Delay of Bond Sale Proves Costly for the State

In the frenzied early days of the energy crisis, Gov. Gray Davis and California lawmakers gave state Treasurer Phil Angelides an urgent task.

California was about to burn through billions of dollars buying electricity to avoid catastrophic mass blackouts. The emergency purchases were going to punch a huge hole in the state budget. To plug it, the treasurer would have to orchestrate the biggest municipal bond deal in American history.

For the ambitious Angelides--a former California Democratic Party chairman and real estate developer who has made no secret of his desire to someday be governor--the financing was a chance to claim a central role in taming the crisis.

He seized the opportunity. In just two weeks last February, following a speedy selection process, Angelides assembled a large team of bankers to execute the bond sale. He did it, in part, by tapping former treasurer’s office employees, old friends and political supporters working in the bond world.

Angelides boldly predicted he would have the bonds sold, and the budget repaid, as early as last May. Months later, however, the bond sale, which has since ballooned to $12.5 billion from $10 billion, has yet to get off the ground. Angelides now says it probably will not happen until the middle of this year. And what was billed as the pinnacle of bond deals has instead turned into a costly debacle, for Angelides and the state.

A squabble among some of the state’s top Democratic politicians over how to handle the financial fallout from the energy crisis continues to prevent Angelides from being able to sell the bonds. The problem threatens to plunge the state into a serious fiscal crisis at a time when it already is wrestling with a major budget shortfall and a faltering economy.

It has led to a loss of confidence on Wall Street, where influential investors and credit rating analysts now regard the bond deal as dead in the water. And it has reignited questions from critics in state government and the bond business, who wonder whether Angelides picked the best financial team possible, or allowed politics and personal relationships to influence the process.

Angelides now says it would have been impossible for him to predict the problems that have befallen the bond deal. But others say the warning signs were clear, that some of Angelides’ actions caused the state’s financial problems to snowball, and complicate efforts to come up with a new solution. Notably, critics say, Angelides brokered a $4-billion loan to help pay for power on the assumption it would be repaid by last October with proceeds from the bonds.

If Angelides had received better financial advice, some of his critics say, perhaps he would not have miscalculated on the numerous hurdles the deal faced and made what turned out to be a bad loan, or a series of broken promises to investors about when the bonds would go to market.

Angelides selected bankers generally regarded as capable industry veterans with years of experience in major transactions. Nonetheless, some regarded his choices as standard operating procedure in a business where personal connections can make the difference between winning and losing a spot on a deal, and cronyism and patronage among public officials have historically been common.

“When I called up to Angelides to find out why we weren’t selected, we were told the bottom line is we aren’t up there schmoozing all the time,” said John Fitzgerald, managing director of Seidler-Fitzgerald, a longtime Los Angeles firm that the treasurer passed over for the energy bond deal.

Bond financiers frequently shuttle back and forth between state government and the private sector, making valuable contacts along the way. Big New York investment banks hire “relationship managers” to cozy up to California politicians, and even smaller in-state firms employ lobbyists in Sacramento.

They do so with good reason: Bond work can be extremely lucrative. And no deal exemplified that more than this one. The underwriters, accountants and lawyers with a piece of the action are expected to take in about $100 million in fees for selling the bonds to investors.

For months, the treasurer declined to be interviewed for this story, deflecting questions to his staff, before agreeing recently to a 15-minute discussion. He also directed the bankers working on the deal not to speak to the press.

In the interview, Angelides declined to discuss specific underwriters, but strongly stressed that all 32 investment banking firms that make up his bond team were chosen purely on merit.

“The way I’ve operated since I got here is that we hire the firms that deliver for the state of California, period,” Angelides said.

Investment bankers serve an important role in any municipal bond deal. They help structure the nuts and bolts of the bonds so they are safe and strong investments, ensuring that buyers have confidence they will be paid the interest and principal they’re owed. They also sell the bonds through a network of traders, making sure the state or city gets the lowest interest rate possible, much like a mortgage broker tries to negotiate the best rate for a new home buyer. And they serve as a sales force, helping market the bonds to investors and persuade Wall Street analysts to give the bonds favorable ratings, which can reduce interest costs by millions of dollars.

