Runaway Train

Why is Muni in such a hurry to win approval for a blindingly complex, potentially risky, $1 billion plan to privatize the city's rail fleet?

It's April 2002, and the city budget is suffering the aftereffects of a half-decade of financial fakery that might be called the Internet-Enron flimflam boom. The airport is almost broke; the Municipal Railway budget is coming up millions of dollars short; and the mayor is about to leave office with a legacy of profligacy greater than that of any local public official before him.

Another big-city mayor might retrench, relax, perhaps live out his days playing golf. But if you're San Francisco Mayor Willie Brown, the political sidelines must seem like death. Why else would you bet your entire wad trying to swing a $1 billion corporate tax shelter that would privatize most of your city's municipal rail fleet?

I swear to God, our mayor actually plans to do this.

On Wednesday, April 10, at 12:30 p.m., Brown's Muni staff is scheduled to propose a deal to lease the city's 118 Breda streetcars to a group of private investors in a blindingly complex series of transactions that would create a multimillion-dollar tax shelter for the investors. The proposed transactions involve Enron-style shell companies, tax accounting of dubious legality, what would seem to be significant financial risk on the city's part, and $10 million worth of consulting contracts apparently custom-tailored for our current government's brand of back-scratching and cronyism. The deal includes a brazen clause that might easily be seen as political blackmail; under it, a supervisorial "no" vote on the Muni/Breda privatization deal would cost the city $1.67 million in "broken deal" fees. The proposal even requires the city to give up its right to a jury trial, in the event the arrangement goes sour and a lawsuit is necessary.

The deal balances on the precipice of several optimistic economic assumptions, the most alarming of which supposes that the Italian Breda streetcars Muni owns will remain in good running order for at least 30 years. (Muni's last set of streetcars survived about 15 years and were screechy, rattling, scary wrecks for the final five of that term.) Perhaps most disturbing, however, is the economic argument Muni is making in favor of the deal. The logic rests almost entirely on the tax advantages that private investors would reap, and then share with Muni, if the lease-leaseback becomes reality. This reasoning is similar to that made in favor of a proposed deal the Massachusetts inspector general denounced for creating "opportunities for favoritism, abuse and corruption." In essence, the city government is being asked to lie to the IRS or some other tax-collecting agency, claiming that it is not creating a series of otherwise ephemeral tax shelters for corporate investors -- and then turn around and do precisely that.

Judging from memos, letters, and other documents associated with this proposed deal, Muni General Manager Michael Burns apparently intends to stand before the Board of Supervisors' Finance Committee on Wednesday and maintain that the deal is a nifty, relatively safe way to obtain more than $30 million of free money. Voting for this measure is a vote for a fiscally sound public transit system, he apparently plans to suggest. Other cities do it, and we should too, he'll say. It's the kind of blithe financial exaggeration that has defined an era, spoken on behalf of a mayor who has truly been a man of his time.


Reduced to its essentials, the proposed arrangement amounts to this: Muni will offer federal tax breaks to private investors, mostly foreigners, who would give the city a cash infusion of $33 million. But those essentials are hidden within and behind a blizzard of financial details and assumptions, many of which could undermine the transaction's supposed benefits, depending on events during the next quarter-century.

Under the proposed deal, Muni would lease 118 of the city's Breda rail cars to a group of private investors; that lease would create a corporate tax shelter that would save the investors tens of millions of dollars. For the right to deduct the value of the cars' annual wear and tear, or depreciation, from their federal taxes, the investors would lease the cars back to Muni -- at a $43 million discount. Muni would pay $10 million to lawyers and financial consultants, and keep $33 million for itself. (While a Muni spokeswoman told me she wasn't yet sure how the agency would spend the money, documents suggest it would mostly be used to cover budget shortfalls.)

City records say the investors will not reveal how much they expect to net in the tax-shelter deal, but those records estimate the investor take to be $31 million.

The magic that can move streetcars back and forth on paper and give the city and a set of private investors $60-plus million in profits is, well, somewhat magical. First, Muni's agents recruited a group of investors -- actually subsidiaries of banks from Canada, Spain, Australia, New Zealand, and San Francisco. These investors created six trusts -- financial shells fashioned expressly for this tax maneuver -- that would prepay Muni the entire present value of the 25- to 27-year Breda-car leases, which Muni and the investment banks have valued at $388.1 million. The banks would contribute $102.6 million of their own money and take care of the rest with a loan of $285.5 million from a bank, headquartered in the Cayman Islands, called FSA Global Funding Limited.

Muni would then invest this money in U.S. government bonds, which would be placed in a trust managed by a company called Premier International Funding (an entity whose name I could not find in federal financial filings or a variety of other finance databases). The account would then be insured by Financial Security Assurance (FSA), a Belgian insurer that owns 29 percent of FSA Global Funding Limited.

(Note to S.F. supervisors: When Michael Burns explains that this arrangement is kind of like putting the money in an ordinary old bank account, please watch for facial tics.)

Over the next 27 years, the city would pay the "investors" (which are actually bank subsidiaries) slightly more than $1 billion in original principal and accumulated interest from the "bank account" (which is actually a can of worms) in 27 annual payments (if the deal doesn't first explode in San Francisco's face).

Sound complicated? Judging from the way Muni appears to be attempting to whisk this past the city's supervisors, you'd imagine it was as simple as signing on a dotted line. Muni officials first explained the deal to members of the current Board of Supervisors' Finance Committee just two weeks ago. Muni's documents on the deal suggest it should be made law by April 12.

