The perfect dung storm: Part 1, falling into the muck

September 12, 2011 | Birmingham, Jefferson County, Municipal finance, Sovereign bankruptcy, Subprime, Theory, US News, Water and sanitation, Workouts

By: David A. Smith

 

In terms of being a perfect dung storm (corruption dung, financial dung, political dung, and human dung) nothing in my experience rivals the fiscal catastrophe that is the Birmingham/ Jefferson County sewer mess, a decade-long crapfest that may culminate this Friday, coincident with the finish of this five-part post, with the nation’s largest municipal bankruptcy filing.

 

 [I’d call it the perfect shit storm except for AHI’s self-imposed language editorial guidelines.   – Ed.]

 

Don’t go down there; it’s not worth a plugged nickel

 

Birmingham’s perfect dung storm has everything: crooked politicians, rampant overspending, bare-knuckle workout negotiations, and complex multi-level politics – and at the beginning and end of the story, we have both poor people and bondholders getting the short end of the stick.

 

Got a wife, got a family

Earn my livin’ with my hand

I’m a roller in a steel mill

In downtown Birmingham

Randy Newman, Birmingham

 

Greatest city in Alabam’

 

Jefferson County’s mess is also a precursor in microcosm – a Spanish Civil War to World War II, as one might say – of what lies ahead for the Eurozone, and may indeed lie ahead the State of California or even the nation itself.

 

There are lessons for everyone here, and they are all painful: lessons for those who are not concerned about the prospect of mounting debt, for those who insist that steep cuts can be relatively painless, for those who think the bill for big spending can safely be put off into the future, for those who have blind faith in the market and for those who think the government can always be relied upon to protect the interests of the people.

 

Because the newspapers track the story by its updates, not its themes, I’ve reordered the tidbits, drawing from four principal sources (distinguished by different fonts):

 

New York Times (July 30, 2011), Debt Crisis? Bankruptcy Fears?

Wall Street Journal (August 11, 2011), Impact on Poor Bedevils Deal

Bloomberg News (August 18, 2011), Jefferson County Needs Hostile Legislature’s Help for Deal

The Birmingham News (August 22, 2011), Jefferson County Officials to Meet with Creditors

 

First, let’s set the stage.

 


All the men and women merely players:

Jefferson County’s current commissioners, praying before the opening of a session

 

1.  Where we are now: the story in brief

 

Like many a good storm, this one has been building for some time.

 

The story that ends in overspending excess began in neglect: in 1996, the federal government accused Jefferson County of sending raw sewage into area rivers and demanded that it rebuild its dilapidated sewer system.

 

Presumably the feds had photographs of spewing pipe to prove their charge, in which case Jefferson County had long been getting away with one, making its neighbors pay what it would not. 

 

Garret Hardin of tragedy of the commons fame

 

That’s a classic example of tragedy-of-the-commons risk, shoveling the crap onto thy neighbor’s plate, the same exclusionary-zoning thinking that exiles affordable housing to the blue-collar town next door to the tony suburb.  And the solutions are similar – the obligation must be imposed equally across the sub-jurisdictions by a higher level of government – and if the state will not do it, then the national government must.

 

Such a project would be costly, but officials hoped to avoid unpopular rate increases –

 

From the beginning, Jefferson County has shown a willful refusal to accept financial reality, in a classic example of public-choice risk.

 

first by pushing that cost into the future, and then by adding a maze of derivatives that were supposed to shield the county from interest-rate increases.

 

Remember, the ‘maze of derivatives’ could be appealing to public officials only if they thought, against all common sense, that somehow the derivatives were economic phlogiston, lowering costs without risk or payments. 

 

Enter the financial maze, roll the big fuzzy dice?

 

But the bond deals were fraught with pay-to-play scandals. Four county commissioners were convicted of taking bond-related bribes. Two bankers are fighting federal accusations that they made secret payments.

 

And of course, they didn’t work.

 

Jefferson County, home to Birmingham and more than 658,000 residents, has been in fiscal straits since a sewer-bond refinancing collapsed more than three years ago during the credit crisis.

 

That’s a lot of debt, and a lot of variable debt

(Auction-rate debt is variable debt also.)

As I’ve posted many times before, there ain’t no such thing as free infrastructure.  If a community seeks to get away cheaply by under-maintaining its system, it will pay later, and if it seeks to wriggle out of paying what it should, it usually take risks that cost even more:

 

The collision of poverty and Wall Street is the latest twist in a financial drama that has haunted the county for about three years. The sewer debt involved a complicated series of interest-rate swaps and other terms that soured during the financial crisis, causing Jefferson County to default.

 

Often the day of reckoning is imposed either by the courts or by a higher unit of government.

 

The refinancing involved what court-appointed receiver John Young described in a report as a borrowing binge to pay for improvements ordered by the federal government.

 

The ‘binge’ consisted of $3.14 billion in municipal bonds, starting with a 1995 EPA consent decree regarding sewer overflows.

