Description

Name:                                  Jefferson County Sewer Bonds 6.25% due 2042 (472682LN1)            

Maturity:                              2/1/2042

Bond Price:                           ~70c

Issue Size:                           $55 million

Total Pari Passu Debt:            $3.2 billion

Shares/Market Cap:               0 / NA (please note the share count and market cap in the table above are placeholders; this is an all debt capital structure) 

Status:                                In default under Chapter 9 – Municipal Bankruptcy

Trade Recommendation: Long 6.25% Jefferson County Sewer Bonds ’42

Synopsis:

The 6.25% Jefferson County Sewer Bonds due 2042, in the low 70s, are meaningfully mispriced and offer a compelling long opportunity for the following reasons: technical overhang due to motivated, uneconomic selling by standby purchasers of sewer bonds unable or unwilling to hold bankrupt municipal bonds, and uncertainty regarding the Chapter 9 bankruptcy process given the limited precedence.

The long thesis for the bonds is based on the following: (1) operational restructuring including an increase in sewer user rates to national levels, improvements in the sewer system’s billing/collection process to reduce delinquent accounts to industry averages and increasing the number of paying customers via greater “hookup” enforcement authority; (2) independent governance and oversight of the sewer system to reduce political influence; (3) inflection point in the case given the Judge’s recent ruling in favor of the bondholders; and (4) legal action and potential equitable subordination of JPMorgan’s ~$1.2 billion pari passu claim.  It is worth noting that shortly prior to the bankruptcy filing, the County proposed a term sheet which included a 25% increase in sewer user rates over 3 years, a $750 million settlement with JPMorgan, a haircut of $250 million for all other creditors and provided for a ~87c recovery to the bondholders.

I believe the combination of advanced settlement discussions prior to the filing, operational restructuring and a strong legal case for equitable subordination provide downside protection in the low 60s (10-15% downside) and potential upside of a par recovery (30-40% upside) to the bondholders.

Business/Situation Description:

Brief History:

The System was established by the Alabama State Legislature in 1901 for the express purpose of protecting all the streams and water courses throughout Jefferson County and ensuring that all the County’s residents have access to a clean water supply. Since its creation, however, the System has never had the necessary funds to fulfill its stated purpose. The severe lack of funding led to a County Commission declaration in 1931 that the System was overloaded and obsolete. By 1941, the System was in disrepair and grossly inadequate to serve the sanitary needs of the County. A 1948 consultant report urged the County to incur $22.5 million in immediate repairs for the System and future maintenance costs of $1 million per annum. The County committed less than $200,000 from its annual sewer ad valorem sewer tax in response. The County finally obtained an amendment to the Alabama Constitution in 1949 that authorized the issuance of bonds to fund improvements to the System and allow sewer service charges to support the bonds and expenses of operating the system. While the County now had the power it needed to adequately fund the System, it still lacked the political will to “tax” its residents. From 1948 to 1996 the pattern of inadequate funding continued. A combination of lack of motivation to make the politically unpopular decision to raise sewer rates (which were unchanged for 20 years between 1951 and 1971, and more recently since 2008) and two main structural barriers preventing the efficient operation of the system ultimately led to the intervention of the Federal Government and the EPA in 1996 with a Consent Decree. The two structural barriers were: 1) divided responsibility between the County and various municipalities (“munis”) for collection and treatment – the munis were only responsible for smaller sewer lines that collect wastewater from residents (not treatment or discharge) while the County was responsible for construction and operation of the larger trunk lines that collect the wastewater from those smaller lines, as well as facilities to treat the wastewater before discharge; because the munis were not responsible for treating and discharging the wastewater before being collected by the larger lines they had little incentive to make the necessary investment to maintain their local collection systems; and 2) lack of mandatory hookup enforcement – prior to 1996 the munis were responsible for enforcing ordinances requiring residents to “hookup” to the system. However, because the munis were not responsible for the treatment of the wastewater they had little incentive to enforce the unpopular hookup requirements and risk the potential political fallout from the decision. The proliferation of non-connected homes and businesses reduced the size of the customer base available to share in the increasing costs to maintain the system.

