No Longer Stranded in the USA

August 01, 2008

By Nicole Gelinas

US utility companies have been issuing stranded-cost securitisation deals in domestic markets without much fanfare for seven years. But a recent favourable risk weighting ruling handed down by the UK’s Financial Services Authority (FSA) at the request of one UK investor in a recent US stranded-cost deal has stoked global interest in the sector. Nicole Gelinas reports from New York.

A recent US stranded-cost transaction that received a favourable risk weighting from the UK’s FSA has re-ignited interest in this asset class. The deal involved Texas utility TXU issuing US$790m in medium-term, stranded-cost debt, through special purpose vehicle TXU Electric Delivery Transition Bond Co LLC in May. The debt issuance – TXU’s second such securitised deal in a year – was jointly led by Merrill Lynch and Wachovia Securities, and was rated triple-A by both Standard & Poor’s (S&P) and Fitch Ratings. Additional underwriters included Banc of America Securities, Bear Stearns, CSFB and MR Beal & Co; advisers Saber Partners LLC counselled the Public Utility Commission of Texas (PUCT) on the transaction.

The debt was broken into three tranches: a US$274m, three-year tranche, priced at 3bp over triple-A swaps; a US$224m, seven-year tranche, priced at 11bp over and a US$292m, 10-year tranche, priced at 14bp over.

The TXU deal was not structurally different from a similar US$500m deal the company did just last August – indeed, since November 1997, US utilities have securitised US$30bn in stranded costs across 25 different deals in 10 states, all rated triple-A due to an airtight repeated structure.

The TXU deal, like its predecessors, is backed by a mandatory charge tacked onto consumer utility bills. Some states in the US enacted laws that mandate such charges in the 1990s, in order to pave the way for deregulation of the formerly tightly regulated rate structure of the power sector.

Formerly monopolistic utilities, that had built excess generation capacity prior to deregulation because they were assured of captive markets in their service territories, needed a way to recapture those now “stranded costs” before they could compete with new upstarts which would not have to build such excess capacity. Thus, the state stranded-cost laws allowed politicians to garner the support of powerful utility lobbyists for aggressive state-level deregulation initiatives in the US.

In the case of the Texas deal, the collateralised utility charge, or “transition property,” was authorised in an August 2002 financing order issued by the Public Utility Commission of Texas, S&P analysts wrote in an analysis of the deal. The charge backing the TXU collateral is considered particularly strong by raters, as it is backed by a “statutory and irrevocable” restructuring act voted into law by the Texas legislature in 1999 and recently upheld by the State Supreme Court. The State of Texas does not provide an explicit payment guarantee, but the state has pledged not to “alter or impair the transition property,” S&P noted – the legal strength of the pledge and the strength of the collateral merits the highest-grade rating.

The transition cost is set to recover the principal, interest and administrative costs of the bonds and relates to previously agreed-upon costs borne by the utilities for their generation-related assets, S&P said.

“Most importantly,” wrote Fitch Ratings analyst Steven Moffitt in that agency’s report on the credit, “the act and the financing order require a [tariff] adjustment at least annually through a true-up mechanism to keep principal amortisation and funding of the overcollateralisation account in line with expected balances.” Overcollateralisation is equal to 0.5% of the original principal; other credit enhancement includes a capital account also equal to 0.5% of the original principal that was funded at closing.

But even with triple-A ratings, strong collateral and good track records, stranded-cost deals always suffered a handicap in Europe. International risk-based capital rules have always assigned US banks a 20% capital risk weighting to all triple-A and double-A rated asset-backed debt in the US, but have assigned a 100% risk weighting to the same securities in the UK and in Europe unless the securities are explicitly guaranteed by the US government or another reputable public-sector entity in the US.

Since deals like TXU are guaranteed by the government’s specific regulatory authority, but only indirectly by its taxing authority, it was assumed until this year that they were assigned a 100% risk weighting in Europe, akin more to corporate deals than to high-grade government deals. The difference is important, because 100%-weighted bonds require banks to back their investment with 8% capital, whereas a 20% weighting requires only a 1.6% capital backing (20% x 8.0%).

But all that changed in May, when a UK investor on the TXU deal requested an individual guidance from the FSA on the risk capital, and privately received a 20% risk assignment on the deal. “No one thought this was possible,” Saber Partners chief executive officer, Joseph Fichera, tells ISR, as high-grade stranded-cost deals have always been assumed in Europe to fall into t he category of riskier-weighted c orporate debt.

