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updated 9/30/2008 2:11:04 PM ET 2008-09-30T18:11:04

It's not just on Wall Street where dubious financial decisions are creating casualties. Municipalities, many of which made enormous financial promises when the economy was strong, are now confronting heavy fiscal burdens. When the last major bank crisis hit public coffers in the late 1980s, 33 municipalities declared bankruptcy. And despite only eight municipal bankruptcies since 2005, some experts believe that Wall Street's troubles could soon squeeze a growing number of municipalities, which will be forced to cover bond payments and outlays to retirees. One prime example of this problem is Jefferson County, Ala., where the state's largest city, Birmingham, is located. The county is now saddled with $3.2 billion in debt from sewer upgrades and finds itself on the brink of becoming the largest municipal bankruptcy in U.S. history.

The current troubles began in 1993 when Jefferson County was sued by residents living near the Cahaba River, who claimed that the county's sewer systems were pumping raw waste into local streams. The county settled the suit three years later, agreeing to fix the situation by overhauling its sewage system and to issue bonds to fund the project. "We didn't know what was under the ground," says Jefferson County Commission President Bettye Fine Collins, who has been on the commission since 1994 and voted against settling the case. The county was forced to rebuild or replace sewer systems in the 22 municipalities inside its borders and agreed not to seek financial assistance from the cities. Some of the systems were found to have clay pipes that had been underground since the first sewers were laid in the early 1900s.

Heeding the advice of financial advisers, Jefferson County officials agreed to restructure the bond debt earlier this decade, moving from a fixed to a variable interest rate. Additionally, the county spent more than $100 million for interest rate swaps, designed to keep the bonds' rates low. Unfortunately, the swaps backfired as interest rates soared amid the spreading credit crunch and ratings agencies lowered Jefferson County's bond ratings. That drastically boosted the county's bond payments.

Deadline looming
County commissioners are now struggling to reach an agreement to restructure their bond debt before they default and are forced into bankruptcy on Sept. 30, the day the county's forbearance agreement expires. For the past seven months, Jefferson County has been negotiating with the six banks that hold the county's sewer bonds, most of which are held by JPMorgan Chase (JPM). Jefferson hopes to ease the burden of high interest rates by asking banks to exchange the county's auction-rate securities for securities with a 3.8 percent fixed rate and by asking JPMorgan and Bank of America (BAC) to buy back some or all of the $2.2 billion of the county's auction-rate securities.

Collins notes that the county commission's unanimous intent to file for bankruptcy has caused some of the county's creditors to "soften" their position, fearful that they'll receive only 50 percent on the dollar for their sewer bond holdings. Nonetheless, the pace of negotiations remains sluggish, and Collins herself admits that the county has mishandled the situation. "I sometimes joke we ought to write a book, and it would be how not to, instead of how to, handle this," she says. The county is also facing the prospect of bankruptcy legal costs that Collins estimates could reach $25 million to $50 million.

What happens next largely depends on the creditors' willingness to accept a slower rate of repayment, something they may be unwilling to do as the credit crisis pinches their own finances. So far, creditors seem unwilling to budge, Collins says. With a mere 48 hours until the agreement's deadline on Tuesday, the county grows increasingly desperate, evidenced by Alabama Governor Bob Riley's decision to assume control of talks with the creditors. The governor and his press staff did not return repeated requests for comment. On Sept. 26, The Birmingham News quoted Riley as saying he is "probably less optimistic now because we've been doing this long enough that if people were going to make the necessary concessions, it seems like they would have been made by now."

The commission's admittedly poor handling of the situation and the slow negotiations have led to a lawsuit. On Sept. 16, the county's bond insurers — Financial Guaranty Insurance Co. and Syncora Guarantee (SCA) — and the Bank of New York Mellon (BK), the county's bond trustee, filed suit against the county, alleging mismanagement of the bond debt and asking that a court-appointed receiver take control of the sewer project. The following week the county countersued for $100 million, claiming that the bond insurers "had the duty to Jefferson County to manage their portfolios and establish reserves against the risk of loss," the counterclaim states. "Syncora and FGIC had insured portfolios of overly risky residential mortgage-backed securities. Syncora and FGIC thus breached their duties to Jefferson County." Collins and the county commission say they were shocked by the bond issuers' involvement with subprime loans. "I had no idea that the bond insurers were getting off into the subprime residential mortgage business," she says. "That was such a shock to my system, because you sit here and you pay millions of dollars for insurance and you feel you're protected -- well, guess what? We weren't." Syncora spokesman Michael Gormley says the company hopes to reach a settlement to avoid a county bankruptcy case.

Future borrowing burdens
A Chapter 9 bankruptcy case, which allows municipalities with debt they cannot pay to restructure financially, is a relative legal rarity. There have been 564 cases in the past 71 years, and municipalities strive to avoid such filings at all costs because of the steep borrowing burdens any future lender will impose. Bankruptcy experts such as Chicago attorney Jim Spiotto warn that while Chapter 9 can initially ease the financial burden, it will scare future creditors away, making life hard for Jefferson County. "Bankruptcy is essentially a narcotic, in legal respects," he says. "First, you have the euphoria of not having to pay people. But, like with most narcotics, reality sets in and the pain starts."

Jefferson County employees may soon be faced with problems similar to those of city workers in Vallejo, Calif., a town of 116,000 just northeast of San Francisco. In May, Vallejo petitioned for Chapter 9 relief after it admitted it would be unable to pay many of its employees — namely, police and firefighters. A court granted the relief, prompting many police and firefighters to look for work in other cities where they wouldn't have to face 13 percent pay cuts or uncertainties regarding their medical retirement benefits and their pensions. Vallejo's police force, which had 147 officers in 2007, is now vastly understaffed, with only 119 officers, according to Chris Norem, a spokesman for Vallejo employees. City officials, including Mayor Osby Davis, did not respond to several requests for comment.

Vallejo's plight may soon prove a lot more common. Experts warn that the U.S. economy's struggles could give rise to a wave of new Chapter 9 filings as massive amounts of unfunded pension debt become problematic. Currently there is $800 billion in unfunded pension obligations for government workers, who account for only 12 percent of the workforce. Compare that with the mere $450 billion in pension money private enterprise owes the bulk of America's workforce, and some think municipalities everywhere will soon have promises to retired workers they will have trouble keeping or may be forced to break altogether. "Promising things to workers that you can't legitimately provide is not good government," says Spiotto. "That has to be addressed." The credit squeeze is also likely to curtail government bond issues. Research firm Municipal Market Advisors has cut its 2008 forecast for new bond issues from $450 billion to $425 billion, the Associated Press reported on Sept. 26, with a further reduction possible.

Copyright © 2012 Bloomberg L.P.All rights reserved.

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