The Federal Shield

The Federal Shield

January 09, 2009

Ken Silverstein
EnergyBiz Insider
Editor-in-Chief

Revelers have bid adieu to 2008. But many folks are having difficulty saying goodbye to some gems of the American economy. Long-standing investment banking and automotive names that been knocked down are being pulled back to their feet.

The federal government has determined that some institutions are "too big to fail" and that any bankruptcy would be unduly disruptive. In other instances, though, the feds are letting the laggards pay the ultimate price. The decisions appear arbitrary but the general thinking among policymakers is that a dour business cycle would become even worse if taxpayers sat idle.

Utilities are not oblivious. Over-reaching and excessive risk-taking have battered such companies in the past. Companies like Enron and Montana Power don't really exist today. By and large, those that got burned from their unregulated ventures have cut back and now focus on their core operations.

In the case of the regulated utility sector, state public utility commissioners are empowered to ensure that the companies are making prudent investments on behalf of their customers and to only allow reasonable costs to be passed through. If a utility is charging sufficient rates to cover costs, then it should not experience financial problems. But if not, should utilities be allowed to fail?

"In general, yes, utilities are too big to fail, or perhaps better worded, utilities provide a vital service and therefore they generally cannot be allowed to completely fail," says Bob Bellemare, chief executive of UtiliPoint International, a consulting firm. "Someone must either take them over or they must get propped up financially to continue to be viable. Somehow, someway, someone has to provide service to customers."

Bellemare cites Pacific Gas & Electric that went bankrupt in the early part of the decade as a result of a regulatory quagmire that prevented it from passing along the rising cost of power to customers and El Paso Electric, which went into Chapter 11 in 1992 and pulled through in 1996. In both cases, the bankruptcy court served as the catalyst to better times.

"The bankruptcy courts were needed to step in to restructure those utilities' finances and businesses," says Bellemare. "After the bankruptcy process, the state regulators will again become fully responsible for regulating a utility's rates and service. Another important role state regulators have in many states is ensuring that a utility's so-called 'unregulated or non-utility operations' won't potentially harm the utility. Some of the bankruptcy or near-bankruptcy cases in the industry were related not only to situations such as costly power generation investments but also to the failing of non-utility investments such as telecommunications, insurance or real estate."

Reasonable Options

The risk-reward ratio for utilities is narrow. But other industries roll the dice. What is government's role? One school of thought says that any asset class that would appear to get preferential treatment must then be subjected to tougher regulation to prevent failures in the first place, like public utilities. Others say strict oversight impedes growth.

The purist view is that taxpayers should not be the insurer of last resort when it comes to incompetence. And if investors perceive certain institutions to be so vital to the country's economic interests that they will not be allowed to fail, then those enterprises will have an unfair economic advantage. They will furthermore be tempted to take extraordinary risks at the expense of their federal insurers while better executives with better ideas will not get the finances they need to bring those products and services to the fore.

To name a few high profile cases, in the 1970s Chrysler first went hat-in-hand to the federal government. It got a loan and did pretty well for a time. In 1984, the feds nationalized Continental Illinois so as to sidestep bankruptcy and then several years later, they re-privatized the bank. By contrast, investment banking giant Drexel Burnham collapsed in 1990 without too many tears. Ditto for Lehman Brothers. Bear Stearns, meanwhile, got a deal in 2008.

In tough times, government has more of a penchant to help failed business models. Fannie Mae and Freddie Mac always had the implicit backing of the feds, motivating them to take on too much (risky) debt. In a typical case, the purist will argue that keeping these institutions propped up means that healthier banks will have a harder time raising capital and that an ultimate economic recovery will be kept at bay.

All told, about $3 trillion has been pledged to the financial sector. Another $2 trillion could be on the way. Accordingly, the heat is on. One side says that banks are already tightly monitored and any excessive rules will cut into profits and jobs. Others say the added oversight is a must to avert unwarranted risk taking at taxpayer expense.

As for the car industry, it has been promised a $25 billion loan. But the economic purists point out here that the lifeline won't last long as the Big Three -- General Motors, Chrysler and Ford -- are losing about $7 billion a quarter. They go on to say that if those car makers would be forced to restructure, then they would have to deal directly with their expensive labor contracts.

By throwing money at a flailing industry, that school of thought suggests that government is inhibiting the innovative vehicles of tomorrow from breaking through. Instead of plug-in hybrids, the country will get more gas-guzzling sport utility vehicles.

Progress and innovation are at the heart of all industries, including utilities. But some businesses are considered more worthy of a federal shield than others. Such protection may prevent economic calamity. But it also breathes new life into bad business models. Government has reasoned, though, it has no better options during tough times.