Were bailouts a bad idea? Alabama bankruptcy could provide test case.

Alabama's Jefferson County, home of the state's largest city and 650,000 Alabamians, filed for Chapter 9 bankruptcy in federal court after defaulting on a massive and corrupt sewer project dating back two decades.

The record $4 billion bankruptcy filing dwarfs the $1.7 billion Orange County bankruptcy in California in 1994.

County officials say the filing is a fresh start and a way for Jefferson County, the city of Birmingham, and the state of Alabama to put one of its biggest fiascoes behind it. Some 22 local officials were found guilty for taking sweetheart deals spun by gung-ho Wall Street speculators. 

But others say the bankruptcy could be a drag on the Alabama economy for years to come. 

Indeed, what happens now is, in some ways, uncharted territory.

The bankruptcy is a test of whether the Republican-controlled state Legislature's tough-love ploy – refusing to bail out the county – will work or backfire. And the bankruptcy is the biggest test yet of Chapter 9 laws devised after the Depression precisely to help indebted cities manage the conflicting priorities of paying back creditors while still providing public services and benefits to taxpayers. 

"The last time we saw a situation with a lot of insolvent states was during the Depression, but the current Chapter 9 laws didn't exist then," says Melissa Woodley, a finance professor at Samford University in Birmingham. "So the extent to which bankruptcies can allow you to reorganize, nobody really knows because the current law is untested. That's why a lot of people are going to be really looking at how this process works."

The ordeal started in 1991 when the Environmental Protection Agency ordered the county to upgrade its sewage system. In the early 2000s, Larry Langford, the county commission chairman who later became mayor of Birmingham, colluded with a former Democratic politician-turned-investment broker to put together a risky bond deal that involved derivatives and interest-swaps – the exact kind of murky instruments that led to the Wall Street crash of 2008.

Mr. Langford was arrested, tried, and found guilty on a variety of corruption charges, including taking bribes and gifts from JP Morgan Chase, a major Wall Street bank. The company paid a $722 million fine to the Securities and Exchange Commission in 2009 as a result.

After coming close to a deal with its chief creditors several times, the county broke off talks and the court-appointed receiver this week, opting to declare bankruptcy. The decision could shake the municipal bond markets, affect Alabama's ability to borrow money at good rates, and affect confidence among corporate developers eyeing Alabama for investment.

It comes as the state is already taking flak for implementing the toughest anti-immigration law in the US, which has caused hardship for Hispanic migrants, farmers, and construction companies.

"The Jefferson County sewer-debt crisis has been an impediment to economic growth in the state, and the bankruptcy filing will now be an even greater challenge to overcome," Gov. Robert Bentley said in a statement.

By the measure of municipal defaults, cities are doing better this year than last. Some 42 municipalities have defaulted on bond payments this year, compared with 74 by the same time last year. Most of these defaults – as well as bankruptcies in Central Falls, R.I., in August and Vallejo, Calif., in 2008 – resulted from communities trying to get out of gold-plated public union contracts.

The Jefferson bankruptcy shares some similarities with the Harrisburg, Pa., bankruptcy filing on Oct. 12, which involved payments to a public utility. But some finance experts say the filing has less to do with the defaulted sewer bonds than the decisions of the state Legislature. The Legislature refused to lend a lifeline of financial support to a county that's had to lay off so many workers that portable toilets now dot courthouse lawns to service slow-moving queues.

"Ideological purity trumps economic common sense, and there has been no effort by the state of Alabama to actually help out, and that's how this bankruptcy is really different and why it's going to hurt the state in the long run," says Andreas Rauterkus, an economics professor at the University of Alabama at Birmingham. "The cost of doing business in Alabama is going to be more expensive in the long run because of this."

Alabama localities do face particular challenges financially. For one, home-rule laws passed by the state limit municipalities' ability to raise local revenues. What's more, when one local tax was recently ruled unconstitutional, state lawmakers failed to address it. The result was a 30 percent drop in local revenues, which led to massive county staff layoffs, including police and sheriff's deputies, and courthouses closing.

State lawmakers said Thursday they believe that Jefferson County can solve its revenue problems without state funds. "Now that they're filing for bankruptcy, we can work on solving the problems with the money they have," said state Rep. John Rogers.

Whether that is true remains to be seen. A bankruptcy judge can't force a government that sits at the pleasure of its citizens to raise more revenue. "Everybody is going to be saying, 'We need more money,' and that's going to be the real debate here," agrees Ms. Woodley of Samford. "There's been some skepticism that maybe we are funding things that maybe don't need to be funded, and this process may allow that to be worked out."

But experts say the filing could also represent a much-needed fresh start for a region that has seen economic development and quality of life hampered by the default.

"Bankruptcy is a good thing," Ben Brooks, a finance professor at the University of Alabama, told the Associated Press. "The sooner Jefferson County can get this behind them the better."