So Who Sold Jefferson County This Bill of Goods?

One of the horrorshows that has been moving along in the background is the disaster of the funding of a sewer project in Birmingham, Alabama, which looks pretty likely to produce the biggest municipal bankruptcy since Orange County back in the mid 1990s.

Orange County did have one Robert Citron to blame for its woes. By all accounts (Frank Partnoy in Infectious Greed is particularly good here) Citron was WAAAY over his head, and not the brightest bulb to begin with.

The South has an even more combustible mix: a proud history of political corruption, plus even less-than-normally finance savvy bunch of officials (if such a thing is possible). There is a very good piece up at Bloomberg, so you can do some one-stop shopping and catch up on this sorry saga. A quick overview:

Jefferson County, Alabama,…anchored by Birmingham, is staring at what one local politician calls financial “Armageddon.”

The spectacle — a tax struck down, about 1,000 county employees furloughed, a politician indicted over $3 billion in sewer debt that may lead to the largest municipal bankruptcy in history — has elbowed its way up the ladder of county lore….

One target of their anger is Larry P. Langford, who was the county commission’s president in 2003 and 2004 and is now mayor of Birmingham. The 61-year-old Democrat goes on trial today, charged in a November 2008 federal indictment with taking cash, Rolex watches and designer clothes in exchange for helping to steer $7.1 million in fees to an Alabama investment banker as the county refinanced its sewer debt….

Under Langford’s stewardship, the county bet on interest- rate swaps, agreements that a representative of New York-based JPMorgan Chase & Co. told commissioners could reduce their interest costs. Instead, the swaps — covering more than $5 billion in all — blew up during the credit crisis after ratings for the county’s bond insurers fell…

Thousands of public borrowers across the U.S. chose a similar strategy, and many are now paying billions of dollars to escape the contracts….Even Harvard University, the world’s richest academic institution with an endowment of $26 billion, fell for Wall Street’s financing in the dark: It paid $497.6 million to investment banks during the fiscal year ended June 30 because it chose to cancel $1.1 billion of interest-rate swaps.

Yves here. I am clearly an old fart. Jefferson County had floating rate and switched to supposedly cheaper fixed rate debt. Remarkably (and insanely) they had a massive maturity mismatch, funding a lot of the program…in auction rate securities! The rest was in floating rate debt dependent on credit enhancement (apparently for the swap) that got whacked in monoline downgrades:

In 2003 and 2004, with Langford as president, the commission plunged into interest-rate swaps with JPMorgan, Bear Stearns Cos., Bank of America Corp. and Lehman Brothers Holdings Inc. Over time, the county, whose fiscal 2010 operating budget is $808.6 million, entered swaps on more than $5 billion in bonds.

Langford said in 2005 that the swaps would save $214 million — an assumption based on the county and its bond insurers maintaining their credit ratings…

The county later hired financial adviser James White of Birmingham-based Porter, White & Co., who estimated that the commission’s cost for the swaps, $120.2 million, was as much as $100 million too high, based on prevailing rates.

Then, in 2007-08, credit ratings for bond insurers that backed the variable-rate bonds plummeted to junk status because of unrelated losses in mortgage-backed securities. The reduction in credit quality killed demand for the bonds they insured.

Banks were forced to buy the securities, kicking in contract provisions that accelerated to four years from 40 the county’s payment schedule on more than $800 million of the debt. The insurers’ fall also affected more than $2 billion in auction-rate securities in late 2007 as bidders’ interest evaporated.

Some of the county’s variable rates more than tripled, to as high as 10 percent. Meanwhile, the bank payments it received were decreasing. In March 2009, when JPMorgan canceled its swap agreements, a county filing said they were worth more than $650 million to the bank, which has agreed to waive termination fees under negotiations on how to restructure the county’s debt.

Worse, the local authorities don’t bother with bids, which sets them up to be fleeced:

Less than 15 percent of $391 billion in new debt offerings were sold last year on the basis of public bidding — down from 83 percent of new sales in 1970. Most issues are now negotiated, meaning borrowing costs are set in private bargaining sessions.

In Jefferson County, the resulting opacity was a gateway to corruption, according to documents filed in Langford’s case. The Securities & Exchange Commission began probing the county’s swaps in 2004; the Federal Bureau of Investigation started inquiring later. In June 2007, SEC investigators deposed Langford in Miami about whether he used the sewer-debt refinancings to pay off political friends.

And that’s just the bond issues, so the transparency of swaps has to be even worse.

