* Decision nervously awaited in the municipal bond market
* County cannot pay legal fees, set aside charges
By Michael Connor
June 29 (Reuters) - The judge in the landmark bankruptcy of Alabama's Jefferson County sided with Wall Street creditors on Friday and sharply limited how the cash-strapped local government can use funds generated by its sewer system.
The ruling, in a months-long court dispute, aggravates a cash crunch for the county that may exhaust its general fund within three months.
In the dispute over the size of payments to owners of $3.2 billion of sewer-system debt, U.S. Bankruptcy Judge Thomas Bennett said the county cannot pay legal fees and set aside charges for depreciation and amortization from net operating revenues owed to creditors.
The judge stopped county officials from putting current monthly revenues into reserves for capital projects, professional fees and other purposes not directly related to present operations - actions which reduced payments to creditors.
County officials were to make payments to sewer system creditors, Bennett said, "without withholding of any monies for depreciation, amortization, reserves, or estimated expenditures that are the subject of this litigation".
Bennett appeared to stop short in a 43-page decision of barring use of such reserve funds indefinitely, but the ruling will impact the already cash-strapped coffers of bankrupt Jefferson County.
Bennett's decision was nervously awaited in America's $3.7 trillion municipal bond market, where revenue bonds of the sort issued by Jefferson County's sewer system might have become riskier to own if Bennett had ruled in favor of the county.
The county had been very aggressive in holding back payments to the sewer system's warrant holders and were rattling long-held assumptions of investors that interest payments on revenue bonds continue in municipal bankruptcies, analysts have said.
Creditors such as Bank of New York Mellon and JPMorgan Chase had argued that the county had been illegally using money for purposes beyond ensuring efficient operations of the system that serves 130,000 customers.
The county claimed the money, which Bennett calculated would deprive bondholders of $54 million for each year the county remains in bankruptcy, was required for future repairs, fees for its bankruptcy case and other capital expenses.
In the ruling issued in Birmingham, Alabama, Bennett said the county had claimed that average monthly operating expenses for the sewer system had risen 92 percent since January over the monthly average during a prior two years.
"If the county prevails on its position for how the revenues from its sewer system are to be applied under its classification of properly recognized expenditures, the impact on the warrant holders is dramatic," Bennett said.
Bennett's ruling did not alter the county's control of the sewer system and would have no effect on its development of a workout plan needed to exit bankruptcy, according to David Carrington, president of the Jefferson County Commission.
"The county can continue to operate the system, and the county's sewer professionals have the resources they need to continue providing vital services to the community," Carrington said in a prepared statement.
Jefferson County, the home of Birmingham, the state's business hub, filed a $4.23 billion bankruptcy claim - the largest ever by a U.S. local government - on Nov. 9. Its massive sewer debt, aggravated by political corruption and loss of local tax in a court case, fueled the financial crisis.
In April, the county skipped a $15 million general obligation bond payment for the first time, as officials said they needed the money to pay for basic government services.
Bank of New York welcomed the judge's decision, according to spokesman Kevin Heine, who added, "It affirms the rights of the warrant holders to continue to be paid from the system revenues they are entitled to."