Teetering on what experts say could become the largest municipal bankruptcy in U.S. history, Alabama’s largest county is causing concern among bond investors and municipalities around the country.

Jefferson County, which includes the city of Birmingham, has amassed $3.2 billion in debt cleaning up its sewer system to meet federal environmental standards. To reduce the impact on taxpayers, county commissioners refinanced the debt through a complex series of interest rate “swaps,” also known as financial derivatives.

Used wisely, derivatives can provide efficient ways for municipalities to manage risk, according to Robert Brooks of the University of Alabama. But the financial management professor said if a purchaser gets biased advice, “bad things can happen.” (Click on the video to hear his comments).

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Just as many individual homeowners ran into trouble with variable interest rate loans, Jefferson County’s refinancing plan backfired when the subprime mortgage crisis spilled over into the municipal bond market. Interest rates went up. The county had trouble making payments. People started pointing fingers.

“This county is not at fault,” said Jefferson Commissioner Shelia Smoot. “The banks that put us in these deals, they’re at fault. When we hire experts, we expect to get an expert opinion. That’s what we thought we were getting.”

Professor Brooks said commissioners should have sought outside advice instead of relying on experts from the banks financing the loans.

“There is a structural problem in the finance industry as whole,” Brooks said. “The consumers of financial products are not used to having to pay for the financial expertise. Their preference is to embed the cost of the financial expertise into the cost of the products that they purchase. They really don’t know, first of all, how much they’re paying for the expertise and, secondly, the expertise is no longer independent.”

Professor Brooks said if Jefferson County were to declare bankruptcy, it would have an impact on local governments across the nation. “When another municipality takes out a loan, it will cost them more, at least for a while, because it will be in the memory of the analyst that they might not get their money back.”

Jefferson County is negotiating with lenders in hopes of avoiding bankruptcy without significant increases in sewer rates. But so far, no agreements — only deferred payments.

Click on the video to watch the story as it aired July 4 on Fox News Channel.

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