 

Ohhhh … need to throw up some of those bonds

 

At about $4,775 in new indebtedness per Jefferson County resident, if we assume a typical bond’s debt service constant is 8.0%, that implies the county sewer commission thought that somehow, some day, it could reap another $381 per person per year in net operating income (after the change in costs of operating the sewer facility).

 

[Actually, the per-capita numbers are quite a bit worse than these, but I’ll save that as a treat for later in the post. – Ed.]

 

Anyhow, Jefferson County defaulted in 2008, then thrashed about like a fish on a hook for a couple of years.  Now, for just about a year, the Jefferson County sewer department has been run by a court-appointed receiver, John S. Young, who has a third of a century’s experience as a senior executive at a New Jersey-based investor-owned water and sewer company.  Mr. Young has done things that should have been done years ago, and certainly before the county racked up three billion plus in new debt:

 

“We’ve put together the first long term business plan that the environmental services department has ever had,” he said Thursday. “We have presented, in my interim receiver’s report, efficiencies that we have achieved or are planning as far as staffing is concerned … power consumption, fleet management, procurement and a number of other areas where we believe we can save money.”

 

About six weeks back, he presented a plan of reorganization – the latest in a series that had been surfaced, mooted about, and rejected by one party or another – with these principal points:

 

Four points in a five-part post

 

Point 1.  Forgive or cancel some of the debt.  Everyone agrees that the current levels of debt principal are unsustainable (the more so as they piled up through accruals from the county’s previous misadventures in high finance). 

 

Bondholders have offered to forgive about $1 billion in debt issued by Alabama’s most-populous county, which includes the city of Birmingham.

 

From a financing perspective, this is a big element: the creditors have long since accepted the notion that they are going to suffer some pain – indeed, a lot of pain.  But how much pain is still a substantial bone of contention, and will be right up until the final reckoning.

 

If only it were that easy

 

Point 2. Reschedule the remaining debt so that the county will be able to pay its restructured debt service going forward. 

 

In the workout field, I call this the “break the arm once” rule.  Basically, people will accept a one-time readjustment, almost any size one-time readjustment, but they really, really want to believe that what they write off now is all they will write off.  There’s little point in going through the trauma – both psychological and financial – of restructuring unless it cures the disease. 

 

Please do it only once, okay?

 

Point 3. Boost sewer system revenue.  The county will raise its water and sewer charges as part of an overall improvement in water/ sewer authority management efficiency, and use the increased net cash flow to pay debt service on the restructured bonds.

 

Along with sharing the misery, workouts are predicated on the principle that whoever winds up in control of the operating property must demonstrate that it is acting in a strong fiduciary capacity, meaning caring as much about the creditors’ recovery as it does about the customers (or, in a public agency, the elected officials or the populist voters).  The county must earn its forbearance by earning investor confidence, which it does by showing it’s working hard to maximize revenue.

 

Look, we’re working really hard now, and we’ve cut out all the fat in our budget

 

Point 4. Involve the state’s stronger credit rating.  The new Jefferson County debt will be buttressed, in one form of another, by assurances from a higher level of government – the State of Alabama.  That assurance can be beneficial in two ways: (1) Directly, by reducing the risk of default.  (2) Indirectly, by allowing the new restructured Jefferson County bonds to be rated higher, and therefore to carry lower interest rates.

 

Absolutely nobody trusts the Jefferson County Authority – after the sorry tale of extraordinary corruption (for details, tune in tomorrow), nobody is willing to bet that the rats won’t return.  Any new debt-related promises the county makes are viewed as barely better than worthless, so many parties want the State of Alabama to put its own credit or credibility behind Jefferson County’s pledges of penance.

 

We’re sorry we borrowed $3.14 billion we can’t repay; our bad

 

Sidebar: recapitalizing defunct sub-sovereign entities

The Eurozone example

 

The above four points are central to the recapitalization of any sub-sovereign entity.  For instance, the ongoing Eurozone bailout arguments can be seen precisely through this lens:

 

1.     Forgive or cancel.  Endless discussions are now circulating as to whether holders of (say) Greek debt will accept discounted payoffs, either overt (actual restructuring) or ulterior (coerced swaps, attenuated repayments).

 

2.     Reschedule the rest.  Most of what the Greek borrowers will use to pay off their old debt will be new Eurozone debt of one form or another.

 

3.     Boost issuer revenue.  Calls for Greece to reduce its budget deficits, delay retirement benefits, raise taxes, or reduce tax evasion are all simply devices to maximized Greek bond-paying power.

 

4.     Involve a higher credit rating.  As no one trusts the Greek government (or future Greek governments), demands are being made for Germany and France to back the new Greek debts.

 

And this is what the Greeks say about themselves!

 

While these four provisions can be universally seen as necessary in the abstract, it’s in the numbers that all the contentions lie.

 

Find your way through the complications

 

[Continued tomorrow in Part 2.]