In the News: Recent Developments

July 01, 2001

Fichera’s long hot summer Joseph Fichera headed to Sacramento to help keep the lights on.

By Steven Brull Institutional Investor Magazine

When Joseph Fichera got the call last February to help California’s Democratic governor, Gray Davis, clean up the state’s energy mess, it seemed to him like the ultimate job. A whiz at raising billions of dollars for utility and power companies at Bear, Stearns & Co. and Smith Barney, Fichera had recently founded Saber Partners, a small financial boutique based in New York. Davis offered the feisty 47-year-old the chance to help fashion a financial solution to California’s energy crisis and then sell the deal to Wall Street.

The offer was irresistible. There was a huge problem to solve – selling more than $30 billion in bonds – which could make the reputation of his fledgling company. There was money to be made – $14 million in advisory fees to be split between Saber and its partner, Blackstone Group. And for Fichera, who spent three years in the late 1970s working on neighborhood development for the U.S. Department of Housing and Urban Development, the deal had another lure: a chance to work closely with Davis, a governor with presidential ambitions. Fichera signed on as Davis’s senior financial adviser.

“It’s a dream transaction,” says Fichera exultantly. “Billions of dollars in securities and a combination of bonds, bankruptcy, public policy and regulation. You name it, we got it.”

Fichera and four other Saber Partners jetted out to Sacramento, the state capital, and camped out in a two-room suite with a foldaway couch at the Marriott Residence Inn – sleeping in shifts to save money. Fichera and Blackstone’s Michael Hoffman set up shop in a cramped, dimly lit, windowless office down the hall from the governor. To establish his Democratic bona fides, Fichera hung photos of himself posing with Bill and Hillary Clinton, Al Gore and Jimmy Carter.

But as winter turned to spring and spring to summer, Fichera’s enthusiasm began to wane. California’s energy crisis increasingly defies easy solutions, and Fichera now finds himself caught in the middle of a contentious political standoff.

The crisis was spawned by a botched 1996 deregulation plan under Republican governor Pete Wilson. The plan deregulated the wholesale price of power but capped retail electricity rates. It required utilities to sell most of their generation capacity but forbade them to sign long-term supply contracts. After supply-demand imbalances last year, prices soared. Forced to buy on the spot market, the utilities’ average wholesale cost of electricity has skyrocketed, from $32.20 per megawatt hour in 1999 to an estimated $224 per MWh in 2001. As a result, the state’s cost for electricity more than quadrupled, from $7.4 billion in 1999 to $32.3 billion in 2000. This year the bill is estimated at up to $50 billion. California has had rolling blackouts since last summer and faces more.

Stuck between sky-high wholesale costs and fixed retail prices, California’s utilities crumbled financially and were cut off from credit. The state was forced to take over power purchases, leaving desperate bureaucrats to negotiate with canny electricity traders. Thus far the crisis has resulted in America’s biggest utility bankruptcy; it threatens another bankruptcy and may throw the state’s $1.33 trillion economy into recession.

But it isn’t the size or complexity of the problem that is frustrating Fichera. It’s the politics. In government all problems – and solutions – are political. Governor Davis has been criticized for failing to act sooner and, now that he has, for acting incorrectly. Fichera’s financial plan has been vilified as a sellout to greedy corporate interests. “In New York I’m a liberal, but out here I’m Attila the Hun,” Fichera says unhappily.

“He was so excited about the opportunity to go to California and work to make a difference,” says Sandra Thurman, a close friend and director of the Office of National AIDS Policy in the Clinton administration. “But sometimes good policy gets lost in politics.”

Of course, Governor Davis’s opponents aren’t the only ones playing politics. Davis has ratcheted up the political pressure himself, branding out-of-state generators as “gougers,” “pirates” and “snakes.” This rhetoric forced the Federal Energy Regulatory Commission to impose some price limits on power sold in the Western states until September 2002, buying Davis time to enact a plan to alleviate the crisis. His plan includes higher retail rates, new power plant construction and conservation. Sixteen new plants have been licensed, ten are under construction, and four will come on line this month. Between new plants and conservation, Davis says, the state will add the equivalent of 24,537 megawatts of new capacity by the end of 2002.

