Deal adds millions to rates for PGW

Customers of Philadelphia Gas Works will pay $60 million to bail the company out of a financial deal gone sour and to bolster an overall bleak financial condition.

Beginning Jan. 1, PGW customers began paying 5.2 percent more to heat their homes. That increase wiped out most of the benefits of a temporary 9.4 percent rate cut PGW had provided, as required by the state, because it was paying less for natural gas.

This means that while utility companies across the Northeast slash rates, customers of the city-owned PGW are seeing little benefit.

PGW may pay as much as $30 million of the $60 million to escape a complicated transaction called an interest-rate swap. The deal was arranged in part by CDR Financial Products, the company at the center of the federal pay-to-play investigation of Gov. Bill Richardson of New Mexico.

CDR, headquartered in Beverly Hills, became known to Philadelphians in 2004 when its name surfaced in a City Hall corruption scandal involving lawyer Ronald A. White and Corey Kemp, the city's treasurer at the time. Kemp is serving a 10-year prison term for his involvement; White died before he could be tried. CDR was never charged in the case and continued to do work for the city.

PGW will use the rest of the $60 million to shore up its finances and prove it can pay its bills.

The state Public Utility Commission approved the emergency rate hike last month. The temporary rate cut that had brought the 9.4 percent relief to customers may expire this spring; the 5.2 percent increase is permanent, said Philip Bertocci, the city's gas consumer advocate.

The average monthly gas bill in Philadelphia households is around $136.

PGW's financial problems come as the city faces a budgetary shortfall of up to $1.5 billion over the next five years.

"Anything bad that happens at PGW affects the city," Mayor Nutter said Friday, adding that he was unaware of the particulars of PGW's interest-swap deal and CDR's role in that deal.

The plummeting economic climate has roiled financial transactions entered into by many states, counties and cities. Baltimore, joined by the cities of Oakland and Fresno, the state of Mississippi, and others, is suing a number of banks and financial advisers. The suit alleges the brokers and banks conspired to fix prices of derivatives by bid-rigging. The case springs from a lengthy ongoing investigation by three federal agencies into municipal derivatives.

CDR and the bankers in the PGW deal, JPMorgan Chase & Co., are included in the Baltimore suit. JPMorgan declined to comment on the lawsuit. CDR maintains it has always acted ethically.

PGW and Philadelphia have not blamed CDR or JPMorgan for their investment problems.

CDR said it was only one of several advisers on the PGW deal and blamed the bad outcome on the economy.

"We obtained the work fairly, and the work performed conformed to highest ethical standards," said Allan Ripp, a spokesman for CDR.

Initially, the deal saved the city as much as $14 million, the firm said, before the economic collapse.

"Unfortunately, this scenario is playing out nationally," said Ripp.

An interest-rate swap is an agreement between parties to exchange one stream of interest payments for another over a set period of time. They usually involve the exchange of a fixed-rate payment for a variable-rate payment.

PGW was a relative newcomer to interest-rate swaps. The deals are designed to reduce debt costs and protect issuers like PGW from costly swings in interest rates.

The swap worked at first - but has ended up increasing PGW expenses.

Barbara C. Bisgaier of Public Financial Management, an adviser to PGW, explained the utility's situation in written testimony before the PUC last fall. She said that if PGW did not exit the deal, it would have to start paying JPMorgan $60 million annually, starting in July. And PGW's ability to get other funding would be compromised, she contended.

In an interview Friday, Bisgaier detailed the deal:

In 2006, PGW refinanced $310 million in debt by selling bonds, to take advantage of lower interest rates.

The company hired JPMorgan Chase & Co. to run the sale. JPMorgan and other banks also promised PGW they would buy back the bonds if investors didn't want them - a common practice that helps keep borrowing rates down.

PGW also paid a bond insurer, Financial Security Assurance, to guarantee the bonds if PGW was unable to keep paying them off - also a common practice with high-debt borrowers like PGW, which would otherwise have to pay higher rates of interest to the smaller group of investors who tolerate extra risk.

PGW could have issued fixed-rate bonds at about 5.25 percent. It could have sold variable-rate bonds at a cheaper rate, but would have run the risk of paying more when U.S. interest rates went up.

Instead, the utility decided to bet on a more complicated arrangement.

PGW turned to longtime adviser Public Financial Management and CDR Financial Products to guide it through the world of municipal derivatives. It paid PFM $10,000, while CDR received $225,000, according to city documents.

CDR set up an interest-rate swap agreement with JPMorgan.

The swap resulted in PGW paying an effective rate of 3.67 percent, saving it roughly $4.5 million a year.

PGW knew it would have to pay more if interest rates rose, and it calculated that risk when it sold the bonds. But, like other swap-buyers, it didn't count on the risk that other elaborate arrangements designed to make the bonds attractive would fall apart - greatly increasing its financial costs.

When bond markets froze in the summer, FSA, like most other bond insurers, saw its credit ratings cut, and investors started fearing the bonds could default. They began dumping PGW bonds back to JPMorgan and the other banks.

PGW is now paying an effective rate of about 7.25 percent on the bonds - an extra $6 million annually compared with what it might have paid without the swaps.

But that's not the biggest problem with the bonds. JPMorgan told PGW in the fall that it couldn't afford to keep owning the bonds indefinitely. Under the deal, if the bonds can't be sold by July, PGW must pay the banks $60 million a year, for the next five years, until the value of the bonds is paid off. PGW says it can't afford that with its other debt.

PGW can cancel the swap agreement but, under the deal, might have to pay JPMorgan more than $30 million to compensate the bank for ending the arrangement early.

Or it can find a new lender willing to sell new bonds, probably at higher rates, Bisgaier added. "We have six months to fix this."

The 2006 gas works deal was one of 14 bond-related transactions that CDR has worked on in the city since 2002, according to city Finance Director Rob Dubow.

In all, the firm netted more than $2 million from its work on city transactions - including a total of $625,000 from city coffers for its ongoing role as Philadelphia's swap adviser.

CDR has earned no money from city financial transactions since Nutter took office last year, Dubow said.

Asked about the extent of CDR's work in the city in light of the New Mexico investigation, Joan Markman, the city's chief integrity officer, said a review of the firm's work here might be "warranted," but she stopped short of making a commitment to do so.

"It's something to think about," Markman said, though she and the mayor agreed it might not also be the best use of her time.

"You could spend forever going backward," Nutter said. "But I think at a certain point you can potentially take your eye off of whatever is going on now. Our number-one focus is making sure that today, and every day going forward, whoever is doing business with the city . . . it is being conducted with high integrity."