March 3 (Bloomberg) -- Jefferson County, Alabama, had $3.2 billion of bonds slashed to below investment grade by Standard & Poor's, putting it at the center of turmoil in the U.S. municipal bond market that has driven up borrowing costs.

The downgrade, made after the markets closed on Feb. 29, came after the county, which includes the state's biggest city of Birmingham, said it may be unable to pay banks holding floating-rate debt for its sewer system or make payments on related interest-rate swaps. Jefferson County, with $193 million in sewer reserves, faces the prospect of having to pay more than $1 billion to banks to buy back debt and unwind the swaps.

``It's a very bad situation,'' said Robert Brooks, the SouthTrust Professor of Financial Management at the University of Alabama in Tuscaloosa.

Jefferson County is paying the price of a faltering credit market as investors and securities firms shun floating-rate securities, including auction-rate debt, guaranteed by bond insurers crippled by losses on securities linked to subprime mortgages. The county's plight shows what can go wrong for public borrowers across the U.S. who rely on financial products engineered by Wall Street and peddled on the promise of lowering costs and reducing risk at little expense to taxpayers.

The county, on the advice of JPMorgan Chase & Co., refinanced about $3 billion of sewer debt in 2002 and 2003 using floating-rate debt, including bonds with rates set at periodic auctions, mostly insured by FGIC Corp. and XL Capital Assurance.

Insurer Downgrades

After the insurers' ratings were cut from AAA in January, rates on the county's debt soared to as high as 10 percent when dealers failed to find buyers for the debt or use their own capital to purchase the securities. The county said it paid $6 million more in interest on its sewer debt in the four months ended in January.

Compounding the problem, interest-rate swaps the county bought 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 have declined, pushing interest costs higher.

The county, in a notice to investors on Feb. 28, said it could ``provide no assurance'' that revenue from the sewer system would be sufficient to pay its increasing debt costs. The disclosure prompted S&P to lower the county's sewer debt by six levels to B, five steps below investment grade, and keep the bonds under review for possible further downgrade.

The downgrade pushed the price of Jefferson County sewer debt lower. A $20,000 block of bonds traded at 78.23 cents on the dollar for a 7.846 percent yield. That compares with a trade of $25,000 of bonds Friday at 99.6 cents on the dollar for 5.041 percent.

Swap Squeeze

The county may be forced to terminate its $5.4 billion of swaps at a cost it estimated at $184 million because its bond rating has dropped so low.

Jefferson County Commission president Bettye Fine Collins didn't return a call seeking comment.

Bloomberg News reported in August 2005 that the county paid fees of $100 million on 11 of its 17 swap contracts, about twice what banks collected for similar deals.

The Securities and Exchange Commission has subpoenaed current and former county commissioners about whether anyone involved in the sewer financings committed securities fraud or failed to disclose ``improper payments made in exchange for municipal securities business,'' court records show.

Dealers Back Off

About $2.2 billion of the county's sewer debt consists of auction-rate securities. The county has experienced failed auctions on $869.45 million of the debt, causing rates to rise to as high as 6.25 percent, up from 4.7 percent.

Dealers that run the bidding to set yields on auction bonds aren't buying unwanted securities as they once did, triggering thousands of failures since last month. Bankers who help to find buyers for so-called variable-rate demand obligations are also declining to hold the debt when they can't attract investors.

Jefferson County has $847 million of variable-rate sewer debt insured by FGIC and XL Capital. The insurers' downgrades may cause Birmingham-based Regions Bank and Paris-based Societe Generale, who agreed at the time of the initial bond sale to repurchase unwanted county floating-rate debt, to terminate their agreements. That would force the county to buy back the bonds.

``It is unclear how the county would be able to meet this obligation,'' Moody's Investors Service said on Feb. 27, when it cut its rating on the debt to its lowest investment grade of Baa3. As of Jan. 31, the county's sewer fund had $193 million, Moody's said.

Options

Jefferson County may reach a forbearance agreement with banks while it restructures its debt to supplement or strip out the insurance.

The state may also provide a mechanism to assure investors that the county's debt will be repaid, said James Spiotto, a lawyer with Chapman and Cutler LLP in Chicago who specializes in municipal bankruptcy law.

It is unlikely that the county would seek bankruptcy protection, an avenue of last resort that has been taken by 554 municipal entities out of 55,000 since 1937, most famously by Orange County in 1994, he said.

``There are ways of providing market support,'' said Spiotto, chairman of the National Association of Bond Lawyers' committee on bankruptcy. ``You don't want to be the person who shut down the sewer system.''

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

Last Updated: March 3, 2008 18:26 EST