“This is a problem that overtook the government like a tsunami,” says Fichera, defending his boss against charges that he procrastinated. “The governor has systematically tackled the biggest energy problem that any public official has had to address since the oil shocks of the 1970s. He didn’t shoot from the hip. He put forth an aggressive, comprehensive plan.”

Fichera’s role is to advise on a financial scheme to make Davis’s plan work – and to sell it to his compatriots on Wall Street. The pillars of the plan are three massive bond issues guaranteed by California’s electricity ratepayers. One, referred to colloquially as power bonds, would be the largest municipal bond issue in U.S. history. It would raise $13.4 billion to repay California’s general fund for the power it has been purchasing for the debt-ridden utilities. Scheduled to be sold in August, it has been delayed until October because of creditor concerns.

The second bond issue, known as securitization bonds, would be for between $8 billion and $12 billion. It is intended to repay the utilities for the debt they incurred – before their credit was cut off in January – while buying power at prices they could not recoup from customers. The third bond sale, for $7.3 billion, would fund the state purchase of the transmission assets of California’s three major utilities: Pacific Gas & Electric Co. (which would get $3.5 billion), Southern California Edison ($2.8 billion) and San Diego Gas & Electric Co. ($1 billion). These so-called transmission asset bonds and the securitization bonds are part of a memorandum of understanding, or MOU. The proceeds would make the utilities financially viable again.

“It’s a bridge to salvation,” says Fichera. “It will get us from June 2001 to January 2003.”

With his energy program in place, financed by Fichera’s plan and guaranteed by California’s ratepayers, Davis reckoned that, by 2003, the shortage of power would become a surplus. And with utilities now permitted to enter into long-term contracts, the market could again function normally. Problem solved.

Not so fast. The financial strategy underpinning the plan – which Saber and Blackstone devised – is under attack by politicians. “It is unconscionable for firms and individuals to be representing themselves as consultants to California when their compensation is derived from bailing out utilities,” said State Controller Kathleen Connell. Many prefer a more radical solution – kicking out the utilities and having the state take over. “Using government powers to control private markets run amok is as American as apple pie,” asserts California Treasurer Philip Angelides.

“It’s extremely frustrating,” Fichera complains. “We all thought we could come and bring some order and structure and that through rigorous analysis and 24-7 work, we’d be able to get the answers. But it’s not in our control. The political system is more interested in blame and punishment.”

If the financial plan failed, all of California’s major utilities would likely go bankrupt, and the state’s intervention in the energy markets would grow deeper – just the opposite of the governor’s intent. Saber and Blackstone would receive their monthly $275,000 retainer, with no expenses, but lose out on their 19-basis-point fee, worth almost $14 million, for a fairness opinion on the $7.3 billion in transmission asset bonds.

The nearly $20 billion in proposed MOU issues is the most controversial component of the financial plan. In addition to selling the transmission assets, the utilities will agree, for ten years, to base wholesale rates on actual costs of generation, plus “reasonable” profits (defined as return on equity of 11.6 percent), for power produced by their hydroelectric and nuclear plants – which they were not required to divest under the 1996 deregulation law – rather than on market prices. Southern California Edison signed the agreement in March.

Southern California Edison’s securitization bonds would be underwritten by Goldman, Sachs & Co. and PG&E’s by Lehman Brothers. With the utilities’ creditworthiness thus restored, the state would be able to stop buying power on their behalf – a program that has already drained the state’s general fund of some $8 billion since the beginning of the year – and to set the stage for this fall’s record bond issue.

But consumer groups and politicians have denounced the scheme as an unjust bailout. “It’s a complete capitulation to the interests of the utilities,” says Douglas Heller, an advocate with the Foundation for Taxpayer and Consumer Rights. “The ratepayers of California don’t owe Southern California Edison or PG&E or the generators’ creditors another dime.” The Los Angeles Times called the MOU the “Edison bailout.” The Utility Reform Network, a consumer group, dubbed the MOU the “Massively Overcompensated Utility.” Said State Senate leader John Burton, “You might as well buy the company.”

Edison’s agreement with the governor’s legal adviser, Barry Goode, is to sell its transmission facilities to the state for $2.8 billion, a rich 2.3 times book value. A June accord with San Diego Gas & Electric, worth about $1 billion, also awaits legislative approval. But PG&E, the state’s largest utility, had little confidence in a deal and filed for bankruptcy on April 6, with nearly $9 billion in unpaid bills.

