The Air Force KC-767 Tanker Lease Proposal: Key Issues For Congress
Released: 2003-09-02T00:00:00

Introduction and Background

Introduction

by [author name scrubbed] and [author name scrubbed]

(707-2577 and 707-7610)

The Air Force is proposing to replace 133 of its oldest Boeing KC-135E aerial refuelingtanker aircraft by leasing 100 new Boeing KC-767 tankers instead of initially buying themoutright. (1) The proposedlease was authorized by Section 8159 of the FY2002 DOD Appropriations Act ( P.L. 107-117 ofJanuary 10, 2002). The lease, if implemented, would represent a significant shift away fromprevious Air Force plans to modernize its tanker fleet, and a significant departure from normal DODprocedures for major DOD aircraft acquisition programs.

The main issue for Congress is whether to approve or disapprove the lease. Congress'sdecision on this lease could significantly affect DOD aerial refueling capabilities, Air Force fundingrequirements, and the U.S. defense industrial base. Congress's decision could also set precedentsfor DOD acquisition practices and have significant implications for future oversight of DODacquisition programs.

This report examines the lease proposal and its ramifications by providing backgroundinformation on the Air Force's tanker fleet, the Boeing 767 tanker, and the proposed lease itself. Then the report analyzes the following potential oversight issues for Congress relating to the meritsof the proposed lease:

Is there an urgent need to replace the oldest KC-135s?

If so, is the KC-767 the best replacement aircraft?

Are there industrial base concerns?

How the does cost of acquiring 100 KC-767 tankers through a lease compareto the cost of acquiring them through a purchase (i.e., a procurement)?

What potential implications might implementing the lease have forcongressional oversight of DOD acquisition programs?

Although the discussions of these four questions are written so that the reader can proceedfrom one discussion to the next, the discussions are designed to be fairly self-contained, so thatreaders who might be interested in only a particular question can read the section on that question.

Background

by [author name scrubbed] and [author name scrubbed]

(707-2577 and 707-7610)

Air Force's Draft Tanker Roadmap. The AirForce's tanker fleet currently consists of 544 aging KC-135E tankers and 59 somewhat newer KC-10tankers. The Air Force's draft Tanker Roadmap of June 18, 2003 -- its draft plan for managing andmodernizing the tanker fleet -- proposes to begin recapitalizing (i.e., replacing) the fleet by leasing100 new Boeing 767 aircraft that have been converted into tankers. The leased 767 tankers wouldbe used to replace tanker capability now provided by the 133 oldest KC-135Es in the fleet. The leaseon the first group of 767s would begin in late FY2006.

The draft roadmap also calls for retiring 58 KC-135s in FY2004-FY2005 and another 68 inFY2006-FY2008, and using the resulting savings to help finance the lease. A third component ofthe draft roadmap calls for conducting a new tanker requirements study and an analysis ofalternatives (AOA) to determine future requirements for the tanker fleet and the tanker characteristicsbest suited to replace the remaining aircraft in the tanker fleet.

The June 18, 2003 draft roadmap appears to depart from long-standing Air Force plans forthe tanker fleet, which called for conducting an AOA prior to acquiring any new tanker aircraft, andfor beginning recapitalization in the 2012 time frame rather than in FY2006. (2) The most recent tankerrequirements study found that by the year 2005, the Air Force would need 500 to 600 KC-135Rtankers -- or their equivalent -- to meet the tanker needs of the national military strategy. The AirForce study concluded that the current tanker fleet cannot satisfy this requirement because a portionof the fleet is always in maintenance and is therefore not operational.

KC-135 Cost and Availability -- The Economic Service LifeStudy (ESLS). The Air Force's most comprehensive study of the KC-135 fleet isthe KC-135 Economic Service Life Study (February 2001), which serves as the most appropriatebaseline, and point of departure for considering the urgency of KC-135 recapitalization. TheEconomic Service Life Study (ESLS) made cost and availability forecasts for the KC-135 fleet forthe years 2001 through 2040. It was conducted by a team of experts from throughout the Air Forceand led by the Air Mobility Command (AMC). Regarding cost, the ESLS found that the KC-135fleet would incur "significant cost increases" between 2001 and 2040, but "no economic crisis is onthe horizon", "there appears to be no run-away cost-growth," and "the fleet is structurally viable to2040." (See Figure 1) Following the ESLS publication, the Air Force planned to wait until 2013 tobegin KC-135 replacement.

Figure 1. KC-135 Annual Cost Forecast

Regarding aircraft availability, the ESLS predicted that the number of KC-135s availablewould increase between FY2001 to FY2004, reflecting improvements made in programmed depotmaintenance, but would then decline gradually until 2040. (See Figure 2.) The ESLS projected threepotential trends: the most optimistic trend ("Upper Bound") showed between 350 and 375 KC-135sbeing available from 2005 to 2039, and ending at 349 aircraft available in 2040. The "most likely"trend showed between 300 and 350 aircraft being available between 2005 and 2035, with aircraftdipping below 300 and ending around 290 available in 2040. The "worst case" trend (assumed thatthe Air Force did nothing to try to arrest the declining trend in availability) showed aircraftavailability gradually and consistently declining from a high point of approximately 330 in 2004 toonly 190 in 2040. The ESLS predicted that the actual future trend would be somewhere between theupper bound (349) and the most likely trend (290).

Figure 2. KC-135 Projected Aircraft Availability

The Tanker Version Of The Boeing 767. TheBoeing 767 has been in production since the early 1980s. Of the more than 900 that have been built,most are used in commercial aviation as airliners or cargo carriers. Military applications for the 767,however, have been envisioned and pursued for at least 10 years.

As early as July 1992, Boeing began publicly exploring the idea of using the 767--200ERversion of the 767 design (3) as the successor for a variety of existing combat-support Air Force aircraft that are based on the oldBoeing 707 aircraft design. (4) Among the Air Force missions mentioned as being suitable for the767-200ER were airborne early warning, aerial refueling, and electronic reconnaissance andsurveillance. In 1993, Saudi Arabia began exploring the potential purchase of new or used 767s orother commercial aircraft for use as military tankers. Since then, Australia, Italy, Japan, Singapore,and the United Kingdom have studied the use of used or new commercial aircraft, including 767s,as tankers to replace their older tanker aircraft.

In March 2000, Boeing created a business unit to market the 767 tanker worldwide. In April2000, Boeing signed a contract to build four new 767 military tankers for Italy, with the first to bedelivered in 2005. This was followed by a second contract to build four new 767 military tankersfor Japan.

In February 2001, Boeing offered to sell thirty six 767 tankers to the Air Force as a stop-gapmeasure for bolstering Air Force tanker capability pending the results of the Air Force's projectedtanker AOA. At a June 6, 2001, hearing before the defense subcommittee of the SenateAppropriations Committee, General Michael Ryan, then-Chief of Staff of the Air Force, mentionedthe Boeing offer in his response to a question from Senator Ted Stevens on the continued viabilityof the service's KC-135s. General Ryan stated that "we're looking out in about the next 15-year timeframe to begin that replacement." (5)

A September 25, 2001, press report stated that Representative Norman Dicks, a member ofthe defense subcommittee of the House Appropriations Committee, planned to "insert an amendmentinto a defense appropriations bill to jump-start the Air Force's purchase of hundreds of Boeing 767tankers and electronic surveillance planes." (6) In an October 12, 2001 interview, Air Force Secretary James Rocheexpressed support for leasing 100 767s and explained the Air Force's rationale for the proposal:

We have a unique business opportunity to get the bestpricing possible to address our critical need for a multimission aircraft that can carry gas and alsodo all kinds of other things. ... This is not a bail out, but taking advantage of a buyer's market. (7)

The Proposed 767 Tanker Lease.

Basic Elements of the Lease . Under the proposed 767lease, the Air Force would lease each of the 100 767s for a period of six years. The 100 aircraftwould be leased in 6 groups. The lease for the first group of four aircraft would begin in lateFY2006 and extend to late FY2012. The lease for the next group of 16 aircraft would begin at thestart of FY2007 and extend to the end of FY2012. The remaining 80 aircraft would be divided into4 groups of 20 whose leases would begin at the start of FY2008, FY2009, FY2010, and FY2011,respectively, and extend to the end of FY2014, FY2015, FY2016, and FY2017, respectively. Figure3 below illustrates the relationship between the annual lease payments, the total lease program costsand the number of aircraft under lease.

Figure 3. Cost of Lease Payments and Total Lease Program, FY2003-FY2017

Notes: Y1=left axis, $ millions Y2=right axis, number of leased aircraft

* Lease payments reflect the number of aircraft that have been delivered. Each setof aircraft is available for a six-year lease from the time of delivery.

** Total Lease program cost includes annual lease payments and all support costs butnot purchase of aircraft. If the at the end of the leases, the Air Force purchases all100 aircraft, the total program cost would be $29.8 billion, or about $4.4 billionmore. If the Air Force does not buy the aircraft, Wilmington Trust would sell theaircraft to pay off the bondholders. If the Air Force sells the planes for more thanneeded to pay off bondholders, the Air Force would receive a rebate, estimated at$800 million.

*** Under the Air Force plan, aircraft would be delivered between 2006 and 2011on the following schedule: 4, 16, 20, 20, 20, 20. Since each aircraft is to be leasedfor a six-year period, the number of aircraft leased grows to 100 by FY2011 when allaircraft are delivered and then declines to zero once all leases are completed. Tocontinue to retain the full fleet of new aircraft, the Air Force would need to beginbuying the planes starting in 2012.

Source: CRS calculations based on Air Force, Business Case Analysis Model ,"Lease/Return Option," July 1, 2003.

Boeing would begin building each group of aircraft three years prior to the start of the leasefor each group. To finance the three-year construction effort for each group of aircraft, Boeingwould draw down on a bank line of credit (i.e., a bank loan). Upon completing construction of eachgroup of aircraft, Boeing would sell the aircraft to a special non-profit entity established specificallyfor the 767 lease. This entity, referred to as a Special Purpose Entity (SPE) or Variable InterestEntity (VIE) and named the Wilmington Trust, would in effect act as a middleman between Boeingand the Air Force. The SPE would purchase the 767s from Boeing using funds that the SPE wouldraise by issuing bonds on the commercial bond market (i.e., funds that private investors would agreeto loan to the SPE in exchange for a promise from the SPE to eventually repay those funds with acertain amount of interest). The SPE would then lease the 767s to the Air Force using leasepayments that are calculated to cover (but not exceed) the SPE's costs, which would include thepurchase cost of the 767s (an average of $138.4 million in FY2002 dollars per plane, including $7.4million in interest costs on Boeing's construction loans), the interest return promised to thebondholders, and the SPE's minor administrative expenses.

The SPE plans to offer three tranches of bonds, each secured by different assets and eachreflecting different risks. The "G" tranche, estimated to make up about one-third of the total leasecost, will be secured by the Air Force's lease payments. Because the Air Force is contractually liablefor an additional year's worth of lease payments in case of termination, these are essentially low-riskbonds. For that reason, the Air Force is projecting that rates will be about 1/2% point above theprojected Treasury bill rates from 2006 to 2011. (8)

The second tranche of bonds, the "A" bonds, covering about half of the borrowing, wouldbe secured by the value of the aircraft itself and would be the second claimant in case of termination. The Air Force is projecting that those bonds would also be relatively low risk, and hence, wouldrequire an interest rate 1% above the projected Treasury rate in each year from 2006 to 2011.Although it could well be difficult to sell the aircraft for their full value, some would argue that thelikelihood that the Air Force would renege would be low because under the contract, they would facelarge, unbudgeted termination liabilities that could be as high as $2.7 billion in current year dollarsat the highpoint of lease payments. In addition, the Air Force sees a compelling need to maintainthe size of the tanker fleet.

The third tranche of bonds, the "B" bonds, to cover about 15% of the total cost of the lease,would be backed by the potential sale of the aircraft to the Air Force at the end of the lease. Thistranche of bonds is a more risky proposition because a purchase requires Congressional approval,and an additional $4.4 billion in current year dollars in funding. However, purchase is an attractiveoption because the Air Force would already have paid 90% of the cost of the aircraft in its leasepayments. Additionally, the aircraft would only have been used for one-quarter or less of theirnormal service lives. (9) Toreflect potential risks, the Air Force projects that a 10% interest rate compounded to the end of eachlease would be required to attract bondholders. (10)

A principal purpose of the SPE is to relieve Boeing of the need to lease the 767s directly tothe Air Force. If Boeing were to lease the 767s directly to the Air Force, Boeing would have toretain ownership of the 767s and would pay off its construction loans gradually, using proceeds fromthe lease payments. This would require Boeing to carry a significant amount of construction-relateddebt for an extended period of time, which might significantly weaken Boeing's financial condition.

Upon the conclusion of the six-year lease period for each group of 767s, the Air Force wouldhave the option of either returning the 767s to the SPE or purchasing the 767s for an additionalpayment of $44 million in current year dollars per plane.

Enabling Legislation and Report Language. Theauthority for the Air Force to lease 100 767 tankers (and also 4 Boeing 737 transport aircraft) wasprovided in the following legislation:

Section 8159 of the FY2002 Defense Appropriations act ( P.L. 107-117 ofJanuary 10, 2002);

Section 133 of the FY2003 Defense Authorization act ( P.L. 107-314 ofDecember 2, 2002);

Section 8117 of the FY2003 Defense Appropriations act ( P.L. 107-248 ofOctober 23, 2002);

Section 308 of the FY2002 Supplemental.

Together, these provisions provide authority for a lease that departs from normal proceduresfor major DOD acquisition programs by:

specifying that a particular acquisition method can be used (i.e., a lease of acommercial asset, which would make it an operating rather than a capital lease or aprocurement);

specifying the number and type of aircraft to be leased (100 Boeing 767s and4 Boeing 737s);

exempting the lease from requirements and limitations that normally governDOD leases of ships and aircraft which are established in 10 USC 2401 and 2401a, includingfunding of termination liability;

exempting the lease from a limit established in 31 USC 1553(b)(2) on theamount of appropriations that, under certain circumstances, may be charged to closed-outappropriation accounts;

exempting the Air Force from the "Buy American" requirements of the BerryAmendment (10 USC 2533a);

establishing a special congressional approval process for the lease whereapproval would be either through authorization and appropriation language, or through a new startnotification to be approved by the four congressional defense committees at anytime.

It should be noted that Section 8159 is not the first provision permitting DOD to leaseaircraft. The FY2000 Defense Appropriations Act ( P.L. 106-79 enacted on October 25, 1999)contained a provision (Section 8133) somewhat similar to section 8159 that permitted the Air Forceto lease six aircraft "for operational support purposes, including transportation of the combatantCommanders in Chief," (i.e., the top U.S. officers in charge of U.S. military forces operating invarious regions of the world).

Section 133 of the FY2003 defense authorization act ( P.L. 107-314 of December 2, 2002)states that the Air Force may not enter into a lease for the acquisition of tanker aircraft under Section8159 of P.L. 107-117 until authorization and appropriation of funds necessary to enter into the leaseare provided by law or until DOD submits to and the four congressional defense committees approvea new start reprogramming notification for the lease in accordance with established reprogrammingprocedures. This is an unusual if not unprecedented way to approve a major procurement programsince reprogramming or transfers of funds between appropriations are generally used for minoradjustments to ongoing programs.

Status of Congressional Approval Process. Section8159 of P.L. 107-117 states that the Air Force may not enter into the lease until it submits a reportto the congressional defense committees -- the House and Senate Armed Services committees andthe House and Senate Appropriations committees -- on its plans for implementing the lease and untila period of not less than 30 calendar days has elapsed after submitting the report. The practical effectof this provision is to prevent the lease from being implemented until the four congressional defensecommittees have signaled their approval of the lease.

On July 10, 2003, the Air Force submitted the report required by Section 8159 of P.L.107-117 to the four defense oversight committees. The 7-page report (plus a 1-page summary and4 pages of appendices listing specific lease terms and conditions) discusses the operationalrequirement for tankers, alternative tanker-force investment options, the estimated costs of leasingand procuring the 767s, the Air Force's plan for implementing the lease, and basing plans for the767s.

Following the July 10th report, the Air Force submitted a new start reprogrammingnotification for 767 lease mentioned in Section 133 of P.L. 107-314 . Through late August 2003, 3of the 4 congressional defense committees had approved the KC-767 new start reprogramming. TheSenate Armed Services Committee has not yet signaled its approval or disapproval. Both the SenateArmed Services Committee and the Senate Commerce Committee have scheduled hearings for earlySeptember 2003.

Issues for Congress

For congressional policymakers, the merits of the decision to approve or disapprove theKC-767 lease relate in part to examining the following questions:

Is there an urgent need to replace the oldest KC-135s?

Is the KC-767 the best aircraft for the job?

What are the industrial base concerns?

Given the uncertainties involved in this unusual acquisition mechanism, arethe costs projected by the Air Force the most authoritative?

What potential long term implications does this lease present in terms ofbudget and congressional oversight?

Is There an Urgent Need to Replace the KC-135?

by [author name scrubbed]

(707-2577)

Much of the Air Force's argument for leasing 100 KC-767s is based on its assessment thatit has an urgent need to replace the oldest KC-135s: that operations and support costs are too high,that mission availability is too low, that the aircraft is wearing out prematurely due to high operationstempo, and that it is vulnerable to catastrophic problems. (11) The Air Force argues that leasing the KC-767 will result in fasterdeliveries -- under the Air Force's self-imposed funding limits - than will purchasing them, whichmay be important if the need to recapitalize is urgent.

A key judgement for policy makers is whether the need to replace the KC-135E fleet is urgentenough to justify the leasing procedure. If the need is urgent, then the higher costs of leasing ratherthan purchasing new aircraft may be justified. If the need is not so urgent, then it may be moreprudent to delay any action on new aircraft. In this case, critics of the lease point out that an analysisof alternatives (AOA) could be performed over the next few years to more accurately determine whatjoint aerial refueling requirements may be, prior to embarking on tanker recapitalization.

Recently, Air Force officials have argued that a number of the ESLS findings that could beinterpreted as supporting a more gradual approach to tanker recapitalization no longer appearaccurate or valid. In congressional testimony, official statements, and numerous press interviews AirForce officials have offered four general arguments for why replacing the oldest KC-135E modelswith new aircraft is urgent:

New data and analysis show that KC-135 O&S costs will rise faster than theESLS predicted;

KC-135s mission capable rates (MCR) are too low, they spend too much timebeing repaired and maintained in depot, and are thus too frequently unavailable to thewarfighter;

The KC-135 is vulnerable to catastrophic problems that could cause the entirefleet to be grounded;

Tanker requirements, and assumptions about KC-135 usage rates, were formedprior to the terrorist attacks of September 11, 2001. Usage rates have, and tanker requirements likelywill, increase in the new security environment.

