California Bankruptcies Show Jefferson County the Cost of Fiscal Failure

John Moorlach, who became treasurer of Orange County, California, after it filed the biggest municipal bankruptcy in U.S. history in 1994, has some advice for the new record-holder, Jefferson County, Alabama.

“What they might be able to learn from us is: Who can you sue for bringing you to this crazy place?” said Moorlach, who got $800 million in settlements from Merrill Lynch & Co., Standard & Poor’s, broker-dealers and bond counsel after the county’s investment pool lost $1.7 billion when bets on interest rates soured.

Jefferson County, with more than $3 billion in sewer debt, follows Orange County in seeking court protection along with Vallejo, California, whose finances unraveled after the city failed to win labor concessions, and Harrisburg, Pennsylvania, which lost money on a trash incinerator.

“Jefferson County, however it turns out, is destined to have at least equal or substantially the same historical significance as Orange County,” said Bruce Bennett, who was the California county’s lead bankruptcy attorney.

Alabama’s most-populous county, with about 660,000 people, sought Chapter 9 bankruptcy reorganization on Nov. 9. The filing came after a deal fell through that would have cut the amount owed on sewer bonds while residents faced higher sewage fees to repay the debt. The filing leaves creditors facing hundreds of millions of dollars in losses.

Photographer: Butch Dill/Bloomberg

The Jefferson County Courthouse in Birmingham, Alabama. Close

The Jefferson County Courthouse in Birmingham, Alabama.

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Photographer: Butch Dill/Bloomberg

The Jefferson County Courthouse in Birmingham, Alabama.

Payments to Politicians

JPMorgan Chase & Co. (JPM), which arranged most of the debt, agreed to a $722 million settlement with the Securities and Exchange Commission in 2009 over payments its bankers allegedly made to people tied to county politicians to win business. That settlement included “partial compensation for its wrongdoing in connection with the sewer-system indebtedness,” Jefferson County said in court papers filed as part of its bankruptcy.

The county, whose seat is Birmingham, the state’s largest city, has been under the threat of bankruptcy for more than three years. It will return to court in December for a hearing on whether it’s eligible to be in bankruptcy.

Orange County’s initial court filings listed debt that was higher than Jefferson County’s. Much of it shrank in the early weeks of the case and the losses listed in the initial filing were reduced through lawsuits.

Vallejo, a former Navy town of about 116,000 near Napa Valley’s famed wineries and 24 miles (39 kilometers) north of San Francisco, entered bankruptcy in 2008 and emerged this year after a protracted battle with local unions.

In that time, the city cut its police by a third, forcing law enforcement to focus on violent crimes while allowing prostitution to thrive and spurring an influx of about 20 medical-marijuana dispensaries. California was the first state to legalize marijuana for medical use in 1996.

‘Draconian Cuts’

“There’s been draconian cuts in our public-safety services and other city services,” Marti Brown, a Vallejo council member, said in a telephone interview. The biggest hurdle was reaching a compromise with its unions, including police and fire, she said.

“There was a countersuit and fighting over whether or not we really had the money,” she said. “That ate up close to two years of the three and a half years we were in bankruptcy.”

Still, she said the city is better off having filed.

“The day we filed bankruptcy, we saved $32 million,” Brown said. The move let the city delay making payments on long- term debt, including bonds and bank loans, she said.

The city expects to be unable to access the credit market for five years because of its damaged reputation, officials say. Vallejo has to establish a history of dealing with its budget problems, keeping its finances in balance and making sure it makes payments, David Millican, Vallejo’s former senior adviser, said in May.

Ability to Borrow

Orange County’s ability to borrow money wasn’t harmed by its bankruptcy. Within 18 months of leaving court protection, Orange County’s credit rating had returned to AA, the same as before the filing, Bennett said. Orange County issued $1.04 billion in debt related to its bankruptcy in 1996, following a debt issuance in 1995 that was an interim step, according to Bob Franz, the county’s chief financial officer.

For Jefferson County, “because of the size of this bankruptcy and the length of time it will take to figure it all out, it will be a longer waiting period before they can issue new bonds,” said Marilyn Cohen, president of Los Angeles-based Envision Capital Management Inc., which manages $325 million in bonds, with about 60 percent in municipal bonds. On Nov. 11, Moody’s Investors Service put Jefferson County bonds on review for possible credit-rating cuts.