“Many bankers skipped their homework and incorrectly compared these bonds to more complex – and lesser quality – securities they trade. But once you strip back the layers, these bonds are among the highest quality, government-supported securities available in the US and international capital markets,” Fichera notes.

The 20% ruling significantly improves the return on regulatory capital for Europe-based investors, because it lowers the investors’ own cost of funds and thus widens the spread. For example, a US-based bank investing in a triple-A rated deal yielding 4.70% (or 20bp over the 10-year swap curve) with a 20% risk rating would net a 12.5% overall return on regulatory capital, but a UK-based investor forced into a 100% risk weighting could not earn an equivalent return unless that same security yielded 5.5% (or 100bp over the swap curve). Indeed, that UK investor would earn just 2.5%.

“This difference in risk weighting treatment represents a real economic cost for European banks, and has led them to shy away from investing in US bonds other than taxable municipal bonds,” Saber Partners’ Fichera says.

Issuers and their financial advisers hope to educate European investors on this new benefit, to capitalise on higher demand on the part of global investors for future stranded-cost deals and achieve the lowest cost of funds possible for the utilities and their customers.

Saber Partners has already won new clients who want to structure similar deals to be sold globally – Saber was hired in April by the State of New Jersey’s Board of Public Utilities to arrange bonds backed by special charges on New Jersey’s retail power consumers’ bills. The bonds will be issued under a New Jersey law similar to that in Texas, which reimburses investor-owned utilities for power costs built during regulation. The bonds will be issued later this year to raise about US$200m.

Fichera notes that, in light of the FSA guidance to that UK investor on the TXU deal, it is “not unrealistic” for other stranded-cost issuers to aim for placement of up to one-third of similarly securitised debt with UK and Continental European investors.

A high level of European interest is expected, because the bonds are not tax-exempt in the US, and thus offer higher yields to investors overall, Fichera notes. Issuers can get away with offerings at low yields in the US because the tax benefits compensate for the lower income, but European investors derive no benefit from that Stateside tax-exempt status on the debt.

European investors have already shown interest in investing the American high-grade municipal market when that debt is taxable and thus higher-yielding. In June 2003, the State of Illinois issued a US$10bn general-obligation taxable bond issue to great European interest; in fact, about 27% of the deal, which garnered a 20% risk weighting due to its high-quality government guarantee, was sold to UK and Continental European investors.

But it may take aggressive international marketing to make the benefits of stranded-cost deals clear to potential investors in Europe, as this is currently an inefficient market.

Stepped-European investment in stranded-cost deals will feed off itself. More investors in stranded cost deals worldwide will improve liquidity in the secondary market, and thus create a more robust, transparent trading market for the overall sector between large-scale issues. While no US utility has yet issued a euro tranche, Fichera notes that euro-denominated facilities are certainly possible if demand warrants such a structure.

Other states are also looking to capitalise on this projected new demand. In Texas, utilities, Centerpoint and AEP are planning deals, although amounts aren’t yet decided. Additional issuers in the pipeline include utilities operating in the states of California (US$3bn); Wisconsin (US$500m); Michigan (US$500m) and Vermont (US$200m).

Risks to the collection of the collateral are minimal, since the collections are spread over millions of customer accounts and are government-mandated. However, one potential risk is that of voter referendum or petition right on the part of citizens – as S&P noted in its legal analysis of the TXU deal, that particular deal is strong partly because “citizens of Texas do not have referendum rights or initiative petition rights regarding laws adopted by Texas”.

But even in states with strong histories of referendums and voter revolts, the risk of a reversal of a statutory state charge on a power bill is considered very low; proof of that is found in the fact that deals in California, with a very high level of voter initiative, have also been awarded the triple-A rating and have performed well thus far.

“Legislation enacted to recover stranded-costs is separate from the routine budgetary appropriation process,” S&P analyst Weili Chen, who covered the TXU deal, told ISR in July. Indeed, the history of the asset class shows it to be a strong one, as early issuers have a robust history of paying their obligations without hiccups even during the post-deregulatory turmoil that has plagued the US power sector over the past four years. In addition, the legislation in each state “is meant to create a property right” according to Chen.

The US Constitution provides for the enforcement of contracts between parties, including when one party is a US state, Fichera adds. Thus, the risk of a state re-appropriation of the right to charge utility users for stranded-cost reimbursement is quite low under US law.