kardashian brand. It’s the $4.1 billion bankruptcy filing by Alabama’s largest county. Jefferson County made the move after banking and political misconduct helped transform a $1.2 billion sewer project into a $3.2 billion monument to the evil of pay-to-play politics.
How big is this Nov. 9 filing in layman’s terms? It’s huge enough to impact all of us.
Jefferson County basically just told Wall Street to “go to hell” with the largest municipal bankruptcy in U.S. history. It sought Chapter 9 federal bankruptcy protection after an agreement among elected officials and investors to refinance $3.14 billion in sewer bonds fell apart.
Jefferson County Commissioner Joe Knight said the bankruptcy was needed to stop pushing a financial problem down the road that has plagued the area for a decade.
“It’s time for us to button up our chin strap, grow a backbone, put a little starch in our shorts and fight for the citizens of Jefferson County and stop being pushed around,” Knight told The Birmingham News.
By declaring bankruptcy, the county effectively just said “no” to bank misconduct by refusing to continue to work with the Wall Street firms that helped structure the bond issuance which created this mess. More than 20 people and five companies have been convicted of wrongdoing in connection with the construction and financing of the outrageously inflated sewer project.
The municipal bankruptcy filing and its consequences are very similar to what happens when a consumer breaks a housing lease. The temporary relief can result in big problems in the longer term.
Why is this big news?
It’s big news because corrupt politicians have been pilfering state, county and city treasuries for decades in conjunction with municipal bond dealers, brokers and underwriters. And because the $2.9 trillion in outstanding U.S. municipal bonds in 2010 dwarfed the $2.6 trillion in taxes collected by the federal government.
The bond market is a huge lever of government most people know nothing about, which has an incredible impact on our quality of life, both for better and worse.
The Jefferson bankruptcy is most decidedly a double-edged sword. It’s good because it slaps bankers in the face with hundreds of millions in losses and holds them accountable for their collective misconduct. It’s bad because some of the bonds that won’t be fully repaid are held by retirement funds, and because municipalities are probably going to have to pay more to borrow money in the future to build things like roads and schools.
It’s also possible Jefferson County residents may see further increases in their sewer bills.
The first thing you need to understand about the Muni bond market is that government entities issue bonds when they wish to borrow money. The people who structure and handle those issuances are called “underwriters” and “advisors,” and those who buy muni debt are called “bondholders.”
Muni bonds are like car loans in the sense that most are secured by collateral. Anything that generates a steady flow of revenue can be used to back bonds, from cigarette taxes to bridge tolls. The Jefferson County sewer debt is secured by sewer charges, which have soared from a few dollars a month to hundreds per residence due to this boondoggle.
The higher rates have hurt residents, while the possibility of further increases has hindered development.
Jefferson County expected the overhaul of its wastewater system to cost $1.2 billion and quadruple sewer rates to $60 a month when it first agreed to the improvements in an informal consent agreement with the Environmental Protection Agency in 1995, according to a report by the Public Affairs Research Council of Alabama. The County has about 658,000 residents and is home to Birmingham – Alabama’s largest city – and the University of Alabama.
Alabama Gov. Robert Bentley said he had hoped to avoid the bankruptcy filing.
“I am disappointed by the commission’s decision,” Bentley said in statement. “Bankruptcy will negatively impact not only the Birmingham region, but also the entire state.”
The muni bond market is the equivalent of rocket fuel for local governments in the sense that it can be a tool for both great good and great destruction. Bonds can be helpful when governments need to spread out the costs of big projects that are too expensive to fund in a single year, such as bridges, tunnels and schools.
Elected leaders can use also bonds like a credit card in order to live beyond their means. And they can generate bribes and favors from bond underwriters competing for their business.
As political corruption has soared along with the growth in political lobbying since 1980, evil in the bond market has kept pace. That’s part of the reason we’ve seen the creation of so many obscure local government bodies for things like water management, airport authorities, downtown business development and drainage. Many have the ability to borrow money through bonds, whch makes them a potential political piggybank that crooked elected leaders can tap to reward their supporters with fat contracts.
When government insiders rant about “pay-to-play politics” they’re referring to these toxic relationships.
Without the big government projects and the bonds that fund them, there’s less money to reward those who play the game. Without the bond market, local governmental entities would be restricted to spending the money they actually have.
