Bankruptcy Filing Raises Doubts About a Bond Repayment Pledge

Birmingham, Ala., is in Jefferson County, Alabama's most populous county. The county's debt totals $4.1 billion.

People who own what is considered the safest type of municipal bond may be in for a surprise.

This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.

But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.

“We all want to know, ‘What’s the truth here?’ ” said Richard A. Ciccarone, chief research officer at McDonnell Investment Management. “The way I learned it, full faith and credit was considered all the taxing power of a community, and that means there’s an infinite pledge. When you get into bankruptcy court, truth is something that can be revealed in a new way.”

Jefferson County filed the biggest Chapter 9 bankruptcy in United States history last month, raising new uncertainty about the safest municipal bonds. Court precedent offers few answers. Municipal bankruptcies are rare, and most have involved tiny, special-purpose districts that did not even have general-obligation bonds, having issued revenue bonds, which are considered riskier because they guarantee repayment solely from money generated by a specific project like a toll road.

The few places that have gone bankrupt with general obligations outstanding have sent reassuring signals, making payments even though they were not required to in bankruptcy. Orange County, Calif., the previous Chapter 9 record-holder, took a few extra months to pay some maturing debt, but it compensated investors for the delay by giving them almost a full percentage point more interest than it otherwise owed them.

The small city of Central Falls, R.I., has been duly paying its general-obligation debtholders in Chapter 9 this year, bolstered by a new state law giving those investors priority over everybody else.

Jefferson County, by contrast, is taking advantage of the automatic stay granted in bankruptcy, which bars creditors from demanding payments or grabbing collateral. Officials say they stopped sending cash to the county’s paying agent in November and will not send any money this month, either.

Bankruptcy experts have long known that in theory a municipality could use the stay to revoke its full faith and credit pledge, but they have not watched a big distressed city or county go through with it. “You’ve got a case here where the rubber has hit the road,” said Kenneth N. Klee, a bankruptcy lawyer representing Jefferson County, whose debt grew out of poorly conceived efforts to finance a court-ordered rebuilding of its sewer system.

The county’s nonpayment is not its only surprise. Like many places, it used newfangled instruments to circumvent constitutional limits on how much debt it could legally issue. In Alabama, counties are required to hold a referendum before issuing any general-obligation bonds. So Jefferson County has not issued such bonds since the 1950s. Instead, it issues warrants, which look nearly identical but do not require the referendum.

Official disclosures promote the county’s warrants as “general obligations,” toward which “its full faith and credit have been irrevocably pledged.” Sounds good, but what does it really mean? Conventional wisdom has it that if a government defaults on a general obligation, its creditors can take it to court, where the judge will order it to raise taxes — as much as it takes, no matter how painful.

But that now appears to be a hollow threat in Jefferson County. Counties in Alabama do not have the legal authority to raise taxes. Only the state can do that.

“There’s a lot of uncertainty, generally, about what full faith and credit means,” said David A. Skeel Jr., a law professor at the University of Pennsylvania. “There’s a whole debate about whether these obligations are ever enforceable. And this is even apart from the weird situation you’re referring to, where the county is pledging its full faith and credit but doesn’t really have the ability to do that.”

Mr. Klee, the county’s bankruptcy lawyer, said about 40 percent of America’s counties appear to be in the same boat, issuing full faith and credit debt even though they have no legal authority to raise taxes, as the term implies.

In Jefferson County, Alabama’s most populous, which includes Birmingham, officials say they had to stop paying even their general obligations because they were draining the cash they needed for essential services.

“Jefferson County made a very different decision than Rhode Island did,” Mr. Klee said. “Rhode Island put bondholders ahead of its citizens, and Jefferson County is not going to do that.”

He called the notion that a full faith and credit pledge was inviolate, and that a debtor must honor it even in bankruptcy, “a myth and a scare tactic.”

“It’s a very reasonable step on the part of the county commissioners to conserve the money to deal with the crisis within the county,” he said, adding that he hoped that in the end the general-obligation debtholders would be paid in full, but he did not know if there was enough money. Finding out could take years.

Most of Jefferson County’s $4.1 billion of debt is, in fact, the revenue type, which does not raise such profound questions because investors know that type can default.

The big question is the general obligations, and the debtlike devices — warrants in Jefferson County’s case — that look like general-obligation debt but turn out to be something else upon closer inspection. The county has a smaller amount, roughly $200 million, of that type outstanding. A little more than half of it, $105 million, had a payment due in November. But that is when Jefferson County filed for bankruptcy, so it invoked the automatic stay and stopped sending the cash.

So far, there has been no outcry because those payments were due to just two financial institutions, JPMorgan Chase and Bayerische Landesbank. Both have been following the events in Jefferson County closely and were not caught by surprise.

But come April, another group of investors is owed a payment on a separate batch of general-obligation warrants worth about $96 million.

County officials said they do not know who holds that debt, but believe some are individual investors, who could be stunned to find themselves caught short after being told they were buying the county’s best paper.

That group of warrants is insured by a unit of MBIA, but it is unclear what would happen if investors filed a claim.

Other insurers, with policies on the county’s revenue debt, have already sued JPMorgan, Jefferson County’s lead underwriter, accusing it of committing improprieties and failing to disclose an engineering report that said early on that the county was getting in over its head.

Mr. Klee said that if investors were shocked to find their supersafe debt could stop paying, they should blame the banks and bond professionals who sold it to them without explaining what could happen in the event of a bankruptcy. He also suggested they take their complaints to the Alabama State Legislature and ask it to appropriate the money to service the debt.

But that could be a lost cause in the age of “no new taxes” and Occupy Wall Street. The State Legislature is averse to backstopping Jefferson County, either as an act of fiscal irresponsibility or a backdoor bailout for the banks.

“The issue of full faith and credit,” Mr. Klee said, “is whose full faith and credit?”