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Crisis Capital

Volatile markets call for alternative financial models.

Fortnightly Magazine - September 2009

In the 2000s, the widespread use of securitized instruments such as credit default swaps and collateralized loan obligations in the power industry spread out the credit risks among a much larger and diversified group of investors, leading to reduced spreads.

Both utilities and merchants enjoyed this confluence of favorable conditions for both project and corporate financing for an extended period of time. Unfortunately, the party couldn’t last forever.

Current Credit Conditions

The seeds of success contained the potential for disaster. In specific, the explosion of debt that provided a windfall for power companies—by adding low-cost debt to their capital structures and allowing them to substitute debt for equity—eventually led to levels of leverage that couldn’t be adequately serviced through their cash flows. This is particularly true for merchants. Utilities, on the other hand, remained regulated, and generated sufficiently stable cash flows to service their debt obligations. 1 After investing in many non-utility industry or overseas operations in the 1990s and early 2000s, most utilities went back to basics. Since then, their steadier approach has allowed them to retain significantly easier access to capital, as their credit ratings didn’t suffer as much and their spreads have remained much narrower than they did for merchants. Additionally, because utilities are viewed as a defensive sector, they’ve enjoyed ready access to capital—albeit at a higher price. The market’s general flight to quality channeled investment dollars toward utility securities, just as it did Treasuries.

As widely reported, the credit crisis in the U.S. (and global) financial markets largely was due to the exposure of banks and investors to sub-prime mortgages originated by banks and sold to investors as mortgage-backed securities. Financial institutions, primarily investment banks, were the key investors in these mortgage-backed securities and other structured products. These institutions issued large amounts of debt in the mid-2000s to fund their purchases. When housing prices started to decline, the financial institutions faced large losses on their investments.

No industrial sector—including power—has been immune to the current credit crisis, even if utilities have been less affected than merchants. The loss positions of the banks and overleveraging obviously have impacted their ability to provide financing and infrastructure project financing in the power sector, in general.

The significance of this change for the power industry is that the credit crisis has caused de-leveraging ( i.e., less debt and more need for equity) and has led to a scarcity of capital for the sector. This scarcity has been reflected in the increasing yields (interest rates) of high-yield bonds (see Figure 2) . Since July 2008 the yield on a non-investment grade “B” bond (the line labeled “Merchants 10 Year”) has risen from 9.5 percent to 12 percent, after reaching a high of 16 percent at the onset of the crisis. The spread has increased by 250 basis points (bps), a significant market change in such a short period. Initially, the increased spreads were slightly offset by lower Treasury bond rates, but recently the spreads have reduced partly because of higher Treasury bond rates. In fact, recently Treasury bonds are trading close to