The 1996 EPA Consent Decree

Recognizing the poor state and “non-compliance” of the System coupled with the aforementioned structural impediments, the Consent Decree ordered the County to take over responsibility for the local collection systems from the munis. As a result, the total miles of pipe in the County’s collection system grew by two-thirds and County assumed responsibility for over 2,000 miles of local sewer lines that had never been properly operated and maintained. Through the Consent Decree, the EPA set compliance objectives for the County to meet. The County was responsible for creating a plan and raising the financing to fund the improvements. The financial responsibility for complying with the Consent Decree and other regulations falls on the County and, possibly, the State, which was also party to the Consent Decree. The Consent Decree did not, however, give the County the clear authority to enforce mandatory hookup in the areas formerly governed by the munis – this authority is commonplace in sewer systems across the country including multiple municipal systems in Alabama. According to the Receiver’s June 2011 report, the inadequate muni lines were the cause of more than 60% of sewer system’s environmental problems.

The Financing and the Default

In the absence of a comprehensive plan or budget, the County engaged in unchecked borrowing and took on unsustainable levels of debt. The underlying political goal was to maintain the status quo and postpone any rate increases, even if doing so exposed the County to financial risk. Between 1997 and 2004, the County engaged in a series of complex financing, refinancing and swap agreements upon the advice of JPMorgan that ultimately saddled the County with unsustainable leverage. The County ultimately raised $3.2 billion in long-term fixed and variable rate debt to carry out remediation and upgrade the System, but without a long-term financial plan on how the debt would be serviced. In 2003, the County even ignored its consultants’ recommendations to immediately raise rates. Owing to a combination of insufficient financial resources, the failure of its bond insurers, the accelerated amortization of certain bonds and an inability to refinance its near-term debt, on February 28^th, 2008, the County issued notice that it would not be able to make its debt service payments. The County’s credit rating was downgraded to junk the next day. Various lawsuits were filed against the County by the Indenture Trustee for the bonds over the ensuing months and years, and the Federal Court declared the County in default of its obligations in July 2009. Despite the appointment of a Receiver (similar to an examiner) to develop a plan to identify operational inefficiencies in the System, increase waste water rates and help negotiate a deal between the County and the creditors, the parties were ultimately unsuccessful in arriving at a consensual resolution and the County filed for bankruptcy on November 9^th, 2011.

Investment Process:

1)       Why are the Sewer Bonds mispriced? Why does the opportunity exist?

• Technical overhang - “motivated selling” by standby purchasers of bonds (mostly banks that were “put” the bonds by money market funds and other par holders) unable or unwilling to hold municipal bonds in default.
• Uncertainty of the Chapter 9 Bankruptcy Process – In a typical Chapter 9, the “enterprise system” (sewer system in this case) and its bondholders would be protected by the Special Revenue Exemption covenant and not be subject to the automatic stay preventing payment. In this case, however, as the unwieldy debt leverage of the System is the principal cause of the filing, there is limited precedence and case law to restructure the debt backed by the revenue of an enterprise system. While a term sheet was proposed by the County to the bondholders, no resolution came from it and in fact, the filing has created uncertainty in terms of both process and timing. Case in point, shortly after the filing, the Judge ruled in favor of the County’s motion to transfer the System’s management back to the County and remove the Receiver.

I believe these two factors have created a temporary overhang and present a compelling long opportunity in the bonds:

i)         Operational Restructuring:

• Increase in sewer user rates – sewer user rates, the principal source of the System’s revenues, have not been increased since 2008. According to the Receiver’s interim findings, “there is no question that the 2008 rate levels are insufficient to meet the System’s costs for 2011 and beyond”. The Receiver retained Citi and Black & Veatch (utility consultant) to advise on the appropriate framework for rate increases and funding needs. In the Receiver’s 1^st interim report in June 2011, he recommended an immediate rate increase of 25% which is in line with the EPA’s financial impact guidelines. The current average customer sewer cost is $426 per annum, which represents 0.92% of the service area median household income. The proposed increase would raise the annual cost to 1.15%, well below the 2% “high” financial impact outlined by the EPA. The County’s term sheet included the 25% increase, but spread over three years, and inflation-indexed thereafter.
• Upgrade the billing and collection system – the Receiver retained SAIC, an engineering consultant, to analyze the efficacy of the System’s billing and collection procedures. The review also covered other ways to improve administrative efficiency such as cost allocation procedures, legal and utility expenses and outsourcing opportunities. SAIC has concluded its review and recommended a number of new and revised policies which is estimated to reduce annual operating costs by ~8% by 2013.
• Enforcement of mandatory hookup – the lack of authority to enforce sewer hookup is a major impediment to an efficient operation of the system. The Receiver and several consultants have submitted formal recommendations to the Bankruptcy Court that the County receive the “desperately needed authority” to increase the base of ratepayers and more equitably spread the cost to all those who benefit from the system’s operation. It is estimated that the number of customers could increase by 20%.

ii)       Independent Governance:

• Overhaul in governance and oversight of the System – the Receiver has also recommended that the State Legislature enact an Independent Public Corporation (IPC) to monitor and govern the operation, maintenance and financial position of the System, including the authority to raise user rates. The goal is to remove County politics from efficient governance and operation of the System. An IPC is a central demand of the bondholders in reaching a consensual “Plan of Debt Adjustment”.

iii)      Inflection Point in Bankruptcy Process:

• Positive Ruling on Capital Expenditures for Creditors – on July 2^nd, 2012, the bankruptcy Judge ruled in favor of the bondholders and against the County by upholding the definition of “Operating Expenses” as determined under the bond indenture. Capital expenditure is excluded from the definition and can only be incurred after the payment of financial costs. The County essentially sought to circumvent its obligation to the creditors and include capital expenditure in operating expenses. This declaration is an obvious setback for the County and victory for the bondholders, and creates an inflection point in the case on a few fronts: (i) the Judge formally upheld the bondholders’ rights as defined by the Indenture thereby removing any uncertainty regarding the creditors’ claim on the System’s Net Revenues; (ii) the ruling may serve to accelerate settlement discussions given the County’s pressing need to fund the System’s annual capex program and avoid another Consent Decree; and (iii) this is the 1^st  major ruling against the County since the filing indicating that the Judge is not predisposed against the creditors. 

iv)      Legal Action and Strong Case for Equitable Subordination against JPMorgan:

• Lawsuit against JPMorgan – in November 2009, the County filed a lawsuit against JPMorgan for “fraud, conspiracy and unjust enrichment” and is seeking ~$3 billion in damages. The County has accused the bank of negligent, fraudulent and even criminal acts including devising a new financial structure for the System based on untenable leverage, bribing elected officials and other influential representatives to support JPMorgan’s plan, and discouraging market participants from bidding on sewer bond swap contracts so that JPMorgan could generate artificially inflated broker fees at the expense of the County. The bankruptcy Judge has “stayed” the complaint in an effort to incentivize a negotiated settlement.
• County Commissioner convicted – in October 2009, a jury convicted Larry Langford, President of Jefferson County Commission between 2002 and 2006, of 60 counts of bribery, money laundering and fraud in relation to the financing activities of the System with JPMorgan. Multiple other participants have also pleaded guilty to counts of conspiracy and bribery in connection with the financing transactions.
• Agreement in principle – prior to the filing, JPMorgan agreed to pay $750 million in reduced claims to settle County’s lawsuit.

2)       What is the level of mispricing? ~30-40%

• Term Sheet Framework – A useful starting point:

-          Settlement includes $1 billion haircut to current debt outstanding: $750 million to JPMorgan, $250 million to the other creditors

-          Table below includes various scenarios of equitable subordination for JPMorgan’s $1.2 billion claim.

-          Annual interest cost of $100 million and capex of $20-30 million going forward

-          Operating Revenue: 8.2% sewer rate increase p.a. for 3 years and 3.5% p.a. thereafter; number of customers remains unchanged

-          Operating Costs: County implements cost efficiency program and operating costs decline 6% over 2 years

-          Does not include enforcement of mandatory hookup 

                                                                                                                   Pre-Ch.9 Term Sheet             Equitable Subordination Scenarios

Haircut to JPMorgan’s Claim   (of the proposed cut to all creditors)                                   75%                         0%                   50%                 100%

Total Pari Passu Sewer System Debt ($M)             $3,153

Proposed Haircut to All Creditors ($M)                   $1,000

Total PF Pari Passu Sewer System Debt ($M)         $2,153

JPMorgan Claim ($M)                                          $1,200

Haircut Scenarios ($M)                                                                                            $750                        $381               $500                 $1,000

