Chapter 1

COPs and Lease-backed Bonds

Many innovative financing techniques do not generate new revenue, per se, but provide a better match between income and outlay, and thus generate benefits by more effective management of a transaction's cash flow. By filling gaps between revenues and expenses, and allowing more, or larger projects to be undertaken sooner, financing decisions can influence project costs and the timing of benefit streams from capital investments.

Certificates of Participation (COPs) are one mechanism for better matching the flow of revenues and outlays. If an agency must replace 50 buses in its fleet, but only has adequate revenue streams to purchase ten in a year, issuing COPs backed by future flows of Federal and local funds could permit the full replacement acquisition to be undertaken at one time.

The benefits of completing the project on an accelerated basis would be realized in the form of:

• potentially lower unit costs from a larger order size;
• reduced risk of higher future prices due to inflation or changes in environmental or other laws;
• lower operating costs from accelerated retirement of older vehicles and maintaining a more standardized fleet;
• higher quality of service to the public and potentially increased patronage;
• better conformance with mandates for air quality, or service to persons with disabilities;
• net cost savings from interest earned on cash balances.

COPs have been used by municipalities to pay for prisons, office buildings, vehicles, and even parks. Transit agencies in Los Angeles, New York and Denver have issued locally-funded Equipment Trust Certificates, COPs, and Beneficial Interest Certificates to finance buses. These securities are very similar in type, differing mostly in the specifics of their implementation and documentation.

One of the most recent developments in transit finance is the ability to promise the use of future Federal transit formula grants as partial security for the leases underlying COPs. While it is not possible to pledge such funds formally (doing so would compromise the tax-exempt status of the debt), providers of commercial credit have viewed such promises as enhancing the creditworthiness of the overall transaction, primarily based on the transit system's record of grant receipts over the years. It is now possible for the interest expense associated with lease payments to be reimbursed by federal grants at the 80 percent matching level. The framework for implementing federally-funded COPs transactions flows from FTA's Final Rule on Capital Leases (49 CFR 639, October 15, 1991).

Thus far, all COPs transactions involving FTA grants have funded bus acquisitions and have been issued with maturities of up to 12 years. However, long term, locally-funded COPs have also been used to finance an entire segment of a light rail system.¹ Given the historical experience in applying the COPs structure to finance a wide range of public investments, it is likely that future transactions supported with grant funds will encompass a broader array of capital projects and exhibit variation in maturities.

The following table summarizes a sample of lease-backed COPs undertaken since 1990. The majority of transactions were reviewed by FTA because they involved FTA-funded equipment. Two of the transactions involved locally-funded buses and a maintenance facility, and thus required no FTA approval.

How do they work?

Thus far, COPs have been issued by state-authorized, tax-exempt entities. Such entities, often called finance corporations, issue bonds to the public, the proceeds of which are used to acquire transit assets. The public is offered three levels of security on these bonds: 1) a lease with the transit system sufficient to redeem the bonds as they mature; 2) a reserve fund sufficient to make at least one scheduled payment; and 3) a promise by the transit system to use subsequent years' grant funds to make the lease payments.² The vehicles are leased to the transit system, which makes semi-annual lease payments from a combination of local funds and Federal grant funds. By structuring the debt with a sliding scale of maturities, the Finance Corporation reduces the overall interest cost of the transaction. (That is, each year 1/12th of the bonds mature. The nearest-term bonds have very low interest rates when compared with the longer-term bonds.)

The process usually begins when the transit system has ordered vehicles, or contracted for a facility, which the Finance Corporation undertakes to complete and to pay for. The asset is then leased to the transit provider at terms sufficient to repay the bondholders. The Federal grants that were committed to the original purchase are thus no longer needed for that purchase. The transit system can therefore reprogram the funds for other projects, accelerating their completion by a year or more.