The treasurer noted that his team includes 11 of the top 20 municipal bond firms in the country, as rated by a respected financial information service. And he pointed out that most of the firms--including many of those that employ known friends or political supporters of his in prominent roles--were doing business with California long before he was elected treasurer in 1998.

“All I can say is that for someone like me, for someone who’s been very active in the civic and financial life of California for . . . 20-some years, that I should know individuals in the financial world should surprise no one,” he said. “You would want your treasurer to know people and to know people who are in the marketplace.”

Budget Deficit Could Swell to $18 Billion

California wound up spending more than $6 billion from the state operating budget to keep the lights on during the energy mess.

If the bond deal does not take place by this summer and state coffers are not reimbursed for that money, a budget deficit most recently estimated at $12.4 billion due to the deteriorating economy could swell to $18 billion or more. That could force Davis and the Legislature to severely cut important government services such as public education, welfare and law enforcement, or impose an unpalatable tax increase during an election year.

Already, California is feeling the financial fallout from the delays. Last fall, the state missed a deadline to pay back a $4.3-billion loan it took out to help cover power purchases until the bonds were sold. The loan was supposed to be repaid with money from the bonds.

The state’s failure to pay on time triggered a series of steep financial penalties and escalating interest rates that will add tens of millions of dollars to the loan’s price tag. California now has to pay it off in quarterly installments of $390 million plus interest beginning this spring.

‘People Are Bored by This Deal Now’

When the bonds finally do go to market, California also will probably have to pay an interest premium to sell them because the botched loan and other state actions during the crisis have caused the state’s credit rating to tumble, driving up its borrowing costs. What’s more, the energy bonds probably will have to compete for investor interest this year with another mammoth financing, a $14-billion New York project to expand the city’s subways.

“People are bored by this deal now. There’s too much slippage going on,” said Dave MacEwen, chief investment officer for American Century Investments, one of many potential buyers that now says it has lost interest in the deal. “Once again, it keeps getting pushed back and there’s this real sense this deal might never get done.”

Angelides says the bond deal’s problems are political.

Before the treasurer can float the bonds, he needs the California Public Utilities Commission to approve a plan to repay them. That is proving more difficult than Angelides and his financiers anticipated.

The bonds are supposed to be paid off over 10 to 15 years by customers of the state’s big private utilities, the beneficiaries of the power the state bought, as part of their electric bills for years to come. But the commission, which regulates electric rates in the state, refuses to approve the repayment plan because the bonds are caught up in the larger political dispute among the commission, state Senate leader John Burton and the Davis administration over the total costs of the crisis.

Angelides says he predicted he could get the deal done because he believed in pushing to make it happen.

“You know, I could have taken a very different route, but I’m not going to do it. I could have taken a different route and just said, ‘When all you folks, the administration . . . the PUC, when you get your work done,’ ” the treasurer will do his part, Angelides said. “But I think I have an obligation as does every elected [official] to not only do their job but try to move the ball along.”

Even before the PUC delayed the bond deal, however, critics of the financial team Angelides selected--including some within the Davis administration--said it lacked bankers with expert knowledge of the commission’s arcane and time-consuming procedures. If Angelides had gotten better advice, they contend, perhaps he would not have turned off investors with failed promises.

Others clearly saw trouble in the making.

“In April, when we cut the state’s [credit] rating, we saw these problems with the PUC, the litigation and the politics coming,” said David Hitchcock, a director with credit rating firm Standard & Poor’s Corp.

PUC President Loretta Lynch and state Controller Kathleen Connell say Angelides’ timetable for selling the bonds was unrealistic from the start.

Even if the PUC granted all the needed approvals tomorrow, Lynch believes it still would be months before the bonds could be sold. Parties have time to appeal the commission’s actions administratively, and can then go to court if they are not satisfied, she said. Pacific Gas & Electric Co., which went into Bankruptcy Court last spring because of losses incurred during the energy crisis, has indicated that it may sue over the PUC’s decision on grounds that it would take too big a slice of electric rates from the utility to pay off the bonds.

