The End of the Road for Long-Distance Companies…and Most Telecom Regulation

When AT&T and MCI decided to accept merger proposals from the two largest Bell companies in the past few weeks, they essentially dismantled the U.S. telecom regulatory architecture that was originally spawned by the 1974 AT&T antitrust suit.[1] These mergers have brought to a quick end the vertical fragmentation of the telecom sector that was created by the 1984 AT&T divestiture and extended by the 1996 Telecom Act. Even though regulators tried to extend this fragmentation by using the 1996 Act to force the Bell companies to grant competitors access to their networks at subsidized rates, few have been able to survive, not even AT&T and MCI.

Most of the new Competitive Local Exchange Companies (CLECs) created by the 1996 Act have failed, and now even AT&T and MCI (formerly WorldCom) are exiting the stage. These latter two companies could not survive as non-integrated suppliers of long distance in competition with wireless (cellular) carriers, the Bell companies and — most recently — Internet telephony, and they could not use the 1996 Act to develop into integrated local/long distance companies despite the best efforts of regulators. As a result, they have been forced by the twin forces of technology and competition into the hands of SBC and Verizon (or, perhaps, Qwest). This consolidation, by itself, will neither assure nor threaten competition, but it surely will bring an end to the regulatory squabbles that have paralyzed U.S. telecom policy for most of the last decade.

AT&T

Before looking forward to the policy issues raised by these two mega-mergers, it is useful to look back for a moment at the environment that fostered them. For ten years after the 1984 AT&T divestiture, it appeared that AT&T had drawn the better hand. The future lay with interstate and international services, not with the tangle of wires and poles required to connect millions of customers to the network. But as the Internet blossomed in the 1990s, attention shifted from voice services to new higher-speed services that would require new types of connections and new types of customer equipment. AT&T and its manufacturing division did not appear to be ready for this transformation.

AT&T subsequently tried and abandoned almost everything in an effort to recast itself as a candidate for survival. First, it bought NCR in an attempt to harvest the alleged synergies between computer and telecom equipment manufacturing. When this did not work, it divested both NCR and Lucent Technologies, its telecom manufacturing arm. Later, it tried to remedy its vertical isolation from its customer base by buying Teleport –- a company with fiber-optics capacity serving major urban business corridors — for about $11 billion and two cable companies for $110 billion. When it could not convert the cable systems into integrated platforms for the delivery of voice, data, and video to the mass market, it divested them to Comcast at a large loss. Along the way, it also spun off its wireless operations, which subsequently were acquired for $41 billion by Cingular, far more than the parent company subsequently brought from SBC.

By late 2002, AT&T had thrown itself to the wolves by stripping down to being just a long distance carrier, competing with the new “bucket plans” of long distance minutes offered by cellular companies and with the various other long distance companies who had over-expanded capacity during the stock-market bubble of the late 1990s. For a short time, it tried to connect to its customers by leasing the entire complement of network facilities from the Bell companies, the so-called “UNE Platform,” at low regulated rates. The FCC had invented the UNE Platform out of the language of the 1996 Telecom Act, but the federal courts soon overturned this gambit, ending AT&T’s short-lived attempt at pseudo vertical integration. No one should think, however, that leasing the entire local network from the Bell companies could have saved AT&T. The UNE Platform was more of a burden to the Bell companies than a life raft for the long distance companies and the gaggle of failing new entrants who tried to use it. Without their own local networks, none of these companies could offer anything new or innovative to their customers. The principal beneficiaries of this regulatory invention were the telemarketers who tried to convince us that a Bell company’s services were better if they were called “AT&T” or “MCI.”

AT&T has now agreed to sell what remained of its business to SBC for $16 billion plus the assumption of about $9 billion of long-term debt. This is not an insignificant amount of money, but it pales in comparison to the $50 billion that AT&T spent on new capital facilities plus Teleport between 1996 and 2003,[2] not to mention the un-depreciated portion of the network assets that remain from pre-1996 capital expenditures. Clearly, AT&T and its brethren invested far too much in network capacity during the telecom bubble, capacity that is now being gobbled up at fire-sale prices.

MCI (WorldCom)

Verizon’s offer to buy MCI comes immediately after a more sordid tale that is now playing out in the New York trial of WorldCom’s former chairman, Bernie Ebbers. MCI, formerly known as WorldCom and MCI-WorldCom, entered bankruptcy in July 2002, the victim of the market forces that sank other long distance carriers, such as AT&T, and of its own accounting irregularities. WorldCom was built out of a seemingly endless series of mergers, the most important of which was the acquisition of MCI in 1998. Soon thereafter, it also bought local fiber-optics carriers MFS and Brooks Fiber for nearly $16 billion in its (overvalued) stock.

WorldCom and MCI reported $45 billion in capital expenditures between 1996 and 2003, even after restatement of their 2000 and 2001 financials.[3] Thus, in pursuing the illusory benefits of the apparently unlimited growth of the Internet, the company spent at least as much as AT&T for network facilities, including the $16 billion spent on Brooks Fiber and MFS and additional billions on the purchases of companies such as Intermedia and UUNet. After being reorganized in bankruptcy, MCI emerged with assets that it appears will bring perhaps $7 billion or $8 billion from Verizon or Qwest. Accounting fraud may have been the event that triggered WorldCom’s bankruptcy, but excessive investment and the cruel economics of the long distance business would surely have targeted it for extinction anyway.

The Regulatory Issues Posed by the Mergers

Major telecom mergers, such as SBC-AT&T and Verizon-MCI must survive regulatory screenings by state commissions, the FCC, and the Department of Justice. One can already hear the buzz of the opponents who hope to get their pound of flesh as each of the two mergers slowly wends its way through the regulatory approval process. The most common charge leveled at these combinations is that they will reduce competition in the large business (“enterprise”) market. Less concern is expressed about the consumer market, largely because most of us have gravitated to wireless for a large share of our long distance calling and still others are lining up for “Voice over Internet Protocol” (VoIP) services offered over broadband connections.

It will be interesting to see how the arguments over the effect of the mergers on the enterprise market play out before the various regulatory bodies. Each one of these regulators was instrumental in delaying the Bell companies’ entrance into the enterprise market by denying them for four to seven years the state-by-state approval required to enter the long distance market under Section 271 of the 1996 Telecom Act. During the early part of this period, this delay also resulted in less competition in the consumer market. The avowed reason for holding up the Bells’ entry into in-region long distance services, and therefore the enterprise market, was the regulators’ desire to perfect the entry conditions for the new local carriers (CLECs), but the futility of this exercise was surely apparent by late 2000 or early 2001 as the CLECs began to fail in droves. Nevertheless, the regulators persisted in trying to keep the illusion of local competition alive by lowering the Bell companies’ wholesale rates, allowing the entrants to lease the entire complement of Bell local-network facilities (the UNE Platform) at these low rates, and delaying the last Section 271 approvals for Bell-company entrance into long distance until 2003.

Are these same regulatory bodies now going to oppose the SBC-AT&T and Verizon-MCI mergers on the grounds that the mergers could nip in the bud the competition finally being provided by SBC and Verizon in the enterprise market? Why, then, did they bend over backwards to delay SBC and Verizon’s entry into this market for so many years? And if SBC and Verizon were not to buy AT&T and MCI, how rapidly would the Bell companies and the wireless carriers drive these flagging giants into the ground anyway? These long-distance behemoths’ revenues have been declining at 10 to 15 percent per year for the last few years. Could they survive much longer with as these revenue declines continued or even intensified?

Surely the existence of excess capacity in national transmission networks and the potential competition from the other two Bell companies, Global Crossing, Level 3, and other carriers should discipline SBC-AT&T and Verizon-MCI if the latter try to raise rates in the enterprise market. Even if these rates do rise for some period of time, however, the losses to consumers will pale in comparison to the $20 billion that the regulators cost consumers by keeping the Bell companies out of long distance between 1996 and 2003.[4]

The Real Benefits of the Merger

The most important source of benefits from these two mergers is not to be found in the telecom marketplace but rather in the political marketplace in Washington. The mergers should bring an end to the intense intramural regulatory squabbles that have gripped and paralyzed the U.S. telecom sector since the 1996 Act replaced the AT&T decree. MCI (or its forebear, WorldCom) and AT&T have played important roles in arguing for increasingly subsidized access to the Bell companies’ networks so that they could try to gain direct access to their customers. These lobbying efforts, in turn, created enormous uncertainty and delayed Bell company investments in new high-speed networks.

The FCC and state regulators had been responsive to AT&T’s and MCI’s pleas for political reasons – these long distance companies employ thousands of workers (i.e., voters) across the country — and because the regulators had desperately hoped that they could perpetuate the illusion of competition created by the entry of scores of new carriers, however artificially induced it may have been. As these new entrants began to fail, the regulators were even more receptive to the pleas of AT&T, MCI (WorldCom), and the surviving CLECs.

Unfortunately for the regulators, each successive new set of regulations designed to ease the plight of these failing local telecom entrants, including the long distance companies, was overturned by the federal courts. The FCC was finally forced to retreat from this effort when the Administration refused last year to appeal the FCC’s latest court reversal to the Supreme Court. This was perhaps the final straw for AT&T and MCI, who must have seen that their lobbying expenditures in Washington had begun to generate returns that were as low as the returns to their network investments over the previous decade. It was time to pack it in and look for an escape from failure.

With AT&T and MCI out of the way, the regulatory battles will surely recede in intensity. It is unlikely that the combined political clout of US LEC, Z Tel, ICG, RCN, Choice One, XO, Covad and the other CLECs still clinging to life will have the weight of AT&T and MCI in the state and federal regulatory arenas. The attention of regulators has already shifted from this battle anyway as the result of repeated court reversals and the failure of the entrants. It is likely that the competitive battleground will now feature the Bell companies, the wireless carriers, and the cable companies slugging it out with the regulators simply watching, as confused as the rest of us are about the eventual outcome. Regulation will increasingly become a struggle to preserve the billions of dollars in annual “universal service” funds that are extracted from telecom revenues to be sprinkled across schools, libraries, rural health facilities, high-cost rural telephone companies, and lower-income subscribers. After the last nine years, what a relief this will be.

1. For a detailed review of the undistinguished history of telecom regulation since 1984, see Robert W. Crandall, “The Remedy for the ‘Monopoly Bottleneck in Telecom’: Isolate It, Share It, or Ignore It?” The University of Chicago Law Review, Vol. 72, No. 1, 2005.
2. AT&T, Annual Reports.
3. MCI (WorldCom), Annual Reports.
4. Robert W. Crandall, Competition and Chaos: The U.S. Telecommunications Sector since 1996. The Brookings Institution, 2005, forthcoming.