JPM Recovery ($M)                                                                                                 $450                        $819               $700                    $200

% Recovery                                                                                                            38%                        68%                58%                     17%    

All Other Creditors Claim ($M)                              $1,953

Haircut Scenarios ($M)                                                                                             $250                        $619               $500                 $  ---

Recovery ($M)                                                                                                       $1,703                      $1,334            $1,453               $1,953

% Recovery                                                                                                               87%                        68%                74%                 100%

Upside / (Downside)                                    70c (current level)                                                 25%                             -2%                      6%                      43%   

The largest customer accounts for 1.6% of revenue and the top 10 contribute 6.6%. The top 10 include institutions like US Steel, University of Alabama, Brookwood Hospital and Barber’s Pure Milk Co. In recent years, the number of active accounts have remained stable since 2006 with residential customers making up 40% and non-residential, 60%.

3)       What are the revaluation catalysts?

• General Fund getting low – the County has stated that the General Fund may run into liquidity problems by the year-end 2012 and is therefore under pressure to increase revenue. As such, the County has indicated a willingness to increase the sewer user rates and enact operational efficiency programs in the near term.
• Framework in place for JPMorgan to settle County’s lawsuit – Prior to the bankruptcy filing, JPMorgan agreed in principle to a $750 million haircut. The bankruptcy court has ‘stayed’ the County’s lawsuit against JPMorgan in an effort to incentivize parties to resume settlement discussions.
• Capex ruling should accelerate settlement discussions - The capex ruling against the County has created a sense of urgency and any agreement on rate increases and operational efficiencies is expected to be part of a broader consensual deal with creditors. The County has scheduled several meetings with creditors’ lawyers in coming weeks to discuss a consensual solution based on the pre-filing term sheet.
• Move towards emergence from bankruptcy – The bankruptcy Judge appears motivated to expedite Jefferson County’s emergence from Ch.9 and return the System back to an efficient “steady-state” of operations with adequate funding for capex. Given the combination of recent rulings (effective removal of Receiver – positive for County; stay of litigation – positive for JPMorgan; and capex ruling – positive for creditors), the bankruptcy Judge has inadvertently or deliberately created an environment conducive to “global settlement” discussions.  

 4)       What are risks to the investment?

• Lack of consensual deal and prolonged bankruptcy process – Ultimately the goal of Ch. 9 is for the County to emerge with a successful plan of debt adjustment in a timely manner. Unlike the Ch.11 process, there is no protection for creditors to terminate the debtor’s exclusivity period or propose a plan in the event the County is incapable of doing so. Additionally, there is no statutory deadline for the municipality to file a plan. Similar to Ch.11 however, in order to be confirmed, the plan must be accepted by 50% in number and 67% in amount of each class of claims that is impaired under the plan. As there is essentially only one impaired class (the System pari passu creditors), the risk of a cram-down is very limited.

 5)       Are there any free/cheap options?

• The Receiver – The Receiver was initially appointed by the Circuit Court of Jefferson County in September 2010 in response to the corruption and mismanagement of the System. In January 2012, the bankruptcy Judge applied the automatic stay to the Receiver and ordered the System to operate under the exclusive jurisdiction of the bankruptcy court. The ruling was clearly in favor of the County. The bankruptcy Judge has the authority to re-appoint a Receiver in the event the County fails to push through operational improvements or/and is unsuccessful in reaching a consensual deal with creditors.
• Hookup Enforcement Authority – While the pre-filing Term Sheet did not include the “hookup enforcement authority” for the County, the Receiver has submitted evidentiary support in the Bankruptcy Court that such authority would be in line with other municipalities in Alabama and around the country, and be very beneficial to the County.

Summary:

Overhang – technical; uncertainty of Ch.9 process.

Valuation – 90-100c, 30-40% upside / 10-15% downside.

Catalysts – pressure to raise sewer rates and execute operational efficiency programs; recent capex ruling should resuscitate settlement discussions with creditors; resolution of legal action against JPMorgan; arriving at “global settlement” necessary to emerge from Ch.9.

Main Risks – lack of consensual agreement leading to prolonged bankruptcy process

Free options – appointment of Receiver; authority for hookup enforcement.

Catalyst