A bad investment ripples through Main Street

ORLANDO -- Main Street USA in Walt Disney World's Magic Kingdom seems far, far away from the meltdown on Wall Street.

Children hug Winnie the Pooh. At Town Hall, the mayor sings, Supercalifragilisticexpialidocious. Yet Wall Street's financial mess has touched even this idyllic world.

The natural gas that cooks the food on Main Street USA was one of the many things that Wall Street bought and sold with borrowed money. The gas deal went belly-up in September, costing investors $700 million when Lehman Bros. failed. Now, it will cost more for Disney to light the flame to roast the chicken to feed the children at the Crystal Palace.

Wall Street's financial crisis flows to Main Street in unexpected and sometimes imperceptible ways. The same bum deal that will raise Disney's natural-gas costs will make it more expensive to buy electricity for residents on Main Street in Tallahassee.

It also cut the value of a dozen mutual funds that lent the money for the deal. And it put a team of bankruptcy lawyers to work in New York and Atlanta.

The tale of Main Street Natural Gas — the sponsor of the obscure financial deal that failed — reveals how risky investments flourished in an era of easy credit and how everyday people are now paying the price.

It's a story of how $700 million was vaporized in just a few months, and of how the deal's investment bankers got paid while investors and consumers got stiffed.

"I feel badly about the investors who lost money and about losing a cheap supply of natural gas," says Arthur Corbin, chief executive of Main Street Natural Gas of Kennesaw, Ga.

The financial system is staggering under the weight of Wall Street-manufactured debt that cannot be repaid.

Main Street Natural Gas' $700 million is a small but revealing part of that problem. Losses on home mortgages alone will reach $1.4 trillion, the International Monetary Fund estimates. Financial institutions are suffering additional losses on home equity loans, student loans, credit cards and other debt.

The details can seem complex when buried in the language of finance — leverage, derivatives, credit default swaps.

Yet, at the core, the deals were simple: Banks and investors borrowed trillions of dollars and bet the money — on home values, natural-gas prices, the probability of bond defaults.

Main Street Natural Gas was typical. It put none of its own money into the $700 million deal. Every penny was borrowed, even the millions paid to the investment bankers. Main Street Natural Gas will lose nothing in the failed transaction.

Instead, the lenders — mutual funds, insurance companies, individual investors — will take the hit.

Long-term promises

Main Street Natural Gas is part of the Municipal Gas Authority of Georgia, a government agency established by the Georgia Legislature 20 years ago to buy natural gas for city-owned utilities that now serve 243,000 customers.

A few years ago, investment bankers from several Wall Street firms approached the authority with a plan to help the agency lock in cheap supplies of natural gas for decades.

The idea: Borrow money at low, tax-exempt interest rates available to government and give the money to the investment banks. The banks would use this inexpensive debt to invest for a profit and, in return, supply natural gas at a below-market price.

In November 2006, the Municipal Gas Authority of Georgia set up Main Street Natural Gas as a non-profit corporation to do the Wall Street deals.

Main Street's sole purpose was to borrow money to buy natural-gas derivatives — contracts that bet on the future price of natural gas.

"A bond lawyer suggested naming the company after 'Main Street' because that's who we were serving," says Corbin, who is also chief executive of the Municipal Gas Authority.

The goal was to secure an inexpensive, long-term natural-gas supply for 73 municipal-owned utilities, including the government district that serves Disney World.

In April, Main Street borrowed $700 million and gave it to the Lehman investment bank. In return, Lehman promised to arrange delivery of 160 billion cubic feet of natural gas over 30 years at a below-market price.

That's like a taxi driver borrowing $7,000 and giving it to a man who promises to supply gasoline for the next 30 years at 50 cents per gallon less than the market price.

The long-term savings would be huge — if the fellow who got the cash doesn't go out of business.

Lehman filed for bankruptcy Sept. 15, having delivered less than 1% of the promised gas.

The fate of the $700 million?

It's in a pool with the rest of Lehman's assets. The money will be spent repaying Lehman's creditors, not buying natural gas.

Main Street Natural Gas' lenders are standing in line with other unsecured creditors, hoping to get 30% to 50% of what they are owed. The bonds they purchased to help finance the natural-gas deal now sell for 5 to 15 cents for every dollar of original value.

City put in money bind

Main Street Natural Gas took advantage of the grand innovation of this Wall Street era: using borrowed money to acquire an asset while transferring risk to others.

Like a homeowner who puts zero-money down, the investor looks smart when the risky deal starts off great.

But things often end badly.

Main Street Natural Gas did its first deal in January 2007. Within 16 months, it borrowed $2.2 billion by issuing tax-exempt bonds and gave them to Merrill Lynch, J.P. Morgan Chase and Lehman.

Main Street planned to borrow more but couldn't when the financial markets came to a standstill.

The investment banks sold Main Street's tax-exempt bonds to investors, mostly mutual funds, insurance companies and wealthy individuals. The investment banks kept the cash and promised to deliver natural gas at below-market prices.