To Fichera, Heller’s belief that ratepayers might fare better with the utilities in bankruptcy belies common sense. “The people who see the court as a more orderly political process have obviously never sat through a creditors’ committee meeting,” Fichera snaps. “Generally, bankruptcy proceedings take two to three years and protect creditors, not ratepayers.”

Still, the MOU seems DOA in the legislature, in part because it turns out the $7.3 billion price tag to buy all three utilities’ transmission assets includes a $4 billion book profit for the utilities. The profit would reduce the size of the securitization bond issue, but that won’t silence the howls of outrage.

Legislators have proposed an array of alternatives to transfer a bigger financial burden from the state to big energy users and creditors. Examples: Regulate consumer rates, but have big customers negotiate market prices; repay a smaller percentage of the utilities’ debt; pay less for transmission facilities. But the chances of even an alternative deal being agreed to by the August 15 deadline for legislative approval of the sale by Edison are receding. A petition to the court by even three creditors could throw the utility into involuntary bankruptcy.

The plans for the $13.4 billion bond issue to repay the general fund have also hit a snag. Bond buyers want certainty that, even with the utilities in bankruptcy, the revenues to service the debt – which are not backed by the full faith and credit of the state – will be secure, since the bonds pay for power that has already been supplied. “It’s a very fine line that has to be worked out,” says A.J. Sabatelle, a vice president and senior credit officer in the power group at Moody’s Investors Service.

The wrangling has delayed the bond issue until October. By then the state’s general fund will run dry. To buy time, on June 19 the state got a bridge loan of up to $5 billion, with $3.5 billion in cash from a group led by J.P. Morgan Chase & Co.

In other states, top officers such as the lieutenant governor and the treasurer work for the governor and usually speak in unison. Not so in California, where they are independently elected and often seem to be running for governor themselves.

For instance, Treasurer Angelides, who is responsible for this fall’s bond issue, is a leader in the push for deeper government involvement in the market – from building its own plants to seizing the plants of others if wholesale prices continue to rise. “This is not a radical notion,” argues Angelides. “The whole history of America in the 20th century is that it didn’t tolerate monopolies, which is what we have when eight sellers have a commodity this economy needs. This is why Teddy Roosevelt busted the trusts. It’s part of the cloth of our democracy.”

Angelides and Senate President Burton teamed up to create a state power authority that could build, buy and operate power plants and issue up to $5 billion in revenue bonds. It will be headed by S. David Freeman, the governor’s senior energy adviser. “The deregulation bandwagon has come to a screeching halt – as it should,” says Freeman, who earlier ran the Los Angeles Department of Water and Power and the Tennessee Valley Authority. “We should have a hybrid with the market and a power authority to make sure there are no shortages.”

The often acerbic Freeman, 75, is a veteran of energy policy. Fond of cowboy hats, he has become a folk hero in Los Angeles for his 1996 decision not to divest the city’s generators, which has spared LA from rolling blackouts and price spikes.

Then there’s California’s attorney general, Bill Lockyer. Speaking to The Wall Street Journal, he suggested a way to pressure Kenneth Lay, the chairman of Enron Corp., to sell the state power at lower rates. “I would love to personally escort Lay to an 8-by-10 cell that he could share with a tattooed dude who says, ‘Hi, my name is Spike, honey.'”

But there is plenty of blame to go around. Sherry Bebitch Jeffe, a political analyst at the University of Southern California, also faults the governor for a lack of leadership. “Davis simply has not engendered party loyalty,” she says. “He is a loner, cautious and deliberate.”

Nor has Fichera helped with his comments. “The controller pays the bills and can shoot at us,” he says. “She’s got the power of the press. It’s all political. It’s government by press release.” He dismisses Angelides’s takeover plan as “the Eastern European model.” Accurate, perhaps, but hardly diplomatic. Notes a credit analyst, “Investors don’t want to hear the adviser slamming the treasurer and controller, even if it’s fair criticism.”

“I’m not the smoothest person in the world,” concedes Fichera. Says his friend Thurman: “He has a tendency not to listen. He knows that. He’s got very little patience for people who don’t do their homework. That doesn’t win you friends.”