Each of these issues will be addressed in the sections below.

New Findings on KC-135 Costs. Air Force andDOD officials argue that recent estimates of KC-135 costs have been higher, and future costs willalso be higher than the ESLS projected. They say that the ESLS study was "extremelyoptimistic," (12) especiallyin its assumptions and projections on key operation and support (O&S) cost drivers. For example,depot labor rates have increased much more quickly than anticipated: from $111 per hour in 2001to $160 per hour in 2002, and $210 per hour forecast for 2003. The cost of repairing the enginestruts on the KC-135Es increased from $1 million per aircraft in 2001 to $3 million per aircraft in2002. (13)

The effect of the optimistic projections contained in the ESLS study becomes evident, DODofficials argue, by comparing ESLS projected 2001 costs to actual 2001 costs. While the ESLSprojected 2001 O&S costs to be $2.1 billion, the Air Force actually spent $2.26 billion, an increaseover ESLS estimates by $250 million or 11.9 percent. Revised Air Force projections now assumethat the annual KC-135 O&S costs will escalate from $2.26 billion to $3.4 billion in 2040. (14) While the ESLS predicted1 percent real cost growth per year and 43 percent cumulative real cost growth by 2040, the newestimates predict 1.5 percent real cost growth per year and 64 percent cumulative cost growth by2040. (15)

Many of those opposed (16) to the KC-767 lease do not dispute the higher O&S costs incurredin 2001. Instead, they take issue with the assertion that costs will continue to rise at the same rate.One year of increased costs, opponents say, does not amount to a 39 year trend. The Air Forceappears to be making a linear extrapolation from 2001 to 2040. The $3.4 billion figure for 2040 costsis derived by assuming that costs will continue to increase by 1.5 percent for the next 39 years ratherthan the ESLS one percent estimate. The Air Force has provided no analysis or proof that theincreased costs incurred in 2001 aren't a one-time anomaly, opponents argue, and thus, the ESLS costprojections to 2040 are still the most authoritative. The increased costs for 2001, lease opponentsargue, are likely caused by the considerable efforts the Air Force made to "fix the KC-135 depot"(see availability section below) and now that the depot is running well, it is not a given that costs willcontinue to increase at the same rate.

Those opposed to the KC-767 lease also take issue with the Air Force claim that the ESLSstudy was optimistic. On the contrary, they say, the ESLS took a conservative approach in itsprojections of future KC-135 costs. For example, the ESLS airframe cost estimates (the largest costdrivers in Figure 1 above) are made up of programmed depot maintenance, major structural repairs,and structural investments. The ESLS identified two structural investments that were needed --KC-135E struts, $1 million per aircraft, and topcoat removal, $500,000 per aircraft. Recognizingthe uncertainty of predicting future repairs, the ESLS estimates included $6 million per aircraft ofnotional repairs that may not, in fact, ever be needed: upper wing skins ($2 million per aircraft),fuselage skins ($2 million per aircraft), and unknown structures ($2 million per aircraft.) Also, whilesome costs (notably programmed depot maintenance, or PDM) have gone up, others have gonedown, or have been eliminated. Depot engineers, for example, have learned how to save $500,000per aircraft by conducting periodic inspections and maintenance instead of removing flaking topcoat(a corrosion preventative material).

Air Force officials state that they have, in fact, gone beyond a linear extrapolation of 2001KC-135 O&S costs and conducted a recent analysis of future costs. (17) In this May 1, 2003 study, the Air Force re-evaluated ESLS projections. The Air Force accepted all ESLS assumptions and dataexcept for PDM estimates, aircraft modifications and military personnel estimates. By updating thesedata, and by using more sophisticated analytical tools, such as compound growth modeling anddiscounting ESLS constant-year dollars (CY) into net present-value (PV) dollars, the Air Forceprojected KC-135 O&S costs to the year 2017 and believes they will be considerably higher than theESLS projected two years ago. Figure 4 illustrates the new projections compared to ESLSprojections. (18)

Figure 4. KC-135 Cost Projections from 2001 (ESLS) and 2003 (BCA)

This new analysis, Air Force officials argue, suggests that KC-1365 O&S costs are not justhigher today than previously anticipated, but will also likely continue to exceed projections. Thesenewer, and higher cost estimates, the Air Force says, support their argument that re-capitalizing theKC-135 fleet sooner rather than later makes good economic sense.

As a recent study, the Air Force's most recent projection of future KC-135 costs has not yetbeen widely disseminated, and thus, reaction to it has been minimal. Lease opponents could expressdissatisfaction with the newer cost projections on at least two levels. First, opponents could arguethat the Air Force does not fully explain its rationale for the changes it made in ESLS assumptionsand data, and the effect that these new data have on future cost projections. What changes weremade in the original ESLS projections on military personnel, for example, and what percentage ofthe newer, higher cost estimates are attributed to this change? The new study provides noexplanation or rationale. Second, opponents could argue that the fact that the Air Force hasperformed two different studies in such a short time period that produce such different outcomescalls into question the credibility of those findings. What confidence can readers have in the newprojections, opponents could argue, when just two years ago, the Air Force presented the ESLS asthe definitive study?

KC-135 Mission Availability. Air Force officialsargue that as aircraft age, the oldest KC-135's mission capable rates (MCR) will decline, and that theaircraft spends too much time in maintenance depots. These two factors will combine to reduce thenumber of available aircraft to unacceptably low levels. The Air Force needs, they argue, torecapitalize the KC-135 fleet with new aircraft that will satisfy mission availability requirements.

The Air Force has a goal of an 85 percent mission capable rate (MCR) for tanker aircraft. The MCR is the percent of time that an aircraft is available to perform its assigned mission. Makingjudgements on the adequacy of KC-135 MCR is complicated because the MCR appears highlydependent on the time period considered and whether the aircraft is in the active or reservecomponent.

Air Force officials have testified that over the last five years, KC-135Rs have averaged a 78percent MCR and the KC-135Es a 71.9 percent MCR, well below the 85 percent goal. (19) This testimony appearsto roughly correlate with a 2002 Air Force study that showed active duty KC-135Rs with an MCRabove 80 percent for FY1997, 1998, 1999, 2001 and 2002. The active duty "R" models MCR's fellslightly below 80 percent in 2000. KC-135Rs in the reserve fleet had generally higher MCRs thanKC-135Es, which fluctuated between the low 60s and high 70s. The 2002 study, also states,however, that "Mission capable rates are holding steady" which appears to contradict some KC-767lease proponents' assertions that the MCR is getting worse. (20)

The General Accounting Office (GAO) has also written that the KC-135 rates are holdingsteady -- "...there has been no indication that mission capable rates are falling or that the aircraftcannot be operated safely." (21) Also, the GAO asserts "KC-135s in the active duty forces aregenerally meeting the 85-percent goals for mission capable rates." (22) Moreover, a January 2003Air Force study also shows the MCR for both the KC-135E and the KC-135R as 85%. (23) The study did not give atime period for this MCR estimate.

Because of the GAO and Air Force studies, some debate has focused on the time, or durationof MCR estimates and the impact that these factors might have on the applicability of estimatingover the long term. For example, the Air Force has discounted some GAO MCR estimates, notingthat they were for short time periods, and that even aircraft with low MCRs can have "spikes" ofhigher availability. The KC-135's performance during Operation Iraqi Freedom is an example of thisphenomenon, KC-767 lease supporters say. The KC-135's 86.4 percent MCR during this conflicthas not been sustained over the long term, lease supporters argue.

Lease opponents would agree that short term MCRs might not be the most reliable of anaircraft's long term MCR. But, lease opponents argue, "when the chips were down," the KC-135 fleetdid achieve, and actually exceeded MCR goals. Also, the KC-135's 86.4 MCR was higher than theMCRs for many other aircraft that participated in the Iraq war: A-10, B-1B, B-2, B-52, E-3B, E-8C,F-117, F-15 (all models), F-16 (all models), KC-10, U-2, and Predator and Global Hawk UAVs. Lease opponents concede that the KC-135's 86.4 percent MCR is higher than normal and likely dueto extraordinary wartime efforts. But that is also likely the case for the 13 other aircraft types thathad lower MCRs than the KC-135. This comparison shows, opponents argue, that KC-135availability can be on par with, if not superior to other aircraft, and claims about low MCR are nota compelling reason to retire the fleet prematurely.

The MCR is only calculated for those aircraft not otherwise unavailable due to depotmaintenance or training requirements. Few KC-135Rs and no KC-135Es are used for training. Therefore, the number of aircraft in depot, and the amount of time they spend there are alsoimportant factors that affect aircraft availability.

The KC-135's maintenance history is well established. As the aircraft has aged and asage-related problems have become more acute, it has taken more effort to complete scheduledmaintenance, called Programmed Depot Maintenance (PDM). The KC-135's maintenance problemsappeared at their worst in 1999, when 176 aircraft (32 percent of the fleet) were in depot at the sametime. It was at this point, both the Air Force and KC-767 lease opponents agree, that the Air Forcehad to make a concerted effort to improve depot maintenance and processes. According to one AirForce study, the Chief of Staff of the Air Force directed his staff and the Air Force MobilityCommand to "fix the depot." (24) The result was a marked improvement in aircraft availabilityfrom FY2001 to FY2003. By some estimates, KC-135s are today spending 45 percent less time indepots than they were two years ago, (25) and 100 more aircraft are now available to the warfighter thanin July 2000. (26) Wherethe Air Force and KC-767 lease opponents diverge, however, is what this recent improvement inavailability implies for the future.

The Air Force acknowledges that fewer KC-135s are in depot. However, this doesn't meanthat less work is being done to maintain the KC-135, officials say. In fact, the opposite is true; morework is being done on them while they are in depot. KC-135 depots added a second shift, and PDMman-hours have doubled from 16,000 to 33,000 despite the improvement in the number of aircraftin depot. (27) Reducingthe number of KC-135s in depot to a manageable level is a real success story, Air Force officials say.However these improvements have come at a real monetary cost, and aren't expected to get anybetter. According to one Air Force official, "we mined all the gold we can there." (28)

Lease opponents say that Air Force assertions that depot maintenance can't further improveare unproven. When the Air Force projects the future costs of acquiring new aircraft (such as theF/A-22) it often banks on "future savings" that will result from manufacturing improvements thatdon't exist today, but are expected to emerge in the future. Why are depot maintenance improvementsa dead end, lease opponents ask, when manufacturing improvements for new aircraft are projectedto occur as an article of faith? For example, depot workers discovered how to save $500,000 peraircraft by conducting 60-hour fuel filter checks and scrubbing fuel tanks rather than engaging intopcoat removal procedures. KC-135 depots improved their processes by paying heightenedattention to critical path management, and "kitting" major structural repair parts. (29) Current workers at Tinker,AFB -- one of three KC-135 depots -- report that present flow time for aircraft in and out of PDMis still decreasing thanks to process improvements. (30) What is prohibiting, lease opponents ask, depot workers from"climbing the learning curve," and discovering new maintenance improvements?

Corrosion and Fleet-Wide Grounding. The AirForce has recently said that the need to replace the KC-135 fleet is urgent because the aging aircraftis prone to mechanical or structural problems that could result in a fleet-wide grounding. The July10th Air Force report to Congress on the KC-767 lease argued that there were "...increasingpossibilities that this 43-year-old aircraft could encounter a fleet-grounding event, crippling ourcombat forces." (p.2.) Former acquisition chief Pete Aldridge, for example, remarked, "'We cannotcontinue to fly the KC-135s forever, and the longer you wait to recapitalize, the more you run therisk...of a fleet of those aircraft being grounded for some reason.'" (31)

Much of the Air Force's concern over the prospects of fleet-wide grounding is based on theKC-135's problems with corrosion. The KC-135 is particularly susceptible to corrosion. Thematerials and manufacturing techniques used to produce this aircraft in the 1950s did not reflectmodern corrosion prevention techniques. The Air Force cannot accurately predict the extent or costof corrosion, Air Force officials now say, and currently lacks mature diagnostic tools that could helpsafely and economically extend the life of the KC-135 fleet. (32) Because of corrosion'sunpredictability, the Air Force is concerned that it has little idea if, when, or how badly the next bigcorrosion problem will appear.

Air Force officials say they have recently experienced a "wake up call" regarding the viabilityof the KC-135 fleet, and it is prudent to take heed of this warning. On January 13, 1999 a KC-135crashed in northwestern Germany, killing all four crew members onboard. Investigating the causeof this accident, Air Force officials found problems with the aircraft's stabilizer trim actuators.Between September 1999 and February 2000, 139 aircraft (24% of the total fleet, 40% of the aircraftavailable) were grounded for repair. (33) If this grounding had happened during an important operation,such as, Operation Iraqi Freedom, the Air Force's ability to project power would have beendiminished, and the conflict could have been prolonged, possibly resulting in higher casualties. Thebottom line for the Air Force is, in the words of acquisition chief Marvin Sambur that "we have noconfidence in the Es right now." (34)

Lease opponents do not dispute the fact that the KC-135 is old or that is has corrosionproblems. They take issue however, with the Air Force's depiction of the problem.

The KC-135 fleet clearly suffers from corrosion, and this causes noteworthy maintenanceproblems. However, lease opponents say, the Air Force makes observations about corrosion thatappear out of sync with the experience of other military services. The Navy and Marine Corps havehad to deal with the effects of corrosion since the inception of naval aviation because their aircraftoperate in much more corrosive environments that the Air Force typically does. Engineers at theNavy's Naval Air Systems Command remark that "corrosion is a known problem that the Navy takesproactive steps to manage." (35)

As far back as 1965, the Air Force recognized that corrosion was a problem that it wouldincreasingly face in the future. One study recognized that the Navy had instituted effective corrosionprotection and prevention measures and recommended that the Air Force emulate Navy proceduresand initiate additional procedures to better mitigate corrosion problems. (36) Why, lease opponents ask,is corrosion difficult for the Air Force to predict, and why are its diagnostic tools "immature," whenthis problem has been known for 40 years? Current claims that corrosion is difficult to predict alsoappear in conflict with Air Force statements in the ESLS of just two years ago that appear quitepredictive: "Aging-related structural repairs due to corrosion will continue to increase at amanageable rate." (37)

Lease opponents also say that the Air Force appears to be exaggerating the risks andpotentially the consequences of a fleet-wide grounding of the tanker fleet. Many note that "By having90 percent of its refueling fleet in one aircraft type, the Air Force for some years now has beenaccepting the risk of fleet-wide problems that could ground the entire fleet." (38) If the Air Force has beenliving with this risk for many years, why, lease opponents ask, has concern only been voicedrecently?

The Air Force claims that the September 1999-to-February 2000 grounding of 24% of theKC-135 fleet was a serious warning that similar groundings could happen in the future, and that suchevents could threaten U.S. power projection capabilities. If true, lease opponents ask, why has theAir Force only begun discussing this recently? The 2001 ESLS study did not mention concern overfleet-wide grounding. No Air Force congressional testimony included discussion of this event untilJune 2003, and no Air Force or DOD official was reported in the press to have expressed anyconcern about fleet-wide grounding prior to April 2002. (39) If the Air Force were concerned about the risks of fleet-widegrounding, lease opponents say, it would have made this case soon after the four-month event. Waiting until the KC-767 lease was being debated diminishes the strength of the Air Force'sargument, lease opponents say. Furthermore, critics say, the Air Force appears to be overstating theconsequences of the four-month KC-135 grounding episode. The United States successfullyprosecuted Operation Allied Force (the air war over Kosovo), with 40% of the fleet unavailable. This conflict saw the largest deployment of air assets and aerial refueling aircraft since the 1991 warin Iraq, proving, critics say, that the Air Force was clearly able to make do with their diminishedassets. Furthermore, the United States also participated in far-flung stabilization and humanitarianoperations in Venezuela and East Timor at the same time as forces were engaged in Kosovo. Aircraftare frequently grounded to address new-found mechanical problems (40) , critics say. Moreover,there's nothing to say that the KC-135 fleet is any more prone to a catastrophic event than many otheraircraft in the Air Force and Department of Navy inventories.

Post 9/11 KC-135 Usage and New MilitaryStrategy. The Air Force has recently argued that another factor contributing to theurgency of replacing the KC-135 fleet is the unanticipated increase in KC-135 flying hours. Relatedly, the Defense Department revised its military strategy in light of post September 11thsecurity requirements, and this new strategy will put increased strains on a force that already fallsshort of tanking needs.

Since September 11, 2001, Air Force officials say, the tanker fleet has been key to protectingthe U.S. homeland (Operation Noble Eagle), and prosecuting the global war on terrorism (OperationsEnduring Freedom and Iraqi Freedom). While performing admirably, Air Force officials say "...theKC-135's...are beginning to show real signs of wear and are being used at a steady state tempo overthe last two years that were never forecast or even imagined before September 11, 2001." (41) Flying hours for theKC-135s averaged about 300 hours per year between 1995 and September 2001. Since thenaccording to the GAO, employment is averaging about 435 hours per year. (42) This unanticipated use,KC-767 lease proponents say, is wearing out the 42 year old aircraft even faster than anticipated justthree years ago.

Lease opponents recognize the upturn in flight hours, but challenge that the consequencesare as negative as the Air Force contends. Corrosion, lease opponents point out, is the limitingproblem with the KC-135, and increased use does not make corrosion worse. If the KC-135'slimiting factors were flying hours, or metal fatigue, for example, the increase in flying hours couldhave a noteworthy detrimental impact on the KC-135's remaining life. Increased flying hours,however, have less impact on the aircraft's corrosion problems, they say. Lease advocates concedethat increased flying hours do not directly make corrosion worse. They point out however, thatincreased flying hours may lead to deferred depot maintenance, where corrosion problems would beaddressed. Thus, increased flying hours can indirectly exacerbate corrosion problems.

The Air Force also argues that today's tanker fleet is facing a new set of requirements that ismore challenging than past requirements -- and that the fleet could not satisfy the old requirements.Rather than defeat two major regional adversaries (the old strategy), the new strategy (outlined inthe Defense Planning Guidance FY2004-09) requires the military to 1) defend the United States, 2)deter aggression and coercion in four critical regions, 3) swiftly defeat aggression in two overlappingmajor conflicts, and 4) upon the President's direction, win decisively against one of the two majorconflict adversaries. According to Air Force documents the new strategy "...coupled withanti-access/area denial challenges show increasing importance and reliance on a viable, sustainable,effective tanker fleet." (43) These increased requirements argue strongly, the Air Force says, for recapitalizing the tanker fleetas soon as possible.