The Lehman deal would have saved the municipalities about 10% of the cost of natural gas.

That promise thrilled officials in Tallahassee.

The city has some of the highest electricity prices in Florida. It operates natural-gas electric plants that consume more than $200 million in fuel a year. The Lehman deal would have supplied enough fuel to save the city $3 million a year.

"It was a nice program," Tallahassee treasurer-clerk Gary Herndon says. "We saved money and had no liability."

Now, the city will pay a price.

Since Lehman went bankrupt, the city has been forced to purchase natural gas at higher prices. The city raised electric rates 8.3% this month, citing higher fuel costs, to an average rate of $158 per month for residential customers.

The higher electric costs will trickle down to all Florida taxpayers. The city's biggest electric customers: Florida State University and Florida's state government.

The Reedy Creek Improvement District — a special government district that contains Disney World outside Orlando — was the second-biggest buyer of natural gas in the deal.

"It was an excellent position for us to be in — cheap gas and no obligations," district administrator Ray Maxwell says.

The natural gas would have been used to generate electricity and supply natural gas for cooking at Disney, he says.

"There's lots of natural gas out there to buy. That's not a problem," Maxwell says.

"We just won't have a long-term contract and as good a price."

'Great tool' — or 'toxic'?

Investors took the loss.

The Franklin Federal Tax-Free Income Fund, for example, bought $25 million of the bonds sold by Lehman.

The interest rate was attractive — as high as 6.6% annually through 2038 — and interest payments were exempt from federal income taxes.

The mutual fund lost about $22 million on the Main Street bonds, based on their current market value. That's equal to a dent of about one-third of a percentage point in the value of the $6.6 billion fund.

Fidelity, Morgan Stanley, Oppenheimer and Nuveen were among the other mutual funds to buy the bonds, according to Securities and Exchange Commission records.

Natural-gas derivatives "can be a great tool if used appropriately," says economist Thomas Lee of the federal Energy Information Administration. "They also can be very dangerous and toxic. The key is to know what you're doing and not cross the line."

Natural-gas derivatives are financial instruments — options, futures contracts, swaps — that are commonly traded on the New York Mercantile Exchange and elsewhere.

In these deals, investors promise to buy or sell natural gas sometime in the future at a specific price.

For example, a contract may call for the purchase of natural gas for $8.25 per million British thermal units (mBtu) in 2013. If the market price of natural gas is $15 per mBtu in 2013, the derivative is a big-time winning bet. If the price is $7.21 per mBtu (the market price Tuesday), the derivative is a money loser.

Lehman commodity traders had the job of betting the $700 million in a way that was profitable for the investment bank and delivering the natural gas to Disney World and Tallahassee when it was due.

Main Street Natural Gas' deal was riskier than ordinary natural-gas derivatives because it placed the entire bet with one company: Lehman.

As it turned out, the deal was a $700 million bet on the financial health of Lehman.

Federal law opened the door

Federal tax law encouraged the deal.

Lehman obtained inexpensively borrowed money by using the tax-exempt status of Main Street Natural Gas.

This borrowing technique had been uncommon until a few years ago because of questions about its legality.

Then the Energy Policy Act of 2005, a 1,700-page energy bill supported by Congress and President Bush, confirmed that tax-exempt borrowing to obtain a long-term energy supply was legal.

Investment banks took advantage of this access to tax-exempt money to raise billions of dollars to bet on the derivatives market.

Lehman was counting on its low cost of borrowing $700 million, plus its investment prowess, to generate enough cash to cover the natural gas it had promised.

For its no-risk role as a tax-break vehicle, Main Street Natural Gas would earn an administrative fee equal to about $4 million over the life of the deal, according to the bond contract. That $4 million would provide earnings to help its parent, the Municipal Gas Authority of Georgia, keep natural gas prices lower for the customers of municipal utilities.

Lehman's bankers, bond lawyers, the bond rating companies and others took home about $4.5 million in April from the bond issue.

Main Street's tax-exempt status would have saved investors — and cost the U.S. Treasury — about $300 million in taxes over 30 years, if the deal hadn't gone bust.

"Lehman Bros. was a highly rated firm," Corbin says.

"We were talking to them right up until they declared bankruptcy."

In April, when the bonds were sold, Lehman stock was trading for about $40 per share. Credit rating agencies gave the bonds good ratings based on the creditworthiness of Lehman, a firm that traced its roots to the cotton trade in the 1840s.

"Every time you borrow money," Corbin says, "there's some risk."

Hitting close to home

At Walt Disney World, the price of roasting chicken at the famous Crystal Palace on Main Street USA is likely to cost more soon.

"It's all very expensive but all very wonderful," says Sandra Rodriguez, an Indianapolis mother who ate at the restaurant with her two children.

When she returns home, Rodriguez and her husband will have to find new jobs. They both were laid off from jobs in the homebuilding business.

"Wall Street problems have affected us," she says.