The cacophony in Sacramento is undermining California’s credibility with the capital markets and will cost the state millions of dollars. “The longer the craziness goes on in California, the more investors and rating agencies start wondering what’s wrong with the state,” said Alan Blinder, a former vice chairman of the Federal Reserve Board who is now a professor of economics at Princeton University and a senior adviser to Saber Partners. Indeed, in April, Standard & Poor’s, citing California’s energy crisis, lowered its rating on the state’s general obligation bonds by two notches, to A+ – the second lowest of any state in the U.S. next to Louisiana. On a $13.4 billion bond issue, the downgrade will likely cost the state more than $70 million per year in additional interest costs for the 15-year life of the bonds.

Even so, no one knows how well the market will be able to absorb such a large debt issue. “It is a significant issue,” concedes Angelides. “But it has to be viewed in the context of the overall municipal bond market, which is about $200 billion. This bond issue doesn’t overwhelm the marketplace.”

Ultimately, the key will be price. “We’re talking about billions of dollars needed by desperate sellers,” says one banker. “[The bonds] will be priced to sell.” The upshot: Little downside risk for underwriters, led by J.P. Morgan. Tens of millions of dollars in fees for sellers. And a great deal for investors.

Underwriters and traders are gearing up for an issue that will be a milestone in the municipal market. “There will be a fair number of challenges to get it all sold,” says John Hallacy, a managing director of research at Merrill Lynch & Co. About a quarter of the bonds will be taxable because to sell such a large issue, the bonds will have to be marketed nationally, and a state can exempt only its own taxpayers from state taxes. Special retail tranches, zero-coupon bonds, euro-denominated bonds and even bonds registered on the New York Stock Exchange are possibilities. There may also be a variety of maturities, from several years up to 15 years.

To win the senior manager slot, J.P. Morgan offered to lead a bridge loan in January, which Merrill and Salomon Smith Barney backed away from. It also helped that Morgan’s lead negotiator, Nathan Brostrom, had worked for four years for then-treasurer Kathleen Brown in the early 1990s and has known Angelides for several years. “We are extremely excited,” says Brostrom. “This has dwarfed anything else I’ve worked on.”

Analysts say the risks, combined with the huge size of the power bond offering, could push up interest rates on the bonds by as much as 30 basis points over the state’s already higher-priced general obligation bonds. The tax-exempt bonds, which will total $10 billion, will probably yield between 4 and 6.5 percent; for a California resident in the highest tax bracket, that equals yields of 9 percent or more on taxable CDs, thus attracting retail interest. The taxable bonds will likely yield between 150 and 200 basis points above U.S. Treasuries.

Nevertheless, says Fichera, “this won’t cost taxpayers a dime. The funds borrowed from taxpayers [the general fund] will be repaid with interest once the power bonds are sold.” Of course, the bond issue will leave ratepayers on the hook, but Fichera argues that amortizing the repayment over the life of the bonds will add just half a penny per kilowatt hour to the cost of electricity. All the bonds together will increase prices from 9 cents per kWh to 10 cents, he says.

California’s political machinations have been humbling for Fichera. On the Street his creativity usually paid off. In 1988, as a vice president at Smith Barney, then a second-tier brokerage, he scored a coup by landing a deal to sell Exxon Corp. a $1 billion private placement of Sabres, a type of preferred stock, invented by Fichera in 1986, that mirrored commercial paper. But his success on Wall Street was always bittersweet. “It was sobering to think that I was spending most of my time trying to lower the cost of capital for Exxon,” he says.

Wall Street’s fat egos and paychecks also offended him. In 1988 he wrote a long essay railing against Wall Street’s bonus system, which he saw as feeding greed, undermining teamwork and lowering the quality of service to clients. Barron’s agreed to publish the piece, Fichera says, but he got cold feet and sent it only to clients. “His bosses would have offered him a pay cut immediately,” says Saber’s Blinder drily.

In 1995 Fichera returned to Princeton University, his alma mater. During a yearlong sabbatical, he studied history, politics, architecture and art. “As gruff as he can be, a part of Joe is extraordinarily naive and innocent,” says Thurman. “It still bothers him that the world doesn’t work like it’s supposed to.”

California has driven that reality home. “I’m definitely going to need another sabbatical to figure it all out,” he says.

Maybe this time he’ll study how public policy gets made.

©Copyright 2001 Institutional Investor, Inc.

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