A Crappy Wall Street Deal Produces Nation’s Largest Ever Municipal Bankruptcy, Finally

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Marvin Gentry / Reuters

A manhole cover bears the logo/design of Jefferson County, Alabama August 9, 2011. Alabama's Jefferson County submitted a second offer to creditors in an attempt to settle its $3.14 billion sewer bond debt, the county commission president said on August 8, 2011. Commissioner David Carrington gave no details of the contents of the latest offer. Jefferson County is struggling to avoid what would be the largest municipal bankruptcy in U.S. History.

Jefferson County has long been the canary in the municipal bond market coal mine – a sign that there were big problems brewing in the market for local government debt that could spread like the bank problems in 2008, and we fear Italy and the rest of Europe’s debt problems now, to the rest of the economy. Indeed, last year, Meredith Whitney, the bank analyst who famously and correctly alerted the world to the problems growing at the nation’s largest banks before the financial crisis, loudly predicted that we could soon see a destabilizing wave of muni-bond defaults.

So it’s easy to see Jefferson County’s bankruptcy, which was filed late on Wednesday and at over $4 billion is the largest municipal bankruptcy in U.S. history (Orange County, Calif., for reference, was a $2 billion bankruptcy), as a sign that the crisis Whitney predicted is now going to play out. Want more evidence? Jefferson is only the latest in a string of recent muni-bond defaults that have been filed in the past few months, including Harrisburg, Pa., Central Falls, R.I., and Boise County, Idaho.

The problem with that logic is that Jefferson County’s bankruptcy will be no surprise to anyone in the muni-bond market, or even a regular reader of national news. Indeed, it turns out municipal bankruptcies are like asteroids, apparently we can see them coming years in advance. Even before the government set up the TARP bank rescue fund, county officials in Birmingham, which is Alabama’s largest city and located in Jefferson County, were calling the Treasury Department and telling officials there that it was their county and not the banks that needed a bailout. A very good Fortune story called Birmingham on the Brink which the magazine published in October of 2008 said Jefferson County’s bankruptcy filing was almost certain, and it implied imminent. Three years and nearly a month later, here we are.

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Jefferson County’s problems stem in part from a, quite literally, crappy Wall Street deal. In the early 2000s local official realized that they had spent too much updating their sewer system, which had regularly overflowed in heavy rains. The sewer system’s alone accounts for $3 billion of Jefferson County’s overall debt. There was no way the fees generated by the sewer system could pay the interest on the debt building it had run up.

Wall Street, thankfully, had a solution. Jefferson County’s financial advisers, lead by JPMorgan Chase, told the county to refinance its sewer debt into something called auction-rate securities – a trick that would allow the county to pay lower short-term interest rates on what was long-term debt. The trick would dramatically lower the county’s financing costs. Some local officials called it magic.

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We now know that the deal, instead of being praised, should have been flushed down Jefferson County’s costly sewer system. Like many other crafty Wall Street creations, auction rate securities blew up in the financial crisis, and Jefferson County’s interest payments shot up, higher than if they had just stuck with their long-term bonds. Worse, along with the refinancing deal, JPMorgan sold Jefferson County a package of interest rate swaps – insurance that was supposed to protect the county from swings in interest rates. Instead, that insurance ended up costing the county over $200 million when the financial crisis struck. Since then, there have been a number of deals to try to save Jefferson County from bankruptcy. A year ago, it looked like the Governor had struck a deal to save the county, but that was based on a new refinancing effort, which eventually unraveled.

(MORE: Are muni bonds about to crash?)

But the point is that municipal bankruptcies take a while, and they are often the result of unusual, and often negligent behavior – a number of Jefferson County officials have gone to jail, though, perhaps unsurprisingly, no one from the Wall Street side of the deal. Harrisburg and Central Falls, too, were well known problem areas. What are Americas other most financial troubled towns or counties? It’s not clear, or at least there are not large enough to be a worry. So Whitney was right to say that the finances of local governments, which are often sinking under the weight of generous pension plans, are generally in bad shape. But could this be the beginning of wave a defaults? Probably not.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel. You can also continue the discussion on TIME‘s Facebook page and on Twitter at @TIME.

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