Bond Industry Knew State Would Need Cash

In their initial response to the energy crisis, California politicians were not focused on the financial fine print. They were trying to avert disaster.

California already was experiencing blackouts, and more seemed imminent. The state’s three large private utilities--PG&E;, Southern California Edison and San Diego Gas & Electric--could not afford to continue supplying their customers. After months of buying power at exorbitant rates for far more than they could charge consumers under a state rate freeze, the utilities were billions in debt.

Davis declared a state of emergency last Jan. 17, issuing an executive order to begin buying electricity. Days later, lawmakers followed with legislation to more formally put the state in the power business, buying about one-third of the electricity for three-fourths of the state until 2003, and floating bonds to help pay for it.

It was at that time, Angelides said in the recent interview, that he realized the magnitude of the financial problem the state faced. The municipal bond industry apparently realized it sooner. Many banking firms sent representatives to Sacramento well before the financing plan was formally announced, since it was common knowledge in the municipal bond grapevine that California would need a large infusion of cash to overcome its energy mess.

“We knew that eventually, if the state was going to take over the purchase of power, it would have to be financed through bonds,” said Napoleon Brandford, a partner with Siebert Brandford Shank, another firm selected as one of the underwriters. “Like other firms, we submitted unsolicited proposals and suggestions to the treasurer early on to tell them about our experience.”

Among those making their case in person was Nathan Brostrom, a JP Morgan banker based in San Francisco. Brostrom has close ties to the treasurer’s office, having worked there in the early 1990s for Kathleen Brown, the last Democrat before Angelides to hold the job. More recently, Brostrom has served as an unpaid technical advisor to one of the investment boards overseen by Angelides’ office.

JP Morgan wound up with the choicest slot on the deal, the one with the greatest responsibility and the greatest share of the bankers’ fees. It was selected to be book-running senior manager, a post from which it will control the distribution of bonds for sale through the other underwriting firms. Brostrom, the only banker Angelides has permitted to comment publicly, declined repeated requests to be interviewed for this story.

Then came the formal process for winning a piece of the big deal. Treasurer’s officials weeded through the applications, but it was Angelides who made the final call. Twenty-six firms initially were selected, about half the number that applied.

Since the original selection last winter, Angelides has added six more banking firms to help market the mountain of bonds, which would make up more than 6% of the nation’s entire annual municipal bond volume in a single transaction. He said the additions are not an indication that the original team was unable to do the job. Rather, he said, he realized the deal’s size required him to cast a wider net than usual and target all potential bond buyers.

While Angelides and many of the firms chosen tout their experience and qualifications, a few concede that lobbying also is important.

Sutter Securities, for example, was picked as a first-tier co-manager on the energy bond, placing it above much larger businesses such as the Bank of New York. Officials at the firm attribute their success to the hiring of longtime Sacramento lobbyist Phil Schott as a consultant to help build relationships in the Capitol.

“When we didn’t have a person there, we found we couldn’t get any business at all,” said Dennis G. Ciocca, a partner at the firm who contributed to Angelides in 1998. “We found we needed to have someone to be in their face.”

‘Pay to Play’ Still Occurs Despite SEC Regulations

In 1994, SEC regulators adopted a rule designed to curtail one of the most controversial aspects of the relationships between investment banks and politicians: the practice known as “pay to play,” in which underwriters give money to public officials who can award them lucrative bond work.

Under the regulation, bankers are prohibited from working on a bond deal for two years if they have contributed more than $250 to the campaign of an officeholder with power to appoint them to the transaction.

The rule, however, has many loopholes.

“The intent to influence the process through money is still there,” said Charles W. “Skip” Fish, the former head of the Municipal Securities Rulemaking Board, an industry self-regulatory panel. Politicians are simply “dancing around the flame” by taking donations and awarding work just outside the time limit, Fish said.

