March 6 (Bloomberg) -- Jefferson County, Alabama, in a move that may cost it $184 million, said it wouldn't pledge reserves against $5.4 billion of interest-rate swaps tied to sewer debt that its bankers may demand.

While county officials say filing for bankruptcy isn't being considered, they concede it's an option. That prompted Standard & Poor's to lower the county's general obligation bond rating three levels to A from AA. Earlier today, the company cut the $3.2 billion sewer debt three levels to CCC, the eighth highest non-investment grade, and said the rating could move up or down in the short-term.

``With county officials still discussing the option for county bankruptcy, depending on the outcome of these discussions, there could be an impact on holders of the county's other warrants and bonds,'' said S&P analyst James Breeding in a news release.

Jefferson County, its interest expense on $3 billion in floating-rate obligations skyrocketing, is caught in a faltering credit market that has more than doubled costs for many borrowers in the municipal-bond market. Investors are no longer willing to trust much of the insurance backing the bonds, as the guarantors face subprime mortgage losses, leaving the county paying interest rates as high as 10 percent.

The county, which includes Birmingham, confronted a March 7 deadline to put up the $184 million in collateral or buy insurance to meet its obligations to JPMorgan Chase & Co. and three other banks on 13 swaps after S&P and Moody's Investors Service began downgrading the sewer debt last week.

`Difficult Decisions'

``The county commission faces difficult decisions on the sewer system debt. However, these decisions will not be made at the expense of the county's employees,'' Jefferson County Commission President Bettye Fine Collins wrote in a memo to the workers.

The county's $270 million of general obligation debt was cut by S&P, reflecting ``uncertainty as to whether the sewer system's deteriorating credit quality could potentially disrupt other county revenue flows,'' S&P said.

While Collins said filing for bankruptcy was an option, ``its not something that they're considering,'' said Leigh Butler, a Collins aide. The county will not cut jobs, dip into its pension fund or curb health and other benefits to generate cash to bail out the sewer system, Collins wrote to employees.

Jefferson County, with a population of 660,000, ended its 2006 fiscal year with a $42.6 million general fund balance. Only $11 million was cash and investments, S&P said. The county currently has about $82 million of cash on hand. A separate sewer fund has about $105 million.

Backfiring Swaps

Compounding the problem, interest-rate swaps the county bought from JPMorgan, Bear Stearns Cos., Bank of America Corp. and Lehman Brothers Holdings Inc. to shield it against rising borrowing costs have backfired. The floating rates it pays on its bonds have climbed while the variable rate banks pay the county under the agreements has declined, pushing interest costs higher.

In a disclosure to investors late yesterday, the county said the counterparties to its swaps could terminate them ``upon notice to the county, in which event the county would be obliged to pay the resulting termination payment.''

JPMorgan spokesman Brian Marchiony and Lehman spokeswoman Kerrie Cohen declined to comment on whether they would terminate the swap contracts. Spokespeople from Bear Stearns and Bank of America couldn't be reached immediately. The firms are all based in New York except Bank of America, which is located in Charlotte, North Carolina.

Cash on Hand

The county's sewer fund had $193 million as of Jan. 31, according to Moody's. In a Feb. 20 disclosure, the county said its sewer construction fund declined to $105 million, after it withdrew $59.8 million from the account to pay debt service on the sewer bonds.

Financial advisers and lawyers for the county met with bankers in New York earlier this week to discuss a possible debt restructuring, Collins said in an interview March 4. She didn't immediately return a call seeking comment on the latest disclosures.

The county, on the advice of JPMorgan Chase & Co., refinanced about $3 billion of sewer debt in 2002 and 2003 using floating-rate debt, mostly insured by FGIC Corp. and XL Capital Assurance, whose coverage is rated A and A-, respectively, by S&P.

$6 Million Additional

After the insurers' ratings were cut from AAA in January, rates on the county's floating-rate bonds soared when dealers failed to find buyers for the securities or use their own capital to purchase them. The county said it paid $6 million more in interest on its sewer debt in the four months ended Jan. 31.

The surging debt costs initially led credit-rating companies to cut the county's sewer bonds to near junk status. That, in turn, triggered clauses in bond and derivative contracts that gave banks the right to force the county to post collateral on the swaps and buy back as much as $847 million of floating-rate debt.

Officials in a Feb. 28 notice said they were unable to assure investors that revenue generated by the sewer system would be sufficient to pay the obligations, which are payable from customer bills. That led S&P to cut the county's sewer debt rating to B and Moody's to lower the ranking to B3, both below investment grade.

CCC Rating

The latest S&P sewer bond rating of CCC means that county's debt ``is currently vulnerable to nonpayment,'' according to S&P's ratings definitions. ``In the event of adverse business, financial, or economic conditions, however, the obligor is not likely to have the capacity to meet its financial commitment on the obligation.''

County fixed-rate sewer debt insured by FGIC and maturing in 2027 traded as high has 92.6 cents on the dollar today and as low as 82 cents on the dollar for a 7.126 percent yield.

Municipal bond lawyers who specialize in distressed issuers say that the county would declare bankruptcy as a ``last resort'' because it would effectively freeze the county's ability to borrow and create a stigma that may last for years.

About $2.2 billion of the sewer debt consists of auction- rate securities, long-term securities whose interest rates are set every 7, 28 or 35 days. The county has experienced failed auctions on $869.45 million of the obligation, causing rates to rise to as high as 6.25 percent on Feb. 25, up from 4.7 percent on Jan. 22.

Auction-Rate Conversion

The county is likely working to convert its auction-rate securities to floating-rate debt and will purchase a bank letter of credit to guarantee the debt, generating a higher rating.

``In one form or another, they want to eliminate FGIC and XL,'' said Scott Fairclough, a New York City-based investment banker with Birmingham-based Sterne, Agee & Leach Inc., which has proposed a restructuring plan to the county.

Lastly, the county could sell or lease the sewer system to a private buyer to pay off bondholders.

As of Dec. 31, the county had $2.4 billion of interest-rate swaps on its sewer debt with JPMorgan, $1.6 billion with Bear Stearns, $643 million with Bank of America and $190 million with Lehman Brothers.

It also has additional swaps with JPMorgan on other bonds.

In a swap, two parties agree to exchange payments over a period of time that can last as long as 30 years. Typically, one agrees to pay a fixed rate and the other to pay a variable rate that changes with a benchmark index or formula defined in the contract.

The contracts generally have provisions requiring the parties to pledge assets in the event their credit rating is lowered to a certain level.

To contact the reporter on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net;

Last Updated: March 6, 2008 18:42 EST