Wall Street's Collateral Damage (Before You Take Public Transportation, Ask Your Banker)

As soon as anyone calls for tight controls on Wall Street, pundits and politicians rush to the defense of "financial innovation." Even after the catastrophic collapse of the latest and greatest financial tools, like synthetic collateralized debt obligations and their many offspring, politicians still seem to believe that financial engineers are always on the cusp of developing new and wondrous products that will make the world a better place... like maybe the financial equivalent of solar energy or wind turbines. But in reality our imaginative financial whizzes invent highly profitable casino games to beat the system... or, as the case may be, smash it into the ground. (See The Looting of America)

Their favorite game is elegantly called "regulatory arbitrage" -- how to find ways around the government rules, and make lots of money doing so. It's particularly profitable to invent new financial tools that allow the wealthy and large financial institutions to avoid taxes, which leaves the rest of us to pay more or be left with lousier public services.

"Not so!" say the financial gurus. They claim these innovative tools actually help public agencies obtain more capital at cheaper rates so that they can provide better public services. Even some highly reputable journalists seem to agree. Here's how NPR's Adam Davidson put it when contemplating the current financial collapse:

"There is a tragedy here too. Over the last thirty years, there have been a series of financial innovations that have just been plain good. They have allowed city governments, local governments, to get money more cheaply, which means more hospitals, more schools, betters sewers, you know, just basic good public services, and that whole system may be permanently broken by this crisis. And that means, really for the foreseeable future, there's just going to be less public service in the U.S."

But sometimes financial innovations are just plain bad, like the one that didn't work out so well for the nine Washington DC Metro riders who were killed in a crash on June 22. In all likelihood they died because they were riding in cars that inspectors said three years earlier should have been removed from the tracks in favor of newer, stronger subway cars. Those stronger cars were not deployed because the old cars had to stay on the tracks to fulfill the terms of a financial innovation called a "lease-back agreement."

Creative bankers and lawyers had figured out that non-profit public agencies pay no taxes and therefore have no use for tax breaks that come from the depreciation of fixed capital -- like subway cars and buses. So how about selling those tax breaks to banks and others who would love to shelter as much profit as possible? In return the public agencies would get some badly needed capital (capital that has not been forthcoming over the past forty years due to outrageous tax cuts for the super-wealthy, large corporations, and banks.)

This particular innovation is simple. The public agency sells its subway cars to the bank and then the bank leases them back to the public agency. The bank now has titular ownership and can claim the depreciation to shelter its profits, and the public agency gets the capital back while paying leasing fees to the banks each year. The subway cars stay on the tracks.

The banks love it because they get an excellent return from the lease, and they get the tax write-offs form the depreciation. The public agencies get the extra needed capital. It's win-win, isn't it?

Well, the banks aren't stupid. They build into the contracts as many fees as they can. There are up front fees to set up the deal and very hefty fees if the public agency wants to get out of the deal. Also, the banks make sure the agency obtains insurance from AAA-rated companies (like AIG used to be) to cover its lease payments. And if the insurer lost its top rating (like AIG did last September) then the contract goes into default and the public agency would have to pay even more hefty fees.

Well, you probably can a guess what happened to the Washington Metropolitan Area Transit Association (WMATA). To secure more capital it got entwined in twenty of these leaseback agreements.

These leases made it difficult for the WMATA to remove the thirty-year old 1000 Series Metro cars from the tracks until the leases expired in 2014, even though the inspectors warned that those cars were less crash-worthy than the newer models. The WMATA did so because they could not handle the fees involved in breaking the leases. And they couldn't afford to pull the cars and still pay the leases. Bloomberg News explains that

"The National Transportation Safety Board had advised Metro to improve its rail cars after a January 1996 collision that killed a train operator. In a 2006 report, the NTSB said it was dropping the matter because WMATA was citing funding concerns related to lease-back agreements in its decision to resist the recommendations to retire or overhaul the 1000 Series rail cars."

Now that's financial engineering with a vengeance.

The IRS finally decided that those leases were, duh, tax dodges! It is demanding that the parties shut them down. There's even more confusion because, as we all know, AIG is no longer AAA-rated which puts the lease-back agreements in technical default. And we don't know the half of it because the lease-back agreements contain confidentiality clauses which prevent prying public eyes from examining the details.

So the next time a lobbyist or a politician rushes to the defense of Wall Street's innovations, let them explain it to the families of those who died from the collateral damage.

Les Leopold is the author of The Looting of America: How Wall Street's Game of Fantasy Finance destroyed our Jobs, Pensions and Prosperity, and What We Can Do About It, Chelsea Green Publishing, June 2009.

