California Pays Dearly for All That Borrowing

California has paid $230.7 million in fees to Wall Street investment firms over the last year -- a largely hidden cost to taxpayers of the huge borrowings needed to keep state government afloat.

An examination of how officials managed the heaviest borrowing in state history shows that the fees and commissions California has paid were in some cases higher than those charged to other state governments.

On one massive loan, officials agreed to fees that were 42% higher per bond than Illinois had paid last year for a similarly large borrowing.

On another, California paid fees at a rate about 25% higher than Washington had paid in the mid-1980s while that state was being penalized for the costliest municipal bond default in U.S. history.

In all, California took on $27.4 billion in debt to cover past and present budget shortfalls. While about half of that amount has been repaid, the ultimate price for the financing could include as much as $8.9 billion in interest. And the state budget now awaiting action in Sacramento contemplates nearly $1 billion more borrowing later this year.

No one can control the fluctuating market conditions that dictate final interest costs. But elected officials did have opportunities to influence the makeup of bond underwriting teams, the loan structures and the fees paid to investment firms.

The officials primarily responsible for negotiating those details -- state Controller Steve Westly, who watches over California’s short-term cash flow, and Treasurer Phil Angelides, who manages long-term finances -- say they had virtually no choice but to accept the terms.

California’s low credit rating -- the worst in the nation -- gave the state little leverage in the negotiations, they said.

“Being as dependent as California has been on lenders to finance its deficit is not fundamentally a healthy relationship,” said Angelides, a Democrat who hopes to be governor some day. “You never want to be at the knees of lenders.”

Some outside experts raise questions about the actions of Westly and Angelides, including Angelides’ decision to set fees by negotiating deals with firms, rather than through competitive bidding.

But even the critics concede that costly bond financing is an unavoidable consequence of the choice that the Legislature and two governors, Gray Davis and Arnold Schwarzenegger, have made: to keep California’s budget balanced by borrowing rather than cutting deeply into programs or raising taxes.

“I don’t think our elected leaders have made an honest accounting of the total cost of all of the borrowing,” said Jean Ross, executive director of the nonprofit California Budget Project in Sacramento.

Each borrowing, during the period from June 2003 to June of this year, was authorized by the Legislature and the governor.

Some of the Wall Street firms were led by executives who for years have been involved in state government. Lehman Bros., for example, was represented by Peter J. Taylor, a longtime friend and political associate of Angelides who was finance director of the state Democratic Party when Angelides served as chairman. He was recently appointed to Schwarzenegger’s government performance review commission.

Most Wall Street investment firms contacted for this report declined to comment about their fees or relationships with state government.

But Cody Press, managing director of the public finance department of Citigroup, corporate parent of Citibank, defended the investment fees.

“We think the fees we received were justified with the amount of risk we were taking,” Press said.

Interviews and an examination of two of the largest deals illustrate how the bill to California taxpayers mounted.

When the first borrowing began to unfold in the spring of 2003, voters were petitioning to recall Gov. Davis. The Legislature was about to miss its budget deadline -- for the 17th consecutive year. And billions of dollars in bills were about to come due.

To pay the state’s bills, Westly needed to borrow $10.96 billion in one-year loans known as “revenue anticipation warrants.” He was having trouble attracting lenders because of the state’s poor credit standing.

Wall Street firms came to the state’s aid -- for a price. In return for $84 million, seven investment banks said they would guarantee that investors would be repaid if the financially strapped state could not do so; in effect, they were allowing the state to take advantage of their own blue-chip credit ratings.

But the investment bankers insisted on hedging their bets. If the state’s credit ratings as set by Moody’s Investors Service or Standard & Poor’s dropped sharply, the fee would rise to offset what they saw as additional risk.

Westly agreed, and the warrants were sold in June 2003. When rating agencies indeed downgraded the state’s credit that July and again in December, the bankers collected an additional $56 million, a 66% increase. That brought the “credit enhancement” fees to $140 million.

There was no countervailing provision for easing the fees if the state’s credit improved -- which it did a few weeks before the warrants matured last month and were repaid in full by the state.