Readers may recall that this sorry drama has been going on for well over a year. So why hasn’t the county filed for bankruptcy, or prepared a filing and gotten into a stare-down with the swaps counterparties to negotiate a settlement? Get a load of this:

Carns and Commissioner Bobby Humphryes, both Republicans, say they reluctantly favor bankruptcy, in part to prevent the appointment of a receiver who might seek increases. “We need a cram-down on the debt,” says Carns, adding that the county can afford to service less than half the obligations, about $1.4 billion worth. A bankruptcy court would have authority to reduce the amount owed.

Democrat Shelia Smoot, along with Democrat William Bell and commission President Collins, opposes filing voluntarily.

“It would be detrimental to our community for the next 50 years,” she says.

Yves here. The last statement is utter hogwash. The idea that not filing for BK is a good idea is as big a bill of goods as the original swaps deals.

The county is nuclear waste NOW due to the unsupportable debt burden. By contrast, lenders are happy to fund post bankruptcy companies, and municipalities even more. They have decent cash flows and have delevered! They might well look like a much better credit than the average municipal borrower post bankruptcy.

The reluctance to file for bankruptcy suggests there is even more dirty laundry the local officials do not want aired.

The story is very well done, and you will find it here.

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    1. catkiller

      crooks are never the best tool in the tool box. this guy gives away a billion for a few party gifts; the families behind G & JP give away an entire empire, fully expecting a greater return on the next one, until Argentina. they will fair no better in china.

      agency does tend to play both sides of the contract, always in a misguided effort to become a permanent establishment, against the laws of physics.

      the drop-dead date for them to implement quantum propulsion already passed, and they didn’t have it.

      the nation / state system will be replaced.

    2. Yves Smith Post author

      No, I mean Infectious Greed, published in 2003. The discussion of Citron is on pages 114-121. Fiasco was published in 1997 and discusses Orange County in passing, as a bullet Morgan Stanley managed to dodge.

  1. Joseph

    The name of the person who lead this deal was Ajay Nagpal, then head of Muni sales at JPM. When I last heard he was global head of equity sales at Lehman…probably with BarCap now

  2. RC Jennings

    A Municipal bankruptcy filing for a business type entity (water/wastewater) that is fee supported will almost invariably result in an adjustment to rates – not a cramdown as the politician hopes. So rates will go up, a lot. To your point, post bankruptcy, with rates high enough to support the debt load Jefferson county would be back in business. The reason they haven’t filed is the law is pretty clear what happens in the BK, and they don’t like it.

    They may have good grounds for arguing criminal behavior on the part of some of their advisors, but it will be tough for them to win, so it’s kick the can down the road time.

  3. RebelEconomist

    You appear to have got this wrong Yves. The Bloomberg article says that the effective debt payments were fixed, because variable rate debt was swapped into fixed. However, the variable rate bonds (auction rate securities?) seem to have had some clause that allowed them to be restructured if the issuer got downgraded – if the swaps were collateralised, the credit rating of the swap counterparty should not have been a major issue. Presumably, this clause was agreed because it made the debt cost lower. And I guess the loss on the swap arose because floating rates would actually have been cheaper, because short rates have fallen so much. Perhaps the terms were not as competitive as they should have been, but this appears to have been a relative minor part of the additional cost.

    So the bottom line seems to be that the county hired some finance officials who sought cheaper funding to please their employers and got it wrong, perhaps because they over-reached their ability. The county elected the politicians who hired those officials and who set the remuneration terms that determined their expertise and incentives, so the electorate should accept that they made a mistake and pay up.

  4. Yves Smith Post author


    This is what Bloomberg says:

    Payments on Jefferson County’s debt, which switched from 95 percent fixed-rate financing to 93 percent variable-rate bonds hedged with swaps, eventually ballooned to $460 million a year, or more than twice the sewer system’s annual revenue.

    Much later in the article, they do give the details, which are at odds with the summary at the top and are sufficiently specific as to be the real description.

    Given the fact that that there is litigation outstanding that suggests corruption (and the story is pretty direct on this point), I see no reason for the county not to do what it can to extricate itself from this deal. Moreover, corporations avail themselves of Chapter 11 all the time, and not one excoriates them, “gee you should liquidate the company.” Do you have any idea what sewer bills like that do to a community like Birmingham? I suggest you visit and have a bit of a reality check.

    In fact, there are basic assumptions like “good faith and fair dealing” that are the bedrock of all contract law. They can supercede the usual US contract boilerplate about how “the contract represents the full understanding between the parties.” I’ve seen this used more than once successfully in real live disputes. This is why the reluctance of Jefferson County to sue says they are badly advised. As the Bankers Trust cases in the 1990s indicated, derivatives dealers who knowingly fleece clients often wind up settling because they know a judge will take a very dim view of bad faith dealings. And the size of the ripoff in the deal suggests they were exploited.

