Why This Florida Regulator is Crying Foul Over Two Letters
C'mon, it's not that complicated.
That, in a nutshell, is the argument that the Florida Public Service Commission is making in a dispute with the three major rating agencies.
The commission regulates utilities, two of which, Florida Power & Light and Duke Energy Florida, have issued bonds backed by special fees assessed on their customers. Its beef is that the rating agencies – Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings – all characterize these deals as a kind of structured finance, rather than as corporate bonds.
The distinction is important. Investors typically demand higher interest rates to compensate for the added risk and complexity of structured finance. Many have investment guidelines that prohibit investments in structured finance, even if they were inclined to do so. Rating agencies, as well as investment banks, also charge higher fees to work on structured finance transactions.
The commission has filed three complaints (one against each rating firm) with the European Securities and Markets Authority in Paris. Since 2010, that European Union body has required rating agencies to add a two-letter identifier, “sf,” to ratings of transactions that meet its definition of structured finance.
The Florida regulator wants the "sf" label removed from its utilities' bonds. If it prevails, utilities that tap this market in the future – not just those in the Sunshine State – would benefit from lower funding costs, and holders of existing paper would enjoy a more liquid secondary market.
The commission argues that utility bonds don’t meet ESMA's criteria for structured finance because they have no tranching of credit risk; cash flow is distributed to all investors with the same priority.
The rating agencies err in adding "sf" to ratings of utility bonds becauase EU regulation directs them to clearly differentiate between structured finance and other kinds of financial instruments, the complaint states.
“We’re trying to determine if the clear and unambiguous rules will be enforced,” said Joseph Fichera, chief executive of Saber Partners, the commission's tenacious financial advisor, and a longtime veteran of this niche of the fixed-income market.
All three complaints are signed by the Florida Commission’s executive director, Braulio L. Baez, its general counsel, Keith C. Hetrick, and by Fichera.
The complaints include a legal opinion from law firm Orrick, Harrington & Sutcliffe that the bonds issued by the Duke Energy Florida and Florida Power & Light do not meet ESMA’s criteria for structured finance. The bonds also do not meet the criteria that each rating agency has stated it would use in applying the “sf” modifier, according to Orrick.
The designation has hurt the utilities, and by extension, their customers, the commission says.
“By assigning the (sf) rating identifier, S&P substantially impaired DEF’s [Duke Energy Florida’s] ability to market the DEF Recovery Bonds to a large portion of the investment community, artificially restricting the distribution of the DEF Recovery Bonds,” the Florida Commission states in one of the complaints. “S&P also has distorted the secondary market both for the DEF Recovery Bonds and for the FPL [Florida Power & Light] Recovery Bonds. The resulting increases in borrowing costs ultimately are borne by electric utility ratepayers in Florida.”
All three rating agencies declined to comment, and the ESMA did not reply to several emails.
Single Layer of Risk
Utility bonds are backed by fees imposed on all customers to recover the cost associated with deregulation, fund major investments, or repair extensive damage. These fees are authorized by state law and are nonbypassable; they are assessed on all customers, even those choosing another supplier. Moreover, there is a “true-up” mechanism that allows the utilities to periodically adjust the level of the fees in order to ensure timely payment of interest to bondholders.
The mandatory nature of these fees allows the issuers to achieve investment grade ratings without creating subordinate tranches that absorb initial losses on the collateral. In presale reports published for these bonds, S&P, Moody’s and Fitch generally identify the primary risk as the possibility that the authorizing legislation could be subject to a court challenge or that the jurisdiction could pass new laws rescinding or revamping the charges.
All three assigned triple-A ratings to $1.3 billion of bonds issued by Duke Energy Florida in June that are backed by a special charge associated with the retirement of the Crystal River Unit 3 nuclear power plant, as well as to $652 million in bonds issued by Florida Power & Light in 2007 that backed by a special charge funding repairs to power lines and facilities from hurricanes. And all three appended the “sf” modifier to their ratings.
Some observers think the Florida Commission faces an uphill battle. Notwithstanding the definition of “structured finance instruments” in the European Union directive, they say, ESMA likely views any transaction that depends upon the performance of an asset or pool of assets as structured finance.
