Complex financial deals and energy projects cost Vernon millions

The city of Vernon has amassed nearly half a billion dollars of debt and suffered major losses over the last six years in an aggressive pursuit of investments through its electric utility, according to a Times analysis of the city’s financial records.

Even as the city’s losses mounted, Vernon’s leaders continued to push for more complex and grandiose projects. Officials bought a 15-year supply of natural gas at a fixed rate expecting prices would rise, only to see them fall precipitously. They also spent heavily on plans for a massive power station project that was later abandoned.

Despite this financial crisis, the city steadily increased spending on salaries, pensions and fees to attorneys and consultants, according to audited financial reports.

Reimbursement records show that top administrators traveled first-class across the country and to Europe, stayed in luxury hotels and saw their pay skyrocket — with one official making over $1 million a year.

In the face of the city’s financial struggles, officials sought to educate themselves more about the energy industry. Eric T. Fresch, the city administrator at the time, purchased $4,000 worth of books with such titles as “Trading Natural Gas: A Nontechnical Guide” and “Lights Out: The Electricity Crisis, the Global Economy, and What It Means to You.”

Vernon’s leaders have traditionally painted a rosy picture of the city’s finances. But when asked for specifics this year, city officials declined several requests to answer detailed questions about the city’s financial history.

“Have we had our ups and downs? Absolutely,” City Administrator Mark Whitworth said in a brief interview. “But we’ve navigated the most difficult waters. We’re doing a good job.”

To better understand the city’s financial situation, The Times hired an accounting firm to review Vernon’s annual financial reports dating to 2001.

Raman Sain, a principal at Holthouse, Carlin & Van Trigt, the largest accounting firm in Southern California, said the reports outline a steady decline in the city’s finances since 2005 due to swelling debt, dwindling revenues and increased spending on salaries, benefits and legal fees.

The firm found that Vernon lost more than $130 million in “net assets” in the last six years. Sain said net assets are an important measure of a city’s financial health because they compare the city’s cash, property and other assets against its debts. Vernon’s own auditor also described net assets as a “useful indicator” of the city’s finances.

“It’s not good,” Sain said. “The net assets of the city are declining significantly, and the trend is so steep.”

John Naimo, Los Angeles County’s assistant auditor-controller who also examined Vernon’s audited records on behalf of The Times, said: “Overall, it’s a deteriorating picture.”

To balance its budget and cover surging interest expenses, the industrial city has been forced to sharply raise electricity rates, which have traditionally been much lower than in surrounding cities.

The financial problems are challenging Vernon’s reputation as a business-friendly hot spot at a time when it faces the threat of disincorporation by the state Legislature after a series of public corruption scandals.

Kevork Khrimian, a Moody’s Investors Service analyst who covers Vernon’s bonds, said the city’s current A3 rating is significantly lower than that of many other public entities in California.

To meet its debt service — estimated at $56 million a year for the next decade — the Vernon Light & Power Department would have to continue to raise rates or find ways of cutting costs, he said.

While there is little chance Vernon will default on its debts, Khrimian said the city has received a relatively low bond rating due to the complexity of its business ventures and the inherent risks involved.

“There’s just a lot going on, they buy gas, they sell gas, they invest in properties….Those things can go wrong, it’s an exposure,” he said. “The average utility system just keeps it simpler.”

Unusual arrangements

Vernon, located near the heart of a key shipping corridor south of downtown L.A., is a 5.2-square-mile city that has long catered to heavy manufacturers, food processors and cold storage companies. There are only about 30 homes and 100 residents within its borders but 1,800 businesses that employ an estimated 55,000 workers.

With an annual budget of about $300 million — dwarfing that of surrounding communities — the city has been an economic powerhouse.

Vernon’s unique makeup has given it an advantage in its power business, experts said. The high, steady power consumption of the city’s industrial users has helped it offer lower rates compared to other utilities, which must also provide energy to residential customers whose use fluctuates during the day.

For most of its history, Vernon’s Light & Power Department acquired energy from private utilities like Southern California Edison or through stakes in outside generation facilities, with the city then transmitting electricity to its industrial customers.

But as the price of power began to surge about a decade ago, the city set out to build the Malburg Generating Station, a 134-megawatt, natural gas-fueled plant named after then-Mayor Leonis Malburg.

At the time, Vernon’s reserves were sufficient to pay for the $142-million project, former employees said. But instead, the city chose to issue its first major bonds.

At the center of those deals was Fresch, a city attorney who later became city administrator.

Under Fresch’s leadership, the city issued over a billion dollars in bonds between 2003 and 2009, both to invest in capital projects and to refinance previous debt. Vernon also became extensively involved in derivative trading, which at the time was a popular method of securing below-market interest rates.

The Malburg Generating Station, which went online in October 2005, proved to be a money loser for Vernon in its first year because of rising fuel prices. Hurricane Katrina struck two months before the plant opened, wiping out suppliers in the Gulf Coast region and causing natural-gas prices to rise above $10 per unit.

Hoping to hedge against the volatility of natural-gas prices, Vernon created a new agency to purchase a long-term fuel supply.

The Vernon Natural Gas Financing Authority issued $431 million in municipal bonds in 2006 to purchase a 15-year supply of natural gas. Three-quarters of the 88 billion cubic unit feet of natural gas were priced at a fixed rate of $7.50 a unit.

