Municipal Bonds Freeze Up

Interest payments soar for cities and counties, some of which loaded up on complex derivative deals similar to ones that swamped many banks

Like other credit markets, municipal bonds are nearly frozen. During the week of Sept. 22, three significant bond deals were done. Normally the tally would be about 100. Those that are getting done—like New York City's Sept. 29 deal—are high-priced.

What's worse, untold dangers may lurk just beneath the forbidding surface of the muni market. Some locales set up complicated derivatives deals with the now-defunct Lehman Brothers and other troubled New York banks. Shedding those investments can be costly and complicated.

Even before the tumultuous past few weeks, many municipalities were facing fundamental problems: quickly rising pension costs, aging roads, and large drop-offs in income and real estate tax revenue. A lot of governments had moved away from safer, fixed-rate bond issues, leaving them vulnerable to a sharp rise in those rates over the past two weeks. These factors could add up to serious trouble for scores of communities.

Going Bankrupt?

An ominous potential harbinger is the case of Jefferson County, Ala. (, 9/28/08), which includes the city of Birmingham. Jefferson borrowed more to build a sewer system than it could repay and entered into damaging derivatives contracts with JP­Morgan Chase (JPM). The derivatives, known as swaps, were private contracts designed to allow the municipality to tap into then-lower variable rates, but give them a predictable payment more like a fixed-rate bond.

Instead, Jefferson has seen its interest payments soar and now seems poised to declare bankruptcy before the end of this week unless it can come to some resolution with creditors. It would be the largest U.S. municipal bankruptcy ever—a development that's likely to make investors even more skittish.

"Unsettling" is how Lasana Mack, treasurer of the District of Columbia, describes the muni-bond landscape. Like many places, Washington borrows to pay its long-term bills, and sometimes its short-term ones. A climb in short-term rates, from 2% two weeks ago to over 7% this week, has already cost the capital hundreds of thousands of dollars (though Mack estimates that prior to the current problems, the district was saving about $15 million a year using the strategy).

Mack's biggest worry: close to $1 billion in new borrowings scheduled for sale in November and December. He has no idea how much interest he will have to pay, or whether he'll find any buyers. "Nothing," he say, "is really functioning normally."

Exposed and Vulnerable

Like residents who took outsize mortgages on risky terms, local governments have greatly increased both the amount they borrow and their exposure to rate increases. According to ThomsonReuters, total municipal borrowing has more than doubled this decade, from $195 billion in 2000 to $425 billion last year. (Next year, Thomas Doe, CEO of Municipal Market Advisors, a research firm in Concord, Mass., says that could fall to $300 billion to $350 billion.) So far this year, one in three borrowed dollars came with a fluctuating rate, compared with one in five in 2000.

Variable borrowing was fine when short-term rates were low. But in the past few weeks rates have soared as investors backed away.

Waiting for a Partner

At the same time, problems have emerged in the swaps used to minimize municipal vulnerability to just this sort of volatility. The counterparties to the local governments in many of these contracts are the investment banks so quickly going down, leaving some municipalities to hunt for new partners to take over the deals.

So far, most have been able to do so without extreme difficulty, but the pool of eligible replacements may be shrinking. When Lehman went bankrupt on Sept. 15, Gary Breaux, finance director of the East Bay Municipal Utility District in Oakland, Calif., found several bidders interested in two swaps he had with that bank. He chose Bank of New York for a $44 million contract. The bigger one, $69 million, he placed with Belgian-French lender Dexia. Just two weeks later several European governments had to put $9 billion into Dexia after its shares fell 30% and its CEO stepped down. If Dexia falters again, the fear is that Breaux might have to find yet another replacement with fewer options to choose from.

In the municipal market, warns Richard Ciccarone, chief research officer at McDonnell Investment Management in Oak Brook, Ill., "major risks are usually the convergence of multiple smaller risks."

Before it's here, it's on the Bloomberg Terminal.