Telecom undone—a cautionary tale

The demise of the telecommunications industry can be traced to a single source—the FCC's own implementation of the Telecommunications Act of 1996. Huber examines how utopianism and meddlesome arrogance on the part of the government have resulted in the near-total collapse of the telecommunications industry.

SELDOM has a chairman of the Federal Communications Commission (FCC) been heard to anticipate the demise of the most important sector of the industry he regulates. Yet in a speech to a Wall Street gathering in October, Michael Powell, chairman of the FCC (and son of the Secretary of State), summed up his view of the state of the nation's telecommunications companies as follows: "Few are prospering. Few are growing. Few are spending. Few are investing. The status quo is certain death."

Powell's biggest worry is the "wireline" telephone industry, which carries most of the nation's data and voice communications. It accounts for the lion's share of the industry's revenues-far more than broadcasting-and supplies critical infrastructure for our entire information-centered economy. Three years ago, this sector was seen as the epicenter of innovation and profitable new investment. Today, it is in shambles.

The hundred-year-old Bell telephone companies, once the rock-solid investment of choice for widows and orphans, are now in sharp decline. The $65 billion poured into the market by their competitors between 1997 and 2001 is now worth under $4 billion. AT&T's stock, which peaked at $60 in 1999, stood at $8 last July. Lucent, the owner of Bell Labs and not long ago the largest vendor of telecom equipment, has lost over 90 percent of its value since January 2001; it has announced a reverse stock split to escape delisting on the New York Stock Exchange. Nortel, its main rival, is in even worse shape. To top it all, antitrust trial lawyers have vowed to turn the older local phone companies-which are the few remaining pockets of solvency in the industry-into (in the words of one legal observer) the "next asbestos or tobacco companies."

Of course, the rest of Wall Street has had its troubles, too-but the collapse of the telecom sector may be what dragged it down. Information technology (IT) delivered about two-thirds of the rise in labor productivity in the last half of the 1990's. Circuit designers, chip fabricators, software companies, and many other elements of the IT economy now depend on new investment and innovation in the telecom sector. In an industry that has historically accounted for between $50 and $150 billion dollars of capital investment every year, capital spending has plummeted.

The telecom collapse is now often chalked up to several years of irrational exuberance on Wall Street, together with accounting fraud by WorldCom, one of the industry's leaders. But-as Michael Powell, for one, appears to recognize-there is a serious case to be made that the industry's refractory problems can be traced to a single source: the FCC's own implementation of the Telecommunications Act of 1996. Thereby hangs a most dismal tale.

THE LAST time Congress enacted a telecommunications law of comparable scope to the 1996 act was in 1934, when it created the FCC itself and codified the core policy of maintaining telephone companies as regulated monopolies. The 1996 act, passed by wide majorities of both houses of Congress and signed by President Clinton with great fanfare in the Library of Congress, was intended to do just the reverse: to open telecom markets fully to competition, and to deregulate them.

The job of deregulation had been started in 1984, when the courts split the old Bell System into its local and long-distance components. The decision left the local phone companies, which account for the majority of telephony's networks and revenues, to their "natural monopolies," barring them from entering other markets. Only on the long-distance side was competition opened up to new carriers and an emerging family of "online service providers," the companies we now know as dot-coms and Internet portals.

By 1996, it had become clear that this upstairs/downstairs division of the industry no longer made sense. Wireless services were booming. Cable companies were upgrading their networks to provide high-speed local connections to the web. Long-distance carriers were poised to invest tens of billions of dollars in new fiber-optic networks snaking through business districts in Manhattan, Chicago, and other major urban markets. E-mail, web pages, and other data services were beginning to offer distinct but nevertheless competitive alternatives to local voice calls. And local phone companies were clamoring for permission to extend their networks and businesses into long distance, video, and data.

One might suppose that the way to open an industry to competition and deregulate it is to do just that. In the early 1980's, that is pretty much how trucks and airlines were deregulated. But, for reasons that seemed sensible at the time, the 1996 act proceeded differently.