John E. Petersen, professor of public policy and finance at George Mason University in Arlington, Va., who spent 30 years as a financial advisor, questioned Westly’s failure to get such a provision in the deal. “That’s a symmetry you would usually try to get in,” he said, adding that the fees the banks charged California were “heavy-duty.”

Indeed, California ended up paying credit enhancement fees that amounted to 1.25% of the loan value, “pretty unprecedented ground,” according to Rod Kiewiet, a political science professor at Caltech in Pasadena. The enhancement fees were higher than the 1% penalty that Washington state paid after its Washington Public Power Supply System nuclear plant bonds defaulted in 1983. (Default occurs when a borrower stops making payments of principal and interest to investors.)

Westly said that “it was a shame we had to pay the extra fees.” His office had refused to pay another $22 million in enhancement fees sought by the firms, he said. Under the circumstances, however, the warrants allowed the state to gain a lower interest rate that, in the long run, saved taxpayers money, he said.

Mark Battey, a former deputy controller who participated in the negotiations, added that, given the state’s credit situation, if officials had rejected the firms’ demand for the higher credit enhancement fees, they “might have been laughed out of the room.”

The other major state borrowing involved so-called deficit bonds sold to bridge the gap in the state’s budget. The evolution of those bonds illustrates how closely Wall Street firms consulted with state leaders to shape how the borrowings were put together.

In the spring of 2003, aides to then-Gov. Davis asked firms for advice on how to cover the deficit through borrowing. Merrill Lynch, Goldman Sachs, UBS and Lehman Bros. responded with written recommendations. The budget approved that summer counted on $10.7 billion in deficit bonds.

Angelides opposed the deficit financing because of its strain on the state’s credit, but to carry out the Legislature’s decision to sell the bonds, he assembled a group of firms that would line up investors to purchase the securities.

That underwriting team included the firms that had offered advice to the Davis aides.

Throughout his first term from 1999 through 2002, Angelides had used competitive bidding to pick underwriters of general obligation bonds, issues backed by general budget revenues.

In a competitive bid, investment firm fees are included in the proposal that each firm submits. The underwriter who bids lowest earns the right to sell the bonds -- an arms-length process designed to guard against favoritism.

Shortly after taking office, Angelides sponsored a change in the law to allow more bonds to be sold through negotiations with investment firms, rather than competitive bidding. Angelides said the change would give him needed flexibility.

In a negotiated sale, fees are usually set at the end. State officials pick the underwriters, work with them to assess the market and shape maturity dates so the bonds have wide appeal. Then they negotiate the underwriters’ fees and the interest rates to be paid investors.

Former state treasurer Matthew K. Fong, a Republican, primarily used competitive bidding during his tenure from 1995 to 1999. In a recent interview, he questioned Angelides’ change in approach.

Negotiation “allows a treasurer to pick the team. You are directing millions of dollars of fees to one firm or a series of firms. That’s the power, the political power of a negotiated sale,” Fong said.

Fong’s predecessor as treasurer, Democrat Kathleen Brown, also used competitive bidding during her term, from 1991 to 1995.

Brown is now a managing director at Goldman Sachs and was a member of the group that endorsed the initial deficit bonds.

She said in an interview that she has come to agree with Angelides that a negotiated process is better. “The fact of the matter is you can structure a financing for the lowest cost of funds” -- what taxpayers pay in interest -- “over the lifetime of those bonds.”

Negotiation also gives the state an opportunity to make a case for the sale in front of investor groups, she said.

Juan Fernandez, director of the public finance division of the state treasurer’s office, said the amount of bonds being sold was too large for bidding to work. If the state had tried, he said, underwriters would have reduced their individual risk by grouping themselves into syndicates and offering fewer bids, defeating the competitive principle.

After Schwarzenegger took office last fall, the deficit bond structure changed: the governor sought and won voter approval to sell up to $15 billion of debt.

Angelides again opposed the approach. But in May, he offered the first installment of so-called “economic recovery bonds,” a $7.9-billion issue described as the largest single general obligation bond in state history. Because they were backed by dedicated state sales tax revenue, the securities were highly rated, AA- by Standard & Poor’s.

