Did Telecom Reformers Dial the Wrong Number?

As the wreckage of once-highflying telecommunications companies such as WorldCom Inc. and Global Crossing Ltd. piles up, attention is turning to whether the root of the disaster lies in the sweeping deregulation set in motion in the mid-1990s that was expected to usher in a golden age of competition.

Prices would fall, service would improve and everyone would make more money. Anticipation ran high that the industry was on the verge of explosive growth, fueled by the still-nascent Internet, wireless phones, satellite television and other telecommunications services that would keep the public in a state of constant connection.

Much of that vision was flawed, leading to more than $2 trillion in investment, much of it squandered in ways that may cause lasting economic damage. On Tuesday, two major telecommunications firms reported quarterly losses of more than $20 billion and said they would cut more than 7,000 jobs.

The telecommunications industry is awash in red ink and tens of thousands of jobs have been lost. Some analysts believe the bankruptcy filings of WorldCom and Global Crossing, two of the most aggressive new companies to arise during deregulation, presage more to come. Since their peak in March 2000, telecommunications stocks, as measured by the American Stock Exchange index of 16 North American companies, have fallen more than 74%.

The meltdown has occurred under the legal structure set up by the Telecommunications Act of 1996. Critics complain that the act has led to poor service and higher costs for consumers, with some of those costs hidden in a proliferation of oddball fees.

“Telecom deregulation from ’96 until now has been an abysmal failure,” said Gene Kimmelman, director of the Washington office of Consumers Union, publisher of Consumer Reports magazine.

The telecom industry bust adds support to critics’ contentions that deregulation has failed to live up to its promise in this industry, as it did in airlines, banking, energy and cable television.

In each of those, the original expectations that huge numbers of new companies would increase competition, improve service and reduce prices have given way to the reality of oligopolies controlling large chunks of the marketplace in ways that leave customers discontented.

More than two decades after the airlines were deregulated, for example, only eight airlines carry the vast majority of passengers and dictate where they’ll provide service. Dozens of new entrants have tried to compete and failed, and many of the survivors remain chronic money losers. The industry lurches from one crisis to the next--labor discord following fuel price hikes following security debacles. Consumers constantly grouse about airline service. Leisure fares have continued to drop, but business fares have surged.

But whether the same scenario is playing itself out in communications--and whether the 1996 act has been a failure--is still open to debate. There is little question that deregulation has led to dramatic changes in the nature of the U.S. telecommunications industry, but there also is little question that those changes have unfolded in ways the law’s backers and the industry’s investors never expected.

When the reform act was written and passed, it seemed that all telecommunications services were about to converge. It would not matter whether one got one’s phone service from a local or long-distance phone company, a cable television or Internet service, even via satellite. All that was missing was a way for all these providers to compete with each other on an even keel, ignoring geographic boundaries, technical specifications or regulatory traditions.

Three key assumptions underlay the law. The first was that the lucrative prize for most competitors would be long-distance service. The drafters reasoned that local phone companies--General Telephone and the seven Baby Bells created by the 1984 breakup of AT&T--would; be so eager to move into long-distance that they would willingly open their local monopolies to competition to earn the right to offer it to customers.

The drafters also assumed that the Baby Bells would jump at the chance to compete for local customers in one another’s markets, triggering even more consumer savings. Finally, they assumed that falling prices would lead to an explosion in telecommunications traffic.

All these assumptions turned out to be fundamentally wrong.

The long-distance market, which had been deregulated earlier, was already experiencing ferocious price competition, with per-minute rates dropping and profit margins shrinking by the day. Instead of the Baby Bells wanting to get into long-distance, companies such as MCI and AT&T; were desperate to start providing local service.

But the local phone companies, often supported by their state public utilities commissions, resisted opening their markets.

“No one anticipated the [Baby Bells’] willingness and ability to play the game and play it well,” said Courtney Quinn, telecom analyst at Yankee Group, a Boston research firm.

Instead of invading one another’s turf as expected, the Baby Bells simply merged with each other. Within a year after the act’s passage, Texas-based SBC took over Pacific Telesis, the California-based Baby Bell. Even more disturbing to observers, however, was the 1997 merger of Philadelphia-based Bell Atlantic with Nynex, the Baby Bell serving neighboring New York and New Jersey.

“That was a critical moment,” said Mark Cooper, research director for the Washington-based Consumer Federation of America. “There were 10 million people living within 50 to 60 miles of the border between those companies. It was the ideal place for cross-border competition.”

The deal’s approval by the Justice Department’s antitrust division and the Federal Communications Commission heralded a trend of consolidating local Bell companies. The country had eight local phone companies in 1996; today it has four--SBC Communications Inc., Verizon Communications Inc., BellSouth Corp. and Qwest Communications International Inc.

Before 1996, the largest four local companies served 48% of all the phone lines in the country; today these four companies serve more than 85%, according to a study by Consumers Union.

Still, in retrospect the most dangerous assumption behind the deregulation bill by far was that communications traffic would mushroom at unprecedented rates.

The overall U.S. market for data, wireless and voice communications services has grown rapidly since 1996, to an estimated $277 billion from $164 billion.

“In 1993 there were 10 million wireless subscribers in the country and revenues were $24 billion,” said Blair Levin, a former chief of staff at the FCC who is at investment firm Legg Mason Inc. “Now there are 137 million users, and this year they’ll pay $75 billion. There’s a lot of gain there.”

But even that growth pales in comparison with the wild expectations of the mid-1990s.

“The financial community anticipated a huge increase in demand that would be never-ending,” said Reed E. Hundt, who was FCC chairman from 1993 to 1997 and is now a consultant at McKinsey & Co. “Many people knew these growth rates were not sustainable.”

But those rates inspired a historic investment spree. From 1996 to 2000, telecom companies assumed more than $1.5 trillion in bank debt and issued $600 billion in bonds.

“There were too many people throwing too much essentially free money at the industry,” said Tom Evslin, chief executive of ITXC Corp., a wholesaler of international phone capacity. “At ITXC we had to beat off the people who wanted to sell us a bond issue when we didn’t need the money.”

Industrywide, most of that money was squandered, and the resulting hangover is exemplified by the WorldCom and Global Crossing collapses.

“A lot of the failure can be attributed to financial markets that funded hundreds of competitors when the market demand [for their services and equipment] wasn’t there to support them,” said Yankee Group’s Quinn.

For all that, the Baby Bells have not escaped scot-free. In the last few days, both SBC and BellSouth have reported sharply lower profits and dim prospects for the near future. Both cited increasing competition, among other challenges.

Among the most troublesome trends, experts say, is a decline in multiple residential phone lines. This was one of the leading growth factors throughout the 1990s, as homeowners put in second lines to accommodate dial-up Internet modems or children’s phones.

Internet service is now increasingly provided by digital subscriber lines, or via cable TV companies. And wireless phones have become ubiquitous substitutes for additional home phone lines.

“Losing the second line is a very big deal for the Bells,” Hundt said. “For them to be relegated to just primary residential line service is not the future they envisioned.”