Three American cities on the brink of broke

    Several downtrodden cities are on the verge of defaulting on their debt, putting financially encumbered states and taxpayers on the hook to pick up the tab. The National League of Cities says municipal governments will probably come up $56 billion to $83 billion short between now and 2012. That's the tab for decades of binge spending; municipal defaults could be our collective hangover.

    Municipal bonds, issued to fund public projects such as roads and public buildings, have historically been seen as one of the safest places to invest, which is why 80% of municipal bond holders are individual households and mutual fund investors, explains Jeffrey Cleveland, municipal bond analyst at Payden & Rygel Investment Management.

    The average five-year cumulative default rate for investment-grade municipal bonds is less than half a percent, according to Moody's data. That's about one-third the amount of corporate debt defaults.

    But municipal defaults are on the rise, and the trend is expected to continue. Last year 183 borrowers -- mostly "risky" municipal issuers, such as suburban developers in Florida -- were unable to make $6.4 billion of payments. That's way up from 31 defaults on $348 million just two years earlier, according to Distressed Debt Securities.

    In the past year only one city has actually defaulted: Menasha, Wis. (Warrens, Wis. narrowly averted a default by agreeing to forbearance on a state loan.) But that could increase, says Matt Fabian, managing director at Municipal Market Advisors.

    Rampant unemployment, tepid consumer spending, and deeply underfunded public pensions are the leading causes of the balance sheet issues cities are having today. But years of political chicanery and poor financial decision-making by city officials are what led to this problem.

    These three municipalities have perhaps the most tenuous grips on staying in the black, thanks to all the above factors:

Jefferson County, Ala.

    Jefferson County, Alabama's most populous county, with some 665,000 residents, is shouldering about $5 billion of debt, most of which was issued to overhaul its sewer system in the mid-1990s. But the county's real troubles stem from a 2003 refinancing of the original fixed-rate bonds and a corrupt local government that accepted kickbacks in exchange for mangling the county's portfolio.

    In an effort to benefit from lower interest rates, the county switched to floating-rate bonds, much like the variable-rate mortgages that clobbered the housing industry. It also bought billions in interest rate swaps, complex financial vehicles intended to hedge against changing interest rates. Needless to say, those instruments didn't perform as advertised and actually ended up costing the county more in fees.

    Most of Jefferson County's bonds are guaranteed by insurers Financial Guaranty Insurance Corp. and Syncora. But those insurers also overextended themselves during the boom. Syncora was unable to pony up its share of a $71 million payment due last year, and now without a net, Jefferson County has warned that a Chapter 9 bankruptcy may be in the cards.