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.

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