"They're saying they're under time pressure, and they're saying the investors may drop out any minute," a board source told me Monday. "They've really been riding this thing kind of hard."

In the world of ordinary, prudent municipal finance, complicated transactions are structured in a way that allows time for elected officials to carefully consider them before passage. In the case of the Breda tax-break transaction, the board is having the deal stuffed down its collective throat, gift-wrapped. But it's not as if the proposal hasn't been kicking around the halls of government for a while.

The Mayor's Office has been lobbying the Assembly for legislation that would provide special state tax breaks specifically designed for this deal -- for the last two years! The law passed late last year, came into effect in October 2001, and will expire in January 2004 -- apparently made to measure for San Francisco. Muni says it has been negotiating with bankers, investors, brokers, consultants, and so on for more than 18 months.


If the Muni records I've seen are any indication, Muni General Manager Michael Burns will present the Breda lease-leaseback as a done deal and a wonderful windfall produced by a piece of "innovative financing" that provides the closest thing there is to free money. The deal might lookrisky, he'll note, but the risks have been managed and tamed through hundreds of millions of dollars of corollary financial transactions. Other cities have done this type of deal -- dozens of cities even -- and nothing bad has happened, Willie Brown's Muni minions will likely say. Then they'll provide a list of transit agencies that have gone this way before.

But Muni's $1 billion bit of tax-shelter privatization flimflam could create more problems than it solves. Its pitfalls are fairly simple.

First, there's the matter of the length of the lease. Muni must promise to lease the Breda cars back from investors for 27 years. Even Muni's own, highly optimistic analysis says that if the "proposed transaction terminates early, the cost to the City would be enormous." If the cars were to wear out before the lease was up, Muni could end up owing huge sums of money -- perhaps more than $100 million.

To assuage supervisors, Muni Deputy Manager for Finance Gigi Harrington says that "none of the more than 20 similar transactions nationwide involving transit agencies have terminated early for any reason," according to a report by the city's budget analyst.

Yet Muni officials fail to note that the vast majority of these deals were consummated during the past few years -- meaning there hasn't been enough time to know if the cars would wear out before the 30-year life span the Muni-Breda lease assumes they would have. The real test will come 15 or so years from now; many of the rail cars in Muni's previous fleet, built by a Boeing subsidiary, were all but worthless within that time.

When I asked why Muni thought the Breda cars would last 30 years, spokeswoman Maggie Lynch faxed me two words: "Industry practice."

If the cars were to fail, and the deal blew up as a result, Muni would have little recourse but to take a huge financial hit: City documents show the agency has relinquished the right to a jury trial in the event the transaction somehow goes bad. Lynch explained that such a waiver is also standard industry practice. Greg Dorbeck, a financial consultant who specializes in representing lessees in municipal and corporate lease financing transactions, explains it another way.

"That's saying, "OK, I'm going to relinquish all my legal rights,'" he says. "That's silly."


Then there's the pesky matter of the Internal Revenue Service.

Three years ago, the IRS issued a ruling that effectively prohibits tax-exempt entities (such as Muni) from engaging in financial transactions (such as lease-leaseback arrangements) that are designed primarily to enable private investors to avoid payment of federal income taxes.

In its push for the Breda lease-leaseback, Muni appears not to address the ruling.

When I asked Muni about the IRS's recent lease-leaseback ruling, spokeswoman Maggie Lynch answered thus: "The IRS requires that the lease be tax-positive over the life of the transaction, and this lease will fulfill that requirement."

Her statement might be understood in several ways. For example, Muni's "investors" are mostly subsidiaries of foreign banks; it's possible they will use their lease of the Breda cars to receive tax benefits under the laws of their home countries, and, somehow, leave the deal "tax-positive" in the United States.

Muni hadn't responded to a request for clarification by my press deadline.


Four years ago, Massachusetts considered a lease-leaseback transaction that would have rented the assets of that state's Water Resources Authority to private interests, which would have rented them right back to the state to gain federal tax deductions. The state's primary watchdog agency, the Inspector General's Office, cried foul.

"In such cases, the federal government views such transactions as shams meant to disguise a tax avoidance scheme," the inspector general said in his report on the matter.

Ultimately, the question of whether the Board of Supervisors should rush to approve Muni's $1 billion proposal to lease most of its rail fleet into a series of tax shelters isn't about philosophy, or morality, or even smelliness. It's a matter of examining readily ascertainable facts.

How does this transaction plan to skirt the federal government's ruling outlawing this type of deal? Is it reasonable to think the Breda cars will last 30 years? Is the deal's proposed maze of Cayman Islands lenders, obscure money-handlers, and apparently conflicted insurers trustworthy? What, specifically, happens if one of our new offshore partners goes bankrupt? Or pretends to? And who, precisely, is receiving the estimated $10 million in overhead costs on this deal?

Supervisor Aaron Peskin, who sits on the Finance Committee with Chris Daly and Sophie Maxwell, was skeptical at first, he said. But Monday, Peskin said he was thinking of supporting the deal.

"It definitely raises the hair on the back of my neck," Peskin said. "If there's no harm done, God bless. But if it's a pig in a poke, shame on us."

Shame, indeed. Before deciding that the city should pay out $1 billion over 30 years through obscure offshore financial firms, our public officials ought to know a lot more than the meager information Muni officials have provided the Board of Supervisors. The supervisors should insist on having time to make sure this isn't the last puff of the flimflam boom.

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