May 30, 2008
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By Michael Quint
May 30, 2008 (Bloomberg) — Joseph Fichera wasn’t wrong about auction-rate securities, he was just 20 years early.
As far back as the 1980s, the banker-turned-adviser to governments and businesses said the market for bonds where rates are set at periodic auctions controlled by dealers posed dangers to borrowers and investors. Those warnings proved prescient when the $330 billion market collapsed in February, pushing rates as high as 20 percent as dealers stopped buying bonds that went unsold and investors couldn’t sell their holdings.
Now, the chief executive officer of New York-based Saber Partners, who advised then-California Governor Gray Davis during the state’s energy crisis in 2001, has a tip for municipalities as they negotiate with Wall Street: Act more like corporations.
“I guess I remembered my mother’s advice, ‘Just because everyone else is doing it, doesn’t mean you should, too,”’ Fichera, 54, said in an interview. “You have to do your own hard work and take your own counsel. At the end of the day, who will look out for yourself but you? She taught me market principles without an MBA.”
In the $2.6 trillion municipal bond market, more than 80 percent of bonds are sold through dealers chosen in advance by issuers instead of through a bidding process, according to data compiled by Thomson Reuters. That’s the case even though a March report by the U.S. Government Accountability Office found state and local governments obtain lower costs when they make banks compete for the right to underwrite their bonds.
‘Culture of Inertia’
“There is a culture of inertia in the municipal market, where borrowers rely on long-standing relationships with bankers and turn to them for guidance and expertise,” said Mitchell Moss, professor of urban policy and planning at New York University. “Fichera is a beacon of light in trying to add transparency.”
The son of a bookkeeper and a hairdresser, Fichera graduated in 1976 from Princeton University in New Jersey with a degree in public and international affairs. After working for the U.S. Department of Housing and Urban Development during the Carter administration, he attended the Yale School of Management in New Haven, Connecticut, where he obtained a master’s of business administration in 1982.
Fichera has a file of news clips about himself going back to 1970, when he was a student representative on the Rochester, New York, Board of Education, agitating for school desegregation. It extends to his years as a banker criticizing the auction-rate securities that were promoted by the largest securities firms.
“He’s arrogant, he’s quoted all over the place and seems to live with a need for publicity,” said Ronald Gallatin, a retired Lehman Brothers Holdings Inc. banker who helped create the auction-rate market in the 1980s.
Fichera found his way to Wall Street, where as a banker for Smith Barney, Harris Upham & Co., he won Exxon Corp. as a client in 1987 by showing the oil company how it could reduce interest costs on floating-rate bonds by making a rigid schedule for resetting yields on the debt more flexible. That way, the company could sell debt when conditions were favorable.
A year later he advised Exxon, now Exxon Mobil Corp., to reject proposals by Wall Street’s largest banks to sell auction- rate securities. Instead, the company sold preferred stock designed by Fichera. A bank sets yields on the stock at levels it expects will attract buyers, rather than conducting an auction in which it may or may not intervene to produce a desired rate.
Fichera’s experience with the auction-rate market led the Securities and Exchange Commission to hire him as a consultant in its probe of bidding practices. In 2006, 15 banks settled with the U.S. regulator and paid $13 million, without admitting or denying that they manipulated auction results. The banks also agreed to disclose that they might intervene in future bidding.
Auction-rate securities turned toxic in February when dealers who routinely bought the bonds for their own account suddenly stopped supporting the market as their losses on debt linked to subprime mortgages mounted. From 2000 through 2007, some 99 percent of the $236 billion in municipal auction-rate sales were handled by 10 banks, led by New York-based Citigroup Inc., with a 23 percent share, and Zurich-based UBS AG, at 18 percent, Thomson Reuters data show.
The rate on municipal auction-rate bonds with weekly bidding shot up to 6.89 percent for the week ended Feb. 20 from 3.90 percent at the start of the year, according to an index compiled for the Securities Industry and Financial Markets Association, which represents about 650 dealers.
Local governments and operators of hospitals and schools have paid about $1.65 billion in additional interest since September, according to data compiled by Bloomberg.
Even the highest-rated issuers weren’t immune. The Metropolitan Museum of Art in New York paid 15 percent for a week in February, up from 3.25 percent. The museum, with a $2.96 billion investment portfolio, is rated Aaa by Moody’s Investors Service and AAA by Standard & Poor’s.
“Joe’s attitude is that borrowers should do their own analysis and not go with the herd, just because that’s what everyone else is doing,” said Brian Mahar, a former assistant treasurer at Exxon who handled the company’s borrowing and is now an unsalaried member of a Saber advisory committee.
Many of the tens of thousands of borrowers in the municipal market routinely rely on the same group of bankers for financings, ceding control over how and when they raise money.
Cities and states aren’t subject to the same disclosure rules as corporations, and don’t have to register their debt with the SEC. Chairman Christopher Cox has called for disclosure more akin to what companies provide, telling Congress last July that there is an “urgent need” to improve the information investors receive.
Fichera, who worked at Bear, Stearns & Co. and Prudential Securities Inc. after Smith Barney, left Prudential in 2000 to form Saber. Clients include the New York State Dormitory Authority, the third-biggest seller of municipal bonds last year, according to Thomson Reuters.
“We saw an opportunity to help issuers reduce their borrowing costs by asking the right questions of bankers,” said William Moore, a co-founder of the advisory firm and now CEO of Westar Energy Inc., an electric power company based in Topeka, Kansas. “Investment banks want deals structured and priced in a way they will sell quickly. We wanted our clients to get the best price possible.”
