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Homeowners aren't the only ones sweet-talked into adjustable-rate trap

April 7, 2008 —  It’s the fiscal narrative that dominates today’s headlines: Cash-strapped homeowner gets sweet-talked into an adjustable-rate loan, only to land in hot water when the mortgage goes up. But what happens when, instead of a homeowner, the debtor is a big urban county?

That, roughly, is the fix Jefferson County is in. The Alabama county, which includes Birmingham, faces what would be the biggest municipal bankruptcy in the nation’s history, twice the size of the 1994 Orange County, California, debt default. And it’s largely due to factors similar to those which have wrecked havoc in the domestic housing market.

“With any good analogy, things break down on closer scrutiny, but I do think it’s correct that the borrowing appetite of Jefferson County got out of control, which is a prevalent American problem,” said Robert Brooks, professor of financial management at the University of Alabama.

JeffCo’s slide into insolvency began six years ago when Charles LeCroy, then a managing director at JPMorgan Chase, convinced the county to refinance the debt for its sewer system improvements into adjustable rate loans, and launch off into a complicated series of debt swaps as a hedge against any future spike in rates. LeCroy later served three months in prison for corruption in an unrelated Philadelphia bond deal.

By that time, the county’s financial problems had begun to multiply.

The county’s $3.2 billion in sewer bonds – part of an overall county debt of $4.6 billion – have since been downgraded to junk status, and their cost to the county is rising at a staggering $2.5 million a week.

The county has suggested diverting money intended to finance its education bonds in order to avoid default, and is negotiating with its creditor banks to find a way out of the mess. But Moody’s Investors Service, in its message downgrading all the county’s bond issues in March, chided the county for the “lack of a concrete plan” to avoid default.

The Securities and Exchange Commission is looking into whether Larry Langford, former county commission chairman and now mayor of Birmingham, may have violated the law in steering some of the bond transactions to a financial supporter and former Democrat state party chairman, William Blount. But the overarching story of JeffCo’s fiscal woes seems less about possible criminality than obvious gullibility.

Its activities in the swap market “never made much sense,” Brooks said, with as much as $2 million in unexplained costs, by his calculations, on a single $75 million swap. The added costs which can be attributed to fiscal mismanagement, he said, “has to approach the hundreds of millions.”

“There was no notion of pay-as-you-go,” Brooks said.

The fancy financing was intended as a way to avoid passing on the costs of the county’s federally mandated sewer improvements to its residents. But sewer rates for residents have quadrupled over the past decade, and when divided up, the total debt amounts to $11,491 per residential customer.

Like your former neighbor down the street, Birmingham may have been especially reckless, but as a dizzying variety of financial instruments like derivatives become available, the potential pitfalls for local governments have increase.

Mayraj Fahim, a local government advisor who writes for the City Mayors website,

said she was a “very big fan” of North Carolina’s system, which monitors municipal bond issuances and provides advice to municipalities. she sees more states moving to a system as the complexities of municipal finance increase.

“Somewhere down the line, the states are going to have to get more involved. I wouldn’t be surprised to see more defaults.  Local government officials don’t have the capacity to understand these complicated instruments,” she said.

Brooks defended the use of derivatives, noting that used correctly, they can be like a CAT Scan in their ability to resolve specific problems. But used incorrectly, he added, “they can be like putting a 19-year-old with no flight training in an F-16.”