Swaping small problems for bigger ones in Alabama

NY Times:

In 2002, a banker named Charles E. LeCroy arrived here with a novel pitch to ease taxpayers’ burden. Some Wall Street wizardry, he said, could lighten their load.

Six years on, officials here are still struggling to untangle the financial web that Mr. LeCroy and his fellow bankers spun. Jefferson County is teetering on the brink of bankruptcy after a series of exotic bond deals that the bankers concocted went wrong, and the interest on its debts, rather than shrinking as the bankers had promised, has ballooned like a bad subprime mortgage.

Officials from Birmingham, the county seat, are trying to persuade Wall Street creditors to let them soften the terms of the deals. If they fail, the county could sink into in one of the biggest public bankruptcies in American history.

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During the last few years, Jefferson County entered into a series of complex transactions, called swaps, worth a staggering $5.4 billion. The accusations and recriminations are flying. Talk of Wall Street tricks — and local corruption — has captivated residents and left many wondering how the county will pay its bills.

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As a managing director at JPMorgan Chase, Mr. LeCroy persuaded the county to convert its debt from fixed interest rates to adjustable rates. He also recommended that the county use interest-rate swaps that he said would protect it if interest rates rose.

Mr. LeCroy, however, is no longer in the bond business. He landed in prison for three months in 2005 in connection with a municipal corruption case in Philadelphia. He has left JPMorgan Chase and declined to comment for this article.

Mr. Langford, now the mayor of Birmingham, previously oversaw the county’s finances. He says he had no idea what Mr. LeCroy and the many other bankers on the deals were doing, and he asked for Mr. Blount’s help in vetting their proposals.

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Mr. LeCroy, first as a swap adviser and broker with Raymond James and later with JPMorgan, helped the county sell bonds to pay for the upgrade. But in 2002, after Mr. Langford was elected county president and vowed to rein in costs, Mr. LeCroy urged the county to reduce its interest payments by refinancing its debt and switching to adjustable rates from fixed rates. As a hedge, he recommended swaps.

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The county ended up with 18 different swaps at one point, an extraordinary number for a county government. The notional value of the swaps surpassed the value of the bonds they were supposed to hedge.

Mr. Langford agreed to the plan — and in the process locked Jefferson County into borrowings that may ruin the county, even though they have richly rewarded its bankers.

Last week, the county warned that it did not have enough money to cover the hedges, which ended up costing it money when rates moved in unexpected ways. The situation became critical when the insurance companies standing behind the bonds had their own credit ratings downgraded. Officials are trying to work out a stabilization plan, but the outcome is far from certain.

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For now, the residents of Jefferson County are bearing the burden of the ill-fated deals. Residents’ sewer rates have tripled. And, residents say, the sewers still do not work properly.

Political subdivisions use financial advisers to calculate the consequences of debt financings. The financial adviser is supposed to run debt service calculations along with cash flow analysis that can let the issuer know what taxes or fees will be required. Adding swaps to the equation in an attempt to adjust the payments enormously complicates the the calculations. With the numbers being tossed around in this article, it appears that the county's debt became highly leveraged beyond reason. I suspect that this happened because the early swaps did not perform as anticipated and more were added in order to bail out the bad ones. This had the effect of accelerating the problem. From reading the story, it appears the mess was the result of a real team effort in incompetence. People who did not understand the transactions failed to say whoa, explain this to me. The fiasco followed.