A Municipal Bankruptcy May Create a Template

Jefferson County, Ala., which just became the first municipality to tap the public bond markets while bankrupt, will go to court on Wednesday to seek approval for its plan to exit bankruptcy by the end of this year.

But there is a catch: Even if Jefferson County does emerge from bankruptcy soon, it will not fully sever its ties to the Federal Bankruptcy Court in Birmingham for 40 more years.

The county’s unusual exit plan, which could offer a possible template for other bankrupt municipalities, calls for the court to retain jurisdiction for the life of $1.8 billion in sewer-revenue debt that it sold over the last few days. If the county falters at some point, even decades from now, the bankruptcy court is supposed to have the power to enforce rate increases to produce the cash needed to pay back the $1.8 billion on schedule, with interest.

For now, the new mechanism appears to have helped Jefferson County, which includes the city of Birmingham, Ala., solve the problem of how to win back lenders after a big default. Municipalities typically go to great lengths to avoid defaulting out of fear that the stigma will ruin their credit for many years.

“To sell new bonds while you’re in default on the old bonds, it really hasn’t happened before,” said Matt Fabian, a managing director at Municipal Market Advisors. “Without the assumption of court protection, the financing would have been more difficult, if not impossible.”

He said that Jefferson County was demonstrating a new source of financing that other municipalities might use to resolve bankruptcies: future rate increases or tax increases. “It’s not just cram-downs on creditors, or terminations of employees’ contracts,” he said, citing the bitter medicine typically used in municipal bankruptcy.

Sewer rates remain a potential flash point in Jefferson County, which built up a crushing mountain of debt in recent years while trying, unsuccessfully so far, to bring its antiquated sewer system into compliance with the federal Clean Water Act. The state constitution calls for public utility rates to be “fair and reasonable,” and two groups of ratepayers have filed objections to the county’s plan of debt adjustment, in part on that basis. The state attorney general has also said Jefferson County’s current sewer rates are unconstitutional, let alone future increases, which have already been ratified by the county commission. No precedent exists for a clash between a federal bankruptcy ruling and a state constitution.

But Jefferson County has told the court that its plan of adjustment should be confirmed because “it is the result of extensive, arm’s-length, and good faith negotiations” and that its creditors have voted overwhelmingly to approve it. The county will also be able to point to its recent, successful debt sale as evidence that the markets believe its financial plans are feasible, something the court must confirm in approving the county’s exit from bankruptcy.

The hearing that begins Wednesday is expected to last several days.

Issuing the $1.8 billion in new debt is central to Jefferson County’s exit plan, and officials have spent recent weeks pitching the deal in financial centers like London, Hong Kong, New York, Boston and Chicago â€" as well as Birmingham, which is the county seat and a regional banking center. Most of the proceeds will be used to pay cash settlements to the holders of the county’s outstanding sewer-revenue debt, worth about $3.1 billion when the county defaulted in 2008.

The bondholders are to write off the remaining $1.5 billion, which Jefferson County called “a remarkable result” in a filing with the United States Bankruptcy Court in Birmingham. In effect, the transaction will extinguish the old sewer debt for 54 cents on the dollar.

When the county declared bankruptcy in November 2011, it was the largest municipal bankruptcy in United States history, although Detroit’s subsequent $18 billion bankruptcy this year has eclipsed it. The sewer-construction debacle, default and bankruptcy made Jefferson County a financial outcast, and its new debt would have been a hard sell without a special provision like the bankruptcy court’s continuing 40-year role.

The proposed exit plan is so unusual that the three largest ratings agencies have been at odds over how to evaluate the new debt at the heart of it. Standard & Poor’s rated the new debt, whose lead underwriter is Citigroup Global Markets, at the low end of its investment-grade scale, either BBB or BBB-minus, depending on whether it was insured or not. The Assured Guaranty Municipal Corporation has charged a $26 million premium to insure $500 million of the total $1.8 billion.

Fitch, on the other hand, rated the county’s new debt at the high end of its junk range, either BB-plus, if insured, or BB if not.

Moody’s Investors Service was not hired to rate the new debt, but it issued a special report on it as part of its general efforts to track distressed municipalities. It said Jefferson County’s debt seemed to qualify for a rating as low as B, indicating a “substantial-to-high credit risk.”

Moody’s and Fitch said they were concerned that the new debt is to be paid back slowly at first, with accelerating payments in later years that will require sewer rates to rise. The county’s rate schedule, subject to bankruptcy court approval, also includes increases to cover the cost of the remaining work to be done to bring the system into compliance with the Clean Water Act.

Fitch said its rating was preliminary and would become permanent once Jefferson County emerged from bankruptcy and completed the settlement with the current bondholders.

Its analyst, Doug Scott, said future rate increases “could spark increased political concerns, litigation, and elasticity in usage,” meaning that homeowners might vote with their feet by leaving the system. That could throw the system’s finances out of balance again. The county has also taken steps to dedicate certain property taxes to supporting the sewer system because not all county residents are on the system.

Moody’s noted in its report that “We are not aware of a precedent for a federal court to compel public utility rates of this nature, given the federalism issues involved in this bankruptcy.”