It started in the right place-telling states they could no longer forbid competition in local phone markets and outlining a process for admitting local companies into long-distance markets, state by state. The latter process, however, was tied to the development of a new body of regulation. Existing (or "incumbent") local companies would be required to interconnect, on reasonable terms, with their upstart competitors, and also to provide nondiscriminatory access to such things as 411 databases. The reasoning was that nobody would sign up for a new phone company's service if the new network were unable to place and receive calls to and from the old. In addition-crucially, as it would emerge-incumbent local phone companies were required to "unbundle" parts of their existing networks and lease them to competitors at wholesale rates. This would allow the competitors to get a foothold without having to replicate every last wire and switch from the get-go. In other words, unbundling would lower the costs of competitive entry.

But the 1996 act did not specify just how much unbundling was to occur; this is something the FCC was expected to work out later on. The single guideline in the act stipulated only that, before defining an "unbundled network element," the FCC should "consider" whether competition would be "impaired" without it. As to what these elements were worth-their wholesale prices-the FCC was told in equally cryptic terms that this calculation was to be "based on cost."

ENTER NOW the human element. In 1996, the man ensconced in the chairman's office at the FCC was Reed Hundt, an old and trusted friend of Vice President Al Gore. The two had been boyhood buddies at St. Albans, a prep school in Washington, D.C., and Hundt had advised Gore on his two Senate campaigns, his 1988 presidential campaign, and his 1992 run with Bill Clinton for the White House. Neither Clinton nor Gore ever bothered to interview Hundt for the FCC chairmanship. Clinton had handed telecom to Gore, and Gore handed it to Hundt.

Hundt was already in the third year of his tenure when the new act became law in early 1996. Up until then, his main focus had been on wireless services, where he had already orchestrated some dramatic changes that were a harbinger of things to come. Although something of a digression from our main concern, that story is too pertinent to ignore.

In 1993, the same year in which it confirmed Hundt's appointment, Congress had for the first time authorized the FCC to auction off licenses for radio spectrum. Such auctions, the reasoning ran, were the most efficient way to go forward, and would allow the wireless industry to get on swiftly with building its towers and rolling out service. Hundt proceeded to sell off a slew of new licenses. For a vigorous young administration committed to reinventing government, it made for a wonderful photo-op when he was able to go to the White House to present a symbolic check for $7.7 billion to the President.

But it turned out that Hundt had also embellished the new auction rules with many-too many-preferences, bidding credits, and low-interest loans. Successful court challenges delayed several of the auctions, and while the bidding went sky high, much of what was bid was never ultimately paid. The most costly misadventure was launched in 1995, when Hundt sold almost $5 billion of radio spectrum to a company called NextWave in an auction reserved for "small businesses and other designated entities." Hundt had neglected to make sure that the small and the designated were good for this kind of money; they were not. In due course, the FCC would reauction the same spectrum for $16 billion, NextWave would sue, and the wireless industry would find itself under a cloud of $21 billion of liability, with no usable spectrum to show for it. The issue is still unresolved today, and a huge block of idle spectrum still hangs in the balance.

While Hundt was conducting wireless auctions, Congress was drafting the 1996 Telecommunications Act. As soon as it passed, the industry began to learn the new meaning of "unbundling." It was unlike anything that had occurred before.

There was a day, remember, when you either leased your phone and your telephone line together, from the one and only phone company, or you did not lease either one; the freedom we enjoy today to buy our telephones and modems separately from Radio Shack or Dell can be traced back to unbundling rules that were put in place in the 1960's. Then came the 1984 break-up of AT&T, which forced a similar unbundling of local and long-distance services.

The unbundling required by the 1996 act was rather different. It was to be a wholesale unbundling of a wide variety of "network elements," and the new elements thereby created were to be leased not to consumers but to competitors. Admittedly, it made a kind of sense. If you live in an apartment on East 87th Street in Manhattan, you really have no interest in leasing a mile of "unbundled" copper loop leading to Verizon's fortress-like central office near the corner of 97th and Lexington so that you can then drop in at Radio Shack to buy a ten-milliondollar telephone switch and all the rest of what it takes to transform a wire into a functioning dial tone. But a long-distance company might well opt to do just that, using its own switches and operators to provide the rest of a service package.

What would this mean from the standpoint of government regulation? The old unbundling had shrunk the effective scope of such oversight: the regulated phone company sold you less, so the regulator had less to regulate. The new would apply a new layer of wholesale-price regulation to as much of the network as the FCC chose to unbundle. Some $300 billion of assets, with a depreciated book value of almost $150 billion, could now be put up for sale, in pieces and at prices to be determined by one of Al Gore's oldest and most trusted friends.

ISSUED JUST four months after the passage of the 1996 act, Hundt's rules unbundled absolutely everything. The $25 electrician's box on the outside wall of most houses, where the phone company's lines connect to the inside phone wiring. The loop that runs to the central office. The switching equipment and software in that office. The high-capacity fiber-optic lines that connect local offices to the long-distance network, along with operator and directory-assistance services. And more-much more.

Astonishingly, the new rules also required incumbents to offer all the unbundled elements as a single re-bundled package-at the new wholesale rate. New entrants, in other words, would not have to build a single new item or a single new inch of network themselves if they did not care to. They could compete simply by placing a new label on the facilities that they had requisitioned, customer by customer, from the old phone company.

No less astonishing were the prices of Hundt's unbundled elements. They were tied not to what it had actually cost to build things but to models that predicted what it would cost a perfectly efficient competitor to rebuild them from scratch, using the latest technology at the latest prices. In an industry characterized by rapid innovation and inexorably falling prices, the models thus effectively wrote off about half the book value of the existing investment.

A competing phone company can now lease from Verizon, in perpetuity, an unbundled copper telephone line from an East 87th Street apartment to the basement of 97th-and-Lexington for about $15.50 a month. It can also lease, at regulated rates and for as long as it may wish, a cage in Verizon's basement to house any equipment it might care to connect to the line. Switching service will run the new company $5 a month. Caller ID-which Verizon itself would sell to ordinary customers for $8 per month-will cost just twenty cents at wholesale. The prices are different in upstate New York, and different again in Kansas (where, above the corn fields, unbundled copper costs $23 a month). Nationwide there are many thousands of discrete prices for unbundled elements.

As Hundt would later explain, he intended to write rules that would "cause a flood of new investment and innovation that would wash away the advantages of the incumbents-and erode their market capitalization." Many would-be competitors enthusiastically supported that plan, as did their financial backers on Wall Street. Competition was going to develop quickly, and would soon be very profitable.

In the meantime, the one thing that was really growing was the regulatory enterprise. Regulating networks inch by unbundled inch required much finer oversight than regulating them by the bundled mile; setting prices by means of computer models required much keener judgment than setting prices on the basis of historical costs. In short order, the FCC added over 10,000 new pages to the Federal Register.

In the summer of 1996, Hundt attended the Democratic National Convention, seated in the Vice President's box. Gore's acceptance speech promised Internet access for every classroom. As Hundt has recalled the occasion, "the FCC, perhaps for the first time in history, drew extended applause from a political party's nominating convention." The following year, with the new rules largely worked out and Clinton-Gore safely reelected, Hundt resigned from the commission, a year before his own term as chairman was to expire.

WHAT WENT wrong? In early 2000, just before the crash, Reed Hundt published a book entitled, You Say You Want a Revolution: A Story of Information Age Politics. Reflecting the financial euphoria that still prevailed as he was writing it, Hundt's book is a recklessly candid, self-congratulatory account of what he did and why he did it in his nearly 48 months as FCC chairman. In hindsight, it makes for a devastating self-indictment.

The passage of the 1996 act, Hundt writes gleefully, offered "the chance of a lifetime." A Republican Congress had authorized a timid blueprint for incremental change in the information sector, but what the country really needed was a revolution. By means of his unbundling and price-setting rules, and in company with Al Gore and "an eclectic set of other political allies," he was going to help shape the new economy of "high growth, low inflation, productivity gains, and explosive entrepreneurial enterprise."

Economists on the FCC's staff warned that if wholesale prices were pushed too low, the stock market would be prompted "to sell off the Bell stocks, [and] bring the Dow crashing down." But Hundt was confident he could calibrate things just right. And he knew he was succeeding because "Bell stocks rose during our deliberations." Hundt's Democratic champions in Congress, Edward J. Markey and Fritz Hollings, gave him the cover he needed to forge ahead. For their part, the Republicans left him alone because they were sedated by the rising stock market.

By the end of 1999, according to Hundt's estimates, some $30 billion had been invested in the new enterprises made possible by his rules. There were hundreds of new local phone companies of various kinds, along with many dozens of new local carriers of data. Nine of the latter had gone public, or were about to do so.

Nobody was bankrupt in 1999, of course-but then, nobody had yet found out what Hundt's rules really meant. At that point, the lift in the telecom bubble was still coming from the promise and not the actuality of what the rules would deliver. The regulatory blueprints written by Hundt had to be implemented by state commissions and cleared through state and federal courts; that process did not go quickly.

Indeed, it was in large part because of all this back-and-forth between the agencies and the courts that the regulatory decisions Hundt made in 1996 and 1997 did not begin to have any real impact on the market until several years later. (Nearly 80 percent of the transfers of unbundled elements have occurred only in the last 24 months.) By then, Hundt himself had joined the party. Very soon after he left the FCC in 1997, he was advising or on the boards of Allegiance Telecom, Ascend Communications, Brience, CoreExpress, eYak, Global Connect Partners, Phone.com, and Sigma Networks, among others. Reportedly he made over $15 million on stock options received for his services, including millions of dollars of stock in NorthPoint Communications that he cashed out just a few quarters before NorthPoint filed for bankruptcy.

WALL STREET itself completely failed to grasp what Hundt's rules entailed, at least until the economic impact finally began to show up on the bottom line. Only then did the markets come to understand that something had gone terribly wrong. Since then, telecom stocks have been in freefall-- and not just some telecom stocks, but all of them. To understand why that should be so, one must consider how Hundt's rules look from the perspective of each major group of players in the industry.

Let us start with the incumbent phone companies, the principal targets of Hundt's unbundling. Every inch of their networks now has two prices. Retail prices-what the companies can charge to consumers-are still regulated, as they have been for the better part of a century, under schemes that are generally pegged to actual historical costs and that subsidize rural and residential users at the expense of urban and business users. Wholesale prices-what they can charge competitors-are regulated by Hundt's models, which look to future costs and which are not supposed to subsidize anyone. The upshot is that, for the exact same service, wholesale prices are sometimes lower than retail prices, and sometimes higher. Ordinarily, imperfections in the price-regulating machinery tend to cancel each other out; here, competitors buy wholesale where wholesale is cheaper than retail, and consumers buy retail where retail is cheaper than wholesale. One way or another, incumbent companies end up with sharply lower revenues.

But the regulatory impact is perhaps even worse for the new investors, who (one might suppose) should be making out like bandits. The trouble is that the serious ones have been building real, competitive networks, mile by mile, for many years-in fact, since well before 1996. Some have been running their own fiber-optic networks to reach large business customers in urban markets-WorldCom and AT&T, for example, spent some $25 billion to purchase two such companies in 1996 and 1998. And cable operators have been aggressively upgrading their own wires to provide both voice and highspeed digital channels. Thanks to Reed Hundt's computer models, however, competitors with real networks-and real liabilities-are now squared off against network-free competitors, and have found their stocks downgraded as a result.

And what about those network-free competitors themselves? Take a company like Z-Tel, founded and run by lawyers, bankers, management consultants, and an antitrust litigator. Such companies have brought to telecom the same talents that Enron brought to electricity. They build networks out of paper, and whatever actual money they invest is poured into complex software and computer systems developed and optimized for playing the regulatory game.

A big problem with running paper networks is that any number of others can play the same game. If there is any margin in this line of business, the competition quickly makes it razor-thin. And it may be razor-thin in any case: rebranding someone else's network as your own turns out to be an expensive proposition, and the cost of inserting a new middleman between the network and the customer often swamps even the ruinous discounts that regulators have imposed. (Z-Tel claims to have invested more than $100 million to create an interface with the incumbent phone companies, and perhaps it has.) As a consequence, many would-be Z-Tels-- there were hundreds of them at one point-have already landed in the financial dustbin.

As I say, all this took a while to work itself out. When Hundt testified about telecom's woes last October before the Senate Commerce Committee, almost his very first words were that it had been five years since he had left office. If the telecom industry was in a shambles (the implication was), it had not happened on his watch.

WILL REGULATORS ever recover their sanity and incinerate Hundt's rules? At this point, that will be more difficult than it sounds. Some nine million customers are now being served with re-bundled packages of unbundled elements, and both sides have a stake in the status quo. Besides, even if a decision were made to curtail unbundling sharply, it is hard to imagine it happening quickly, or things ever being taken back to where they ought to have started. The harried Michael Powell is now overseeing a major review, but fundamental changes in so large a regulatory system take years to implement and fight out in the courts.

The 1996 act could be amended, and the new Congress might conceivably do just that. The Senate Commerce Committee will now be headed by John McCain, one of only five Senators (and the only Republican) to have voted against the 1996 act. But in its six years of operation the act has so sharply divided the interests of telecom carriers that one cannot easily imagine how a coalition could be formed to bring about a change of direction. Climbing out of this quagmire will be far more difficult than sliding into it.

In the meantime, as Hundt's rules meander back and forth through the federal courts and the FCC itself, the center of action has shifted to the state commissions where they are actually implemented. In a handful of the most influential states, most notably New York, California, Texas, Ohio, and Illinois, ambitious regulators-mini-Hundts-see litde to lose and much to gain by pushing wholesale rates lower and lower. In the near term, the spoils of regulation can be spread around to create more friends than enemies.

Most ominously of all, the trial lawyers are now circling the regulatory road kill. Countless failed enterprises and disappointed investors are searching for someone to blame. They cannot sue Hundt, or his computer models, or the state commissions that now run those models; they can sue the still-wealthy companies that own the legacy network. So the plaintiffs' trial bar-the most loyal, aggressive, and well-financed interest group in the camp of the Democratic party-is now litigating to transform Hundt's rules into treble-damage antitrust suits. Some thirty-six such suits have already been filed.

Is there any basis to them? WorldCom, Z-Tel, and others have undoubtedly encountered many problems as they have labored to build new businesses out of unbundled network elements, but certainly no worse problems than those faced by the incumbent phone companies that they or their customers are now suing. Implementing Hundt's rules has been a logistical nightmare all around. Tens of billions of dollars have been spent to facilitate the transfer of tens of millions of elements from old companies that built them to new companies that want them. The incumbents have certainly fouled up in their scramble to comply with the new rules; the competitors have fouled up even more in administering their side of things, and in more than a few documented instances they have deliberately falsified their records in an attempt to shift the blame. Thrashing out these issues between carriers has been difficult enough; the antitrust suits now raise the stakes enormously.

Just what the courts will do with the suits remains entirely unclear. Two years ago, a federal appellate court in Chicago held that Hundt's rules go well beyond the antitrust laws; the 1996 act has its own enforcement structure, centered in the FCC and state regulators. This June, however, a second ruling by the federal appellate court in New York held just the opposite. It will take several more years to determine whether Hundt, an antitrust lawyer himself before he landed at the FCC, has indeed transmuted the law of telephones into the law of tobacco. If he has, the torch will have been passed-from Al Gore, to Reed Hundt, to the class-action racketeers.

AT THE end of this depressing tale one is still left wondering: how do generally rational and responsible people create such a gigantic mess?

There is no hint of outright corruption in this history, though there is something distinctly malodorous about an FCC chairman prospering so handsomely, and so quickly, when he signs up to help companies exploit the rules he wrote just a few months earlier. No, in the end the failure of the 1996 act reflects corruption of a different kind, a corruption of political culture.

Hundt was a Clintonite who eagerly embraced the Clintonite ethos. Exuding confidence, daring to be bold, he was a man in a hurry, impatient with the plodding engineers who build real networks. So his rules set prices based on models rather than on experience, and allowed new entrants to assemble new networks entirely on paper. All you had to do to compete in Hundt's village was to buy low and sell high. Potemkin could hardly have done it better.

But all this quick and painless competition required a stupefyingly complex labyrinth of rules. Such rules regulated the price of everything, not once but twice; they suppressed competition rather than promoting it; and they enriched no one but legions of lawyers (like me), plus accountants, economists, and still more legions of expert witnesses for hire. It was Hillary-care for the telecom industry, but better, since with it came the added conceit that this all-consuming regulation was just a stepping stone to-deregulation.

Tellingly, two of the strongest critics of Hundt's legacy have been Democrats of the old deregulatory school-in fact, the two men who orchestrated the deregulation of trucking and airlines two decades before Hundt took on telephones. They are Supreme Court Justice Stephen Breyer and Alfred Kahn, who chaired the New York Public Service Commission and later the Civil Aeronautics Board as it was being dismantled. Kahn has referred to Hundt's pricing rules as TELRIC-BS. TELRIC is the FCC's own acronym for Hundt's scheme-it stands for "total element long-run incremental cost." The BS is Kahn's codicil, which (he pretends to insist) stands for "blank slate": prices based on forward-- looking computer models rather than historical books of account.

Could it have been done differently? A less ambitious and more patient man than Hundt would have unbundled much less. In two separate cases, the Supreme Court and three appellate judges have since concluded that that is what the 1996 act required him to do. A more modest and patient man would also have linked prices to actual rather than theoretical costs. As Justice Louis D. Brandeis argued in a 1923 opinion about the telephone industry, tying price regulation to monies actually spent in the past anchors prices in solid reality. By contrast, forward-looking models of what things ought to cost in the future are unanchored to anything and can quickly lose touch with reality, especially when yoked to a wildly misplaced confidence in the power of a federal commission to reallocate several hundred billion dollars' worth of assets for the better.

AND THAT is pretty much the whole story: utopianism and meddlesome arrogance, both empowered by government. The telecom bubble of the late 1990's rose alongside the dot-com bubble because, like web programmers, regulators convinced many people that they could conjure up competition and wealth out of thin air. And behind this delusion lay politics-politics in the sense of public policy, and politics in the ruder, partisan sense as well. In fact the two were inseparable. As Hundt himself revealingly comments about a particular set of broadcast rules that he engineered: "we were helping the President and Vice President win reelection."

Hundt was in the room the day after the 1992 election when the new Vice President-elect huddled with his closest advisers in Little Rock. "Al grinned at us and said, `Now we're running the White House. This is going to be fun.' We all laughed. . . . We would slay enemies, reward friends, celebrate victories, and find out what the Navy stewards served at the White House mess." So they did. Reed Hundt was Al "Information Highway" Gore one step down in the federal bureaucracy, where the policy work does not just talk of reinventing government, he publishes 10,000 new pages in the Federal Register, sets the stage for decades of destructive litigation in the courts, and transforms a cautiously phrased law into a death warrant for a vital industry.