Those skeptical of the KC-767 lease challenge the Air Force assertion that the new strategywill automatically result in increased tanking requirements. Opponents challenge this assumptionfirst, because the Air Force has not conducted a tanker requirements study since the new strategy hasbeen declared. When asked how the Air Force could be so sure of its future requirements consideringthe lack of analysis, one Air Force official replied:

Because we're convinced that the requirement for airrefueling is large and will continue to be very large. As we talked just a moment ago, the requirementis growing, actually, although I can't give you a specific number right here for how much it's grown,based on the new Defense Planning Guidance, yet. But we know it's growing, we know it's going tocontinue to be very large... (44)

Lease opponents agree that conventional wisdom suggests that the new military strategycould demand increased tanker capabilities. However, they say, conventional wisdom is oftenwrong. Determining future tanker capabilities is very complex, and really requires serious analysis. The Air Force does not know what its requirements are going to be 10, 20, 30, or 40 years hence, andit certainly does not know what future Navy or Marine Corps tanker requirements will be. What willbe, opponents ask, the net effect on tanking of more aggressive and pervasive fielding of unmannedaerial vehicles (UAVs)? Will these more fuel efficient platforms reduce requirements as they replacemanned aircraft in the inventory? Or will UAVs continue to augment, rather than replace mannedaircraft, and thus add to tanker requirements? Many suggest that air ships (blimps) and unmannedtethered balloons (aerostats) will likely replace AWACS for a variety of surveillance missions in thefuture; such as homeland defense. If this transition occurs, and when, may have implications forfuture tanker requirements.

Lease opponents also note that dramatic improvements in targeting and weapon miniaturization is translating into fewer combat sorties, which, in turn, means fewer refuelingsorties. Although a simple comparison, lease opponents say one can compare airpower in the lasttwo wars with Iraq and conclude that, the Air Force can already do "more with less." How muchmore effective will tomorrow's air operations become as current R&D programs reach fruition, andwhat effect will this have on tanking needs? These questions, lease opponents argue, require a studyto answer, and it cannot be assumed that tomorrow's aerial refueling needs will exceed today's.

Table 1. Aerial Refueling and Combat in TwoConflicts

a. Gulf War Air Power Survey . Statistical Compendium and Chronology. Vol. V. Washington, DC.1993. P.232.

b. Operation Iraqi Freedom -- By the Numbers . USCENTAF. Assessment and Analysis Division.April 30, 2003. p.7-8.

Finally, lease opponents ask why the Air Force is planning to prematurely retire 68 KC-135Emodels. If the current fleet is deficient today, and tomorrow's requirements are to be even moredifficult to satisfy, why doesn't the Air Force want new tankers in addition to, rather than in lieu of,the 68 KC-135Es, lease opponents ask. Premature retirement of 68 KC-135Es, they say, reduces thestrength of the Air Force's argument that recapitalization is required to satisfy growing tankerrequirements.

Air Force officials recognize that, on one level, retiring 68 KC-135Es can appear inconsistentwith the stated concern over increasing tanker requirements. Also, Air Force studies, such as the May1, 2003 BCA, do indicate that early retirement does incur a small amount of risk in terms of reducedtanker capabilities between the years FY2003 and FY2014. However, the O&M costs of maintainingthe oldest KC-135Es is so onerous, the Air Force says, that cost savings achieved from retirementmore than make up for this slight decrease in capability. Furthermore, savings from retiring the 68aircraft can be reinvested in the remaining fleet to increase its availability, and also help fund tankerrecapitalization efforts. (45)

Is the KC-767 the Best Aircraft for the Job?

by [author name scrubbed]

(707-2577)

If the Air Force need to replace the KC-135E fleet is urgent, then the number of replacementoptions is narrowed. Those options that can be implemented more quickly become more attractivethan those that take longer to implement. The Air Force presents the KC-767 lease as the most timelysolution to its recapitalization problem, and the KC-767 airframe as the most effective way toimprove aerial refueling capabilities.

It is important to understand how well KC-767 attributes match Air Force needs because ifleased and then purchased, these 100 aircraft could likely be in the inventory for at least 50 years. Also, many believe that if the Air Force is successful in leasing and purchasing these 100 aircraft,it will attempt to lease and/or purchase some additional number of KC-767s, perhaps up to another100. (46) Former defenseacquisition chief Pete Aldridge, for example, was reported to have said that DOD plans to purchasemore than the initial 100 KC-767s. Aldridge said that DOD was successful in negotiating a lowerprice for the KC-767 by promising follow-on purchases. (47) Boeing officials deny any government commitment for anythingbut the number of aircraft in the current KC-767 lease. (48)

Five comparisons can be made when considering the KC-767 aircraft and its ability to satisfythe aerial refueling mission needs:

How does the KC-767 compare to the aircraft it willreplace?

How well does the KC-767 meet operationalrequirements?

How does the KC-767 compare to surplus aircraft available on the commercialmarket?

How does acquiring the KC-767 compare to re-engining theKC-135Es?

How does acquiring the KC-767 compare to leasing aerial refuelingservices?

KC-767 vs KC-135. The Air Force compares theKC-767 to the KC-135, and says that the new aircraft is clearly superior to the old. The KC-767 ismore flexible and more capable than the KC-135, supporters argue. All KC-767's for example, likethe KC-10, will be aerial refuelable. The KC-767 can carry 108 patients in its Aeromedical role,compared to the KC-135's 24 patients. The KC-135 can only refuel Navy and coalition aircraft aftermaintenance personnel spend six-to-24 hours attaching a temporary drogue to the refueling boom. The KC-767's drogue is integral to the aircraft. Furthermore, the KC-767 can use either the boom(to refuel Air Force aircraft) or the drogue (to refuel Navy, Marine Corps, or allied aircraft) on thesame mission. The KC-135 can use either the boom or the drogue on the same mission, but not both. The KC-767's cargo carrying capacity is over twice as large as the KC-135s: 77,000 lbs on 19 palletscompared to 36,000 lbs on 6 pallets. (49) Also, the KC-767's ability to operate from shorter runways (8,000feet) than the KC-135 (12,000 feet) will provide greater flexibility and options. There areapproximately 8,000 airfield world wide from which the KC-767 will be able to operate comparedto 228 for the KC-135. (50)

In addition to being more capable, the KC-767 should also be much more available than theKC-135, the Air Force says. As demonstrated by Table 2 below, the KC-767 is estimated to be moreavailable to the warfighter than the KC-135. Over a six-year period, a given KC-135E aircraft canbe expected to be available only 60 percent of the time. The 870 days of unavailability (out of a totalnumber of 2,190 days in six years) is caused by the maintenance activities and modificationsdescribed below. Flight line and scheduled depot maintenance cause the bulk unavailability.

Table 2: Projected Aircraft Availability

( Days not available tothe warfighter in a six-year period peraircraft ) (51)

* Based on actual data extended over a six-year operational time frame

** Based on FY2012 fleet projections extended over a six-year period.

KC-767 versus Operational Requirements. Inmany ways, lease opponents admit, the KC-767 does compare favorably to the KC-135. However,lease opponents say, the Air Force does not make the most important comparison between theaircraft, which is maximum fuel capacity. Despite its modernity, the KC-767 only carries 1 percentmore fuel (2,000 lbs) than the KC-135. The KC-767's cargo and aeromedical capabilities, forexample, are second order issues for consideration, lease opponents say. These aircraft are beingacquired to provide fuel, and when comparing total fuel carrying capability, the KC-767 representsalmost negligible improvement over the KC-135.

Another more meaningful evaluation of the KC-767's performance is how it compares to AirForce requirements. Air Force aerial refueling requirements are expressed in the OperationalRequirements Document (ORD) (HQ AMC/XPR, October 22, 2002). Lease opponents say that theKC-767, while looking good compared to the KC-135, does not measure up in many important areasto the ORD yardstick.

The ORD requires, for example, that the KC-135's replacement be able to refuel two aircraftsimultaneously with the hose-and-drogue system. The KC-767 variant being considered in this leasecannot satisfy this requirement. It can only refuel one aircraft at a time with the hose-and-droguewhich considerably reduces, opponents say, its operational capabilities.

Another KC-767 shortcoming, opponents say, is the aircraft's inability to offload multipletypes of fuel on the same mission. The ORD lists this objective because it would greatly enhancethe aircraft's ability to simultaneously fuel both Air Force and Navy and Marine Corps aircraft. Bothservice's aircraft can operate on the same fuel if necessary. However, to minimize the hazard ofshipboard fires, Navy and Marine Corps aircraft regularly use a type of fuel less prone to ignitionthan the standard Air Force fuel. Carrier-based Navy and Marine Corps aircraft will only use AirForce fuel infrequently, because their tanks must be emptied prior to landing, and their fuel systemsmust be flushed clean to avoid contaminating the carrier's fuel supply with the Air Force's morecombustible fuel. Thus, a KC-767 able to offload only one type of fuel on a single mission is muchmore limited in the types of aircraft it can service, contend lease opponents.

Some of the capabilities that the Air Force and Boeing tout sound attractive,

opponents say, but they aren't required by the ORD. This brings into question how important thesecapabilities really are. The ability to operate from runways less than 12,000 feet is one example. The Air Force also reportedly wanted the KC-767 built in a "combi" configuration that would permitit to carry passengers and cargo at the same time. This configuration, however, would have requiredbuilding a special bulkhead, and would have presumably increased the cost of the aircraft, so the planwas dropped. (52) Theloss of this capability, opponents say, is another example of how the KC-767 might look goodcompared to a 42 year-old aircraft, but still might not have the attributes most attractive in a newaerial refueling aircraft.

The Air Force and other lease supporters could counter these criticisms by pointing out thatthe KC-767 does satisfy the majority of ORD requirements. It is unrealistic to expect an aircraft tosatisfy all of the requirements, and the many that the KC-767 does satisfy more than make up for theone or two that it does not. The ability to offload more than one type of fuel on a single mission isan ORD objective, lease supporters argue, not a requirement. Also, supporters point out, provisionshave been made to add hose-and-drogue wing pods -- which would enable simultaneous refuelingof two aircraft -- if future needs warrant.

KC-767 versus Other Aircraft. Another way todetermine if the KC-767 is the best aircraft for the job is to compare it to other available aircraft. TheAir Force says that it evaluated 747, 757, 767, 777, and A330 aircraft, and found the 767 the bestcandidate for the aerial refueling mission. (53) These aircraft are not the only alternatives to be considered,critics argue. Lease opponents note that there is currently a glut of excess commercial airliners onthe market, and the Air Force could more cheaply buy some number of these unwanted aircraft andconvert them into tankers. Some estimate that over 700 surplus commercial airliners are in long-termstorage facilities in the American southwest alone. (54)

Surplus Boeing DC-10 aircraft, for example, appear to be excellent candidates for conversioninto tankers and for recapitalizing some portion of today's KC-135 fleet, lease opponents say. TheAir Force already operates 59 converted DC-10s -- called KC-10 Extenders . These aircraft havealmost twice the maximum fuel capacity of both the KC-135 and the KC-767. Using the Air Force'sown comparative metrics, the KC-10 is a 1.95 KC-135 equivalent -- in other words, it has 195percent of the KC-135's fuel carrying capabilities. Thus, 50 KC-10s have roughly the same tankercapabilities as 100 KC-135s. Also, lease opponents point out, the KC-10 can use the refueling boomand the hose-and-drogue systems on the same mission. The KC-10 also has a much larger cargocarrying capacity (170,000 lbs) than either the KC-135 or the KC-767. This large capacity wouldalso be a boon to the Air Force's strategic airlift capabilities, which are currently hard pressed to meetthe requirements established in the Air Force's latest requirements study. (55)

In addition to these operational advantages, lease opponents point out that buying andconverting surplus DC-10s into KC-10s offers significant financial advantages over the KC-767. Surplus DC-10s are being offered for sale for $600,000 to $10.3 million each. (56) If 50 surplus DC-10s couldbe purchased for $10 million each, and if the tanker conversion cost another $40 million (57) , the Air Force couldreplace the oldest 100 KC-135s with 50 tankers that are twice as capable for a only $2.5 billion, leaseopponents say. Just as important, the Air Force has already invested in KC-10 training, O&M, andmilitary construction. These investments would have to be borne anew for a KC-767 fleet. Between42 and 57 DC-10 aircraft were available for sale or lease between September 2002 and August2003. (58) At least twentyfive of these aircraft were equipped with the same CF6-50C2 engines as the Air Force's KC-10fleet. (59)

The Air Force could counter the arguments above with several points. First, surplus DC-10sare used aircraft. Used aircraft conditions vary widely, and not all may be in acceptable condition. How much life is left in each aircraft? Commercial airlines put many more flight hours annually ontheir aircraft than does the military. How well has the aircraft been maintained? The Air Force haspurchased and converted surplus commercial aircraft before, it says, and has run into difficulties. TheAir Force's first two E-8A JSTARS development airplanes were 20-year-old commercial Boeing707s. Conversion difficulties and questions of remaining service life convinced the Air Force thatit needed to design and implement a more robust inspection and verification program to ensure thethat surplus aircraft being considered actually have the capabilities and characteristics advertised. Relatedly, the Air Force could argue, the DC-10 is yesterday's technology. While the Air Force's 59KC-10s are very capable tankers, their future is limited. The DC-10's 1980s-era design andcomponents do not offer all the opportunities represented in a brand new aircraft. The KC-767 willoffer room for technological growth that the KC-10 can't match.

Figure 5. DC-10 Availability

KC-767 versus Re-Engining KC-135Es. Anothercontentious debate has arisen over re-engining KC-135E aircraft -- essentially turning them intoKC-135Rs. KC-767 lease critics say that re-engining the KC-135E has many merits that should beconsidered as an alternative to leasing 100 new aircraft. Upgrading the E's engines will increase theaircraft's takeoff power, cruise speed and other performance parameters. Despite their old age, theKC-135Es have only used approximately half their flying hours. Re-engining them to improve theirperformance over their remaining lifetime, perhaps 35 more years, would be a cost-effective andprudent step, many argue.

A major advantage of this approach, lease critics say, is timeliness. If the need for improvedtanker capabilities is urgent, as the Air Force argues, then upgrading the "E" fleet to R models maybe the quickest solution. (60)

The second advantage of this approach is cost. The GAO estimates that re-engining 127KC-135Es would cost $3.6 billion, a much lower figure, lease opponents say, than the Air Force's$17.2 billion estimate for leasing the KC-767, or the $24.6 billion total program cost (plus the $4.4billion likely spent at the end of the lease to purchase the aircraft.) (61) Not only is the cost of there-engining procedure low, compared to the 767 lease, but this approach also saves money byavoiding projected maintenance on the old engines that will be replaced. Much of the increased costprojections for the KC-135 from 2001 to 2040 have to do with engine maintenance. According tothe ESLS study: "E-model per A/C Engine Costs are 20 times the R-Model." (62) Thus, the out-yearmaintenance costs avoided by this re-engining will help finance the $3.6 billion initial investment,lease opponents argue.

A third advantage of re-engining is that it will eliminate one of the KC-135E's mostchallenging maintenance problems: corrosion of the engine strut. Corrosion-induced maintenanceand repair of the KC-135E engine struts have recently been estimated at $3 million per aircraft. (63) Concerns over the effectsof corrosion on this key structure have also led the Air Force to impose flight restrictions on theE-models. Eliminating these problems, in addition to the cost savings and performanceimprovements, argues strongly for re-engining, lease opponents say.

The Air Force is strongly opposed to re-engining the KC-135E fleet. According to the GAO,the Air Force has not requested funds for re-engining E-models since 1993. Congress or DOD haveadded funds to upgrade approximately 2 E Models per year to R Models at a cost of about $29million per aircraft." (64) The Air Force makes a number of arguments against re-engining. First, only 100 of the E-modelsare candidates for re-engining. (65) So, if re-engined, the final number of R-models in the inventorywould be at least 27 fewer than advocates of this approach believe. Second, re-engining will improvesome of the KC-135E's capabilities, but it does nothing to address the underlying issue of the agingaircraft fleet. According to former DOD acquisition chief Pete Aldridge, the upgrade from E-modelsto R-model "will not buy you any lifetime, and that's what we need to buy: additional life." (66)

The third argument the Air Force makes against re-engining the KC-135Es is one ofimmediate and longer-term availability. Re-engining the Es would remove them from the activeinventory for at least six months. Re-engining, the Air Force argues, would decrease the availabilityof air refueling tankers when the Air Force has the highest demand on tankers -- now, during a war.Re-engining the KC-135E fleet would leave "tired iron" in the inventory that would degrade missioncapable rates relative to a new aircraft.

Fourth, the Air Force says, while re-engining may obviate corrosion problems with the enginestrut, it will not address any of the numerous remaining problems such as the wing attachmentfittings, electrical wire replacement, and body skin replacement that will continue to plague theKC-135R fleet.

The final Air Force argument against re-engining the E-fleet is economic. KC-135Es haveapproximately 80 percent the capability of a KC-135R. If the Air Force were to re-engine andconvert the E-model to an R-model, it would gain a 20 percent increase in capability for the $38million investment. This is a poor deal, the Air Force argues. Also, according to Air Force studies,converting E-models to R-models exacerbates the recapitalization problem considerably, becauseit does not satisfy recapitalization requirements, it only postpones them. Furthermore, it postponesrecapitalization with a significant investment ($3.87B for 100 aircraft) that will take decades to payfor itself, the Air Force argues. (67)

KC-767 versus Leasing Tanker Services. Thosecritical of the proposed 767 lease also say that there are other alternatives to purchasing or leasingan aircraft. Instead, the Air Force could reduce the KC-135's workload and buy time to explore otherrecapitalization options by leasing tanker services. The U.S. Navy, for example, has signed afive-year deal with a private company to refuel Navy and Marine Corps aircraft participating inexercises or flying from Atlantic to Pacific Coasts. The Navy does not own, or even lease the aircraft.It contracts to have tanker services provided. The Navy is reportedly satisfied with the company'scost -- about half that of military aerial refueling -- and reliability. (68)

The United Kingdom is also soliciting bids from private firms to provide its military withaerial refueling services. As a private finance initiative the source of refueling services wouldprovide the Royal Air Force (RAF)with both the tanker and the support services. The RAF willown the services of the fleet -- 10 aircraft for 27 years -- but not the aircraft. The vendor wouldtechnically own the aircraft (which appear likely to be 767s) and would also make them availablefor third-party usage when not demanded by the RAF. (69)

Leasing tanker services would be more advantageous than leasing or buying KC-767's, leaseopponents argue, for several reasons. Leasing tanker services could augment the Air Force's tankingquickly, thereby satisfying the Air Force's stated urgent need. Also, leasing service would avoid anykind of cost associated with recruiting, training and paying an aircrew. The Air Force currentlysuffers from very high operations tempo (OPTEMPO), as it deals with the unanticipated strains offighting the global war on terrorism, lease opponents point out. This high OPTEMPO exacerbatesa long standing problem the Air Force has had with too few KC-135 crews. Leasing tanker servicescould immediately ameliorate this problem. The current DOD leadership has a consistent trackrecord of promoting outsourcing and privatization. Why not apply the same principles torecapitalizing the aerial refueling fleet, critics of the 767 lease ask?

