Distressed Volatility

And you thought the sub-prime mortgage market was bad, take a look at Jefferson County, AL. Yea a county, which is supposed to act like a low risk muni-bond credit. Turns out Jefferson County made some risky interest rate swap transactions against $3.2 billion of debt originated mostly by J.P Morgan. In the early 1990s Jefferson County had sewage problems and was sued by it's residents, so it was forced to incur fixed rate debt backed by sewer/water revenues to rebuild the infrastructure. The financial problems started when the County took advice from J.P Morgan to refinance their fixed rate debt into variable rate and auction debt, or long term bonds auctioned off on a short term basis (weekly to monthly) which kept interest rates low. The County also bought interest rate swaps as a hedge against their variable rate debt, which would indirectly create a fixed-rate bond (bank pays County 1-Month Libor, County pays bank fixed rate on swap). Later on the County even got cash up front by structuring a swap where both parties were obligated to pay a % of 1-Month Libor, with the bank adding .49%. (read the Bloomberg article below). This was all done for large unnecessary fees ($100 Million) to the bank, which could have been used to pay down their debt!.

In early 2008, the sewage hit the fan when the auction rate market froze and banks refused to be the buyers of last resort which caused interest rates to double. On top of that, Moody's and S&P downgraded the County's insurance company FGIC that insured the bonds, which in turn forced investor liquidations and boosted rates even higher. And to finish it all off Moody's and S&P cut Jefferson County's debt rating to junk due to their debt service coverage issues. Eventually Jefferson County couldn't pay their interest payments and defaulted on billions of dollars now owed to swap obligees, and debt holders through insurers. Weren't those interest rate swaps supposed to hedge against interest rate risk? The swaps were not protecting against default or marketability (failed auction) risk which spiked up their interest costs. The swaps were protecting against floating market rate risk since the County refinanced into variable rate debt. In Feburary of 2008, floating market rates were actually moving lower while Jefferson County's interest rates were spiking, so the hedge worked against them. Below is a chart of one of the sewer bonds which is distressed yielding 21%. More information on this sewer bond can be found at finra.org. (Sources: Bond Buyer, Businessweek, Bloomberg, BusinessStandard).


Jefferson County, AL Sewer Revenue Capital Improvement Bonds
As of 10/8/2008 (Last Sale) - Finra.org


It's also interesting that it looks like both the banks and the County are trying to hold off a bankruptcy court hearing for as long as they can, and from this article it looks like Jefferson County is trying to squeeze tax revenue from other sources.

October 13, 2008
"Jefferson County commissioners spar over sewer debt solutions

A Jefferson County commissioner in favor of bankruptcy said today that bringing an opposing sewer debt rescue plan to the state Legislature will draw gambling into the solution talks. Commissioner Jim Carns, who favors declaring Chapter 9 bankruptcy, said Commission President Bettye Fine Collins "better be careful" moving forward with a plan to get legislative approval for using excess education sales tax money toward reducing the $3.2 billion debt. "Because if it goes to the Legislature, gambling will be part of the scenario, in my opinion," Carns said. Carns comments followed a committee meeting earlier today and touched off the latest controversial exchange between commissioners at odds over solutions to county's sewer debt crisis." Source Al.com

Here's a 2 part video on BloombergTV interviewing Christopher Taylor, the former Executive Director of the Municipal Securities Rulemaking Board, about Jefferson County, AL.







This story shows that even municipalities are falling victim to the lax lending standards and risky derivatives originated in the early early 2000s. My next post will look at Municipal Bond Indexes and ETFs to watch.