CREDIT CRUNCH: Why the Fed Really Cut Rates

Did the credit worries of California utilities contribute to the Fed's "surprise" decision to lower rates between FOMC meetings?
Ed ZwirnJanuary 5, 2001

Did the plight of California’s utilities force Alan Greenspan and his cohorts to cry “uncle” and cut interest rates earlier in the week?

The Fed action, which lowered the Fed Funds rate by 50 basis points and the Discount Rate by 25 basis points, puzzled many at the time because it occurred between FOMC meetings. The last “intra-meeting” easing — one of lesser magnitude — was made in October 1998 in response to the Russian debt meltdown and the Long Term Capital Management debacle.

As bleak as both the economic numbers and stock market performance were prior to the cuts, most observers were caught off guard by the timing and magnitude of the action. for more on this

But a closed meeting held Dec. 26 among Fed Chairman Alan Greenspan, Treasury Secretary Lawrence Summers and California Gov. Gray Davis set off a round of “hopeful” speculation among bond market specialists that an interim Fed easing would accompany a ruling by the California Public Utilities Commission. (click here for more).

Sure enough, on Thursday, one day after the Fed cut rates, Pacific Gas & Electric and Southern California Edison, the two largest utilities in the country’s largest state, were granted a temporary 10 percent rate “surcharge” in an attempt to resolve the state’s utility crisis.

Why This Is Serious

It appears we may never know whether or not this cause and effect scenario is more than unsubstantiated rumor.

“We think it would be inappropriate for the Fed to comment on the decision of another agency,” says Lillian Ruiz, spokesperson for the San Francisco Fed.

But the economic threat posed by the California utility situation seems real enough.

The two utilities had been seeing their more than $10 billion of heretofore investment- grade debt trading at junk-like prices for at least a month.

However, the two utilities say the rate relief is insufficient to stave off bankruptcy for long.

And the ratings agencies are in apparent agreement.

On Friday, Fitch Ratings downgraded the debt of both firms to junk status while Moody’s Investors Service and Standard & Poor’s cut their ratings to the lowest investment grade level.

An Impetus For Greenspan?

While the official ruling by the CPUC didn’t come until Thursday, the release of similar CPUC staff recommendations the day before sent shock waves through financial markets and may have contributed to the “surprise” Fed easing which followed shortly in its aftermath.

The hours immediately preceding Thursday’s official CPUC decision saw the price of the utilities’ bonds plunge from around 80 cents on the dollar to about 60 cents on the dollar.

However, equity holders lost much more. Both PG&E and Southern California Edison stock lost nearly half their value in reaction to the ruling. Why? Because most analysts were expecting the utilities to receive at least a 30 percent rate increase. The 10 percent surcharge is deemed by most experts to be inadequate.

The temporary surcharge granted by the CPUC may help to stave off either bankruptcy or power outages, or both for at most a few weeks, say analysts.

If that’s the case, shareholders stand to lose a great deal more than they have already.

“The firms are both extremely low on cash and if this thing goes through, no one’s sure what will happen,” said Lori Woodland of Fitch, shortly before the official CPUC decision was announced.

In the meantime, California is sticking to the policy set in 1996. At that time, the legislature froze utility rates from 1998 through 2002, as part of its energy deregulation policy.

This is the ostensible reason for the CPUC’s decision not to grant a 30 percent rate increase, despite claims that the two utilities may have incurred as much as $11 billion of new debt just by selling power since the summer, when the cost of wholesale energy began a dramatic rise.

Containment Achieved

Assuming the Fed had taken the easing action at least in part to avoid “contagion” of more general financial markets by the California situation, this action can be seen as a success.

Despite the seriousness of what has been going on out West, there has been no perceived threat to the liquidity of the markets as a whole.

While the equity markets enjoyed a one-day delirious buying spree followed by two days of sober profit-taking, the investment-grade debt market has held its own.

Not only has investment-grade debt firmed since these developments, even the damage to the utility sector has been nonexistent as other firms have remained strong despite the woes of PG&E and Southern California Edison.

But don’t forget that utility firms are more debt-market sensitive than most other types of operations. They must be able to access capital markets frequently in order to obtain funds, both as a “hedge” against varying energy market conditions and to smooth over cash flows greatly affected by the seasons.

And underlying this potential debt market debacle are scores of creditors, who have yet to be named.

Prominent among these, according to one market source, is Bank of America. The West Coast financial giant is poised to be the biggest potential loser here, after the utilities and the people of California themselves. Notes a source: “There is such a thing as investing too heavily in one regional industry.”