Unlike the Navy, the Air Force has not yet hired private refueling services to supportexercises or training. Supporters of the proposed 767 lease may argue that such services areinherently limited in their application: companies have a difficult time getting insurance for aircraftthat fly into war zones. Also, it would be difficult, they argue to get private pilots to fly intocontested areas. During Operation Iraqi Freedom the Air Force aggressively flew tankers well intoIraqi airspace. Would private pilots balk if asked to do the same? The number or companies willingto engage in such business is limited, lease supporters argue, and it is unlikely that companiescurrently in this line of work could provide the Air Force with the number of aircraft required tomeet anticipated needs. So, while there may be some niche applications for leasing tanker services,most believe it is no replacement for fleet recapitalization. Also, most private companies can refuelNavy and Marine Corps aircraft, but not Air Force aircraft, so their application may be limited in thatdimension as well. Outsourcing and privatization do have their applications, lease supporters agree,but Air Force tanker aircraft are combat systems, not a commissary or depot. To be effective andreliable, combat systems must be operated by, and controlled directly by the military, who are trainedand disciplined to deal with combat situations.

Industrial Base Concerns

by Dan Else

(707-4996)

In addition to the operational urgency arguments outlined above, the Air Force and leasesupporters say that two industrial base concerns argue strongly for immediately implementing theKC-767 lease: leasing the 767 before its production line closes, and supporting the Boeing Companyduring a period of unusual economic hardship.

Viability of the 767 Production Line. The Air Forceargues that the KC-767 lease should be implemented immediately because a lack of business mayforce Boeing to shut down this production line in the near future. In essence, if the Air Force doesnot act now, it may not have this opportunity again. (70)

A review of publically available information on the 767's business suggests that the 767production line is not in imminent danger of being shut down. The backlog of production orders onthe 767 line as of mid-August 2003 appears to be sufficient to sustain minimum-rate productionthrough at least February 2006. (71)

Boeing's 767 production line has been able to maintain a production rate of 20 aircraft or lessper year (less than two per month), and industry analysts estimate that the minimum sustainable ratefor Boeing's commercial aircraft lies at approximately one aircraft per month. (72) At the end of 2002, thirtynine 767s had been ordered but not delivered. During 2003, 19 of these aircraft were completed anddelivered, and another 11 were put on order. This means that, as of mid-August 2003, there is a production backlog of 31 commercial 767s. At the minimum sustainable production rate of 1 aircraftper month, therefore, Boeing's production line for the 767 could possibly operate until February 2006without any additional orders being placed. (73)

Beyond February 2006, the viability of the 767 production line is less certain. Commercialmarket demand for the 767 appears weak and shows few signs of future strength. The aircraft hassteadily lost ground to its near-peer competitor, the Airbus A330, since 1998. (See Figure 6 below.) Boeing is in the late developmental stages of a new aircraft, the 7E7 Dream Liner , that will beoffered for sale in 2004 and is expected to enter service in 2008. (74)

Figure 6. Boeing 767 and Airbus A330 Production Backlog

Some analysts have predicted that Boeing's alleged lack of commitment to marketing andimproving the 767, coupled with the introduction of the 7E7, will not add many new sales to thecurrent backlog, and could kill the civil airliner version of the aircraft. (75) The production of thecivilian 767 is now projected (See Figure 7 below) to continue at the rate of 12-15 aircraft per yearonly through mid-2008. (76)

Figure 7. Projected 767 Production

Source: Teal GroupCorp.

Lease opponents are likely to point to these current and future business projections and arguethat there is no urgency to leasing the KC-767. It could be available to the Air Force until at least2006 and perhaps until 2008. Lease supporters, however, may say that these projections prove thatthe Air Force must move more quickly than its previous plan, which was to begin recapitalizationin 2012. No one expects the 767 to remain in production that long, they may argue. Furthermore,supporters may argue, there is no guarantee that the line will stay open until 2006. The profit marginrealized from building 767s at the minimum sustaining rate (one aircraft per month) is likely to bevery small. Boeing could decide that in light of dwindling business, it may be more profitable in thelong term to shut down the line sooner than 2006. (77)

The Need to Help Boeing . Some critics have portrayed the leasing arrangement as somewhatof a financial boost for a company in difficulty, (78) and other analysts have speculated on the benefits of the numberof jobs the construction and deployment of 100 new airplanes are likely to preserve and create. (79)

Boeing is the largest manufacturer in the U.S. aerospace industry, directly employing 166,000workers and generating more than $54 billion in sales during 2002 that was split almost exactly inhalf between its two major divisions, Commercial Airplanes and Integrated Defense Systems. Inaddition, it provides work for many thousands of employees in companies that supply parts,components, and services to its operations. Boeing is ranked No. 15 in the most recent Fortune 500and No. 104 in the Financial Times Global 500 lists of corporations. It is included in both theStandard & Poor's 500 index and the Dow Jones industrials index. (80) In the civil aviationindustry, Boeing has traditionally dominated world sales in large commercial jet aircraft, but isfacing strong competition from rival Airbus. In the defense sector, Boeing and Lockheed Martincompete for the number one spot in world sales.

Perhaps because of the recent softening in general worldwide demand for commercialaircraft, Boeing recently restructured its corporate organization, moving its headquarters from theSeattle, Washington, area (where its principal commercial aircraft manufacturing facilities lie) toChicago, and combined what had been its military aircraft and space and communications units intoIntegrated Defense Systems. One analyst has characterized this as a "controlled de-emphasis" of thecompany's traditional focus on commercial air transports in order to concentrate on areas such assatellite communications, space-imaging, flight services, and unmanned aerial and unmanned combataerial vehicles (UAVs and UCAVs respectively). (81)

The impact of a 100-aircraft order on Boeing's Overall Production Output. The delivery of 100 new 767 Tankers to the United States Air Force over a six-year period wouldrepresent a relatively small addition to existing and anticipated production. However, some analystsexpect the profit accruing to the company upon the sale of each 767 Tanker to exceed that of acomparable commercial jet, exerting a positive influence on corporate profits.

Boeing Commercial Airplanes delivered 379 aircraft of various models worth approximately$25 billion during 2002 (this was down from the 526 aircraft delivered during 2001). Of these 379airframes, 35 were 767s. Figure 8 illustrates Boeing new aircraft deliveries from 1998 through 2002and projects production through 2011 (82) with 767 and KC-767 production highlighted.

Figure 8. Boeing Civil Airframe Production

Sources: Aerospace Industries Association(1998-2002); Teal Group (2003-2011).

Without the KC-767, Boeing will have built 5,308 civil aircraft during these fourteen years,including 293 767s. This represents 5.5% of the airframes manufactured. If 86 KC-767s are added(the remaining 14 are scheduled for 2012 delivery), the total 767 production accounts for 7.0% ofBoeing production. Therefore, it appears that the KC-767 program is not critical to BoeingCommercial Aircraft, but is critical to one of the company's six existing civil aircraft assemblylines. (83)

A May 2003 report prepared by Morgan Stanley Research calculated and compared theexpected profit of the sale of Boeing's KC-767 with other Boeing commercial jet aircraft. (84) The report finds that thesale of each Boeing KC-767 under the conditions announced publicly by Boeing and the U.S. AirForce would generate approximately seven times the profit of a single Boeing 737, the company'smost popular commercial airplane.

A comparison such as this is more valid if the KC-767 is compared with a commercial saleof the civil 767. If the assumptions published in the report are used to calculate and compare profitson the 767, it seems that the KC-767 may generate company profits equal to approximately three tofour 767s. Table 3 illustrates how this number was generated.

Table 3. KC-767 and Civil 767 Profits

Data Source: Morgan Stanley

* Boeing has agreed to cap its operating profit margin at 15% of the converted tanker sale price.

** Boeing's advertized list price for the 767-200ER is $101.0-$112.0 million in 2002 dollars. Theactual price of a given aircraft depends on the configuration and special features selected by thecustomer. Price quotes are available on the World Wide Web at http://www.boeing.com/commercial/prices/ . Aircraft prices are negotiable, though, and airlinecustomers can often win substantial discounts.

*** Profit calculation: CRS

The KC-767 as a Jobs Program. An order for 100 767 aircraft and theirconversion to tanker configuration is likely to increase the number of workers that would otherwisebe employed by Boeing's Commercial Airplanes unit and by the company's second-tier and belowsuppliers. (85) In anOctober 2002 letter to the White House Chief of Staff, Secretary of the Air Force James Rochequotes Boeing as estimating that the program would create 11,000 new jobs at Boeing itself andanother 28,000 at its component makers, for a total of approximately 39,000 new positions. (86)

In order to gain an appreciation of what this means, it should be viewed in the context ofBoeing's recent job losses, which have been significant since 1997 (See Figure 8). That year, the yearafter Boeing acquired McDonnell Douglas, the Commercial Airplanes unit employed more than108,000 workers. This rose in 1998 to more than 117,500 as the company increased the pace of itsjet deliveries. During 1999, however, Commercial Airplanes employment fell by more than 22,000,to 94,700, mirroring a slowdown in the deliveries of both single- and multi-aisle aircraft.Employment continued to decline through 2000 and 2001 until, at the end of that year, the unitemployed 89,400, or more than 28,000 workers below the 1998 employment peak. Near the end of2001, the company announced that the post-September 11 effect on the airline industry would requirethe layoff of approximately 30,000 workers.

By the end of 2002, Commercial Airplanes unit employment stood at 66,500 workers, a lossof 22,900 during the year and an overall loss of more than 59,000 jobs from the peak year of 1998.Assuming an average of $49,700 in annual wages per production position, with approximately 2.5supplier jobs linked to each Boeing job, this five-year decrease in employment represents as muchas $10.4 billion in wages in 209,000 jobs nationwide, and $2.9 billion in wages at Boeing, that havebeen either diverted to other employment within the aviation industry, moved to positions outsidethe aerospace sector, or eliminated. (87)

If the 11,000 anticipated direct employment positions at Boeing's Commercial Airplanes unithad materialized during 2002, the limiting best case, they would have reinstated slightly less thanhalf of the positions actually lost during that year. Figure 9 presents Boeing's Commercial Airplanesemployment history in graphic form. The thick line on the right of the graph represents the additionof 11,000 hypothetical jobs during 2002.

Figure 9. Boeing Commercial Airplanes Direct Employment

However, it is not clear whether all of these jobs will be new, or whether some might betransferred from the 747 production line, which is also facing difficulties. Should the 747 productionline be shut down or its workforce cut back, this skilled labor would presumably be available for useon the 767 production line, potentially reducing the number of new or rehired workers. (88)

Total Costs for Leasing and Procuring the KC-767

by [author name scrubbed]

(707-7610)

If there is an urgent need to acquire tanker aircraft, and if tankers based on the Boeing 767are the best aircraft to acquire, then a follow-on question is how the cost of acquiring these aircraftthrough a lease compares to the cost of acquiring them through a purchase (i.e., procurement).

Estimated Total Cost and Factors That Can Change TheCalculation. The Air Force report presents estimates for the total cost of the leasingand procurement options that have been calculated on a net present value (NPV) basis (see AppendixB for a description of NPV analysis). The report states that when calculated on an NPV basis,leasing the 767s would be about $150 million, or about 1%, more expensive than purchasing (i.e.,procuring) them. Specifically, the report states that leasing would have an NPV of $17.2 billionwhile purchasing would have an NPV of $17.1 billion. These two NPV figures are rounded to thenearest tenth of a billion. When the difference between them is measured more precisely, it becomes$150 million. (89)

Although the Air Force report presents this $150-million difference as a single answer to thequestion of the comparative total costs of leasing vs. purchasing the 767s, the cost comparison, asthe report notes, can be significantly affected by decisions one makes on certain key variables orassumptions involved in the calculation. Included among these variables and assumptions are thefollowing:

Should a multi-year procurement (MYP) arrangement be used in calculatingthe cost of the procurement option?

How much would using MYP arrangement reduce the cost of the procurementoption?

What is the correct discount rate to use in performing the NPV costcomparison?

What progress payment schedule should be used in estimating the cost of theprocurement option?

How should inflation be used in calculating the cost of the progress paymentsunder the procurement option?

What interest rate should be used for the bonds floated by the Special InterestEntity (SPE)?

What interest rate should be used on the construction loans that the SPE wouldtake out under the leasing arrangement to finance the building of the 767s?

What estimate should be used for the imputed government self-insurance costincluded in the cost of the procurement option?

Each of these questions is discussed below. Several of these factors could individually shiftthe result of the NPV analysis by hundreds of millions of dollars. In combination with one another,they could shift the result by an even greater sum.

Use of MYP Arrangement For Procurement Option. In calculating the costs of the 767 leasing and procurement options, the Air Force assumed that theprocurement option, like most major DOD acquisition programs, would use annual contracting. Ifthe calculation had instead assumed the use of multi-year procurement (MYP) for the procurementoption (see Appendix C for a discussion of MYP), the NPV analysis could have favored theprocurement option by several hundred million additional dollars. (90)

The Air Force states that it used annual contracting rather than MYP for the procurementoption for the following reasons:

MYP has never before been used at the start of a DOD aircraft procurementprogram.

Using MYP at the start of a procurement program would not be consistent withthe statutory requirement that weapons and platforms being considered for MYP have a stable design(i.e., a design that has been in production for several years and been proven through actual use, andis thus unlikely to need to be altered during the period covered by the MYP due to the discovery ofdesign problems).

Congress passed a provision authorizing a lease of 767s and did not pass aprovision authorizing a multi-year procurement of 767s. If Congress had been open to consideringan MYP arrangement for the 767s, it would have passed legislation granting such authority. (91)

Those who support the idea that the Air Force should have assumed the use of MYP incalculating the cost of the procurement option might argue the following:

The leasing arrangement approved by Congress inherently involvesmaking a multi-year commitment to the 767 program . Leasing opponents may maintain thatsince the leasing option is inherently a multi-year option, it should have been compared to amulti-year procurement option to ensure an apples-to-apples comparison ofcosts.

Supporters of the lease have argued that it constitutes an innovation indefense acquisition. Using MYP at the start of a 767 tanker procurement would equallyrepresent an innovation. Opponents may argue that although DOD has leased aircraft in the past,the 767 lease is precedent-setting in several regards, including the larger number of aircraft involved,the large total cost of the lease, and the use of a relatively short-term operating lease for an asset thatthe Air Force will likely continue to require for a much longer period of time. In addition, thelegislation setting up the lease exempted the Air Force from a requirement to include the full amountof funding that the government would be liable for in case of cancellation, and established a specialcongressional process for approving the lease. Leasing opponents may assert that Congress arguablysent a signal in passing the legislation setting up the lease that, in the case of the 767s, it is preparedto consider highly novel acquisition approaches. From their perspective, using MYP for the 767swould be no more irregular, and possibly less irregular, than the leasing arrangement. The fact thatCongress approved one kind of authority (leasing) and not another (MYP) does not prove lack ofcongressional interest in approaches other than leasing. They might maintain that it is the role ofCongress, not the Air Force, to decide what options Congress would be willing toconsider.

There is precedent for Congress granting DOD a multi-year contractingauthority similar to MYP at the start of a major DOD acquisition program involving aplatform with a complex design: Congress, in acting on the FY1998 defense budget, passed aprovision granting the Navy a special block-buy contracting authority for the first four Virginia-classnuclear-powered attack submarines. This authority was similar to MYP authority in that it permittedthe Navy to sign a single contract covering 4 submarines that were to be procured over the five-yearperiod FY1998-FY2002. These 4 submarines have a combined estimated procurement cost of morethan $10 billion. In terms of design and engineering, nuclear-powered submarines are at least ascomplex, if not more complex, than tanker aircraft, and Congress passed this legislation in 1997,before construction of the first Virginia-class submarine had even started.

There is precedent for a service requesting MYP authority for a programthat has not yet produced a single completed unit and consequently has not demonstrateddesign stability through the traditional means of successfully testing one or more fully builtunits in their intended operating environment: The Navy, as part of its FY2004 budgetsubmission, requested that Congress grant full MYP authority for a group of 7 Virginia-classsubmarines to be procured during the five-year period FY2004-FY2008. The Navy requested thisauthority even though construction of the first Virginia-class boat is still not complete. (It was about85% complete at the time the Navy submitted its proposed FY2004 budget to Congress in February2003.) Instead of demonstrating the stability of the Virginia-class design in the traditional manner-- by completing construction of at least one boat and showing, through real-world operations, thatthe boat's design does not need to be changed to fix previously undiscovered design problems -- theNavy is advancing the novel argument that the relatively small number of design changes that haveoccurred during the lead ship's construction (compared to the number of design changes thatoccurred during construction of the lead ships of previous classes of U.S. submarines) is sufficientto demonstrate that the Virginia-class design is stable.

There is precedent for a service assuming the use of a precedent-settingMYP in a major defense acquisition program when making an important cost calculation thatwas forwarded to Congress: In estimating projected cost growth in the Virginia-class program --a projection that the Navy forwarded to Congress -- the Navy this year assumed the use of MYP inthe Virginia-class program for FY2004-FY2008. The Navy made this assumption even thoughCongress has not yet approved the MYP arrangement for the Virginia class, and even thoughapproving it would set a precedent because the first boat has not yet been completed, let alone tested. If the Navy had not assumed the use of MYP in its cost calculation, the projected amount of costgrowth in the program would have been substantially higher, and would have triggered theNunn-McCurdy provision (10 USC 2433), a law under which a defense program reporting more than25 percent projected unit cost growth is to be terminated unless the Secretary of Defense submits toCongress certain certifications about the program's importance and management.