The transit system does need some additional local capital to make this structure work, as the reserve fund (which is deposited in an interest bearing account) usually comes from the local match for the original Federal grant.³ To reprogram the Federal grant funds, thetransit system must provide additional local match. Part of the original grant is used to make the first lease payments, and subsequent years' grant funds are used to make those years' lease payments. The local match in the reserve fund is drawn down over the life of the bonds, providing part of each lease payment.

If Federal grant funds are not available in time to make a lease payment, the transit system must make the payment from its own resources. Thus, it is common for COPs transactions to be based on a December/June or January/July payment schedule, which minimizes the negative impact of possible delayed appropriation of Federal funds.

Direct, Local Impact

A simple calculation can demonstrate the most direct benefits of a lease-backed COPs transaction. Suppose a transit system (or several transit systems) needs to replace 100 buses. At a cost of $300,000 each, that is a $30 million expenditure. But the locality only receives about $15 million in Federal grant funds each year. Combined with local matching funds, this amounts to a maximum of $18 million available for the purchase. Issuing $32 million in COPs to finance the vehicle purchase would reduce the immediate impact on the transit system's capital budget, and spread the cost over the useful life of the buses.

COPs Project - Example Cash Flow - the first year

Thus, after issuance of the COPS, the transit system has all the new buses it needs and it retains a significant proportion of its current and future capital funding for other projects.

Cost savings also result from a larger vehicle purchase at one time, as well as from purchasing the vehicles sooner rather than later. Assuming a mere 5 percent cost advantage from purchasing the buses all at one time, the transit system realizes a benefit of $1.5 million. In addition, if the transit system decided to purchase these buses 10 at a time, it would face a "real" inflation cost of at least $150,000 each year. Thus, the total benefits from this structure sum to over $3 million.

Other Considerations

How are benefits being counted?

The benefits arising from the application of COPs will be more intangible than those attributed to other kinds of leases. How can the value of accelerating capital projects be fully quantified?

Anticipated inflation savings, for example, appear to be subject to interpretation. It is possible that year-to-year cost fluctuations may be more influenced by the level of factory capacity being utilized, ancillary equipment required by mandates (pollution control equipment, and whether or not the vehicles have alternative fuel power plants) than by order size or general inflation. In instances where cost savings from reduced maintenance and parts inventories are indicated, have before-and-after calculations been made to quantify the differences experienced once the new equipment is placed in service?

If COPs are applied to fixed facilities, is the same form of analysis appropriate to apply? Unfortunately, in many cases the issue may not be accelerating a capital project, but whether or not the project is undertaken at all. The benefits to the public from new or improved service are difficult to quantify objectively and are reviewed on a case-by-case basis by FTA.

Working through a methodology to assess objectively the benefits of adjusting capital program outlays by employing COPs should be just one element of a much broader effort to make capital investment decisions in the transit industry on a more business-like, quantitative basis. It is not a matter of FTA approving individual projects, but for the transit industry to have reasonably sophisticated capital budgeting tools for making informed investment decisions at the local level.

How significant is a dedicated revenue source in successfully executing a COPs transaction?

All of the COPs transactions to date have involved agencies with dedicated sales tax revenues. Similarly, most, if not all, of the non-federally supported COPs transactions by transit issuers were undertaken by agencies who have access to dedicated sources of revenue. In one instance, Philadelphia's SEPTA leased commuter rail maintenance facilities at a time when it did not have access to dedicated revenues (which are now provided under Pennsylvania's recent Act 26 legislation). SEPTA's financing had back-up credit support from the City of Philadelphia.

It is likely that an agency without dedicated revenues can meet FTA's financial capacity criteria as well as pass muster with the credit agencies, if it obtains a credit back-up from its principal state and local funding sources. The COPs issue would then be rated primarily as an appropriations risk of the supporting local or state entity providing capital and operating subsidies.

Are grant-related COPS of greater value to large or small transit agencies?