None of the contributions Angelides received from players in the energy bond deal appears to violate the regulation. While some of the bankers employed on the bond issue gave money to Angelides’ 1998 election campaign, for example, they all did so within the $250 limit.

However, several appear to illustrate Fish’s point. Banking firms are not necessarily bound by the rule. It only applies to contributions made by the specific bankers and branches of a corporation that do bond business. So, to cite one of many examples, Angelides received $5,000 from Bank of America in 1999. But that did not prevent him from hiring Banc. of America Securities, the company’s bond-selling arm, to work on the energy bond or other bond deals.

Moreover, spouses and relatives are mostly immune, though the rule does prohibit making contributions through intermediaries. And law firms, which serve as bond counsel on many big deals, are not covered by the SEC regulation.

One such firm, Orrick, Herrington & Sutcliffe, has been among the largest donors to Angelides, with more than $40,000 in contributions last year. It has a piece of the energy bond deal, working for the Department of Water Resources, the state agency buying electricity. And its lobbying arm represents Morgan Stanley, one of the investment banks working on the deal.

Among the firms selected for the lucrative second-place slot of co-senior manager was Lehman Bros. One of its main California bankers is Peter Taylor, a longtime friend and political associate of Angelides.

When Angelides chaired the California Democratic Party in the early 1990s, Taylor worked with him as its finance director. Like Brostrom, Taylor has provided free technical counsel to a state investment board overseen by Angelides, and contributed to Angelides’ political campaigns. He did not respond to requests for an interview.

“Lehman Bros. has been one of the most substantial underwriters for the state of California for years, under Kathleen Brown, under Matt Fong,” Angelides said, naming his Democratic and Republican predecessors. “They do excellent work and continue to do excellent work for this state. That I know someone who works for Lehman Bros. should not be a surprise. I’ve known Peter Taylor for years.”

Botched Deal May Hamper Recovery

California’s energy storm appears to have passed. Power prices have plummeted, shrinking the state’s electricity costs to a fraction of what they were last winter. But the financial mess the crisis created still lingers.

Because the PUC dramatically raised electric rates this year to account for the inflated market prices, it is now collecting a surplus of cash from consumers. That money could be used to get California’s private utilities back to financial health faster, and thus allow the state to exit the power business sooner. It could even allow California to float less than $12.5 billion in bonds.

But the botched $4.3-billion loan looms over the recovery. The Department of Water Resources, the state agency buying electricity, now needs a bigger share of utility rates to make the $390-million quarterly payments and pay higher interest rates.

To overcome the problem, the state’s political leaders agree, they need to put an end to their infighting and get the bond deal done so the budget and loan can be repaid. However, some question whether Angelides’ loyalty to his bond team is interfering with a political compromise.

The main lenders on the loan are JP Morgan and Lehman Bros., the same firms that got the choicest pieces of the bond deal. Angelides, in fact, said they were selected as underwriters in part because they pledged to help the state out with the loan. It was no small commitment: JP Morgan lender Morgan Guaranty put up $2.5 billion, the largest loan in the firm’s history.

Lynch, the PUC president, and Burton, the Senate leader, have promoted legislation that would allow the state to sell bonds under an alternative plan. But JP Morgan has opposed the proposal and threatened to sue the state, arguing the alternative would impair its loan contract.

To Lynch, the investment bank’s position appears to be a conflict of interest and raises questions about whether the bank should be advising Angelides on ways out of the logjam. The treasurer’s office contends the concerns are unfounded.

“It seems clear that JP Morgan cannot give independent, disinterested advice on the relative benefits and risks of the different financing plans that are currently under consideration,” Lynch said in a letter to the treasurer.

Negotiations on the bond deal, after months of being stalled, have now intensified.

Angelides said he continues to work toward a solution, and to focus on the future. He refuses to dwell on the past.

“But for the politics of this state, we would have been in the market at this point, with, I believe, a successful sale,” Angelides said. “Now, we’re not there yet. It doesn’t do any good to decipher why.”