Sept. 17 (Bloomberg) -- Jefferson County, Alabama, was sued by bond insurers Syncora Guarantee Inc. and Financial Guaranty Insurance Co., seeking to strip local officials of control over the sewer system that has pushed the county toward bankruptcy.

The companies filed the lawsuit in U.S. District Court in Birmingham yesterday asking that a receiver be placed in charge of the sewer system, which doesn't make enough money to cover the interest on $3.2 billion of debt, the two said in a statement. The insurance companies guarantee $2.8 billion of the bonds against default.

The lawsuit is intended to pressure officials of Alabama's most-populous county following months of talks with insurers and banks led by JPMorgan Chase & Co. over the debt, whose interest costs have tripled in the past year. County commissioners scrapped a plan to divert tax money to the sewer system and are preparing to file for bankruptcy should talks falter.

``We felt the talks were at a standstill,'' said John Williams, a managing director for Syncora in New York. ``This is in very large part designed to restart those talks in a real fashion.''

Jefferson County was stung this year by its reliance on bonds with interest rates that periodically reset, a strategy promoted by Wall Street as a way for borrowers to save money by giving them short-term interest rates on debt that didn't mature for decades. The bonds were paired with interest-rate swaps meant to protect against rate swings.

The strategy backfired this year, when Syncora and Financial Guaranty lost their top credit ratings following losses on mortgage-related securities. That caused investors to shun the Jefferson County sewer bonds they insured, pushing the interest rates as high as 10 percent in February from 3 percent the month before.

Fuel on Fire

The county's interest and principal payments on its bonds have since swelled to $460 million a year, more than twice the amount it collects in revenue, according to former county financial adviser James White, the president of Porter White & Co.

Since April, the county has won reprieves from banks led by JPMorgan and the bond insurers to give it more time to negotiate an agreement. The latest agreement expires at the end of September, and Commissioner Jim Carns said the lawsuit may not help advance talks between the county and Wall Street.

``This does not do anything except throw gasoline into a fiery situation,'' Carns said.

Jefferson County has proposed raising sewer rates 2.85 percent annually and exchanging about $3 billion of floating- rate debt for fixed-rate bonds with lower interest rates and longer maturities.

`Far Greater Loss'

County officials have said they can't raise sewer rates enough to cover the increased interest costs, and proposals to use taxes the county collects to pay for the sewer encountered opposition from some commissioners and local citizens. Creditors balked at the county's latest plan.

Officials proposed ``a far greater loss than we think our policyholders should be expected to bear,'' Williams, the Syncora executive said.

Should the county renege on all of its sewer debt, it would be the largest municipal bond default in U.S. history, exceeding the Washington Public Power Supply System's $2.25 billion default in 1983 of revenue bonds sold for nuclear plants. A bankruptcy would be the largest for a U.S. local government since Orange County, California, sought protection in 1994.

The suit filed by the insurers yesterday adds to the legal thicket surrounding the Jefferson County sewer system, whose costs were more than double initial estimates.

Officials Sued

In 2007, former Commissioner Chris McNair, who was in charge of the sewer department, pleaded guilty to conspiracy to commit bribery for accepting money from a contractor. In April, the Securities and Exchange Commission also sued Birmingham Mayor Larry Langford, a former county commissioner, for failing to report that he received $156,000 from the head of a regional underwriting firm that earned $6.7 million from county bond deals, including the sewer debt. At least two lawsuits have also been filed against banks by taxpayer groups.

The insurance companies in their lawsuit say that even before the credit crisis slammed the county, officials failed to raise sewer rates enough to meet obligations to bondholders. According to the lawsuit, a consultant advised that sewer rates would need to rise 13 percent a year between 2004 and 2011, while the county's increases have been ``well below'' that amount.

Naming a Receiver

The insurance companies said a receiver should be appointed with the power to raise revenue and run the sewer system. In California, the prison hospital system was placed in the care of a receiver because of lawsuits over inadequate care.

Courts are typically reluctant to take such steps, said Thomas Richey, chair of Powell Goldstein LLP's securities, corporate and fiduciary litigation group in Atlanta.

``It's pretty uncharted water,'' Richey said. ``Receivership is considered to be a very serious remedy and one that the courts do not like to impose just to act. There's a natural reluctance on the part of courts to impose receiverships.''

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

Last Updated: September 17, 2008 00:01 EDT