But the deal, Vernon’s largest ever, proved to be a weight around the city’s neck as the price of natural gas plummeted. Since 2008, natural gas has dipped as low as $3 per unit and now sits at $4.12.

Ken Costello, a principal at the National Regulatory Research Institute in Maryland who has researched and written about hedging by public utilities, said many other utilities around the country lost tens of millions of dollars speculating on the price of natural gas.

But Costello said Vernon’s deal surprised him because of how long the city was willing to commit itself to a set price for such a volatile commodity.

“That’s a big liability to sign that kind of a long-term deal. That’s just too risky,” he said, adding that he was not aware of another hedge like Vernon’s. “Most rational people would not commit themselves to that long a period.”

Fred MacFarlane, a Vernon spokesman, said the city was still optimistic. “If something shifts, and natural-gas prices rise…the hedge may end up working out very well,” he said.

Other municipal utilities in Southern California were more cautious, said Bill Carnahan, executive director of the Southern California Public Power Authority.

Vernon officials were “doing their own thing, kind of off on their own, and now it appears to have created some unintended consequences,” Carnahan said.

“They certainly made some ill-advised decisions,” he added.

Despite the losses, Vernon moved forward on another major investment in its energy business, submitting proposals to the California Energy Commission in June 2006 to build a much larger power station: the 943-megawatt Southeast Regional Energy Center.

The proposed plant would have produced far more electricity than Vernon’s customers could use, positioning the city as a major seller to neighboring communities.

According to the city’s filings with the commission, the second station had an estimated cost of nearly $500 million. Vernon spent heavily on lawyers and lobbyists to push the project over the next three years, but it got bogged down by opposition from neighboring communities such as Maywood, Huntington Park and Boyle Heights. The city eventually abandoned the project.

By the time the recession hit with full force in late 2008, financial markets were reeling and Vernon’s economic losses became even more severe.

As interest rates fell sharply, Vernon’s derivative trades became extremely costly. The city reported about $24 million in investment losses in 2008, $25 million in 2009 and $20 million in 2010, which the city’s own auditors largely attributed to a “decrease in fair value of derivative instruments.” The city chose to get out of some of the agreements last year, according to a source familiar with the decision, paying about $40 million to terminate the deals.

Vernon began to sell properties and other assets during this period, including the Malburg Generating Station. The plant is now owned by a private operator that sells the power back to Vernon.

Some deals paid off, such as the city’s purchase of wind-farming land in the Tehachapi Mountains, a portion of which was sold for a profit. But the city struggled overall.

John Kruissink, a former Vernon consultant, said the losses weighed heavily within the city. He recalled running into Fresch in late 2008 in downtown Los Angeles.

“He put his hands up to both sides of his head like his head was going to explode and talked about how the city was taking terrible losses,” Kruissink said.

By this time, the recession was further dragging down the city’s bottom line by reducing demand for energy. In fiscal 2009, the power department posted a $48-million loss of net assets.

The economic downturn also drove down sales at its power department. Between June 2008 and June 2010, annual operating revenues dropped $29 million.

Sain, the accountant hired by The Times to review Vernon’s financial statements, said it was notable that despite the losses, general governmental expenses continued to rise, driven primarily by the salaries and benefits awarded to top officials.

Five city officials earned $500,000 a year or more between 2007 and 2009. Fresch led the way as city administrator, making $1.5 million in 2007, $1.6 million in 2008 and $1.1 million in 2009.

Risky ventures

Last year, as Vernon’s financial struggles continued, Fresch proposed a bold plan.

He suggested the City Council sell or lease much of the power department’s assets — up to $800 million worth of land holdings, infrastructure, fuel supplies and other investments. Under the plan, Vernon would seek a partnership with a private equity fund or a pension fund.

Fresch said the deal would give Vernon access to new capital that it could use for even more investments in energy, including the purchase of power facilities in Arizona or Nevada.

As it was first proposed, Fresch, who had left his position as city administrator in mid-2009 to become a special consultant, would have supervised the deal in exchange for a multimillion dollar commission. Then a separate agreement was introduced to have one of the city’s financial advisors, Bond Logistix, oversee the deal.

“Either you can do something dramatic like Project Volt…you don’t have to, you can make the decision, ‘Look, we’ll raise our rates, and that’s it. Let’s pull out of the capital markets and of course all these fancy consultants can go,’ ” Fresch told the council, according to the Vernon Sun newspaper.

By this time, some in the city were growing skeptical. The Chamber of Commerce expressed strong concerns about the plan, saying the city should not proceed without an independent second opinion.

Project Volt came to a halt later in 2010 when legislation was introduced in the state Assembly calling for Vernon to be disincorporated. The city and the Chamber have fiercely challenged the bill, AB 46.

Fresch’s presence in Vernon has receded substantially, but he remains on the city payroll as a consultant based in Marin County. So far this year he has made about $460,000. Whitworth, the city administrator, says Fresch has earned it. “He’s known throughout the United States,” Whitworth said. “He’s quality.”

In recent months, the City Council has passed several reforms, including reducing the salaries and benefits of council members and other top city officials. It also formed a new committee to advise the council on electric rates.

To the dismay of some businesses, the city announced a 16% rate increase in June and warned of 5% annual rate increases for the next decade.

sam.allen@latimes.com

hector.becerra@latimes.com