Heed the Warning of Jefferson County

The sewer authority of Jefferson County, Ala., was once considered among the most sophisticated issuers in municipal finance. Now they are on the brink of Chapter 9. What happened, and can it happen to other municipal issuers?

It all started when investment bankers cooked up a clever way to use derivatives to lower interest expense for municipal issuers. The municipality would sell auction-rate debt, then enter into a swap wherein they would pay fixed and receive floating interest rates. For tax-exempt issuers, the floating end of the swap is either based on a percentage of LIBOR or the SIFMA Index, which is an index of floating-rate municipal debt rates.

The result of these transactions was a synthetic fixed-rate bond. The initial floating liability had been turned into a fixed liability via the derivative transaction. Bankers were able to show that through these machinations, even after hefty fees to the investment bank, the issuer would realize an interest rate savings.

For Jefferson County, those savings were important. They had been ordered by a federal court to make significant upgrades to their sewer system to comply with environmental standards. As a result, there has been a threefold increase in sewer rates over the last 10 years. In fact, the sewer system became highly leveraged in an attempt to spread out construction costs over time, which in turn would prevent the pain (and political embarrassment) of even larger rate increases.

Historically, auction rate municipal debt had consistently reset at or very near the SIFMA rate, which in turn was always highly correlated with LIBOR. But the recent liquidity crisis changed all that. Starting in January, auction rate municipals began routinely failing, or at best, resetting at rates considerably higher than the SIFMA or LIBOR indices. In other words, the pay-floating side of the interest rate swap was substantially lower than the actual amount being paid by the sewer system.

Because the sewer system was so leveraged, the extra interest expense was more than their budget could bear. Had they been a stronger credit, the sewer system probably could have refinanced their auction-rate debt with variable-rate put bonds. That structure offers investors a weekly put option, and therefore has not suffered the liquidity problems of auction-rate bonds. Or they might have been able to cancel the swap arrangements and refinance their debt as fixed-rate. But because of the extreme leverage employed and the rapid deterioration of what balance sheet they had, these options were not viable.

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Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.