    I am correcting the post on the fixed-floating matter, it did make no sense to me. Thanks for catching that.

    1. anonymous

      The issue is that JCty entered into two types of swaps: a traditional floating to fixed but also a floating to floating (JCty pays 67 percent of the one-month LIBOR but receives 56 percent of one-month LIBOR plus 49 basis points). The second set of swaps were done in 2004 and enabled JCty to receive approximately $25M in cash on approximately $1.5B notional value. The floating-to-floating swap, with the collapse of interest rates plus the VRDO and ARS failures, results in the skyrocketing debt service. The downgrades of the monolines results in the collateral calls on the swaps.

      The analogy that JCty is a homeowner who makes $50K a year w/ a $1M mortage is incorrect; JCty is more like a levered-up hedge fund that gets a capital call.

      Bloomberg articles with details here:

  5. RueTheDay

    There are DOZENS of these unexploded landmines still out there, which is one reason why the Fed is in a huge pickle over when/how to raise rates. The moment the Fed starts raising rates, we’ll be right back to March 2008 as far as the financial crisis goes. ZIRP is temporarily papering over some of these problems, unfortunately it’s also encouraging new leverage and new maturity mismatch as Wall Street borrows essentially free short funds to make risky long bets.

  6. RebelEconomist

    “I see no reason for the county not to do what it can to extricate itself from this deal.”

    The reason is that such behaviour will lead US creditors to demand increased insurance for future deals and make future debt burdens even heavier. As I used to write often on Brad Setser’s blog, the US today reminds me of Britain in the 1970s – a nation refusing to accept emerging challenges and looking for easy ways out and others to blame. In my opinion, the major cause of the present crisis has been moral hazard, especially through monetary policy. But talk of negative interest rates and calculated bankruptcy suggests that they are going to take another run at it, and probably produce an even bigger crisis. In short, the US is on the road to Argentina. That’s why.

    1. Siggy

      There is always that, the politicians have corruption plus the financial problem to deal with. A proper resolution would bare the corruption and that would put the politician out of office.

      Can someone please show me how auction rate securities make sense for a municipality? All there doing is borrowing long while they periodically adjust the coupon to the current market; AND, at each and every reset they pay substantial fees. Just what is the true cost of such financing?

  7. RebelEconomist


    Despite their notionally long term, ARS were believed to be liquid, cash-like investments, because the periodic auction process (which served to reset the coupon) gave ARS holders a historically reliable opportunity to sell. Even if there was a shortage of buyers, by convention the ARS dealers were supposed to provide a backstop bid. This assumed liquidity meant that buyers would accept a lower interest than other long term floating rate securities, hence the popularity of ARS with issuers as well as investors. However, as we saw, when the weakness of the municipal bond insurers prompted huge selling of ARS, the dealers backed away from what was only an informal commitment to support the market, meaning that rates soared and investors were unable to liquidate, exposing the false assumptions that had underpinned the ARS market.

  8. Francois T

    “The reluctance to file for bankruptcy suggests there is even more dirty laundry the local officials do not want aired.”

    Anyone smell jail time in the morning mist?

  9. Lavrenti Beria

    Yet another case in which the argument for the wholesale detention, interrogation and trial of all holding public office in the United States is given added weight. Looking to the future, however, I would see such steps as likely following on the mass demonstrations and strikes required to bring about convocation of the second constitutional convention. Surely you’ll agree that it would be entirely unreasonable to expect trials prior to such a conclave since sitting justices would be considered defendants and the legal and security structures needed properly to manage their cases would not as yet be in place. And after all, a peoples justice needn’t always follow the pattern of the lynch mob. Rest assured, there will be time for everything.

  10. mrfender

    Check what happened to the Bethlehem Pa School District.
    You can read stories about it in the Allentown Chronicle. They got pulled into the same type of investment by a “financial expert” who made millions on the fees and then left them with tens of millions to pay yet. I have yet to see anything on how they can get out from under this, if they can, or if anyone is going to be held responsible. The money they owe would build another school.

  11. LeeAnne

    Notice how Representative Grayson in his congressional questioning of Bernanke emphases ‘foreign.’ I’ve transcribed the testimony for a close look below.

    Destruction of the financial sovereignty of the American people is well underway. Consolidation of capital in the finance sector is being reinforced by consolidation of political power. Its like watching a nazi cult take over the country. Another Goldman Sachs appointment -this time a 29-year-old to head the SEC. Is that conceivably for securities law enforcement?

