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Tuesday, April 15, 2008

Jefferson County, Alabama May Declare Bankruptcy

City and state governments have a special perk. When they issue bonds, the interest payments are exempt from Federal income taxes. Coupled with negative real interest rates, this is a huge incentive for local government to issue debt.

Local government typically have a large amount of debt. Negative real interest rates are an incentive to fund projects out of debt instead of an accumulated tax surplus. Why should a local government have a revenue surplus, when its value would merely be eroded by inflation?

That's the inherent flaw with debt-based money and negative real rates. The incentive is to fund projects via debt instead of accumulated savings.

During the bust phase of the business cycle, the weakest debtors are forced into bankruptcy. The current economic bust isn't over yet, and now it's Jefferson County's turn. There hasn't been an official bankruptcy filing yet. Jefferson County has defaulted on its bonds, because it missed an interest payment.

Jefferson County can't be fully bankrupted. Via property taxes, Jefferson County's government has full allodial title to all land in the county. Via income taxes, Jefferson County has full allodial title to all labor performed in the county. The only question is who pays for the loss. Do Jefferson County's residents pay, or do the financial industry insiders pay? (Hint: The financial industry always wins.) Either taxes will be raised, or government services cut, to pay the financial industry its tribute.

I heard two conflicting reports about how Jefferson County got into trouble.

When a local government borrows money, it does not need to IMMEDIATELY spend that money on a project. It merely needs to be earmarked for a project. In the meantime, the proceeds can be invested. A local government borrows at an artificially low rate. A local government can profitably issue bonds and invest the proceeds elsewhere, such as subprime mortgages. Jefferson County invested the proceeds of its borrowing in subprime mortgages, and got shafted when the subprime market collapsed. When you borrow at 4% and buy bonds that yield 5%, that's a sure profit. When you borrow at 4% and buy bonds that yield 2%, you're headed for ruin.

The second explanation involves interest rate swaps. Jefferson County switched from issuing fixed-rate bonds to variable-rate bonds. Then, Jefferson County bought interest rate swaps to protect it from changing interest rates. That makes absolutely no sense to me. If you're going to issue variable-rate bonds *AND* hedge, then why not issue fixed-rate bonds in the first place?

By making the transaction more complicated, extra transaction fees and commissions are paid. Further, the true cost of complicated derivative transactions can be hidden. Insiders lobbied Jefferson County's politicians to give them lucrative debt contracts and huge commissions.

There's another risk of complicated hedges. If you calculate the hedge wrong, you wind up *AMPLIFYING* your risk instead of decreasing it. I suspect that Jefferson County miscalculated its hedge, and is now in trouble.

If Jefferson County could roll over its debt by issuing new bonds, inflation would eventually run its course and Jefferson County would be fine. However, Jefferson County's creditors are demanding payment *NOW*. With a junk credit rating, Jefferson County cannot roll over its debt by issuing more bonds. Jefferson County is ruined by the Compound Interest Paradox. If taxes are "temporarily raised" to pay the creditors, that tax increase willl probably be permanent.

Jefferson County's problems are merely one symptom of a corrupt economic and political system.

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