There is precedent for a service requesting MYP authority for anair-vehicle program that has not demonstrated design stability through the traditional meansof completing testing and having multiple production copies completed and in the operationalinventory: The Navy, as part of its FY2004 budget submission, requested that Congress grant MYPauthority for 1,748 Tactical (Block IV) Tomahawk cruise missiles to be procured during the five-yearperiod FY2004-FY2008. The Tactical Tomahawk is a reengineered (redesigned) version of the olderTomahawk cruise missile (the Block I through Block III version) that ended procurement in FY1999. The Tactical Tomahawk was reengineered to be built at roughly half the cost of the older Tomahawkand differs in many ways from the older Tomahawk at the piece-part level. The first TacticalTomahawks meant for operational use were procured in FY2002. Construction of these missiles isto begin at the subcontractor level in 2003, and assembly of the missiles is scheduled for 2004. TheNavy requested an MYP arrangement for the Tactical Tomahawk program even though testing ofthe Tactical Tomahawk is still underway, and even though the first production missiles procured inFY2002 have not yet been completed, are being built following a two-year (FY2000-FY2001)interruption in procurement of new-built Tomahawks, and are not scheduled to enter the operationalinventory until May 2004. In addition, a DOD decision on whether the Tactical Tomahawk programis ready to proceed to full-rate production is not to be made until May or June 2004. (92)

The 767 tanker will have as much, if not more, design stability than theVirginia-class submarine or Tactical Tomahawk cruise missile. The 767 tanker design is basedon the airframe for the Boeing 767 commercial airliner. Boeing has considerable experiencebuilding this airframe: It delivered the first 767 airliner in 1982 and has delivered a total of 908through June 2003. The equipment that is to be added to the basic 767 airframe to convert the planeinto a tanker is not new technology. And the task of integrating these components into the basic 767design will be done to sell the 767 tanker design to the governments of Italy and Japan, which arein line to acquire four 767 tankers each before 767 tankers are to be delivered to the AirForce.

The start of the MYP arrangement could in any event be delayed untilsometime after the start of the procurement option. As noted in the August 26, 2003,Congressional Budget Office (CBO) report on the 767 lease proposal, Congress in any event couldwait until the third 767 production lot (i.e., the 21st plane) to grant MYP authority, and use the firsttwo production lots (totaling 20 planes) to demonstrate design stability in the program. Such anoption, CBO stated, would still capture roughly 80% of the cost-reduction benefits of using MYPfor the procurement option. (93)

Air Force officials have stated that the issue of whether to assume MYP in the procurementoption is in any event moot, because the Air Force budget is insufficient over the next few years tomeet the near-term funding requirements of a 767 procurement program without requiring unduereductions in other Air Force programs. Indeed, they could argue that using MYP would requireeven more near-term funding than an annually contracted procurement program, due to the need tofund the MYP's economic order quantity (EOQ) purchase (i.e., up-front batch order) of selected 767tanker components. (94)

Those who believe that an MYP arrangement should be used in calculating the cost of theprocurement option could argue that the issue is not necessarily moot, because it is possible tostructure a 767 tanker procurement option using MYP that features reduced near-term fundingrequirements. Specifically, they could argue, the Air Force could procure the 767s under anapproach that combined MYP, incremental funding, and possibly a delayed EOQ purchase or noEOQ purchase at all. Such an approach, they could argue, would (through MYP) reduce the totalprocurement cost of the 767s below what the Air Force estimated in its report and defer (throughincremental funding) portions of the procurement cost of the 767s into future years, so as to addressthe Air Force's requirement to minimize near-term funding requirements.

Deferring the EOQ purchase (and thereby applying it only to later planes in the 100-planeeffort, rather than to all 100 aircraft) would reduce the amount of savings achieved through the MYP(since EOQ purchases are a significant contributor to overall MYP savings), but it would also deferthe funding requirements of the EOQ to a later year and reduce the scope and cost of the EOQ whenit does occur, addressing the Air Force's need to minimize near-term funding requirements. Completely eliminating the EOQ purchase would further reduce the savings achieved by the MYP,but still permit some MYP-related savings to be achieved (through work force optimization andinvestment in improved production equipment at the final assembly plant) while eliminating theEOQ purchase as a possible source of near-term funding pressure.

Opponents of an incrementally funded MYP could argue that it would not only set aprecedent by using MYP at the start of an aircraft procurement program, but also violate the fullfunding policy governing defense procurement. In acting on the FY2003 budget request, they canargue, Congress altered the Air Force's proposed funding profile for the C-17 program and passedother legislation specifically to reinforce the principal that procurement programs using MYP areno less subject to the full funding policy than annually contracted programs. (95)

Supporters of an incrementally funded MYP with a delayed or eliminated EOQ purchasecould argue that although Congress, in acting on the FY2003 budget, reinforced the application ofthe full funding policy to MYP programs, this was intended to send a general signal on defensebudgeting procedures that need not apply to the 767 program because Congress, in passing thelegislation setting up the 767 lease, indicated that, in the case of the 767s, it was prepared to considerhighly novel and irregular acquisition approaches. An incrementally funded MYP with a delayedor eliminated EOQ purchase, they could argue, would be no more irregular, and possibly lessirregular, than the leasing arrangement. Supporters of the lease have argued that it constitutes aninnovation in defense acquisition. Supporters of an incrementally funded MYP could argue that it,too, would represent an innovation. As recent precedents for the use of incremental funding in amajor DOD acquisition program, they could cite the following examples:

Congress, in the FY2000 and FY2001 defense appropriation bills, directed theNavy to use incremental funding to procure an amphibious assault ship called LHD-8 -- a relativelyexpensive ($2.0 billion) ship that, if fully funded in a single year, could have required reductions inother Navy programs that year.

The Navy, through use of advanced procurement funding in FY2001-FY2006and so-called split funding in FY2007-FY2008, plans to procure a new aircraft carrier calledCVN-21 in FY2007 using a funding profile that amounts to a form of incremental funding, eventhough this ship is nominally subject to the full funding provision. CVN-21 is a very expensive($8.6 billion) ship that, if fully funded in a single year, could require significant reductions in otherNavy programs that year.

DOD in the 1990s in effect used a form of incremental funding to acquiremilitary sealift ships called Large, Medium-Speed, Roll-on/Roll-off ships (LMSRs) that wereprocured through the National Defense Sealift Fund (NDSF). The NDSF is a DOD revolving fundthat is not subject to the full funding provision because it is outside the procurement title of the DODappropriation act. Future ships procured through the NDSF, including Navy Lewis and Clark(TAKE-1) class auxiliary cargo ships, could be built using a similar fundingapproach.

Supporters of an incrementally funded MYP for the 767s could argue that procurement of767s, if necessary, could be moved to a DOD budget account that is outside the procurement titleof the defense appropriations act and therefore not subject to the full funding policy. Pastcongressional action, they could argue, establishes some precedent for this: As part of its action onthe FY2001 defense appropriation bill (H.R. 4576/S. 2593), Congress establisheda National Defense Airlift Fund (NDAF) -- a revolving fund outside the procurement title of theDOD appropriations act that was analogous to the NDSF -- and directed that C-17 airlift aircraft beprocured through this fund rather than in the Air Force's aircraft procurement account. (96) Although Congressdirected that C-17 procurement in the NDAF conform to the full funding policy, supporters of anincrementally funded MYP for the 767s could argue that Congress, in passing the legislation settingup the 767 lease, signaled that, in the case of the 767s, it was prepared to consider new approaches,such as incremental funding.

Amount of Savings From Using MYP In ProcurementOption. The Air Force's estimate that using MYP for the procurement optionwould reduce the cost of the procurement option by about $900 million on an NPV basis was derivedby reducing the estimated cost of the procurement option by 7.4%. The 7.4% figure was taken froma 2001 report from the RAND Corporation that examined the estimated savings of 12 previous actualor proposed uses of MYP in DOD procurement programs. (97) The 7.4% figure was anaverage obtained by excluding the highest and lowest estimated savings rates in the programsexamined (more than 14.3% for the Army Javelin anti-tank missile and 3.9%-4.7% for the Air ForceF-22 fighter, respectively). Including these two cases would produce an estimated savings rate of7.7%. The remaining 10 cases varied between 5.4% and 10%.

If applying MYP to the 767 procurement option produce savings of as little as 5.4% or asmuch as 10%, then MYP might reduce the cost of the procurement option on an NPV basis by aslittle as about $660 million (using the 5.4% figure) or as much as about $1.2 billion (using the 10%figure). Using a delayed (and thus reduced) EOQ, or no EOQ at all, would result in a smalleramount of cost reduction.

Discount Rate Used in NPV Analysis. OMB circularA-94 provides guidance to executive branch agencies on what discount rates to use in calculatingthe NPVs of leasing and purchasing options. These rates are based on the yields (i.e., interest rates)on U.S. Treasury notes and bonds of specified maturities. As set forth in the most recent (January2003) version of Circular A-94, those rates are as follows:

Table 4. Discount Rates for Lease-vs.-Purchase NPVComparisons

(Appendix C, OMB Circular A-94, revised January2003)

Section 8(c) of Circular A-94 further instructs agencies, in choosing a discount rate, to use "the Treasury borrowing rate on marketable securities of comparable maturity to the period ofanalysis." In selecting a rate to use from the table above, OMB and the Air Force considered at leastthree alternatives that might qualify as being "of comparable maturity to the period of analysis" --a six-year rate (which would cover the six-year lease period for each aircraft), a nine-year rate (whichwould cover both the three-year construction period and six-year lease period for each aircraft) anda 15-year rate (which would span the entire period from the start of construction of the first aircraftthrough the end of the lease of the 100th aircraft). OMB and the Air Force settled on using anine-year rate, which was then calculated by interpolating between the seven-year and 10-year ratesshown on the above table. (98)

Was a nine-year Treasury bond rate the correct rate to use as the discount rate in the NPVcalculation? (99) CRSanalysis indicates that a different Treasury bond rate should have been used. Specifically, CRSanalysis indicates that the NPV calculation should use the Treasury bond rate for bonds having an average maturity equal to the bonds that the U.S. government would likely use to raise the fundsneeded for the cash flows involved in the lease arrangement. In the case of the 767 lease, CRScalculates this average maturity at something between 3.5 and four years. (100) Using a four-yeardiscount rate instead of the nine-year rate in the Air Force report would favor the procurement optionby an additional $520 million. (101) Using a 3.5-year rate instead of the nine-year rate would favorthe procurement option by an additional $610 million. (102)

It is possible that the interest rates shown in Table 5, particularly the rates for the shorter-termbonds, are too low. The Congressional Budget Office is projecting 10-year government borrowingrates that are higher than those shown in Table 5 (103) Using higher interest rates than shown in Table 5, particularlyfor shorter-term bonds (such as a bonds with a 3.5- or four-year maturity) would by itself favor theleasing arrangement by some additional amount of money. If government borrowing rates shift upfrom the rates shown in Table 5, however, corporate borrowing rates would likely also shift up,offsetting some portion (possibly all) of the relative advantage gained by the leasing option ofassuming an upward shift in Treasury bond rates.

Progress Payment Schedule For Procurement Option. In estimating the cost of the procurement option, the Air Force report used a 15/30/30/25 progresspayment schedule, meaning that the Air Force under the procurement option would provide Boeingprogress payments during the construction of each aircraft (or group of aircraft) as follows: 15% ofthe cost of the aircraft three years prior to delivery, 30% two years prior to delivery, another 30%one year prior to delivery, and 25% at delivery. The Air Force states that it used the 15/30/30/25schedule in modeling the cost of the procurement option because this is the schedule that has beenused in discussions of the lease option under which Boeing would draw on the SPE's bank line ofcredit (i.e., the construction loan) to finance the construction of the planes for sale to the SPE. Usingthis same schedule for modeling the progress payments under the procurement option, Air Forceofficials argue, ensures a more apples-to-apples cost comparison.

An alternative view is that regardless of the line of credit draw-down schedule that was usedin discussing the lease option, the procurement option should be modeled using a progress paymentschedule that reflects actual progress payment schedules used in previous Air Force aircraftprocurement programs involving aircraft built over a three-year construction period. An exampleof such a schedule, based on part programs, would be 10/24.5/43.5/22. This alternative schedule hasbeen referred to by some observers as a "compressed" schedule. Others, however, might view it asa traditional or typical schedule for a procurement program involving aircraft that take three yearsto build. Compared to the 15/30/30/25 progress payment schedule, this alternative schedule wouldshift a portion of the progress payments into later years, with the result that they would be discountedmore heavily, reducing the NPV of the procurement option. The Air Force states that using thisalternative progress payment schedule for the procurement option would favor the procurementoption by an additional $200 million.

Treatment Of Inflation In Progress Payments For ProcurementOption. In estimating the cost of the procurement option, the Air Forcecalculated each progress payment to include an amount of inflation that would result as if all fourprogress payments for a given aircraft (or groups of aircraft) were made at the time of delivery, eventhough three of the progress payments would actually be made in earlier years. The Air Forces statesthat it calculated the progress payments for the procurement option this way because this was thesame basis for calculating the lease cost of the aircraft under the lease option. Using this samemethod, Air Force officials argue, ensures a more apples-to-apples cost comparison.

An alternative view is that procurement programs in the past have calculated progresspayments in one of two ways -- by including inflation through the year of delivery on all thepayments, as described above, or by including an amount of inflation on each progress paymentsufficient to cover inflation up to the point in time when each payment is made. The Air Force statesthat using the second method would favor the procurement option by an additional $500 million.

Interest Rates For Bonds Floated By SPE. Comparingthe costs of the leasing and procurement options involves making an assumption, for the leasingoption, about the interest rates of the bonds that would be floated by the Special Purpose Entity(SPE) to raise the cash needed to purchase the 767s from Boeing. The higher (or lower) theseinterest rates are, the higher (or lower) the lease payments would need to be to cover the SPE'sborrowing costs, and thus the higher (or lower) the total cost of the lease option.

Under the proposed approach for implementing the 767 lease, the SPE would float threekinds of bonds called G bonds, A bonds, and B bonds. These bonds would present different amountsof risk for the bondholders and would thus carry different interest rates.

In the Air Force report, the assumed interest rate for the G bonds was derived by taking theJanuary 2003 OMB forecast for five-year Treasury Bonds and then increasing it by 56 basis points(i.e., 56 hundredths of a percentage point). (104) The result was that the interest rates for the G bonds wereassumed to be 5.70%-5.91% during the period FY2006-FY20011 (the period during which the bondswould be floated).

The assumed interest rate for the A bonds was derived by taking the January 2003 OMBforecast for two-year Treasury bonds and then increasing them by 100 basis points (i.e., a fullpercentage point). The result was that the interest rates for the A bonds were assumed to be5.84%-6.04% during the period FY2006-FY2011.

The assumed interest rate for the B bonds was based on expected (i.e., forecasted) rates forhigh-yield corporate bonds, which resulted in a 10% interest rate for the period FY2006-FY2011.

The actual interest rates for all these bonds will not be known until the SPE actually floatsthem in the bond market. These actual rates could be higher or lower than the rates assumed in theAir Force report. If the actual rates turn out to be higher (or lower) than assumed in the Air Forcereport, then the cost of the lease will be higher (or lower) than shown in the Air Force report.

As a means of illustrating the sensitivity of the NPV cost calculation to any differencebetween the assumed and actual interest rates for the SPE bonds, it can be noted that if the actualinterest rates for all three kinds of bonds turn out to be 50 basis points higher (or lower) thanassumed in the Air Force report, then the total cost of the lease, when calculated on an NPV basis,would be about $270 million higher (or lower) than the cost shown in the Air Force report. (105) This figure of about$270 million can be used as a rough yardstick for estimating changes in the cost of the leaseresulting from a difference between assumed and actual rates that is different than 50 basispoints. (106)

Potential questions for Congress arising out of the issue of the assumed SPE interest ratesinclude the following:

What was the analytical basis for the approach that was used in the Air Forcereport to derive the estimated interest rates for the SPE bonds? Was this approach reasonable? Whatother approaches might have been used to estimate these interest rates?

Given changes in various economic factors since January 2003, includingprojected federal borrowing needs, what is the likelihood that the interest rates forecasted by OMBin January 2003 will turn out to be higher or lower than actual rates?

Historically, in situations where similar estimates had to be made about futurebond interest rates, how much of a difference did there turn out to be between projected and actualinterest rates, and was the difference more likely to be in one direction thananother?

Interest Rates for Construction Loans Taken Out BySPE. Comparing the costs of the leasing and procurement options alsoinvolves making an assumption, for the leasing option, about the interest rates of the constructionloans that the SPE would take out from banks to finance the construction of the 767s prior to Boeingselling them to the SPE. The higher (or lower) these interest rates are, the higher (or lower) wouldbe the construction-financing cost that is included in lease price for each airplane, and thus the higher(or lower) the lease payments would need to be to cover the lease cost of the airplanes.

The Air Force report assumes that the SPE will be able to borrow money for 767 constructionloans at an interest rate that would result in an average of $7.4 million in construction-financing costsfor each plane. This $7.4-million cost is added into the lease price of each 767, bringing the averagelease price to $138.4 million per plane.

The actual interest rates for the construction loans will not be known until Boeing takes outthese loans. These actual rates could be higher or lower than the rates assumed in the Air Forcereport. If the actual rates turn out to be higher (or lower) than assumed in the Air Force report, thenthe cost of the lease will be higher (or lower) than shown in the Air Force report.

As a means of illustrating the sensitivity of the NPV cost calculation to any differencebetween the assumed and actual interest rates for the construction loans, it can be noted that if theactual interest rates turn out to be 50 basis points higher (or lower) than assumed in the Air Forcereport, then the total cost of the lease, when calculated on an NPV basis, might be several tens ofmillions of dollars higher (or lower) than the cost shown in the Air Force report. (107) This potential degreeof change can be used as a rough yardstick for estimating changes in the cost of the lease resultingfrom a difference between assumed and actual rates that is different than 50 basis points.

Inclusion of Imputed Self-Insurance Cost in ProcurementOption. The total cost of the 767 lease option includes a cost for privateinsurance policies that the SPE would take out to protect bondholders against events such as theaccidental crash and loss of one or more of the 767s. In the event of such a loss, the proceeds fromthe insurance policy would be used to pay off the bondholders.

If the 767s were procured rather than leased, no such insurance policy would be taken out bythe government. Instead, the government would simply bear the risk of such a loss (i.e., employself-insurance). Bearing this risk incurs no immediate additional cost to the government. OMBCircular A-94, however, instructs agencies, when comparing the costs of leasing and purchasingoptions, to include in the cost of the procurement option an imputed (i.e., synthetic or virtual)self-insurance cost. OMB Circular A-94 instructs agencies to include such a cost because there isa risk that one or more of the 767s would be lost during their years of operation, and the government,in the case of the procurement option, would have to bear the cost of such a loss either operationally(due to the reduced capacity of the remaining 767 fleet) or financially (due to the need to spendadditional funds to procure replacement aircraft). For this reason, OMB believes, including animputed self-insurance cost ensures a more apples-to-apples comparison of costs between leasingand purchasing options.

The cost comparison in the Air Force report, as instructed by Circular A-94, includes animputed self-insurance cost for the procurement option. The Air Force report estimates this cost at$100 million on an NPV basis.