Follow Les Leopold on Twitter: www.twitter.com/les_leopold

Comments

[HenryDavid]

The best financial innovation we could create would be to outlaw PAC funds. As long as congress can be bought, we will have more devious "Gordon Gekko greed-is-good financial vehicles".

Another financial innovation would be to have congressmen take an oath that if they're convicted of taking illegal gains in any form, they agree to go to prison for ten real years. And that's a trip to Leavenworth, not Club Fed.

We had a great congressman in Indiana. Andy Jacobs Jr. served for 30 years (beginning in the mid-1960s) and NEVER took PAC funds. He may be singular in the example he set for so long. An honest representative should be so noted in history.

[Nosybear]

Then sue the owners of the obsolete cars: The bank.

[ClarcKing]

Now you must see the importance of getting rid of the monetary financial debt based economic system we, the country, are operating under. Get rid of the Fed. and usury: create the U.S. National Bank. Credits and currency will be issued into the population's physical economy. State and local governments can be funded. Jobs and purchasing power will be introduced into the economy. Stop the foreclosures, enact the Homeowners and Bank Protection Act. Expand Social Security and Medicaid. Start the construction of 100 nuclear generation and distribution systems. Water harvesting and distribution systems are needed. Excess auto industrial capacity can be used to construct a modern mass transit system. Outer space, that is our immediate solar system should be explored and become "our sea": Mediterranean: for mineral resources and later trade routes. The science and technological benefits reaped from such projects will lift and sustain the population for generations. Only the self imposed limitations on our perspectives and imaginations are holding us back. Americans must start to think in terms of the unthinkable. The present economic system has turned into a killing machine and its' market pressures continue to exert contraction on vital life sustaining sectors of our economy. Only massive organized political pressure can create the changes necessary for the lives of the population and the preservation of the nation.

[Alterion]

I'm against financial innovation at all, but couldn't they at least support some kind of 'review' process for new financial 'products', something like the way the FDA has to approve food and drugs?

[zjr909]

A little stroll down history's "Memory Lane" nicely reveals any ruling class's mentality to be rife with madness. Whether any particular ruling class starts out that way or not, they all seem to end up that way. Why should ours be different? Don't we have plenty of "in-breeding" among the super-wealthy? For generations we had maybe a dozen ruling families that inter-married so as to maximize their wealth. That's bound to take its toll on the gene pool. Sociopaths, even psychopaths, are not uncommon among the in-bred. So if anybody imagines for a moment that people like this give a flying f**k about the rest of us - that would definitely have to be labeled an "over-active imagination."

[Alterion]

Interesting post, its something I've wondered for a long time. Why is there so much 'evil' in the upper class aristocracy of America, and throughout the history of the human race? Is it just in human nature?

It was disturbing to see just how many of the bankers were in on the take in this latest financial crisis. I've wondered, do you have to be a self-centered sociopath to become rich and powerful, or does becoming rich and powerful make you one?

[leeannethethird]

we don't want no in no va tion

[Dynamohum]

Innovation is critical to our society!! Innovation based on GREED and malfisience is NOT. There is a big difference. Innovation = great , Innovation controlled by GREED and BANKS = BAD BAD BAD

[ash711]

Les,

Thank you for the article and to those that write favorably about Wall Street innovations, I wonder if they are bought and paid for. If the collapse of the whole financial system does not get someone thinking that WALLSTREET IS OUT OF CONTROL AND DESTROYING AMERICA, then nothing is going to get thru. If you contiue to screw the consumer, we will become a third world country and these hedge fund managers and other Wall Street types will need to watch their back cause the citizens won't take much more. Even the police and armied forces will have to think WHO IS THE REAL ENEMY OF THE STATE. Do you support billionaires making 3.7 billion in one year as John Paulson did. Is that the America you are willing to support as the status quo.

[The Meek]

Yawn, more words about boring greed, boring narcissists, boring sociopaths and boring psychopaths. Hasn't this been written about since writing was invented and nothing has changed. The fact is that 80% of any population would do the same thing if they had the chance. Like the lobbiest said about politicians, "Their campaign rhetoric is about cleaning up the sewage pond in Washington and after they are sworn in they find out it's a Jacussi."

I made up the 80% number but it isn't far off. It maybe a little low.

[jbatch]

Well, we used to have checks that kept most of the 80% out of congress, and that made it very difficult for sleeze bags to temp the weak.

Now, it's greed -a-go-go.

So, I'm not sure what your point is. Relax and enjoy it?

