The Jefferson County Default

by Lyle Fitterer, CFA, Wells Capital Management

Yesterday, Jefferson County, AL declared the largest municipal bankruptcy in U.S. history, with a total of $4.15 billion in municipal debt. News stories have highlighted that the county was a victim of the financial crisis. That is only partially true. First and foremost the construction and cost overruns on a federally mandated sewer project that was too expensive for the residents. Second, the scale of the project and cost overruns were exacerbated by misguided derivatives contracts. These derivatives were sold to the county under the assumption that they could keep the large debt burden from being prohibitively expensive for residents, but unfortunately, the financial crisis worked against the county’s new derivative contracts. Finally, fraudulent dealings between a bank and the county leaders further increased costs and landed people in jail. Sewer rate hikes would not have been enough to counteract the bad decisions, illegal behavior, and jail sentences, and now bankruptcy is the result. Needless to say, this combination of extraordinary circumstances is rare.

Proposals have swirled in recent months regarding a resolution. The insurers, banks, and bondholders had agreed upon concessions to aid in restructuring the county’s debts and make strides for resolution. The State of Alabama’s legislature was unable to agree about how the state would support a problem like Jefferson County.

The bankruptcy may be new, but the default is not. The $3.8 billion in sewer debt and warrants default is already baked into the default statistics for municipals. Many bonds continue to pay interest from insurers or other guarantors. Because the market was anticipating continued distress in Jefferson County, many securities had already priced in steep declines. We’ll continue to learn more about ultimate recovery rates on the debt as proceedings develop. Recovery rates tend to be high in water/sewer finance, but we do not expect par in this case. Some bondholders stand to lose, but some stand to gain depending on their specified security provisions and purchase price.

Clients have asked if this filing will prompt further municipal bankruptcy filings nationwide. We don’t think so. Bad decisions and criminality in isolated situations in the municipal market will continue to be made in good economies and bad economies. The costs and pain of this bankruptcy will serve as a wake-up call to other leaders that they should remain proactive and ensure that their finances are in order. We believe that this is ultimately a positive development. Municipal defaults remain low. Most of the headlines continue to be the recycling of the same headline stories we have all read about for a few years now. Names like Jefferson County, AL, Harrisburg, PA, Vallejo, CA, and Central Falls, RI come to mind.

The state has set a poor precedent for bondholders at a time when many other states have supported their municipalities or given them tools to navigate through troubles. That support from the state helps to ensure that local government’s financing costs remain low and that they have easy market access. Other issuers in Alabama may see their financing costs rise because the state did not provide adequate support of the bondholder’s plan in Jefferson County.

We’ll continue to monitor the situation and keep you informed with any future material developments.

The information above has been written and provided from Wells Fargo. Brinker Capital takes no responsibility for the accuracy of the content and is meant for informational purposes only. Please visit for more information.

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