When the nearly bankrupt city of Berlin was looking for a way to finance its public-transportation system a decade ago, some American investors had an idea that seemed too good to be true. Unfortunately for Berlin, it was.
The scheme seemed a bit convoluted from the start, but it offered oodles of money to the participants. An American investor agreed to lease tram and subway cars from BVG, Berlin’s mass-transit company. And BVG, in turn, leased them back for terms ranging from 12 to 30 years. Under U.S. tax law at the time, the American investor was able to take a depreciation tax benefit on the equipment because it was held on a long-term lease — a financial benefit the investor shared with BVG.
Between 1997 and 2004, Berlin’s public transportation company entered into 22 such lease and lease-back deals, covering a total of 511 tram cars and 647 subway cars, with various American investors.
And they quickly paid off. Over the many deals, BVG received cash payments from the American investors totaling €68.9 million, or about $90.6 million at current exchange rates. BVG in turn paid the American investors monthly rent to use the equipment, a return the Americans enhanced with that big tax break. For its part, BVG used the money it derived from the deals to pay down debt, which has saved it €35 million in interest payments. It was a shell game of sorts, but everyone made out — except, of course, the U.S. taxpayers, who were unwittingly subsidizing Germany’s transit system.
Such transactions were so attractive that from the late ’90s until 2008, when the IRS stopped the practice, cross-border leasing schemes became commonplace in Germany. Between 150 and 200 cities and towns across Germany used such deals to finance everything from public transportation to sewage systems and garbage incinerators. “Back in 1997, no one warned us about the risks. You were considered crazy if you didn’t join in,” says Petra Reetz, a spokeswoman for BVG.
But there was a risk, and it would end up costing German taxpayers dearly. It related to a term set down in the leasing contracts — massive tomes, written in English, which required the Germans to take out policies with AAA-rated insurers to cover the value of the assets for the life of the lease. Should the insurer lose its top rating, the Germans would have to either find another insurer or, in the worst case, provide additional collateral to guarantee the assets. It was a scenario that no one expected could emerge — until the financial crisis hit.
In more than two-thirds of the deals, German cities insured their assets with AIG or Lehman Brothers. So after those two pillars of U.S. finance crumbled, German cities suddenly faced the risk of having to make huge payments — taken together, as much as €30 billion , according to some estimates — to their American investors.
“The contracts are incredibly complicated, a thousand pages and more, and all in English,” says Franz-Reinhard Habbel, spokesman for the Federation of German Cities and Municipalities. “Many cities were just out of their depth and unable to understand them.”
In the case of BVG, the insurance was provided by Hypo-Vereinsbank, the Landesbank Berlin and Credit Suisse. The LBB was privatized in 2007. Expecting that LBB would be downgraded by ratings agencies, BVG was planning
to insure its assets through another state-owned bank in Germany, the Landesbank Baden-Wuerttemberg. But city officials say BVG’s advisor, J.P. Morgan, suggested the transit company spread the risk by insuring the deal
through a collateralized debt obligation, or CDO, backed by a consortium of some 150 banks and insurers that included AIG and Lehman Brothers.
With the collapse of Lehman Brothers and the uncertain future of AIG, BVG fears that the U.S. investors could demand as much as $200 million in additional collateral. As a precaution, the transit company has taken a risk provision of €157 million on its balance sheet. BVG says that when the deal was done, J.P. Morgan assured that it would not be liable unless the majority of its CDO backers became insolvent. “But they misled us,” says
Reetz. “It now appears that we could be made liable even if just one of the backers becomes insolvent, as has happened.” J.P. Morgan declined to comment.
J.P. Morgan has yet to demand payment from BVG, but in October the bank filed with a London court to ensure that London would be the jurisdiction for any court proceedings with BVG. That move possibly suggests that J.P. Morgan is preparing a claim against BVG. Reetz, the BVG spokeswoman, says the transportation company learned of the J.P. Morgan filing last week when
BVG filed to have a trial in Berlin should there be one. “So far, no one has come forward with any demands for payment. But if they do, we will fight them in court. And we want to do that in Berlin, in our own language.” says Reetz.
Similar stories are playing out all across Germany.
In Frankfurt, the Messe Frankfurt GmbH, a company that operates Frankfurt’s convention center, leased its exhibition halls to an American investor for 99 years and signed a deal to rent it back for 28 years. The Messe would not disclose any details of the deal or say whether AIG is providing its credit insurance.
Heag Mobilo, a public-transportation company in Darmstadt, financed its purchases of new street cars through a similar arrangement. The city of Stuttgart leased and rented back its drinking-water system. Bottrop, a city in the Ruhr industrial region, financed a sewage-treatment plant in the same fashion, and Ulm, a southern German city, did such a deal to pay for construction of a refuse incinerator.
Most of the CBL contracts with German municipal authorities were concluded in the late ’90s. After a while, the IRS caught on to what was clearly a tax scam on the part of the American investors. The tax write-off applied to purchases of foreign infrastructure assets. But the German assets were not purchased; they were being leased. So in 2004 the loophole was closed.
Now German towns and cities are appealing to the German government to bail them out. In March, a group of municipal authorities appealed to the Kreditanstalt für Wiederaufbau, or KfW, Germany’s Marshall Fund–era state-owned bank for reconstruction and development, to buy out AIG and replace it as their credit insurer. The plan might work, but KfW is reluctant. “We are looking into the matter,” a KfW spokeswoman says.
Like many players on Wall Street, German city officials have learned that if something sounds too good to be true, it probably is.
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