An American Meltdown

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America is on the verge of having “the largest municipal bankruptcy ever,” said David R. Kotok, Chairman and Chief Investment Officer of Cumberland Advisors, while at the American Enterprise Institute (AEI).

AEI released a report to show just what financial state Alabama is actually in. “Jefferson County, Alabama has to declare bankruptcy. The county needs protection from creditors, from bankers, from politicians-and from itself,” AEI found. “Jefferson County has issued $3.2 billion in adjustable-rate sewer bonds. Jefferson County, in an attempt to hedge its interest rate risk-entered into $5.8 billion of interest rate swaps, more than any other U.S. county.”

“This hedged position turned into huge losses as a result of financial market illiquidity, and the county now owes banks more than it can pay,” said Kotok.

“I’m concerned about the people that would let people make decisions like this,” said Richard A. Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, “Problems develop when the expectations of the borrower and lender prove to have been too optimistic. Such optimistic expectations may lead many individual borrowing units into accepting future commitments dangerously large in relation to their resources and without sufficient allowances for possible future emergencies.”

“The failure with Jefferson County was not only individuals, but with the system and single-member districts,” said Larry Lavender, Republican staff director of the House Financial Services Committee. “The county couldn’t even balance their books; they even hired outsiders to oversee it and they couldn’t manage it either.”

Lavender, who is also a native of Jefferson County, explained that “Jefferson County is an industrial town. It is relatively prosperous, having 660,000 people, but does have a pocket of poverty.”

“The crisis we are facing in municipal bonds is large and could be systemic,” Ciccarone said. “We have liability now that we didn’t have before, not even during the Great Depression.”

“In the aftermath of the bond insurance crisis, there have been cries from members of Congress and state and local finance officers that the recent low default rate on municipal bond governmental issuers relative to all global borrowers begs for a wholesale upgrading of municipal bond ratings,” according to a study released by McDonnell Investments on April 14, 2008. More than likely, as the study indicates, “bond ratings on state and local government obligations would substantially be lifted to AAA and AA levels.”

“The intellectual foundations of financial regulation today rest on three pillars: greater transparency, increased disclosure and more rigorous risk management by firms,” said Christopher Whaler, managing director at Institutional Analytics in Torrance, California. “For not only does the consensus fail to address the problem of systemic risk –and liquidity is above all a systemic issue—it also fails to recognize that the enforcement of a common approach to risk management enhances the homogeneity of the behavior of market participants and hence exacerbates financial crisis.”

In July 2008, Peter J. Wallison released an AEI statement claiming, “subprime mortgage brokers unconcerned about the quality of their loans, subprime borrowers taking loans they knew they could not repay, sloppy underwriting by lenders, condo-flippers hoping to sell their properties before the mortgage reset, impenetrably complex securitized instruments created by financial whiz kids, poor rating agency models, shoddy risk management at banks, laziness or inattention by investors, irresponsible sales practices by securities firms, and ineffective supervision by regulators are all elements that are properly cited as contributing causes.”

In the end, Lavender explained in light of Jefferson County’s municipal bond scandal, 21 people are now facing criminal charges or financial civil suits.

Irene Warren is an intern at the American Journalism Center, a training program run by Accuracy in Media and Accuracy in Academia.