Future of San Joaquin Hills Toll Road May Hinge on County’s Past Financial Failure

I must admit to having felt a little queasy the other day when I heard that a bunch of Orange County politicians had meddled in an important public financing transaction and torpedoed the deal.

After all, this is the county that won a permanent place in the Municipal Finance Hall of Shame for losing a couple of billion dollars in an investment debacle almost exactly 10 years ago. Ever since then, it seems, the county fathers have been chary of any transaction that smacked of the D-word -- “derivatives,” those complex financial instruments that wrecked the county treasury in 1994.

It’s reasonable to ask whether the shadow of 1994 is partially to blame for the financial confusion swirling around the county’s toll road system, one part of which was downgraded this week to junk-bond status -- and not even the highest-rated junk -- by the Moody’s credit-rating agency. (The other two credit rating companies, Standard & Poor’s and Fitch, had downgraded the bonds earlier.)

The hobbled highway is the San Joaquin Hills toll road, which runs 16 miles between Newport Beach and San Juan Capistrano. San Joaquin’s traffic has so consistently fallen below projections that within the next couple of years it is likely to technically default on its construction bonds -- that is, it will raise enough revenue to pay its debt service, but not the additional 30% cushion that was promised to bondholders. A cash default is likely a few years after that. As a consequence of even a technical default, tolls would have to rise, driving traffic back onto local arterials and Interstate 5 -- exactly the crush the toll road was designed to relieve.

Meanwhile, a second, separately managed toll road, the 35-mile Foothill-Eastern running between the Riverside County line and Mission Viejo, is comfortably making its numbers right now, generating more than enough cash to cover its debt service and the required cushion. But its resources are likely to be strained when it tries to finance a $700-million, 16-mile extension south to San Clemente in the next few years.

To make things a little more interesting, consider that the Foothill South extension is expected to depress traffic further on the San Joaquin, whose board might even consider suing to block its sister agency’s project.

Asked to figure out how to save the San Joaquin Hills road, improve the financial standing of Foothill-Eastern, and get Foothill South built, a team of high-powered financial analysts labored for 20 months and recommended merging the two existing roads. This would entail refinancing each road’s construction bonds by issuing $4 billion in new bonds for the combined entity. Although huge and complex, the proposed bond issue already had been provisionally awarded investment-grade status by the bond rating agencies when it came before a joint board of the two roads for what was expected to be easy approval earlier this year.

That’s when Orange County Supervisor Bill Campbell, a member of both toll road boards and the joint board, cleared his throat.

“The first thing that made me nervous was the interest-rate swap,” he told me this week. This was a reference to a complicated $1-billion component of the deal, through which fixed- and floating-rate obligations are exchanged between two parties that may have different financing needs. The component would have the effect of reducing the tollways’ debt costs, but it is -- let’s face it -- a derivative, which was enough to elicit scowls across the Orange County landscape.

Then Campbell discovered that the deal required paying up to $160 million in premiums to a Wall Street bond-insurance agency to lower the rate on the new bonds. He noticed that this was the very same firm that would be on the hook for the San Joaquin bonds if the toll road defaulted. “We were taking out their liability and they were charging us more,” he says. Another $40 million or so of other fees and commissions wrapped into the refinancing also stuck in Campbell’s craw.

Campbell’s objections led to lengthy and, apparently, not entirely polite discussions between the boards and the merger advisors. The latter were plainly ticked off at having spent two years crafting a financial deal, only to have it second-guessed at the last minute. They were also insulted that opposition to the plan seemed to be driven by the notion that the county was poised to get mulcted by the same Wall Street types that ripped them off a decade ago.

It can’t help that the rescue plan now being considered by the toll road boards is one that Campbell proposed and that he has described as “a simple business deal” -- evidently to distinguish it from the cabalistic merger transaction cooked up by the financial experts, presumably in an iron caldron in the dead of night.

“Our plan was rated, had insurance commitments and was ready to go to press and market, and they chose a plan that wasn’t rated and just didn’t fly,” says Mark Young of the financial advisory firm Gardner, Underwood & Bacon, which helped craft the merger plan. Young says the only way to make Campbell’s plan work financially would be to push back Foothill South and all of the system’s other scheduled improvement and construction programs by at least four to six years. The ultimate lifting of tolls, originally expected as early as 2041, would also be delayed.

Campbell’s proposal is for the healthier Foothill-Eastern road to pay the San Joaquin $120 million upfront to cover the potential impact of the Foothill South and loan it as much as $1 billion over about 20 years to meet its debt service. He says Foothill will still be able to borrow enough to build its extension and other needed roadway improvements.

Whether that’s accurate will be studied by the experts over the next weeks and months. The roads’ financial advisors say Campbell’s proposal is of questionable legality, involves floating a bond issue that the capital markets wouldn’t stomach, and would deprive both toll roads of such benefits as a sizable federal line of credit incorporated in the merger plan. This column doesn’t have the space to go into all the details of the mutual critiques, but neither would the Encyclopedia Britannica. What does seem to be true is that if a solution isn’t found in the next few months, it may be too late to save San Joaquin from default.

What’s discomfiting about the financing dispute is the hint that a sensible merger and refinancing plan was derailed by unfounded fears of financial complexity and suspicions that its designers were Wall Street scoundrels out to cheat this fair county one more time.

Perhaps the county leaders have reason to be leery, but there’s reason to believe that their suspicions have blinded them to a good deal. Some opponents of the merger have alluded so often to their unhappy experiences with high finance that they sound like the cat in the Mark Twain aphorism about the dangers of drawing too broad a conclusion from a single lesson: Having sat down on a hot stove lid once, she will never sit on a hot stove lid again. But she will never again sit down on a cold one, either.

Golden State appears every Monday and Thursday. You

can reach Michael Hiltzik at golden.state@latimes.com and read his previous columns at latimes.com/hiltzik.