When it comes to budget finance, a municipality more or less works the same as the federal government. It carries a surplus, deficit, or balanced budget. If a muni has a budget shortfall, it needs to finance it through the sale of bonds. That is how a federal budget deficit is managed as well.

The difference lies in the price to finance. The U.S. government can sell treasury notes at a high price with a low yield. This is not always the case for the muni, and recently yields have gone through the roof. Obviously many of the factors that affect the two debt markets differ, but all in all the yield is supposed to represents the risk to default.

Recently the credit spreads between muni and federal debt have gotten extremely wide. In fact, the tightness in credit markets has resulted in a massive default and potentially the largest municipality to go bankrupt since Orange County, California went broke in 1994.

Jefferson County, Alabama

Before going on, I must say I told you so. Like many of the other shoes to drop in the credit market, I have been calling for the munis to be the next victim of tight credit markets. We must understand that this is a systemic failure that still has many unclaimed victims. Moving on…

Jefferson County, Alabama, home of Birmingham, defaulted on an $83.5 million interest payment on its $3.2 trillion in outstanding debt. More specifically, Jefferson County had agreements with creditors to forego the due payment on its $850 million sewer project resulting in the interest payment that was defaulted on. Jefferson County Commissioner Bettye Fine Collins stated, "we just don’t have the funds to cover these interest payments." Currently, the county is set to vote tomorrow morning in an attempt to obtain a 10-day grace period on the debt.

This is a benefited case of pure exotic debt instruments blowing up. Jefferson County was using variable-rate bonds paired up with paired with interest rate swaps. By the way, these are the exact instruments that the investment banks are being sued for selling.

Variable-rate bonds paired with interest rate swaps…say that ten times over. These debt instruments, paired with tunnel vision budgeting based on absurd prediction of projected tax revenue, is a nasty combination for any muni.

Let’s first touch on the tax revenue issue. I’ve discussed this in prior issues of B&B, but I want to reiterate them here. It is a very simple ripple effect of the housing recession. When an individual forecloses on their home, they no longer pay property tax. When the value of a home declines, the owner will pay a smaller property tax. There’s your first ripple. The second ripple effects consumer spending. As the economy slides into recession, unemployment rises, wages fall, and consumers spend less. This means less sales tax. The third ripple which is starting to show is the lack of available credit to finance corporate projects. Again, this will result in less corporate tax revenue for the state.

Then there’s the issue of these exotic debt instruments. Both Jefferson County and the company that insured the county’s bonds have had their credit ratings reduced. A long story short, the reduction of credit worthiness resulted in the County having to pay unanticipated installments on their swaps.

On the other side of the debt casserole, we had the variable-rate, or auction-rate bonds. This is debt that is regularly reprised. It is reported that in attempts to refinance this debt, the county was facing bids as high as 10% on the yield.

Future for Muni Debt

As far as Jefferson County goes, I believe their lesson learned in fiscal/financial responsibility will end in bankruptcy. Jefferson County still has $2.2 billion in auction-rate debt to roll over, and at 10% yields, that’s all but impossible. It appears that the Jefferson County Commission is about to wave the white flag soon. Two of its 5 members have already approved a declaration of bankruptcy. Just to note, it would be the largest default on municipal bond history according to the county’s debt load.

What about the rest of the municipalities? We can expect more of the same, and definitely on a larger scale. Jefferson County was not the only muni to finance deficits with exotic debt instruments. They also weren’t the only ones to misproject tax revenues. There are $2.6 trillion dollars of stressed muni debt facing extreme prices to refinance. Then there’s the credit default swaps on the $2.6 trillion. We are again talking numbers in the neighborhood of tens of trillions of dollars here.

Nicholas Jones
Analyst, Oxbury Research