Meeting Tests

The first legal hurdle Jefferson County will face is a challenge to the filing itself. The county must show that it has met all the tests for being in bankruptcy, including that it has negotiated in good faith with creditors and is in danger of being unable to pay its bills.

The receiver who runs the county’s insolvent sewer system is fighting to maintain his control. Because he was appointed by a state court, John S. Young Jr. claimed in court papers filed Nov. 10 that the federal judge overseeing the bankruptcy lacks authority to return the system to the county. Young said the 10th Amendment of the U.S. Constitution, which reserves for the states powers not expressly given the federal government, trumps bankruptcy law.

The county’s lead bankruptcy attorney, Kenneth Klee, said in court that a fight over control of the sewer system’s finances may take place before the hearing next month on whether the county should remain in bankruptcy.

Klee was involved in preparing Orange County’s bankruptcy, though he left management of the case to Bennett after the petition was filed.

Years in Court

Jefferson County’s bankruptcy could last “two to three years,” Klee said in an interview, which would make it longer than Orange County’s case.

In Harrisburg, the capital of Pennsylvania, officials will go before a federal bankruptcy judge on Nov. 23. Harrisburg City Controller Dan Miller said his community can learn from Jefferson County.

“What’s happening in Harrisburg is the forces are trying to get us to pay 100 percent of the bond and still have debt left over,” Miller said in a telephone interview.

“We think if we could have a road map of the way Jefferson County negotiated -- they did several things that I think are really positive that are not what’s going to happen here,” Miller said.

Jefferson County didn’t sell its assets, instead negotiating a more than $1 billion reduction in its debt, and the state was going to help refinance the rest, Miller said.

“I would very much like to see us pursue a similar deal of what Jefferson County was able to achieve,” Miller said.

Miller said he didn’t expect Harrisburg’s services to diminish in the near future.

Debt Services

“We are in this position where we haven’t made any debt service payments, so we haven’t been forced to make those cuts,” he said.

The Pennsylvania city hasn’t been able to borrow for about five years, he said.

“Our debt is so tremendous we have to pay it off,” Miller said. “Borrowing is the last thing we should be doing.”

The city recently borrowed $7.4 million to balance its budget through the Harrisburg Parking Authority at an inflated 10.7 percent interest rate, Miller said.

Harrisburg and Jefferson County have one thing in common: the unwillingness of bondholders to negotiate a deal acceptable to elected officials, said Mark Schwartz, the attorney who filed the Harrisburg bankruptcy petition on behalf of the city council.

Local Politics

“I think that being before a federal bankruptcy judge takes the local politics out of the situation,” Schwartz said by e-mail. “I believe that bankruptcy does give Jefferson County an advantage in negotiating with bondholders and more importantly the investment bankers and lawyers who brought this plight to the residents.”

Schwartz will be in federal court next week trying to persuade a judge not to throw out the case. Harrisburg Mayor Linda Thompson and Pennsylvania Governor Tom Corbett have both asked that the bankruptcy be dismissed. Thompson said the four council members who hired Schwartz to file the case violated local law, while Corbett says the filing wasn’t authorized by the state, as required under Chapter 9.

Jefferson County is the 12th municipality to file for bankruptcy this year. Three were by small governments: Harrisburg; Boise County, Idaho, and Central Falls, Rhode Island. The rest were special-purpose districts or public- benefit corporations eligible to use Chapter 9.

Diminished Services

In Birmingham, Lora Perry, a 43-year-old public school teacher, said she was concerned the county’s bankruptcy would result in diminished public services, including safety, job cuts, larger class sizes and longer lines for services such as car tags.

“It’s just a bad thing,” Perry said after lunch at a downtown food court last week. “We’ll be dealing with this for a long time. This is just the beginning.”

The case is In re Jefferson County, 11-05736-9, U.S. Bankruptcy Court, Northern District of Alabama (Birmingham).

To contact the reporters on this story: Alison Vekshin in San Francisco at avekshin@bloomberg.net; Steven Church in Birmingham, Alabama at schurch3@bloomberg.net

To contact the editors responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net; John Pickering at jpickering@bloomberg.net

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