Five Truths about Boeing's Tanker Lease

The Air Force contract isn't a scam -- as the critics would realize if they knew more about business practices. Still, it's not so smart

By Stan Crock

If Washington has to be prepared to wage war in places far from friendly military bases, a reliable fleet of airborne-refueling tankers is critical. Neither long-range bombers nor shorter-range fighters can make extended journeys without mid-air refueling. But the current fleet of 545 KC-135 tankers are an average of 43 years old. Corrosion, maintenance costs, and long periods when they're out of service are all mounting.

Trouble is, the solution the Air Force, Congress, and Boeing devised was to insert stealthily in a defense spending bill language explicitly handing Boeing a lease deal for 100 new 767s. That has produced outrage in some circles in the nation's capital. (see BW, 7/7/03, "Inside Boeing's Sweet Deal"). But the critics of the transaction -- a series of six-year leases totaling $15.5 billion, plus a $4.1 billion option to buy -- are getting hung up on the wrong questions. Let's take a look at some of the canards:

Lease vs. sale: Leases are more expensive than outright purchases for the simple reason that buying generally avoids finance charges. The Air Force and Boeing say they want to lease because the Pentagon doesn't have what could be as much as the $8 billion it would need upfront to buy the planes outright. I hadn't noticed any congressional reluctance to pony up, say, $70 billion when the Pentagon unexpectedly says it needs it, but let's pass on that issue.

For me, the problem is that critics like Senator John McCain (R-Ariz.) and some watchdog groups seem to oppose leasing on principle. Leasing itself should not be the focus. Leasing can make sense. Take telecommunications equipment and sensors, where technology improves at warp speed. Why get locked into obsolete technology by buying it? Lease it for three years or five years, then get more innovative stuff.

The real issue is not whether to lease but what to lease. By this standard, however, a plane you're going to keep for decades doesn't seem to be a prime candidate for a lease.

Special purpose entity: The lease will be financed through a special purpose entity (SPE). That conjures up images of Enron, which used SPEs to keep liabilities off its balance sheet. Despite the stench, the fact is that most commercial airplanes are leased, and the transactions are conducted through SPEs. Suspicion from some lawmakers and their aides is the price to be paid for bringing a very conventional private-sector practice to a Washington untutored in business matters.

Cost: Sure, a lease costs more, but maybe not that much more. According to the Air Force and Boeing, the tanker leases cost less if you assume commercial efficiencies in the lease -- because it has multiyear lease authority. Don't assume such efficiencies for a purchase, because there's no multiyear purchasing authority from Congress.

If you assume the same efficiencies for both and compare apples with apples, purchasing comes out cheaper. That's hardly a surprise. But it means leasing may not be so outlandishly more expensive. After all, interest rates are low. The estimated interest rate for the less risky pair of the three tranches of bonds needed to finance the deal is under 4%. The estimate is based on Office of Management & Budget assumptions that are far higher than current rates, so the cost may actually be lower.

One tranche is backed by the full faith and credit of the government, so it's essentially a Treasury rate. A second tranche is backed by the lease revenues and would carry a slightly higher coupon. If the Air Force terminates the lease, it would be required to make that year's payment plus the following year's, so as you get to the fifth year of the lease, remaining payments become government-guaranteed.

That reduction in risk means the premium above Treasuries shrinks. Since the government is running a deficit and would have to borrow money for an outright purchase, which apparently isn't included in the comparison of purchase and lease, the difference in cost could shrink further. By Stan Crock Second sweetheart deal: The final tranche may go for 10% because it's the riskiest one. Payment would be contingent on the government actually buying the planes at the end of the lease. It's hard to imagine Washington won't, but there's a risk premium here.

Some sources on Capitol Hill are taken aback because of the possibility that Boeing will be able to buy a healthy chunk of those bonds, perhaps in excess of 10%. Getting double-digit, government-backed returns ain't too shabby, so it looks as if Boeing will be making a killing coming and going.

It turns out, however, that manufacturers often buy some of the riskiest bonds, especially if they're not selling well. This means that the plane maker will shoulder some of the risk. That's neither a bad idea nor unusual, but that won't stop Washington from being suspicious.

The wrong plane? Hardly anyone seems to be focusing on whether the 767 was the right plane to buy. From Boeing's standpoint, it clearly was. The production line had only 27 more orders. The planemaker had done tests to see if the model could function as a tanker, and it already had sold four tanker versions to Italy and Japan, so it had some experience. And from the Air Force's point of view, Boeing had a production line with very little waiting time.

But the 767 is a dinosaur headed toward extinction. That's why it has so few orders. Some analysts wonder whether the Air Force should have waited for Boeing's blended-wing aircraft, which would be more efficient to operate and could refuel more than one plane at a time. It's expected to be available in a decade, around the time the Air Force originally expected to see delivery of new tankers. And advocates say the blended-wing aircraft could assure Boeing's survival in the medium term.

Perhaps the Air Force also should have looked more seriously at Airbus's A330, which flies hundreds of miles farther than the 767, though it doesn't yet have a well-developed boom, the pipe used to transfer fuel to another plane. All of these possibilities were scotched when lawmakers specified leases for 767s in the 2002 defense appropriations bill, however.

This isn't the brightest way to spend $20 billion. And I fault not only Boeing and its supporters but their critics. Serious issues are involved that haven't been publicly aired. Fortunately, a House Armed Services subcommittee started to probe them June 24, when it began looking into the tanker fleet's condition. One general who testified said it was time for a study of the Air Force's needs -- a rather belated epiphany.

Congress has 30 days to reject the Boeing deal once the Pentagon sends up a report on its terms. The Air Force and Defense Dept. civilians are still haggling over some of the details, including the economic assumptions. That gives lawmakers time for the debate that's sorely needed on all of these issues before it's too late.

Crock covers national security and foreign affairs for BusinessWeek from Washington. Follow his views in Affairs of State twice a month, only on BusinessWeek Online

Edited by Beth Belton