Large municipal bond disasters have been rare, but I suspect there will be more. The Jefferson County bankruptcy may serve as a precedent for forcing bondholders to take losses in bankruptcy. Despite lots of legal protections, loans to municipal governments can be just like loans to people and companies: if the borrower truly can’t afford to pay what was promised, it won’t be paid.
Jefferson County’s problems involve corrupt politicians and bad luck, but they also include a longstanding reluctance to face facts about the county’s sewer system — and a bond market that failed to face the facts about the county and kept lending money long after it was prudent to do so.
The corruption involved was breathtaking. More than 20 people, including politicians, contractors and influence peddlers, have been convicted. JPMorgan escaped criminal charges, but the Securities and Exchange Commission penalized it for paying bribes through local middlemen.
That corruption was important and no doubt raised the financing costs for the county. But the basic financial decisions about the structure of the county’s debt were different only in scale from what many other municipalities did.
The disaster provides an example of how derivative securities can be oversold. Not all risks can be hedged, and certainly not at acceptable costs, but that is something Wall Street salesmen tend to overlook when they make their pitches. When such contracts are written, you can be sure that the Wall Street firm will make sure it will come out O.K., even if that increases the risk that the customer will not.
The county’s sewer debt used to be long-term, fixed-rate debt. The county would have been better off if that had not changed. But Wall Street persuaded it, and a lot of other municipalities, that such debt was too costly. The county could save some money by issuing what the salesmen called synthetic fixed-rate debt.
And what is that? The county issued long-term variable-rate debt, where the interest payments would fluctuate based on short-term market rates. Just doing that would have left the county at risk if interest rates surged, so JPMorgan also entered into an interest rate swap. That provided that the county would pay a long-term rate to JPMorgan, which would pay a short-term rate to the county.
The net cost of that was a little lower than the cost of fixed-rate debt would have been.
There was an important catch: the swap payments were not based on what the county actually had to pay. They were based instead on indexes that might, or might not, move in the same way that rates moved on the county’s actual debt. It was not really “fixed rate,” the title notwithstanding.
Another risk, probably never considered, was that the monoline insurance companies, which routinely guaranteed munis for a fee, would collapse.
Those risks were not necessarily large, and if Jefferson County had not structured 90 percent of its debt that way — rather than the 10 or 20 percent some advisers recommend — they might not have become crucial. But in the credit crisis, a lot happened that had not been expected.
Jefferson County issued two types of variable-rate debt, both of which blew up.
The largest was auction-rate debt. That debt paid rates that were set every week at auctions. The risk to investors was that an auction could fail and they would be stuck with the bonds. If that happened, the county would pay a penalty rate, often twice the London Interbank Offered Rate, known as Libor.
When auctions began to fail, that penalty rate was not enough to attract investors, but it was high enough to raise the financing costs for the county significantly. The interest rate swap did not protect it because it was based on an index, not on the actual cost the county was paying. Suddenly the “fixed rate” went up.
Floyd Norris comments on finance and the economy at nytimes.com/economix.
Article source: http://www.nytimes.com/2013/06/07/business/bankruptcy-in-alabama-county-offers-warning-for-other-municipalities.html?partner=rss&emc=rss
Graphic: Earnings Calendar