Transit Agencies in Bind Due to SILO Deals, AIG Collapse
October 25, 2008
Many major newspapers are reporting on a financing crisis that is hitting many transit systems in the United States this week. The situation is a result of (1) a series of leaseback transactions these agencies conducted, (2) federal policy to first encourage and then discourage them, and (3) the collapse of insurer AIG.
When a private company builds an asset, they are permitted under federal income tax law to deduct from their taxes the depreciation (wearing out) of the asset over time, reducing their overall tax bill. Cities and transit agencies also build and own assets, but because they are governmental instrumentalities, they are exempt from federal income taxes. Given that they don’t pay taxes, these reductions in taxes owed are worthless to them.
Enter the SILO (sale in, lease out) transaction. Beginning in the 1980s, cities started these deals, whereby they sell (actually a long-term lease, but it’s a sale for tax purposes) a city-owned asset to a private investor. The private investor can thus use the depreciation deductions to reduce his or her taxes over time. Not needing the asset, the investor leases it back to the city, and the city promises to make annual lease payments. The city takes part of the purchase price it received to make these payments for the life of the lease, and a surplus is usually left over that can be used for other projects or needs.
One typical example of such a deal is one entered into by the San Diego Trolley in 1981. The agency’s first line had just entered service and it was seeking funds to build an extension. A San Diego corporation, Signal Companies, offered to purchase the agency’s 14 trolley railcars, which had been paid for by state funds. Signal would immediately lease the cars to the Trolley, with the lease payments equivalent to Signal’s purchase payment installments. The profit from the transaction, derived from then-existing tax laws permitting Signal to deduct the depreciation over five years as well as deduct the interest on the payments, would be split between the Trolley and Signal. The Trolley received its share up-front, about 15 to 25 percent of the railcars’ cost. It also retained the right to purchase the railcars back at the end of the lease for $1 each. The deal resulted in a net profit to the Trolley of $2.28 million, which was used for construction. Federal and state officials OK’d the deals as a way to reduce on-budget transit operating and construction subsidies.
Although the IRS and Congress moved at various times to shut down these deals, they flowered especially for transit agencies from the mid-1990s onward. Each agreement had to approved by the Federal Transit Administration, and transit agencies say that federal transit officials encouraged the deals. For budget purposes, the lost revenue to the Treasury (estimated to be $4.4 billion in 2003, when the Treasury Department ruled that depreciation deductions from such deals would be denied) would be considered a tax reduction, not an appropriation. Some 30 agencies made such deals that remain outstanding.
Because Treasury has now made these deals worthless for the banks, they were pretty much looking for any opportunity to get out of the contracts. That opportunity came when American Insurance Group (AIG), an insurer that had guaranteed many of the deals, had its credit rating lowered as a result of nearing bankruptcy and then being bailed out by the U.S. government. The lowering of the guarantor’s credit rating triggered a clause in the agreements that placed them in technical default, requiring the agencies either to find a new guarantor or pay termination fees to cancel the agreements.
The Treasury action ensured that the banks and investors are unwilling to renew the agreements and the agencies are unable to find a new guarantor due to the credit crisis. Some, like Washington’s Metro system, are demanding that the U.S. Treasury become the new guarantor. Metro estimates that it would cost $400 million to pay the termination fees, money that neither it nor any other agency had budgeted. Los Angeles’s MTA estimates that the fees would be $1.8 billion, half its annual operating budget.
Broadly, this shows some of the problems with the federal budgeting process, whereby “tax cuts” are seen as more palatable than “spending” even in a case where they are pretty much the same thing. Federal officials wanted to encourage transit capital projects but not fund them, so they pushed the agencies to use SILO financing. They then reversed course and these agencies are left in a bind.
In the short term, it’s hard to say what the best option is. They are essentially a tax shelter and it’s likely that the U.S. Treasury won’t support any action that doesn’t unwind these deals, and the government becoming guarantor for yet another bankrupt obligation is getting tiresome. At the same time, these agencies just don’t have the cash to terminate these agreements to which they’ve lived up their part.