Just before the sale, Angelides decided that the large underwriting team led by Lehman Bros. should be permitted $39.5 million in fees, or an average of $4.99 per $1,000 bond.

Illinois raised $10 billion in a June 2003 bond sale to infuse its pension funds and help balance its budget. Illinois used competitive bidding and paid $35 million in fees, an average of $3.50 per $1,000 of bonds.

Illinois budget director John Filan said the size of the deal alone made it attractive to investment firms.

“When you sell a lot of widgets,” Filan said, “you can afford to sell them cheaper. We had a lot of widgets.”

Fernandez said the Illinois bonds were “not a comparable deal” because they carried a higher credit rating and were taxable investments, while California’s were tax exempt and therefore faced different market conditions.

In any case, Mitchel Benson, Angelides’ chief spokesman, said it was wrong to judge the state’s borrowing by the fees paid to investment firms.

“When the state has to borrow money, the way to get there is through Wall Street,” he said. “And the fact of the matter is that doing business with Wall Street costs money.”

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Lucrative territory Wall Street firms got $230.7 million in the last year for helping California borrow to cover budget deficits. In the two largest deals, Controller Steve Westly paid $140 million in credit enhancement fees to seven investment banks, and Treasurer Phil Angelides paid underwriter commissions totaling $39.5 million.

Fees on the largest budget borrowings overseen by:

Steve Westly

Amount borrowed: $10.96 billion Date: June 2003 Type: Revenue warrants Credit enhancement fees* (in millions) Merrill Lynch: $46.25 Citibank: $25.00 Bank of America: $18.75 Goldman Sachs: $12.50 Morgan Stanley: $12.50 Lehman Bros.: $12.50 Societe Generale: $12.50 Total: $140.00

* These are fees paid to the banks so the state could use the banksÕ credit to get a better bond rating, which lowered the interest cost to taxpayers.

**

Phil Angelides

Amount borrowed: $7.9 billion Date: May 2004 Type: Deficit bonds Underwriter commission** (in millions) Lehman Bros.: $18.32 Citigroup: $2.54 Morgan Stanley: $2.00 Merrill Lynch: $1.55 Goldman Sachs: $1.47 UBS Financial: $1.34 Bear Stearns: $1.32 J.P. Morgan: $1.27 Banc of America: $0.68 E.J. De La Rosa: $0.50 Others: $8.51 Total: $39.50

** 10 largest banks Sources: California controller, California treasurer

**

Borrowing to balance the budget Five times since June 2003, California officials turned to Wall Street for money to cope with the stateÕs budget deficit. Some of the $27.4 billion in borrowings has already been repaid. Others could take from 19 to 40 years. Wall Street investment firms received $230.7 million in fees along the way.

CaliforniaÕs recent borrowing history

When: June 2003 Amount: $10.96 billion Type: Revenue warrants Maximum repayment term: 1 year Projected interest cost: $124.7 million Wall Street fees: $140 million* When: Sept. 2003 Amount: $2.57 billion Type: Tobacco bonds Maximum repayment term: 40 years Projected interest cost: $4.09 billion** Wall Street fees: $17.3 million When: Oct. 2003 Amount: $3 billion+ Type: Revenue notes Maximum repayment term: 8 months Projected interest cost: $33.69 million Wall Street fees: $30.8 million When: May 2004 Amount: $7.9 billion Type: Deficit bonds++ Maximum repayment term: 19 years Projected interest cost: $3.25 billion Wall Street fees: $39.5 million When: June 2004 Amount: $2.97 billion Type: Deficit bonds++ Maximum repaymenr term: 19 years Projected interest cost: $1.45 billion Wall Street fees: $3.1 million+++ Total: $27.4 billion Projected interest cost: $8.96 billion Wall Street fees: $230.7 million

* ÒCredit enhancement feesÓ allowed state to use banksÕ credit to get better bond rating, which lowered interest cost to taxpayers.

** Interest rate unusually high because of legal issues then facing tobacco companies.

+ Combines a $1.8-billion public sale and a $1.2-billion private sale.

++ Part of $15-billion deficit borrowing plan approved by voters in March.

+++ Letter of credit charges could increase this by $41.7 million over the life of the bonds.

Source: California controller, California treasurer