AlabamaWith a Thursday afternoon deadline fast approaching, investors and officials in Alabama are working to review new proposals to avert the biggest municipal bankruptcy in American history. Jefferson County, home to Birmingham, Ala., may have to file Chapter 9 on its $3.14 billion debt if is isn't able to negotiate a settlement.

So far, the negotiations have come up short by $300 million. Jefferson County has asked bondholders to forgive $1.3 billion of its debt, while creditors have offered to write off $1 billion, according to Bloomberg.

"I think they should have filed bankruptcy a year and a half ago," Craig Harris, mayor of Jefferson County town Kimberly, Ala., told the North Jefferson News. "This is a no-win situation."

Even as negotiations come down to the wire, bankruptcy and debt expert James Spiotto, an attorney with Chapman and Cutler, tells DailyFinance it is in the county's best interest to find a solution outside of bankruptcy. He cites New York City's debt crisis in 1975 and Philadelphia's in 1991 as historical precedents.

"[An alternative solution] saves time, expense and market disruption," he says. "It has been to the benefit to state and local to do it that way. They prefer that they pay their bond debt so they can maintain access to markets and [have cash flow] to pay for [expenses]. It allows local governments to make decisions locally."

Sewers, Scandals and Derivatives

The bankruptcy drama stems from a federal court order requiring the county to rebuild its sewer system years ago. To finance the project, the county issued bonds that were ultimately linked to derivatives. Some of the deals were marred by scandals, and then, in 2008, the financial crisis took its devastating toll, according to The New York Times.

This year, things took another turn for the worse after a key tax revenue stream was lost, forcing the county to lay off hundreds of employees, slash services and raise sewer rates.

If Jefferson County does file Chapter 9 tomorrow, it will have a long-term effect and will prevent the county from accessing capital down the road, Spiotto says. Bankruptcy would not eliminate the debt, but would allow the municipality itself to present a debt-adjustment plan.

"This is not the time to see how much charity there is in capital markets," Spiotto says. "They will see that the market is not that forgiving. It's cheaper in the long run to find [an alternative solution.]"

A default in Alabama also could rattle the $2.9 trillion municipal bond market, which has already seen plenty of fluctuation in the last six months.

More Municipal Bankruptcies

The possible bankruptcy comes on the heels of at least five other municipal bankruptcies this year, including those in Central Falls, R.I., which filed Chapter 9 on Aug. 1 over pension problems. Harrisburg, Pa., has also been talking about filing for bankruptcy over its $5 million deficit, even as the City Council struggles to find an alternative plan by its Sept. 6 deadline.

The largest municipal bankruptcy to date was that of Orange County, Calif., in 1994. The county suffered losses of $1.6 billion from bad investments. Since 1980, there have been 254 municipal Chapter 9 filings, mostly by small special-tax districts and municipalities, according to Spiotto. One-third of these have been dismissed, he adds.

"We need to keep in mind that municipal bankruptcies are extremely rare, so in that sense it is best to look at them as outliers," Gregory Minchak, spokesperson for the National League of Cities, tells DailyFinance. "They are very specific to the cities and where we see them happen and there usually has been some big event that caused it."

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