Infrastructure privatization: Can banks be trusted?

Commentary about business and finance.
March 15 2011 6:30 PM

Cities for Sale

Psst! Wanna buy the New Jersey Turnpike?

New Jersey Turnpike. Click image to expand.
New Jersey Turnpike

Almost lost in the deluge of news out of Wisconsin was a paragraph tucked into Gov. Scott Walker's original "budget repair bill" giving the state government the right to sell state-owned power-generation facilities—which supply heating, cooling, and electricity to Wisconsin's government buildings—essentially without any oversight, checks, or balances. As the bill put it, any such sale would, by definition, be "considered to be in the public interest." The blogosphere erupted in a storm of speculation—and New York Times columnist Paul Krugman joined in —that the sale of the plants was intended as a gift to Koch Industries, the mammoth private company run by the Koch brothers, the billionaire Tea Party Medicis who provided conservative support for Walker's agenda. 

Bethany  McLean Bethany McLean

Bethany McLean is a contributing editor at Vanity Fair and the co-author of All the Devils Are Here: The Hidden History of the Financial Crisis.

Bethany McLean writes a weekly business column for Slate and is a contributing editor to Vanity Fair. She is the author (with Joe Nocera) of All the Devils Are Here: The Hidden History of the Financial Crisis and (with Peter Elkind) "The Smartest Guys In The Room."

But the language didn't make it into the final bill.  So what had been just a local Wisconsin issue is now a nonissue, right?  

Actually, the privatization of state and, especially, local government assets is a very real, very national issue, albeit one in which the left's favorite villains in Wisconsin—the Koch brothers—don't figure as prominently as the left's other favorite villain—the banks.  The deep budgetary woes of states and cities around the country have made the quick (but one-time) infusion of cash resulting from an asset sale a handy temporary solution. The big banks advise cities about whether privatization is a wise choice. They also control the ability of states and cities to access the market for their financing needs. But the banks' investment funds may also stand to make money off privatizations.  As Josh Rosner, a managing director at the research firm Graham, Fisher who was a prescient critic of the housing boom, says,  "Given what we've seen [in other deals], I have concerns that the banks will or could use their lending power" to push privatization deals that get done via closed bids, aren't publically debated, and may not be in the public interest.

Privatization of assets that most of us consider public goods—like airports and highways—has a long, often-uncontroversial history. Australia and Europe have used so-called "private public partnerships" to fund infrastructure projects that otherwise might not have been feasible. But as a 2008 report by the Government Accountability Office noted, there is a right way and a wrong way to privatize.  The right way includes shorter leases, some revenue sharing between the private owner and the government allowing taxpayers to benefit from any upside, and a transparent, deliberative decision-making process.

In the U.S, infrastructure privatization has been less prevalent, partly because of fierce local opposition—after all, privatization of an existing asset involves turning an apparently "free" asset into one for which people have to pay. But in the years before the financial crisis hit, the talk in financial circles was that the wave was coming to the United States. Proponents of privatization argued that cities and states needed private capital to fund all the upgrades that our decaying infrastructure so desperately needed.  A 2007 report by Ernst & Young and the Urban Land Institute estimated that the United States needed $1.6 trillion in infrastructure investment over the next five years.  Anticipating a privatization wave, big financial-services firms, including Goldman Sachs, Citigroup, Morgan Stanley, and JPMorgan, raised multibillion-dollar infrastructure investment funds. According to Reason Foundation, 2007 was a record year for private infrastructure fundraising, with a total of $34.3 billion raised.

No city embraced privatization more eagerly than Chicago, where I live.  In 2004, the city leased the Chicago Skyway, a 7.8-mile toll road, to a fund run by an Australian firm called Macquarie Bank.  Then, in 2008, Chicago entered into a 75-year lease of its 36,000 parking meters to Morgan Stanley Infrastructure Partners in exchange for an upfront $1.157 billion.

Then the financial crisis hit, and would-be buyers could no longer raise the cheap debt that made these deals doable. Chicago had entered into a deal to sell its Midway Airport to a group of investors that included Citigroup's infrastructure fund, but it had to cancel it because the buyers couldn't get financing. Gov. Ed Rendell of Pennsylvania, who had struck a deal in 2008 to sell the state's turnpike to a group that also included Citi's fund, lacked the political support to push the deal through—an analysis commissioned by the Democratic Caucus said the turnpike would be more valuable if the state kept control—and in any event, the buyers pulled the bid due to lack of debt financing.  The privatization business dried up. (Earlier this year, Rendell joined the investment bank Greenhill & Co. to work as a senior adviser on privatization deals.  He'll work with the former Morgan Stanley banker who advised him on the failed turnpike deal.)