Fact is, we can do something about this, if we have the courage and wisdom to do so.

[RoloTomassi]

Well then, if it's so GD uninteresting, why did you take obviously NOT busy day to post such pointless drivel?

[beaupritchard]

Thanks for shining a little light on another dark corner ... "financial innovation" seems to be the new phrase for "picking the publics pocket".

[John Horner]

We don't need innovative financial products. These are always a way for the bankers to get more money at the expense of customers, employees and/or taxpayers. Nothing good has come of all the bs financial engineering of the past forty years.

[jeanrenoir]

As usual, the problem is that the mass of American voters, the ones in the lower classes who should be most effectively outraged, are hapless and helpless, because they're so dumb and ignorant. They can see the obvious effects on their lives of the Wall St. looting of America, but they are totally clueless about how Wall St. works. So it's kind of hard for them to mount an effective protest. They have no idea what to ask their Congressmen to do about the situation, since they don't actually understand the situation, except in its most obvious effects in their own lives. This is why the lower classes have been so easy for the Republicans to bamboozle, except in moments of outright economic debacle and high unemployment, like the Great Depression and the Great Recession now. Then the public howls in pain and rage as they lose their homes, their jobs, their lives. But they remain as clueless economically, and thus as helpless, as ever.

[joeperc]

I wonder if the crash victims can sue the owners of the cars (i.e. the banks)

[just saying]

I'm telling you, the entire govt is owned by the bankers and the president is their front man to work for their interests:

http://www.youtube.com/watch?v=eAaQNACwaLw

[seawall]

Les, you're leaping to some extreme conclusions. I'm not going to defend the leaseback agreements since I do not know the terms and do not know the details behind the quotation you put in your piece. However, it's a bit of a stretch to say that the leaseback is a significant contributor to the injuries and deaths when the actual accident is the unfortunate confluence of a number of mistakes made (intentional or not). By your argument I could blame every transit accident on politicians who don't properly fund the agencies.

[Les Leopold - Huffpost Blogger]

You're of course correct to suggest that a confluence of factors came together to actually cause the accident, and those are still under investigation. But I'm hoping to make a larger set of points. First of all the public sector in the US is starved for funds because of our failure to adequately tax the wealthy. Second, the lease-back agreements came into existence as a tax dodge and as a way to make up for inadequate funding. And finally, I don't believe that financial innovation is all its cracked up to be. Our current crisis is largely the result of such innovation run wild.

But also I'm haunted by the idea that those cars were left on the tracks because the lease-back agreements made it to hard to remove them. That just doesn't seem right to me.

Your final point has me thinking. When accidents are caused, for example, by cutbacks in maintenance and other cost-cutting measures, it's not just an accident. Someone set up the conditions for that to happen. Shouldn't someone be held responsible?

[ProfessorDuh]

Yes, as I've said all along. The destruction of the world economy was either a criminal conspiracy or criminal negligence. In any case, it was criminal, and a lot more people than Bernie Madoff ought to be spending the rest of the lives in prison.

[seawall]

Thank you for your thoughtful reply. We're generally on the same page. The problem I've always had with private "purchase" or leasing of turnpikes and airports is that it just seems wrong that public agencies fight for funding, but GoldmanSachs and others somehow guarantee investors a comfortable rate of return on an "investment" and/or help them not pay taxes. The leasebacks do seem fishy .

You're very right about how cutbacks must be considered in any incident investigation. A good manager will shut down or curtail his/her serviceand take the heat in light of a lack of appropriate funding to do the right thing to keep everyone safe. If you have enough money to fix 75% of your fleet, do you do 75% of the appropriate maintenance or do you cut service by 25% so that you can still perform the appropriate 100% of the maintenance on 75% of the fleet? Lack of money is no excuse for putting an unsafe train on the tracks or putting trains on unsafe tracks. Agencies must work within their means to provide safe service, even if that means less service. People who make the incorrect decision (at any level in an organization) must be held accountable.

And your final point has me thinking too... I wonder if the leaseback agreements have any provisions relating to the system safety. I sure hope so That has to be risk that the investor takes, and maybe he/she loses money to rectify that situation.

[JJeter]

What these people covet and lust after is not money itself,or even what money can buy.Their only desire is for more money.The billions of dollars already in the sack mean little;mer­e“counters­”,they no longer satisfy the hunger or quench the burning.All meaning attaches to the next dollar,the next million,the next billion.There can never be enough to such as these.The very concept of enough is meaningless.Their greed is,indeed,­limitless.­What a sad and hideous thought.