The question is whether $100 million figure is a reasonable estimate of the government'sself-insurance cost. The government's self-insurance cost would likely be lower than the cost ofprivate insurance, since the cost of private insurance includes, among other things, a profit for theinsurance company. The government's self-insurance cost would also likely be greater than zero,since there is a risk greater than zero of losing one or more of the 767s during their years ofoperation. Beyond these two bounding observations, however, calculating the cost of self-insuranceposes methodological uncertainties that could lead to results either higher or lower than $100 millionon an NPV basis. If alternative estimates put the cost of self-insurance at something higher than$100 million, this would make the cost comparison more favorable to lease option. If they put it atsomething lower than $100 million, thus would make the comparison more favorable to theprocurement option.

The table immediately below summarizes the potential effect of the above variables andassumptions on the outcome of the cost comparison.

Table 5. Summary of Variables, Assumptions, and PotentialChanges in NPV Cost Calculation

Source: Congressional Research Service.

Congressional Oversight and Budgetary Issues

by [author name scrubbed]

(707-7627)

A final set of questions addresses implications of the tanker lease for Congressional oversightof defense programs and long-term budget plans. If all four congressional committees approve the$720,000 new start notification submitted on July 11th, the Air Force will sign a contract with BoeingAircraft that will commit the Air Force to a $24.6 billion program over the next fifteen years. Approving a major weapons system program with substantial funding over a long period through anew start notification, rather than through approval of funds in DOD's annual appropriation andauthorization bills, appears to be unusual if not unprecedented. (108)

The Air Force and others argue that the lease is attractive because it allows the Air Force toacquire 100 tanker aircraft with relatively little money spent up front. (109) On the other hand, theproposed lease appears to be, in many ways, an unprecedented method of undertaking a major newdefense procurement and is at odds with longstanding laws and regulations that apply to budgetingand procurement of defense systems. The proposed tanker lease raises a number of broader policyissues, particularly, the visibility of full cost of planned defense programs in the Congressionaloversight process. The chief issues raised are the following.

Locking in substantial budgetary resources when long-term budgets areuncertain. If Congress approves the new start notification, the Air Force will make a contractualcommitment that "locks-in" an estimated $24.6 billion or more between 2003 and 2017 for theBoeing tanker lease. These funds have not been included in the Air Force budget. And while thelease approach reduces Air Force budget requirements in the short-term, it does so only by pushingcosts out into future years when potentially necessary trade-offs with other defense programs are lessvisible to policy makers but may be no less difficult.

Locking in funding when program costs are uncertain. By proposing tolease rather than purchase the aircraft, the Air Force adds considerable uncertainty to the cost of theprogram that might not be experienced in a straight purchase. In this proposed lease, the Air Forcewould make itself subject to the volatility of the bond markets. Because of the high cost oftermination liabilities, the Air Force would be unlikely to cancel the lease even if financing costsincreased substantially. The total cost of the program is also likely to be higher because, accordingto many observers, the Air Force is likely to purchase the aircraft at the end of each six-year lease.

Does the proposed lease comply with the statutory requirements and OMBrules for operating leases? Some observers have questioned whether the K767 tanker proposal isappropriately categorized as an operating lease. Budget rules provide that payments for operatingleases are to be counted or scored in agency budgets on an annual basis as payments are made. Ifthe tanker deal is categorized as a capital lease, then OMB would require that DOD budget $11.6billion up front to cover the full cost of the lease in present value terms. (110) Those rules aredesigned to ensure that the full scope of the government's obligations are visible to policymakers inorder to foster cost-effective decisions.

Use of a Special Purpose Entity decreases visibility . The Air Force plan torely on a Special Purpose Entity (SPE) or Variable Interest Entity (VIE) to float the bonds to financethe program creates additional uncertainties and reduces visibility about likely cost. Some observershave suggested that using an SPE also masks the financial commitment of the government becausethe full government liability is not scored or counted in terms of budgetaryresources.

Is the proposed lease a good deal for the government? The dollar value ofthe proposed lease is predicated on covering 90% of the "fair market value" of the aircraft in orderto minimize the amount of funding that would be considered risky - and hence command a largerpremium - by bondholders. That pricing does not reflect either the length of the lease or the wearand tear on the aircraft. Some have also questioned whether the "fair market value" of the aircraftis the best price for a tanker particularly since the Air Force negotiated both the lease and supportcontract without competition.

Deviation from full-funding of the government's contractual liability. Thestatutory language applying to the multi year tanker lease exempts the Air Force from therequirement to budget for its potential termination liability, i.e. penalty payments for cancellationof the contract. Congress has thus exempted this Air Force action from the longstandingAnti-Deficiency Act which requires that government agencies have resources on hand to cover thegovernment's contractual liabilities.

The following discussion analyzes each of these issues in turn. The previous sectioncompares costs of various program options using net present value or discounted dollars in order tocapture the effects on costs of different funding streams. The section below compares costs incurrent year dollars because that is the way program costs are generally expressed and how budgetchoices are generally made. Unless stated otherwise, all figures in this section are in current yeardollars and convert Air Force numbers from outlays to budget authority. (111)

Locking in Substantial Resources When Long-term Budgets AreUncertain. Locking in the tanker lease program over the next 15 years couldsqueeze other programs. Although the Air Force has included some future funding for a newundefined tanker in DOD's planning documents and hopes to reap savings from retiring 68 oldKC135Es, those funds are not sufficient to fund the proposed lease. There is also someCongressional opposition to the proposed retirements, which could reduce resources further ifincluded in the final version of the FY2004 DOD Authorization Act. (112) Based on a recent CBOreport, budgetary pressures on all Air Force programs could be substantial beyond 2008 at the samepoint as lease payments would grow substantially (see Table 6). (113) If total defensespending grows only modestly in later years as is predicted in the FY2004 budget resolution, AirForce choices could be still more difficult.

Implications of Air Force Decision To Opt For A Lease Over ABuy. According to Air Force figures, the total program cost of the proposedlease is $24.6 billion compared to $20.7 billion for a non-multi-year buy in current dollars. The leaseis $3.9 billion or 19% more expensive than a non-multi year buy (see Table 6 below). (114) Both options includeover $8 billion in support costs. Since support costs are comparable, the more valid comparison maybe between the lease payments and the non-multiyear buy. In that case, the lease would be more than30% more costly. (115)

Although the Air Force acknowledges that the lease is more expensive, the Air Forcecontends that resources are not available to fund a buy in the next several years because of otherprogram demands. Table 6 shows that from FY2003 through FY2009, only $5.5 billion would berequired for the lease compared to $17.0 billion for a non-multiyear buy. On the other hand, thebudgetary pressures would simply be transferred to later years. From FY2009 to FY2017, the leasewould require $19.9 billion compared to $3.7 billion for the non-multiyear buy.

Table 6. Comparison Of Lease vs. Buy Options For The Tanker Lease Program Using Air Force Assumptions

in billions of current year dollars

Sources : CRS Calculations based on Air Force Model, Business Case Analysis Model 1, July 2003.

Notes :

a Assumes lease and return of planes to Trust to be sold; for comparability, assumes purchase and then sale of aircraft. Includes cost of leasing or buyingaircraft and support costs for operating, maintaining and training on aircraft, aircraft insurance for potential damage. Program total includes aproposed rebate, estimated by the Air Force at $800 million, that it would receive at the end of the lease assuming the sale price of aircraft exceededoutstanding loans to bondholders. Negative numbers reflect sales or lease rebates. That rebate is not included in the individual lease and supportcosts.

b Includes other government support and contract costs.

Future Budget Pressures On The Air Force MayIncrease. A recent CBO report that estimates long-term costsof the current program suggests that the Air Force's investment programs are likelyto continue a sharp upward path in the years beyond 2009 reflecting the demands onthe budget of buys of the F/A-22 new fighter aircraft, the Joint Strike Fighter,increases in intelligence and command-and-control as well as a tanker lease andsubsequent buy. In later years, pressure may grow on the Air Force budget becauseof investment in a successor to the B-2 long-range bomber and a replacement of theMinuteman intercontinental missile. CBO projects that Air Force investment wouldhave to grow from $58 billion in 2009 to an average of $64 billion annually between2010 and 2020 in 2004 dollars if all planned Air Force programs are funded. (116)

Funding such increases could be difficult unless the defense budget continuesto grow substantially. The FY2004 budget resolution, however, projects thatincreases for defense will drop from $20 billion per year to less than $10 billionbeginning in FY2009. (117) If this path materializes, DOD would facesubstantial pressures to make trade offs between defense programs. Such choicescould be more difficult with the resources for the lease program off-limits.

While estimates of future defense spending could, of course, change, over thelong-term, pressures to hold defense spending down could re-surface starting aroundthe end of the decade with the retirement of the baby boom generation. If the tankerlease is approved, some observers have predicted that operating leases could be usedmore widely. That could, in turn, lock in large amounts of future budget resourcesand reduce congressional choices and oversight.

Locking in Resources When Program Costs AreUncertain. The Air Force's current $24.6 billion estimate for totalprogram costs could prove unrealistic for several reasons. Even if costs grow,however, the Air Force is unlikely to cancel the program.

Air Force Is Likely To Purchase thePlane. Although current Air Force plans do not envisionpurchase of the aircraft and the Air Force would have to request funds fromCongress, many observers believe that a purchase is likely. The Air Force wouldcontinue to need the plane, particularly if they retire 68 older KC-135s as planned,and the plane would have a useful life of another twenty years or more after the leaseis complete. And with all but 10% of the "fair market value" of the aircraft alreadypaid for, few would question that a purchase would be a good deal unless the aircraftperformed poorly. A purchase of all 100 planes would cost an additional $4.4 billionraising total program cost from $24.6 billion to $29 billion. The structure of theoperating lease makes it likely that the Air Force would choose to buy the planes,which could reduce the risk faced by the "B" tranche bondholders who are financingthe final 10% of the cost to be paid off when the planes are ultimately sold.

Changes in Interest Rates Could Change Program CostsSignificantly. According to the Air Force's analysis, the totalcost of the multiyear lease itself is about $17.1 billion in current dollars, excluding$8.3 billion for support costs. (118) Of that total, about $3.9 billion, or about19%of the lease total represents financing costs (see Table7 below). (119) Whenthe bonds are floated starting in 2006, those costs could change in response toeconomic circumstances, prospects for the defense budget, or programmaticdevelopments.

Based on information provided by the Air Force, Table 7 shows how shiftsin interest costs of plus or minus .5% and 1.5% for all three tranches would affectfinancing and total costs. If interest rates proved to be .5% higher or lower thananticipated by the Air Force, the cost of the lease would rise by $400 million incurrent year dollars. A sharper change of 1.5% from current assumptions wouldincrease or decrease the cost of a lease by $1.4 billion in current year dollars.

Table 7. How Interest Rates Change 767 TankerLease Program Costs

in billions of current year dollars a

Notes:

a All costs are in current dollars which include the effects of inflation.

a Based on comparisons to the Air Force's baseline case, a non-multiyear buy.

Sources : From sensitivity runs of Air Force Model, August 2003.

By obligating the government to cover the cost of financing the aircraft, theAir Force subjects itself to the volatility of the bond market between 2006 and 2011,which would not be the case in a purchase. The Air Force would also have a contractual commitment to the entire program as well as substantial penalties fortermination.

Compliance of Lease With Statute and RegulationsIs An Issue. Some observers have questioned whether the proposedlease complies with the statutory language in Section 8159 of the FY2002 DODAppropriations Act, P.L 107-117. That language requires that the lease be consistentwith OMB Circular A-11 which establishes the criteria that distinguish operatingleases from capital leases.

Appropriateness of Using An OperatingLease. Operating leases are generally intended to be usedwhen an asset is needed for only a limited period of time and the user does not needor intend to purchase the asset. If the business or agency needs the asset on along-term basis, however, then a purchase generally makes more economic sense.

To guard against agencies using operating leases to "buy on the installmentplan," or incrementally fund a purchase, the government has adopted a series ofguidelines for analyzing the trade-offs and for accurately reflecting the cost to thegovernment. Both CBO and OMB follow the same guidelines, which reflect the1997 Budget Enforcement Act. (120)

Much of the debate about the proposed Air Force tanker deal has focused onthe appropriateness of using an operating lease rather than a straight buy. If thetanker deal were scored or counted as a capital lease rather than operating lease,under current budget rules, the Air Force would be required to provide $11.6 billionin budgetary authority (BA) upfront to reflect those costs. (121) Thatrule is designed to ensure that government policymakers are fully aware of the fullcost when decisions are made.

The Air Force believes that the tanker deal, as currently structured, isconsistent with the budgetary guidelines. (122) The issue of whether the tanker proposal meetsthe criteria for an operating lease has been disputed within the Administration andCongress since passage of the 2002 leasing authority.

Criteria For Operating Leases. Toqualify as an operating lease, OMB Circular A-11 requires that a lease must fulfillthe following six criteria:

(1) Ownership of the asset remains with the lessor during the term of thelease and is not transferred to the government at or shortly after theend of the lease term;

(2) The lease does not contain a bargain-basement price purchase option;

(3) The lease term does not exceed 75% of the estimated economic lifeof the asset;

(4) The present value of the minimum lease payments over the life of thelease does not exceed 90 % of the fair market value of the asset at thebeginning of the lease term;

(5) The asset is a general-purpose asset rather than being for a specialpurpose of the government and is not built to the unique specificationof the government as lessee; and

(6) There is a private-sector market for the asset. (123)

These criteria are designed to ensure that federal agencies are not usingoperating leases with the ultimate intent of buying the asset once the lease is over. Similarly, the 75% cap on the length of the lease and the 90% cap on the fair marketvalue of the asset are intended to stop agencies from leasing assets which they needfor a long time and therefore would be better off buying. Finally, the last two criterialimit operating leases to items which are not peculiar to the government and have acommercial market because the government is more likely to get a reasonable pricefor assets which could also be leased or sold elsewhere.

Congressional Intent About The TankerDeal. Although the statutory language for the tanker deal inDOD's 2002 Appropriation Act does not explicitly authorize an "operating lease," thelanguage requires that the Air Force "accept delivery of the aircraft in a generalpurpose configuration," and return the aircraft to the lessor "in the sameconfiguration." The act also does not authorize purchase of the aircraft. These are allOMB criteria that distinguish an operating lease. (124)

The lease is also not to include modification of this commercial configuration"unless and until separate authority for such conversion is enacted," and budgetauthority is provided. (125) This language is designed so that a tankerlease would comply with OMB's criteria that the system be a "general purpose asset."

In its report language, the Senate Appropriations Committee signaled itsintent that the authority was to be used for an operating lease. (126) Theconference committee simply notes that the statutory language was expanded inconference. (127) In addition, in a colloquy with Senator Inouyeabout the 767 lease, Senator Murray asked Senator Inouye whether

a general purpose aircraft that will meetthe general requirements of many customers; that can operate as a passenger aircraft,a freighter, a passenger/freighter "combination" aircraft, or as an aerial refuelingtanker; and is available to either government or private customers meets thedefinition of a general purpose, commercial configured aircraft? (128)

Senator Inouye agreed with this characterization, which implies that even if the AirForce modified the Boeing 767 to make it an air refueling aircraft, a military use, theaircraft could still be considered "commercial" item as required for operating leases.In support of this characterization, Senator Roberts noted that both Italy and Japanhave purchased modified 767 aircraft as tanker aircraft. (129) Although a colloquy on the floor is an indication of Congressional intent, it does notcarry the same force as language included in a conference or committee report, whichreflects the views of the authorizing or appropriating committee.

Disputes About Whether The Tanker Deal Is An OperatingLease. Within both the Administration and Congress, somehave questioned whether the proposed lease complies with OMB's criteria for anoperating lease. Below is a summary of the chief arguments made on both sides. (130)

(1)Whether ownership will be transferred to the government shortly afterthe end of the lease.

The Air Force would say that the Special Purpose Entity,Wilmington Trust, owns the asset if and until the Air Force makes a decision aboutwhether to buy the aircraft. The lease calls for return of the aircraft after six yearsalthough the Air Force would be permitted to buy the planes at any time if it getsauthorization and appropriation of funds.

Others have pointed out that even though the Special PurposeEntity technically owns the plane, that entity only exists as a conduit for the AirForce. Under revised OMB regulations issued in July 2003 - after completion of thetanker proposal - Wilmington Trust would be considered a "governmental" ratherthan a private entity. (131) Others have noted that the contract permits thegovernment to buy the aircraft at any point during the lease and that the lease pricemakes purchase of the aircraft after the lease attractive because the Air Force willalready have paid 90% of the fair market value, and will have a continuing need forthe aircraft. The Air Force Report to Congress also notes that DOD is committed to"earmark an additional $2 billion in FY2008 and FY2009 for the purchase of aircraftcovered by the multi-year pilot program." (132)

(2) The lease does not include a bargain-price purchaseoption.

The lease permits the Air Force to purchase the aircraft for $44million per aircraft, the remaining balance of the loan to the bond holders, or 10%of the fair market value.

The Air Force estimates that the aircraft could be sold asfreighters for about $51 million per aircraft at the end of the lease, a price that isabout 15% higher than the Air Force will pay.

(3) The lease does not exceed 75% of the economic life of theasset.

The six-year lease constitutes one-quarter of the estimated 25year life of the aircraft.

(4) The present value of the lease payments does not exceed 90% of thefair market value of the aircraft.

The Air Force argues that its payments are 89.9% of the initialfair market value of the KC-767 tanker based on a per plane price of $138 million in2002 dollars.

In its report to Congress, the Air Force acknowledges that thelease payments would be 93% of the fair market value, thus breaching the threshold,if the Air Force used the $131 million (2002$) price for the aircraft, which excludes construction financing as part of the price. (133) Somewould not consider those financing costs to be part of the value of the aircraft sincethey would not be part of the government's purchase price. (134)

(5) The asset must be general purpose rather than built to governmentspecifications.

The Air Force notes that the 767 was commercially developed,and that other customers have added as much as 35% "customer specific"equipment.

Critics would argue that the tanker configuration in the leaseis unlikely to be used by many other customers, and is therefore not a commercialaircraft. The fact that the Air Force version of the aircraft is priced substantiallyhigher than the cost of a freighter version suggests substantial governmentmodifications although Air Force estimates do not include monies to 'de-convert' theaircraft.

(6) Asset must have a private sector market.

The Air Force argues that Italy and Japan have already boughttankers and suggest that there is a potential market in as many as 25 countries as wellas commercial buyers (e.g. Fed Ex, UPS).

In its current configuration, critics suggest that the commercialmarket is small and that there would not be customers for 100 aircraft, and that at theAir Force cost of about $165 million per aircraft - substantially higher than the $60million cost of a commercial 767 - there would be few takers.

