By Joseph S. Fichera
Asset Securitization Report
February 9, 2005
Texas transition bonds have even garnered a 20% counterparty capital risk weighting from U.K. bank regulators, the first non-U.S. agency corporate security ever to receive less than 100% risk weighting. What’s preventing the new issue market for utility tariff bonds from expanding and achieving spreads commensurate with their true credit quality?
The answer lies, in part, in the way these securities have been offered to investors. As odd as it may sound, the people responsible for repaying the debt have not been represented in negotiations with underwriters and investors. Bankers consistently have failed to expand the market or to advocate the bonds’ true value. As a result, the full benefits of securitization have not been realized by electricity consumers.
About $30 billion of securitized utility tariff bonds have been issued to date. When one reviews historical new issue pricings, a problem becomes apparent. Until utilities in Texas came to market, under the watchful and active eye of regulators, as a late-night television hawker would say, the bonds were “priced to sell” in vastly oversubscribed transactions. Utilities took the proceeds, bankers took the fees, favored investors took the bonds, and ratepayers got the bill.
The problem is not in the credit or the structure. Securitized utility tariff bonds, also known as transition bonds, stranded cost bonds, or rate reduction bonds, have a specific state law enacted to establish the program. The state government specifically pledges never to interfere with a bondholder’s right to repayment and to adjust the tariff on electricity as needed from time-to-time to guarantee repayment. No issuer — Citibank, N.A., Fannie Mae, Sallie Mae, or even the U.S. government — has such a law protecting bondholders. The credit clearly appears better than that of a double-A rated bank and much closer to the low risk inherent in U.S. Treasuries. Even when adjusting for liquidity and payment windows, new-issue spreads are substantially out of line when compared to the “relative value” of alternative investments.
But saying so won’t make it so. Money talks, and substantial financial rewards should go to bankers who educate market participants and “sell” the security. To start, this means more underwriters should be given an opportunity to lead manage these transactions, and non-bookrunning syndicate members should be allowed to participate meaningfully. Financial rewards should be given to syndicate members who in fact bring in orders from nontraditional investors, thus expanding liquidity and driving spreads tighter. And sales performance, as judged by achieving tighter spreads, needs to be rewarded. Consequently, the traditional “fixed economics” for underwriters should be replaced by compensation based on marketing and pricing performance.
New-issue spreads for these triple A-rated utility securitization bonds have been as high as 60 basis points above the swap index for an approximate 10-year weighted-average life tranche, with the average new issue spread for a similar tranche since 2001 being 30 to 40 basis points over swaps. These spreads were at times even wider than a comparable single-A rated unsecured utility bond.
A typical utility tariff securitization program is simple and straightforward. It 1) puts a charge on the electric bill of substantially all consumers in a utility’s service territory, 2) collects the charge and turns it over to a special purpose, bankruptcy-remote subsidiary of a fully regulated sponsoring utility to pay principal and interest on the bonds, and 3) guarantees that the government will raise the charge whenever it is anticipated that collections may be insufficient to pay principal and interest on time. That’s it.
As one bond trader put it: “They are the gems of any portfolio.”
The origins of the pricing problem are manifold and arise from an almost “perfect storm” for inefficient pricing. In utility securitizations, normal “checks and balances” that address the inherent conflicts of interest between issuer and underwriter in new-issue price negotiations are absent or skewed.
Most utility issuers (and the commissions who regulate them) are not equipped to challenge this system. Additionally, no incentive exists for utilities even to try. They are often one-time issuers, unlikely to access the securitization market again. Investment banks are eager to participate in these deals with such relaxed negotiations and some are reluctant when accountability is increased. Once more, normal market disciplines are missing.
With generous pricings, narrow distributions, and little competition, new issue spreads on these securities have been only marginally better (if at all) than lower-rated conventional utility debt. Only by applying the proceeds to replace expensive equity do ratepayers gain large benefits.
To grow the new-issue market substantially, legislators and utility regulators — the guardians of the market’s most stable and secure asset base, the electric bill — need to be the advocates. One way to gain support, is to drive spreads tighter, much closer to relative value, and achieve a significant spread differential between conventional utility debt and securitized bonds.
To align the interests correctly in pricing negotiations, utility regulators should approve the bonds’ structuring, marketing, and pricing. Since the law makes financing orders irrevocable, prohibiting after-the-fact review of these securities even though the financial burden rests exclusively upon ratepayers, regulators need to get involved up-front. Unfortunately, regulators typically lack the expertise and do not have access to market information that is free from conflicts of interest (i.e., not promoting an investment banker’s own “book” of underwriting and trading businesses). Both are needed to go “head to head” on pricing issues with sophisticated investment bankers and major investors.
As demonstrated in Texas, active regulator oversight of negotiations can have dramatic results. The regulators there used an independent financial advisor to assist them, along with carefully-crafted and fully accountable certifications from all lead participants. An independent study by the Wisconsin Public Service Commission found that for a 10-year maturity, Texas securitizations were priced upon issue 15 to 20 basis points more efficiently than bonds issued in other states.
Underwriters should also be required to expand the investor base dramatically to include more “buy and hold” accounts, corporate accounts, and foreign investors. The recent Texas deal won the coveted 20% capital risk weighting from U.K. bank regulators, demonstrating the potential market beyond the U.S.
The securities remain a “new” asset class to many even in the U.S. because with uneven supply bankers have not invested the time to identify appropriate accounts, overcome misinformation and sell investors on the superior quality of the bonds. Bankers should be accountable advocates of “relative value” and of the unique credit and liquidity qualities of these bonds. Instead of banking on relationships, they should be banking on the quality of the security being offered. They need to return to their roots of being disciplined brokers between willing buyers and willing sellers.
If negotiation incentives are aligned correctly, if conflicts of interest are managed effectively, and if the market is expanded, new issue yield spreads will likely be dramatically lower. Markets can be made, not just followed. As John F. Kennedy once said: “A high tide raises all boats.”
Published in “Asset Securitization Report” February 9, 2005
© 2015 Joseph Sebastian Fichera