Most expensive sewage system in history
If you say “Jefferson County” to a professional in muniland, you will likely get a shudder of mild revulsion. This Alabama county is the biggest example of Wall Street aggression towards a public entity since Orange County, California declared bankruptcy in 1994 after buying too many interest-rate derivatives. Dodd-Frank, the financial-reform law that’s been in effect for a year, changed the rules for municipal bonds and derivatives. But did it change them enough to avert a repeat scenario?
First, a little background: Jefferson County was ordered by the federal EPA to build a sewer system at an estimated cost of $1.2 billion. The construction went over budget and was rife with massive corruption that has ensnared 17 people. The funding of the sewer project was equally corrupt. JP Morgan was under investigation for bribery in 2009 and eventually reached a settlement with the SEC. The Washington Post reported this at the time:
J.P. Morgan Chase agreed to a $722 million settlement with federal regulators over accusations that the bank and two former executives made illegal payments to win municipal bond business from Jefferson County, Ala.
The Securities and Exchange Commission said Wednesday that J.P. Morgan and former managing directors Charles E. LeCroy and Douglas W. MacFaddin paid $8 million to friends of Jefferson County commissioners who voted to hire the bank to carry out municipal bond offerings and other transactions to finance a new sewer system. The friends worked for local financial firms, but did not work on the deal.
The financial deals arranged by J.P. Morgan ultimately resulted in millions of dollars in losses and pushed the county to the brink of bankruptcy, causing residents to pay much higher rates for water and sewer services.
The securities issued as a result of these bribes were a deadly combination of floating interest-rate bonds and derivatives created to protect the county against rising rates. The financial crisis of 2008 caused these products to fail, and the county’s interest rate soared to an unpayable 10% at one point. The residents of the county have been paying increasingly higher sewer and water rates to support these bigger payments to bondholders, but it’s not sustainable. The County Commission met with several nationally known bankruptcy attorneys today to discuss filing for Chapter 9. They also have a proposed settlement on the table to the creditors. It’s the endgame for this sad tale.
But will Dodd-Frank keep this from happening again? Actually there is a good chance that new rules developed and enforced by the SEC and Municipal Securities Rulemaking Board will keep this particular set of problems from recurring. Dodd-Frank requires any party who is advising a municipal entity to be registered. And, perhaps more importantly, there’s a new rule on the books that says an adviser can’t take actions that harm a public entity. Here is a more professional description from the law firm K&L Gates:
Dodd-Frank also prohibits municipal advisers from providing advice, or from acting on behalf of an obligated person engaging in fraudulent, deceptive, or manipulative acts or practices, and imposes a fiduciary duty on advisers who advise a municipal entity and prohibits municipal advisers from engaging in any act, practice, or course of business that is not consistent with the municipal adviser’s fiduciary duty.
This is powerful stuff because previously these entities had no responsibilities to those they advised. Of course, all this is too late to help the residents of Jefferson County. They will likely continue to pay more and more for the most expensive sewage system in history. Hopefully, the rank practices of Wall Street towards municipal entities will be flushed down the sewer pipe.