    Representative Grayson at Congressional hearing –questioning FED chairman Bernanke on swaps with foreign central banks:

    Grayson: One of the entries under Assets is Central Bank Liquidity Swaps which shows an increase at the end of 2007 from $23 Billion to $553 Billion and change at the end of 2008. What’s that?

    Bernanke: Those are swaps that were done with foreign central banks. Many um foreign banks are short dollars, so they come into our markets looking for dollars and drive up interest rates and create volatility in our markets. What we’ve done is -with a number of major central banks like European Central Bank for example -we swap our currency dollars for their currency Euros. They take the dollars, lend it out to the banks in their jurisdiction. That helps bring down interest rates in the global market for dollars. And meanwhile we’re not lending to those banks; we’re lending to the central bank. The central bank is responsible for repaying us.

    Grayson: So, who got the money?

    Bernanke: To -financial institutions in Europe and other countries.

    Grayson: Which ones?

    Bernanke: I don’t know.

    Grayson: Half a trillion dollars and you don’t know who got the money?

    Bernanke: ah -the loan went to the -the loans go to the central banks and they -they then (arm wave) put them out to their um -to their institutions to try to bring down short term interest rates in dollar markets throughout the world.

    Grayson: Well, let’s start with which central banks got the money.

    Bernanke: There are 14 of them which are listed um in our – (lifting open document he’s leaning on toward the camera) I’m sure they’re listed in here somewhere.

    Grayson: awright –so who actually made that decision to hand out a trillion dollars that way -half a trillion dollars? Who made that decision?

    Bernanke: The Federal Open Market Committee.

    Grayson: ok. And was it done at one time or in a series of meetings?

    Bernanke: a series of meetings.

    Grayson: and under what legal authority?

    Bernanke: We have a long standing legal authority to do swaps with other central banks –its not an emergency authority of any kind.

    Grayson: Any thing specific about it?

    Bernanke: turning to back from consultation:
    My counsel says section 14 of the Federal Reserve Act.

    Grayson: awright –we actually looked at one of the arrangements and one of the arrangements is $9 Billion for New Zealand. That works out to $3,000 for every single person who lives in New Zealand. Seriously wouldn’t it be better to extend that kind of credit to Americans rather than to New Zealanders?

    Bernanke: It’s not costing Americans anything; we’re getting interest back and it comes back –its not at the cost of any American credit –we are extending credit to Americans.

    Grayson: Well, couldn’t -wouldn’t it necessarily affect the credit markets if you extend half a trillion dollars in credit to anybody?

    Bernanke: We are lending to all US financial institutions in exactly the same way.

    Grayson: Well, look at the next page. The very next page has the US dollar nominal exchange rate which shows a 20% increase in the US dollar nominal exchange rate at exactly the same time that you were handing out a half a trillion dollars to foreigners. Do you think that’s a coincidence?

    Bernanke: Yes.

    Grayson: (ha ha ha) awright. well, the Constitution says ‘no money shall be drawn from the Treasury but in consequence of appropriations made by law.’ Do you think –

    Bernanke: It’s not drawn from the Treasury.

    Grayson: Well, let’s talk about that. Do you think its consistent with the spirit of that provision of the Constitution for a group like the FOMC to hand out a half a trillion dollars to –foreigners? –without any action by this Congress?

    Bernanke: Congress approved it in the Federal Reserve Act.

    Grayson: When was that?

    Bernanke: Quite a long time ago. I don’t know the exact date.

    Barney Frank: The Act was in 1914, I believe.

    Bernanke: I don’t know if the provision was in 1914 or not, but the Federal Reserve Act was in 1913.

    Grayson: awright -And at that time the entire GNP of this country was well under half a trillion dollars-wasn’t it?

    Bernanke: I don’t know.

    Grayson: Is it safe to say that nobody in 1913 contemplated that your small little group of people would hand out to foreigners?

    Bernanke: This particular authority’s been used numerous times over the years.

    Grayson: well -actually, according to the chart on page 28 virtually the entire amount that’s reflected in your current balance sheet went out starting in the last quarter or 2007, and before that going back to the beginning of this chart the amount of lending was zero 0 to foreigners.

    Bernanke: It was zero before the crises. Yeh. This was part of the process working with other central banks to –again –to try to get dollar money markets working normally in the global economy.

    from page 5 of the document</a
    The 14 central banks referred to are:
    European Central Bank and the Swiss National Bank, the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Denmarks National bank, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, Norges Bank, the Monetary Authority of
    Singapore, Sveriges Riksbank.

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