November 3, 2008
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Transit Agencies Face Catch-22 in Fiscal Meltdown
More than 31 public transportation agencies across the U.S. are facing the grim consequences of the financial meltdown under assault from the investors in dozens of Lease-in/Lease-out and Sale-in/Lease-out (LILO/SILO) transactions promoted and approved by the Federal Transit Administration—which could lead to severe service cuts and termination costs in excess of $2 billion.
Transit agencies that have never missed a payment and do not expect to are nevertheless threatened with default. The catch-22 comes from the fact that, although the payment funds are adequate and safe, the holders of these funds have suffered downgraded credit ratings, allowing investors to bring default actions.
“The bottom line is that, during a time when transit ridership is at record high levels, we have to face this precarious situation that could possibly put a very big dent in our service,” said Carol Kissal, chief financial officer for the Washington Metropolitan Area Transit Authority. “We would be obligated to make payments that are so very unnecessary.”
Request from Senators
Four members of the U.S. Senate have sent a letter to U.S. Secretary of the Treasury Henry Paulson and Ben Bernanke, chairman of the Federal Reserve, asking them to delegate officials to work with U.S. DOT and major U.S. public transit agencies to find a way to resolve the issue.
“AIG was used as a go-between in many of these transactions. Now the banks that are parties to these transactions are using AIG’s credit downgrading to terminate these transactions in terms favorable to them,” states the letter, signed by Sens. Robert Menendez (D-NJ), Richard J. Durbin (D-IL), Frank R. Lautenberg (D-NJ), and Barbara Boxer (D-CA). “As a result, the banks may have the opportunity to gain 100 percent of the tax benefits which have been disallowed, and in turn devastate transit agencies. Any reduction or degradation in transit service could mean that our constituents will struggle getting to work or school, squeezing our state economies and family budgets even further. This is a time when we should encourage mass transit use and a financial blow to our transit agencies such as this one is a major setback to that effort.”
In addition, U.S. Rep. Diane Watson (D-CA) raised the issue at an Oct. 23 hearing of the House Oversight and Government Reform Committee. Testifying on the role of federal regulators in the current financial crisis were Alan Greenspan, former chairman of the Federal Reserve; John Snow, former secretary of the treasury; and Christopher Cox, chairman of the Securities and Exchange Commission.
Watson used the example of the Southern California Regional Rail Authority in Los Angeles, operator of Metrolink commuter rail. The agency sold much of its rolling stock in four lease-back deals, receiving $1 billion in loans from AIG, and now it has been forced to find another firm.
Greenspan, Snow, and Cox agreed with her suggestion that the financial crisis may lead to “a wide variety of bankruptcies that involve small businesses and other corporations.”
How It Works
The mechanics of LILO/SILO are as follows: Transit agencies have received cash for operations and capital purchases as investors took advantage of depreciation and other tax incentives by buying assets such as rail cars, buses, and transit facilities, then leasing them back to the transit agencies over the life of the assets. The agencies used the proceeds of these transactions to buy government securities that would mature over time, providing necessary funds to make payments over the life of the deals; the agencies typically were able to obtain about 6 to 7 percent of the value of their facilities or equipment to maintain service, buy new equipment, and avoid rate increases.
FTA reviewed every transaction that involved federally assisted assets to ensure that it was sound, that all necessary payments were accounted for in advance, and that the transit agencies would maintain “satisfactory continuing control” over their equipment and facilities. These transactions proved so popular that FTA published “how-to” guides for agencies, and promoted them as an aspect of innovative financing.
How, then, did it fall apart?
After years of LILO/SILO deals, the Internal Revenue Service decided that investors did not take real risk in these transactions, claiming that they lacked “economic substance.” The IRS began denying investors the tax benefits, in the form of deductions for depreciation and interest paid, ultimately leaving them with long-term investments with no profit.
As the current financial crisis came to a head, investors saw a way to get back the profits the IRS denied. Although the government securities remain adequate to make every payment, a provision of almost every agreement requires the holder of the securities, or “payment undertaker,” to itself maintain a AAA credit rating. As AIG, a frequent payment undertaker, saw its credit rating slip, transit agencies were obligated to replace AIG within a short time, typically 60 days. In the current financial climate, that has proven all but impossible.
When investors can declare transit agencies in default in this process, even though the securities guaranteeing their payments remain completely sound, the investors can demand “stipulated loss values.” These values amount to all lost profits the investors had hoped to earn, even those denied them by IRS enforcement actions—all at the expense of the transit agencies.
Effect on Transit Agencies
The Los Angeles County Metropolitan Transportation Authority is among the transit agencies threatened by this situation, which could lead to severe service cuts as a result of the fiscal shortfall.
“Even without the federal bailout, AIG was able to pay the share because we gave them money and they pledged us treasury and agency securities. AIG, for us, was always able to perform; the shortfall is coming from the credit downgrade,” said Terry Matsumoto, chief financial service officer and treasurer for Los Angeles Metro.
He continued: “The contract documents, the lease-leaseback documents, require us to replace AIG solely because of the downgrade [in credit rating]….Under the deal documents, Metro is obligated to find a credit-worthy party that would do what AIG was supposed to do for this. In the current marketplace, with everybody being downgraded, few if any people are qualified and interested in taking over for what AIG can do, but our deal documents say we must replace them. That’s what creates the stress.”
WMATA’s Kissal agreed with Matsumoto. “What happened is that when AIG, the bond insurer, went below a triple-A credit rating, the investors could trigger an event of default,” she said. “If the transaction stood on its own, it would keep going; the rental payments would continue regardless of whether the entity making them had a triple-A rating or a single-A rating. There’s no risk to the transaction.
“In this situation,” she continued, “you have to replace the bond insurer with another triple-A in the marketplace, but there is no other triple-A insurer in the marketplace. Even if the agency wants to replace the insurer, it can’t.” According to Kissal, WMATA may have 12 to 20 deals affected by this situation, at an average cost of $100 million to $150 million.
The Next Step
APTA is working closely with dozens of member agencies and their advocates, led by Jeff Boothe of Holland and Knight and John Cline of the C2 Group, to pursue relief for the transit agencies through the recently passed federal “bailout” legislation, the Emergency Economic Stabilization Act. APTA and its members believe this legislation authorizes the Treasury Department to step into the shoes of AIG and other downgraded payment undertakers and, in effect, hold the basket of securities, allowing the transactions to continue and normal payments to be made, and avoiding technical defaults to bankrupt transit agencies.