Lehman Swap Burns New Jersey Residents With Loss

Lehman Swap Burns New Jersey Residents With Loss
Bloomberg, 23-Feb-08
By Michael Quint

Every month, when Anthony Smith of Trenton, New Jersey, pays his Public Service Electric & Gas Co. bill, part of the money covers a $201.3 million loss from a bet the utility made with Lehman Brothers Holdings Inc.

``I just look at the fees and say, `Damn, I don't even know what that is,''' Smith, 31, said of the charges listed in the fine print on the back of his monthly statement.

PSE&G's 2 million customers pay extra because executives of the Newark-based utility and state regulators left them on the hook for a gamble that backfired eight years ago. The so-called forward interest-rate swap involved a promise to exchange interest payments with Lehman as the power company prepared to sell $2.5 billion of bonds.

While borrowers routinely use swaps to reduce risks, this one was unusual because it was a win-win situation for PSE&G shareholders. The electric company would get paid by New York- based Lehman if interest rates rose and made its borrowing costs too expensive. PSE&G's customers, not its investors, would foot the bill if interest rates declined.

``It was irresponsible and not in consumers' best interest,'' said Adam Garber, consumer advocate at the New Jersey Public Interest Research Group.

PSE&G arranged the swap in 1999 while preparing for New Jersey to open its electricity market to competition. The plans included a bond sale to cover the costs of making the transition.

New Jersey's Board of Public Utilities approved the borrowing and allowed the utility to add a special fee, called a ``securitization transition charge,'' to customers' bills that would cover the costs of selling the debt, arranging the swap, and making principal and interest payments.

Other Alternatives

The utility's Treasurer Morton A. Plawner said PSE&G, now owned by Public Service Enterprise Group Inc., proposed the swaps after the company and bankers at Lehman considered other hedging arrangements. They decided that the forward rate swaps were the best way to ensure the debt offering could go ahead even if rates rose, he said.

PSE&G could have protected itself from rising rates with an interest-rate cap that wouldn't have left customers vulnerable to losses, said Robert Brooks, the SouthTrust Professor of Financial Management at the University of Alabama in Tuscaloosa. A cap would have placed a ceiling on bond yields in exchange for a single payment with no additional cost if rates fell.

Mark Beyer, chief economist for the utilities board, and Herbert Tate, the former president of the three-member panel, said they approved the swap based on a recommendation from New York-based Bear Stearns Cos., the fifth-biggest U.S. securities firm by capital.

Unique for Utilities

``We relied on the advice and expertise of Bear Stearns, our financial adviser,'' said Tate.

J. David Rush, senior managing director at Bear Stearns and adviser to the New Jersey regulators, declined to comment. Amany Attia, a Lehman banker who worked on the deal for the fourth- largest U.S. securities firm by market value, didn't return a telephone call seeking comment.

While states including Texas and Illinois sold similar bonds to prepare for deregulation, they didn't agree to a forward interest rate swap like PSE&G's in New Jersey. The strategy wasn't used again in the state.

``When utilities borrow or spend money that ratepayers are obliged to pay for, it is the responsibility of regulators to make sure that those costs are prudently incurred,'' said Timothy Brennan, professor of public policy and economics at the University of Maryland, Baltimore. Brennan wasn't familiar with the PSE&G forward swap loss.

Eight Parts

Swaps are a type of interest-rate derivative, a market that has grown to more than $250 trillion as thousands of borrowers from companies to small towns used the contracts to lower debt costs and protect against rising interest rates. Derivatives are financial contracts whose values are derived from changes in the value of stocks, bonds, loans, currencies or commodities.

The forward swap required PSE&G to make fixed-rate payments to Lehman at a future date in exchange for receiving floating rates based on the London interbank offered rate.

The PSE&G contract with Lehman included eight arrangements that matched parts of the proposed bond sale. The largest was tied to $456.9 million of bonds due in 2015. PSE&G agreed to pay Lehman 7.379 percent on that amount in exchange for floating- rate payments equal to three-month Libor, the rate for wholesale deposits between banks.

`Looked Like Heroes'

The agreement was initially profitable for PSE&G as interest rates rose. Yields on benchmark five-year Treasuries climbed as high as 6.81 percent in May 2000 from 5.97 percent when the swap was put in place in October 1999, as a booming economy prompted the Federal Reserve to boost rates.

``We all looked like heroes,'' said Tate.

When interest rates began falling amid slowing U.S. growth and a slump in share prices, the value of the utility's contract plunged. Tate said the board stuck with the arrangement ``because that was our guarantee the bonds would be sold.''

By the time of the sale in January 2001, the 7.379 percent PSE&G agreed to pay was 1.175 percentage points more than the 6.204 percent calculated market rate and the utility owed Lehman $49.4 million for just one part of the forward swap.

PSE&G terminated the swap at the time of the bond sale, at which it paid an average interest rate of 6.48 percent. By that point, the loss on the agreement was $201 million.

Not Disclosed

The full loss wasn't disclosed at the time. The prospectus for the bond sale said that $125 million of the proceeds went toward financing costs, which included underwriting fees, legal expenses and about half of the charge on the swaps. The rest is still being paid by consumers.

As of June 30, customers still owed about $77.7 million for the swap losses, according to a letter from James T. Foran, general corporate counsel at PSE&G.

The costs of the bet were little noticed in the state. Joseph J. Seneca, a professor at Rutgers University's Edward J. Bloustein School of Planning and Public Policy and chairman of the New Jersey Council of Economic Advisors, wasn't aware of it. Nor was Michael Crew, a professor of finance and economics at Rutgers who is director of the university's Center for Research in Regulated Industries.

New Jersey Governor Jon Corzine, former head of Goldman Sachs Group Inc., who took office last year, declined to comment, said his spokesman, Brendan Gilfillan.

As he stood outside PSE&G's Trenton bill-paying center, Smith said he is no longer surprised by extra charges on his utility bill.

``I don't know and I don't pay attention, I just pay the bills,'' he said.

To contact the reporter on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net .