When Jefferson County, Alabama declared bankruptcy, the bashers had a ball.
Soothsayers, whose earlier predictions of a widespread muni market collapse didn’t pan out, saw potential vindication. After all, the $4 billion debt faced by Alabama’s largest county was about twice the amount that plagued Orange County, California, the previous record holder, when it went bankrupt in 1994. Perhaps, the Cassandras thought, Jefferson County would be a harbinger of a wave of defaults that would redeem their debunked prophecies.
As is often the case, the jarring headlines were misleading, and the details tell a much different story for bond investors. The Jefferson County debacle is far from an accurate reflection of the overall municipal bond market.
Notorious ‘swaps’
The seeds of Jefferson County’s current financial travails were planted in the 1990s, when it was forced to upgrade its dilapidated sewer system to meet federal clean-water standards.
The original cost of the project was $1.5 billion, but costs soon ballooned to more than $3 billion. As officials tried to meet the rising costs, they relied on big-name Wall Street banks and others who recommended a series of complex variable-rate interest “swaps.” This creative financial architecture pushed the debt far into the future, without regard to rapidly escalating costs. Later, these deals were found to be rife with bribes and influence peddling. Meantime, global credit markets struggled and the county couldn’t meet its soaring loan payments.
The level of corruption and incompetency involved in these transactions was extraordinary: After an FBI investigation of the sewer construction program, 21 people were convicted, including former county commissioners, county employees and sewer contractors. Most of the charges involved bribery. The debacle spawned numerous other lawsuits involving JPMorgan, Bank of New York Mellon and a host of underwriters, the county and former officials. In fact, in 2009, JPMorgan agreed to a $722 million settlement with the Securities and Exchange Commission. The bank allegedly made payments to people tied to county politicians in order to win business.
No surprise
How might Jefferson County’s woes affect the bond market? Despite a failed last-ditch effort to avoid a bankruptcy filing last month, the county’s troubles have been well documented for years and surprised no one. In fact, there are serious questions as to whether the filing is even legal. Creditors are fighting it in court. Another recent high-profile filing, by Harrisburg, Pennsylvania, was dismissed after a bankruptcy judge ruled it wasn’t authorized under state law.
The market yawned. It didn’t budge after Harrisburg’s filing, nor was it affected by Jefferson County’s action. (For more on Harrisburg’s filing, see “Is There Less Than Meets the Eye in Harrisburg?”
Furthermore, many Jefferson County bonds are insured, providing protection for individual investors.
So much for the theory that bond insurance is a waste of money, another popular notion promulgated by pundits, who pounced soon after insurers found themselves wounded by their foray into toxic subprime mortgages. These glib, though misleading epithets favored by doomsayers are again off base.
For example, Assured Guaranty said after the filing that investors with bonds directly insured by the company “remain fully protected by our unconditional and irrevocable guaranty of scheduled payments of principal and interest when due. This commitment is backed by our strong capital base.”
The substance of these remarks is evidenced by the fact that uninsured debt of the sewer authority is valued at pennies on the dollar while bonds insured by FSA and AGM continue to trade close to 100.00.
Once again, for muni bond investors, perspective is key. Absent a cataclysmic last-minute development, the tsunami of defaults gleefully predicted by many TV talking heads won’t happen this year. There were fewer than 500 municipal bankruptcies over more than 60 years since 1937, according to Bloomberg. Through the first nine months of 2011, the number of municipal defaults fell by almost half from a year earlier; a decline from $2.89 billion to $949 million.
Further confounding the self-anointed seers, municipal bonds have returned 10.10% year-to-date, even outstripping the broad U.S. Treasury index, which delivered a robust 9.95%.
Jefferson County’s problems resulted from a unique combination of malfeasance, professional bungling and a bad market. Though it makes great fodder for eye-popping headlines, the real story isn’t nearly as exciting, though it’s considerably more accurate.