Bloomberg News recently featured the following headline and story, “Alabama County Sued by Bond Insurers Amid Stalled Debt Talks”. Jefferson County was stung this year by its reliance on bonds with interest rates that periodically reset, a strategy promoted by Wall Street as a way for borrowers to save money by giving them short-term interest rates on debt that didn't mature for decades.

The bonds were paired with interest-rate swaps meant to protect against rate swings. County officials have said they can't raise sewer rates enough to cover the increased interest costs, and proposals to use taxes the county collects to pay for the sewer encountered opposition from some local citizens and commissioners.” One thing this financial crisis will be is simulative for the legal industry. As we speak, the lawyers are parachuting into the financial markets which by all accounts are in a tizzy akin to the clichéd rats jumping off and deserting a sinking ship. Credit markets are frozen, the Fed is engaged in commercial lending, branches of government are countermanding each other and the courts are clogged with mountains of legal action. Completed litigation thus far has been limited to governmental entities suing banks and brokerages for misrepresentation or other forms of subterfuge. In that regard this is a unique scenario, that of public entities defaulting on their debts.

According to the Bloomberg story, “The companies filed the lawsuit in U.S. District Court in Birmingham yesterday asking that a receiver be placed in charge of the sewer system.” Syncora Guarantee Inc. and Financial Guaranty Insurance Co., the insurance companies involved in the dispute, had issued a guarantee of $2.8 billion to the banks against default. For all intents and purposes a default has already occurred. The insurers will have to pay investors the entire amount in default. Like other so called “insurers”, these companies keep ridiculously small reserves because default never occurs. The municipal bond insurance market has been nothing more than collecting premiums for over 50 years. At these levels one default is enough to bankrupt an entire company. So when the county goes bankrupt, most likely, so do the insurers.

The banks and investors that hold the original bonds will then be forced to take the entire loss onto their balance sheet. Insurance companies like MBIA and AMBAC who have already sustained enormous losses on mortgage insurance, now face the prospect of total annihilation when low risk municipal bonds start to default. Without any insurance to rely upon, investors and banks alike will attempt to disgorge themselves of the now high risk bonds that make up an incredibly large portion of America’s investment portfolio. According to Bloomberg “should the county renege on all of its sewer debt, it would be the largest municipal bond default in U.S. history, exceeding the Washington Public Power Supply System's $2.25 billion default in 1983 of revenue bonds sold for nuclear plants. A bankruptcy would be the largest for a U.S. local government since Orange County, California, sought protection in 1994.”

TIME LINE OF THE CRISIS

Fannie and Freddie Rescue September 7, 2008

Lehman Brothers Bankrupt September 15, 2008

Merrill Lynch Sells Out September 15, 2008

NY Fed Lends AIG $85 Billion September 16, 2008

Short Selling Stopped September 18, 2008

U.S. Bailout Revealed September 19, 2008

Washington Mutual Collapse September 26, 2008

$700-Billion Rescue Proposal September 27, 2008

Bailout Deal Defeated September 29, 2008

Wachovia Bank Sold September 29, 2008