Wednesday, March 12, 2008

The Credit Crunch Hits Jefferson County Alabama

The credit crisis triggered by the subprime mortgage meltdown has claimed its latest victim: Jefferson County, Alabama and investors in the county’s municipal bonds and auction-rate securities.

Jefferson County’s troubles began in 1996 when a federal court action resulted in the county agreeing to update its aging and polluting waste water facilities. The county used swaps to borrow $3.2 billion to pay for its new sewage system. About $2.2 million of the sewer debt consists of auction-rate securities. At this time, the county has experienced failed auctions on $869.45 million of the debt and is underwater in its swap transactions by some $360 million. This makes the viability of Jefferson County questionable and investors in Jefferson County’s debt may sustain significant losses.

In addition, Jefferson County’s bond insurers, Financial Guaranty Insurance Co. and XL Capital Assurance Inc. were hit with credit downgrades recently. These downgrades affected the market for short-term municipal bond debt, including auction-rate securities and variable-rate demand notes. As a result, the county’s interest costs on their debts rose from 3%-4% to as high as 6%-10%. Following this increase, the credit-rating agencies began cutting ratings. On February 27, 2008 Moody’s downgraded the county to B3 from A3.

Auction-rate securities have been popular with issuers like state and local governments, colleges, universities, hospitals, charitable organizations, cultural institutions and other non-profit entities because financing costs are low, no third-party bank support is required and there are usually fewer parties involved in the financing process.

Until recently, auction-bond failures were a relatively rare occurrence. Unfortunately, this is no longer the case. As Martin Braun reported in a February 13, 2008 article on Bloomberg.com, during the past few weeks, investor demand for the securities has declined precipitously as a result of increasing skepticism regarding the credit strength of insurers backing the underlying debt obligations, and the reluctance of banks like UBS, Citigroup and Goldman Sachs to submit bids and risk holding too many bonds. Indeed, nearly half of the $20 billion in securities put up for auction on February 12 failed to generate sufficient interest among bidders and none were sold. Merrill Lynch recently announced that it is reducing purchases of auction-rate securities that fail to attract enough bids from investors, and UBS has decided that it simply will not buy such securities at all. Investors' concerns about the credit ratings of the bond insurers backing the securities essentially caused the failure of these auctions.

For Jefferson County, all these factors have caused its lenders, Bank of America, Bear Stearns Cos., J.P. Morgan Chase and Lehman Brothers, to demand $200 million for additional collateral to support obligations the county owes them. To date, Jefferson County has refused to meet the banks’ demands or to produce additional collateral. The county now faces tough choices on how to raise additional money to cover the debt or face default.

It is not just the county experiencing pain. Investors in auction-rate securities have also been hurt. Many investors — individuals and institutions alike — who purchased the bonds believing that they were safe, low-risk securities equivalent to cash, now find themselves holding an investment for which there is no market. Several investors have already taken legal action against the brokers who sold the securities. Merrill Lynch, for example, is a defendant in a Texas action in which Metro PCS alleges that the firm misrepresented the risks involved and the suitability of the securities under the company's guidelines. Lehman Brothers is the respondent in a FINRA arbitration complaint filed by two wealthy New Jersey brothers, alleging that the firm's investment of $286 million in auction rate securities was inconsistent with the claimants' stated investment objectives. Additional investor suits against other firms are likely to follow.

No comments: