Tales of the Sausage Factory

When last we left our story, the good folks at Verizon had recognized that the FCC’s concerns around spectrum concentration, the “spectrum gap” between AT&T and Verizon and everyone else, had grown exponentially in the last few months as it looked like the “spectrum crunch” (the general lack of new spectrum for all wireless providers in the face of increasing mobile data use) would continue for the foreseeable future. Yes, the “spectrum crunch” increases the desire to get spectrum into productive use (for example, by moving it from cable companies who can’t figure out what to do with it to Verizon). But it also makes spectrum a zero-sum game, where any gain to Verizon or AT&T translates directly to a loss by all other competitors. At this point, the spectrum gap has become so large that conferring any further advantage to Verizon (or AT&T) threatens the ability of any rival to offer competing services.

Faced with this change in the environment, Verizon announced last week that it would auction off its Lower 700 MHz A&B block licenses to competitors (including AT&T, natch) if it got the AWS spectrum from Spectrumco and Cox. Verizon explained on its Q1 results call for analysts that no one had forced it to offer these divestitures, but that if it got the AWS spectrum, Verizon would no longer need the capacity from these licenses. To translate: “we’re not spectrum hoarding, but if we get what we want from SpectrumCo we won’t need the super-duper wonderful 700 MHz spectrum we picked up at auction in 2008, so we will sell them off and make more spectrum available for our competitors.”

As I explain below, this is an utterly brilliant Aikido move by Verizon. Unfortunately, it doesn’t address the key problem with the transaction — the three side agreements between Verizon and its cable competitors to team up in a variety of ways — that make this look an awful lot like a would-be cartel. Even if we set that aside, as other folks have also noticed, the most likely winner of any private auction Verizon would hold for its Lower 700 MHz A&B blocks would be AT&T. Letting AT&T bug Verizon’s Lower 700 MHz A&B licenses would make the spectrum gap much, much worse.

More below . . . .

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Verizon has clearly studied everything AT&T did wrong last year when it tried to acquire T-Mobile. That includes staying alert for early signs of trouble and taking preemptive moves to keep the course of approval running smoothly. It also includes showing grace under fire rather than trying to browbeat the FCC into submission. To head off concerns about the growing “spectrum gap” between Verizon (and AT&T) and its competitors, Verizon has offered to sell its Lower 700 MHz A&B block licenses in a private auction if the FCC grants the application to transfer the AWS-1 spectrum to it from Spectrumco.

At the same time, Verizon also insists that it is doing this of its own free will and not because the FCC is making it do so or because it has run into any trouble. As I will explain, I believe Verizon is telling the truth. The 700 MHz A&B block licenses Verizon promises to auction to competitors is not nearly as useful to it as the AWS-1 spectrum it will get from Spectrumco and Cox. Given that everyone has extolled the virtues of the 700 MHz spectrum as the most important, game changing super-duper useful for mobile broadband spectrum in the entire universe, and since the licenses in question do cover some major markets, that no doubt comes as a surprise to many. Indeed, rather like the stereotypical used car salesman offering to swap your beat up lemon for his hardly ever driven luxury cream puff, this offer looks too good to be true. Why would Verizon want to swap Magic Elixir 700 MHz spectrum for Totally Awesome But Not Magic AWS-1 spectrum?

Below, I give a run-down of my guesses as to why Verizon decided to make a preemptive offer to divest when so many experts opined this would sail through without serious problems. I also explain why, despite the real virtues of the 700 MHz spectrum, Verizon has good reason to want to ditch these licenses (and was already starting to sell them off before the Spectrumco deal). Finally, I’ll explain why, IMO, this doesn’t address the fundamental problems of the VZ/Spectrumco deal because (a) it doesn’t address the side agreements that make this look like the formation of a cartel; (b) for reasons I have explained at length before, AT&T is the most likely winner of any “private auction” Verizon will hold; and, (c) even if AT&T were excluded from getting the licenses, the Spectrum Gap will actually be worse, not better, as a result of the transaction.

In chess terms, Verizon is offering to sacrifice two pawns to gain a queen. Hopefully, the FCC will resist the invitation and avoid a Fool’s Mate for competition.

Because this ended up being rather long, I’ve divided it into three parts. Part I explains how the spectrum situation changed dramatically in just a few months, so that concern about the Spectrum Gap, the difference in spectrum between the two largest providers and all other wireless providers, came to have such increased significance in the FCC’s thinking. This prompted Verizon to make public what it already planned to do, ditch the 700 MHz A&B blocks, despite the fact that this leaves them open to accusations of spectrum warehousing during the pendency of the Spectrumco/Cox deal.

In Part II, I explain why AT&T will likely win the licenses (a conclusion others have reached as well), absent some condition by the FCC to keep AT&T out of the private auction (which I consider politically unlikely). Part III explains why, even if AT&T were excluded from the private auction for Verizon’s Lower 700 MHz A&B licenses, it still would aggravate the spectrum gap. Since the transaction would make competition worse off post-transaction (and fail to address the whole ‘cartel’ thing), the FCC should still deny the application for transfer.

More below . . . .

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Recently, I talked about the tension between spectrum efficiency and competition policy in auctions.  Briefly, for reasons I will elaborate below, the largest wireless providers (AT&T and Verizon) can extract more value out of a wireless license than their significantly smaller rivals (especially when we include the foreclosure value of keeping the license out of the hands of competitors). As a result, we should expect over time that the biggest wireless companies will eventually have an unbeatable edge in wireless capacity unless the FCC takes some measures to balance out the spectrum holdings.

Not surprisingly, the same problem surfaces when companies buy spectrum licenses from each other.  After all, a license transfer is essentially a private auction (only with less transparency and higher transaction cost – factors that work in favor of the largest companies). We should therefore expect to see the same tension around spectrum efficiency and concern for competition policy play out in license transfers.

Two recent transactions put these concerns in stark relief: AT&T’s recent acquisition of spectrum from Qualcomm and Verizon’s proposed  acquisition of licenses from Spectrumco. Both cases arguably represent an improvement in spectrum efficiency by moving the licenses from those who were ultimately unable (or unwilling) to use them efficiently to those able to pay the most for them (and therefore, presumably, extract the greatest value). At the same time, however, the transfers aggravate the existing spectrum imbalance between the largest wireless providers and competitors.

I explore the trade offs posed by these transactions, and discuss how they are essentially another version of the same spectrum efficiency v. competition policy I discussed in auctions, below . . .

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As I’ve previously reported, Congress is weighing spectrum legislation as part of the Payroll Tax Holiday and Everything Else extension. One critical change pushed by House Republicans (with the enthusiastic support of AT&T, surprise surprise . . .) involves whether the FCC should be able to keep companies that have a lot of spectrum (AT&T and Verizon) from bidding on some licenses in the future. This is called “eligibility restrictions” (i.e., are you eligible to bid in the auction or not). The FCC has authority to impose eligibility restrictions now, but generally doesn’t. As the spectrum gap between AT&T and Verizon and everyone else in the wireless world gets bigger, however, there is some talk of possibly bringing them back.

Needless to say, AT&T and its supporters think this is both unfair and bad policy. Others, such as the folks at T-Mobile (now no longer being absorbed into the Bell Borg) have responded to the fairness argument.  For myself, I am always deeply suspicious whenever incumbents start arguing about “fairness,” as it usually means “please consider this particular detail in a total vacuum without ever thinking about all the unfair advantages I have, and use my framing because I appeal to basic values and use sports metaphors like ‘level playing field.'”  But lets set that aside and do the cold-hearted  policy wonk think. As Paul Krugman occasionally likes to say “economics is not a morality tale.” And in any event, even if we decided this on “fairness,” we’d still want to know the right answers and outcomes, right?

Two usual policy arguments are advanced for no eligibility restrictions. The first is that “auctions put spectrum in the hands of those who will use it most efficiently.” The second is that auctions with open participation increase total revenue. Lets pretend for a moment the first statement is true. Based on this, I shall prove below that not only does open participation decrease revenue, but it creates a serious conflict with competition policy. If we maximize auction efficiency, it is inevitable that the largest players will win the majority of the licenses and that this problem will grow worse over time.

So meet below the line for a video blog explaining this and some serious policy trade off discussions . . . .

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