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Jefferson County, Alabama reached an agreement for an extension with it’s creditors late Friday to avoid default.  It has nearly $3.2 billion in outstanding debt for it’s sewer system and had stopped making payments when their interest rates more than doubled back in March.

The county — threatened by the biggest municipal bankruptcy in U.S. history — avoided missing an Aug. 1 deadline to pay $100 million in interest on the debt thanks to the extension, according to county commission President Bettye Fine Collins.

“The extension of the deadline gives Jefferson County a chance to fine-tune a plan that will keep us out of bankruptcy and court,” Collins told the meeting.

Bond markets have been in turmoil ever since a number of insurers lost their top credit ratings which sent prices tumbling and yields soaring for all the debt they guaranteed.  Jefferson is just one of the many municipalities who are struggling with their debt issues as financial markets have gone haywire in the wake of the subprime collapse.

The county refused to pay the higher costs were associated with interest rates that kicked in when investors shunned the auction rate bond market and investment banks who act as brokers refused to buy up the securities to keep the auctions from failing.  In normal times auction rate bonds became popular because it offered communities essentially short term money market rates for long term debt but when auctions failed, interest rates shot up to over 20% in many cases.

Investment banks and bond insurers are facing numerous lawsuits stemming from ratings downgrades due to their risky involvement with residential mortgage securities and other Collateralized Debt Obligations.  Although the new extension gives Jefferson County until Nov. 17, it is seriously considering declaring for bankruptcy protection as it has very few options to meet it’s overwhelming sewer debt.

One can’t help but have sympathy for Jefferson and other communities who are now faced with paying hundreds of millions in higher interest payments through no fault of their own.

Many clients of the bond insurance industry had interest payments skyrocket earlier this year when the auction rate securities market failed.  When many of the bigger names in the industry like Ambac and MBIA lost their top credit ratings, their clients paid the price when demand for bonds that lost their AAA status evaporated.

For years municipalities have been forced to purchase bond insurance due to the dual credit rating system between them and corporate entities.  Despite municipal bonds having a stellar history of low default rates, very few communities earned AAA status so it was just cheaper to purchase bond insurance and get lower borrowing costs.

Most communities were for the most part content with this arrangement until insurers started insuring high risk residential mortgages bundled into Collateralized Debt Obligations(CDOs) and put AAA rated municipal bonds in jeopardy as well.  State and local governments had to pay hundreds of millions in higher interest costs and now many of them are filing lawsuits against the insurers as well as the investment banks that normally purchase bond issues if an auction is in danger of failing.

Lately there has been a strong push from many different sides to abolish the dual rating system and things seem to be moving in that direction.  Ratings agencies are also facing their own intense scrutiny for rating these high risk CDOs as investment grade in the first place.

Let’s face it a lot of companies are going to get sued over this whole fiasco.  When your interest rates shoot over 20% through no fault of your own, you’re taking somebody to court.

For bond insurers, maintaining the highest of credit ratings is of the utmost importance in order to attract new business. So what do troubled bond insurers do when they don’t like their credit ratings?  They fire the ratings company apparently.  Bloomberg reported that Ambac Financial has terminated it’s contract with Fitch Ratings in what has become a disturbing trend.

The second-largest bond insurer is reevaluating its ratings needs as it realigns its business, New York-based Ambac said today in a statement. “As part of this review, we have asked Fitch to remove its ratings on Ambac and all its subsidiaries effective immediately,” the company said.

Ambac’s request follows one by larger rival MBIA Inc., which in March asked Fitch to stop providing a financial strength rating on its insurance unit. In September, Radian Group Inc., which owns mortgage and financial guaranty companies, asked Fitch to stop issuing ratings and said it would no longer provide information to the unit of Paris-based Fimalac SA.

Fitch has been much quicker to the gun than it’s counterparts, S&P and Moody’s, in downgrading  credit ratings for troubled firms in the industry.  Do theses companies think they can hide from their financial difficulties by killing the messenger?

In what amounts to acts of petulant children, a number of firms have announced they will cease raising new capital since they believe there is no point anymore with the loss of the their highest ratings.  I’m sure that is thrilling news for their clients especially communities who have had debt service payments in some cases triple because of the industry’s forays into the disastrous subprime bond market.

Public officials within these communities haven’t stood still while this is all happening and have put increasing pressure on ratings agencies to end the double standard of credit ratings between municipal and corporate bonds.  Municipal bond insurance could become a dinosaur in the financial services industry but it will depend if investors are willing to purchase new issues without insurance.