Fichera’s early successes at his new firm came in the $40 billion market for ratepayer bonds. The debt, sold through public utility commissions on behalf of electric power companies, is backed by surcharges on customers’ monthly bills, so the lower the rate, the less impact on consumers.
Ratepayer bonds, rated AAA, should be compared to so-called U.S. agency bonds like those sold by government-chartered companies Fannie Mae and Freddie Mac, not credit-card backed securities as was the practice, he said. That’s because of state laws promising utility rates would be adjusted to make certain that the ratepayer surcharge would always be sufficient to pay the bonds.
Fichera’s claims were confirmed by the Financial Services Authority, Britain’s securities markets regulator, in December 2004, when it said in a letter to an unidentified investor that “the state of Texas is one of these ratepayers and therefore would be payer of last resort.”
‘Pushing and Prodding’
The FSA determined that the bonds qualified for the same 20 percent risk weighting as government debt, allowing issuers to sell the bonds to U.K. investors at a lower rate than if they had to rely only on U.S. buyers.
“Joe doesn’t accept the idea that because we’ve done something this way in the past, we’ve got to continue doing it that way,” said Robert Reger, a partner at New York-based law firm of Thelen Reid Brown Raysman & Steiner, who has sat opposite Fichera at the negotiating table as a representative for underwriters. “He’s constantly pushing and prodding to do things better.”
Saber’s advice helped state utility commissions reduce interest costs on 10-year ratepayer bonds by as much as 0.20 percentage point, or $1 million a year on a $500 million sale, Steven Kihm, an economist at the Wisconsin Public Service Commission, said in a 2004 report comparing deals Fichera worked on with others. Besides Wisconsin and Texas, Fichera worked for regulators in Vermont, New Jersey, Florida and West Virginia.
“He gave us the best chance of getting the lowest cost, and ended up saving ratepayers millions of dollars,” said Jon McKinney, a commissioner on the West Virginia Public Service Commission, which hired Fichera to advise it on a $462 million ratepayer bond sale last year. “That doesn’t mean his fee was the lowest, because it wasn’t.”
Saber collected $9.8 million of fees for its work on $7.6 billion of ratepayer bond sales since 2001. Fichera says his fees are higher than other advisers “because I do more than watch the sale take shape and then opine that the terms are ‘reasonable.”’
“Joe is a very hands-on adviser,” said Vincent Matrone, a managing director at Albany, New York-based Depfa First Albany Securities, which has worked as an underwriter for bond sales where Fichera was an adviser. “Some banks don’t want to put up with the extra steps he wants, but there’s no doubting that he always has the best interest of the client at heart.”
In California, Saber worked with New York-based Blackstone Group Inc. to create a plan for selling as much as $33 billion of bonds to keep the state’s investor-owned utilities in business, and refinance the cost of high priced wholesale electricity bought by the companies and the state.
By the time the assignment ended in November 2001, electricity prices had fallen and most of the borrowing plan was scrapped, except for $12.6 billion of tax-exempt bonds the state’s Department of Water Resources sold to repay the treasury for money used to buy electricity in the summer crisis.
“The governor gave a five-minute speech describing the plan, and then we held a conference call with over 300 investors, bankers and analysts that lasted 2 1/2 hours until every question was answered,” Fichera said.
Fichera’s firm is concentrating its efforts on the municipal market, where he says borrowers might benefit by adopting practices used in corporate finance.
States and local governments should question the practice of keeping cash in reserve to meet debt payments for six months, which isn’t required of corporations with lower ratings than municipal borrowers, he said.
Rather than selecting groups of underwriters for years at a time, issuers could be more flexible and make underwriters compete for their bond sales as they do for corporate debt. New York budget officials, in a capital and financing plan released this month, said the state saved 0.5 percentage point in interest costs last year, or $500,000 annually per $100 million borrowed, on bonds it sold through competitive bidding among underwriters compared with offerings where it negotiated terms with bankers.
“Naming the banks who will be your lead underwriters for the next few years weakens the borrower’s negotiating position,” Fichera said.
Fichera says there are several ways the auction-rate bond market could be improved. For one, borrowers could require that many dealers, including discount brokers, handle their auctions rather than relying on one bank. Also, agreements to pay bankers a flat fee for conducting auctions might be changed to a performance-based fee, like Fichera arranged for Tucson Electric Power Co., when he was hired to rescue the Tucson, Arizona-based company’s auctions in 1991.
Another auction-rate flaw highlighted by Fichera was that bankers kept secret the extent to which they helped auctions by bidding for their own account. In 1995, Lehman settled allegations by the SEC that it improperly bid at some American Express Co. auctions. Lehman, which the SEC said manipulated bids 13 times and prevented two auctions from failing, paid an $850,000 fine without admitting or denying wrongdoing.
“The only way for investors to assess the risk of a failed auction is to disclose the amount of investor bids and the extent of brokers’ intervention,” he said.
The high cost of auction-rate bonds is now being compounded as issuers rush to refinance auction bonds they might be able to buy back at a discount through a tender offer, Fichera said. Too many governments sold fixed-rate bonds in recent months when yields were close to record highs relative to Treasuries.
Other issuers sold new variable-rate bonds without considering how those securities might be improved. Some highly rated local governments might reduce costs by using excess cash or creating a revolving credit line with many banks competing to participate to help assure investors they would get their money on demand, rather than paying a single bank for that backstop, he said.
“That’s what corporations do,” Fichera said.
—With reporting by Michael McDonald in Boston. Editors: Beth Williams, Robert Burgess
—Last updated: May 30, 2008 17:54 EDT