Municipal bankruptcy in Alabama: Will other local governments follow suit?

Cash-strapped local governments across the US are closely watching the $4 billion, Chapter 9 bankruptcy filed this week by Jefferson County, Ala. – the largest municipal bankruptcy in American history.

Beyond the dozens of US municipalities that have already defaulted on bond payments this year, hundreds of others are being crushed by gold-plated union contracts and municipal-bond refinancing deals that blew up in the real estate crash of 2008. It's a situation that some fear could lead to a wave of destabilizing defaults on usually rock-solid muni bonds.

The Jefferson County bankruptcy case, along with three other major municipal bankruptcies filed this year, may offer new avenues for cities and counties to renegotiate their debts. But as it hits the courts, the Alabama case is also likely to be scattered with cautionary tales and caveats that may give municipal fiduciaries pause before ducking into the courthouse to seek protection from creditors.

Either way, "there are going to be other municipalities in financial distress looking at what happens in this case," says Melissa Woodley, a finance professor at Samford University in Birmingham – the seat of Jefferson County.

Indeed, Jefferson County became the fourth municipal entity to declare bankruptcy this year – with Harrisburg, Pa.; Central Falls, R.I.; and Boise County, Idaho, coming before. However, such filings remain rare. Fewer than 500 have taken place since 1937 and only 40 since 1981, according to Bloomberg. The previous record was set in 1994 when Orange County, Calif., asked the courts to reorganize $1.7 billion in debt.

"This [Jefferson County case] was not the first casualty in municipal bankruptcies, and it very likely won’t be anywhere close to the last," writes Jon Ogg for 24/7 Wall St., an online investment newsletter.

Analysts like Meredith Whitney, who predicted the 2008 Wall Street crash, have warned for years about a looming municipal-bond crash – where a spike in local governments defaulting on bond payments could trigger a mass exodus of investors out of the usually safe municipal bond market. That, in turn, could force local governments to either raise taxes or dramatically reduce budgetary outlays and services.

"I think next to housing, this is the single most important issue in the United States and certainly the largest threat to the US economy," Ms. Whitney told "60 Minutes" last year.

Faced with massive budget deficits and little hope of another Washington bailout, revenue-starved cities like Miami and Detroit have discussed bankruptcy. They've hinted that where there's a lack of political will to either raise taxes or cut services in order to pay off debts, a judge might have to do that work.

John Young Jr., the court-appointed receiver in the Jefferson County bond debacle, told Reuters that politics was a factor in the 4-to-1 decision by the Jefferson County commissioners to declare bankruptcy. "Politicians don't want to be attached to [utility] rate increases and tax increases, and both were going to be necessary," he said.

Indeed, beleaguered municipalities struggling with political stalemates over revenue and debt pressures could look to bankruptcy courts as a process "that may allow [those issues] to be worked out" in a more neutral, nonpartisan way, says Ms. Woodley at Samford University.

Still, few expect a sudden rush of municipal bankruptcies. For one thing, such bankruptcies, including the one in Jefferson County, are usually signaled years in advance, giving investors time to adjust. Right now, there aren't an overwhelming number of municipalities sending such signals.

Moreover, Jefferson County remains a unique case. While most municipal debt problems today stem from generous pension packages negotiated during better economic times, Jefferson County managed to overpay for a new sewer system and years later refinance its overbearing debt using untested and risky Wall Street derivatives and interest-rate swaps.

Also, malfeasance was rife: Twenty-two officials have been found guilty of corruption in setting up the sewer bond deal, and JPMorgan Chase, the primary note-holder, has paid hundreds of millions of dollars in penalties to the Securities and Exchange Commission for its role in the debacle.

And then there are the costs of bankruptcy. Jefferson County has hired two well-known Hollywood bankruptcy attorneys charging about $1,700 an hour combined – a rate at which the lawyers will have earned the average per capita annual income in Jefferson County in just over three days.

"This can drag on for years, meaning millions of dollars in just attorney's fees," says Andreas Rauterkus, a finance professor at the University of Alabama at Birmingham.