The state becomes the guarantor

July 27, 2011

Jefferson County, Alabama is getting a lot of attention as it negotiates with the holders of $3 billion of sewer bonds. The county would like to pay $2 billion to settle the $3 billion of bonds outstanding and limit the rate increases county residents would have to pay. This arrangement would pay bondholders (led by JP Morgan) 66 cents on the dollar — not a great recovery but not outrageous either. Bondholders want the state to guarantee this new arrangement and stand ready to pay in the event of another default.

There is an alternative option for settling the matter: a Chapter 9 municipal bankruptcy. The county is now prepared to go that route if necessary and have hired an expert attorney to lead them through the process if they so choose.

The county accumulated this sewer debt over a number of years to fund the development of an EPA-mandated sewer system. Its construction was laced with delays, cost overruns and corruption. It’s the poster child for disastrous public works and bad dealing by Wall Street. The credit rating for this debt started out as AAA in 1997 when it was issued. The bond insurer FGIC stood behind the debt and helped raise the credit to the highest level, AAA, from Baa1. In the chart above you can see the rating move in February 1997 as the insurer came in and pledged to repay bondholders if default occurred.

Jefferson County issued another very large amount of bonds in 2003 to pay for project overruns. This caused the rating on these earlier 1997 bonds to be lowered. This is due to the Jefferson County now having a heavier debt load to service. Credit ratings are a reflection of an issuer’s ability to carry and service the debt they have outstanding.

The financial crisis of 2008 decimated the bond insurer and caused Jefferson County’s rating to plunge. The rating briefly spiked in March 2008 as the guarantor briefly recapitalized their business. Since then the rating has been sinking lower and reflects that these bonds are near default.

The state of Alabama could be a good guarantor of the bonds for Jefferson County, and there appears to some political willingness to do this. The rating agency Standard and Poor’s rates the state as AA and says (emphasis mine):

Despite Alabama’s frequent use of authority and lease debt, in fiscal 2010 its projected total tax-supported debt obligation is moderate and debt service carrying charges are low, in our view.

Although usually the state would be required to seek legislative and voter approval to issue new bonds, there’s a loophole:

General obligation debt can only be issued through constitutional amendments and requires authorization by three-fifths of both of the Legislature’s houses and voter approval.

The Alabama Supreme Court, however, has held that these restrictions do not apply to debt incurred by separate corporations functioning as instruments of the state. Furthermore, the state Supreme Court has ruled that the Legislature can authorize limited-obligation debt with a pledge of certain taxes or other revenues securing that debt.

This course of events, although delayed, is similar to other recent credit crises where the public, as represented by the state, has stepped in to guarantee the debts of others.

The ground is shifting in Jefferson County and old problems will soon be made right. Public officials have been called to craft a complex solution with many moving parts to protect the public interest. Their efforts will right years of corruption and wrongdoing. This is a heavy burden and I wish them well. If done properly Jefferson County and the state of Alabama will be transformed from a place of endless incompetence and corruption into a place where the public interest shines brightest. Continue on public officials. We have your back.


1997 offering documents for Jefferson County Revenue Warrants

Moody’s rating history on 1997 Jefferson County Revenue Warrants.

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