Jefferson County kicked in the ARS

For the past few years its has been hard to ignore America’s crumbling infrastructure, from the devastating breach of New Orleans’s levees after Hurricane Katrina to the collapse of a big bridge in Minneapolis last summer. In 2005 the American Society of Civil Engineers estimated that $1.6 trillion was needed over five years to bring just the existing infrastructure into good repair. This does not account for future needs. By 2020 freight volumes are projected to be 70% greater than in 1998. By 2050 America’s population is expected to reach 420 million, 50% more than in 2000. Much of this growth will take place in metropolitan areas, where infrastructure is already run down.

Now the good people of Jefferson County, Alabama, will this November vote on a $3.2 billion bill for a new sewer system that threatens to push Jefferson into the largest municipal bankruptcy ever, beating easily the Orange County, California default of 1994. Jefferson’s predicament sums up the growing crisis in U.S. local finance. Investing in new pipes to clean up its rivers, the county turned to Wall Street for innovative financing. Unusually, it was all done at variable rates, about two-thirds through auction rate securities (ARS), all hedged with interest rate swaps. But with ARS about as popular as raw sewage, Jefferson’s costs have soared.

Simply raising customer charges is problematic. Standard & Poor’s reckons most households in Birmingham – the state’s largest city, in Jefferson County – already pay a high 4% of median income in water fees. Meanwhile, Jefferson relies on vulnerable property and sales taxes for 30% of public revenue, so options are limited.

No wonder politicians have batted the issue to the people, in effect asking them if they want to pay more or have the county declare bankruptcy. Alarmingly, the head of Alabama’s state pension plan is urging voters to choose the latter. Higher taxes are never popular and most voters will probably be unaware that despite bankruptcy, Orange County had to pay its bondholders eventually, and suffered spending cutbacks and higher taxes for years. Messy litigation would almost certainly ensue. Wall Street, already paying for the ARS debacle, should also be worried: stories of city-dwellers having their water cut off due, in part, to derivatives bets gone wrong will not play well.

Jefferson’s crisis serves to re-emphasize one of the biggest challenges faced by politicians: the spreading economic impact on Main Street of America’s credit binge.