By allowing money for government projects to be borrowed over time, the bond market permits a current administration to spend the money of future administrations and obligate future leaders to repay its debts, thereby subverting any future vote to change course. It also helps inflate the cost of such projects.
Everything costs more with borrowed money. A lot more. Not only is there the interest that goes to the lender, aka the bondholders, but there are commissions for the bond underwriters, agents, and financial advisors. There’s even bond insurance.
However, it takes time for a government to wean itself off bonding the right way, just as it takes time to pay off your credit card debts. Opting not to pay them at all, as Jefferson County has done, can create more problems than it solves.
Jefferson County has been trying to find a way to avoid declaring bankruptcy due to the sewer project since 2008. Its predicament prompted provisions in the federal Dodd-Frank law seeking to protect localities from complex financial trades involving derivatives, according to Bloomberg News.
It’s still possible that lawmakers and bondholders will be able to work something out. They thought they had a deal in September that would have permitted the county to avoid bankruptcy. The settlement proposal the county worked out with a group of Wall Street investors led by JPMorgan Chase & Co called for bondholders to forgive about $1 billion in debt while the county refinanced about $2 billion, and covered the rest via higher sewer rates, which have already soared due to the project.
The county and the Wall Street investors group were unable to reach a deal on the remaining $140 million and county leaders finally grew weary of playing chicken with a banking industry now facing widespread social condemnation.
“Despite our best efforts the negotiations had not produced any decision that fairly treats the county and our citizens,” Commissioner Jimmie Stephens, who made the motion to file for bankruptcy, told the Associated Press. “And it did not appear that further negotiations would produce that.”
JPMorgan was the lead underwriter on the sewer bonds. The Securities and Exchange Commission has awarded Jefferson County $75 million in compensation for “unlawful payments” obtained by the investment bank, which settled charges it bribed elected officials to win the sewer bond business. JPMorgan also agreed to forfeit another $647 million in fees, without acknowledging it acted improperly.”
“JPMorgan worked very hard with the county and other creditors to avoid a bankruptcy filing,” JPMorgan spokesman Justin Perras told The Bond Buyer. “We offered very substantial financial concessions to make the deal happen while keeping sewer rates within the parameters proposed by the county. While we’re disappointed by the county’s decision to file, we will continue to work toward a fair and reasonable solution for the county and all creditor constituents involved.”
There’s a big difference between this kind of Chapter 9 filing and the Chapter 11 bankruptcy filings favored by for-profit corporations. Municipalities have more power over their creditors under Chapter 9.
Jefferson County is the fourth municipality to seek Chapter 9 bankruptcy protection in 2011. The other filings were made by Boise County, Idaho; Harrisburg, Pa.; and Central Falls, Rhode Island. Eight special purpose districts and public-benefit corporations have also filed for protection, according to Bloomberg News.
Jefferson’s $4.1 billion shortfall is more than double the 1994 bankruptcy by Orange County, Calif. Orange sought protection after losing $1.7 billion in interest rate bets. In Jefferson’s case, outside advisers suggested a series of complex deals with variable-rate interest.
Jefferson County lawmakers basically “bet the family farm” on risky interest-rate swap agreements in 2002 and 2003 and lost. They hoped to reduce rising loan payments, but the move had the opposite effect.
The contracts were arranged by JPMorgan and were supposed to save money by offsetting the floating rates the county paid and by giving it a fixed rate that was lower than on traditional bonds, according to The Bond Buyer.
The strategy backfired as the subprime-mortgage market meltdown undermined the credit ratings of companies that insured Jefferson County’s bonds in 2008. In both Orange and Jefferson counties, elected leaders with little knowledge of complex financial instruments leaned heavily on the knowledge of Wall Street insiders.
As time has shown, allowing elected leaders in small and medium municipalities to dabble in the muni bond market is akin to letting a small-town farmer play cards with professional gamblers. It’s bad enough when they’re just playing for table stakes, but once the sharks talk their dupes into betting the family farm, financial disaster is quick to follow.
Bonds are the municipal equivalent of the family farm.
The painful truth is that the local politicians who love to issue them often lack both the sophistication to understand exactly what they’re agreeing to and the internal staff to explain it to them. That paucity of expertise makes them meat for the bond industry’s bottom feeders.
David Carrington, president of the Jefferson County Commission, told the BBC in February that there is “no doubt that people from Wall Street offered bribes” and “have to take a huge responsibility for what happened.”