"The rating agencies are doing what they are supposed to do. They’re being conservative to make sure, from a regulatory point of view, they won’t get dinged,” said Ron D’Vari, CEO of New Oak, a financial consultancy that specializes in risk and regulatory compliance. “And all three of them were doing it that way … so the risk of not getting the business [being hired to rate a deal] was lower.”
Jeffrey Manns, an associate professor of law at George Washington University, said he believes the utility bonds meet the European regulatory definition of structured finance. Whether treating all structured finance the same is a good idea is another question.
“The real argument that the Florida utility regulator is making is that the EU regulator’s definition of structured finance is overly inclusive; it draws in products that really don’t post that great a risk,” Manns said. “The structure of utility securitizations makes them far less risky than the other types of securitization that we think of as contributing to the financial crisis.”
The Florida Commission should try a more nuanced argument, Manns said. “They should advocate that the EU should have a more granular analysis in determining structured finance risks. It’s unfair to throw all structured finance into a single basket. “
But he said that ESMA is likely worried that, if it carves out an exception for this asset class, it could face greater pressure to carve out one for others.
Fichera said the issue is not the amount of risk posed by utility bonds, but the nature of the risk. Unlike bonds backed by, say, residential mortgages or auto loans, utility fee bonds are not backed by a finite pool of assets. That’s why there is no tranching of credit risk.
Question of Market Integrity
“It’s a question of market integrity,” Fichera said. “What does ‘sf’ signify?”
Perhaps the closest comparable securities are bonds backed by credit card receivables, which are issued from a master trust that allows the sponsor to contribute new assets – and issue additional credit card-backed securities. But sponsors of credit card backed securities contribute additional collateral at their discretion. (Credit card securitizations also have multiple layers of risk.) By comparison, sponsors of utility fee bonds are obliged to true up the fees backing these bonds.
Fichera said that the Florida Commission and Saber Partners approached ESMA to get additional guidance, but the European regulator responded that it does not issue guidance in advance and responds only after receiving complaints.
It’s not the first time that Fichera is taking an unpopular position. He was a consistent critic of auction rate securities, long-term bonds that are designed to act like short-term instruments because their rates are reset at periodic auctions, and was hired by the Securities and Exchange Commission in 2004 as an expert adviser in a probe of bidding practices. (Auction rates were widely marketed to companies and individual investors as cash equivalents, but in early 2008 the auction market failed and most securities froze, leaving investors unable to dispose of their securities.)
Should ESMA look favorably on the Florida Commission’s complaints and instruct S&P, Moody’s and Fitch to stop classifying utility bonds as structured finance instruments, a number of other utilities stand to benefit.
In August, the Long Island Power Authority raised $475 million via bonds backed by restructuring charges imposed on its retail electricity customers. Entergy New Orleans raised nearly $100 million in July 2015 via bonds backed by storm recovery fees. Likewise, Consumers Energy Company, a Michigan utility, issued $378 million of utility fee bonds in 2014; and in 2013 three utilities issued bonds backed by special fees: Appalachian Power, which serves parts of Virginia and West Virginia, and two Ohio utilities, Ohio Power and FirstEnergy.
Not including the bonds issued on behalf of Duke Energy Florida in June, there are approximately $11 billion of bonds backed by utility fees outstanding, according to the offering prospects for Duke Energy Florida’s bonds.
In theory, removing the “sf” designation from utility fee bonds would allow sponsors to borrow money at interest rates comparable to those paid by triple-A rated corporate issuers (of which there are relatively few).
Duke Energy Florida managed to close some of the gap by marketing its June offering as corporate bonds, at least to U.S. investors.
The securities have unusually long durations for this sector; over $500 million had maturities from 15 to almost 19 years. By comparison, most other deals in the utility sector have original terms under 10 years. The tranche with the longest duration pays a yield spread over Treasuries similar to those of triple-A rated bonds issued by Johnson & Johnson and the Tennessee Valley Authority. However spreads on the bonds with shorter durations are wider than comparable corporates.
The day after the bonds were priced, Barclays announced it would classify the bonds as corporates for the purposes of its bond indexes – which could attract a broader investment base