Implications of Using A Special PurposeEntity. The Air Force's reliance on a special purpose entity (SPE)has raised questions about whether the total cost and financial risks to thegovernment may be obscured leaving decision makers less able to makecost-effective decisions. Budget scoring rules - as expressed in OMB Circular A-11and the 1997 Budget Enforcement Act - did not anticipate government use of SPEs,and reliance on SPEs makes it easier for agencies to argue that the full costs of aprogram should not be considered as government liabilities even when there is noreal distinction between the trust and the government. In the case of WilmingtonTrust, the government is the sole beneficiary, making it essentially an "extension ofthe government" according to CBO's definition. (135)

In the case of the tanker lease, this lack of distinction is captured by the factthat Wilmington Trust is a non-profit entity that bears no risk but instead, actsessentially as a conduit for funds between Boeing, the Air Force, and thebondholders. Through its contractual commitment to the Trust, the governmentshoulders the financing risks, including most of the risk of cancellation of the lease. The bondholders would bear a portion of the risk of termination of the lease and thefull risk that the Air Force would not buy the planes at the end of each lease.

Concerns With Precedents. The AirForce use of an SPE for this lease raises additional concerns because it maystrengthen the trend in which federal agencies use SPEs to budget off-line, and notshow or record the full cost of obligations of the government. Budget rules areambiguous about how to identify government liabilities in public/private ventures. In its February 2003 report, CBO describes several cases in which federal agencieslaunched programs without "scoring" or counting the full scope of the government'sliabilities. For example, CBO estimates that DOD has used public/private venturesto obtain about $2.3 billion in military housing while recording $255 million inobligations, almost a ten to one ratio.

In the case of the tanker lease, the ratio would be even more dramaticassuming that the lease is scored as an operating lease. OMB has not taken anofficial position on whether the lease should be scored as an operating or a capitallease.

Oversight Mechanisms For SPEs . Inreaction to the tanker lease, as well as increasing use of SPEs by governmentagencies, OMB recently revised its scoring rules in OMB Circular A-11. Issued inJuly 2003, the revised rules specify that in any public/private partnership where thegovernment benefits by leasing back the asset, the arrangement would be considereda capital lease and the net present value of all lease payments scored up front. Unlessthere is substantial private participation in the SPE, its transactions are to be scoredas governmental. (136) If these new rules had been in effect, the AirForce tanker lease would probably have been considered a capital lease.

Some might consider that scorekeeping rules might not ensure that thebudgetary and financial implications of leases were fully considered by decisionmakers. Based on current rules, CBO scores leases when legislation is beingconsidered and OMB scores leases upon enactment or when the government makesa contractual commitment. CBO has proposed that all leases be authorizedindividually. (137) In the tanker lease legislation, the Air Forcehad two ways to get approval of the proposal - with authorization and appropriationlanguage or a new start notification. The Air Force chose the latter simpler route.

Questions About Whether The Proposed Lease IsA Good Deal for the Government. Some observers have questionedwhether the lease is a good deal for the government - as a lease or as a way to acquiretankers. GAO and others have raised concerns about the lack of competition for boththe lease and the support cost package. To meet concerns within the Administration,the Institute for Defense Analysis was commissioned to assess the price.

Air Force's Lease Price Is Higher Than CommercialRates. On July 24, 2003, John Plueger, CEO of InternationalLeases Finance Corporation, a large, company that leases 600 jet aircraft to about 160airlines worldwide, testified to the House Armed Services Committee about howcommercial leases work. In light of today's oversupply of commercial aircraft, JohnPlueger suggested that a lease of 100 wide-body aircraft like the 767, particularly tothe U.S. government, "the most creditworthy buyer" would "certainly command thehighest concession levels offered by any aircraft manufacturer forcommercial/civilian airliners." (138)

Mr. Plueger suggested that commercial lease rates on new widebody aircraftlike the 767 generally range from about five-tenths to eight tenths of a percentagepoint per month times the cost of the aircraft. (139) If thatrate were applied to the Air Force's estimated fair market value of the 767 tanker -an average of about $165 million in current dollars - the cost of the Air Force leasewould range from $59 million to $95 million per aircraft per six-year lease, or about35% to 57% of its value. The Air Force is planning to pay about 90% of the aircraft'smarket value, or about 40% to 60% more than suggested by the commercialformula. (140)

In a competitive market, why would the Air Force negotiate a lease at 90%of the value of the aircraft for a lease that would use the aircraft for less thanone-quarter of its useful life? According to the Air Force, the lease price wasnegotiated in order to minimize the amount of the loan that would need to be repaidto bondholders at the end of the lease. That decision, in turn, was designed to limitthe amount of funds that would be loaned at the highest rate, estimated to be 10% (ajunk bond rate), to cover the risk that the Air Force would not buy the plane at theend of the lease.

Instead of negotiating the lease price to reflect the usage - either the length oftime or the amount of hours flown - the Air Force negotiated the price to minimizefinancing costs and to make it easier for the Air Force to find resources to buy theaircraft at the end of the lease.

Proposed Cancellation Payments. Theproposed contract for the lease includes substantial penalties for cancelling the lease,which could make it difficult for the Air Force to cancel. According to the proposedcontract, the Air Force would be liable to make a "special payment" or penaltycharges of an additional year's lease costs in case of cancellation. At the height of thelease, those payments would be about $2.7 billion (see Table 8). In addition, the AirForce would be liable for unamortized costs incurred by the contractor on aircraft thatwere planned to be built but where Boeing had not yet started construction. The AirForce has not estimated those costs. (141)

Table 8. Estimated Air Force TerminationLiabilities, 2003-2017

in billions of current year dollars

Notes:

a The Air Force would also be responsible for unamortized costs associated with theremaining aircraft out of the 100 in the lease that had not yet been built; the Air Forcehas not estimated the size of these potential costs.

Sources: Air Force Model and CRS calculations.

Is The Lease A Good Deal Compared To A MultiyearBuy? As discussed previously, some would argue that thecost of the proposed multiyear lease should be compared to a multiyear buy to set upa "level playing field." In its report to Congress, the Air Force acknowledged that onthis basis, the gap would widen between the cost of the lease and a buy in terms inboth present value and current dollars.

As discussed previously, other changes in other assumptions that would affectthe comparison of costs made in the Air Force analysis were debated within theAdministration, including:

whether to assume a progress payment rate closer to standardrates for Air Force aircraft programs rather than the rates desired byBoeing;

whether to compute inflation based on progress payments ratherthan compounded to the amount experienced at the time when the entire set ofaircraft was completed as the Air Force assumed; and

whether to decrease the government's imputed cost of insurancebelow commercial rates to reflect lower risk.

If these assumptions are changed, the gap between the cost of the lease compared toa multiyear grows from $3.9 billion to $5.7 billion in current dollars (see Table 9). Hence, by opting for a lease, the Air Force would be agreeing to pay a premium offrom 19% to 27% more in order to have the convenience of paying lower amountsin earlier years.

If the Air Force were to spend the lease dollars on aircraft rather thanexploiting the lease in order to pay less in earlier years, those additional dollars couldpurchase about 35 more tankers. (142)

Table 9. Cost of Lease vs. Multiyear Buy andAlternate Assumptions

(in billions of dollars/percent difference)

Notes: This table compares the cost of the lease payments and a subsequent purchaseof the aircraft to a multiyear purchase with lower inflation, insurance, and progresspayments. It excludes support costs, which would not be affected by the options.

Source: CRS calculations based on Air Force Model, July 1,2003.

Deviation From Full Funding. Under Section 8159 of P.L. 107-117 ,which sets up the special rules for the tankerlease, the Air Force is exempted from the requirement to budget for potentialtermination liabilities. (143) This exemption is a significant departure fromthe longstanding government policy to provide full-funding of potential governmentliabilities in order to ensure compliance with the Anti-Deficiency Act, a law datingback to 1861. (144) That law prohibits any government employeefrom authorizing government spending unless there are sufficient appropriations topay the government's contractual obligations. The Air Force considered providingthe substantial funding for termination liability too difficult, and Congress authorizedan exemption.

Section 8159 permits the Air Force to include special payments forcancellation of up to one year's additional lease payments. The proposed contract forthe tanker lease adopts that cancellation schedule (see Table 8 above). Under thiscontract clause, the Air Force would be liable for termination payments that could bemore than $2.7 billion at the high point of the lease in 2011 without having funds inits budget. In 2003, Congress provided that the Air Force could draw onappropriations for operations and maintenance or for procurement to make thosepayments. (145) This language parallels the special exemptionfrom funding termination liabilities that is provided for multi-year procurement.

Comparison To Statutory Requirements For MultiyearProcurement. Like the proposed long-term tanker lease, amultiyear procurement also represents a long-term commitment by the governmentover a period of years, and is also exempted from funding termination liability. DOD's multi-year programs, however, are required to meet a set of criteria set out instatute, to get specific authorization, and DOD must certify that budgetary resourceshave been set aside for the program. (146) These strict rules are designed to ensure thatthe loss of budgetary flexibility and the exemption from the funding terminationliability are offset by the benefits to the government.

For DOD's multiyear programs, Congress established the followingconditions:

the program results in substantialsavings;

the requirement, funding, and design arestable;

the cost estimates are realistic; and

the Secretary of Defense certifies that funds have been set asidein future years. (147)

These criteria are designed to ensure that programmatic risks are low and DODachieves significant savings that offset the loss of flexibility of a long-termcommitment.

Because multi-year procurements must also be specifically authorized, thesecriteria are considered during the normal budgetary review. In addition, DODgenerally provides funds for the annual portion of the contract as well as additionalinvestment to increase the overall efficiency of the production. DOD must certify thatresources have been included in future years.

In the case of the tanker lease, Congress provided special authorities for thetanker lease and exempted the Air Force from the requirement to budget fortermination liability with the following requirements:

the Air Force must submit a report that outlines the terms andconditions of the proposed contract and "expected savings, if any," between a leaseand a purchase as well as annual reports thereafter;

a contract cannot be signed until at least 30 calendar days haveelapsed since submission of the report;

the present value of the total payments of the lease cannotexceed 90 percent of the fair market value of the aircraft as required by OMBCircular A-11;

the Air Force must accept delivery and return aircraft in acommercial configuration; and

aircraft cannot be modified unless special authority is providedin an appropriations act or the aircraft is transferred to the Air Force, which requiresseparate authorization. (148)

Under these requirements, the benefits to the government from locking inresources and shouldering additional financial risk are less clear.

Appendix A. The Law Authorizing the Lease

Statutory authority for the Air Force to lease 100 767 tankers (and alsoBoeing 737 transport aircraft) was provided in sections included in the FY2002 DODAppropriations Act ( P.L. 107-117 ), the FY2002 Supplemental ( P.L. 107-206 ), theFY2003 DOD Appropriations Act ( P.L. 107-248 ), and the FY2003 DODAuthorization Act, ( P.L. 107-314 ). Statutory language for the relevant sections arein italics below).

Section 8159, FY2002 DOD Appropriations Act ( P.L. 107-117 )

Section 8159 of the FY2002 DoD appropriations act ( P.L. 107-117 )authorizes the Air Force to undertake a lease of up to 100 Boeing 767s in acommercial configuration, exempts the Air Force from standard requirements forlong-term leases, including providing funding for termination liability (see Section2401 and 2401 of Title 10 below) if the Air Force submits a report to Congress onthe lease and wait thirty days.

SEC. 8159. MULTI-YEARAIRCRAFT LEASE PILOT PROGRAM. (a) The Secretary of the Air Force may, fromfunds provided in this Act or any future appropriations Act, establish and makepayments on a multi-year pilot program for leasing general purpose Boeing 767aircraft and Boeing 737 aircraft in commercialconfiguration.

(b) Sections 2401 and 2401a oftitle 10, United States Code, shall not apply to any aircraft lease authorized by thissection.

(c) Under the aircraft lease PilotProgram authorized by this section:

(1) The Secretary mayinclude terms and conditionsin lease agreements that arecustomary in aircraft leases bya non-Government lessor to anon-Government lessee, butonly those that are notinconsistent with any of theterms and conditionsmandated herein.

(2) The term of any individual lease agreement into which theSecretary enters under this section shall not exceed 10 years,inclusive of any options to renew or extend the initial lease term.

(3) The Secretary may provide for special payments in a lessor if theSecretary terminates or cancels the lease prior to the expiration of its term.Such special payments shall not exceed an amount equal to the value of 1year's lease payment under the lease.

(4) Subchapter IV ofchapter 15 of title 31,United States Codeshall apply to the leasetransactions under thissection, except that thelimitation in section1553(b)(2) shall notapply.

(5) The Secretary shalllease aircraft underterms and conditionsconsistent with thissection and consistentwith the criteria for anoperating lease asdefined in OMBCircular A--11, as ineffect at the time of thelease.

(6) Lease arrangementsauthorized by this section may not commenceuntil:

(A) TheSecretarysubmits areport to thecongressionaldefensecommitteesoutlining theplans forimplementingthe PilotProgram. Thereport shalldescribe theterms andconditions ofproposedcontracts anddescribe theexpectedsavings, if any,comparingtotal costs,includingoperation,support,acquisition,and financing,of the lease,includingmodification,with theoutrightpurchase of theaircraft asmodified.

(B) A period ofnot less than30 calendardays haselapsed aftersubmitting thereport.

(7) Not later than 1 year after the date on which the first aircraft isdelivered under this Pilot Program, and yearly thereafter on theanniversary of the first delivery, the Secretary shall submit a reportto the congressional defense committees describing the status of thePilot Program. The Report will be based on at least 6 months ofexperience in operating the PilotProgram.

(8) The Air Force shallaccept delivery of theaircraft in a generalpurposeconfiguration.

(9) At the conclusionof the lease term, eachaircraft obtainedunder that lease maybe returned to thecontractor in the sameconfiguration in whichthe aircraft wasdelivered.

(10) The present valueof the total paymentsover the duration ofeach lease entered intounder this authorityshall not exceed 90percent of the fairmarket value of theaircraft obtainedunder that lease.

(d) No lease entered into under this authority shall provide

for--

(1) the modification ofthe general purposeaircraft from thecommercialconfiguration, unlessand until separateauthority for suchconversion is enactedand only to the extentbudget authority isprovided in advance inappropriations Actsfor that purpose;or

(2) the purchase of theaircraft by, or the transfer of ownership to, the Air Force.

(e) The authority granted to the Secretary of the Air Force by this section isseparate from and in addition to, and shall not be construed to impair orotherwise affect, the authority of the Secretary to procure transportation orenter into leases under a provision of law other than thissection.

(f) The authority providedunder this section may be usedto lease not more than a totalof 100 Boeing 767 aircraft and4 Boeing 737 aircraft for thepurposes specifiedherein.

U.S. Code, Title 10l Sections 2401 and 2401 (a)

Sections 2401 and 2401a of title 10 of the U.S. Code, referred to in subsection(b) of Section 8159 above, are laws that set forth the requirements and limitationsthat normally govern DoD leases of aircraft and ships. Those requirements include:

that the contract include a substantial termination liability(defined in law);

that the lease be specifically authorized inlaw;

that a specific description of the terms of the contract beprovided to the defense committees and a period of 30 days of continuous session ofCongress elapse;

that the Secretary of Defense submit an analysis of the cost ofthe lease vs. the cost of a buy that has been evaluated by the Director of the OMB andthe Secretary of the Treasury, who must submit their evaluation to Congress within45 days of when DOD submits its analysis;

that the Director of OMB and the Secretary of the Treasurydevelop guidelines for determining when to lease and when to purchase ships andaircraft.

U.S. Code, Title 31, Chapter 15, Subchapter IV

Section 8159 states that Subchapter IV of chapter 15 of Title 31 applies to thelease except for Section 1553(b)(2). Subchapter IV sets out the rules for theavailability of unobligated balances after the closing of accounts (see below). Thelimit of 1% of the appropriation in section 1553(b)(2) of title 31 that can be paid outdoes not apply to the lease, however. Section 1553(b)(1)) permits funds to be drawnfor the same purpose after the closure of an account for:

obligations and adjustments to obligations that would have been properly chargeableto that account, both as to purpose and in amount, before closing and that are nototherwise chargeable to any current appropriation account of the agency may becharged to any current appropriation account of the agency available for the samepurpose.

FY2002 Supplemental Appropriations Act, P.L 107-206

Section 308 of P.L. 107-206 , the FY2002 Supplemental Appropriations Actexempts the lease that is authorized in Section 8159 above from the Title 10, Section2533a, popularly known as the Berry amendment, which requires that DOD rely onU.S. sources unless the Secretary of Defense determines that relying on U.S. sourceswould be inconsistent with the public interest (Title 10, Section 2533a).

Sec. 308. During the current fiscal year and hereafter, section 2533a of title10, United States Code, shall not apply to any transaction entered into to acquire orsustain aircraft under the authority of section 81598 of the Department of DefenseAppropriations Act, 2002 (division A of Public Law 107-117; 115 Sta. 2284).

Report language in H. Rept. 107-732 accompanying H.R. 5010, the FY2002DOD Supplemental states:

APPLICATION OF BERRY AMENDMENT TO MULTI-YEAR AIRCRAFT

LEASE PILOT PROGRAM

Due to the special circumstances surrounding the Multi-Year Aircraft Lease PilotProgram authorized in fiscal year 2002, Congress enacted Section 308 of P.L.107-206 to clarify Berry Amendment restrictions on the use of foreign sourcedspecialty metals in commercial aircraft to be leased under this program. In this case,the Congress concurred with the views expressed by Air Force officials that theunique financial and time-sensitive requirements of the aircraft lease arrangementand the administrative complexity involved in making Berry Amendmentdeterminations on a plane-by-plane basis for over 100 aircraft built under commercialpractices instead of under military acquisition procedures would add so much costand delay the entire program would be undermined. Enactment of Section 308 wasintended to provide the opportunity to ensure that the Air Force would be able toeconomically procure air refueling tanker replacement aircraft necessary to thenational security while maintaining the overall integrity of the Berry Amendment forfuture application.

FY2003 DOD Appropriations Act, P.L. 107-248

Section 8117 of P.L. 107-248 , the FY2003 DOD Appropriations Act amendsSection 8159 to provide that:

the Air Force can make annual lease payments in advancerather than at the end of the delivery period as is the standard practice (see Title 31,Section 3324); and

permits the Air Force to draw on available operation andmaintenance and procurement appropriations to fund the lease or the specialpayments for termination, thus exempting the Air Force from the requirement tobudget for special payments for termination (see Section 8159 (c) (3). Multiyearprocurement is also granted an exemption from budgeting for termination liabilitywith language similar to that in paragraph (g) below (see Title 10, Section 2306(b)(f)).

Sec. 8117. Section 8159 of the Department of Defense Appropriations Act,2002 (division A of Public Law 107-117; 115 Stat. 2284) is revised as follows:

(1) in subsection (c) by inserting at the end of paragraph (1) the followingnew sentence: "Notwithstanding the provisions of Section 3324 of Title 31,United States Code, payment for the acquisition of leasehold interest underthis section may be made for each annual term up to one year in advance."

(2) by adding the following paragraph (g):

(g) Notwithstanding any other provision of law, any payments required fora lease entered into under this Section, or any payments made pursuant tosubsection (c) (3) above, may be made from appropriations available foroperation and maintenance or for lease or procurement of aircraft at the timethat the lease takes effect; appropriations available for operation andmaintenance or for lease or procurement of aircraft at the time that thepayment is due; or funds appropriated for those payment."

FY2003 DOD Authorization Act, P.L. 107-314

Section 133 of P.L. 107-314 , the FY2003 DOD Authorization Act amendsSection 8159 to require that in addition to submitting the report required by Section8159, the Secretary of the Air Force must get approval for the lease through

either :

authorization and appropriation of funds is provided bylaw;

or:

DOD request and receive approval from the four congressionaldefense committees for a new start reprogramming notification for funds to start thelease using standard reprogramming procedure.

SEC. 133. LEASES FOR TANKER AIRCRAFT UNDER MULTIYEARAIRCRAFT-LEASE PILOT PROGRAM.

The Secretary of the Air Force may not enter into a lease for the acquisitionof tanker aircraft for the Air Force under section 8159 of the Department ofDefense Appropriations Act, 2002 (division A of Public Law 107-117; Stat.2284; 10 U.S. C. 2401a note) until--

(1) the Secretary submits the report specified in subsection (c) (6) ofsuch section; and

(2)either--

(A) authorization and appropriation of funds necessary to enter intosuch lease are provided by law: or

(B) a new start reprogramming notification for the funds necessaryto enter into such lease has been submitted in accordance withestablished procedures.

FY2000 Defense Appropriations Act, P.L. 106-79

Section 8133 of the FY2000 defense appropriations act ( P.L. 106-79 ) issomewhat similar to section 8159 above that permitted the Air Force to lease sixaircraft "for operational support purposes, including transportation of the combatantCommanders in Chief," which are the U.S. military officers in charge of U.S. militaryforces operating in various regions of the world.

Appendix B. Net Present Value (NPV) Analysis(149)

Net present value (NPV) analysis is a method of calculating and comparingcosts that takes into account the time value of money. The time value of moneyrefers to the fact that a dollar available today (i.e., in the present) is worth more thana dollar available in the future, because inflation reduces the purchasing power ofmoney over time, and because money available today can be invested to generate andreturn and grow over time. NPV analysis essentially adjusts the value of future sumsof money to account for the investment value of money over time.

Both businesses and governments use NPV analysis. Governments can useNPV analysis for comparing spending options that involve making payments indiffering years. The Office of Management and Budget (OMB) instructs executivebranch agencies to use NPV analysis in comparing the costs of leasing andprocurement options. This guidance is provided in OMB circular A-94, which setsforth guidelines for executive branch agencies to use in conducting benefit-costanalyses and evaluating federal programs. (150) Sinceprocurement options usually involve making relatively large payments in the nearerterm while leasing options usually involve making a series of smaller payments overa longer period of time, OMB officials and financial analysts elsewhere believe thatNPV analysis, by accounting for the time value of money, provides for amethodologically more fair comparison.

Alternatives to NPV analysis include nominal (unadjusted) analysis and real(i.e., inflation-adjusted) analysis. Since procurement options usually involve makingrelatively large payments in the nearer term while leasing options usually involvemaking a series smaller payments over a longer period of time, nominal costcomparisons tend to be the least favorable to leasing options, real cost comparisonstend to be somewhat more favorable to leasing options, and NPV cost comparisonstend to be the most favorable to leasing options.

To illustrate the differences between nominal, real, and NPV costcomparisons, consider a simplified example involving hypothetical options forprocuring or leasing four airplanes. For purposes of the example, assume that thefour planes have a total of procurement cost of $500 (i.e., they cost an average $125each to procure); that under the procurement option, the planes would be purchasedusing two annual payments of $250; and that under the leasing option, the planeswould be leased for a period of five years, with annual lease payments of $108 peryear. Assume also that the anticipated rate of inflation during this five-year periodis 2% per year, and that the anticipated nominal rate of return on investments duringthis period is 5% per year (i.e., 3% per year more than the anticipated rate ofinflation). What are the comparative costs of these two options?

In a nominal (i.e., unadjusted) calculation, also called a then-year dollarcalculation, neither the effect of inflation on eroding purchasing power nor theinvestment value of money over time is taken into account, and the cost comparisonlooks like this:

As can be seen in the table, when calculated this way, the lease option is $40more expensive than the procurement option.

In a real calculation, which adjusts the values of sums of money in futureyears to account for how inflation (in this case, at 2% per year) erodes the purchasingpower of those sums, the cost comparison looks like this:

As can be seen in the table, when anticipated inflation is taken into account,the difference in cost between the two options is reduced from the $40 shown in thenominal calculation to $23.83. The entries in this table can be used to answerquestions such as: "What is the purchasing power, in today's prices, of $108 in Year5?" The answer is that, assuming a 2% annual rate of inflation, $108 in Year 5 wouldpurchase $99.62 worth of goods in today's prices.

In an NPV calculation, which adjusts the values of sums of money in futureyears to account for the investment value of money over time (in this case, a 5%annual return on investment), the cost comparison looks like this:

As can be seen in the table, when the investment value of money over timeis taken into account, the difference in cost between the two options is reduced fromthe $40 shown in the nominal calculation to $2.86. The entries in the NPV table canbe used to answer questions such as: "What sum of money, if invested today at a 5%annual rate of return, would grow to a nominal total of $108 in Year 5?" The answeris that $88.85, if invested today at a 5% rate of return, would grow to a nominal totalof $108 dollars by Year 5.

As shown in the table above, the NPV of the procurement option is $488.10while the NPV of the lease option is $490.96. What these NPVs mean is thatspending $488.10 now (i.e., in the present) is the same, from a financial point ofview, as spending $250 now and $250 next year, while spending $490.96 now is thesame, from a financial point of view, as spending $108 per year for the next fiveyears.

The annual rate of return on investment used in an NPV analysis is called thediscount rate because this is the rate at which the value of future sums of money isadjusted downward (i.e., discounted). Discount rates can be expressed in nominalterms (so as to include the annual inflation rate) or in real terms (so as to show therate of return above the anticipated inflation rate). The example discussed here useda nominal discount rate of 5%, which was equivalent to a real discount rate of 3%(i.e., 5% minus the anticipated inflation rate of 2%).

The higher the discount rate, the greater the reduction in value over time. Consequently, a key factor in NPV analysis is to choose the correct discountrate. (151)

Appendix C. Multi-year Procurement (MYP)(152)

What Is MYP And How Does It Differ From Annual Contracting?

Three Key Differences. Multi-year procurement (MYP), also called multi-year contracting, is a specialcontracting authority that Congress approves for a few major DoD procurementprograms. The statute covering multi-year contracting for acquisition of property is10 U.S.C. 2306b. (153) Key differences between annual contracting,which most DoD procurement programs use, and MYP include the number of yearsof purchases covered, authority for Economic Order Quantity (EOQ) purchases, andtermination liabilities.

Contracts Cover two to five years of PlannedPurchases. The principal difference between annualcontracting and MYP concerns the number of years of purchases that can be coveredby a single contract. Under annual contracting, DoD is permitted to sign a contractto purchase no more than a single year's purchase of a weapon or platform, and onlyafter Congress has provided the necessary funding for that year's purchase. UnderMYP, in contrast, DoD is permitted sign a contract covering two to five year's ofplanned purchases of that weapon or platform, including the initial year's purchasethat Congress has already funded and one to four additional years worth of plannedpurchases that will not be funded until Congress passes the DoD budgets for each ofthose future fiscal years.

As an example, consider a case in which DoD plans to procure a total of 40airplanes during the five-year period FY2004-FY2008 in annual quantities of 4, 10,10, 10, and 6. Under annual contracting, following enactment of an FY2004 DoDbudget that funds the procurement of the first 4 planes, DoD could sign a contract topurchase those 4 planes. A year later, following enactment of an FY2005 budget thatfunds the procurement of the next 10 planes, DoD could sign a second contract topurchase those 10 planes. And so on.

Under MYP, in contrast, following enactment of the FY2004 budget thatfunds the procurement of the first 4 planes, DoD could sign a contract covering upto5 years of planned purchases (all 40 planes), even though Congress at this point hasfunded the procurement of only the first 4 planes.

Authority For Economic Order Quantity (EOQ)Purchases. A second difference between annual contractingand MYP is that programs approved for MYP have the authority to make use ofEconomic Order Quantity (EOQ) purchasing. EOQ authority, which is written into10 USC 2306b, permits programs using MYP to make up-front batch purchases ofcertain components of all the weapons or platforms being procured under the MYPcontract, so as to get better prices on those components from the subcontractors thatprovide them. Ordering components this way can be referred to as o rdering them in e conomic q uantities, which (after some reversing of word order) leads to theacronym EOQ. EOQ purchases are a principal means by which MYP contractingreduces costs compared to annual contracting, and programs approved for MYP areexpected to take advantage of EOQ purchases so as to generate these savings.

As an illustration using the example from above, if DoD has been grantedauthority to sign a five-year MYP covering the 40 planes planned forFY2004-FY2008, DoD might bundle together the 50 sets of landing gear intendedfor those planes and order them all together in FY2004, the initial year of thecontract. The FY2004 budget for the program consequently would include fundingsufficient to procure not only the first 4 planes, but 40 sets of landing gear as well. In a detailed presentation of the FY2004 budget request for the program, the fundingfor the 40 sets of landing gear would appear as advanced procurement (AP) fundingin support of the MYP, sometimes abbreviated as AP (MYP).

Larger Termination Liability. A thirdway in which MYP differs from annual contracting is that MYP contracts can featurelarger termination liabilities (i.e., cancellation penalties) than annual contracts. Theselarger termination liabilities protect contractors from the financial consequences ofa decision by DoD to change its mind in the middle of a multi-year procurement andnot procure the minimum number of units each year established in the MYP contract. Specifically, the larger termination liability is intended to ensure that a contractor iscompensated for any investments in work force optimization and improvedproduction equipment that the contractor has made as a consequence of thegovernment's MYP commitment, but which the contractor will no longer be able tofully exploit due to DoD's change of mind. The larger termination liability detersDoD from changing its mind, giving the contractor confidence that DoD will fulfillits MYP commitment.

One Similarity: Full Funding Policy StillApplies. One way in which MYP does not differ from annualcontracting is that MYP programs, like annually contracted programs, are subject tothe full funding policy regarding defense procurement. Obtaining MYP authority fora program, in other words, does not exempt that program from the requirement tofully fund each year's worth of procurement. The up-front EOQ purchase in an MYPprogram must also be fully funded. Thus, in the example above, the FY2004 budgetmust fully fund the 4 planes being procured that year as well as the 40 sets of landinggear being purchased under EOQ authority. No portion of the procurement cost ofthe 4 planes or the 40 sets of landing gear may be funded in a fiscal year afterFY2004. The FY2005 budget must fully fund the 10 planes to be procured inFY2005 (minus the cost of their landing gears, which were paid for in FY2004), andno portion of their procurement cost may be funded in a fiscal year after FY2005. And so on. (154)

How Does Use of MYP Reduce Cost?

Using MYP generally reduces the procurement cost of the items coveredunder the MYP contract in two ways. One way, discussed above, is by reducing thecost of components that are procured up-front in large batches through the use of theEOQ authority that comes with MYP.

The second way that using MYP generally reduces the procurement cost ofthe items covered under the MYP contract is by giving the prime contractor theconfidence to make investments in work force optimization and improved productionequipment that the contractor would not be able to justify making in a situation ofannual contracting. Under annual contracting, the prime contractor faces someuncertainty about whether procurements planned for future years will actuallyhappen. MYP reduces that certainty and thus makes it less risky for the contractorto make investments in work force optimization and improved production equipmentthat can reduce unit production costs but would make economic sense for thecontractor (i.e., generate a sufficient return on investment for the contractor) only ifthe contractor produces a certain minimum number of units over a period of severalyears. Investments in work force optimization can involve providing extra trainingto workers to improve their productivity, or keeping on the payroll highly productiveworkers who might be laid off after completing their portion of the work involved inproducing a single year's worth of production. Investments in improved productionequipment can involve purchasing new machine tools that make components morequickly, more accurately, or with less waste.

How Much Does Use Of MYP Reduce Costs?

Savings from use of MYP vary from program to program, but typically, theycan reduce the combined procurement cost of the items being procured under theMYP contract by 5% to 10%. A significant share of this savings is achieved by usingthe EOQ authority that comes with MYP. If an MYP program uses a delayed (andthus smaller) EOQ than would be typical for the program (a possibility discussed inthe main body of this report), then the total savings in procurement costs achievedwould likely be smaller than the typical 5% to 10%.

Why Not Use MYP For All DoD Procurement Programs?

If using MYP can reduce the cost of a DoD procurement program, why doesCongress grant authority only sparingly, for a few DoD programs? One reason is thatCongress as a general practice prefers to avoid taking actions that commit futureCongresses to a particular course of action, which is sometimes called "tying thehands" of future Congresses. Permitting the use of MYP on a program effectivelyties the hands of future Congresses with respect to that program by committing futureCongresses to procuring a certain minimum number of units over a period of severalyears.

In addition to tying the hands of future Congresses, MYP, by effectivelylocking a program into place for several years, reduces the DoD's and Congress'options for making adjustments (particularly downward adjustments) to the DoDbudget to respond to changing military needs or budgetary circumstances. DoD andCongress usually cannot make substantial downward adjustments to MYP programsunless they are prepared to incur the sizeable termination liability costs that can bewritten into MYP contracts. As a result, any changes that DoD or Congress mightneed to make to the DoD budget to respond to changing circumstances will now fallmore heavily on the non-MYP programs in the DoD budget. The larger the numberof DoD programs that are approved for MYP, the more heavily the remainingnon-MYP programs might have to bear the burden of any downward adjustment inthe DoD budget. Shifting all DoD procurement programs, or many of them, to MYPwould eliminate or significantly reduce DoD's and Congress' flexibility in adjustingthe DoD budget in future years to respond to changing circumstances.

Thus, in considering a DoD request for MYP authority for a particularprocurement program, Congress balances the potential savings that can be achievedby using MYP on the program against the effect that approving the use of MYPwould have in tying the hands of future Congresses and reducing DoD's andCongress' flexibility in making adjustments to the DoD budget in the future torespond to changing circumstances. This weighing of potential advantages anddisadvantages traditionally has resulted in a situation where only a few major DoDprocurement programs at any one time are given MYP authority while most DoDprocurement programs use annual contracting.

How Does Congress Approve MYP?

Defense Appropriation Act. Subsection (l)(3) of 10 USC 2306b states that "The head of an agency may notinitiate a multi-year procurement contract for any system (or component thereof) ifthe value of the multi-year contract would exceed $500,000,000 unless authority forthe contract is specifically provided in an appropriations Act." The appropriation actthat usually provides MYP authority for DoD procurement programs is the annualdefense appropriation act. The authority is usually granted through a provision inTitle VIII of the act, which is the general provisions title. In recent years it has beenSection 8008. In the FY2003 defense appropriations act, for example, Section 8008provided MYP authority for the Air Force C-130 cargo plane program, the Army'sFamily of Medium Tactical Vehicles (FMTV) program, and the Navy's F/A-18E/Fstrike fighter aircraft program.

Defense Authorization Act. Subsection (i)(3) of 10 USC 2306b states that "In the case of the Department ofDefense, a multi-year contract in an amount equal to or greater than $500,000,000may not be entered into for any fiscal year under this section unless the contract isspecifically authorized by law in an Act other than an appropriations Act." The "Actother than an appropriations Act" where DoD MYP contracts are authorized isusually the defense authorization act. In the defense authorization act, MYP isauthority is usually granted on a program-by-program basis through separate sectionsin Title I of the act (the procurement title). In the FY2003 defense authorization act,for example, MYP authority was provided for the Air Force C-130 cargo planeprogram in Section 131, for the Army's FMTV program in Section 113, and for DoDprocurement of certain chemicals relating to the U.S. space program in Section 826. In addition, Section 121 of the act extended the duration of a previously authorizedMYP for the Navy's DDG-51 destroyer program.

Associated Committees. Giventhat MYP authority for a DoD procurement program is usually provided throughprovisions in both the defense appropriation and authorization bills, the granting ofMYP authority for a DoD procurement program usually reflects a favorablerecommendation on the issue by the committees with principal jurisdiction over thesetwo bills -- the House and Senate Appropriations committees and the House andSenate Armed Services committees, respectively.

What Criteria Do Programs Need To Meet To Qualify For MYP?

Subsection (a) of 10 USC 2306b sets forth 6 criteria that DoD procurementprograms need to meet to qualify for MYP:

To the extent that funds are otherwiseavailable for obligation, the head of an agency may enter into multi-year contracts forthe purchase of property whenever the head of that agency finds each of thefollowing:

(1) That the use of such a contract willresult in substantial savings of the total anticipated costs of carrying out the programthrough annual contracts.

(2) That the minimum need for theproperty to be purchased is expected to remain substantially unchanged during thecontemplated contract period in terms of production rate, procurement rate, and totalquantities.

(3) That there is a reasonableexpectation that throughout the contemplated contract period the head of the agencywill request funding for the contract at the level required to avoid contractcancellation.

(4) That there is a stable design for theproperty to be acquired and that the technical risks associated with such property arenot excessive.

(5) That the estimates of both the costof the contract and the anticipated cost avoidance through the use of a multi-yearcontract are realistic.

(6) In the case of a purchase by theDepartment of Defense, that the use of such a contract will promote the nationalsecurity of the United States.

Criterion (1) is intended to disqualify programs where the anticipated savingsfrom using MYP are relatively minor and thus not worth the consequences in termsof tying the hands of future Congresses and reducing DoD's and Congress's flexibilityfor making adjustments to future DoD budgets in response to changingcircumstances. The clause previously required a minimum anticipated savings of10%, but was changed in the early 1990s to a requirement for "substantial savings,"which in practice might be understood to mean at least 5% or so, and preferablysomething closer to a minimum of10%.

Criterion (2) is intended to disqualify programs where there might be asignificant risk of DoD changing its mind about the need for procuring the item inthe annual and total quantities set forth in the MYP contract due to changing militaryrequirements -- a decision which could incur a sizeable termination liability. Criterion (3) is similarly intended to disqualify programs where there might be asignificant risk of DoD changing its mind about the need for procuring the item inthe annual quantities set forth in the MYP contract due to a service's inability to fullyfund the program. Criterion (4) is intended to disqualify programs where there mightbe a significant risk of incurring the potentially high costs associated with issuingchange orders to alter the design of weapons and platforms that are underconstruction.