Based upon the transactions closed thus far, it appears that smaller agencies may be deriving proportionately greater benefits from the ability to increase bus order sizes than the bigger agencies. The absolute level of dollars flowing to the smallest transit systems is often insufficient to support economic levels of investment and purchase order quantities. The alternatives for the smaller transit systems are to spread out purchases, undertake joint procurements with other agencies, or wait until adequate funds are "saved-up" to initiate needed projects. All of these options carry with them significant economic disadvantages.

What are the barriers to broader applications of COPs to assets other than buses?

Given the costs, benefits, and procedures already in place for applying COPs to bus purchases, what obstacles exist for the application of this concept to facilities, other equipment, and more sophisticated rolling stock such as LRVs, locomotives, heavy rail cars, and commuter rail coaches?

The precedents for application of leasing to assets other than buses are well established in both public transit and municipal finance practices in general. For facilities and rail-related assets, the lease term is likely to extend beyond 12 years. For example, Sacramento's COPs for its light rail segment had a maturity of 27.5 years, with two-thirds of the certificates maturing in the last year. This compares to the structure of the FTA-supported COPs transactions closed thus far, with maturities of 12 years and level annual principal payments.

The primary consideration in applying FTA-related COPs to longer term assets is the value added by the formula grant funds. If the financial markets perceive the reliability of formula grants to be limited, and FTA's financial capacity criteria are taken seriously, then higher interest expenses and lower credit ratings may result, diminishing the amount of up-front capital which can be derived by leveraging future formula funding.

Therefore, seeking to finance assets with lives beyond 12 years becomes less of a grant-related consideration and more of a local finance question: is the agency better off issuing lease-type debt on a subordinated basis, or using its senior debt ⁴ capacity to achieve the most favorable interest rates? The answer will vary depending on the agency's available debt capacity, its credit rating, the nature of its capital investment needs in relation to its anticipated revenues, and market conditions at any point in time. For an agency without a dedicated revenue source, the same questions must be answered by the state, county, city or regional governmental unit that is appropriating the underlying funding.

At the other end of the spectrum, for short-lived assets, it is possible that the format of the "lease vs. buy" cost effectiveness calculation tends to favor purchases. The period over which interest can be earned on invested balances is reduced, short-term interest rates tend to be lower, and the net present value calculations may not prove to be as attractive. Given the increasingly high technology content of transit equipment, it is important that this potential area of analytical bias be evaluated. Financial structures which encourage rapid deployment of new technologies and system up-grades will become increasingly essential to controlling the costs of transit services, as well as offering improved services to the community. The differences in cost on a net present value basis must be balanced against the high risk of rapid obsolescence associated with new technologies (either as a result of system upgrades, or the exit of a vendor from the marketplace leaving "orphan" equipment behind). Properly factoring the risks of asset ownership into the financing equation may encourage broader use of FTA-supported leases for shorter-lived assets.

Footnotes

1. In 1985, the City of Sacramento issued $29.4 million of COPs to fund the additional costs required to complete the Sacramento Regional Transit District's light rail system. The original project budget was $131.2 million, of which 75 percent was federally-funded. When the cost to complete the system rose to $157 million, the City's share of the total project budget increased from 5.1 percent to 19 percent. The COPs were issued to cover the over-runs.

2. The promise to use future years' grant funds carries weight with finance rating agencies largely because of the longevity of the Federal transit assistance program. Many transit systems have received Federal capital grant funding for 20 years or more. While this is no indicator of continued grant receipts, it implies that many economic and governmental processes would have to be in disarray to disrupt the appropriation process.

3. Only local funds may be used, because of the restriction on depositing Federal funds in an interest-bearing account. The Treasury considers this arbitrage, and would require revenues thus generated to be turned over to the U.S. Government

4. Senior debt is the first to be repaid in a bankruptcy situation, and is usually rated more highly by financial rating services. However, these services also establish stringent security and earning requirements on the transit agency, to protect the integrity of the debt.