It may be a little too soon to say that privatization is back, but the factors that made it so attractive before are even more evident today. States and cities are desperate for money, and big banks need new sources of revenue. In a recent issue, BusinessWeek ran a piece titled "The Governors' Garage Sale." The article posited that sales or leases of assets were one solution to the budget woes facing states and listed a number of assets that were in play, including the Garden State Parkway, the New Jersey Turnpike, and Pennsylvania's liquor stores. Probitas Partners, which tracks fundraising, says that more than 99 new funds entered the market in 2010, supporting the view that infrastructure investing is back.  And later this week, Democratic Sen. John Kerry of Massachusetts is going to introduce bipartisan legislation to create a federal "infrastructure bank" in which the government will partner with private funds to upgrade the nation's infrastructure.

But as Rosner asks, why is Kerry's infrastructure bank, with its split allegiances between profit-seeking private capital and social-policy-focused public assets, any different than National Partners in Homeownership?  For those who don't remember, that was a public-private partnership between the government and the banks, announced with much fanfare by President Bill Clinton, to expand homeownership.  We all know which group benefited the most from that effort, and it certainly wasn't citizens or taxpayers!

What's good for the banks isn't necessarily good for the rest of us.  That 2008 GAO report looked at the privatizations of the Indiana Toll Road and the Chicago Skyway.  It found many benefits to these deals, including the availability of cash upfront and the transfer of both operating and financial risks to the private sector.  But it also warned that these deals could result in a loss of long-term value—stealing from the future to pay bills today.  The GAO also noted that the  United States failed to emulate Europe's example of employing a systematic, standardized set of procedures to make sure that such important considerations were taken into account—and that debate would be held in public. 

Take Chicago's deal to sell its parking meters to the Morgan Stanley fund. In 2009, the city's Office of the Inspector General, which at that time was run by David Hoffman (full disclosure: He's a friend of mine), issued a scathing report. Among its conclusions: that Chicago was paid almost $1 billion less for the lease than it would have received had it retained the parking-meter system under the same terms that the city agreed to in the lease.  You might argue, and the city did, that a private-sector company had more freedom to raise rates without provoking a public furor. But as a Chicagoan, I can attest that when the new owners raised parking-meter rates dramatically, the public expressed plenty of rage. [Update, March 16: Morgan Stanley points out that the rate increases for parking meters in Chicago, though carried out by the new owners, was mandated by the city.] It didn't dampen the ire that Chicago Mayor Richard Daley's nephew William Daley Jr., son of the current White House chief of staff, was and is an executive at Morgan Stanley, although the firm has said he played no role in this deal.

The Inspector General's report also concluded that there had been no meaningful public debate about the deal.  It had been a closed process. The Chicago CFO's office never bothered to calculate what the parking meters might be worth to the city. The argument was that the city simply had to sell—it needed the money to fill a budget gap. As the report noted, "Numerous aldermen stated that they felt obligated to support the lease deal because the City's 2009 budget—passed one month earlier—was enacted with $150 million in revenue from the (potential) lease deal already included. To reject the lease deal in December would have been to jeopardize the entire budget passed in November, they said." (Morgan Stanley and the City of Chicago have both argued that the deal was in fact a good one for Chicago; Morgan Stanley also points out that it won a bidding process, and that the firm didn't advise Chicago on this deal.)

Morgan Stanley is a huge presence in the municipal bond market. The firm's Web site notes that since January 1998 it has "participated in municipal bond underwritings worth approximately $200 billion in par value, totaling more than 25% of industry volume."  Nor is Morgan Stanley an oddity in the infrastructure world:  Nationwide, of 2010's top underwriters of municipal debt, three of the top four have infrastructure funds.  The banks, of course, will argue that there are strict firewalls between their infrastructure-investment funds, which seek to put public assets into private hands, and their municipal bond businesses.  Morgan Stanley notes that there are information barriers in place so that information is not shared across businesses.  But count me as a skeptic of the efficacy of such firewalls at each and every bank.

None of this is to say that privatization is necessarily the wrong answer.  But with state and municipal budget holes in desperate need of plugging and banks  looking out for their own bottom lines, the ingredients are ample for compromised decision-making.  Given the magnitude of the sums involved, the decades-long time frame of many of these deals, and their impact on people's lives, mistakes in this area will not be small.