Jefferson County, Alabama, "is broke and owes more than it can pay," AEI's Alex J. Pollock explained at a conference on September 9, "and it may turn out to be the largest municipal bankruptcy ever." Although this particular crisis primarily affects the 660,000 citizens of the county that is home to Birmingham, the state's largest city, it may expose underlying problems in the municipal finance sector that could endanger the fiscal health of municipalities nationwide.

What brought Jefferson County to the brink of fiscal ruin? According to Larry Lavender, a former chief of staff to the mayor of Birmingham, decades of deferred maintenance on its sewer system led the county to promise, under federal duress, to overhaul its sewer lines within a ten-year period. Although officials initially budgeted $250 million for the project, the costs soon ballooned to $3.2 billion, and the county issued an equivalent amount in adjustable-rate sewer bonds to fund the repairs. In an attempt to hedge its interest rate risk and keep rates low, county officials--on the advice of investment bankers--entered into $5.8 billion in interest rate swaps. These swaps, however, did not hedge against the breakdown of the auction-rate bond market, and when interest rates on these bonds rose, Jefferson County had insufficient funds to cover the higher rates.

Bloomberg's Joseph Mysak Jr. said that county officials were financially unsophisticated, entering into complex financial agreements that they admit they did not understand. "The municipal market is [filled with] overwhelmingly unsophisticated issuers," he added. "People like journalists, math teachers, and bricklayers . . . [are] confronted with masses of information about how to borrow money for the school district or city or county. These are people who do not speak the language of Wall Street, so Wall Street concocts various swap and derivative products and sells them to Main Street."

Jefferson County's precarious position was exacerbated by several other financial sector problems, including the downgrading of municipal bond insurers. Richard A. Ciccarone of McDonnell Investment Management explained that as insurance companies covered more and more of the bond marketplace--at its peak, about half of the market was covered--"a lot of the traditional investors and analysts who would have screened deals weren't looking" at the details of the bonds and were relying on the mere existence of insurance to make their investment decisions.

Rating agencies also may have relied too heavily on the presence of credit insurance when ranking municipal bonds. For example, from December 2007 to March 2008, ratings of Jefferson County's sewer debt plummeted from AAA to D (for default). This decline was precipitated by the problems of the insurers, but Lavender noted that the underlying financial condition of the county never changed--and should not have merited a AAA rating in the first place. "If you look at someone who has borrowed at variable rates that can change," he explained, "and they don't have any money except to pay for the rates at the low point, how can you possibly think that they're not going to run into trouble?" Indeed, he said that the municipal bond situation is analogous to the subprime mortgage crisis, calling it "subprime on steroids."

Could this happen elsewhere? David R. Kotok of Cumberland Advisors said that the market could "cure on its own, without federal intervention," but R. Christopher Whalen of Institutional Risk Analytics endorsed government action to eliminate the use of complicated and confusing financial instruments in the municipal bond market. He argued that states should impose "draconian restrictions and limits on the types of securities and derivatives that a public agency may purchase as an investment."

For video and audio of this event, visit www.aei.org/event1773/.