Wall Street loves stranded costs. No kidding. For stockbrokers and underwriters accustomed to selling utility issues to widows and orphans, the prospect of asset-backed financing opens a whole new world. I'm talking here about "securitizing" stranded costs.
In a securitization, a trust takes beneficial title to utility assets (tangible or intangible) that have lost their value in the market, and sells "transition bonds" to a new set of investors, funneling the bond sales proceeds back to the utility and to its equity investors. Who pays the coupon? Why, it's the customer of course. The utility customer ("ratepayer" may be a better term in this context) pays tariffed rates designed by state regulators to recover the stranded costs. The revenue stream just keeps on flowing.
And guess what? Since regulators can't be trusted, the state legislature steps into the game. The lawmakers pass a law that virtually guarantees the collection of revenues which support the bond, even as the trust holds the assets as collateral. The law may well require a true-up mechanism to ensure revenues continue to cover costs (em to compensate for changes in demographics or usage patterns among the customers who pay the transition charges.
Dan Scotto, senior managing director for corporate bond research at Bear, Stearns & Co., puts it this way: "This guaranteed recovery would replace the normal regulatory process (em a balancing of interests (em normally performed by the regulators." Bear Stearns put out a report on utility securitization in February. It notes that California, Pennsylvania and New Jersey already have securitization laws in place, and predicts that Connecticut, New York, Michigan, Texas and Vermont are likely to consider similar laws.
"Once the securities are sold," says Scotto, "neither regulators nor legislators would have the legal authority to interfere with this charge during the lifetime of the bonds."
That's how the game works. Talk about low risk. You'd think the bonds would sell themselves.
"We think it's better than anything in the market," says Tracy Van Eck, senior managing director for asset-backed securities at Bear Stearns, on predicting the success of stranded-asset bonds among other ABS issues.
"Historically," says Van Eck, "New asset types [new categories of ABS issues] have come in at a `new issue premium,' reflecting the need to educate bond investors ... but we think these utilities [ABS issues] deserve the tightest benchmarks."
In other words, rate reduction bonds to securitize stranded costs should sell at the lowest interest rate premium above no-risk debt (U.S. treasury issues) of any asset type in the ABS market, which includes credit card installment debt, home equity loans, auto and truck purchasing and leasing, student loans, equipment lease financing and loans for other assets.
"So where should utility securitization ABSs be traded?" asks Van Eck. "Close to risk free," she says, noting the reliable cash flow, virtually guaranteed by the state law. "It's as close to a tax as you can get."
Floating the Bonds
There are risks, nevertheless, with these new asset-backed securities. But the risks are different from those we usually associate with the typical, corporate-backed utility bond.
In a report issued in February, Moody's Investors Service took a stab at evaluating the risks in these new ABS financings. That report, entitled "Stranded Utility Costs: Legislation Jolts the ABS Market," predicts some $50 billion to $75 billion in new ABS issues over the next four years.
Lesley Goldwasser, also a senior manager for
ABS issues at Bear Stearns, projected $7 billion in new ABS issues in 1997 to secure utility stranded costs
(out of $175 billion for the total ABS market). By contrast, reports Goldwasser, credit cards ($46 billion), home equity loans ($35.7 billion), and auto loans ($26.3 billion) drove the ABS market in 1996.
For this new breed of utility investor (em the one who casts his lot of ABS issues (em the risks may likely include a host of new factors specific to the utility's wires franchise area. As Moody's notes, the region's tax climate, jobless rate and index of economic activity and new business formations may affect the revenue stream for ABS debt as much as anything. So too will the area's weather patterns, its energy consumption preferences, its population growth rate and its demographic profile.
This catalog of risks reflects the special nature of ABS bonds. Contrary to the typical utility bond supported by corporate assets such as loans or leases, the securitized asset for a stranded cost bond, says Moody's, is the future revenue stream from fees paid from the utility's customer base (or from customers who sign on after having switched energy providers). New questions arise in evaluating risk. Who are the utility's customers? How old are they? How much energy do they buy? Do they keep their thermostats turned up high during the winter? Do they sleep with the windows open in the summer?
In fact, this revenue stream does not even depend upon the continuing corporate existence of the originating utility, notes Moody's. It explains that state legislation enabling these securitization deals will typically require the successor in interest to satisfy all the obligations of the issuing utility, including collection of fee revenue for the securitization even after bankruptcy.
The True Up
Not everyone loves securitization. In New York state, Assembly Speaker Sheldon Silver has joined with Majority Leader Michael J. Bragman and Energy Committee Chair Paul D. Tondo, to issue a scathing critique on Governor Pataki's bill to allow securitization of utility stranded costs.
Their briefing paper, "Shedding Light on Securitization," raises alarms at the prospect of $15 billion to $25 billion in new ABS debt, which the lawmakers describe as akin to "public debt."
"Under the Governor's securitization bill," say Sheldon Silver, et al., "utilities would be guaranteed the right to charge ratepayers for the full amount of any sum fixed by the PSC [public service commission]. This guaranteed recovery for utilities would replace the balancing of interests normally performed by the commission.
"The bill does not require that there be any relation between the savings achieved and the amount of utility recoveries that are guaranteed."
In California, where the securitization craze began, the Legislature met this objection by mandating a rate freeze and reduction. But as the public utilities commission has now begun to realize, the rate freeze in California places regulators in a bind. It narrows the maneuvering room (or "headroom" (em see the March 15 issue) for performing true-up adjustments if the utility's energy sales (the revenue support for the bonds) fall short of predictions.
How can you have a rate freeze and at the same time guarantee the revenue stream? Wall Street loves these bonds. Wanna buy one?
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