Abracadabra! Bankrupt Cities are Suddenly Un-Bankrupt! (Or Not)

Last month, the capital city of Pennsylvania filed for Chapter 9 bankruptcy protection. Harrisburg had taken out a $317 million loan to fund a municipal incinerator, but it didn't have the money to pay even interest on the loan, much less the principal.

So the Harrisburg City Council did what any debtor, backed into a corner and seeing no way out, would do. It filed for bankruptcy protection.

Court Calls "Backsies"

That was a big black eye for Harrisburg, for the state that surrounds it, and, crucially, for the mayor who allowed things to deteriorate so badly. So the mayor challenged the council's bankruptcy petition, and according to U.S. Bankruptcy Court Judge Mary France, Harrisburg was indeed legally required to get the mayor's sign-off before filing for Chapter 9.

The court threw the bankruptcy petition out, and voila! Harrisburg is magically not bankrupt anymore. Or is it?

Not So Fast, Tex

It's true that Harrisburg's not technically bankrupt. But unless Judge France slipped the mayor a 10-spot to tide the city over till it gets back on its feet, it still has the same problem it had before.

Bankrupt or not, Harrisburg is still insolvent. Keeping current on its debt would require selling off pretty much every revenue-generating asset the city possesses. And once Harrisburg sells them to pay this year's interest, it won't have any revenue streams left to pay next year's.

The only question now is whether the mayor makes a U-turn and leads the parade back into bankruptcy court or sells off assets to postpone the day of reckoning, setting the stage for Harrisburg Bankruptcy, Round 2, a few years from now. Or maybe the generous taxpayers of the rest of Pennsylvania will be asked chip in to save their capital -- by way of a state takeover of the capital city's finances.

In Even Deeper Debt Down South

Meanwhile, south of the Mason-Dixon Line, another high-profile municipal bankruptcy has struck, and it's a doozy.

Harrisburg's bankruptcy grabbed headlines because it's not every day you see a state capital pauperized. But in terms of size, its problems pale in comparison with the $3.2 billion hole that Jefferson County, Alabama, dug for itself while financing its new sewer system.

The biggest municipal bankruptcy in U.S. history was declared two weeks ago, when negotiations to reduce the county's debt to creditors including JPMorgan Chase (JPM) and Regions Financial (RF) broke down. Knowing they would get paid only what the county could afford if a bankruptcy case went to court, and also facing questions as to the validity of the debts (political corruption was alleged), lenders worked aggressively to cut Jefferson County's debt to manageable levels -- offering to write off as much as $1.2 billion. But it was all for naught. Negotiations collapsed two weeks ago, and Jefferson became the fourth municipality to declare bankruptcy this year -- following in the footsteps of Central Falls, R.I., Boise County, Idaho, and Harrisburg. (Like Harrisburg's, Boise's bankruptcy has since been rejected in court.)

The Story Behind the Bankruptcies

Unless you live in the cities and counties affected, you may wonder whether any of this matters to you. It does.

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Eleven months ago, banking analyst Meredith Whitney went on 60 Minutes to predict that a wave of municipal bankruptcies would sweep the United States in 2011. Public finances were in such disarray that "50 to 100" municipal failures were likely, costing "hundreds of billions" of dollars. Happily, this hasn't happened. Whitney may have been right in 2007 when she was the lone voice crying "banking apocalypse" about Citigroup (C), but it looks as if she overstated the case on the municipal-debt crisis.

Or did she?

Just look at what happened in Jefferson County again, before the bankruptcy: The county owed $3.2 billion to its lenders, and the lenders offered to cut that debt to $2 billion, no questions asked. Why? You have to assume that the banks had their insurance set up to protect themselves in the event of a default, or that a peer such as MBIA (MBI) or Berkshire Hathaway (BRK.A) (BRK.B) had been contracted to step in and make good on its debt if the county couldn't.

So why offer to take a one-third haircut at all?

A Sneaking Suspicion

One has to wonder whether there's a reason the bankers didn't just trust their guarantors to pay off Jefferson County's debt.
Maybe they thought a bankruptcy so unlikely that they never took out insurance against it. Or maybe they worry that MBIA's balance sheet shows $12 billion more debt than cash, or that Assured Guaranty's (AGO) cash and debt are roughly equal, while the better-heeled Berkshire Hathaway has quietly exited the municipal-debt market, reducing its exposure to risks such as those we now see in Jefferson County.

It may not even matter whether the bankers have decided to forgo insurance against municipal bankruptcy risk, or whether they don't believe that insurance is worth the paper it's printed on. Either way, this pending local debt crisis doesn't look good for America's big banks -- or anyone who owns their stocks.

Motley Fool contributor Rich Smith owns no shares of any companies named above. The Motley Fool owns shares of JPMorgan Chase, Citigroup, and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway.