[Senate Hearing 108-572]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-572
 
 THE PROPOSED LEASE OF 100 KC-767 AERIAL REFUELING TANKER AIRCRAFT BY 
                           THE U.S. AIR FORCE

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON ARMED SERVICES
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                           SEPTEMBER 4, 2003

                               __________

         Printed for the use of the Committee on Armed Services



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                      COMMITTEE ON ARMED SERVICES

                    JOHN WARNER, Virginia, Chairman

JOHN McCAIN, Arizona                 CARL LEVIN, Michigan
JAMES M. INHOFE, Oklahoma            EDWARD M. KENNEDY, Massachusetts
PAT ROBERTS, Kansas                  ROBERT C. BYRD, West Virginia
WAYNE ALLARD, Colorado               JOSEPH I. LIEBERMAN, Connecticut
JEFF SESSIONS, Alabama               JACK REED, Rhode Island
SUSAN M. COLLINS, Maine              DANIEL K. AKAKA, Hawaii
JOHN ENSIGN, Nevada                  BILL NELSON, Florida
JAMES M. TALENT, Missouri            E. BENJAMIN NELSON, Nebraska
SAXBY CHAMBLISS, Georgia             MARK DAYTON, Minnesota
LINDSEY O. GRAHAM, South Carolina    EVAN BAYH, Indiana
ELIZABETH DOLE, North Carolina       HILLARY RODHAM CLINTON, New York
JOHN CORNYN, Texas                   MARK PRYOR, Arkansas

                    Judith A. Ansley, Staff Director

             Richard D. DeBobes, Democratic Staff Director

                                  (ii)

  




                            C O N T E N T S

                               __________


                    CHRONOLOGICAL LIST OF WITNESSES

 The Proposed Lease of 100 KC-767 Aerial Refueling Tanker Aircraft by 
                           the U.S. Air Force

                           september 4, 2003

                                                                   Page

Roche, Hon. James G., Secretary of the Air Force.................    34
Wynne, Hon. Michael W., Acting Under Secretary of Defense for 
  Acquisition, Technology, and Logistics.........................    47
Kaplan, Joel D., Deputy Director, Office of Management and Budget    50
Curtin, Neal P., Director for Defense Capabilities and 
  Management, U.S. General Accounting Office.....................   132
Sunshine, Robert A., Assistant Director for Budget Analysis, 
  Congressional Budget Office....................................   145
Nelson, J. Richard, Ph.D., Assistant Director, Cost Analysis and 
  Research Division, Institute for Defense Analyses..............   162

                                 (iii)


 THE PROPOSED LEASE OF 100 KC-767 AERIAL REFUELING TANKER AIRCRAFT BY 
                           THE U.S. AIR FORCE

                              ----------                              


                      THURSDAY, SEPTEMBER 4, 2003

                                       U.S. Senate,
                               Committee on Armed Services,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 9:35 a.m. in room 
SH-216, Hart Senate Office Building, Senator John Warner 
(chairman) presiding.
    Committee members present: Senators Warner, McCain, Inhofe, 
Roberts, Allard, Sessions, Collins, Chambliss, Levin, Reed, 
Akaka, Bill Nelson, and Clinton.
    Also present: Senator Patty Murray.
    Committee staff members present: Judith A. Ansley, staff 
director; and Kenneth Barbee, security clerk.
    Majority staff members present: William C. Greenwalt, 
professional staff member; Carolyn M. Hanna, professional staff 
member; Ambrose R. Hock, professional staff member; Gregory T. 
Kiley, professional staff member; Patricia L. Lewis, 
professional staff member; Thomas L. MacKenzie, professional 
staff member; and Scott W. Stucky, general counsel.
    Minority staff members present: Richard D. DeBobes, 
Democratic staff director; Creighton Greene, professional staff 
member; and Peter K. Levine, minority counsel.
    Staff assistants present: Andrew W. Florell, Michael N. 
Berger, and Sara R. Mareno.
    Committee members' assistants present: Christopher J. Paul, 
assistant to Senator McCain; John A. Bonsell, assistant to 
Senator Inhofe; Jayson Roehl, assistant to Senator Allard; Arch 
Galloway II, assistant to Senator Sessions; James P. Dohoney, 
Jr., assistant to Senator Collins; Lindsey R. Neas, assistant 
to Senator Talent; Clyde A. Taylor IV, assistant to Senator 
Chambliss; Christine O. Hill, assistant to Senator Dole; 
Russell J. Thomasson, assistant to Senator Cornyn; Mieke Y. 
Eoyang, assistant to Senator Kennedy; Elizabeth King, assistant 
to Senator Reed; Davelyn Noelani Kalipi, assistant to Senator 
Akaka; William K. Sutey, assistant to Senator Bill Nelson; and 
Andrew Shapiro, assistant to Senator Clinton.

       OPENING STATEMENT OF SENATOR JOHN WARNER, CHAIRMAN

    Chairman Warner. Good morning, everyone. The committee 
meets to receive testimony on the proposed lease of the 100 KC-
767 tanker aircraft by the United States Air Force. Pursuant to 
Section 133 of the National Defense Authorization Act of 2003, 
to establish guidelines for congressional review of this lease, 
the administration has submitted to the congressional defense 
committees a new start notification for this lease of 100 
aircraft. Only if all four committees act favorably on the 
notification can the Air Force and Department of Defense (DOD) 
proceed with the lease.
    When my distinguished colleague Senator Levin was chairman, 
he indicated that a hearing was appropriate. Now that I am in 
the chair, I concur in his judgment, and therefore this hearing 
is jointly called by the ranking member and myself.
    We were also urged by other members of this committee to 
have this hearing to help inform the committee's consideration 
of this lease proposal. We are pleased to welcome today's 
witnesses on the first panel: Secretary of the Air Force Jim 
Roche; Acting Under Secretary of Defense for Acquisition, 
Technology, and Logistics Mike Wynne; and Deputy Director of 
the Office of Management and Budget Joel Kaplan. I look forward 
to your testimony and the testimony of our second panel of 
distinguished witnesses, which I will announce later.
    This proposed tanker lease is a departure from the 
traditional acquisition process and has been the source of, I 
think, very important debate within the Senate and within the 
administration over a period of some 2 years. One point in the 
debate is eminently clear. It is vital to the national security 
of the United States that we have a robust aerial refueling 
capability. Tanker aircraft enable our forces to project 
military power around the world and are critical to our success 
in Operations Enduring Freedom and Iraqi Freedom. Far into the 
future the United States will require a fleet of aerial tankers 
to protect U.S. national security interests by extending the 
range of our fighters, bombers, lift, and surveillance 
aircraft.
    The chiefs of all of the Services have personally 
communicated with me, I think in a most appropriate way, their 
concern for the need that this issue be addressed and somehow 
these tankers be acquired by this country.
    So the issue today is not whether to replace the tanker 
fleet, but when and how and through what mechanism. The Air 
Force proposal, really the Department of Defense proposal 
because it has the concurrence of the Department as a whole, so 
the DOD proposal that we have before us today to lease 100 new 
tanker aircraft, is only the first step. The Air Force must 
come up with an integrated plan for the overall 
recapitalization of the 600-plus aircraft in the tanker fleet.
    Well over $100 billion will be spent to modernize and 
maintain this fleet over the next 2 decades. Decisions made in 
the course of the deliberations on this issue will either cost 
or save the American taxpayers billions of dollars. We have an 
obligation to the taxpayers to very carefully assess this 
issue.
    While there is disagreement about the costs of leasing 
these 100 tankers versus the cost of buying them, there is 
agreement that this lease will indeed cost more than an 
outright capital purchase of the fleet. But for this added 
cost, the Air Force will receive these aircraft into the fleet 
earlier. That is the pivotal decision, as to whether or not the 
added costs justify the military requirement of receiving this 
fleet at an earlier date. Is there such an urgent and 
compelling case to be made for these aircraft that would 
justify incurring an additional expense on the American 
taxpayer? That is a pivotal question.
    How does this lease comply with the terms of Section 8159 
of the Department of Defense Appropriations Act of 2002, which 
requires the lease be an operating lease that meets the 
criteria described in the Office of Management and Budget (OMB) 
Circular A-11? How much is the premium that would be paid to 
lease the tankers versus an outright purchase? What impact 
would this added cost have on the Department of the Air Force's 
future overall acquisition requirements?
    Why were other alternatives rejected, alternatives such as 
the re-engining of older KC-135s or multi-year funding 
authority for a future buy of KC-767s, which some believe could 
have saved a considerable amount of taxpayer funds? How does 
that lease proposal address the maintenance and training 
issues, and is that the most cost-effective proposal?
    I am confident this hearing will provide the committee 
valuable information in answering these and other questions. I 
note also that yesterday the distinguished chairman of the 
Committee on Commerce, Science, and Transportation conducted a 
hearing. We are in the process of reviewing the record of that 
important hearing yesterday. Now, once this committee has had 
time to review all of the information we deem appropriate, it 
is my intention to hold an executive session where our members 
can freely discuss this issue and share our views. I am not 
scheduling that session at this time. It depends on the volume 
and the amount we have to look at.
    As a part of that discussion, we will then schedule the 
time at which this committee will vote. So we are not going to 
rush to judgment on it.
    I would like to also just make another observation. My 
colleague on the right, Senator Levin, and I have been 
privileged to be on this committee for a quarter of a century. 
Other members have had very long terms. You look at this 
situation, and I went back and reviewed last evening the 
actions by the Appropriations Committee in which there is a 
legislative provision and indeed the actions taken by this 
committee in a conference report last year, to come to the 
conclusion that slightly more than 50 percent of the Senate, as 
reflected by the 29 or so members of the Appropriations and 25 
on this committee, are making a decision without the benefit of 
the balance of the Senate, without the benefit of other 
Senators who are not on these committees participating in an 
open floor debate on the issue.
    Now, historically we have done things in the Appropriations 
Committee by way of legislation. That has always been the case 
in the past and probably will be long after I am dead and gone. 
But with the magnitude of this contract, the importance and its 
relevance to our national security, I would be less than candid 
if I did not tell you as I work through this process with an 
open mind in no way have I indicated how I would eventually 
vote. I will not even entertain that thought in my mind until I 
have shared the views of all the colleagues on this committee 
and such others that can contribute. I have this in my mind and 
it will be a factor.
    [The information referred to follows:]
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    Chairman Warner. Senator Levin.

                STATEMENT OF SENATOR CARL LEVIN

    Senator Levin. Mr. Chairman, first let me thank you for 
your typically thoughtful opening statement laying out many of 
the issues facing us and doing it in a way which puts it in a 
context which is very important for us and for the entire 
Senate. In addition to your last comment pointing out the 
responsibility that falls on our shoulders as of the moment 
without the full Senate considering the pros and cons of this 
lease, there are also some very significant implications in 
terms of budget principles and budget precedents here.
    The Budget Committee, as far as I know, has not looked at 
those. Those implications are in terms of what these long-term 
leases or a long-term lease of this nature would mean in terms 
of circumventing certain budget controls, such as limits on 
deficits and caps on deficit spending.
    But I, too, approach this with an open mind. At this 
moment, I do not know how I would vote on this. I have 
determined to not reach a conclusion until after this hearing 
and after consideration of any other hearings of any other 
committees and carefully consider the materials presented to 
us.
    There are, however, very significant issues which we must 
address. We are going to address those in a thorough way and in 
a thoughtful way and hopefully, even though the whole Senate 
may not end up participating in this decision, the entire 
Senate will feel as though it was given the kind of thorough, 
objective, and balanced consideration that it deserves.
    This issue involves really two sets of issues. One are the 
military capabilities that are involved, and the importance of 
those capabilities. But there are also on the other side some 
very significant budgeting and financing principles which are 
at issue. They may or may not be in conflict, but in any event 
they are all worthy of our most thorough consideration. I again 
thank you, Mr. Chairman, for laying out the parameters of that 
consideration.
    Chairman Warner. In my judgment, the importance of this 
issue merits that those Senators who desire to make some 
preliminary opening comments should be given that opportunity. 
I would hope that we could keep them fairly brief and see to 
our witnesses.
    Senator McCain.
    Senator McCain. Thank you, Mr. Chairman. I note that the 
second panel is composed of Neal Curtin of the General 
Accounting Office (GAO) and Robert Sunshine of the 
Congressional Budget Office (CBO) and Dr. Richard Nelson of the 
Institute for Defense Analyses (IDA). These organizations 
testified before the Commerce Committee, all in opposition to 
this deal, both on grounds of cost as well as violation of the 
fundamental rules of the way that the government does business.
    I hope we will pay close attention to CBO, CRS, and GAO, 
three respected institutions that give us the kind of technical 
expertise that is necessary to make these kinds of decisions.
    Mr. Chairman, I made a long statement yesterday. I have a 
lot of questions for our witnesses. More and more information 
comes to light as we examine this issue, including a June 20, 
2003, memorandum from the Director of Program Analysis and 
Evaluation (PA&E): ``Our analysis indicates that the provisions 
of the aircraft lease cost more than the equivalent purchase of 
tanker aircraft measured in this-year dollars.'' All three 
witnesses testified that it is about a $5 billion difference in 
cost to the taxpayers.
    PA&E memorandum: ``We find that leasing provides no 
inherent economic efficiencies relative to direct purchase of 
tankers and is therefore more expensive in the long run.'' That 
is something we all agree on, as you said, Mr. Chairman. It is 
more expensive. ``Our analysis shows that the current draft 
lease fails to meet the requirements of OMB Circular A-11.'' 
That is what the CBO, CRS, and GAO also testified to. This is 
shell games. This is an Enron entity run by the Air Force, 
owned by the Air Force, and yet a way of funneling money in a 
rather bizarre fashion, and one that is without precedent.
    Here is an interesting memo. I will go into them later on, 
but it says ``Ask us to put pressure on Mike Wynne to convince 
PA&E to write a new letter essentially undoing the first 
letter. Said he was not going to give answer, would get in 
trouble no matter how he answered. Roche said he was going to 
talk to Wolfowitz tomorrow.''
    The relationship between Boeing here and the Air Force is 
really remarkable. Mr. Chairman, there is no distance between 
the two of them. This is exactly what President Eisenhower 
warned us about. They are all on a first-name basis. They refer 
to my staffer as ``Chrissy-Poo.'' It is really a remarkable 
kind of incestuousness that--I guess with the consolidation of 
the defense industries, now we are really down to two. I guess 
with this rotation of people back and forth from the defense 
industry into the Pentagon and back, it probably breeds a lot 
of this. They are all buddies.
    There is now a criminal investigation opened by the Office 
of the Inspector General because of alleged leaking or giving--
not leaking--giving the information that is proprietary by 
Airbus to Boeing. That is another allegation that is surfacing 
this morning.
    This is really an unsavory deal, Mr. Chairman. Let me try 
to lift the level up a bit and point out, in The Washington 
Post this morning the editorial says: ``Underlying all the 
controversy over the precise numbers is a far more troubling 
question: whether the leasing arrangement represents just one 
more way for this administration to push the costs of 
government onto future administrations and future generations 
of taxpayers, an end run around normal procurement procedures.
    ``Leasing would effectively lock the government into buying 
the tankers without having enough money set aside to pay for 
them. That is reflecting a broader problem. The Defense 
Department wants to build and buy far more equipment, far more 
fighter systems, submarines, more combat systems, than it has 
funding to pay for. If the Air Force needs to begin to replace 
its tankers, it should do that and Congress should provide the 
necessary funds. If that requires tradeoffs with other 
programs, that decision should be made and made honestly, not 
put off for future administrations to deal with. The CBO said 
the tanker lease does not eliminate difficult budgetary 
decisions but `merely postpones them.' This may be what a 
family needs to do when it is short on funds. It is no way to 
run a government.''
    [The information referred to follows:]

                          The Washington Post

                SEPTEMBER 04, 2003, THURSDAY, EDITORIAL

    LEASE OR BUY? As with a family that's strapped for cash but needs a 
new car, that's the choice facing the Air Force, which says it must 
replace its aging fleet of Vietnam-era tanker aircraft as soon as 
possible but doesn't have the funds to buy the planes outright. 
Instead, under a novel financing deal that has been in the works for 2 
years and is on the verge of winning final congressional approval, the 
military wants to lease 100 767s from Boeing to be outfitted as 
tankers, which are used for midair refueling to extend the range of 
warplanes. This deal--worth between $20 billion and $30 billion, 
depending on how it's measured, including the cost of buying the planes 
at the end of the 6-year lease--would have the advantage for the hard-
pressed manufacturer of helping to keep its 767 production line open. 
The advantages for the country are more open to debate, but it's been 
promoted energetically by influential lawmakers including House Speaker 
J. Dennis Hastert (R-Ill.), whose congressional district is near 
Boeing's new Chicago headquarters. Three of four congressional 
committees have given the required approval, and the fourth, the Senate 
Armed Services Committee, will hold a hearing on the lease arrangement 
today.
    There are two interrelated questions about this arrangement. One is 
whether new tankers are urgently needed. Tankers are increasingly 
important in an era of far-flung military operations. As recently as 2 
years ago, the Air Force said its fleet would last until 2040 and that 
a new purchasing program could therefore be put off until 2013. Now the 
Air Force says that with tankers being used at a level not anticipated 
before the September 11 attacks, maintenance problems are increasing 
and replacements are needed soon.
    Assuming that replacement is warranted and that the Boeing 767s are 
the right aircraft, there is the question of cost. Everyone agrees that 
leasing will cost more than a traditional purchase. The Air Force 
calculates that, given the lower cost of paying money later rather than 
writing the check now, the differential will be as little as $150 
million. Other analysts peg the cost far higher. The Congressional 
Budget Office concluded that, even taking into account the financial 
benefit to the government of not having to pay the full cost up front, 
the leasing arrangement would cost $1.3 billion to $2 billion more than 
purchasing over time. Others who have questioned various aspects of the 
leasing arrangement include the General Accounting Office, the 
Congressional Research Service and the Defense Department's own 
inspector general.
    Underlying all the controversy over the precise numbers is a far 
more troubling question: whether the leasing arrangement represents 
just one more way for this administration to push the costs of 
government onto future administrations and future generations of 
taxpayers, as Senator John McCain (R-Ariz.) suggested at a hearing 
yesterday. An end run around normal procurement procedures, leasing 
would effectively lock the government into buying the tankers without 
having enough money set aside to pay for them. That's reflective of a 
broader problem: The Defense Department wants to build and buy far more 
equipment--more fighter jets, more submarines, more combat systems--
than it has funding to pay for. If the Air Force needs to begin to 
replace its tankers, it should do that, and Congress should provide the 
necessary funds. If that requires trade-offs with other programs, that 
decision should be made, and honestly--not put off for future 
administrations to deal with. The CBO said that the tanker lease does 
not eliminate difficult budgetary decisions but ``merely postpones 
them.'' This may be what a family needs to do when it's short on funds. 
It's no way to run a government.

    No analysis of alternatives (AOA) was conducted. Perhaps 
one of the reasons for this--and I was talking about the 
relationship that exists before--is a memorandum briefing 
Boeing, Mr. Gower: ``Objective: Establish clearly-defined 
requirements in order for the U.S. Air Force tanker 
configuration that results in an affordable solution, meets the 
USAF mission needs, and will prevent''--``and will prevent an 
AOA''--an analysis of alternatives--``being conducted.'' That 
was Boeing's objective. That was the Secretary of the Air 
Force's objective, and that is what they achieved.
    There was no AOA conducted, which is normal in any 
acquisition process. There was no study of the Air Force 
corrosion problem, a dramatic turnaround from 2 years before, 
where the Air Force said that their tankers were good for the 
next 20 years. No analysis of that.
    Mr. Chairman, the fix was in and it is really a remarkable 
and unfortunate kind of situation that we are here today asking 
the taxpayers to pay $5 billion in additional funds with a 
shell game, Enron-like entity funneling the money through and, 
by the way, a $5 billion maintenance contract that itself was 
not competed.
    Mr. Chairman, we are talking about real money here, and 
since we obviously have dramatically increased expenses 
anticipated, according to reports this morning $65 to $70 
billion for our operations in Iraq, I think we ought to really 
look carefully at this. Again, if the Air Force makes the case 
that they need to replace this tanker fleet, then why do we not 
do it in a procurement fashion with an authorization, not by 
the Appropriations Committee without a hearing, but through the 
proper process, which is that the military comes forward, the 
Department of Defense comes forward, with a request, with a 
proposal, we have hearings for it, and we authorize the 
procurement of those aircraft.
    Instead, as The Washington Post points out, an end run was 
completed. To show the enormous influence of the special 
interest, three of the four committees approved this deal 
without ever having the lease being completed. I understand, 
according to reports, that last night Boeing and the Department 
of Defense finally completed a deal. But three of the four 
oversight committees approved the deal without the deal being 
completed and without us ever seeing it. By the way, I have 
questions about what I have heard about that deal.
    So, Mr. Chairman, I hope that what we really need to do 
here, as I think you may have indicated in your opening 
remarks, is take a little time. Have this committee exercise 
its oversight responsibilities, as you are seeing today. Look 
at all the evidence, see why the major watchdog agencies, the 
people we ask, the CBO, CRS, and GAO, all say that this is a 
bad deal for the American taxpayers, and then make a measured 
decision.
    I appreciate your and Senator Levin's interest and 
involvement in this issue. Thank you, Mr. Chairman.
    Chairman Warner. Senator, you noted the second panel, the 
participants. That was intentionally done to give a balanced 
perspective to this hearing.
    I also suggest--are you going to incorporate those 
documents in the record?
    Senator McCain. Yes, I will.
    Chairman Warner. Without objection.
    [The information referred to follows:]
      
    
    
      
    
    
      
    
    
      
    Chairman Warner. Further, you used the term ``criminal'' in 
connection with the Inspector General of the Department of 
Defense. I met with him extensively yesterday on another 
matter, but we did have some discussion, preliminary 
discussion, on what you alluded to. But in my listening to him, 
he did not invoke the word ``criminal.'' So I am going to ask 
this morning the staff call him and to ask him to prepare a 
very short letter describing precisely what it is he intends to 
do with material that has been given him, so that we have that 
matter clarified before this hearing is completed, and that 
will be done.
    Senator McCain. Thank you, Mr. Chairman. I point out, I was 
referring to media reports that an investigation had been 
called for. From the information that I have received, maybe an 
investigation is called for.
    Chairman Warner. I probed it pretty carefully last night 
with him.
    We will now turn to Senator Reed. Do you have an opening 
statement?
    Senator Reed. I have no opening statement.
    Chairman Warner. Fine.
    Senator Inhofe.
    Senator Inhofe. Mr. Chairman, it is not my intent to have 
an opening statement. I would have to echo your opening 
statement and that is that there are serious concerns. I am 
coming to this meeting with an open mind, and this is a very 
rare thing in government, that we get to this point and minds 
are not already made up. So I will be looking forward to the 
hearing, looking forward to trying to make the right decision.
    Chairman Warner. I thank you. I enjoyed our exchange last 
night on the issues. You were helpful to me, Senator, as you 
always are, because you have a special insight into the 
aircraft business.
    Senator Clinton.
    Senator Clinton. Mr. Chairman, I too want to thank you for 
holding this hearing. I think it is indicative of your 
leadership and your openness. I would just add a few points.
    I think there is general agreement that the Air Force needs 
more tankers. I would posit that. I think that should be the 
basis on which we go forward. The issue is how best to obtain 
those tankers as soon as possible, put them into service, and 
have them utilized.
    I am struck by the various questions concerning this 
particular approach to obtaining the tankers. I do not have a 
positive or negative feeling about the process. I appreciate 
the effort to find out more information. But I do think there 
are other related issues, that the context of this should be 
recognized.
    We are going over this leasing arrangement with a fine-
toothed comb and we are putting out billions of dollars in 
contracts for the reconstruction of Iraq and not knowing a 
single thing about them. Senator Collins and I and Senator 
Wyden have been trying to find out information about 
Halliburton and Bechtel and others who just basically have been 
handed billion-dollar open checkbooks, and there has been very 
little, if any, oversight by anyone in Congress.
    So I hope that this hearing and the rather significant 
amount of information that has been forthcoming will serve as a 
model for other contracts that are being entered into, in this 
case without any information or oversight.
    Second, part of the dilemma we find ourselves in is our 
failure to be honest about the costs that we confront and the 
ability of our Government to sustain these costs into the 
future without adequate revenues. This is not a problem that is 
going away, no matter how often people try to pretend that it 
does not exist. It is, to use an appropriate metaphor perhaps, 
it is the giant elephant in the room. This is a huge issue.
    We are not paying as we go and we are not acting 
responsibly about how we fund critical needs like national 
defense. So this leasing agreement, looked at on the side as 
though it were some aberration, is part of a much larger 
pattern of fiscal irresponsibility and failure to acknowledge 
the real costs of our undertaking the kind of missions that we 
are currently committed to.
    So, Mr. Chairman, I think that it is imperative that we 
come to an answer on this because clearly, in my review of what 
I have been given, the Air Force needs these tankers. Our 
continuing missions require this kind of capacity. But I think 
we should take a very hard look at the broader context in which 
this hearing is being held, because we are focusing on one 
relatively small, albeit very important, issue and we are 
failing to look at the entire context that this is occurring 
in.
    So I thank the chairman for having this hearing and I look 
forward to the information.
    Chairman Warner. Senator, I appreciate that. I note also 
your reference to contracts in Iraq. You will recall the debate 
that we had on the floor with the Boxer amendment. She took an 
initiative and we joined on that and did put some piece of 
legislation in.
    But I will refer to what we did on the floor and the 
subsequent actions by the Department. I think you raise a 
question that is certainly within the province of this 
committee to look at.
    Senator Clinton. Thank you.
    Chairman Warner. Thank you.
    Senator Roberts.
    Senator Roberts. Thank you, Mr. Chairman. I do have a 
statement, and I come to this issue as chairman of the 
Subcommittee on Emerging Threats and Capabilities, not as, as 
has been alleged, in terms of special interest concerns.
    Mr. Chairman, Scottish novelist Tobias Smollett, a name 
that does not ring in history, he said and noted once that: 
``Facts are stubborn things.'' He is right. They often get in 
the way of the arguments that we want to make. In Dodge City, 
Kansas, we simply say nothing hurts the truth so much as 
stretching it or ignoring it.
    In the run-up to today's hearing, we received a number of 
reports asserting various claims regarding the cost and the 
justification for the Air Force's proposed tanker lease. It 
seems to me that much of the criticism contained in those 
reports ignores key facts and obvious facts. Those facts are 
these:
    Number one, our tanker fleet is absolutely critical to our 
military's ability to defeat the many threats we have abroad. 
That has been testified to over and over again by Chairman 
Myers and also Secretary Rumsfeld.
    Number two, 90 percent of our aerial refueling fleet is 
more than 40 years old, most of them around 42 to 45, older 
than many of the pilots flying the KC-135, resulting in 
increased maintenance costs and higher risks of fleet-wide 
problems. If you shut down this fleet, if you have a class 
problem in terms of corrosion or any other problem, you stop 
the war or you stop our ability to wage war, you endanger our 
national security in regards to access denial.
    Number three, the proposed lease will allow the Air Force 
to begin to modernize its fleet 5 years earlier than a 
traditional procurement and will save up to $5 billion in 
modifications planned to keep the KC-135E flying. Operations 
Noble Eagle, Enduring Freedom, and Iraqi Freedom once again 
demonstrated the importance of tankers to our military's 
ability to defeat various threats abroad.
    No one challenges the importance of these aircraft, but 
some ask why we need to modernize the fleet now. The answer is 
simple: Our tankers are the oldest combat aircraft in the Air 
Force. Seven years ago, the GAO noted that the KC-135s were 
taking progressively more time and money to maintain and 
operate and questioned the fleet's long-term serviceability. 
After avoiding the issue of tanker modernization for years, the 
Department and the Air Force have now come forward with a plan, 
along with some of us in Congress, that will field 100 new 
tankers 5 years earlier than the traditional procurement and 
would allow the Air Force to avoid again up to $5 billion in 
KC-135E modification costs, that is not reflected in the OMB 
estimate by the way.
    The Air Force has acknowledged that leasing the aircraft 
will be more expensive than buying them outright, but justifies 
the premium not only on the basis of saving maintenance costs, 
but also the enhanced ability and capability available to the 
warfighter through the 767 lease. That is my number one 
concern, the warfighter.
    I am well aware of the various cost analyses on the lease 
proposal. Many of these analyses are based on very sensitive 
assumptions. However, these studies do not address the fact 
that this proposal will reduce the KC-135 maintenance and 
operation cost while increasing warfighter capability.
    Why would we reject this plan and choose to spend up to $5 
billion to keep 40-, then 45-year-old aircraft flying? The time 
has come to solve, not put off, this problem.
    Finally, I am well aware of the other criticisms of the 
proposal as well: allegations that the lease does not satisfy 
OMB requirements, suggestions that the corrosion problems are 
not as significant as the Air Force claims--and I will have a 
question for Secretary Roche as to that claim or as to that 
allegation--and questions about the competition.
    However, in the final analysis the issue comes back to 
stubborn facts. OMB has concluded the proposed lease satisfies 
its requirements. The corrosion problems and the costs of 
continuing to operate the KC-135 will continue to escalate in 
the future. With regard to competition, what other aircraft 
manufacturer currently has an aircraft in production that meets 
the Air Force's requirements?
    It seems to me that if we reject this proposal or 
continually put it off it will only ensure that future missions 
and the men and women who fly them are put at greater risk than 
need be while the government continues to spend increasing 
amounts of money to keep 40- and 45- and 50-year-old planes 
flying.
    I would urge my colleagues to approve the lease. I know we 
are going to take time in doing that.
    Mr. Chairman, I have three press articles: one from the 
Wall Street Journal as of September 3; one from the Defense 
News as of September 1; and one from the Washington Times as of 
September 3, and would ask permission that they be inserted in 
the record at this point.
    Chairman Warner. Without objection.
    [The information referred to follows:]
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    Chairman Warner. Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    This proposal I believe before us is unprecedented. The Air 
Force strongly believes it needs new aerial refueling aircraft. 
I agree that new aircraft is a requirement that must be met, 
and in fact I would strongly support the appropriation of funds 
for such aircraft. However, this is not what the Air Force 
intends to do. Instead, the Air Force has brought a proposal 
before this committee that would circumvent our budget and 
appropriations processes and potentially cost the taxpayer 
billions more than if the Service would have purchased the 
planes directly.
    I participated in a hearing yesterday, Mr. Chairman, on the 
Budget Committee and I specifically asked the question, had 
they ever seen this procedure before in budgeting. The answer 
was no, implying that this was a budget precedent that had 
never been used before. I hope that our panel members that you 
have called can affirm or perhaps bring forward a different 
view on the answer that I got yesterday from the Budget 
Committee.
    It is my view that if this proposal is adopted by other 
agencies it would make our budget meaningless. It creates a 
hidden liability, disguising our true deficit and debt numbers.
    I believe we must be very careful as we listen to our 
witnesses today. There is more at stake than 100 tanker 
aircraft. Congress must agree to fund this program in its 
entirety or else risk incurring substantial termination fees. 
Congress must also agree to purchase the planes at the end of 
lease or risk wasting nearly $20 billion of the taxpayers' 
money.
    We must also recognize that this is only the beginning. The 
lease program before us will replace just over 100 tankers. 
There are still another 400 that will eventually need to be 
replaced. This tanker recapitalization proposal in my view is 
not the end. In fact, it is only the beginning.
    I would also share the same concerns that my colleague 
Senator McCain brought up on the acquisition processes that 
Boeing has been applying recently. I also read the same article 
Senator McCain had read, where it said the Air Force--it talked 
about how the Air Force had canceled more than $1 billion in 
contracts with Boeing to launch rockets after it was determined 
that the company improperly obtained thousands of sensitive 
documents belonging to rival Lockheed Martin. Then--it stated, 
it talks about how the Pentagon has launched a formal 
investigation to determine whether a former Air Force official 
broke the law by passing information to the Boeing Company 
about a rival bid for a $21 billion contract to lease aerial 
tankers.
    Ignoring the procurement rules seems to be a chronic 
problem with Boeing and I am concerned about that. Mr. 
Chairman, I think this committee ought to spend some time in 
reviewing the lack of competition among defense contractors and 
how ineffective it is, in many cases applying penalties when 
the procurement rules are ignored.
    Mr. Chairman, I have many questions and, to be honest, many 
doubts. I believe that there is a genuine requirement for 
recapitalization, but I am not certain that the requirement 
must be addressed now. I believe that the Air Force does not 
have the funds to buy these planes directly. But I am not 
certain the Air Force will ever be in a position to buy these 
planes in the near future, given its priorities.
    I believe that we should encourage innovative business 
practices, but I am not certain that such practices should be 
utilized if it requires us to obligate future Congresses to 
this lease program.
    I believe we must be judicious and deliberate as we 
proceed. We must make certain that this is the best deal, for 
more is at stake than the taxpayers' hard-earned dollars. Our 
national security could be put at risk as well.
    Thank you, Mr. Chairman, for the opportunity to share some 
of my thoughts. I look forward to the testimony of our 
witnesses.
    Chairman Warner. Thank you very much, Senator Allard.
    Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman. I just 
want to add my welcome and thanks to Secretary Roche and 
Secretary Wynne, as well as Director Kaplan, for being here 
this morning. I look forward to their testimony and want to add 
my welcome to you as we discuss the Air Force proposed tanker 
aircraft lease.
    Thank you very much, Mr. Chairman.
    Chairman Warner. Thank you.
    Senator Collins.
    Senator Collins. Mr. Chairman, I am very eager to hear the 
testimony of our witnesses today, so I will withhold my opening 
comments.
    Chairman Warner. Senator Chambliss.
    Senator Chambliss. Mr. Chairman, thank you. No opening 
statement.
    Chairman Warner. Secretary Roche, you may proceed. I failed 
to state in my opening comments that I and my staff were not 
able to locate any historical reference to the Department of 
the Air Force having ever requested an authorization that 
addressed these critical needs with regard to tanker aircraft 
procurement. Perhaps in your statement or at some point in time 
you can supply the record with whether I am correct in that 
observation or there was at some point in time before this 
committee a request, either from the Defense Department or the 
President's Budget Office, in the annual message from the 
President, a request and/or a departmental request from the Air 
Force.
    Thank you.

  STATEMENT OF HON. JAMES G. ROCHE, SECRETARY OF THE AIR FORCE

    Secretary Roche. Thank you, Mr. Chairman, Senator Levin, 
members of the committee. It is my great honor to join 
Secretary Mike Wynne and Mr. Joel Kaplan today to testify on 
our need to begin the modernization of our air refueling fleet.
    The air refueling capability delivered by the airmen who 
fly, maintain, and support our KC-135s, of which we have 544, 
and our KC-10s, of which we have 59, is absolutely vital to our 
Nation. Mr. Chairman, I agree, my research says that the only 
request was for the KC-10s and that was in the late 1970s. 
There has not been one subsequent to that.
    Chairman Warner. Right, and that was granted by Congress.
    Secretary Roche. Yes, it was, sir.
    Chairman Warner. I remember it very well. Thank you.
    Secretary Roche. Air refueling tankers enable our entire 
joint force to protect our homeland, conduct combat operations, 
and provide humanitarian relief around the world. They enable 
Air Force, Navy, Marine Corps, and allied strike, electronic 
warfare, reconnaissance, and mobility aircraft to perform their 
missions. They have been essential in Operations Enduring 
Freedom and Iraqi Freedom, as well as in the skies over the 
United States.
    As we recently demonstrated in the war on terrorism, the 
Air Force tanker fleet was a critical force enabler that 
allowed our coalition force to operate over distant 
battlefields. In Afghanistan, air refueling made joint 
operations in a distant, landlocked nation possible. In Iraq, 
our ground forces' overwhelming speed, firepower, and decisive 
maneuvering were enabled by air dominance over the entire 
country, a condition that was made possible through the 
thousands of air refueling sorties that moved the forces to the 
fight and kept reconnaissance and strike aircraft overhead 24 
hours a day. Of our roughly 69,000 sorties to date in Operation 
Iraqi Freedom, close to 10,000 have been tanker aircraft.
    I have with me today, Mr. Chairman, a couple of our airmen 
who have flown and worked on the maintenance of the KC-135s. 
Lieutenant Colonel Smiedendorf and Colonel Westhoff are here 
should you have any questions of any of the pilots on that 
subject, sir.
    This distinctive capability, our Nation's ability to 
rapidly project air, land, and sea forces around the globe, is 
critical to our Nation's ability to deter enemies, assure our 
friends and allies, project force, and, when necessary, win our 
wars. In short, Mr. Chairman, our national security strategy 
cannot be executed without aerial refueling tankers. This 
dependence and the advanced age of the Nation's air refueling 
aircraft fleet drive our urgency to recapitalize.
    The ongoing global effort to fight terror heightens our 
aging aircraft concerns, particularly because of the need to 
protect our Nation's skies with fighters, requiring our tanker 
capability, as well as the need to maintain our global reach 
capability.
    Chairman Warner. Secretary Roche, I am going to interrupt. 
We will admit for the record the full statements of all 
witnesses.
    Secretary Roche. All right, sir.
    To the point of Operation Noble Eagle, we keep a number of 
aircraft, tankers, on alert every day, around the clock. Today, 
the on-average 42-year-plus old KC-135 represents 90 percent of 
our combat air refueling capability or about 82 percent of our 
capacity. The 544 KC-135s on duty today have the oldest average 
age of any of our aircraft combat aircraft, and the E model, 
the 131 aircraft we are choosing to replace with this lease, 
are now 44 years old on average.
    Our 135s in general, Mr. Chairman, are older than the 
average age of Navy oilers, which is roughly 40 years, I am 
told.
    During Operation Iraqi Freedom, we severely restricted the 
deployment of these aircraft due to operational limitations--
the E models I am referring to. They were unsuited for the high 
temperatures and short runways in the operating area and they 
had insufficient fuel capacity and less efficient engines. 
Instead, we limited their use to the European theater in order 
to support the air bridge and global power operations, and the 
commander of the Air Mobility Command made the point to me that 
we only used them at three hubs where there were a lot of spare 
parts and support for aircraft of this age.
    While demand for these assets is increasing, the data show 
their availability steadily decreasing, while the costs to keep 
them flying are swelling. In the last 12 years, mission capable 
rates are down 7 percent, program depot maintenance costs 
tripled, depot work packages doubled, and the depot flow days 
more than doubled, primarily due to the challenges posed by 
aircraft aging.
    Just to correct fatigue and corrosion problems in the KC-
135E engine struts will cost over $3 million per aircraft. If 
these repairs are not done, the fleet will be grounded. Both 
General Jumper and I have visited the depot where much of this 
work is being done. I can tell you that the men and women who 
are keeping these planes flying are performing magnificently, 
but they are doing much more than our Nation should reasonably 
expect of them.
    I would also point out proudly, sir, that the Air Logistics 
Center (ALC) at Tinker Air Force Base has by virtue of 
benchmarking with other ALCs and with commercial firms, is now 
judged to be more productive than the two commercial firms that 
are also overhauling 135s, and we would expect by benchmarking 
the commercial firms will come up. But it is an example of 
where a Government-owned institution can perform very well.
    Across the Air Force, we are now migrating dollars from 
procurement to operation and sustainment accounts to sustain 
our aging fleets. In 1997, the direct cost of corrosion 
maintenance for all U.S. aircraft was $795 million. Today we 
estimate it will cost over $1 billion a year, despite a 5-
percent reduction in aircraft inventory over the same period of 
time. Currently, roughly 30 percent of the depot hours for our 
135s are dedicated to fixing corrosion, and we expect over the 
next 4 years for that to increase.
    Given the value of air refueling tankers to our Nation's 
security, the operational risks of flying these aged aircraft, 
and the spiral costs to operate and sustain this fleet, we 
believe there is a compelling set of circumstances that demand 
we begin recapitalizing our Nation's tanker force. After a 
comprehensive and deliberate review that validated the urgent 
need to start modernizing our tankers now and the advantages of 
leasing, we urge your support for our proposal to enter into a 
multi-year lease of 100 KC-767 tanker aircraft.
    Even if we were to begin this, Mr. Chairman, we will still 
have KC-135s that will be flying well into their 70s. So we 
will have to maintain these other aircraft over a very long 
period of time.
    The dominant reason for proposing a lease is the advantage 
it affords for quickly delivering needed tankers to our 
warfighters without requiring significant up-front funding. 
This will hedge the risk to the force of KC-135s across the 
board.
    I want to assure both you and your colleagues that we 
looked at several alternatives to our tanker needs. We 
seriously evaluated a tanker offering from Airbus and we took a 
hard look at re-engining the KC-135s. The fact is we could 
spend billions to put new engines on an old airframe, but still 
not stem the corrosion and structural challenges we face in the 
main body of the aircraft.
    We looked at stored commercial aircraft that would be 
suitable, the 767-ER200. There were very few of them because 
they are the choice of freighters, people who do air freight 
work. Those that were in storage had an extraordinary number of 
hours on them.
    We looked at fee for service, which is something Navy has 
looked at as well, and it is not suitable for our fleet given 
our projection forces. We looked at designing a new aircraft 
and realized that would be extraordinarily expensive to do, as 
any new program has done. So we conducted a request for 
information to both of the manufacturers, Airbus as well as 
Boeing.
    Mr. Chairman, we recognize that this lease will cost 
marginally more from a net present value analysis than a normal 
procurement program. But in the Department's view the immediate 
and long-term benefits, including operational savings which are 
not included in the calculations, greatly offset the 
differentiated costs of the lease option. By operational 
savings, Mr. Chairman, I mean if you use this aircraft you do 
not have to use a lot of others. You get savings as you go.
    So for instance, if we had to maintain a combat air patrol 
(CAP) somewhere that consisted of Navy aircraft as well as Air 
Force aircraft, or that consisted of coalition aircraft, we now 
would require three KC-135s. In the case of the 767 tanker, it 
would only be one. If we were to move Marine Corps aircraft 
from Cherry Point over to Japan, we would use half the pounds 
of fuel, using the newer aircraft than existing aircraft 
because they also can carry cargo.
    So there are savings as you go. We did not project any of 
those because you cannot tell how often you would do that and 
therefore we felt it would not be part of the analysis. But it 
is one of those things that we would benefit from if they were 
in place.
    Our report shows, as has been discussed, that we can lease 
and deliver 100 767 tankers 5 years sooner than we can under a 
normal procurement program. Most significant, to purchase these 
aircraft on the same schedule we would need $5 billion in 
additional funding in the Air Force account through fiscal 
years 2006 and more than $11 to $14 billion more across the 
Future Year Defense Program (FYDP). This is money the Air Force 
does not have and is not programmed for and will result in 
significant impacts and delays to our other modernization 
programs.
    We agree that in the past this should have been addressed 
and allowing the tankers to get to the age they are without 
addressing a recapitalization program was wrong.
    There are a number of safeguards, we believe, in the 
leasing program which can be discussed. For instance, part of 
our proposed contract, the third party trust, will buy the 
aircraft from Boeing and will lease them to the government. The 
trust will not make a profit, but will provide for the funds 
necessary to pay bondholders and pay off the debt after the 
sale of the aircraft.
    At yesterday's Commerce Committee hearing I was in error. I 
said that the trustee was the Air Force. The trustee is not the 
Air Force. The administrator of the trust is an employee of the 
Wilmington Trust Company, not Boeing nor the Air Force.
    Further, any residual funds acquired from a possible sale 
of any aircraft subsequent to the termination would be refunded 
to the government as an overpayment.
    We have also insisted, and Boeing has agreed, that the 
contract will include most favored customer clauses stating 
that if Boeing sells comparable aircraft during the term of the 
contract for a lesser price the government will receive an 
equitable adjustment.
    To further guarantee the taxpayers receive a favorable 
deal, Boeing has agreed to a return on sales cap of 15 percent, 
whereby any return on sales in excess of 15 percent in either 
commercial or military manufacturing centers will be returned 
to the government. This is something unprecedented in military 
acquisitions and we believe is a way to account for the 
different models and different estimates. If we are wrong and 
in fact the planes are cheaper, this provision allows money to 
be returned to the government because it will be audited and it 
will be audited annually.
    Thus, I am pleased to report to the committee that, through 
the combined efforts of the OMB and the Office of Secretary of 
Defense and, honestly, Congress, we arrived at what I can 
characterize as a good deal for the Air Force and the American 
people. In addition to the business considerations that make 
this approach attractive, there are compelling operational 
benefits to the KC-767. It can offload 20 percent more fuel. It 
can use many more runways, and it can refuel itself as well as 
pass fuel. Therefore it can be used for consolidation like the 
KC-10, which has proved so valuable to us.
    Mr. Chairman, as I note in my written testimony to this 
committee, our proposal for using commercial airline bodies as 
tanker platforms is not without precedent. In the late 1970s, 
Secretary of Defense Harold Brown arranged to begin to acquire 
DC-10 aircraft converted into tankers. Secretary Weinberger 
continued this program. The DC-10, like the Boeing 767 today, 
was nearing the end of its production run. The airliner had 
been designed and proven successful as a platform, the result 
of billions of dollars by the contractor, not the taxpayer.
    In hindsight, the success of the KC-10 fleet, with 59 of 60 
still in the inventory, proves the wisdom of Secretary Brown's 
approach. Even though the KC-135 fleet at that time was only 16 
to 18 years old, they believed they needed a hedge.
    We hope you will agree with us that this innovative new way 
of delivering capability is as compelling today as it was to 
Secretaries Brown and Weinberger 20-plus years ago. I would 
point out, Mr. Chairman, that in Operation Iraqi Freedom we 
made use of 80 percent of our KC-10s, 50 percent of our R model 
135s, but only 25 percent of the E models.
    Mr. Chairman, America's Air Force is able to perform the 
extraordinary feats asked of us because we are blessed with the 
full support of the American people, Congress, and the 
President of the United States. I join my colleagues here today 
in urging your support for this proposal.
    I also would like to tell you, Senator, that my good 
colleague our new Vice Chief of the Air Force General Buz 
Moseley is here. He was the coalition forces combined air 
component commander, and if there are any questions about the 
use of tankers in the recent conflict he would be glad to 
address them.
    So on behalf of General Jumper, we thank you for the 
investment you have made in our future and trust that you have 
placed in us. Thank you, sir.
    [The prepared statement of Secretary Roche follows:]

               Prepared Statement by Hon. James G. Roche

    Thank you for the opportunity to appear before you today to discuss 
the necessity of the Air Force's tanker lease proposal and the status 
of the KC-135 fleet. In my testimony I will outline the importance of 
the Air Force's tanker fleet to this Nation's security, the status of 
that fleet, the proposals that were before us, and finally, our choice 
of the tanker lease proposal which best serves this Nation's security 
interests, the American public's interests, and the operational needs 
of the Air Force and our warfighting combatant commanders.
    Before I begin, I must commend the men and women who fly, maintain, 
and deliver the impressive combat capability that is our topic today. 
Without these incredibly talented uniformed and civilian airmen, this 
discussion would be irrelevant. These airmen, the heart of our air 
refueling force, operate everyday all over the globe. From active duty 
and our Reserve component units, we draw our vital tanker capabilities 
from places like Selfridge, Michigan; Phoenix, Arizona; Altus, 
Oklahoma; Forbes, Kansas; Birmingham, Alabama; Honolulu, Hawaii; 
Bangor, Maine; Tampa, Florida; Lincoln, Nebraska; Warner-Robins, 
Georgia; Grissom, Indiana; Niagara, New York; and Goldsboro, North 
Carolina.
    During the past 2 years, these airmen and our tanker fleet have 
been tested hard, flying Operation Noble Eagle (Homeland Defense), 
Operation Enduring Freedom (Afghanistan), and Operation Iraqi Freedom 
(Iraq). They delivered far more than could reasonably be expected while 
operating and maintaining the oldest fleet in the United States Air 
Force inventory.

                        CURRENT STATUS OF FLEET

    Tanker dependence in recent wars and the advanced age of the 
Nation's air refueling aircraft fleet drive the Air Force's urgency to 
recapitalize as soon as possible. Today, a single 44-year-old aircraft 
type, the KC-135, supports 82 percent of our combat air refueling 
capability. Beginning manufacture under the Eisenhower administration, 
732 KC-135s entered military service between 1957 and 1965. The 
remaining 544 KC-135s on duty today have the oldest average fleet age 
of any Air Force combat aircraft, and the ``E'' model (131) is 44 years 
old on average. It is the old KC-135Es we seek to replace soonest. The 
ongoing war on terrorism heightens our concerns regarding these aging 
aircraft. Our new ``steady state'' includes tankers supporting fighters 
defending the homeland as well as the need to maintain the Nation's 
global reach capability.
    Aircraft life can be measured in three ways--usage (flight hours), 
physical age (years), and utility (usefulness). The KC-135's physical 
age is the driving need to recapitalize. Through the 1990s, the KC-135 
fleet started to show its age. In 1991, Air Force Materiel Command 
initiated aging aircraft inspections and repairs to maintain the 
airworthiness of this legacy fleet. By 2000, 32 percent of the KC-135 
fleet (a significant portion of this Nation's overall Air Force 
refueling capability) was unavailable due to programmed depot level 
maintenance as the number and complexity of repairs drastically 
increased. This reduced the refueling capability to our warfighters and 
caused a backlog at the depot facilities, as the average number of days 
in depot-level maintenance peaked at over 400 days.
      
    
    
      
    Annual depot price per aircraft grew significantly as the fleet 
availability decreased. The combination of increasing costs and 
decreasing availability projected into the future compels the Air Force 
to act now to balance cost, capability, and risk; it compels us to 
begin recapitalization of the KC-135 fleet.
    Although General John Jumper, our Chief of Staff, and I have 
visited the depot at Tinker Air Force Base to investigate the condition 
of our KC-135s, we do not rely on our observations or anecdotal 
evidence alone. Independent teams, including teams from Office of the 
Secretary of Defense, the GAO, and many others, that have visited the 
KC-135 depot maintenance line at Tinker Air Force Base unanimously 
recognized the risk that this 44-year-old aircraft could encounter a 
fleet-grounding event, negatively impacting combat operations across 
all services and coalition partners.
    It should be noted that aircraft corrosion is a significant concern 
for aging aircraft, both military and civilian. Congress enacted the 
Aging Aircraft Safety Act, Title IV of Public Law 102-143, in October 
of 1991 after the in-flight structural damage of a Hawaiian Airlines 
737 in April 1988. As you may remember, corrosion had so weakened the 
fuselage of the aircraft that it burst when it reached altitude and 
could not sustain the pressure differential between the pressurized 
cabin and the atmosphere outside. The Federal Aviation Administration 
has enacted additional rules regarding corrosion and inspections for 
corrosion since it is of such critical concern for aging aircraft.
    The KC-135E fleet--our oldest--is beset with problems that 
adversely impact its utility to the Air Force, our sister services, and 
our friends and allies. The planes are operating under flight 
restrictions pending interim repair of an engine strut--interim repair 
costs $150,000 per aircraft, must be complete by September 2004. If the 
repairs are not made at that time, the unrepaired aircraft must be 
grounded. The interim repair will only last for 5 years at which time 
the permanent repair must be made. Permanent repair of the engine strut 
would cost $2.9 million per aircraft. If the permanent repairs are not 
made, the unrepaired aircraft in that case must also be grounded. We 
are facing a continual set of repairs and maintenance actions that only 
delay that event. There is also the KC-135 fuel system, which requires 
repair to deteriorating internal corrosion barriers. Those repairs are 
estimated to cost $500,000 per aircraft. Of course, there are always 
the ``unknown unknowns'' which become much more prevalent in aging 
hardware--for example, 40 percent of the KC-135 fleet was non-mission 
capable from September 1999 to February 2000 as a result of a 
requirement to replace the horizontal stabilizer trim actuator--an 
unexpected event that grounded a major portion of our fleet.

                    REQUIREMENT FOR RECAPITALIZATION

    The cost of continuing to operate the existing KC-135 air refueling 
force will continue to escalate dramatically. Corrosion, major 
structural repairs, and an increased rate of inspection are major 
drivers for increased cost and time spent in depot. More time in the 
depot directly decreases operational aircraft availability. Operational 
availability is expected to continue to decrease throughout the 
remainder of the KC-135's lifespan. Under these conditions of 
increasing costs and steadily declining availability and performance, 
combined with the increasing operational demands, actions to replace 
the KC-135 must begin now.
    Our proposal--using commercial airline bodies as tanker platforms--
is not without precedent. In the late 1970s, Secretary of Defense 
Harold Brown began to buy DC-10 aircraft converted into tankers, and 
Secretary Weinberger continued the program, resulting in the 60 KC-10s 
that ultimately became our lifeblood. The airplane had been designed 
and proven successful as a platform, the result of investment by the 
contractor, not the taxpayer. In hindsight, the success of the KC-10 
fleet (59 of 60 are still in the inventory) proves the wisdom of 
Secretaries Brown and Weinberger's decision to buy commercially 
developed aircraft, even though the KC-135 fleet at that time was only 
16 to 18 years old.
    In the case of the KC-135, military aircraft was specially 
developed for the Air Force. From this model the industry created the 
commercial carrier, the B-707. These commercial airplanes have been 
retired for the most part in favor of newer airplanes. In this case, it 
was the contractor who benefited from the investment made by the Air 
Force.
    You will recall that we capitalized the original 732 KC-135s at a 
rate of 90 aircraft per year. To recapitalize the 544 that remain at an 
economical but affordable rate could take more than 30 years. We may 
already be behind the power curve. We can no longer accept the risk of 
these venerable aircraft continuing their age-induced death spiral 
without taking immediate action. A realistic replacement program will 
take decades to recapitalize a fleet of this size. Even beginning 
today, some of our KC-135s will pass their 70th birthday before they 
retire.

                      OPERATIONAL NEED FOR TANKERS

    We do not propose leasing tankers as a bailout for Boeing or any 
other aircraft manufacturer. We propose leasing tankers because we need 
tankers to fight our Nation's wars, and we do not believe we should 
take the risk to wait for years before we begin.
    The Air Force tanker fleet delivered over 375 million pounds of 
fuel during 30 days of Operation Iraqi Freedom, 90 percent of the total 
fuel delivered by all joint and coalition forces. In addition, our 
tanker fleet participated in air bridge operations, long-range strike 
missions, and other global commitments during this time. This great 
feat allowed Air Force strike aircraft to put relentless pressure on 
the Iraqi leadership and the Iraqi armed forces. It was the key to 24-
hour airborne surveillance. Aerial refueling was the reason that the 
Air Force could dedicate so many assets to on-call close air support, 
on-call strikes on time-sensitive targets, and on-call support for our 
highly successful special operations forces.
    But more than just an Air Force asset, our tanker capability 
enables the combat capabilities that our sister services and coalition 
partners bring to the fight. For instance, tankers made it possible for 
Navy and Marine fighters to launch from carriers in the Persian Gulf 
and strike targets deep inside Iraq. Tankers permitted C-17s to take 
off from Italy and drop Army paratroopers in northern Iraq. United 
States Air Force air refueling aircraft delivered over 90 percent of 
fuel offloaded to our sister services and allies during OIF. On a 
global scale, General John Handy and his folks at US Transportation 
Command managed the tanker air bridge throughout these campaigns, 
simultaneously sustaining our airlift to the theater while our combat 
forces continued to deter our enemies in the Pacific. Without these 
vital refuelings, troops and materiel that our Nation needed halfway 
around the world would have been less effective and slower to respond, 
jeopardizing our ability to project global land, sea, and air power.
    Air refueling tankers enable our entire force to protect our 
homeland, conduct combat operations, and provide humanitarian relief 
around the world. They enable other Air Force, Navy, Marine Corps and 
allied aircraft to fly farther, stay airborne longer, and carry more 
weapons, equipment, and supplies. As we just experienced in Operation 
Enduring Freedom and Operation Iraqi Freedom, the Air Force tanker was 
a critical force enabler and force multiplier that allowed our 
coalition force to operate over a distant battlefield. Air refueling 
tankers ensure our Nation has the global reach to respond quickly and 
decisively anywhere in the world. In short, our National Security 
Strategy is unexecutable without air refueling tankers.

                     NEED/UTILITY OF THESE TANKERS

    But again, 90 percent of our current air refueling fleet rests in 
this single aged weapon system. In fact, the warfighter had to adapt 
his basing plan to address the limitations of the ``E'' model of the 
KC-135. During Operation Iraqi Freedom, the ``E'' models were deemed 
incapable of sustained operations in the area of responsibility (AOR) 
due to the high temperatures and shorter runway lengths in theater and 
the lower fuel capacity and less efficient engines of the ``E'' model. 
We found use for them in EUCOM locations during the war, but their 
support was limited to airbridge, homeland defense, and global power 
operations. The KC-767A, however, will truly enhance our warfighting 
flexibility. We will replace 131 KC-135Es with 100 KC-767As, and 
greatly increase our capabilities.
    The KC-767A is a tanker version of the long-range commercial 
aircraft. This tanker was developed and commercially offered to the 
international community by the Boeing Company as the Global Tanker 
Transport Aircraft (GTTA). Italy was the first customer, ordering four 
aircraft, and has been followed by Japan. The KC-767 tanker will be the 
world's newest and most advanced tanker. It can offload 20 percent more 
fuel than the KC-135E, and unlike the E-model, but like the KC-10, can 
itself be refueled in flight. The KC-767 tanker also has the capability 
to refuel probe- and receptacle-equipped aircraft on every mission--an 
enormous benefit for joint operations. While the KC-767 will have 
roughly the same maximum fuel offload as the KC-135R, it can takeoff at 
maximum gross weight in approximately 3,500 ft. less runway--hence, 
along with greater operational capabilities, the KC-767A is able to 
operate from four times as many runways as the KC-135. As delivered, 
the KC-767A will be configured as a convertible freighter being able to 
carry all passengers (approximately 200) or all cargo (19 pallets vs. 6 
on the KC-135).
    It will have a digital cockpit, cargo door, auxiliary fuel tanks, 
remote air refueling boom operators station, centerline hose drum unit, 
crew rest facilities, larger 120 kilovolt-Ampere generators, advanced 
air refueling boom, and aeromedical evacuation capability.
      
    
    
      
                        ALTERNATIVES CONSIDERED

    In selecting the KC-767A, the Air Force considered a variety of 
airframes and acquisition strategies. By DOD regulations, the Air Force 
was not required to conduct an analysis of alternatives (AOA) for the 
KC-767 tanker lease, the reasons for which I will address in more 
detail later. Even though the Air Force did not complete a formal AOA 
on the KC-767A, we performed several trade analyses to ensure the KC-
767A was the right solution to meet the operational requirements.
    Maintain current force structure: The Air Force first considered 
maintaining the current force structure. The damaging effects of aging 
quickly became apparent from KC-135 depot work. The unpredictable 
nature of age-related corrosion--its timing, location, and extent--
increases our concern for the risk of an event that would ground the 
KC-135 fleet. Thus, continuing the status quo was rejected because of 
unpredictable and potentially calamitous operational mission impacts.
    Re-engine: The Air Force also quickly recognized that re-engining 
the venerable KC-135Es did not address the aging issues, risks to our 
combat operations, or increasing costs. Re-engining would amount to 
spending billions of dollars for only a 20 percent improvement over KC-
135E capability, but without addressing the ``old iron'' that needs 
replacing. Re-engining was not selected as the solution.
    Commercial alternative: The Air Force considered acquisition of 
commercial derivative platforms in tanker configurations. This strategy 
acquires air refueling tankers derived from commercially available 
airframes to avoid the high costs of new aircraft research and 
development. The use of a commercial-based airframe forges synergy with 
industry in worldwide logistics networks and other support. The 
question then became: How can we get these mission critical assets to 
the warfighter in the most expeditious way, at a reasonable cost to 
taxpayers? Our answer: lease a tanker aircraft that is already 
commercially available.
    In February 2002, the Air Force issued a request for information 
(RFI) to both Boeing and European Aeronautic Defense and Space Company 
(EADS) to evaluate available technologies and associated risks. 
Consideration of acquisition of commercially derived platforms included 
the B757, B767, B777, and the Airbus A330 in tanker configurations, 
considering both a lease option and a direct purchase. Based on the 
responses to the RFI, the Boeing 767 was found to be the most 
favorable. The Boeing 757 was too small to replace KC-135 one-for-one, 
and would drive additional manpower requirements on a tanker force that 
is already limited by available crews. The Boeing 777 required almost 
twice as much ramp space as a KC-135--more than a KC-10--but had a 
reduced fuel offload capability when compared to the KC-10. Further, 
the B777 required significant engineering analysis and design work to 
be modified into a tanker, including the possibility of a shortened 
fuselage to accommodate a refueling boom during takeoff. The Boeing 767 
was selected over EADS aircraft as a result of its favorable design, 
schedule, risk factors, and proven boom technology.
      
    
    
      
    To begin the recapitalization of the 544 KC-135 aircraft, the Air 
Force considered two primary alternatives as acquisition strategies--a 
traditional procurement of 100 KC-767A aircraft, and an operating lease 
of commercially derived air refueling tankers in accordance with 
section 8159 in fiscal year 2002 legislation. In addition, the Office 
of the Secretary of Defense Leasing Review Panel considered several 
alternate procurement approaches in contrast to the lease or planned 
purchase, including purchases on the same delivery schedule as the 
lease and applying the funding stream required for a lease to a more 
traditional purchase program. The Secretary of Defense determined that 
the lease option best satisfied this nation's military needs.
    The Air Force, with permission from Congress, began negotiations 
with Boeing for an operating lease of 100 commercially developed KC-
767A air refueling tankers. At the time of the fiscal year 2004 
President's budget (PB) submittal, negotiations for the lease were 
unfinished. Plan A, a KC-X procurement program, was included in the 
President's fiscal year 2004 budget, with the program to begin, because 
of affordability constraints, in fiscal year 2006. This program in the 
fiscal year 2004 PB would deliver one tanker to the warfighter in 
fiscal year 2009. The 100th aircraft would be delivered in fiscal year 
2016.
    In contrast, under the negotiated lease, the contractor will 
deliver 60 new tankers to the warfighter by fiscal year 2009, and 
deliver all 100 by fiscal year 2011 which is 5 years sooner than the 
fiscal year 2004 PB procurement program. This plan provides for a 
quicker start to recapitalization of the tankers. To match such a 
recapitalization schedule under a purchase option would require 
billions of additional dollars to be invested during the FYDP as well 
as waivers of various acquisition rules. Since those funds are already 
committed to other uses, there would have to be significant 
restructuring and/or cancellation of ongoing and planned programs.

                         BUSINESS CASE ANALYSIS

    Obviously, cost is a big driver when choosing an acquisition 
strategy. In isolation, a leasing strategy requires additional funds in 
then-year dollars relative to the cost of a traditional purchase. 
Economic considerations, however, are not limited to expected funding 
flows, which ignore the time-value of money. To account for this time-
value of money and gain insight into the economic implications of 
leasing as an acquisition strategy, Office of Management and Budget 
Circular (OMB) A-94 directs a present value comparison between the 
proposed lease and a hypothetical purchase based on the same delivery/
return profile. The financial analysis for the A-94 test is highly 
sensitive to the underlying assumptions such as purchase price, 
expected inflation and appropriate discount rate. Since OMB oversees 
governmental leases, the A-94 analysis, and the defining requirements 
for an operating lease, the Air Force consulted them in developing its 
analytic assumptions. Applying the A-94 test the Air Force determined 
that the net present value of the multiyear lease option and a 
traditional purchase option results in a net present value difference 
favoring a purchase by $150 million--about 1 percent of the total cost. 
These calculations do not take into account any operational savings 
which the lease would permit to accrue sooner.
    The advantages in schedule and reduced impact to currently budgeted 
programs outweighed the results of the A-94 analysis and drove the 
leasing decision. The Air Force and Department of Defense selected 
leasing as the acquisition strategy primarily based on affordability--
by reducing the near-term cost--and minimizing the budgetary impact to 
our plans for getting accelerated capability of the new weapon system 
to our frontline troops.
    Under the lease option, the Air Force can afford to field this new 
fleet of tankers at a quicker pace than under a traditional purchase 
plan. Jumpstarting replacement of the older, less-capable tankers 
enables faster modernization of air expeditionary forces. The lease not 
only advances the first delivery by 3 years, it puts the 100 aircraft 
fleet at the disposal of our frontline commanders for combat operations 
by fiscal year 2011, 5 years ahead of the planned purchase. If we were 
to purchase these aircraft in a traditional buy on the same delivery 
schedule, while maintaining our financial top-line, we would have to 
take billions of dollars out of other important programs.

                          IMPLEMENTATION PLANS

    Under this pilot program, the Air Force intends to lease 100 KC-
767A aircraft with congressional approval of the new start 
notification. The lease program will be sole source, using terms and 
conditions germane to commercial aircraft leases and commercial 
business practices in accordance with the Federal Acquisition 
Regulation and section 8159. Terms and conditions of the lease 
arrangement meet all requirements of the fiscal year 2002 Defense 
Appropriations Act including OMB Circular A-11 criteria for an 
operating lease. Full details of the lease are included in the Report 
to the Congressional Defense Committees.
    This will be a three-party contract between the U.S. Government, 
Boeing Integrated Defense Systems, and a third-party Trust, the KC-767A 
USAF Tanker Statutory Trust. The Trust will issue bonds on the 
commercial market based on the strength of the lease contract with the 
U.S. Government (rather than the credit worthiness of Boeing), will buy 
the aircraft from Boeing, and will lease them to the Government. The 
Trust will not make a profit but will provide for the funds necessary 
to pay bondholders and pay off the debt after the sale of the aircraft. 
Any residual funds acquired from the possible sale of the aircraft 
subsequent to lease termination will be refunded to the Government as 
an overpayment.
    The contract will include ``most favored customer'' clauses stating 
that if Boeing sells comparable aircraft (up to 100) during the term of 
the contract for a lesser price, the Government will receive an 
equitable adjustment. Besides being a fixed-price contract, and to 
further guarantee the taxpayers receive a favorable deal, Boeing has 
agreed to a return-on-sales (ROS) cap of 15 percent, whereby in 2011, 
any ROS in excess of 15 percent in either commercial or military 
manufacturing centers will be returned to the Government. Again, this 
is something unprecedented in military acquisitions.
    It is not unexpected that new ways of doing business might raise 
questions or controversies. There have been several questions with 
respect to this arrangement that I would like to address.
    Analysis of alternatives: As stated earlier, the Air Force was not 
required to conduct an AOA for the KC-767 tanker lease. There is no 
statutory requirement to conduct an AOA. Regulatory requirements for 
AOAs are contained in our DOD instruction, Operation of the Defense 
Acquisition System, which provides for their flexible application. 
Under ``Plan A,'' an AOA was planned to complement the work done under 
the Tanker Requirements Study and the Economics Service Life Study, to 
lead to a traditional purchase beginning with the delivery of one 
aircraft by 2009. However, the operational requirements of the global 
war on terror and the increased demand on the tanker fleet highlighted 
the need to accelerate the recapitalization of this national asset. 
``Plan B,'' this lease program, addressed the critical need the 
Congress and we saw for jump-starting recapitalization and it made good 
business sense.
    In fact, it is not unusual for a major program to not conduct an 
AOA. The GAO has previously stated (NSIAD-94-194), ``Applicable defense 
acquisition regulations allow management discretion in these matters 
for the purpose of minimizing development time and reducing costs.'' 
There is additional precedence for not completing an AOA when either 
the item is a commercial product or there is a low-risk in delivering a 
product that will be militarily useful. The Air Force did not complete 
an AOA for the C-130J program since this was an acquisition of a 
commercial product that had already been marketed to foreign 
customers--similar to the KC-767A tanker. No AOAs were conducted for 
programs such as the KC-10 or the F/A-18 E/F.
    Even though the Air Force did not complete a formal AOA on the KC-
767A, we performed several trade analyses to ensure the KC-767A was the 
right solution to the operational requirements. We looked at 
maintaining the status quo, but we judged the risk too high to not 
begin the recapitalization effort now as a result of September 11, 
increased tanker operations tempo for homeland defense and Operation 
Enduring Freedom, increased operations and support costs and risks of 
an aging fleet (catastrophic/grounding event that would significantly 
erode our ability to meet our mission). We evaluated the feasibility of 
re-engining KC-135Es, but this does not reduce the aging aircraft 
risk--we would still have old aircraft that will need to be 
recapitalized, and the payback of the re-engining cost AND retirement 
savings [if we were allowed to retire 31 KC-135Es] exceeds 11 years. We 
researched using ``stored'' commercial aircraft, but all the aircraft 
had high hours, different engines, required heavy modifications and 
there were insufficient numbers of aircraft available to be cost 
effective. We investigated using a commercial fee-for-service, but 
while this has been successful in Navy training scenarios, it did not 
meet our overall operational requirements. We looked at other 
operational commercial platforms to include an Airbus 330, Boeing 757, 
and Boeing 777. The Airbus 330 had significant technical risk with 
integrating boom technology into the aircraft. The B-757 could not 
carry enough fuel to make it an efficient tanker. The B-777 was too 
large, reducing the airfields where the aircraft could be deployed. 
Finally, we researched the feasibility of building a new tanker from 
the ground up, but this alternative carries a much higher cost and 
developmental risk, and would not be available within the timeframe the 
KC-767As would be delivered. The decision to select Boeing was based on 
Boeing's response to our RFI, including its favorable design, schedule, 
risk factors, and boom technology.

WHY WE NEED TANKERS SO URGENTLY DESPITE THE 2001 ECONOMIC SERVICE LIFE 
 STUDY (ESLS) REPORT THAT INTIMATED THAT THE CURRENT FLEET WOULD LAST 
                               UNTIL 2040

    Much has been made about the ESLS's prediction that we could 
operate the current tanker fleet until 2040. What is rarely mentioned 
is that even the optimistic 2001 study predicted that operations and 
sustainment (O&S) costs would increase 43 percent by 2040 with 15 
percent decrease in availability. The study assumed only 1 percent/year 
cost growth, but even in as little time as 18 months, that figure was 
seen as flawed. The updated report raised that figure to 1.5 percent/
year. The study was based on statistical calculations, but actual depot 
sales rates show much greater increases in O&S costs. There have been 
several studies regarding the aging aircraft.
    1995 Fatigue Life Study: Boeing and the C/KC-135 SPO continued 
their evaluation of the KC-135 expected service life with a fatigue 
analysis in 1995. This analysis indicated that the KC-135R fleet would 
not exhibit significant fatigue damage, in the absence of corrosion or 
widespread fatigue damage, until 70,000 flight hours (66,000 for the 
KC-135E).
    The Air Force and industry debate over the unknown effects of 
corrosion on fatigue life prompted the C/KC-135 SPO to contract with 
Boeing to update the fatigue life to include effects of increased 
stress from corrosion-associated material thinning. Using this combined 
``net-area'' fatigue/corrosion life, the KC-135R service life was 
adjusted to 39,000 flight hours and the KC-135E life was adjusted to 
36,000 hours. Today, the average flight-hour distribution for R models 
is 16,000-17,000 hours, and 17,000-19,000 hours for the E models. An 
Air Force/industry ``Blue Ribbon Panel'' convened in 1996 and 
acknowledged operation of the fleet out to 2040 is achievable, assuming 
aggressive corrosion control. Further analysis would conclude that the 
KC-135 service life is actually limited by age in years, not flight 
hours.
    As early as the Air Mobility Master Plan of 1995, Air Mobility 
Command (AMC) acknowledged corrosion as a ``major factor in the 
continued service life of the KC-135 forces.'' At that time, AMC 
pursued corrosion forecasting technologies and planned on initiating 
replacement of the KC-135 fleet in fiscal year 2007 pending 
verification of the magnitude of the corrosion problem. The 1998 Air 
Mobility Master Plan again noted that corrosion studies were required 
with a notional replacement date of fiscal year 2013. However, as more 
and more of these inspections took place, it was obvious by 2001, that 
our reports may have been overly optimistic. In Air Force studies 
conducted in 2001 we proposed a notional replacement date of fiscal 
year 2010.
    The depot level maintenance cost growth experienced due to the 
aggressive maintenance practices implemented with the Aging Aircraft 
Program caused concern within AMC. The Mobility Master Plan of 2000 
called into question the high cost required to maintain the aging KC-
135 fleet. The plan states, ``The major factor limiting structural life 
is fleet corrosion. Previous studies did not include corrosion as a 
significant factor in the service life, nor did they address increased 
costs and decreased availability that would result from the aggressive 
maintenance practices required to maintain adequate safety margins.'' 
Consequently, previous service life estimates and projected retirement 
dates may be overly optimistic.
    1994-1995 RAND studies: The Air Force contracted RAND to conduct 
aging aircraft studies based on commercial and military aircraft fleets 
in order to determine the feasibility of long-term sustainability of 
the Air Force's aging fleets. RAND completed a series of five studies 
beginning in 1994 and ending in 1999. These studies raised technical 
concerns regarding the 1) viability of retaining commercial aircraft 
past their design lives, 2) viability of retaining Air Force aircraft 
past their design lives, 3) potential maintenance cost growth 
associated with aging aircraft, 4) potential engine cost growth, and 5) 
projection of Air Force fleet-specific Program Depot Maintenance (PDM) 
and engine cost growth through 2022. The results of the studies 
concluded that ``major support challenges may result from corrosion, 
insulation cracking, composite delamination, and other material 
degradation processes for which there are no scientific aging models or 
relevant historical experience. Most important, many of the challenges 
associated with aging material have emerged with little or no warning. 
This raises the concern that a new challenge may suddenly jeopardize an 
entire fleet's flight safety.'' The final study recommended a three-
pronged strategy for maintaining aging aircraft: 1) risk management 
strategy to identify age-related hazards that affect cost and safety 
hazards and develop solutions to reduce their effects, 2) fleet 
contingency strategy to reduce aircraft design and production lead 
times of obsolete replacement parts to minimize fleet-wide failures, 
and 3) mission management strategy to implement acquisition and 
retirement plans that balance fleet ages within mission areas, making 
the Air Force less dependent upon a particular fleet of aging aircraft.
    The Air Force has implemented two out of three prongs of RAND's 
strategy for maintaining aging aircraft. The C/KC-135 SPO's Aging 
Aircraft Program created a risk management strategy by establishing 
major structural repairs and tracking their repair. The SPO also 
developed fleet contingency strategies by contracting with new vendors 
for obsolete parts. The Air Force partially implemented a mission 
management strategy with the acquisition of the KC-10s; however, 90 
percent of the refueling fleet still resides within the KC-135 fleet, 
creating the potential for fleet-wide system failure. At least partial 
recapitalization of the KC-135 fleet is needed to satisfy all of RAND's 
recommendations.
    1996 GAO study: The GAO drafted this report in 1996 to validate Air 
Force actions to preserve its aging tanker fleet and to examine the 
effects of increased demands on the services' air refueling fleets 
after Operation Desert Storm. The study noted that ``the Air Force's 
principal tanker aircraft--the KC-135s--are 30 to 40 years old and, as 
a result, are taking progressively more time and money to maintain and 
operate.'' The results of the study noted, ``Air Mobility Command 
doubts that the KC-135 can be economically operated beyond 2020.'' This 
is the result of projected cost-per-flying-hour increases of 24 percent 
from 1996 to 2001, and historical depot labor hour increases of 36 
percent, and depot flow day (aircraft time spent in depot) increases of 
55 percent from 1991 to 1995. The study recommends recapitalizing the 
air refueling fleet with a ``dual-use replacement aircraft (that) could 
fulfill both airlift and air refueling missions.''

                            NEGOTIATED PRICE

    The Air Force negotiated this agreement at the highest levels 
possible. We employed standard commercial ``best'' business practices 
as we negotiated the deal. We firmly believe that the Air Force price 
is the best price--the best price that can be achieved in the 
commercial market place in the real world. The difference is primarily 
one of assumptions. The Air Force treated the tanker lease as a 
commercial item. The Air Force followed the guidance for buying 
commercial items contained in Federal Acquisition Regulation (FAR) Part 
12. In addition, Section 8159 of the fiscal year 2002 DOD 
Appropriations Act specifically authorized the Air Force to use terms 
and conditions that are customary in non-Government leases. The final 
price is a product of a careful analysis and market research by the Air 
Force and extensive price negotiations with the contractor. We believe 
the Air Force has received a fair and reasonable price under the lease. 
However, we are not relying solely on our price analysis. The lease 
agreement contains most favored customer provisions and a 15-percent 
limitation on the contractor's total return on sale for the tankers. In 
addition, the contractor bears the risk of delivering conforming 
aircraft at a fixed price.
    Also, the aircraft price must be viewed in a larger context. The 
aircraft must meet the performance specifications stated in the 
contract and must have a high [80 percent] operational availability 
rate. The contractor must maintain the aircraft to the specifications 
and the high (80 percent) availability rate throughout the term of the 
lease.
    In contrast, the study conducted by IDA used a different basis of 
estimate; they looked at the manufacturing process used, associated 
development costs, risk management, and contract type. Nonetheless, the 
Air Force capitalized on much of the additional information derived 
through the review by the Office of the Secretary of Defense in our 
final negotiations.

                         PROGRAMMED RETIREMENTS

    Our plan to retire 68 KC-135Es in fiscal year 2004 will increase 
fleet utilization by freeing money and personnel that would be required 
for maintaining KC-135Es that could be used on KC-135Rs. This is true 
even if we do not lease the 767. This retirement of 13 percent of the 
fleet would result in only 4 to 5 percent decrease in average sortie 
generation. If we only retire 12 aircraft in fiscal year 2004 versus 
going with the original 68-reduction plan, we would need approximately 
$40 million fiscal year 2004 dollars to cover the additional costs of 
keeping the Es around. This is based on 3 additional programmed depot 
maintenance requirements at approximately $8 million a piece and 13 
additional engine overhaul requirements at $962,000 a piece. 
Additionally, we will need to replace $75 million in funds offset in 
fiscal year 2004 to divest 44 tankers. This includes flying hours and 
military personnel costs. The total bill in summary: added depot 
purchased equipment maintenance costs plus fiscal year 2004 offset, $40 
million + $75 million = $115 million. The ``retire 12 in fiscal year 
2004'' plan has no monetary impact on the ``68-reduction'' plan in 
fiscal year 2005 and fiscal year 2006, assuming that we use fiscal year 
2005 to ``catch up'' on aircraft retirements, but may require some 
operational workaround to account for the rapid retirement.

                               CONCLUSION

    I want to thank the committee for allowing the Air Force to share 
its concerns about the need for a new tanker. I believe the KC-767A 
Multi-Year Aircraft Lease Pilot Program offers us the opportunity to 
jumpstart recapitalization of our aging KC-135 tankers. Recent events 
and increased requirements to support homeland defense have spotlighted 
our reliance on these critical refueling assets. Tanker dependence in 
recent wars and the advanced age of the Nation's air refueling aircraft 
fleet drive the Air Force's urgency to begin recapitalization as soon 
as possible. The KC-767A supports the requirements for our next 
generation tanker aircraft. The negotiated lease proposal would provide 
for the delivery of 60 aircraft within the FYDP and field the 100th 
aircraft by 2011, 5 years faster than current purchase plans. This 
minimizes near-term budgetary impact to other important programs.
    I fully support this leasing alternative to provide the warfighters 
with new equipment as quickly as possible. This leasing program 
supports the Air Force's essential mission requirements that support 
the defense of America.
    I appreciate the support provided by Congress and look forward to 
working with this committee to best satisfy our warfighter needs in the 
future. Thank you for the opportunity to provide this statement for the 
record.

    Chairman Warner. Secretary Wynne.

 STATEMENT OF HON. MICHAEL W. WYNNE, ACTING UNDER SECRETARY OF 
       DEFENSE FOR ACQUISITION, TECHNOLOGY, AND LOGISTICS

    Secretary Wynne. Mr. Chairman, Senator Levin, members of 
the committee: I am pleased to come before you today to talk 
about the Air Force's new start request to lease 100 KC-767 air 
refueling tanker aircraft. There is consensus within the 
Department that we must start recapitalizing the airborne 
tanker fleet as soon as possible. It is a vital component to 
our defense capability and it is aging badly.
    Re-engining the KC-135E aircraft may not be sufficient to 
extend their service life. Options included an aircraft 
incorporating a new design or a variant of an existing 
aircraft. An aircraft based on a new design would cost the 
Department research and development funds and some estimates 
are that such a new aircraft would cost in the range of $200 
million to $250 million a unit, while the planned commercial 
derivative, if it was available at the time, was estimated to 
cost between $150 million to $161 million.
    There are only four suppliers that I consider as capable to 
develop and produce such a tanker aircraft. That would be 
Boeing, Lockheed Martin, European Air Defense Systems, and the 
Russians. Only three currently produce wide-body aircraft.
    The Department's plan in the President's fiscal year 2004 
budget was to begin a tanker development program or commercial 
derivative in fiscal year 2006, with the first tanker delivery 
targeted for fiscal year 2009. However, when Congress gave us 
the opportunity in this pilot program authority to lease, this 
allowed the Department to aggressively pursue the tanker 
version of the 767 aircraft, an option which might not have 
been available in the fiscal year 2006 should Boeing have been 
unable to maintain the commercial production line due to no 
current market.
    On its face, this is clearly a less expensive alternative 
than new development. It has far less cost risk than waiting 
until fiscal year 2006 when the same commercial opportunity 
might no longer exist.
    The Air Force proposed leasing tankers and brought their 
proposal to the Leasing Review Panel, which compared the merits 
and shortcomings of both leasing and purchasing KC-767 
aircraft. Based on input from the co-chairs of this panel, 
Under Secretary Aldridge and Under Secretary Zakheim, the 
Secretary has determined that the lease option best met the 
needs of the Air Force and was preferable because leasing 
minimizes the near-term cost to the Department of Defense and 
delivers these aircraft sooner, gaining those benefits.
    If we were to purchase the aircraft and Boeing were to 
deliver them on the same schedule as it will under the lease, 
it would require billions of dollars more in the FYDP. As we 
have pursued a goal of stability in programs and that was 
fostered by our goals that we set out in the acquisitions, 
technology, and logistics (AT&L), such a reallocation would 
have been counter to our goals and disrupted many ongoing 
programs, barring further appropriation of needed funds.
    While the proposed lease will provide for delivery of a 
total of 100 KC-767s, approximately 60 of which will be 
delivered in the period covered by our Fiscal Year Defense 
Plan, fiscal year 2005 to 2009, the Department does intend to 
go further and recapitalize the airborne tanker fleet. The Air 
Force has thus been directed to develop a long-range 
recapitalization plan beyond the current lease proposal, and we 
will address that plan in the President's fiscal year 2006 
budget.
    At my request, the Department of Defense Inspector General 
(DODIG) has recently completed an evaluation of the process by 
which the Department arrived at the decision to lease tankers 
from Boeing. The results of this evaluation frankly have 
provided insight as to how to strengthen the leasing panel's 
deliberation. During a review, the DODIG indicated there were 
no impediments that they were currently aware of to entering 
this lease agreement. I intend to carefully consider all the 
recommendations from this report as future lease opportunities 
come before this panel.
    I do recall in the mid-1970s the lease of maritime 
prepositioning ships that your staff may go see. They are still 
on station. It was a long-term, 25-year lease, as I recall, to 
build, operate, and charter. It is a dim memory of mine, 
because I happened to be with the corporation that did that, 
but you might look into that, sir.
    Chairman Warner. I remember the precedent quite well.
    Secretary Wynne. Thank you, Mr. Chairman, for the 
opportunity to testify before this committee. I urge this 
committee to approve this lease and the replacement plan it 
represents. I stand ready to answer any questions that you and 
the members of the committee might have.
    Thank you, sir.
    [The prepared statement of Secretary Wynne follows:]

              Prepared Statement by Hon. Michael W. Wynne

    Mr. Chairman and members of the committee, I am pleased to come 
before you today to talk about the Air Force's new start request to 
lease 100 KC-767 air refueling tanker aircraft.
    On May 23, the Department announced the Secretary's decision to 
approve the Air Force's proposal to enter into a multi-year pilot 
program for leasing general purpose Boeing 767 tanker aircraft.
    There is consensus within the Department that we must start 
recapitalizing the airborne tanker fleet as soon as possible, and that 
re-engining the KC-135E aircraft may not be sufficient to extend their 
service life. Options included an aircraft incorporating a new design, 
or a variant of an existing aircraft. An aircraft based on a new design 
would cost the Department research and development funds and some 
estimates are that such a new aircraft would cost in the range of $200-
$250 million per unit, while the planned commercial derivative, if it 
was available, was estimated to cost between $150-$161 million.
    There are only four suppliers who could develop and produce such a 
tanker aircraft--Boeing, Lockheed Martin, EADS, and the Russians--and 
only three currently produce wide-body aircraft. The Department's plan, 
in the President's fiscal year 2004 budget, was to begin the tanker 
development program--a commercial derivative--in fiscal year 2006, with 
the first tanker delivery targeted for fiscal year 2009. However, when 
Congress gave us pilot program authority to lease, this allowed the 
Department to aggressively pursue the tanker version of the 767 
aircraft, an option which might not have been available in fiscal year 
2006 if Boeing had shut down the commercial production line. On its 
face, this is clearly a less expensive alternative than new 
development. It also has far less cost risk than waiting until fiscal 
year 2006 when the same commercial opportunity might no longer exist.
    The Air Force proposed leasing tankers and brought their proposal 
to the Leasing Review Panel, which compared the merits and shortcomings 
of both leasing and purchasing KC-767 aircraft, given the 767 line 
remained open for both leasing and purchasing. Based on input from the 
co-chairs of this panel, Under Secretary Aldridge and Under Secretary 
Zakheim, the Secretary determined that the lease option best met the 
needs of the Air Force and was preferable because leasing minimizes the 
near-term cost to the Department of Defense and delivers the aircraft 
sooner. If we were to purchase the aircraft and Boeing were to deliver 
them on the same schedule as it will under the lease, it would require 
billions of dollars more in the Future Years Defense Program (FYDP). As 
we have pursued a goal of stability in programs, such a reallocation 
would have been counter to that goal, and disrupted many ongoing 
programs.
    On July 10, the Secretary of the Air Force notified the Defense 
Committees of the Department's intent to lease 100 Boeing 767 aircraft 
under the Multi-year Aircraft Lease Pilot Program and provided a report 
on tanker leasing to those committees, in accordance with section 8159 
of the Department of Defense Appropriations Act, 2002. Section 8159 
requires the Air Force to wait at least 30 calendar days after it 
submits the report before entering into the lease contract.
    On July 11, the Air Force provided to the Defense Committees and to 
the Appropriations Committees a new-start notification associated with 
the proposed lease of 100 KC-767 air refueling tankers. As the Air 
Force has noted in both cover letters for the report and this 
notification, it is the Department's intention not to award a contract 
until the Defense Committees of Congress indicate that they concur with 
the Department's plans as set forth in the notification. To assist the 
Defense Committees in their review of the lease proposal, the 
Department has supplied all four committees with draft versions of the 
contract with Boeing. Thus far, the House and Senate Defense 
Appropriations Subcommittees and the House Armed Services Committee 
have indicated to us that they concur.
    While the proposed lease will provide for delivery of a total of 
100 KC-767 aircraft, approximately 60 of which will be delivered in the 
period covered by the FYDP, the Department intends to recapitalize the 
airborne tanker fleet. The Air Force has been directed to develop a 
long-range recapitalization plan beyond the current lease proposal and 
we will address that plan in the President's fiscal year 2006 budget.
    At my request, the DOD Inspector General has recently completed an 
evaluation of the process by which the Department arrived at the 
decision to lease tankers from Boeing. The results of this evaluation 
provide insight into the decisionmaking process conducted by the 
Leasing Review Panel.
    Thank you, Mr. Chairman, for the opportunity to testify before the 
committee. I would be happy to answer any questions that you and the 
members of the committee may have.

    Chairman Warner. Thank you very much.
    Mr. Kaplan, we welcome you.
    Mr. Kaplan. Thank you, Mr. Chairman.
    Chairman Warner. This is your first appearance?
    Mr. Kaplan. Other than my confirmation hearing, yes, sir, 
Mr. Chairman.
    Chairman Warner. You are on your own. [Laughter.]
    Mr. Kaplan. I appreciate that.
    Senator Levin. Unlike your confirmation hearing, by the 
way.
    Mr. Kaplan. It felt like I was on my own there too, 
Senator. [Laughter.]

    STATEMENT OF JOEL D. KAPLAN, DEPUTY DIRECTOR, OFFICE OF 
                     MANAGEMENT AND BUDGET

    Mr. Kaplan. Thank you, Mr. Chairman and members of the 
committee. I am pleased to be here today to discuss the Air 
Force's planned lease of Boeing KC-767A refueling aircraft. I 
will make a brief statement describing OMB's role in the 
process that led to the decision to approve the lease proposal, 
and I will be happy to answer any questions you may have.
    As with all lease proposals, OMB reviewed the terms of the 
lease as they were developed by the Air Force. OMB's role in 
such transactions is to ensure that our warfighters have the 
resources they need, while maintaining fiscal discipline to 
protect the taxpayer.
    Both the Secretary of the Air Force and the Office of the 
Secretary of Defense convincingly argued that a modernized 
tanker fleet made available on an expedited basis was and 
remains essential to ensure that our military is adequately 
supported in the war on terror and other critical missions. The 
facts supporting the military necessity for the lease are 
discussed at length in the Air Force's report to Congress and 
in Secretary Roche's testimony before you. I will not repeat 
those facts in detail, but simply highlight the Air Force's 
strong belief in the urgent need to recapitalize its aging 
tanker fleet.
    The arguments in support of the need for new tankers may 
also have informed Congress's judgment in enacting section 8159 
of the Fiscal Year 2002 Defense Appropriations Act. In section 
8159, Congress expressly authorized the Air Force to lease 
Boeing 767 aircraft for these purposes.
    Shortly thereafter, the Air Force proposed a tanker lease 
that was extensively reviewed both by OMB and within the 
Department of Defense. OMB's unflagging focus during nearly 2 
years of review and negotiation was to ensure that the Air 
Force entered into the most advantageous deal possible under 
the circumstances.
    The tanker lease proposal was not without its challenges. 
The Air Force presented an exceedingly complex lease proposal 
that raised many unique issues. During the review process and 
pursuant to its longstanding institutional responsibilities, 
OMB posed a number of tough questions regarding the need for 
the aircraft, the business case supporting the lease proposal, 
and the aircraft price.
    Of all these issues, from OMB's perspective ensuring that 
the price represents the best value for the taxpayer was 
paramount. As a result, OMB was aggressive in working to hold 
down costs while preserving capabilities. Early on, OMB was 
concerned that the initial price of the tanker aircraft was too 
high and believed that through negotiation with Boeing the Air 
Force should and could reduce the price. By the time 
negotiations were concluded, the aircraft price had dropped 
from an early estimate of $150 million to a final price of $131 
million. Reducing the price per plane $20 million achieved $2 
billion in savings for the taxpayer.
    The committee has requested that I address the decisions to 
proceed with a lease instead of purchase and to classify the 
lease as an operating lease. Both of these issues were 
challenging, involving subjective judgments on difficult 
analytical questions. Under our Circular A-94, OMB requires a 
lease versus purchase analysis for any agency proposing a lease 
and the results are an important part of our decision-making 
process.
    OMB worked closely over many months with the Air Force to 
understand its business case supporting the lease proposal and 
the give and take of these discussions resulted in significant 
improvements to the Air Force's model. While OMB and the Air 
Force agreed that leasing in present value terms is a higher 
cost option than purchase, the magnitude of the difference 
varies depending on certain assumptions. The Air Force 
estimates that the net present value of the lease proposal is 
$150 million more than a purchase. However, the Air Force 
report to Congress also states that the difference between the 
net present value of the lease and purchase could be as high as 
$1.9 billion depending on a variety of complex assumptions.
    The administration decided to approve the lease 
understanding this range of financial costs in order to satisfy 
an important military requirement in the post-September 11 
world. Leasing these aircraft will result in delivery of 60 new 
767 tanker aircraft by 2009. There is no question that without 
a substantial reallocation of resources that would have a 
negative impact on other programs critical to national 
security, direct purchase would take much longer to acquire for 
the Air Force the same number of aircraft.
    Determining whether the proposed lease qualifies as an 
operating lease under OMB Circular A-11 also raised difficult 
analytical questions. Of necessity, the assessment of whether 
or not a lease is an operating lease under A-11 is based on 
estimates and assumptions that can be subject to honest 
disagreement. Some of the A-11 criteria contain considerable 
ambiguity. As a result, capable and impartial analysts applying 
those criteria to the same information may reach different 
conclusions about whether a lease is a capital lease or an 
operating one, especially when the proposal is right at the 
margin.
    In light of the Air Force's conviction that these planes 
are needed to meet an urgent military need and in light of 
clear congressional intent to support a lease as expressed in 
legislation, OMB believed it appropriate to resolve ambiguities 
in favor of classifying this transaction as an operating lease.
    Throughout its review process, OMB repeatedly questioned 
numerous aspects of the deal in order to press the Air Force to 
complete the best possible deal for the taxpayers. In addition 
to helping the Air Force to negotiate the price down, OMB, 
together with the Office of the Secretary of Defense, also 
raised concerns about other aspects of the proposed contract, 
including operational restrictions and the lack of adequate 
liability protection. As a result, the Air Force went back to 
the negotiating table and improved these contractual provisions 
to the benefit of the military and the taxpayers.
    OMB believes that the lease proposal satisfies Congress's 
intent in enacting the legislation authorizing this lease and 
represents the best achievable lease. Over the next few months, 
we will work with the Department to ensure that the funds 
required for the lease are included in the Air Force's fiscal 
year 2005 budget and their future plans.
    Thank you, Mr. Chairman, for the opportunity to testify on 
this important issue. I will be happy to answer any questions 
you and the members of the committee may have.
    [The prepared statement of Mr. Kaplan follows:]

                  Prepared Statement by Joel D. Kaplan

    Thank you, Mr. Chairman and members of the committee. I am pleased 
to be here today to discuss OMB's role in reviewing the Air Force's 
planned lease of Boeing KC-767A refueling aircraft. Although I was not 
at OMB at the time the decision to proceed with the tanker lease was 
made, I will make a brief statement describing OMB's role in that 
process and I will be happy to answer any questions you may have.
    As with all lease proposals, OMB reviewed the terms of the lease as 
they were developed by the Air Force. OMB's role in such transactions 
is to ensure that our fighting men and women have the resources they 
need, while maintaining fiscal discipline to protect the taxpayer. Both 
the Secretary of the Air Force and the Office of the Secretary of 
Defense convincingly argued that a modernized tanker fleet, made 
available on an expedited basis, was and remains essential to ensure 
that our military is adequately supported in the war on terrorism and 
other critical missions.
    The facts supporting the military necessity for the lease are 
discussed at length in the Air Force's report to Congress on the lease 
proposal of July 10, 2003, and in Secretary Roche's testimony before 
you today. I will not repeat those facts in detail, but simply 
highlight the Air Force's strong conviction about the urgent need to 
recapitalize the aging tanker fleet. The arguments in support of the 
need for new tankers may also have informed the debate in Congress at 
the time section 8159 of the Fiscal Year 2002 Defense Appropriations 
Act was enacted. In section 8159, Congress expressly authorized the Air 
Force to lease Boeing 767 aircraft.
    Shortly thereafter, the Air Force proposed a tanker lease that was 
extensively reviewed both by OMB and within the Department of Defense. 
OMB's unflagging focus during nearly 2 years of review and negotiation 
was to ensure that the Air Force entered into the most advantageous 
deal possible under the circumstances. The tanker lease proposal was 
not without its challenges: the Air Force presented an exceedingly 
complex lease proposal that raised many unique issues. During the 
review process, and pursuant to its long-standing institutional 
responsibilities, OMB posed a number of questions regarding the need 
for this aircraft; the business case supporting a lease proposal; and 
the aircraft price.
    Of all these issues, from OMB's perspective, ensuring that the 
price represented the best value for the taxpayer was paramount. As a 
result, OMB was aggressive in working to hold down costs while 
preserving capabilities. Early on, OMB was concerned that the initial 
price of the tanker aircraft was too high, and believed that, through 
negotiation with Boeing, the Air Force should and could reduce the 
price. By the time negotiations were concluded, the aircraft price had 
dropped from an early estimate of $150 million to a final price of $131 
million. Reducing the price per plane by $20 million achieved $2 
billion in savings for the taxpayer.
    The committee has requested that I address the decisions to proceed 
with a lease instead of a purchase and to classify the lease as an 
operating lease. Both of these issues were challenging, involving 
subjective judgments on difficult analytical questions. Under our 
Circular A-94, OMB requires a lease vs. purchase analysis from any 
agency proposing a lease, and the results are an important part of our 
decisionmaking process. OMB worked closely over many months with the 
Air Force to understand its business case supporting the lease 
proposal, and the give and take of these discussions resulted in 
significant improvements to the Air Force's model. While OMB and the 
Air Force agreed that leasing, in present value terms, is a higher cost 
option than purchase, the magnitude of the difference varies depending 
on certain assumptions. The Air Force estimates that the net present 
value of the lease proposal is $150 million more than a purchase. 
However, the Air Force's Report to Congress also states that the 
difference between the net present value of lease and purchase could be 
as high as $1.9 billion, depending on a variety of complex assumptions. 
The administration decided to approve the lease understanding this 
range of financial costs in order to satisfy an important military 
requirement in the post-September 11 world: leasing these aircraft will 
result in delivery of 60 new 767 tanker aircraft by 2009. There is no 
question that without a substantial reallocation of resources that 
would have a negative impact on other programs critical to national 
security, direct purchase would take much longer to acquire the same 
number of aircraft.
    Determining whether the proposed lease qualifies as an ``operating 
lease'' under OMB Circular A-11 also raised difficult analytical 
questions. Of necessity, the assessment of whether or not a lease is an 
operating lease under Circular A-11 is based on estimates and 
assumptions that can be subject to honest disagreement. Some of the A-
11 criteria contained considerable ambiguity. As a result, capable and 
impartial analysts applying those criteria to the same information may 
reach different conclusions about whether a lease is a capital lease or 
an operating one, especially when the proposal is right at the margin. 
In light of the Air Force's conviction that these planes are needed to 
meet an urgent military need, and in light of clear Congressional 
intent to support a lease, as expressed in legislation, OMB believed it 
appropriate to resolve ambiguities in favor of classifying this 
transaction as an operating lease.
    Throughout its review process, OMB repeatedly questioned numerous 
aspects of the deal in order to press the Air Force to complete the 
best possible deal for the taxpayers. In addition to helping the Air 
Force to negotiate the price down, OMB, together with the Office of the 
Secretary of Defense, also raised concerns about other aspects of the 
contract, including operational restrictions and the lack of adequate 
liability protection. As a result, the Air Force went back to the 
negotiating table, and improved these contractual provisions to the 
benefit of the military and the taxpayers. OMB believes that the lease 
proposal satisfies Congress' intent in enacting the legislation 
authorizing this lease, and represents the best possible lease under 
the circumstances. Over the next few months, we will work with the 
Department to ensure that the funds required for the lease are included 
in the Air Force's fiscal year 2005 budget and their future plans.
    Thank you, Mr. Chairman, for the opportunity to testify on this 
important issue. I would be happy to answer any questions you and the 
members of the committee may have.

    Chairman Warner. Thank you. We will proceed to a 6-minute 
round of questions.
    Secretary Roche, this committee and indeed Congress would 
never want to ask any uniformed member of the Armed Forces to 
take risks as a consequence of aging equipment, such risks 
being over and above the normal risks that they all take every 
day, whether it is the takeoff or the landing of a brand-new 
airplane or an old one. You have in this room as I understand 
it several who have experienced the problems with these 
aircraft. Could you just summarize the anecdotal evidence that 
you present to this committee that it is imperative that we 
not, I presume the word would be, continue to require these air 
crews to take risks associated with aging equipment?
    Secretary Roche. Mr. Chairman, thank you. We would never 
ask any pilot or crew to go on an aircraft that ought not to be 
flown. The concern is not so much the risk that they would have 
been flying. It is the risk of the fleet being grounded or not 
being available to be used in a particular operation.
    As of today, not counting the aircraft that are in depot, 
of the 135 fleet, roughly 78 percent are ready to be used or a 
third is not ready to be used. If you count the aircraft that 
are in depot, it is something like 35 percent are not 
available.
    The concern is when you have airplanes that are as old as 
they are, we do not know how they will fail. We worry about a 
major class problem which would cause us to ground the entire 
force because we do not know how they are going to behave as 
they get older. We have been surprised on a number of 
occasions.
    The issue, as we propose it, is to have sufficient number 
of newer aircraft to be able to hedge against that happening. 
If we had 100 new airplanes and the 59 KC-10s, which are only 
about 18 years old now, that 159 number is a dramatic hedge in 
any particular scenario to be able to make sure we could 
satisfy the requirements of the deployed forces as well as 
aircraft overhead.
    I have been on a KC-135E and had two of the three 
generators go out over the Atlantic, and it gets a little dicey 
looking for divert fields in Canada. A second generator came 
on, we were fine. Another time, 2 hours west of Honolulu, we 
lost all hydraulics on one side of the aircraft, which when we 
understood the plane was so old that the hydraulics are really 
boosting cables, you can fly without hydraulics on one side of 
the airplane, and we went from island to island until we could 
get to Okinawa and have an emergency landing.
    So it is a third of the time these planes are unavailable.
    Chairman Warner. An Air Force economic service life study, 
ESLS, of KC-135 tanker aircraft in February 2001 stated that 
the tanker fleet was structurally viable to 2040 and there was 
no urgent need to replace the KC-135s. Now, what has changed? I 
presume that this was a well thought through report.
    Secretary Roche. In fact, Mr. Chairman, as we look back on 
that report, we would not have submitted it. It used old data 
and it just compared the rising costs to maintain as compared 
to the budget allocation for maintenance. When we took a look 
at that in 2003, the costs assumed to have been in place in 
2003 in fact were much higher.
    What it did not take a look at was what were the conditions 
of the aircraft in the depot, what was the condition of the 
corrosion factor.
    Chairman Warner. So you think this, frankly----
    Secretary Roche. It was a faulty study.
    Chairman Warner. A faulty study?
    Secretary Roche. Yes, sir.
    Chairman Warner. Now, Secretary Wynne and perhaps Mr. 
Kaplan, I am sure you are aware of the cost analysis conducted 
by the CBO which estimates that a lease of these 100 767s would 
be over $5 billion more expensive than outright purchase in 
then-year dollars. In the DOD analysis, what was the estimate 
of the cost of the lease versus purchase in then-year dollars?
    Secretary Wynne. I do not think I have a disagreement in 
then-year dollars, sir. I think I have a disagreement as to 
whether we should use then-year dollars in comparison. The 
better comparison on any financial arrangement is net present 
value, and that comes out to be, it ranges between $100 million 
and $150 million----
    Chairman Warner. Is the CBO estimate accurate in your view, 
or are they just using different----
    Secretary Wynne. I have not reviewed their thing to 
comment. I can take that for the record.
    Chairman Warner. Hey, wait a minute. You have not reviewed 
the CBO report?
    Secretary Wynne. I have not looked at it in depth, sir. I 
just have looked at it in very surface amount.
    Chairman Warner. I find that somewhat disturbing, that you 
have not in your preparation looked at it, because it is a 
valuable contribution. We will get testimony on it later.
    Do you have any comment on that, Mr. Kaplan?
    Mr. Kaplan. Yes, Mr. Chairman, I have had an opportunity to 
review the CBO analysis. There are significant differences in 
OMB's analytical approach. There are not ultimately significant 
differences in the fact that everyone I think who has looked at 
this lease ultimately concluded, which is that the lease option 
is more expensive in both then-year dollars terms and in terms 
of net present value.
    The Air Force's discussion in its submission to Congress 
did conclude that there was a range, as I said in my testimony, 
of between $150 million and $1.9 billion, I believe, in net 
present value. Net present value is the criterion that our OMB 
Circular requires us to use.
    Chairman Warner. Secretary Roche, having had some 
experience in a military department as you have had, and you 
have been a student of Congress and this committee for many 
years, you have professionally had a long association, what is 
your understanding of why your predecessors, be they civilian 
or uniformed, did not address this question in the depth and 
with the conviction that you have addressed it to push the 
situation towards what I view as a most extraordinary exception 
to the way we do business, Congress and the Department of 
Defense?
    Secretary Roche. Mr. Chairman, the only conclusion I can 
come to is that, given the procurement holiday and given the 
low budgets of the 1990s, there were so many other priorities 
that the sense was that tankers were not that important.
    Second, the planning models that were used assumed two 
major conflicts and you plan for those, and I think when they 
looked at that they felt they had enough excess capacity in the 
tanker force, as compared to looking at the reality of how we 
were using AWACS, et cetera, in various contingencies. In July 
2001, we could not have predicted a war in Afghanistan and a 
war in Iraq that would have required us to go to battle in 
landlocked areas, or that our tanker fleet would be used more 
than half the time by non-Air Force aircraft, by Navy and 
Marine Corps aircraft and coalition partners.
    Chairman Warner. Those are operational studies. I have to 
presume that in the vast number of studies conducted by the 
Department, we had this two major and one minor that somebody 
addressed.
    But my last question to you is a very simple one, and that 
is the magnitude of the added costs being thrust on the 
taxpayers by this proposal prompts me to ask: Did you look at, 
say, an emergency buy with a lease along these lines of, say, 
25 aircraft of the 100 aircraft, thereby giving time for the 
traditional process of a budget submission by the President 
and, if necessary, a decision by the Secretary of Defense to 
create a wedge for the Department of the Air Force to handle 
this situation?
    Secretary Roche. Mr. Chairman, we did not look at 5, 25, or 
50. We looked at the buy of 100 after Congress had passed the 
bill that said we had the authority to try to lease 100. So we 
used that number.
    Chairman Warner. Did you feel that that legislation bound 
you?
    Secretary Roche. No, sir, no, it did not. It just gave us a 
point. We talked about looking at 50 at some point and then 
just stuck to the 100 number because it was a good comparison 
and a full 100 plus the 59 gave us a full hedge.
    The issue was that the up-front budget authority was simply 
not available and we did not think it would become available. 
There were also procurement rules, like the color of money that 
was used for development versus production.
    Chairman Warner. Let me ask you quickly: Is it a viable 
option? Even though you seized the 100 and Congress may have in 
the course of the language put in two bills--and I acknowledge 
clearly that Congress in a sense, the full Senate, has acted on 
the appropriation and indeed the insertion in the 
authorization. I take notice of that.
    Secretary Roche. Mr. Chairman, you would be a better 
authority than I would as to whether Congress could in fact 
give us $5 to $11 billion more over the next 5 years just for 
tankers. We were trying to put this in our budget over a longer 
period when we in fact could handle the costs of the lease 
because our existing expenses for things like C-17 would come 
down.
    Chairman Warner. I am going beyond my time, but Congress 
has to react to the budget request by the President. Initially 
the President has to make the decision whether he wants this 
wedge for the Department of the Air Force. Then it is up to 
Congress to decide.
    Senator Levin.
    Senator Levin. The CBO has concluded that the use of long-
term leases reduces the ability of our budgets to depict the 
government's financial commitments; undermines fiscal 
discipline by circumventing controls, including the limits on 
deficits and caps on discretionary spending; and allows 
agencies to avoid facing the full costs of their purchasing 
decisions.
    As a matter of fact, the Air Force has stated that the 
dominant reason for the lease approach is that it enables the 
Department to enable tanker aircraft without requiring 
significant up-front funding. So the added costs here that 
exist are just delayed, put on the backs of future budgets.
    I am wondering, Mr. Kaplan, whether or not you agree or 
disagree with the CBO's conclusion that the use of long-term 
leases has the effect of weakening fiscal discipline by pushing 
costs off into outyear budgets?
    Mr. Kaplan. Senator, I think it is fair to say that OMB 
shares CBO's institutional skepticism when presented with an 
individual lease proposal and, for that matter, whether lease 
proposals across the board would be the right way to go. I 
think that skepticism is evident in Director Daniels' 
correspondence, and his review of the lease. I think the 
process that the Air Force and OMB and the Department of 
Defense and, for that matter, Congress has undergone for almost 
2 years now in review of this lease suggests that this is not 
the normal course of events, that this is a unique proposal 
that we are looking at in light of unique requirements 
identified and recognized more clearly post-September 11.
    Senator Levin. Why not lease other DOD assets if we are 
going to lease these tankers? There are a lot of other 
requirements that are unmet. We have a whole long list of unmet 
requirements. Why not use this then as a precedent to lease 
cargo ships or cargo aircraft or Navy ships or Army combat 
vehicles? We have a lot of unmet requirements.
    Mr. Kaplan. We do and the President's budget that he 
submitted to Congress and so far has received the support of 
Congress I think has gone a long way towards meeting those 
requirements. Those requirements have significantly increased, 
obviously, post-September 11.
    Senator Levin. My question is what is different about this? 
We have a lot of unmet requirements.
    Mr. Kaplan. We are trying to meet all of those 
requirements.
    Senator Levin. But we are not.
    Mr. Kaplan. Well, but this lease proposal gives us an 
opportunity within the FYDP to meet those requirements and meet 
this requirement. Some of the alternative proposals that have 
been mentioned here today--purchasing, for instance, on the 
same delivery schedule--would make it that much more difficult 
to meet those requirements.
    Senator Levin. This proposal pushes the cost beyond the 
future years, the FYDP.
    Mr. Kaplan. It does push some of the costs beyond----
    Senator Levin. A major part of the costs.
    Mr. Kaplan. A major part of the cost, that is true, 
Senator.
    Senator Levin. You are not answering my question, it seems 
to me. We have a lot of unmet requirements. Why not meet those 
in the same way through a lease? Those are requirements, they 
are unmet, they are significant, and we are not meeting them.
    Mr. Kaplan. I think our practice, Senator, is we are going 
to try to meet as many of those requirements as possible 
through the procurement process. After Congress authorized us 
to consider the lease proposal in this individual circumstance, 
the Air Force developed a proposal. In light of the needs and 
in light of our unwillingness to do a substantial reallocation 
that would preclude us from meeting some of those important 
needs, we thought this was an acceptable way to go for this 
lease.
    Senator Levin. Okay, thank you.
    Secretary Roche, you indicated that the study which was 
referred to by the chairman, which was a 2001 study I believe, 
showing that the tankers would be viable through the year 2040, 
was not a good study?
    Secretary Roche. Sir, I thought it was not based on a 
sufficient amount of data. Some of the aircraft will last that 
long.
    Senator Levin. My question is this: Why not conduct another 
comprehensive study, then, to substitute for that? You have not 
done that, right?
    Secretary Roche. In the course of coming together on this 
lease, we have looked at a number of things, including prior 
corrosion studies, and also we have reexamined the costs and 
projected additional trends.
    Senator Levin. Have you made another comprehensive study to 
substitute for that one?
    Secretary Roche. That was not a comprehensive--we have, 
yes, done modifications of that we can clearly give you, sir.
    Senator Levin. All right, so you have done a study which is 
as comprehensive as the one you disagree with?
    Secretary Roche. I would think, yes, sir. I think yes, it 
is.
    Senator Levin. Thank you. Please send us those subsequent 
studies then, if you would, that you say are just as 
comprehensive.
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    Senator Levin. You say in your testimony that: ``By 2000, 
32 percent of the KC-135 fleet, a significant portion of this 
Nation's overall Air Force refueling capability, was 
unavailable due to program depot level maintenance and this 
reduced the refueling capability of our warfighters and caused 
a backlog at the depot facilities, as the average number of 
days in depot-level maintenance peaked at over 400 days.'' That 
is your testimony.
    Secretary Roche. Yes.
    Senator Levin. You used 2000 instead of the current depot 
level maintenance period. Why did you go back to 2000, since 
that period is now significantly better than it was in 2000?
    Secretary Roche. The 2000 number was used, as I recall, 
Senator, because that was comparable to the prior work, the 
2001 study which used data around that time. Subsequent to 
that, the depots have become far more efficient. We move things 
through. But the amount of the work package that goes to each 
135 is still increasing.
    Senator Levin. Is it true that in a number of ways there 
have been improvements since 2000? Let me just read to you some 
of those ways. The number of KC-135s in the depot now stands at 
91, which is down from 171 aircraft 3 years ago; is that true?
    Secretary Roche. Yes, it is.
    Senator Levin. Is it true that the number of KC-135 
aircraft are now spending roughly 200 days in the depot on the 
average, down from approximately 400, the figure that you used?
    Secretary Roche. Yes, it is.
    Senator Levin. Is it true that now the aircraft are 
requiring roughly 31,000 man-hours of work in depot, down from 
a peak of 36,000 man-hours in 1999?
    Secretary Roche. Yes, sir. It is a tribute to the depot, 
not to the aging of the aircraft.
    Senator Levin. All right. Is it true that the mission-
capable rates for the fleet have risen from slightly less than 
71 percent in 2000 to more than 79 percent now?
    Secretary Roche. Those numbers differ, sir, in terms of 
which models. It is roughly 78 percent.
    Senator Levin. I mean the total.
    Secretary Roche. The standard is higher.
    Senator Levin. I talk about the total fleet there.
    Secretary Roche. The total 135 fleet.
    Senator Levin. Right; is it true that the mission-capable 
rate for the total fleet has risen from slightly less than 71 
percent in 2000 to more than 79 percent now?
    Secretary Roche. It is not 79. I think it is like 78. But 
it has risen, and one of the reasons is a lot of spare parts 
have been made available.
    Senator Levin. Thank you.
    My time is up. Thank you.
    Chairman Warner. Senator McCain.
    Senator McCain. Thank you, Mr. Chairman.
    I want to repeat again, no analysis of alternatives was 
conducted. The Institute for Defense Analyses, who will testify 
later on, who did a study at the request of the Air Force, 
concluded that these were overpriced. That, as far as the 
authors of that study know, their recommendations were just 
disagreed with.
    Secretary Roche, if you did another analysis that would 
rebut the Extended Service Life Study (ESLS), it has not been 
made available to this committee. I would be very interested in 
seeing that. In your response to Senator Levin, you said that 
an intensive study was done. We have not seen anything of that 
nature.
    Secretary Roche. I agree, Senator. It is in bits and 
pieces, and we tried to go back and see----
    Senator McCain. Why did you not just do another analysis? 
If you did disagree with the analysis, then you had plenty of 
time to do another analysis, a comprehensive one, just like you 
refused, apparently at the behest or certainly in keeping with 
the objectives of Boeing, to avoid an AOA being conducted. An 
AOA was not conducted. It is normal, it is routine, to do an 
AOA, and you did not do it.
    Secretary Roche. May I address that, Senator?
    Senator McCain. Sure.
    Secretary Roche. Senator, I have no idea, nor have I seen 
anything from Boeing saying they were trying to work against 
doing an AOA.
    Senator McCain. I would be glad to show you this.
    Secretary Roche. No, sir, I am sure what you have is there. 
I am telling you that was never communicated to me by Boeing. 
There was a discussion of whether or not to do an AOA with the 
Under Secretary of Defense for Acquisition, people from Program 
Analysis and Evaluation (PA&E), Service Chiefs, the Under 
Secretary of Defense. We discussed it as to whether it was 
necessary or not. The authority for doing it is not a 
requirement. It is a best practice which has emerged and there 
are examples where it has not been done.
    The authority to decide or not is the Under Secretary for 
Acquisition. In this discussion it was felt for the purpose of 
this lease there was no reason to do more. However, I think----
    Senator McCain. That is remarkable. That is a remarkable 
statement and a remarkable decision in view of the magnitude of 
this acquisition, and I would argue that no initial acquisition 
of this size has ever been done in recent years without an AOA, 
and I would be glad to supply that for the record.
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    Senator McCain. Mr. Chairman, I received a letter from Mr. 
Daniels, the former Director of the OMB, on August 1, 2002. 
First of all, Mr. Kaplan, you state in your previous statement 
it will cost more to lease than it is to buy, right?
    Mr. Kaplan. That is right, Senator.
    Senator McCain. I quote from Mr. Daniels' letter: ``I 
believe it would be inconsistent with OMB Circulars and 
irresponsible to support any lease proposal which would cost 
taxpayers more than direct purchase. While it may seem 
appealing to spread out funding, the excess cost will 
inevitably crowd out funding for essential warfighting needs. 
We would strongly oppose any effort to alter or manipulate 
scoring rules and leasing procedures which have served 
taxpayers so well.''
    What has changed, Mr. Kaplan, besides we have a new 
Director of the OMB, since Mr. Daniels wrote me that letter?
    Mr. Kaplan. A couple things, Senator, if I may. First of 
all, the deal was approved under Director Daniels, not under 
the new Director of OMB, although the new Director supports it 
as well.
    Second of all, the deal has changed significantly since 
Director Daniels wrote that letter to you, Senator, in August.
    Senator McCain. It will not cost more to lease than to 
purchase?
    Mr. Kaplan. It will, but by less than $2 billion difference 
from when that letter was written.
    Senator McCain. Only $2 billion, I see. But Mr. Daniels 
said it is irresponsible--by the way, CBO, GAO, and IDA all 
disagree with it. They say it is $5 billion. But you are free 
to disagree with those numbers.
    Mr. Kaplan. I think I just----
    Senator McCain. I want to know what has changed since the 
objection to any leasing arrangement which costs more than 
purchase?
    Mr. Kaplan. If I may, Senator, the $2 billion I was 
referring to was the reduction in price of the aircraft that 
was negotiated in part by Director Daniels', I think 
appropriately, skeptical approach to this deal, as reflected in 
the letter he wrote to you. So that is the $2 billion decrease 
in the price, which is a decrease in the cost to taxpayers.
    That is a very significant change from when Director 
Daniels wrote that letter, and I think Director Daniels would 
not have approved the deal had very difficult negotiations not 
achieved substantial cost reductions.
    Senator McCain. It is still costing more. So Director 
Daniels did not tell me the truth, because he said he would 
strongly oppose any leasing arrangement that costs more than a 
direct purchase, because that is what he said. That is what he 
said to me in the letter. Obviously, we now approve of a lease 
which would cost more than a purchase, so either Mr. Daniels--
in other words, Mr. Daniels did not tell me the truth in his 
letter.
    Mr. Kaplan. I would not characterize it that way, Senator.
    Senator McCain. Pardon me?
    Mr. Kaplan. I would not be in a position to be prepared to 
characterize----
    Senator McCain. But when he said he would never approve of 
a lease that is more expensive than a purchase, what does that 
mean?
    Mr. Kaplan. Senator, it means that this was an ongoing, 
extended process of negotiations and Director Daniels was in 
negotiation----
    Senator McCain. It means to me he would have never 
approved--I hate to get argumentative, but it says ``I believe 
it would be inconsistent with the OMB Circulars and 
irresponsible to support any lease proposal which would cost 
taxpayers more than direct purchase.'' This costs the taxpayers 
more than direct purchase, so Mr. Daniels did not tell me the 
truth in the letter that he sent to me.
    But let us go on here. ``After analyzing the Air Force's 
report and receiving additional information''--this is CBO's 
assessment of the Air Force's plan--``about the proposed lease 
from the Air Force and Boeing, the Congressional Budget Office 
has concluded that the transaction would essentially be a 
purchase of the tankers by the Federal Government, but at a 
cost greater than would be incurred under the normal 
appropriation and procurement process. The special purpose 
entity that has been established to buy the aircraft would in 
fact be substantially controlled by and act on behalf of the 
Federal Government, and its transactions should be reflected in 
the Federal budget. Even if one were to view the arrangement as 
a lease, CBO's analysis indicates that the proposal does not 
meet the guidelines for an operating lease described in the 
Congressional scorekeeping guidelines and in OMB Circular A-11 
and thus does not comply with the terms of section 8159 of the 
Department of Defense Appropriations Act of 2002.''
    Now, you are claiming there is some kind of ambiguity. What 
is ambiguous here, Mr. Kaplan?
    Mr. Kaplan. The ambiguity lies in the criteria, not in 
CBO's statement. I think there is ambiguity in how you 
determine fair market value. I think there is ambiguity in what 
constitutes a general purpose aircraft. There is ambiguity in a 
private sector market.
    Senator McCain. Is the entity being substantially 
controlled by and acting on behalf of the Federal Government 
and its transactions being reflected in the Federal budget, yes 
or no?
    Mr. Kaplan. No, we do not believe the special purpose 
entity (SPE) is a part of the Federal Government, and as a 
result its transactions should not be reflected in the Federal 
budget.
    Senator McCain. Is it substantially controlled by and 
acting on behalf of the Federal Government?
    Mr. Kaplan. It is controlled by the trustee, who is an 
employee of the Wilmington Trust Company. The Air Force does 
have a seat on the financing board and so as a result does have 
a say in the lease terms and the activities. The purpose of the 
SPE--and Senator, this is one of the areas where I think OMB 
asked a number of questions in order to satisfy itself is to 
ensure that there was a lower interest rate achieved on the 
bonds, and that translates into a reduced cost to the 
taxpayers. So the SPE's purpose is to reduce the cost to the 
taxpayers.
    Senator McCain. Is it of interest to you that the CBO, the 
GAO, the CRS, and every objective observer in the financial 
markets agree that this is an entity substantially controlled 
by and acting on behalf of the Federal Government? Is that of 
any interest to you, Mr. Kaplan?
    Mr. Kaplan. Yes, Senator.
    Senator McCain. I thank you, Mr. Chairman.
    Chairman Warner. Senator McCain, might I suggest that the 
letter of Mr. Daniels be copied and given to Mr. Kaplan, so 
that he could reflect on it a few minutes and maybe come back 
with a response to your important question.
    Senator McCain. I would be glad to. I thank you.
    [The information referred to follows:]
      
    
    
      
    
    
    Chairman Warner. Thank you.
    Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman.
    Secretary Roche, I am concerned about the maintenance 
aspects of the proposed leasing arrangement and also the 
implications it would have for the Title 10 requirements. 50-
50, at least 50 percent of maintenance be performed in public 
depots. What assumptions were made about tanker maintenance and 
the Air Force's long-term strategy?
    Secretary Roche. Senator, in terms of the short-term we are 
going to use contractor logistics support because there is a 
warranty and these are aircraft under lease. Over the long 
term, it is our intent, as we are trying to do with the C-17s, 
to migrate maintenance to a partnership between one of our ALCs 
and the original equipment manufacturer, so that we can 
maintain Title 10 capabilities and get the best of both worlds.
    Where we have been able to partner with our ALCs and the 
company, we have benefited across the board. The ALC has 
benefited and the company has been able to participate, and 
that has helped us, and that is where we would like to go.
    Senator Akaka. If the lease is approved, how valid are 
those assumptions?
    Secretary Roche. Sir, these we believe are policies of the 
Air Force and we would go forward with them. These aircraft, if 
they were purchased at the end of the lease period by the Air 
Force, we would start to migrate those towards one of our ALCs 
in a partnership with the original equipment manufacturer. We 
have done that with the KC-10 and we have gotten tremendous 
results.
    In the lease we have a 90-percent mission-capable rate that 
is guaranteed. Therefore, the contractor has to do a lot to 
ensure that we can make that 90 percent.
    Senator Akaka. What changes to planned maintenance would be 
required if the lease goes forward? Will workload that was 
previously planned to be performed in the private sector have 
to be brought into the depots, or will planned areas of 
expertise be shifted among depots in order to accommodate other 
changes?
    Secretary Roche. Senator, I do not see a shift. The 
partnership arrangement in fact increases the expertise at the 
ALC as well. Because we will be operating some of the 135s well 
into their 70s, we expect the demand on the depots by the aging 
135s will only increase. The depots have become more efficient, 
but these aircraft are aging and we expect the amount of time 
spent on corrosion, for instance, to go up by 10 percent just 
because of the age of the aircraft.
    Senator Akaka. Secretary Roche, I am concerned with the 
total costs of this proposal, but I am also very concerned 
about, as you mentioned, corrosion and its effect on our 
current tanker fleet. What preventive steps will be taken with 
regard to corrosion?
    Secretary Roche. We are finding across the board, Senator, 
especially in the aircraft that are near salt water are 
affected much faster than the others, and we rotate aircraft 
out of a salt water environment when we can. So for instance, 
at McDill Air Force Base we do not keep planes there all the 
time. We will have them there 6 months, then put in a new set. 
We are inspecting more. We are assuming there is more 
corrosion.
    As we track it, we are in fact looking at others, and we 
have formed an Aircraft Viability Board, which is analogous to 
the Navy Board of Inspection Survey, to go tail number by tail 
number to get an individual assessment of every single one of 
our aircraft and start dealing with them as if they were 
patients in the hospital, to keep track of corrosion by tail 
number over the long period of time.
    Senator Akaka. Mr. Secretary, has the Air Force budgeted 
for any other costs that it will incur, for example training 
personnel?
    Secretary Roche. Yes, sir. In the package that goes along 
with the lease there is money for contract logistics support, 
as well as initial training, initial spares, and they will 
continue.
    By the way, just to make sure, sir, we do keep track of 
each tail number. This is to be a more in-depth version of 
keeping track of each tail number, to my earlier point.
    Senator Akaka. Thank you very much, Mr. Secretary.
    Thank you, Mr. Chairman.
    Chairman Warner. Thank you, Senator Akaka.
    Senator Inhofe.
    Senator Inhofe. Thank you, Mr. Chairman.
    First of all, just for clarification, in the statements you 
alluded to something like a flow time for the maintenance of 
each KC-135, without distinguishing between E&R, as being 
around 400 days, and it is my understanding now that, at least 
at Tinker, it is 222 days in the last year. Do you disagree 
with that?
    Secretary Roche. No, sir. I think the tanker depots have 
done a magnificent job.
    Senator Inhofe. Thank you very much.
    It seems like we talk a lot about the 100 aircraft that are 
there and do not really go beyond that. After the lease is 
expired, one of two things can happen. You can either return 
the planes or you can go ahead and re-order more. I think the 
likelihood is very great that they would re-order more.
    I would like to get one option off the table and that is of 
returning them. Mr. Curtin will be coming up in the next panel 
and I want to pursue this with him, but he says: ``If the 
aircraft are returned, the Air Force will have to find some way 
to replace the lost capability even though lease payments would 
have to be paid almost to the full cost of the aircraft.'' He 
goes on to say why that would not be a good scenario.
    Do you agree with his statements?
    Secretary Roche. I do not know the details of the numbers. 
I know that we have plenty of time to look to see whether these 
are working as well as we think they will work. If not, we can 
return them. If so, we would come back to Congress and make 
that case that we would like to then have authorization and 
appropriation to purchase.
    There is a third option, by the way, Senator. In the way 
this lease is negotiated, if any time during the construction 
period we choose to turn it into a buy, we can. So that if in 
fact there is concern with the long-term lease, we could buy 
them.
    Senator Inhofe. But the point I am trying to get at here is 
even the likelihood of stopping at 100--and I would probably be 
supportive. If this thing goes through, we are going to have to 
be looking for the future and stopping at 100 would not make 
sense.
    In a memo from Secretary Aldridge to you just a short while 
ago, it says: ``It is the intent of the Department to go beyond 
the initial 100 aircraft as we begin the recapitalization of 
the airborne tanker fleet.'' Then again in Aviation Week, he 
reemphasized that, saying: ``We indicated the intent of the 
government to begin recapitalization of the tanker fleet so it 
would go beyond the 100 aircraft.''
    I think that this is realistic, that most likely, that it 
would, and I think you would agree with that.
    Secretary Roche. Yes, sir.
    Senator Inhofe. But with that in mind, why is it that we do 
not have a good long-term maintenance and training program that 
would go with this?
    Secretary Roche. When we come back in November to the Under 
Secretary for Acquisition with a long-term strategy, which I 
doubt will include additional leases because we believe this is 
a one-time thing, we will also reflect how we would intend to 
maintain and how we would intend to train.
    Senator Inhofe. Senator Akaka brought up this thing on the 
50-50 and I understand the response that you gave him. However, 
would this not require a change in the law, because if you go 
back and you have it in an ALC, but it is actually being done 
in a partnership--which have been successful, I might add--
would this not require that you have some type of a change in 
the law?
    Secretary Roche. Senator, I am not sure. May I turn to a 
colleague and ask to answer the question, or may I come back to 
you for the record.
    Senator Inhofe. Just for the record is fine.
    [The information referred to follows:]

    No, the law does not have to be changed. The 50/50 law--10 U.S.C. 
section 2466--states that not more than 50 percent of the funds made 
available in a fiscal year to a military department for depot-level 
maintenance and repair workload may be used for the performance by non-
Federal Government personnel of such workload. In applying the 50/50 
law, the value of the work performed by ALC personnel pursuant to a 
partnership with the contractor will be included in the Government's 
share. Therefore, a change to the law is not necessary.

    Senator Inhofe. Now, I would like to get into the thing on 
which I have been concerned, after having chaired the Readiness 
and Management Support Subcommittee for a number of years, in 
our lift problem that we have in general. I am talking about 
tankers, I am talking about all types of lift vehicles. When 
you stop and think of what we did in Kosovo and Bosnia and 
Afghanistan and of course now Iraq, it has put a tremendous 
strain and we are right at the capacity, and I think everyone 
agrees that that is a real serious problem right now.
    The reason I bring this up is that when you talk about the 
existing KC-135s--and I know people like to talk about how old 
they are and it is going to be 80 years old at the end of this, 
some of these aircraft, and they will still be in use. That 
does not really make that much difference. I have flown 
airplanes in the last 2 weeks that were 60 years old. It 
depends on how often they are used, how they are rotated. We 
have studies to show that they could be used for a long period 
of time.
    I bring this up, not just to say that there are 
alternatives to a lease, but in addition I think we all, 
everyone in this room who understands the issues, knows that we 
have a tremendous shortage of tankers and lift capacity. Would 
you agree with that?
    Secretary Roche. Our lift capacity is demonstrating great 
progress, and the 767s would also be lift aircraft because they 
are good cargo aircraft.
    Senator Inhofe. I understand that, but it is today I am 
talking about--we have a deficiency.
    Secretary Roche. Our plans show, with taking a look at the 
C-5s, increasing the life of them, we meet the requirement that 
the Joint Staff has given us. This would add to our capacity.
    Senator Inhofe. What I am getting around to is the 68 that 
you are talking about retiring. It would seem to me that if we 
need the capacity out there--let us say the lease goes through. 
I would like then to look at this thing and re-evaluate what we 
would want to do with the 68 that they are talking about going 
into retirement.
    We can remember just a short time ago--and I will see if I 
can find it in here--that the Air Force testified to us--here 
it is, right here--``With proper maintenance and upgrades, we 
believe that the aircraft may be sustainable''--we are talking 
about Es and Rs here--``for another 35 years.''
    I think Senator Warner mentioned a report that would go all 
the way to 2040. I think if the need is that great, if this 
thing does go through, how receptive would you be to re-
evaluating what you would want to do with some of the existing 
KC-135s? I know we are going to have them anyway. I am talking 
about the 68 that they are talking about going into retirement.
    Secretary Roche. Our sense, sir, is that retiring those 68 
could give us quite a savings. We could always look at your 
idea, which is different, which is could they be converted to 
freighters and used as freighters, and we could take a look at 
that.
    Senator Inhofe. Then the last thing I want to be sure to 
get in the record--I know my time has expired, but--it was 
brought up by Senator Levin, the mission-capable rates. I 
happen to have a breakdown of the KC-135 Rs and Es, and they 
have actually gone up since 2000 or the end of 1999: KC-135Rs 
from 78 percent to 82 percent; the KC-135Es from 62 percent to 
75 percent. That is in the active service, not counting the 
Guard and Reserve.
    So would you disagree with those figures?
    Secretary Roche. Sir, the Guard and Reserve ones have gone 
from 64 percent to 74 percent. It is a matter of what we 
average. But they are not the 85 percent total level. I think 
the average is near 85 percent or it was in 2003. In terms of 
the mission-capable rates of those aircraft, in the last year 
with the use, those that we have used in the operating area 
have had a higher mission-capable rate, those who have stayed 
behind have had a lower mission-capable rate.
    Senator Inhofe. I understand that. I understand the 
rotation and how that works. But nonetheless, the mission-
capable rate is actually improving and it has over the last 3 
years.
    Secretary Roche. It has, because of spare parts and depot 
work. But it has not made the 85 percent goal.
    Senator Inhofe. I think a lot of that is because the depots 
have done a very good job; do you not?
    Secretary Roche. Absolutely.
    Senator Inhofe. Thank you very much.
    Secretary Roche. Spare parts. Congress gave us a lot of 
spare parts.
    Chairman Warner. Senator Inhofe, your question about the 
alternate use of these aircraft for airlift other than fuel, I 
think it is important that we put into this record today 
exactly what--I understand 6 pallets could be placed in there 
and up to 200 individuals. Can you give us some rough 
parameters?
    Secretary Roche. Yes, sir, and I am going to ask my 
colleagues to correct me because I am sure I am going to be 
wrong.
    Chairman Warner. Please do not be wrong. Let us start off 
right.
    Secretary Roche. That is right. Six pallets on a KC-135.
    Chairman Warner. If you want you can just do it for the 
record.
    Secretary Roche. We will.
    Chairman Warner. But it is roughly what?
    Secretary Roche. It is 6 on a KC-135, and on a 767 it is 
19, but on a KC-10 it is 19 to 27. So this class of aircraft, 
although smaller than a KC-10, gives you much more lift 
capability in carrying 19 pallets as compared to 6.
    Chairman Warner. I think the record should have a reference 
to that alternative use. If there were an emergency and we had 
to move a significant amount of equipment quickly, they could, 
assuming there was not a demand elsewhere.
    Now we go to our distinguished colleague here, Mr. Nelson.
    Senator Ben Nelson. Thank you, Mr. Chairman, gentlemen. The 
question for me is not, Mr. Chairman, whether or not we need 
these tankers. I think we do. The question for me is the 
question that the Senator from Arizona as my chairman of the 
Commerce Committee probed yesterday in the Commerce Committee, 
the question of leasing versus the purchase.
    So my question would be to you, Mr. Secretary. Yesterday 
you sat at a table with three other folks in the Commerce 
Committee: someone from GAO, someone from CBO, and someone from 
the IDA. They all said that they thought it was a better deal 
to purchase than lease. Could you respond to that, please?
    Secretary Roche. Briefly, Senator, the same point I made 
yesterday, is that it depends on the model that is used. The 
net present value calculation has two streams of outflows of 
money. One is lease and one is acquiring. How you acquire, what 
models, when you can do it, how you can do it, becomes very 
important, and the underlying assumptions there are quite 
important.
    We used the current situation where there was no additional 
money and we had to go in the normal acquisition manner, and on 
that basis we saw the comparison to be very close, favoring 
purchase by $1.5 million per airplane. If you could take some 
extraordinary measures for acquisition which we could only 
hypothesize, but not really say would be approved by Congress, 
then you could in fact favor purchase by as much as $1.9 
billion. But it would require such things as a lot of up-front 
money we do not see, changes to how, for the rules of when you 
can amortize non-recurring and not amortize, colors of money, 
other things.
    If those all could be put in place, then the purchase is 
favored. But under normal acquisition process, you have to 
spend all the money up front without getting anything and then 
you start to buy airplanes.
    Senator Bill Nelson. There was a question, Mr. Secretary, 
yesterday about a part that was not competed, a part that 
between--okay, it was special purpose entity. Would you respond 
to that, why that was not competed?
    Secretary Roche. Special purpose entity was a mechanism to 
be able to effect a lease and it is a nonprofit entity, so the 
sense of someone competing to be that does not feel compelling. 
We did look around and agreed with the manufacturer what would 
be a sensible third party, detached third party. I can get you 
more details as to how that party was chosen and I would be 
glad to provide that for the record.
    [The information referred to follows:]

    The requirements of the Competition in Contracting Act were met 
with the Justification and Approval (J&A) for sole source of the 
aircraft lease program. The J&A for the Multi-Year Aircraft Lease Pilot 
Program was signed by the Assistant Secretary of the Air Force 
(Acquisition) on 4 November 2002.
    The SPE is not a ``contractor'' under the Competition in 
Contracting Act. Rather, the SPE is a legal entity that holds title to 
the tanker aircraft and accounts for lease-related funds. The legal 
authority and roles of the SPE are expressly set out in the trust 
agreement. The SPE benefits the Government by shielding aircraft title 
from potential claims by third parties and by assuring lenders of 
prompt payments from rents received, thereby lowering the Government's 
overall cost of borrowing. The SPE does not make a profit.

    Senator Bill Nelson. Thank you, Mr. Chairman.
    Chairman Warner. Thank you very much.
    Senator Roberts.
    Senator Roberts. Yes, sir, Mr. Chairman. Thank you.
    I am intrigued by the suggestion by my good friend from 
Oklahoma in regards to the 68 tankers that you plan on retiring 
and his suggestion that we find some other use for the tankers, 
which I endorse. I thought perhaps they could be used for 
CODELs and then the members could work on the corrosion 
problems as they fly from place to place around the world. Just 
a thought.
    Mr. Secretary, there is more than one way to skin a cat 
than sticking his head in a boot jack and pulling on his tail. 
That is just about like what I think we have done in terms of 
handling this situation. Good intentions that I do not 
challenge or impugn aside, that is what I think is happening 
now.
    Senator Levin posed a very interesting and good question 
about other requirements and why we should go into a leasing 
plan on tankers as opposed to other requirements. I am fully 
familiar with this, being chairman of the Intelligence 
Committee, and that we have quite a bit of infrastructure that 
we pay for on a regular basis and then we have to beg, borrow, 
or steal from supplementals in regards to get the analytical 
product that we need. That is not right, and that is really 
basic in terms of our national security.
    So I agree with Senator Levin, with the exception that Mr. 
Kaplan pointed out this is not a normal course of events. We 
are talking about access denial. We are talking about post-
September 11. We are talking about 2 years ago nobody would 
have ever thought we would be in Afghanistan or Iraq or 
possibly North Korea or possibly Iran, or the Southern 
Hemisphere, where we have 31 nations several of which are in 
trouble, or Africa. We are talking about access denial of our 
troops to get to a place where our national security is 
involved and I think that that is the difference.
    Let me ask you just a couple of questions if I might. Over 
90 percent of your aerial refueling fleet is over 40 years old. 
What concerns do you have regarding possible fleet-wide 
groundings and access denial that I am talking about, a class 
problem, if you will?
    Secretary Roche. That has been the concern, sir. As planes 
get older, we are not sure how they are going to break. General 
Mike Ryan, the prior chief, made a point that we are learning 
that airplanes can break in ways we did not understand in the 
past, because we are flying them as we did before, with the 
same amount of weight, we are using them a lot more. We have 
actually had an increase in the use of these aircraft, about 25 
percent in the case of the 135s, actually over 70 percent in 
the case of the KC-10s because they are newer, and that the 
increased use will put greater demands on them and greater 
maintenance demands and a class problem could emerge.
    It is a hedge against the class problem, given our 
projection needs, that leads me to support the notion of 
acquiring 100 of these planes in a fast fashion.
    Senator Roberts. Some critics of the proposal claim that 
the corrosion problems associated with the KC-135 are no worse 
than the corrosion problems associated with other aircraft and 
we can simply fix them and go on. What is your response to this 
claim?
    Secretary Roche. In certain aircraft like the F-15Cs that 
we have, we are finding that those that are near salt water are 
corroding a lot faster. I think we are going to have to retire 
aircraft that have been at Kadena Air Base for years. We have 
placed restrictions in g-force and restrictions in speed on 
these other aircraft because of corrosion problems. So we see 
the age and corrosion issue affect the other aircraft as well 
and causing us to put limitations on the plane.
    Senator Roberts. I have been to McConnell Air Force Base. I 
have not been to Tinker. I should go to Tinker. I will go to 
Tinker with you, Jim.
    Senator Inhofe. Good.
    Senator Roberts. I think both depots are doing an 
outstanding job, and they now have more spare parts and so 
those numbers are increasing. But I viewed first-hand the 
corrosion problems now plaguing the tankers as pertaining to 
the question of Senator Akaka.
    Let me show you what I mean. This [indicating] is the belly 
skin of the KC-135E.
    [The information referred to follows:]
      
    
    
      
    
    
      
    This is a major problem. If you look on the other side you 
do not think that there is a problem, but here is a big-time 
problem. This could not be fixed with normal maintenance. It 
takes a special plan. It takes a special effort to fix this 
problem. Basically, it takes 100 man-hours to fix this problem, 
$150 an hour, and that is about $15,000 and weeks and months 
that we have to deal with this.
    This is a much more common experience than it used to be. 
This is the kind of corrosion problem that could lead to a 
class problem with all of the tanker aircraft.
    I do not want the warfighter fighting in this kind of 
plane. I have seen this kind of corrosion at McConnell AFB. 
More especially, I do not want to get on the plane. I would 
simply close by saying that Mr. Kaplan said this is not a 
normal course of events. We do not want this to happen. I was 
trying to get a screwdriver so I could punch through this. We 
do not have a screwdriver with us. I am certainly not going to 
use my fist.
    I think that we are slow-dancing with this issue, and I 
thank all the witnesses.
    Chairman Warner. Does that conclude your questioning?
    Senator Roberts. I think it is a pretty good question to 
conclude on, yes, sir. Thank you.
    Chairman Warner. Senator Chambliss.
    Senator Chambliss. Mr. Chairman, I apologize for having to 
run back and forth to another hearing. I know that some of my 
concerns have been raised already because I have heard parts of 
the questions.
    Secretary Roche, I am wondering why we have decided to 
proceed with the lease as opposed to the multi-year buy that we 
are doing so successfully on the C-130 and the C-17. If that 
has been asked, I apologize.
    Secretary Roche. No, sir, it has not. The multi-year buy in 
both of those cases had an aircraft that was produced, looked 
at, tested, so that the concerns about it were reduced before 
Congress said, all right, now it can be multi-year. We know of 
no example where something starts out as multi-year without 
having a demonstration aircraft, and that would cost more time.
    The issue we are trying to raise is to hedge against time 
and to get aircraft in the fleet faster. If we were to try the 
normal multi-year, we would have to go through development, 
field a plane, demonstrate to Congress that in fact it is a 
viable plane to go into production with very little 
uncertainty, and then build that out in a multi-year fashion.
    Senator Chambliss. Well, it looks like that is a major 
problem in and of itself that we ought to try to overcome. I 
mean, if the airplane is there and we are going to lease it we 
ought to be able to multi-year buy that weapon system.
    Secretary Roche. Under the lease that we have, if we had 
the funds in budget authority we could buy out the lease at 
almost any time.
    Senator Chambliss. With respect to depot maintenance, I am 
concerned about the fact it appears that we are just, as a part 
of the price of the lease, contracting out in effect the depot 
maintenance up front. I am concerned about that being in the 
best interest of the taxpayer and the best interest of the 
warfighter. We have had these philosophical arguments and you 
and I have had a number of discussions about that. You know my 
concerns and you know my interest.
    I do have a serious concern about the fact that we are 
just, without any competition whatsoever, all of a sudden 
saying we are just going to lease these? Are we going to let 
the contractor do the maintenance, because that is in the best 
interest of the weapon system?
    So if this does come about--and I will be honest; I do not 
know where I am yet--but I would hope that, and I have heard 
you mention briefly, that there is the potential for a 
partnering arrangement not unlike the C-17. Of course, this 
does not affect my depot. But, the overall system I think 
demands that we continue to provide the availability or the 
ability within the depot system to do work on new weapon 
systems, and this could be another one of those unintentional 
or unintended consequences. It could be a situation where we 
have an unintended consequence of removing from the depot the 
availability or the ability to do depot maintenance on a newer 
weapon system and we continue to be relegated to working on old 
systems.
    So if this does come about, I know everybody on the 
committee is going to want to make sure that we do the right 
thing with respect to the depot maintenance.
    Secretary Roche. Yes, sir. We have talked in the case of C-
17s of the partnership to have the depot involved. What we 
would like to look at in this case is to have the depot partner 
earlier during the warranty period with the manufacturer, so 
that the depot develops expertise during that same period. If 
that is possible, we would like to head in that direction.
    Chairman Warner. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman, and thank you, 
gentlemen. This is a very important issue. It is a complicated 
issue. My knowledge of this complicated financial transaction 
is only exceeded by my knowledge of materials engineering. So 
it is an interesting topic.
    Let me just say, though, that it seems to me that in a 
commercial transaction you would get a fairness opinion from an 
outside objective party. All of the opinions that we are 
hearing from CBO and GAO, the ``outside parties,'' seem to be 
negative with respect to this proposal. Is there any non-
involved party that has rendered an opinion or an evaluation of 
this?
    Secretary Roche. Seen from the point of view of the Air 
Force, Senator, for the last year and a half we have had 
everybody reviewing this. Certainly a number of staff within 
the Office of Secretary of Defense, culminating in the creation 
of a leasing panel to take a look at it separate from the Air 
Force, and then independently the OMB. So we believe our 
fairness opinion which would occur in a commercial sense has 
been done, both by the Office of the Secretary of Defense for 
Secretary Rumsfeld and by the OMB.
    Senator Reed. Then there is the argument about how 
disinterested these parties are and how insulated they are from 
the pressures which we have noted, both political pressures and 
other pressures. Frankly, it does not strike me as particularly 
independent. The Air Force has been an advocate for replacing 
their fleet and doing it in a creative way. The company 
certainly is an advocate for selling their aircraft.
    Secretary Roche. Yes.
    Senator Reed. I think within the Department of Defense 
there are some indications that at least initial reviews by 
PA&E were similar to CBO and others which were quite negative. 
So I guess it would help me tremendously if there was something 
out there that was truly independent and a true fairness 
opinion about a transaction which in a normal business 
proceeding you would--this complicated lease arrangement, 
financing, would be accompanied by a bevy of fairness opinions 
from hired guns who presumptively do not have anything in the 
mix.
    Secretary Roche. May I ask Secretary Wynne to comment on 
that, because I believe they have come at us from all sides, 
where we have had to go back and improve things because it 
would not have met their criteria for a fairness opinion.
    Secretary Wynne. I will admit in advance, Senator Reed, 
that the OSD can hardly be described as a disinterested party. 
I think we have as much interest in protecting and preserving 
our Armed Forces and doing it in the most timely manner than 
anyone else.
    That did not deter us, however, from, as Secretary Roche 
indicated, questioning them fairly determinedly. In fact, we 
considered the PA&E memorandum. They often do financial red 
teams on arrangements that we want to do. I myself, for 
example, asked for the most favored customer clause, which I am 
not going to take credit for its ultimate evolution. I think 
Secretary Sambur did a marvelous job of pushing that home. But 
it was a very difficult thing to determine best value in a sole 
source acquisition sense.
    I think, however, we arrived at a conclusion that was 
beneficial, and on a net present value basis we see it to be 
fair and balanced. $150 million without consideration of the 
operations and support costs that we believe is going to be 
there is tantamount to being on balance. So I would tell you 
that the leasing panel and Dov Zakheim as well did a pretty 
thorough review and just on balance we felt that getting these 
airplanes sooner, sooner than later, and not disrupting the 
ongoing programs, to achieve our goal of program stability, all 
merited approval.
    Senator Reed. Thank you, Mr. Secretary. I appreciate 
certainly your efforts and the energy you put into this. But 
still, an observation is that on one side you have agencies 
that seem to be removed from the transaction; on your side you 
have everyone who is involved in the transaction, and I think 
it would favor your position if there was someone more 
objective that was rendering an opinion that supported your 
position. That is just an observation.
    Let me ask, Secretary Roche. It seems to me that critical 
to all these different evaluations are the assumptions. Without 
going into the detailed analysis, what are the key assumptions 
that you have made that makes this deal work for the Air Force?
    Secretary Roche. The key assumption, Senator, that we used 
was that the procurement side, the purchase side, would be 
according to the normal set of rules, regulations put in place, 
the fact that you spend the money for a development program, 
you then go through a lot of tests of that program, and only 
after all that is done you go into limited production, and then 
other tests, and then you go into production.
    It is a time phasing of it, and the delay of the planes is 
the issue.
    Senator Reed. It seems to me, Mr. Secretary, that is an 
assumption that one could question, since you have an aircraft 
that is sitting down, already designed. Boeing did a lot of 
that to build the 767, and that you have to make some 
modifications. They are not trivial. But if that is the 
assumption, again I would question the assumption.
    Secretary Roche. We went by the rules, sir. I grant you 
that a development program would be a lot shorter because it is 
an existing aircraft. But the assumption in following the rules 
is that you have to do it that way.
    Senator Reed. You seem to be following the rules in one 
aspect and asking us to bend the rules considerably to do this 
lease job. We are not going to Boeing and saying, build us an 
aircraft from scratch and then we will lease it. We are saying, 
you have this aircraft--in fact, they are telling us: We have 
these aircraft; we can modify them and give them to you.
    Again, this goes to the analysis.
    Secretary Roche. The second point was the assumption of the 
availability of money.
    Senator Reed. Yes.
    Secretary Roche. We did not assume that there would be $5 
to $11 billion additional made available in this period.
    Senator Reed. Let me ask a final question, which I am sure 
has been covered before. That is, you have done the life cycle 
cost comparisons and your conclusion I presume is that the life 
cycle cost, the maintenance and the operations and the timing 
of the aircraft going into the fleet, favor the lease and 
disfavor the purchase. Is that a fair insight?
    Secretary Roche. It is a fair insight, especially if you 
note that having these planes in earlier has operational 
savings, and we would not replace one for one. We do not 
believe when all is said and done with new aircraft that we are 
going to have a one for one replacement of 544 airplanes for 
the needs of the future. We think it will be a much lower 
number.
    Having 100 and observing what they can do will give us a 
very good idea of the total for the long run.
    Senator Reed. Again, thank you very much, gentlemen. This 
is I find a very important issue, a very complicated issue, and 
it has been useful from my perspective to hear your views.
    Thank you, Mr. Chairman.
    Chairman Warner. Thank you, Senator Reed.
    Colleagues, we have a second panel that deserves the 
thoroughness with which we have had our exchange of views and 
questions with the first. Senator Sessions, you have not had 
the opportunity for your first round. It is the desire of the 
chair to have you proceed with your first round and then we 
will--I have but one question and I hope other members 
remaining can limit their second round of questions so that we 
can get to the second panel and proceed.
    Senator Sessions.
    Senator Sessions. Thank you, Mr. Chairman.
    Mr. Wynne, you used the phrase I believe earlier that if we 
do not use the lease arrangement it will take much longer to 
get 100 aircraft. If we utilize the expected expenditure levels 
for leasing and applied that to a purchasing system, do you 
know how much longer it would take?
    Secretary Wynne. Sir, the terms of the lease are so 
favorable that it would probably be 7 or 8 years difference 
between receipt of aircraft, even if we were to purchase the 
airplane outright, as some have indicated, and pay up front the 
appropriate amount. But frankly, the cash flow savings that you 
get from leasing do not catch up to payments for several years.
    That having been said, I think the minimum everybody has 
anticipated in delay is 5 years. You would get 12 airplanes 
during the Future Years Defense Plan now by purchasing and you 
would get 60 airplanes by leasing.
    Senator Sessions. In 5 years?
    Secretary Wynne. In the Future Years Defense Plan, yes, 
sir.
    Senator Sessions. Mr. Chairman, I have looked at the KC-
135E, which is the oldest upgrade, which is about $25 million 
for that. I guess the question we have in this fleet is just 
how big a crisis we are facing, just how quickly it needs to be 
brought on line.
    I am not happy with creating a lease system that results in 
a bow wave down the line, that we now have to alter our budget 
to figure out whether we are going to have the money to bring 
this on. It seems like to me that in general I would favor the 
purchase agreement, the purchase system. So I have some doubts 
about that.
    Now, we have in the Senate version of this bill a 
requirement for an AOA. I do not know what will come out of 
this conference. We are talking about changing that, I suppose. 
But what would happen if we waited a year and had an AOA? This 
may not be technically a purchase, but it is certainly a lease-
purchase and it amounts to the same thing. Why should we not 
have an AOA, Secretary Roche?
    Secretary Roche. Senator, our sense is that the due 
diligence we did in forming the lease package covered what 
would normally be covered in an AOA, an informal AOA. Delaying 
a year would just delay getting a hedge against any problems of 
these aging aircraft.
    It would also continue to have us invest in some very old 
aircraft. The ones we seek to replace are the E models. A 
number of the Rs will in fact be in service until they are 70-
some years old. So there will still be plenty of 135s flying 
around. It is trying to get the E models off the books and 
substitute aircraft that have more capability and that are far 
more reliable.
    Secretary Wynne. Senator Sessions, I would tell you, sir, 
that an AOA often goes to product, in other words would the 
product be appropriate. I think the discussion and the debate 
has been about process, i.e., how do you acquire that product. 
Going back and looking at an AOA of how do you deliver air 
tankerage to note only our forces, but also coalition forces, 
probably would determine product content.
    We do not see that the Es, which are facing fleet 
standdowns and some of whom I believe, Secretary Roche, have 
gone over all of the reliability statistics that Boeing 
originally did, because they did not believe we would be flying 
them this long when they were originally produced and 
qualified--it would seem to me that, as I mentioned in my 
testimony and I think as we submitted in the report, the 
informal AOA to get this product consisted of new aircraft, 
consisted of getting a commercial derivative aircraft, and 
consisted of re-engining the KC-135s.
    The KC-135 re-engining on the Es was determined to be 
insufficient to extend their life because of the corrosion 
aspect and the price, frankly, even in the strut situation, of 
impinging upon our operations and support (O&S) costs.
    The idea of whether you go get a commercial derivative was 
in fact the Air Force's plan. The cost risk there is whether or 
not Boeing could sustain this commercially available derivative 
aircraft. If they do not sustain this commercially derivative 
aircraft, then we would be paying for essentially the creation 
of a brand new airplane, and that cost risk would be between 
$150 and perhaps $200 million.
    So all of those things I think drove us to the informal 
analysis of alternatives to not only do a commercially 
available 767, but to get it in the shortest possible time.
    Senator Sessions. Just to get the numbers straight, Mr. 
Kaplan, your analysis at OMB was that we would come out, the 
lease arrangement would cost $150 million to $1.5 billion more? 
Was that your analysis?
    Mr. Kaplan. Actually, I think the analysis reflects, 
Senator, a range of $150 million to $1.9 billion in net present 
value.
    Senator Sessions. That is the net present value procedure. 
CBO used the--what is their standard? They came out with $5 
billion.
    Mr. Kaplan. Actually, Senator, if I may, I believe what you 
are referring to is CBO, as we did and as the Air Force did, 
calculated the difference in then-year dollars and then also, 
as is required by OMB Circular A-94, presented a net present 
value calculation. Under net present value, I believe that 
CBO's number is $1.3 billion.
    Senator Sessions. What is the best one in this 
circumstance? I know you do one and they can do another one. 
When applied to these circumstances, what is your opinion of 
the best approach and the best figure?
    Mr. Kaplan. Senator, because the A-94 analysis requires the 
comparison of an actual proposed deal, which is the lease deal, 
to a hypothetical purchase, it just depends on the assumptions. 
I think the range is right. I think $150 million is on the low 
end. I think OMB would include some of the other assumptions, 
not necessarily the same ones CBO did, but some assumptions 
that would make the net present value higher, somewhere in the 
$1 billion and up range.
    Senator Sessions. That would run something like 15 percent 
or so more at least, would it not, and a lot more than that if 
you took the CBO numbers? Your range would be about 15 percent 
more expensive leasing?
    Mr. Kaplan. In net present value terms, I think that is 
right, Senator. I have not done the math. But that is why we 
did present the range, the Air Force did present the range in 
its report to Congress, so that Congress would have that 
information and could make its judgment accordingly.
    Senator Sessions. Thank you, Mr. Chairman.
    Chairman Warner. Thank you very much.
    I will proceed to ask my one question and then recognize 
others. I have here the submission by the GAO today, in which 
there is a chart showing the bow wave in the out years as a 
consequence should this program be approved by Congress. Having 
some familiarity with the military departments and these types 
of charts, this thing will suck the life's blood right out of 
the Department of the Air Force, the magnitude of this bow 
wave.
    It is also going to have repercussions on the annual, I 
call it, scramble between the three military departments to get 
their fair share of the budget each year.
    Now, I have to say with all due respect, gentlemen, when I 
asked the question of whether or not anyone had looked at a 25 
buy I recognized, Secretary Wynne, the predicament with the 
manufacturer and the possibility his line goes down. I am going 
to pursue that a little bit here and take the views of my 
committee to possibly see whether or not we can quickly look at 
some bifurcated situation where we take part of this proposal, 
but then go back to traditional ways of budgeting and planning 
for the three military departments.
    So I guess I put that in the way of a statement. But I 
would have to say, if you want to comment, do you think it is a 
reasonably accurate bow wave?
    Secretary Roche. Yes, sir, I think that is. The alternative 
would be a bow wave that is in the front end if we were to try 
and purchase on the same schedule. We were required to take 
into account all of the lease payments and possible purchases 
if in fact we had an authorization and appropriation into a 
modest Air Force budget over time.
    What is not reflected there, Mr. Chairman, is that programs 
like the C-17 will have ended just before that point. We showed 
that it could be accounted for in our budget, but if in fact 
there was more money, more budget authority available, we could 
buy out the lease and buy down that hill.
    Chairman Warner. I have taken my time. Senator Levin, let 
us proceed as quick as we can to conclude with this panel.
    Senator Levin. Mr. Kaplan, you in answer to Senator 
Sessions' question gave us a very critical piece of 
information. I want to make sure I understood it correctly. You 
said that basically you believe that with the correct 
assumptions that the difference in net present value between 
leasing and regular purchasing would be somewhat over $1 
billion; is that correct?
    Mr. Kaplan. I think it would be in the neighborhood, that 
is right, Senator.
    Senator Levin. Did you say slightly over $1 billion?
    Mr. Kaplan. I think I did say $1 billion or slightly over. 
I would have to look at the record.
    Senator Levin. Is that OMB's best assessment?
    Mr. Kaplan. That is my assessment based on what I have 
learned. I think that represents a consensus within OMB. There 
are different views within OMB.
    Senator Levin. Are you speaking on behalf of OMB here 
today?
    Mr. Kaplan. I am, Senator.
    Senator Levin. Okay. So we are going to have to----
    Chairman Warner. Let me articulate it for the record. Are 
you speaking with your professional personal opinion or on 
behalf of the Director and the OMB?
    Mr. Kaplan. I am speaking on behalf of the Director and 
OMB, Mr. Chairman.
    Senator Levin. So that the Air Force presented a $150 
million difference, but it is OMB's best judgment that it is $1 
billion or slightly more using an apples and apples comparison, 
the net present value approach, which is required by I believe 
executive order or by OMB regulation; is that correct?
    Mr. Kaplan. Actually, Senator, I believe the Air Force in 
its report to Congress reflected exactly the range that I have 
discussed here today.
    Senator Levin. Yes, they expressed a range, the higher part 
in a footnote; is that not correct?
    Mr. Kaplan. That is correct, Senator.
    Senator Levin. As a matter of fact, they did it because OMB 
really pressed them to do it; is that not correct?
    Mr. Kaplan. I believe there were ongoing negotiations. I 
was not there, but I think that was----
    Secretary Roche. Correct.
    Senator Levin. Secretary Roche is saying ``Correct.''
    Mr. Kaplan. That would be consistent with my testimony here 
today, Senator.
    Senator Levin. You should not be reluctant, if you had to 
pressure the Air Force into putting it in there, to say so. The 
Air Force is acknowledging that they put it in there because 
OMB urged them to put it in there.
    But my point is you have tried to give us here a range, it 
is somewhere between $150 million and $1.9 billion, but within 
that range it is OMB's judgment that it is $1 billion or 
slightly more, the difference between leasing and buying, in 
apples and apples comparison; is that correct?
    Mr. Kaplan. It is OMB's view that, in a range of 
assumptions, that is probably the better range of assumptions, 
is to take the higher end, roughly in the neighborhood of $1 
billion or slightly more.
    Senator Levin. That is your view? That is the best estimate 
you have? Within that range, that that is the best estimate?
    Mr. Kaplan. In comparing an actual lease to a theoretical 
purchase which is based on, Senator, a very difficult and 
complex range of assumptions----
    Senator Levin. Of course.
    Mr. Kaplan.--that deal with the discount rate and other 
things which are subject to disagreement.
    Senator Levin. Of course.
    Mr. Kaplan. That is why we presented a range, yes, Senator.
    Senator Levin. Look, you might as well give us a direct 
answer. Within that range, it is your best estimate that it is 
slightly more than $1 billion?
    Mr. Kaplan. I believe I said that, yes, Senator.
    Senator Levin. I am glad you believe that and I am glad the 
record will show that belief.
    One last question. On this, Secretary Roche, I gather it is 
your intention to ultimately buy these planes; is that not 
true? That is your current intention?
    Secretary Roche. Our current intention is to lease the 
planes and if they work out to consider coming back to Congress 
to get authorization and appropriation. But we would want to 
take a look at how these planes work out as tankers.
    Senator Levin. You want to lease them before you know how 
they work out, and you are going to spend about how much on 
this?
    Secretary Roche. That is because by virtue of a lease we 
can always return them.
    Senator Levin. How much are you committed to pay under that 
lease before you know whether they work out?
    Secretary Roche. Senator, that would depend on how many 
were available, how we used them in conflict.
    Senator Levin. Is it not about 90 percent of the value?
    Secretary Roche. That is if you go through to the full 
lease.
    Senator Levin. That is what you are committed to lease, 
right?
    Secretary Roche. I would think we would come in much 
earlier than that to discuss authorizing and appropriating to 
purchase, because you can also purchase out of the lease.
    Senator Levin. That is not my question. You said before you 
knew whether they work. You are committing to pay about 90 
percent of the value under this lease, are you not, before you 
know whether they work?
    Secretary Roche. No, sir, we will know a lot earlier. We 
are committed to paying 90 percent of the lease during the 
normal lease terms and then we have a small residual to pay if 
in fact we chose to purchase them.
    Secretary Wynne. If I could help, I do not think we are 
actually committed to accepting those airplanes if they really 
do not work at all.
    Senator Levin. Of course not.
    That is the reason given for the lease, though. A minute 
ago we were told we were leasing it because, gee, we do not 
know if they work. Now you are saying, gee, if they do not work 
we are not committed to lease. I hope we are not committed to 
lease if they do not work.
    Secretary Roche. I am sorry, Senator. I was using the word 
``work'' in a different manner. If they worked out as well as 
we expected them to and there were no other alternatives. 
Obviously, they would have to meet spec.
    Chairman Warner. Work out, are you talking about mission 
performance or financial transactions?
    Secretary Roche. All of those things, Mr. Chairman.
    Chairman Warner. What are you talking about?
    Secretary Roche. All of those things. In other words, we 
cannot at this point say we definitely would purchase them at 
the end, although we have provisions, if we would, that we have 
a price----
    Chairman Warner. In this 2 years time you did not get a 
mockup or borrow one and run a little test on it?
    Secretary Roche. No, sir. The first one that is being 
developed is being developed for the Italian air force and it 
is under development now.
    Senator Levin. The reason given for leasing that you just 
gave is that we really do not know if they are going to work, 
therefore we want to lease them.
    Secretary Roche. No, sir, the reason for----
    Senator Levin. The reason for leasing is you do not have 
the money now to buy them.
    Secretary Roche. That is right, that is exactly right.
    Senator Levin. Why do we not be just straightforward on 
that. You do not have the money now to buy them or else you 
would. Why do we not just be straightforward.
    Secretary Roche. I am sorry, sir. I think we said that. I 
said that earlier. It was whether we should buy them at the 
residual.
    Senator Levin. Okay. I think it is important, though, that 
you be straight on that. If you had the money now you would buy 
them, you would not lease them.
    Secretary Roche. If we had the money now and we could buy 
them, we would.
    Senator Levin. Okay, under the usual procurement approach?
    Secretary Roche. We would ask that the procurement approach 
be changed so we get them at the same schedule, because getting 
them earlier is----
    Senator Levin. Of course. But under the usual rules of 
procurement you would do it with a multi-year; is that correct?
    Secretary Roche. If there were all of the things necessary 
to get the same number of planes in the same amount of time and 
the money were available in the beginning, yes, we would 
purchase, because it is less complex.
    Senator Levin. Less complex? It also is the way we 
ordinarily buy things, for good reasons.
    Final question: The CBO letter said the following--Mr. 
Kaplan, let me address this to you. It says that: ``The 
proposed contract between Boeing and the Air Force, as well as 
the financing arrangement, clearly indicates that the statutory 
trust exists solely to borrow money on behalf of the Federal 
Government to allow the Air Force to acquire an asset that has 
been built to its unique specifications.'' Do you agree with 
that?
    Mr. Kaplan. No, Senator.
    Senator Levin. Okay. You do not agree that the contract 
between Boeing and the Air Force, as well as the financing 
arrangement, indicates that that trust exists to borrow money 
on behalf of the Federal Government, to allow the Air Force to 
acquire an asset that has been built to its specifications? You 
disagree with that?
    Mr. Kaplan. I agree with the first portion of it and then 
there were other elements of it that I disagree with. First of 
all, the Air Force does not acquire the asset. The special 
purpose entity acquires the asset. The purpose as I understand 
it of the special purpose entity was to achieve a lower 
borrowing rate from the bondholders, which would reduce the 
cost of the lease to the taxpayers.
    Senator Levin. Is this special purpose entity out there 
going to be flying planes and carrying out missions, or is it 
the Air Force?
    Mr. Kaplan. It is the Air Force, Senator.
    Senator Levin. This entity is not there to carry out Air 
Force missions, is it? It is there to help acquire property 
that we cannot pay for now. Why are we not straight on that 
issue?
    If you had the money now, we would buy it. Let us just be 
honest about it.
    Mr. Kaplan. Senator, I do not believe I have suggested 
otherwise.
    Senator Levin. So the purpose of that entity is because we 
do not have the money now. We are going to create an entity to 
borrow money for the government and we are going to pay more 
for it. Your estimate is $1 billion in an apples and apples 
basis.
    The argument is not--okay, maybe we ought to do that. I can 
accept that argument. If we do not have the money now, let us 
do it this way because it is such a desperate need to do it, 
instead of raising the budget, borrowing money now, pay, borrow 
money later and pay more. I may not agree with the argument, 
but at least it is an honest argument.
    But to suggest that somehow or other we are not acquiring 
this property, it is some special purpose entity out there that 
is acquiring it, it seems to me is engaging in a fantasy. I do 
not want to engage in those kind of fantasies.
    Mr. Kaplan. I do not either, Senator. The Air Force does 
not acquire these planes at the end of the lease. Congress will 
have to----
    Senator Levin. It is intended that the Air Force will 
acquire these planes. That is the whole purpose of this, is 
that we acquire planes without money up front. That is the 
purpose of this thing.
    Secretary Wynne. But it does presume, sir, on Congress.
    Senator Levin. That is the intent, the purpose, that we 
acquire these planes, because we are doing it by lease now 
because we do not have the money up front. Why not be straight 
about it?
    Secretary Wynne. As the Inspector General said, he did say 
that the Air Force should proceed apace to give the business 
case to Congress for purchase. Otherwise we would be presuming 
on Congress.
    Senator Levin. Last question----
    Chairman Warner. Oh, no, you have--another member just came 
and we are getting----
    Senator Levin. Can I have 30 more seconds? Okay. I will 
hold it off and do it later. No, no, that is okay.
    Chairman Warner. Take 30 seconds.
    Senator Levin. No, that is okay. If I have overstayed, I 
will come back again.
    Senator McCain. I just have one.
    Chairman Warner. Okay, you have one. You have 30 seconds. 
We have to get this organized and run along on this railroad 
here.
    All right, Senator Allard, this is your first round.
    Senator Allard. Mr. Chairman, thank you. I apologize, I had 
to step out just a moment.
    We heard in the Budget Committee yesterday that the lease 
is inconsistent with Federal budgetary principles. I have just 
a couple questions in that regard for Mr. Kaplan. Would this 
proposal bypass the budget process?
    Mr. Kaplan. No, Senator. The money for the proposal, the 
money for the lease payments in the FYDP, is budgeted and is 
accounted for.
    Senator Allard. Does it concern you that this future 
liability will not be scored and will not be counted in terms 
of budgetary resources?
    Mr. Kaplan. It is scored, Senator. It is scored as an 
operating lease.
    Senator Allard. So each year as an operating lease then it 
will be brought into the budget; is that correct?
    Mr. Kaplan. I believe that is correct, Senator.
    Senator Allard. Okay. Then you think it will be accounted 
for in the budget process?
    Mr. Kaplan. Yes, Senator, ultimately all of the lease 
payments will be accounted for in the budget process.
    Senator Allard. Okay. Now it is not a lease-purchase?
    Mr. Kaplan. No, Senator.
    Senator Allard. It is not a lease?
    Mr. Kaplan. It is an operating lease, Senator.
    Senator Allard. But it does not meet all the requirements 
which ordinarily you have for a lease. There are six 
parameters. This only meets two of those parameters. The other 
four parameters, from what I understand from the testimony 
yesterday, are not met.
    Mr. Kaplan. That is not my testimony, Senator. My testimony 
is, as I stated at the outset, that this is a close call. The 
proposal on a number of these criteria is right at the margin. 
We recognize that, OMB recognizes that, and in light of the 
congressional interest as expressed in legislation and in light 
of the compelling need that the Air Force and the Department of 
Defense have presented we have concluded that it does satisfy 
the criteria for an operating lease.
    Senator Allard. Okay. Here are some of the things that have 
been brought up by the Budget Committee and I would like to 
have you respond to me if you would, please: that CBO reached a 
determination that the asset was not a general purpose asset, 
which is one of the requirements. Would you respond to that? 
They say you have a tanker plane and the only use you can use a 
tanker plane is to fly for fuel and you cannot put it out on 
the general market and use it. These are requirements for a 
lease-purchase.
    Mr. Kaplan. Yes, Senator, and Boeing developed the 767 
global tanker transport aircraft commercially. It was not 
responding to a request from the administration or from the 
Federal Government. It markets it commercially. It marketed it 
on its Web site before Congress authorized it, I believe. It 
has sold it to other governments. It has sold it to the Italian 
government. It, I believe, is in final stages of negotiation 
with the Japanese government. In its freighter configuration it 
expects to have a commercial market, both within governments 
and outside of governments.
    Senator Allard. Are they sold to these other countries as 
refueling planes, or what is their purpose?
    Mr. Kaplan. Yes.
    Senator Allard. What do they do? Then we have to pay to 
take off the retrofit that we did to carry fuel in order to 
make them marketable? Is that what has to happen?
    Mr. Kaplan. Senator, I believe Italy purchased these in 
their tanker configuration. I believe that is Japan's intention 
as well.
    Senator Allard. Do you believe the Air Force included the 
construction loan financing in its assessment of the fair 
market value of the aircraft? Is this treatment unusual, and 
how do the interest rates affect the fair market value?
    Mr. Kaplan. It is certainly the case that the Air Force 
included the cost of construction financing in their 
calculation of the lease payments and the comparison to fair 
market value, and they came up with a number of $138.4 million, 
I believe.
    The test is whether the sum of the lease payments exceeds 
90 percent of the fair market value. This is one of the 
difficulties of A-11. We have to establish a fair market value. 
If you look at what the Italians paid for these planes in a 
similar configuration, it is $175 million. I do not think $175 
million is the fair market value. I think something between 
$138 million and $175 million is a reasonable place to end up, 
and that gets you below 90 percent.
    Senator Allard. I want to move on to this trust. I know 
there was some discussion earlier. Here is the way that the CBO 
report to Congress describes this trust, and I want to know if 
you agree with what they say or not: ``The borrowing activities 
of the special purpose entity''--that is the trust--``will be 
directed by a financing committee composed of the Air Force, 
Boeing, and the lease administrator,'' just those three 
entities apparently. ``The Air Force has asked Boeing to serve 
as the lease administrator. Under the operating guidelines for 
the financing committee, the Air Force must approve all of the 
terms and conditions of the financing plan and must review and 
approve all financing documents. CBO concludes that the action 
of that committee will be explicitly controlled by the Air 
Force.''
    Would you agree with that?
    Mr. Kaplan. Senator, I had actually thought that the lease 
administrator was not Boeing, but that the trustee was a member 
of that financing committee. I will take it for the record and 
get with my staff.
    [The information referred to follows:]

    As with a number of the issues that arose with this very 
complicated leasing transaction, reasonable minds can come to different 
conclusions. In this case, we do not agree with CBO that the Air Force 
will have explicit control over this entity. The SPE benefits the 
government by shielding the aircraft title from potential claims by 
Boeing's creditors. The SPE will also be able to borrow at a lower cost 
than Boeing, which translates into lower lease payments and savings for 
the taxpayers. However, the SPE is managed by the trustee (a Wilmington 
Trust employee), and its legal authority and roles are expressly set 
out in the trust agreement. It is not directed by the financing 
committee. Rather, the financing committee has the specific role of 
evaluating and executing the financing arrangements required to 
conclude the construction and lease of the aircraft to the government. 
The committee is comprised of the government, Boeing, and the lease 
administrator (a contractor employee). As laid out in the committee's 
operating guidelines, it must act with the concurrence of both the 
government and the contractor, and any financing plan must be 
reasonably acceptable to the contractor, although it must be approved 
by the government. The government retained approval authority for 
specific financing arrangements to ensure that it will receive the best 
possible financing arrangement and will not be forced into an 
unfavorable arrangement. Because the committee's authority is limited 
to financing arrangements, it will play no role in any sale of the 
aircraft.

    Secretary Roche. May I help on that point of fact?
    Senator Allard. Yes, Mr. Secretary.
    Secretary Roche. The lease administrator is really the 
lease manager. The trustee is the administrator of the trust. 
Two different jobs.
    Senator Allard. Okay, thanks for clarifying that.
    I want to move on, and I have a question in regard to the 
various options. I understand the Air Force has conducted 
several analyses on other options to a lease proposal. Some of 
these options included re-engining our current fleet of the KC-
135Es, leasing tanker services, or even purchasing commercial 
aircraft. I was particularly intrigued by the last option. I 
understand the Air Force could purchase these aircraft at 
reduced costs. DC-10, for example, is already in the Air 
Force's aerial refueling fleet and would not require new 
military construction. I have been told that there is from the 
commercial side some DC-10s that might be available.
    Now, I understand that some of them have a lot of mileage 
on them and some of them may not be in good shape. But there 
might be some out there that are in good shape. Has there been 
any effort to try and see if that option is available?
    Where I am driving at in this question is has the Air Force 
looked at some interim, bring on some of these planes, buy them 
or lease them, whatever, that would be much less expensive, to 
work you into a purchasing program for the 767 tanker that you 
are wanting to work in as a new plane?
    Secretary Roche. Yes, sir. I would like to doublecheck to 
make sure we checked on used DC-10s. We certainly looked at 
used 767s of the 200ER configuration, which are the freighter 
versions, and there were very few of those available and they 
had an enormous number of hours.
    In the case of the DC-10, it has been out of production as 
a commercial plane since the late 1970s and out of production 
for the Air Force since the early 1980s. So the infrastructure 
supporting it around the world is not that great as compared to 
the 767.
    Senator Allard. The thing I was bringing up, the 767, that 
means you have to have a whole new maintenance line out here. 
You may have to build new buildings for that. I do not know 
whether it would fit in any of your current buildings or not. 
But those are questions that come up. I know the commercial 
airlines look at that. In fact, a lot of them are trying to 
keep too much diversity in their flight, in their flying 
planes, because it creates problems with maintenance because 
you have to maintain so many crews that are experts in the 
various planes and what-not.
    I assume that you have looked at some of that?
    Secretary Roche. Yes, sir. At some point you transition, 
and our issue is that these planes, these tankers, have to be 
recapitalized at some point.
    Staff has just provided me, sir: We did look at the DC-10s. 
There were very few that were of the configuration needed, 
freighter configuration DC-10s, and they had quite a number of 
hours on them, about 27 years old. Our experience with taking 
old 707s and refurbishing them for Joint Surveillance, Target 
Acquisition, and Reporting System (JSTARS) shows that they 
really do not start out as new planes; they start out as old 
planes.
    Senator Allard. Thank you.
    Chairman Warner. Now we will proceed to Senator McCain.
    Senator McCain. Secretary Roche and Secretary Wynne, you 
are familiar with a June 20, 2003, memorandum for Under 
Secretary of Defense, Acquisition, Technology and Logistics, 
Under Secretary of Defense-Comptroller, ``Subject: PA&E 
Analysis, KC-767A lease program''? Are you both familiar with 
that?
    Secretary Roche. I am, sir.
    Senator McCain. Are you familiar with it, Secretary Wynne?
    Secretary Wynne. Yes, sir.
    Senator McCain. It basically says that ``Our analysis 
indicates that the provisions of the lease cost more than the 
equivalent purchase. We find that leasing provides no inherent 
economic efficiencies relative to direct purchase of tankers, 
therefore more expensive in the long run.'' You are familiar 
with this, basically a memorandum objecting to the lease 
proposal from PA&E?
    Secretary Roche. A question of fact, Senator: Does it begin 
by saying ``The report to Congress,'' ``The draft report to 
Congress''?
    Senator McCain. No, it says ``This memorandum provides a 
summary of the A-94 and A-11 analysis developed by PA&E in 
response to taskings from the leasing review panel and 
subsequent leasing working groups. Analysis based on the latest 
version leasing contract provided my office on June 17, 2003.''
    Secretary Roche. Yes, sir. We both met with Mr. Krieg the 
next day.
    Senator McCain. Are you familiar with it?
    Secretary Roche. Yes.
    Senator McCain. Now, then that was on June 20. On June 23 
did you have a meeting, Mr. Roche, with Thomas Owens of Boeing?
    Secretary Roche. I do not know if I did or not, sir.
    Senator McCain. Well, let me say, I have an email here that 
is written from Thomas Owens to Jim Albaugh, with a copy to 
Andrew Ellis: ``Subject: Roche Meeting 23 June 2003.'' Do you 
remember it now?
    Secretary Roche. No, sir.
    Senator McCain. I tell you what. Maybe I can refresh your 
memory. ``Tankers''--this is from the email that he sent. 
``Tankers.'' He started with: ``We have a big problem,'' 
referring to the apparent PA&E question: ``If you need tankers 
so bad, why is Air Force retiring KC-135s early?'' Unquote. 
``He made reference to Chrissy-Poo several times. He is a 
McCain staffer. With regard dialogue reference best price 
effort, he seemed to be concerned more for Marv's benefit than 
he was himself. Marv having trouble with some over the issue of 
$138 million versus $131 million. Ask us to put pressure on 
Mike Wynne to convince PA&E to write new letter essentially 
undoing the first letter. He said he was not going to answer, 
would get in trouble no matter how he answered. Roche said he 
was going to talk to Wolfowitz tomorrow. Meanwhile, the report 
is stalled until Krieg or someone else figures out the letter 
is going to embarrass the SECDEF.''
    Do you have any recollection of that meeting?
    Secretary Roche. No, sir. I do recollect meeting with Ken 
Krieg on a Monday. The letter from PA&E comes to the office on 
a Friday afternoon----
    Senator McCain. I am asking about a meeting with Thomas 
Owens.
    Secretary Roche. I do not recall it, Senator. I do not 
recall.
    Senator McCain. You have no recollection whatsoever of 
telling Mr. Owens to put pressure on Mike Wynne to convince 
PA&E to write a new letter essentially undoing the first 
letter?
    Secretary Roche. No, sir. That is Mr. Owens' 
characterization of what I may have said. I certainly said to 
someone at that time--it could have been Owens; I just do not 
remember if he was in the office--that we were working with 
Mike Wynne to deal with this. We also met with Ken Krieg that 
day, who made it clear that this was more like a red team 
letter.
    But it was not pressure as much as it was, we have to get 
on with this.
    Senator McCain. So this email is essentially false? You did 
not ask Boeing to put pressure on Mike Wynne to convince PA&E 
to write a new letter essentially undoing the first letter?
    Secretary Roche. As they----
    Senator McCain. Is that true or not, Mr. Secretary?
    Secretary Roche. I do not think it is exactly that way, 
Senator.
    Senator McCain. Did you or did you not----
    Secretary Roche. I believe it was a matter that I----
    Senator McCain. Secretary Roche, I would like you to 
respond to the question.
    Secretary Roche.--did suggest that they talk to Secretary 
Wynne, yes. But the word ``pressure''----
    Senator McCain. Did you or did you not----
    Secretary Roche. I did not ask them to put pressure.
    Senator McCain. Did you or did you not request Boeing to 
put pressure on Mike Wynne to convince PA&E to write a new 
letter essentially undoing the first letter? Did you or did you 
not?
    Secretary Roche. I have no recollection of that, Senator. I 
know that we met with Ken Krieg and we decided not to write 
another letter, but to work out each of the issues.
    Senator McCain. I am asking about a meeting that you had 
with Boeing, employees of Boeing----
    Secretary Roche. I cannot recollect saying that, Senator, I 
am sorry.
    Senator McCain. Secretary Wynne, was any pressure put on 
you?
    Secretary Wynne. No, sir, I reflect no pressure from 
Boeing.
    Senator McCain. I see, but you had plenty of meetings with 
them?
    Secretary Wynne. I had a relatively few meetings with 
Boeing, sir.
    Senator McCain. I have no more questions, Mr. Secretary.
    Chairman Warner. I suggest this be part of the record.
    Senator McCain. Without objection.
    [The information referred to follows:]
      
    
    
      
    Senator Inhofe. Two very short questions. First of all, I 
think there might have been a misunderstanding, Secretary 
Roche, with my line of questioning concerning the shortage of 
tankers. I was not referring to the 68 potentially retired KC-
135s as lift vehicles or something else. I was really referring 
to them as tankers.
    Do you agree that we have a shortage of tankers today?
    Secretary Roche. We meet the requirements today in the 
total number of tankers. It is the fact that over time this is 
going to become more difficult as we have scenarios that are 
around the world. But in fact we do meet all the requirements 
of the contingencies we have right now.
    Senator Inhofe. Yes, but we do not know what contingencies 
we are going to have in the future.
    Secretary Roche. That is the point.
    Senator Inhofe. Are you personally comfortable? What is 
your comfort level with the number of tankers we have right 
now?
    Secretary Roche. In terms of total numbers, it is not--I am 
not uncomfortable. It is in the reliability of the tanker force 
that I am uncomfortable.
    Senator Inhofe. Second, one thing that has just been left 
out of this discussion has been the idea of centralized 
training. We have used centralized training on the C-141, C-5, 
C-17, and KC-135. It has been a successful program. Do you feel 
if this lease should go through or if any of the other 
arrangements that have been discussed here today should occur, 
that centralized training is desirable?
    Secretary Roche. In the long run it most certainly is, sir. 
We typically take a new plane and train where they are first 
deployed and then migrate to a centralized position, and we 
would intend to do the same thing.
    Senator Inhofe. In the case of the C-17s, I think the 
original purchase was 120. That decision was made I think when 
the 40th one was delivered. Does that time frame sound 
reasonable?
    Secretary Roche. I would have to take a look and discuss 
with others. It is somewhere between there and 100, or maybe it 
is beyond 100. It depends on the aircraft and the amount of 
training that is being done, for instance, where we would like 
to go.
    Senator Inhofe. Why would it be different with, say, a 767 
and a C-17?
    Secretary Roche. It may not necessarily be different, 
Senator. It may not necessarily be different.
    Senator Inhofe. In retrospect, was not the C-17 program 
pretty successful?
    Secretary Roche. It was very successful.
    Senator Inhofe. All right, sir. Thank you very much.
    Chairman Warner. Thank you very much.
    Senator Allard. Just one question, Mr. Chairman?
    Chairman Warner. We actually will go to Senator Levin for 
his 30 seconds, and 30 seconds with you, because I am very 
anxious to move to this next panel.
    Senator Levin. Thank you, Mr. Chairman.
    I want to just pursue something that Senator Allard asked. 
He read a long paragraph from the CBO report and the answer was 
that there was some confusion between the lease administrator 
and the trustee. I do not think that is the point this 
paragraph makes and so I am going to re-read it: ``Under the 
operating guidelines for the financing committee,'' the CBO 
writes, and this is the financing committee of this trust, 
``the Air Force must approve all of the terms and conditions 
for the financing plan and must review and approve all 
financing documents. CBO concludes that the actions of that 
committee will be explicitly controlled by the Air Force.''
    My question of you, I think, Mr. Kaplan first, would be: Do 
you disagree with that?
    Mr. Kaplan. Senator, the SPE will continue to own this 
aircraft. For purposes of the A-11 analysis, the relevant 
question is whether the ownership remains with the lessor 
throughout the term of the lease. The answer in this case is 
that the lessor is the SPE.
    Senator Levin. I understand. I know what you are saying. 
That is not my question. I am not asking you for a legal 
technicality. I am asking you for actual control. I think you 
know what I mean.
    The question is, is CBO wrong in concluding that the 
actions of the committee will be controlled by the Air Force?
    Mr. Kaplan. Some of the actions of the committee, I think 
is the right answer, Senator.
    Senator Levin. The important actions, the relevant actions, 
the key actions?
    Mr. Kaplan. Not for purposes of the A-11 analysis, Senator. 
I believe that refers to the financing terms of the 
transaction. It does not, for instance, refer to the sale of 
the aircraft at the end of the lease. That is, for the purposes 
of the A-11 criteria, determining whether this is an operating 
lease or a lease-purchase, it is the retention of ownership 
that is important.
    Senator Levin. Is it not true that if in fact the Air Force 
decides to buy these that that financing committee must 
purchase?
    Mr. Kaplan. The Air Force has the option, yes, under the 
contract. The Air Force has the option, if Congress approves, 
to purchase the planes, absolutely.
    Senator Levin. Right, and then the financing committee must 
buy; is that not correct? It must arrange to buy the aircraft?
    Mr. Kaplan. Yes, there is a contractual provision that 
there is an option to buy.
    Senator Levin. Of course. Is it not true that the Air Force 
has a veto over any action of the financing committee?
    Mr. Kaplan. I would have to check. I think that is the 
case, but again the area of responsibility of the financing 
committee I believe is limited to the terms and conditions of 
the lease itself.
    Senator Levin. So you do not agree with the statement of 
the CBO?
    Mr. Kaplan. As I said I think at the outset, there were 
parts of it I agreed with and parts that I did not, Senator.
    Senator Levin. Just the one I read at the end, that the 
actions of that committee will be explicitly controlled by the 
Air Force? You just disagree with that statement?
    Mr. Kaplan. The financing committee I believe will be 
controlled by the Air Force in conjunction with the other 
members of the committee.
    Senator Levin. Thank you.
    Chairman Warner. Senator Allard, a quick wrap-up.
    Senator Allard. Mr. Chairman, I just want to make clear 
that I do think we have a need for new tankers and I want to 
see it done. I just have some concerns about how we are going 
to handle this from a budget point of view.
    So my last question is that the trust that we have set up 
here--is this the first time this mechanism has ever been used? 
I asked this question yesterday of the CBO and he thought it 
was. Does OMB know whether this is the first time this process 
has ever been used in the budgeting process?
    Mr. Kaplan. Senator, I think it is fair to say that this 
very complex transaction is unique in many respects. As to 
whether a special purpose entity has ever been used, I cannot 
say. But there is no question that this is an extremely unique 
lease transaction.
    Senator Allard. I am wondering. I wonder if you would 
confirm that and see as to whether it is the first time this 
has been used or not and get something back to me and the 
committee in that regard.
    Mr. Kaplan. We will do that, Senator.
    [The information referred to follows:]

    Trusts have been used as part of lease arrangements in the past. 
For example, the Veterans Administration has used trusts in at least 
eight building leases since 1986. In 1989, the Architect of the Capitol 
entered into a similar trust arrangement to finance the construction of 
the Federal Judiciary Office Building. The National Archives and 
Records Administration did the same in constructing the Archives II 
facility.

    Senator Allard. Thank you.
    Chairman Warner. We will now proceed to the second panel. 
But before you depart, I would say to our witnesses that I feel 
that in a period of 3 hours we have had a very intense period 
of questioning here and I think the members of this committee 
are to be commended for the fairness of the questions and the 
sincerity to try and reach what, I cannot predict the 
conclusion, but would be a solution to a problem that is in the 
best interests, security interests, of this country and the 
taxpayers.
    So we will now proceed to the second panel.
    Secretary Wynne. Thank you, Senator.
    Secretary Roche. Thank you very much, Senators.
    Chairman Warner. We thank the witnesses of the second panel 
for their patience, but I believe that, and I hope you concur, 
that we had a very thorough exchange of viewpoints with the 
first panel.
    This second panel will provide independent views on the 
specifics of the lease proposal. I want to welcome: Neal 
Curtin, Director, Defense Capabilities and Management at the 
GAO; Robert Sunshine, Assistant Director for Budget Analysis at 
the Congressional Budget Office; and Dr. Richard Nelson, 
Assistant Director, Cost Analysis and Research Division, 
Institute for Defense Analyses.
    I thank you, gentlemen, for your willingness to appear 
today and express your views. We will place into the record 
your statements and the chair requests that you summarize your 
statements and then we will proceed to questions.
    Mr. Curtin.

STATEMENT OF NEAL P. CURTIN, DIRECTOR FOR DEFENSE CAPABILITIES 
         AND MANAGEMENT, U.S. GENERAL ACCOUNTING OFFICE

    Mr. Curtin. Thank you, Mr. Chairman and members of the 
committee.
    About a year ago we provided this committee a report on our 
preliminary observations on the Air Force's negotiation as it 
stood at that time, and you asked us to take another look at 
this when the Air Force presented its proposal to Congress, 
which it did on July 10. So we have reviewed the Air Force 
proposal, and I appreciate the opportunity to be here today to 
present GAO's observations on issues that we hope are useful to 
the committee in its deliberations on this.
    I will be very brief since my full statement is in the 
record. I will summarize a couple key points.
    Chairman Warner. I would like to ask you to draw up the 
microphone because there are a number of people in the 
audience, particularly those in the back, that are anxious to 
hear your statements.
    Mr. Curtin. Thank you.
    First, the Air Force report acknowledges that leasing is 
more expensive, but its analysis indicates that a net present 
value difference of only $150 million favoring purchase out of 
a total program estimate of about $17 billion. Since this type 
of analysis is so sensitive to the assumptions used--and you 
went into great depth on that with the first panel--we reviewed 
some of those same analyses that the other panelists have.
    The sensitivity analysis that we did shows that the cost 
difference in favor of purchase could be as much as $1.9 
billion in net present value. That is an extra cost of over 10 
percent for leasing versus the 1 percent shown in the Air Force 
report. We think that is a better reflection of the real 
difference between lease and purchase.
    Second, the Air Force really does not make a case that 
leasing is cheaper. Instead, their main argument is that there 
is an urgent need to begin replacing the current tanker fleet 
and that leasing provides the aircraft earlier and completes 
the deliveries more quickly than purchase under the current 
budget constraints. Leasing would provide the first planes in 
August 2006, whereas under the current procurement plan in the 
Air Force budget they would not receive the first planes until 
fiscal year 2009.
    In our view, the urgency of the need is really a matter of 
how much risk the Air Force and Congress are willing to accept. 
Now, the Air Force has not made replacement of the tanker fleet 
a procurement priority in past years. We pointed out as far 
back as our 1996 report that the Air Force needed to start 
planning to replace the aging fleet of KC-135s. At that time 
they were already 35 years old, and the Air Force said at that 
time in response to our report, and has continued to say up 
until about 18 months ago, that the tankers were a lower 
priority and replacement could wait until later in this decade.
    KC-135s are increasingly difficult and expensive to 
maintain, there is no question about it. The Air Force has been 
able to meet the heavy demands of the past 2 years with the 
existing fleet. The risk is that the aging planes would incur 
some fleet-wide problem in the intervening years that would 
jeopardize the overall mission, and there is no way to predict 
how likely that is or how serious such a fleet-wide grounding 
might be.
    The third point: Congress also needs to be aware that as 
part of the lease agreement DOD plans to contract with Boeing 
for logistics support that will total over $5 billion during 
the period of the lease, or an average of about $6.4 million 
per year per aircraft in fiscal year 2002 dollars. Boeing would 
handle all maintenance above the flight line level.
    We do not know at this point to what extent the Air Force 
considered other options for maintenance. There was some 
discussion this morning that they are looking at public-private 
partnerships and things like that. But there was no competition 
of this contracting provision for maintenance and there are 
many private contractors out there who perform maintenance now 
on commercial 767s.
    We asked the Air Force for documentation on how they 
arrived at the maintenance agreement with Boeing and agreed on 
the price, but the documents the Air Force provided really did 
not shed much light on their basis for how they arrived at the 
price.
    Fourth, there are some issues that Congress needs to 
consider when these leases expire, and there was some 
discussion of that earlier as well. At the end of these 6-year 
terms, the agreement says the aircraft are supposed to be 
returned to the owner. At that point the Air Force would have 
made lease payments of about 90 percent of the value of the 
aircraft, maybe more than 90 percent under different analysis 
there, and the Air Force would actually incur additional cost, 
estimated at about $778 million, to return the aircraft to this 
special purpose entity in the maintenance condition specified 
in the lease.
    More importantly, if the Air Force in fact returns those 
airplanes they would be losing tanker capacity that would have 
to be replaced somehow. So in other words, if the Air Force 
really leases these planes for 6 years and turns them back in 
this proposal really does not make much sense at all, 
financially or militarily. So the very strong likelihood is 
that the Air Force will seek authority and funding to purchase 
the tankers at the expiration of the lease. So Congress should 
be aware that the full cost of this program should really 
include an additional $4 billion to account for the purchase 
cost at the end of the program.
    Moreover, the tanker fleet consists of over 500 KC-135s, 
which all must be replaced eventually, or at least some portion 
of that 500, as the Secretary said. It may not be all 500. If 
the Air Force continues procurement beyond these first 100, the 
leasing proposal complicates the Air Force's budget situation 
in future years. Because leasing results in deferring payments 
until future years, the Air Force will still be making large 
lease payments on the first 100 aircraft at the same time it 
will need to commit funds to follow-on procurements, and that 
is the chart you showed earlier, Mr. Chairman.
    In that chart it shows that at the peak of the lease 
payments you would also be reaching one of the peaks in your 
follow-on procurement of the second batch of airplanes. In that 
analysis, the Air Force could need as much as $6 billion per 
year in the 2012 to 2014 time frame just for tankers.
    Chairman Warner. That procurement you refer to is a capital 
acquisition----
    Mr. Curtin. Absolutely, yes.
    Chairman Warner.--vice lease.
    Mr. Curtin. Absolutely.
    Just to sum up the key points: The lease proposal in our 
view is clearly more expensive than outright purchase, and by a 
greater amount than the Air Force analysis shows. So from a 
purely economic standpoint the proposal really does not provide 
the best return for the taxpayer. It really comes down to a 
judgment then of whether other factors outweigh the extra cost.
    There is a need for new tankers, but the urgency of 
proceeding more quickly through this tanker proposal has really 
not been made strongly to us, because the problems of the KC-
135s have been known for some time and yet the Air Force has 
not made tankers a priority for procurement funding.
    I will stop there. My statement does raise additional 
issues that I would be glad to go into in the questions period 
and be glad to take whatever other questions you have.
    [The prepared statement of Mr. Curtin follows:]

                  Prepared Statement by Neal P. Curtin

    Mr. Chairman and members of the committee: I appreciate the 
opportunity to appear before you today to discuss the Air Force's 
report on the planned lease of 100 Boeing 767 aircraft modified for 
aerial refueling. Aerial refueling is a key capability that is 
essential to the mobility of U.S. forces. Section 8159 of the 
Department of Defense Appropriations Act for Fiscal Year 2002 
authorizes the Air Force to lease up to 100 Boeing 767 aircraft; the 
leased aircraft would be known by a new designation, KC-767A. The act 
also requires the Air Force to report to Congress with a description of 
the proposed lease terms and conditions and any expected savings before 
proceeding. The Air Force sent its report to Congress on July 10.
    Last year, we provided you with information on the Air Force plan 
to lease KC-767A aerial refueling aircraft.\1\ For this hearing, you 
asked for our analysis of the Air Force's business case and our views 
on the proposed lease arrangement. In my statement today, I will: (1) 
summarize the proposed lease as presented in the Air Force's recent 
report to Congress, (2) present our observations on the Air Force's 
lease report and its justification for the lease, and (3) identify 
related issues and costs that we believe Congress will want to consider 
as it assesses the Air Force's proposal.
---------------------------------------------------------------------------
    \1\ Air Force Aircraft: Preliminary Information on Air Force Tanker 
Leasing. GAO-02-724R. Washington, DC: May 15, 2002.
---------------------------------------------------------------------------
    To summarize and analyze the report of the proposed lease, we 
reviewed the report to Congress, examined the draft lease (which is 
still in negotiation and is subject to change), and reviewed documents 
and briefings from the Office of the Assistant Secretary of the Air 
Force for Acquisitions, Air Mobility Programs, to identify issues and 
costs that are material to the contract. We also reviewed the Air 
Force's analysis and data used in its analysis of the lease versus buy 
comparison as required by Office of Management and Budget (OMB) 
Circular A-94. Finally, we used data gathered for our ongoing review of 
tanker requirements being conducted for the House Armed Services 
Committee's, Subcommittee on Readiness.

                               BACKGROUND

    Aerial refueling is critical to carrying out our national security 
strategy because it allows other aircraft to fly further, stay airborne 
longer, and carry more weapons, equipment, and supplies. While numerous 
military aircraft provide refueling services, the bulk of U.S. 
refueling capability lies with the Air Force's fleet of 59 KC-10 and 
543 KC-135 aircraft. These are large, long-range aircraft that have 
counterparts in the commercial airlines but have been modified to turn 
them into tankers. The KC-10 is based on the DC-10 aircraft, and the 
KC-135 is similar to the Boeing-707 airliner. Because of their large 
numbers, the KC-135 is the mainstay of the refueling fleet, and 
successfully carrying out the refueling mission depends on the 
continued performance of the KC-135. Thus, recapitalizing the fleet of 
KC-135s will be crucial to maintaining aerial-refueling capability, and 
it will be a very expensive undertaking.
    There are two basic versions of the KC-135 aircraft, designated the 
KC-135E and KC-135R. The R model aircraft has been refitted with modern 
engines and other upgrades that give it an advantage over the E model. 
The E model aircraft on average is about 2 years older than the R 
model, and the R model provides more than 20 percent greater refueling 
capacity per aircraft. The E model is located in the Air National Guard 
and Air Force Reserve. Active Forces have only the R model. Over half 
the KC-135 fleet is located in the Reserve components.
    The rest of the Department of Defense's (DOD) refueling fleet 
consists of Air Force HC-130 and MC-130 aircraft used by Special 
Operations Forces, Marine Corps KC-130 aircraft, and Navy F-18 and S-3 
aircraft. However, the bulk of refueling for Marine Corps and Navy 
aircraft comes from the Air Force KC-10 and KC-135. These aircraft are 
capable of refueling Air Force and Navy/Marine aircraft, as well as 
some allied aircraft, although there are differences in the way the KC-
10 and KC-135 are equipped to do this.
The Air Force's Report on the KC-767A Aircraft Lease
    Section 8159 of the Department of Defense Appropriations Act for 
Fiscal Year 2002,\2\ which authorized the Air Force to lease the KC-
767A aircraft, specified that the Air Force could not commence lease 
arrangements until 30 calendar days after submitting a report to the 
House and Senate Armed Services and Appropriations Committees that 
would (1) outline implementation plans and (2) describe the terms and 
conditions of the lease and any expected savings. At about the same 
time that the Air Force submitted the required report (on July 10, 
2003), it submitted a New Start Notification \3\ and stated that it 
would not proceed with the lease until it received approval from all of 
the committees. The House and Senate Appropriations Committees and the 
House Armed Services Committee approved the new start in July. We 
previously testified before the House Armed Services Committee and its 
Subcommittee on Projection Forces, and we issued a briefing report in 
2002 on the status of the proposed lease to date (see our Related GAO 
Products page for a complete list of products to date related to 
refueling requirements and the proposed lease).
---------------------------------------------------------------------------
    \2\ Department of Defense and Emergency Supplemental Appropriations 
for Recovery from and Response to Terrorist Attacks on the United 
States Act, 2002, Pub. L. No. 107-117, Sec. 8159, 115 Stat. 2230, 2284-
85 (2002).
    \3\ The New Start Notification, submitted to the Armed Services and 
Appropriations Committees on July 11, 2003, was required by section 133 
of the Bob Stump National Defense Authorization Act for Fiscal Year 
2003, and is being used by the Air Force as the trigger for executing 
the lease. Pub. L. No. 107-314, Sec. 133, 116 Stat. 2458, 2477 (2002).
---------------------------------------------------------------------------
    The key elements of the Air Force's proposal, as presented in the 
report to Congress, are summarized below:

         The Air Force proposes to lease 100 KC-767A aircraft 
        for 6 years each; the first aircraft would be delivered in 
        August 2006 and the final ones by the end of 2011. Leases on 
        the final group of aircraft would terminate in 2017. The report 
        indicates that the total program for the leased aircraft would 
        cost about $17.2 billion in net present value over the lease 
        period.\4\
---------------------------------------------------------------------------
    \4\ When costs and benefits are evaluated over time, a net present 
value calculation is used to account for the time value of money 
through an interest rate called a ``discount rate.''
---------------------------------------------------------------------------
         The Air Force's report includes an analysis required 
        by OMB Circular A-94 comparing the net present value of the 
        lease approach against that of purchasing the aircraft. The Air 
        Force acknowledges that its analysis indicated that purchase 
        would be cheaper than leasing by about $150 million in net 
        present value terms. Nevertheless, it proposes to use the 
        leasing approach because it allows the Air Force to take 
        delivery of the aircraft more quickly than it could through 
        purchase (and avoid creating major disruptions to other 
        procurement programs for which funding has already been 
        identified in the Future Years Defense Program). Specifically, 
        the Air Force said that if the aircraft were purchased at the 
        same rate as planned under the lease, it would need $5 billion 
        more funding through fiscal year 2006 and more than $14 billion 
        more for the 6 years reflected in the Future Years Defense 
        Program. Under the procurement budget plan that the lease would 
        replace, the Air Force would not begin acquiring new tankers 
        until fiscal year 2009 and would not have 100 new tankers until 
        2016, 5 years later than planned through the lease.
         The key justification for the lease, according to the 
        Air Force, is an urgent need to replace the current fleet of 
        KC-135 aircraft. The Air Force has stated that the KC-135 is 
        aging and becoming increasingly costly to operate owing to 
        corrosion, the need for major structural repair, and increasing 
        rates of inspection to ensure air safety. Moreover, the report 
        indicates that the Air Force believes it is incurring a 
        significant risk by having 90 percent of its aerial-refueling 
        capability in a single, aging airframe and that a ``fleet 
        grounding'' event could jeopardize the tanker's mission.\5\
---------------------------------------------------------------------------
    \5\ A fleet grounding event would involve some systemic problem or 
equipment failure affecting all aircraft of the same type and would be 
serious enough to require replacement before the aircraft could resume 
normal operations.
---------------------------------------------------------------------------
         The Air Force plans to award a contract to a special 
        purpose entity (SPE), a trust to be created under the laws of 
        Delaware, that will issue bonds to raise sufficient capital to 
        purchase the new aircraft from Boeing and lease them to the Air 
        Force.\6\
---------------------------------------------------------------------------
    \6\ The special purpose entity would pay the interest on the bonds 
using lease payments it receives from the Air Force and would pay off 
all the bonds at the conclusion of the lease term.
---------------------------------------------------------------------------
         The entity is to issue bonds on the commercial market 
        based on the strength of the lease and not the creditworthiness 
        of Boeing. The lease is part of a three-party contract between 
        the Air Force, Boeing, and the SPE. Figure 1 depicts the 
        relationships of the three parties to the contract and the 
        transactions that are to take place under the contract, once it 
        is signed.
      
    
    
      
         Office of Management and Budget Circular A-11 requires 
        that an operating lease meet certain terms and conditions, 
        including a criterion that the net present value of the lease 
        payments not exceed 90 percent of the fair market value of the 
        asset at the time that the lease is initiated. The report to 
        Congress states that DOD believes the proposed lease meets 
        those criteria and that payments over the life of the lease 
        will be equal to 89.9 percent of the fair market value of the 
        aircraft. At the same time, the report points out that the 
        percentage is based on the cost to buy the aircraft--$131 
        million plus the cost of construction financing of $7.4 
        million, for a total of $138.4 million. If the fair market 
        value is assumed to be the cost to buy the aircraft, then the 
        lease payments represent about 93 percent of the fair market 
        value and would not meet the requirement.
         If Boeing sells up to 100 comparable aircraft during 
        the term of the contract to another customer for a lower price 
        than that agreed to by the Air Force, the government would 
        receive an ``equitable adjustment.'' The report also states 
        that Boeing has agreed to a return-on-sales cap of 15 percent 
        and that an audit of its internal cost structure will be 
        conducted in 2011, and that any return on sales exceeding 15 
        percent would be reimbursed to the government.
         According to the report, if the government were to 
        terminate the lease, it must: (1) do so for all of the 
        delivered aircraft, and any aircraft for which construction has 
        not begun, (2) give 12 months advance notification prior to 
        termination, (3) return the aircraft, and (4) pay an amount 
        equal to 1 year's lease payment for each aircraft terminated. 
        If termination occurs before all aircraft have been delivered, 
        the price for the remaining aircraft would be increased to 
        include unamortized costs incurred by the contractor that would 
        have been amortized over the terminated aircraft and a 
        reasonable profit on those costs.
         The government will pay for and the contractor will 
        obtain commercial insurance to cover aircraft loss and third-
        party liability as part of the lease agreement. Aircraft loss 
        insurance is to be in the amount of $138.4 million per aircraft 
        in calendar year 2002 dollars. Liability insurance will be in 
        the amount of $1 billion per occurrence per aircraft. If any 
        claim is not covered by insurance, the Air Force will indemnify 
        the special purpose entity for any claims from third parties 
        arising out of the use, operation, or maintenance of the 
        aircraft under the contract.
         At the expiration of the lease, the Air Force can 
        return the aircraft to the SPE after removing, at government 
        expense, any Air Force-unique configurations added by the Air 
        Force after delivery of the aircraft from the SPE. 
        Alternatively, the Air Force also has the option to purchase 
        the aircraft at residual value (the estimated value of the 
        aircraft after the lease term ends). However, the purchase can 
        take place only if it is authorized and funded by Congress at 
        or before the expiration of the lease.
         The contractor will warrant that each aircraft will be 
        free from defects in materials and workmanship and that the 
        warranty will be of 36 months' duration and will commence after 
        construction of the commercial Boeing 767 aircraft but before 
        they have been converted into aerial-refueling aircraft. Upon 
        delivery to the Air Force, each KC-767A aircraft will carry a 
        6-month design warranty, 12-month material and workmanship 
        warranty on the tanker modification, and the remainder of the 
        original warranty on the commercial components of the aircraft, 
        estimated to be about 2 years.

Our Analysis of the Air Force's Report and Lease Proposal
    I will now present our observations on the Air Force's lease report 
to Congress and on some of the details of the lease proposal. We 
believe there are a number of aspects of the report and lease that 
Congress needs to be aware of in considering the Air Force's proposal, 
including the following:

         The cost differential between leasing and purchasing 
        was presented by the Air Force as about $150 million favoring 
        purchase in net present value terms, although the differential 
        can rise to $1.9 billion favoring purchase, depending upon the 
        assumptions used. For example, according to the Air Force 
        report to Congress, had Congress provided multiyear procurement 
        authority and had DOD been able to accommodate that while 
        preserving ``program stability,'' the net present value could 
        favor purchase by up to $1.9 billion.
         The Air Force report states that there is an urgent 
        need to begin tanker replacement 3 years earlier than 
        previously planned, but until recently, recapitalization of the 
        fleet has not been a high enough priority in the Air Force 
        budget to successfully compete for funding.
         The Air Force proposal may not meet all the criteria 
        specified by OMB to qualify as an operating lease since the Air 
        Force would pay 93 percent of the fair market value of the 
        aircraft if construction financing were not assumed to be 
        included in the fair market value of the aircraft.
         As required by section 8159 of the fiscal year 2002 
        Defense Authorization Act, the Air Force report to Congress was 
        limited to the costs of leasing the aircraft. However, the 
        report does not present the total costs of this program, 
        including the costs to acquire the aircraft at the expiration 
        of the lease or to maintain the aircraft during the period of 
        the lease.
    Net Present Value Analysis
    OMB Circular A-94 specifies that whenever a Federal agency needs to 
acquire the use of a capital asset, it should do so in the way that is 
least expensive to the government as a whole and further specifies how 
a lease versus purchase analysis should be conducted. Specifically, the 
circular directs a net present value comparison between the proposed 
lease and a hypothetical purchase on the basis of the same delivery and 
return profile. This approach permits an accounting for the time-value 
of money.
    In its report to Congress, the Air Force's net present value 
calculations between the proposed multiyear lease and a hypothetical 
purchase indicate that purchasing the aircraft would be cheaper than 
leasing by about $150 million; however, the report contains a footnote 
indicating that the net present value could favor purchase by an 
additional $1.7 billion (for a total of $1.9 billion less in costs 
compared with leasing). The $1.7 billion is based on four assumptions 
(all in net present value terms). First, the Air Force assumes that 
using a multiyear contract \7\ for purchasing the aircraft would lead 
to $900 million in savings. Second, the Air Force assumes that using a 
shorter span of time for the period when progress payments \8\ are made 
would lead to another $200 million in savings. Third, it assumes that 
if a shorter span of time for calculating inflation for progress 
payments is used, then savings of $500 million will occur. Fourth, it 
assumes that if a 30 percent discount on the imputed cost of insurance 
is included (since the government self-insures), savings of $100 
million will occur.
---------------------------------------------------------------------------
    \7\ In multiyear procurement, all items are bought under one 
contract as opposed to a series of annual contracts.
    \8\ Progress payments, which are made to contractors before they 
deliver items, reduce contractors' financing costs and in turn result 
in a lower purchase price for the government.
---------------------------------------------------------------------------
    The net present value analysis is also sensitive to the appropriate 
discount rate and other expected inflation. The Air Force followed OMB 
guidance contained in Circular A-94 in doing its analysis, to include 
using the discount rate of 4.1 percent. Our analysis shows that a 1-
percentage point change in the discount rate can cause a change of over 
$660 million in the net present value results. Table 1 shows the 
sensitivity of the net present value analysis to different discount 
rates, including the discount rate of 4.2 percent that we would use on 
the basis of the July 10, 2003, date on which the report to Congress 
was issued.\9\
---------------------------------------------------------------------------
    \9\ The Air Force used a 9-year discount rate from Appendix C of 
Circular A-94, which is revised annually. The date of the revision used 
by the Air Force was January 2003. GAO policy for determining a 
discount rate is that it should be the interest rate for marketable 
U.S. Treasury debt with maturity comparable to the term of the project 
being evaluated. On the basis of the date the report was issued, the 
discount rate that we would use would be 4.2 percent.

  TABLE 1: SENSITIVITY ANALYSIS OF DISCOUNT RATES FOR THE A-94 ANALYSIS
                        [In millions of dollars]
------------------------------------------------------------------------
                                                  Net present value of
         Discount rates in percentages           leasing minus purchase
------------------------------------------------------------------------
3.5...........................................                   $567.6
4.1 (Air Force discount rate).................                    154.7
4.2 (GAO discount rate).......................                     89.5
4.5...........................................                  -100.4
------------------------------------------------------------------------
Sources: Air Force (data); GAO (analysis).

    The assumptions being used for the analysis regarding rates of 
expected inflation for construction of the aircraft, for military 
construction of facilities, and for operation and maintenance are 
reasonable; however, if the actual cost increases for the construction 
of the aircraft are higher than the assumed cost increases in the Air 
Force analysis, the cost of leasing will be higher than the cost 
presented in the report to Congress. The reverse could also be true.
    Urgency of Tanker Replacement
    In its report to Congress, the Air Force stated that ``our National 
Security Strategy is unexecutable without air refueling tankers'' and 
that ``the risks involved with indefinitely operating a fleet of aging 
aircraft are unacceptable.'' These statements indicate that tankers 
are, or should be, a very high priority; however, the Air Force has for 
many years faced the issue of an aging KC-135 fleet and yet has not 
planned, until recently, to begin replacing them.
    After reviewing a wide variety of Air Force reports and documents 
as well other documents, we have concluded that neither the Air Force 
nor DOD have been willing to make the difficult decision to reallocate 
procurement funds from other programs in the near term. For example, 
the Air Force put a replacement tanker program (known as the ``KC-X'') 
in its submission for the President's fiscal year 2004 budget. But in 
view of ``affordability constraints'' in the near term, the program 
would not begin to be funded until fiscal year 2006, and the first 
aircraft would be delivered in fiscal year 2009.
    Until the authority to lease tanker aircraft was established by 
section 8159 of the fiscal year 2002 Department of Defense 
Appropriations Act, we did not perceive that concern within the Air 
Force about the condition of its KC-135 fleet was serious enough to 
successfully compete with other programs for funding. Instead, the Air 
Force has expressed belief in the necessity of continuing to operate 
and sustain the 540-plus aircraft fleet for several more decades, and 
it has also expressed confidence in its ability to do so, as 
illustrated in the following:

         In our 1996 report on aging tanker aircraft,\10\ we 
        stated that procurement of a commercial-derivative aircraft 
        could take as long as 4 to 6 years and that development of a 
        new aircraft could take up to 12 years. Therefore, we stated, 
        the Air Force will need to quickly initiate studies to develop 
        a replacement strategy for mobility aircraft and should 
        consider a multirole aircraft that could be used for air 
        mobility as well as aerial refueling. In response, DOD stated 
        that ``while the KC-135 is an average of 35 years old, its 
        airframe hours and cycles are relatively low. With proper 
        maintenance and upgrades, we believe the aircraft may be 
        sustainable for another 35 years.'' Thus in 1996, the Air Force 
        was planning to continue to rely on the KC-135 aircraft until 
        about 2030. The Air Force's comments notwithstanding, we 
        pointed out at the time of our report that the long-term 
        serviceability of the aircraft was questionable and we continue 
        to believe it.
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    \10\ U.S. Combat Air Power: Aging Refueling Aircraft Are Costly to 
Maintain and Operate, GAO/NSIAD-96-160 (Washington, DC: August 8, 
1996).
---------------------------------------------------------------------------
         The KC-135 Aircraft Sustainment Master Plan (1997), an 
        Air Force strategic guide for investment, repair, and 
        modification decisions, concluded that ``with continued 
        aggressive maintenance, the KC-135 will fly safely well beyond 
        the fiscal year 1997-2002 time frame.'' The report added that 
        the aircraft can continue to be a safe and affordable weapon 
        system that will meet the operational requirements well into 
        the next century ``if there is a consistent investment in 
        maintenance and the aging aircraft programs.''
         The Air Mobility Command's Air Mobility Strategic Plan 
        for 2002 (October 2001) established a time frame of fiscal year 
        2008-2013 to begin fielding an updated fleet of refueling 
        aircraft. However, the report also identified additional 
        problems hampering operations, including tanker aircraft and 
        aircrew shortfalls, an increase in the number of KC-135 
        aircraft in the depot, and a decrease in mission capable rates. 
        The strategic plan acknowledged that the KC-135 Programmed 
        Depot Maintenance Improvement Plan had been developed to reduce 
        the number of aircraft in the depot. In addition, the strategic 
        plan indicated that an Analysis of Alternatives would be 
        conducted over the next 2 years to determine the most effective 
        solution set to meet the Nation's future air-refueling 
        requirements, although, to our knowledge, the analysis has not 
        been done yet.
         In the Mission Need Statement: Future Air Refueling 
        Aircraft (AMC 004-01, November 2001), the commander of the Air 
        Mobility Command (AMC) stated that the ``Air Mobility Command's 
        priority is to continue with C-17 acquisition and C-5 
        modernization in the near term. As the airlift priority is met, 
        AMC will begin to shift resources to address the next air 
        refueling platform in the mid- to long-term. Air Mobility 
        Strategic Plan 2000 envisions KC-135 aircraft retirement 
        beginning in 2013 with the concurrent fielding of a replacement 
        air refueling platform.'' The mission need statement also 
        stated that ``definition of future air refueling mission needs 
        and examination of opportunities for technology enhancement 
        must begin in the near-term.''
         In a May 2002 response to our briefing on our 
        preliminary analysis to the Senate Armed Services Committee of 
        the planned tanker lease, the Air Force stated that while it 
        had programmed funds for a traditional replacement tanker since 
        2001, the first new aircraft would not enter the fleet until 
        fiscal year 2009. The Air Force maintains an aggressive program 
        of inspection and repair to keep the KC-135 fleet operational 
        and to meet mission requirements. Consequently, while the KC-
        135 fleet was built from 1957 through 1965, significant 
        portions of the aircraft have been upgraded or modified in the 
        intervening years.
         From 1975 through 1988, the Air Force replaced about 
        1,500 square feet of the aluminum skin on the underside of the 
        wings of most KC-135 aircraft with an improved aluminum alloy 
        that was less susceptible to fatigue. In addition, engine strut 
        fittings were replaced.
         Beginning in the mid-1980s, the Air Force began to 
        replace the engines of the original KC-135A aircraft. Over 410 
        KC-135 aircraft have been converted to the R model by 
        installation of fuel-efficient, quiet F108 (CFM-56) engines 
        that enhanced the aircraft's performance and capability. In 
        addition to new engines, this modification includes 25 other 
        changes per plane, including reinforced floors, new and 
        strengthened landing gear, reinforced wing structures, new 
        engine struts, and over 12 miles of wiring.
         The Air Force modernized the cockpits on all of its 
        KC-135 tankers through a program called PACER CRAG (compass, 
        radar, and Global Positioning System receiver) to enhance 
        reliability, maintainability, and capability.
         In addition to specific large-scale, fleet wide 
        upgrade programs such as those that I described above, most 
        aircraft have had major structural components replaced as 
        necessary. Moreover, if--as KC-135 aircraft undergo their 
        periodic programmed depot maintenance--trend analyses indicate 
        the potential for fleet wide problems, some major components 
        may be replaced on all aircraft. Examples of some of these 
        major structural repairs include segments of fuselage skins, 
        floor beams, fuselage bulkheads, and upper wing skins. As 
        components such as these are replaced, the use of new and 
        improved materials, fabrication, and corrosion prevention 
        techniques are designed to solve problems and to last for the 
        remaining life of the aircraft. In the case of the upper wing 
        skins, for example, the Air Force reported, ``as we work 
        through the fleet, this level of replacement will decrease as 
        most of the bad skins have been or shortly will be replaced. 
        Replaced skins are installed with attention to corrosion 
        prevention and should last more than 40 years.''

    Despite the Air Force's aggressive maintenance and upgrade programs 
to keep the KC-135 mission capable, since 2001, the Air Force has come 
to believe that the condition of the fleet has deteriorated to the 
point where replacement has become more urgent. For example, Air Force 
officials have cited the Air Force's Economic Service Life Study, which 
showed that program depot maintenance has become increasingly costly on 
the KC-135. Air Force officials told us that the E-model of the KC-135 
is currently operating under flight restrictions owing to corrosion.
    The KC-135 fleet averages over 40 years in age, but the aircraft 
have relatively low levels of flying hours. Flying hours for the KC-135 
averaged about 300 hours per year from 1995 through September 2001. 
Since then, utilization is averaging about 435 hours per year. The Air 
Force projects that E and R models have lifetime flying hour limits of 
36,000 and 39,000 hours, respectively--according to the Air Force, only 
a few KC-135 aircraft would reach these limits before 2040, at which 
time some of the aircraft would be about 80 years old.
    The KC-135 fleet has not been meeting its mission capable rate 
goal. Mission capable rates measure the percentage of time on average 
that the aircraft are available to perform their assigned mission. The 
Air Force has a goal of an 85-percent mission capable rate for the KC-
135 fleet. As shown in figure 2, KC-135 aircraft have not met the 85 
percent mission capable rate in any of the last 3 fiscal years, 
although aircraft in the Active component have consistently reached a 
mission capable rate of over 80 percent.
      
    
    
      
    By most indications, the fleet has performed very well during the 
past few years of high operational tempo. Operations in Kosovo, 
Afghanistan, Iraq, and here in the United States in support of 
Operation Noble Eagle were demanding, but the current fleet was able to 
meet the mission requirements. Approximately 150 KC-135 aircraft were 
deployed to the combat theater for Operation Allied Force in Kosovo, 
about 60 for Operation Enduring Freedom in Afghanistan, and about 150 
for Operation Iraqi Freedom.\11\ Additional KC-135 aircraft provided 
``air bridge'' support for the movement of fighter and transport 
aircraft to the combat theater, for some long-range bomber operations 
from the United States, and to help maintain combat air patrols over 
major U.S. cities since September 11, 2001.
---------------------------------------------------------------------------
    \11\ Air Force officials told us that combat commanders refused to 
permit the E-model of the KC-135 to be deployed to recent combat 
theaters.
---------------------------------------------------------------------------
    According to Air Force projections, the KC-135 operating and 
support costs will increase substantially in the coming years. The 
costs for the current fleet totaled about $2.4 billion in fiscal year 
2002 (2002 dollars). The Air Force projects that the cost will total 
about $3.5 billion (2002 dollars) in fiscal year 2012 for a fleet of 
510 aircraft. According to Air Force officials, increased programmed 
depot maintenance costs were a significant cause of the increase. The 
officials said that, based on historical experience, programmed depot 
maintenance costs are expected to increase about 18 percent per 
aircraft per year. By the same projections, the operating and support 
costs for the fleet of 100 KC-767A aircraft will total about $808 
million.\12\
---------------------------------------------------------------------------
    \12\ The projections assume that the KC-135Es and KC-135Rs will fly 
308 and 368 hours per year while the KC-767A will fly 750 hours per 
year.
---------------------------------------------------------------------------
    The concept of an aging KC-135 fleet, and the problems and costs 
associated with operating and sustaining old aircraft, is not a sudden 
manifestation, but rather a fact of life that the KC-135 support 
infrastructure has had to deal with for years. Many of the problems 
currently being reported as reasons to begin tanker recapitalization 
immediately--including corrosion, increasing operating and support 
costs, and reduced aircraft availability--are not new and were issues 
that the Air Force was addressing in the mid-1990s, when we last 
examined aerial-refueling matters and when the Air Force concluded that 
recapitalization was not urgent.
    Operating Lease Requirements
    OMB Circular A-11 provides certain criteria that must be met for an 
operating lease:

         Ownership must remain with the lessor throughout the 
        term of the lease and is not to transfer at or shortly after 
        the end of the lease period.
         No bargain price purchase option is allowed.
         The lease term may not exceed 75 percent of the 
        asset's economic lifetime.
         The present value of the minimum lease payments cannot 
        exceed 90 percent of the fair market value of the asset at the 
        beginning of the lease term.
         The asset must be a general-purpose asset and not 
        government-unique.
         The asset must have a private-sector market.

    The Air Force report says that the proposal complies with all of 
the criteria.
    However, the report also points out that, depending on the fair 
market value used, the net present value of the lease payments in the 
case of the KC-767A may exceed the 90 percent of initial value 
threshold. On the one hand, if the fair market value is considered to 
include the cost of construction financing of $7.4 million per aircraft 
(or $740 million for all 100 aircraft),\13\ then the lease payments are 
estimated to represent 89.9 percent. This is the formula that the Air 
Force used to document compliance with the circular and which the Air 
Force cited in its report to Congress; it results in a cost of $138.4 
million per aircraft. On the other hand, if the fair market value 
excludes construction financing, it totals $131 million per aircraft, 
and the lease payments represent 93 percent, thus exceeding the 90 
percent threshold. According to the Air Force report, construction 
financing, however, must be included to meet the OMB Circular A-11 
requirement.
---------------------------------------------------------------------------
    \13\ Construction financing will be raised by the special purpose 
entity through borrowing in order to make progress payments.
---------------------------------------------------------------------------
    However, it is not clear that including the construction financing 
represents the fair market value of the aircraft. The SPE will borrow 
money on the commercial market to raise funds to pay Boeing to finance 
construction of the aircraft and will repay the banks up to $7.4 
million in interest on the loans per aircraft. Once constructed, the 
aircraft will be delivered to the SPE, and the SPE will pay Boeing $131 
million less the amount of financing already paid to Boeing for the 
aircraft. The Air Force will then lease the aircraft for up to $138.4 
million per aircraft over the life of the lease. Consequently, the $7.4 
million (reported by the Air Force as construction financing) 
represents interest on the loans to the SPE, and it is not clear that 
interest should be included in the fair market value of the aircraft.
    Total Cost of the Program
    While the Air Force report includes the cost of leasing and other 
government costs such as training, as well as operations and support, 
the report does not include the costs of buying the tankers at the end 
of the lease.\14\ At the end of each 6-year lease, the aircraft are to 
be returned to the owner, the SPE, or they can be purchased by the Air 
Force for their residual value, estimated at about $44 million each in 
then-year dollars. If the aircraft are returned, the Air Force tanker 
fleet will be reduced, and the Air Force will have to find some way to 
replace the lost capability. In other words, the lease payments will 
have paid almost the full cost of the aircraft, and then the capability 
would be lost. Thus, the total cost of this 100-aircraft program should 
include the eventual acquisition cost. In addition to the cost to lease 
and subsequently purchase the aircraft, Air Force operations and 
support costs range from $4.6 billion to $6.8 billion, depending on 
which dollar calculation is used. The Air Force also plans to construct 
new facilities and would incur other costs ranging from $1.2 billion to 
$1.5 billion. Table 2 summarizes total cost in three different dollar 
calculations--then-year (or current) dollars, constant fiscal year 2002 
dollars, and net present value.\15\
---------------------------------------------------------------------------
    \14\ The Department of Defense and Emergency Supplemental 
Appropriations for Recovery from and Response to Terrorist Attacks on 
the United States Act, 2002, Pub. L. No. 107-117, Sec. 8159, 115 Stat. 
2230, 2284-85 (2002) required that the Air Force report on the costs to 
purchase or lease the aircraft but did not require that other costs be 
reported.
    \15\ Current dollars or then year dollars are the dollar value of a 
good or service in terms of prices at the time the good or service is 
sold. These contrast with constant dollars, which measure the value of 
purchased goods or services at price levels that are the same as those 
for the base year. Constant dollars do not contain any adjustments for 
inflationary changes that have occurred or are forecasted to occur 
outside the base year. When costs and benefits are evaluated over time, 
a net present value calculation is used to account for the time value 
of money through an interest rate called a ``discount rate.''

TABLE 2: ESTIMATED COST OF THE CONTRACT TO LEASE, MAINTAIN, AND PURCHASE
      100 KC-767A AIRCRAFT UNDER THREE DIFFERENT TYPES OF ANALYSIS
                        [In billions of dollars]
------------------------------------------------------------------------
                                                   Constant
                                          Net       fiscal     Then-year
              Category                  present    year 2002    dollars
                                         value      dollars
------------------------------------------------------------------------
Lease payments with aircraft return.       $11.4       $12.3       $16.3
Aircraft purchase and other costs...         3.1         3.4         5.2
                                     -----------------------------------
  Subtotal..........................        14.5        15.7        21.5

Operations and Support..............         4.6         5.7         6.8
Military construction and other              1.2         1.3         1.5
 costs..............................
                                     -----------------------------------
  Lease-buy Total...................       $20.3       $22.7      $29.8
------------------------------------------------------------------------
Sources: Air Force (data). GAO (analysis).

    In addition, the Air Force will have to pay an additional estimated 
$778 million if the entire 100 aircraft are returned, to ensure that 
the aircraft are returned in the maintenance condition specified in the 
lease. For these reasons, returning the aircraft would probably make 
little sense, and Congress will almost certainly be asked to fund the 
purchase of the aircraft at their residual value as the lease expires.
    Related Issues and Concerns
    Our preliminary analysis indicates that certain other costs 
associated with the lease may deserve further examination by Congress. 
Specifically, we have concerns related to contractor logistics support, 
the extent of Boeing's profit margin, and the impact of the lease on 
follow-on tanker acquisitions.
    Contractor Logistics Support
    The Air Force estimates that the maintenance agreement with Boeing 
will cost between $5 billion and $5.7 billion during the lease period. 
It has negotiated a noncompetitive agreement with Boeing as part of the 
lease negotiations, covering all maintenance except flight-line 
maintenance, which is to be done by Air Force mechanics. This 
represents an average of about $6.4 million per aircraft per year in 
fiscal year 2002 dollars. We do not know how the Air Force determined 
that this was a reasonable price or whether competition might have 
yielded savings because the Air Force did provide sufficient documents 
on a timely basis for us to evaluate its price analysis. A number of 
commercial airlines and maintenance contractors already maintain the 
basic 767 commercial aircraft and could possibly do some of the 
required maintenance if given the opportunity to compete for the 
contract.
    Profit Margin
    The Air Force report indicates that Boeing can earn no more than a 
15-percent profit on the Boeing 767 aircraft and that an audit will be 
conducted after the final planes are delivered to ensure that the 
company's profit does not exceed that amount. However, since this 
aircraft is basically a commercial 767 with modifications to make it a 
military tanker, it is not clear why the 15-percent profit should apply 
to the full cost. One financial analysis published recently states that 
Boeing's profit on commercial 767 aircraft is in the range of 6 
percent.\16\ If the Air Force negotiated a lower profit margin on that 
portion of the cost, with the 15-percent profit applying only to the 
military-specific portion, this could lower the cost by several million 
dollars per aircraft. For example, assuming the commercial tanker 
portion of the cost is about $80 million, the difference between 
profits of 6 percent and 15 percent would be about $7 million per 
aircraft, or $700 million for all 100 aircraft.
---------------------------------------------------------------------------
    \16\ See Morgan-Stanley, Does 767 Tanker Equate to 700+ Comml 
Orders?, (May 30, 2003).
---------------------------------------------------------------------------
    Effect on Follow-on Tanker Acquisitions
    One of the key advantages of leasing is that it enables the Air 
Force to take delivery of aircraft without the large, up-front 
obligation of funds required for purchase; thus by the end of fiscal 
year 2011, the Air Force will have received 100 new tankers. The flip 
side of this, however, is that payments are spread out over many years 
and represent an obligation that must be met throughout the term of the 
lease. The Air Force will be making lease payments on the leased 
aircraft through fiscal year 2017, and will likely pay about $4.4 
billion (in then-year dollars) in fiscal years 2012-2017 to purchase 
the aircraft at the expiration of the lease. Funds spent during those 
years on these 100 aircraft are therefore funds that are not available 
for the procurement of additional tanker aircraft that will be needed 
to replace the remaining 400-plus aircraft in the KC-135 fleet. If the 
Air Force wants to procure additional tankers starting in this 2012-
2017 period, it will need an even larger budget during those years to 
accommodate both the continuing lease payments and new procurement. 
Figure 3 illustrates the annual outlays that would be required to lease 
the aircraft as proposed and the additional outlays needed to purchase 
an additional block of 100 aircraft. This assumes that delivery of the 
additional aircraft would begin after the first 100 had been delivered. 
If additional aircraft are to be obtained before the planned end of 
delivery of the first 100 leased aircraft in 2011, then the additional 
funds for the second block of aircraft would be needed even sooner.
      
    
    
      
    Mr. Chairman, this concludes my prepared statement. I would be 
happy to answer any questions that you or members of the committee may 
have.
Contacts and Staff Acknowledgments
    For future questions about this statement, please contact me at 
(757) 552-8111 or Brian J. Lepore at (202) 512-4523. Individuals making 
key contributions to this statement included Kenneth W. Newell, Tim F. 
Stone, Joseph J. Faley, Stephen Marrin, Kenneth Patton, Charles W. 
Perdue, and Susan K. Woodward.
                          related gao products
    Military Aircraft: Observations on the Air Force's Plan to Lease 
Aerial Refueling Aircraft. GAO-03-1143T. Washington, DC: September 3, 
2003.
    Military Aircraft: Considerations in Reviewing the Air Force 
Proposal to Lease Aerial Refueling Aircraft. GAO-03-1048T. Washington, 
DC: July 23, 2003.
    Military Aircraft: Information on Air Force Aerial Refueling 
Tankers. GAO-03-938T. Washington, DC: June 24, 2003.
    Air Force Aircraft: Preliminary Information on Air Force Tanker 
Leasing. GAO-02-724R. Washington, DC: May 15, 2002.
    U.S. Combat Air Power: Aging Refueling Aircraft Are Costly to 
Maintain and Operate. GAO/NSIAD-96-160. Washington, DC: August 8, 1996.

    Chairman Warner. Mr. Sunshine.

STATEMENT OF ROBERT A. SUNSHINE, ASSISTANT DIRECTOR FOR BUDGET 
             ANALYSIS, CONGRESSIONAL BUDGET OFFICE

    Mr. Sunshine. Thank you, Mr. Chairman. I would like to 
start by expressing the regrets of our director, Dr. Holtz-
Eakin, who would have liked to be here to testify this morning. 
He is a very capable fellow, but he could not be in two places 
at one time, and he had to testify before the House Budget 
Committee on our new economic analysis.
    I would also like to acknowledge the fine work of our 
analyst who did our analysis of this transaction, David Newman, 
who is here with me.
    CBO's analysis was performed at the request of Senator 
Nickles, chairman of the Budget Committee. It is presented in 
my written testimony, which I will summarize this morning. That 
analysis is pretty limited in its scope. CBO has not analyzed 
the need for new tankers. It has not analyzed possible 
alternatives to acquiring new tankers or the impact on our 
defense capabilities of this tanker acquisition decision.
    Our analysis and my testimony address only the proposed 
financing mechanism, its long-term costs, and its budgetary 
treatment. In that regard, I would like to make three major 
points this morning.
    First, the objective of the proposed transaction is to get 
new tankers into the hands of the Air Force as quickly as 
possible while avoiding any significant budgetary impact in the 
next few years. However, CBO believes that if this transaction 
is treated properly in the budget, it should be shown as a 
purchase of the tankers by the Government and therefore would 
require substantial up-front budget authority.
    Second, the proposed transaction will result in costs to 
the government over the next 14 years that are $5 billion to $6 
billion more than would result from a straightforward purchase 
of the same aircraft with the same delivery schedule, using a 
multiyear procurement arrangement. Discounted to this year's 
dollars and depending on the exact methodology one uses to do 
so, the additional cost is between $1 billion and $2 billion in 
net present value terms. There seems to be a broad consensus on 
that.
    Third, these types of transactions have ramifications 
beyond the defense budget and beyond national security 
concerns. Each year in its budget resolution, Congress sets a 
limit on discretionary budget authority, and it allocates that 
sum among various functions. Sometimes, Congress sets these 
limits in law for a number of years. Presumably, those figures 
represent Congress' best judgment as to the amount of 
discretionary obligations that it believes the government 
should enter into during that time period.
    Transactions that create obligations of the government that 
are not recorded as obligations of the government make these 
budgetary limits less meaningful and less effective.
    I will elaborate briefly on each of these points. When one 
steps back from the technical and financial intricacies of this 
proposal, it becomes clear, at least to us, that the 
arrangement is simply a governmental purchase of the tanker 
aircraft. The purchase is being made by the special-purpose 
entity created specifically to borrow money on behalf of the 
government in order to buy aircraft for the government. These 
borrowing arrangements will be overseen by and must be approved 
by the government, and the trust has no other function.
    Thus, as you can see in this chart, which you have all 
seen, we view the trust as an instrument of the government, and 
we think that the budget should reflect the transactions of the 
trust as transactions of the government.
    [The information referred to follows:]
      
    
    
      
    That would require about $17 billion in budget authority 
over the 2004 to 2008 period and would result in outlays of a 
similar amount from 2004 to 2011.
    In our view, the lease payments from the Defense Department 
to the trust are essentially intragovernmental, basically the 
government paying itself. The real budgetary transaction here 
is the government's purchase of the aircraft through the trust.
    It does not look like the administration is going to treat 
the transaction this way. The Air Force plans to treat the 
trust as an independent private-sector entity and to record 
these transactions as an operating lease. That would mean 
recording the lease payments in the budget year by year as they 
were paid. Such a treatment would have the effect of deferring 
the budgetary impact of buying these aircraft for several 
years. Instead of $17 billion in budget authority over the 2004 
to 2008 period, the agency will need less than $2 billion, and 
that in fact is the stated objective of the proposal.
    But even if one does not accept our view that the trust 
should be treated as an instrument of the government, we find 
it difficult to see how this could be considered an operating 
lease. We have discussed and members have pointed out that 
there are six criteria specified in OMB Circular A-11 for an 
operating lease. This arrangement meets hardly any of them.
    For example, the asset is supposed to be a general-purpose 
asset that is not built to the unique specification of the 
government and for which a private-sector market exists. 
Basically, operating leases are intended to apply to widely 
used, commercially available assets like automobiles and 
commercial office space. Aircraft refueling tankers are very 
different. They are highly specialized assets, used almost 
always for governmental purposes, and there is very little, if 
any, private-sector market for them.
    In addition, the asset is not supposed to be transferred to 
the government at or shortly after the end of the lease term, 
and the lease is not supposed to contain a bargain-price 
purchase option. Under this proposal, the Air Force is planning 
to buy the aircraft after the 6-year leases expire and would be 
able to do so at a pretty low price.
    Therefore, we believe that if the trust is to be considered 
nongovernmental, which is not what we think it should be, then 
this financing arrangement should be treated in the budget as a 
lease-purchase, which would require up-front budget authority 
and outlays similar to those for a direct purchase. So whether 
the trust is viewed as governmental or not, we believe that if 
the government's standard budgetary principles are properly 
applied, the proposed arrangement would not accomplish its aim 
of deferring the budgetary impact of the aircraft purchases.
    My second point is that this transaction will cost more 
than a straightforward purchase. We estimate that the 
transaction as it is structured will cost taxpayers between $5 
billion and $6 billion more between now and 2017 than a 
straightforward purchase through the appropriations process of 
the same planes with the same delivery schedule and the same 
maintenance and operating costs.
    The second chart in your handout, with the three sets of 
numbers, displays how we think these figures play out over 
time. The first set of numbers describes our estimate of the 
transaction if it is treated as a purchase or a lease-purchase, 
in other words, the proposed transaction as we believe it 
should be treated. The second set of numbers shows how we think 
it would be treated if it is recorded as an operating lease. 
The third set of numbers shows what we think it would be as a 
direct purchase of the tankers up front under the same 
timetable.
    [The information referred to follows:]
      
    
    
      
    
    
      
    As we have also discussed at some length, when you have 
different flows of money over time, it is useful to do a 
present-value calculation to try to capture the differences in 
the timing of payments. Our estimate of the difference in cost 
is between $1 billion and $2 billion, or 10 to 15 percent, 
depending on exactly what assumptions are used.
    The administration or the Air Force had talked about a $150 
million difference. The biggest difference between our estimate 
and theirs is the difference in the assumptions about what a 
direct purchase would look like. We assumed that if Congress 
was willing to engage in this leasing agreement, it also ought 
to be willing to provide the kind of multiyear procurement 
authority that has sometimes been exercised for some weapons 
systems.
    The Air Force in calculating its present value added 7.4 
percent to the cost of the aircraft under the assumption that 
that kind of multiyear procurement authority would not be 
available. That accounts for close to $1 billion of the 
difference between our estimate and theirs.
    If you were to compare this leasing arrangement with a 
purchase assuming multiyear procurement authority, even under 
the administration's numbers you would get a number in the 
vicinity of $1 billion or a little bit more. There are other 
differences, but that looks to me to be the major difference 
between those two sets of numbers.
    Why is it more costly? It is more costly because, instead 
of borrowing at Treasury rates, which are the lowest possible 
rates, the government via the trust will be borrowing at higher 
rates. The Air Force estimates some of the borrowing at 50 to 
100 basis points above Treasury rates but expects that some 
will be at junk bond rates, hundreds of basis points above 
Treasuries. The government will have to bear those costs 
through its lease payments.
    Finally, we have a broader concern, namely, how this 
transaction and others like it could affect the government's 
overall budget process. Federal budgeting is generally based on 
the principle that spending decisions are best made if the full 
costs of the programs and commitments are recognized explicitly 
up front when the spending decisions are being made. Through 
its budget resolution, Congress specifies the amount of 
discretionary budget authority and outlays for each year and 
then goes through a very painful process of allocating those 
funds among competing national needs and priorities.
    When an agency of the government enters into transactions 
that involve significant obligations of the government but that 
are not fully reflected in the budget figures, those figures 
become less meaningful, and making trade-offs on a level 
playing field among competing demands for scarce resources 
becomes more difficult. Programs with a special non-budgetary 
treatment have a clear advantage over other programs in 
obtaining funding, regardless of their relative merits.
    We at CBO cannot predict how much budget authority will be 
available over the next few years and how much of that will be 
for defense procurement. We cannot judge how easy or hard it 
would be to allocate through the regular appropriations process 
sufficient funds to make a straightforward purchase of the new 
tanker aircraft, either by drawing upon funds that would have 
been used for other purposes or by simply adding to the total 
pot of money. You are in a much better position than we are to 
make that judgment.
    The key question, it seems to me, is whether the Air Force 
needs to acquire these aircraft as quickly as it proposes and, 
if so, whether the proposed transaction is the best way to do 
so. If it is determined that the aircraft need to be acquired 
and if it is possible to find the funds to finance a 
straightforward purchase, the taxpayers would save some money 
and the budget process would be more meaningful and effective.
    Thank you, Mr. Chairman. I will be happy to answer any 
questions.
    [The prepared statement of Mr. Sunshine follows:]

                Prepared Statement by Robert A. Sunshine

                                SUMMARY

    The Department of Defense Appropriations Act, 2002 (Public Law 107-
117), authorized the Air Force to pursue a pilot program for leasing as 
many as 100 Boeing 767 aircraft for up to 10 years and directed the 
service to describe its plan to Congress before entering into such a 
lease. The Air Force, Boeing, the Office of the Secretary of Defense, 
and the Office of Management and Budget (OMB) reached an agreement in 
May 2003 for the service to acquire 100 Boeing KC-767A aerial refueling 
aircraft through a complex financing arrangement. The Air Force 
submitted the required report to Congress on July 11, 2003. In that 
report, the Air Force concludes that the proposed leasing arrangement 
meets all requirements of the Department of Defense Appropriations Act, 
2002, which specified that the terms had to be consistent with the 
criteria for an operating lease as defined in OMB Circular A-11, 
Preparation, Submission, and Execution of the Budget. The report 
further concludes that, while leasing would cost about $150 million 
more (expressed in net present value terms) than an outright purchase, 
leasing is the preferred approach because of the ``advantage it affords 
for quickly delivering needed tankers to our warfighters without 
requiring significant up-front funding.''
    After analyzing the Air Force's report and receiving additional 
information about the proposed lease from the Air Force and Boeing, the 
Congressional Budget Office (CBO) has concluded that the transaction 
would essentially be a purchase of the tankers by the Federal 
Government but at a cost greater than would be incurred under the 
normal appropriation and procurement process. The special-purpose 
entity that has been established to buy the aircraft would, in fact, be 
substantially controlled by and act on behalf of the Federal 
Government, and its transactions should be reflected in the Federal 
budget.
    Even if one were to view the arrangement as a lease, CBO's analysis 
indicates that the proposal does not meet the conditions for an 
operating lease described in the Congressional Scorekeeping Guidelines 
and in OMB Circular A-11 and thus does not comply with the terms of 
section 8159 of the Department of Defense Appropriations Act, 2002.
    Finally, CBO concludes that implementing the Air Force's proposed 
arrangement would be more expensive than the service has estimated. 
While the Air Force estimates that its proposal would cost $150 million 
more than an outright purchase, CBO's analysis indicates that the 
proposal would cost $1.3 billion to $2 billion more in present-value 
terms, or 10 percent to 15 percent more than an outright purchase. On 
average, the Air Force would spend $161 million per plane in 2002 
dollars to lease and then purchase the aircraft, compared to a cost of 
$131 million per plane for an outright purchase.

           THE AIR FORCE'S PLAN TO ACQUIRE 100 BOEING TANKERS

    The Air Force plans to sign a single multiyear contract that will 
include leasing 100 KC-767A aerial refueling aircraft from a special-
purpose entity, called the KC-767A USAF Tanker Statutory Trust 2003-1 
(the Trust). The tankers will be delivered to the Air Force in six 
groups--four aircraft in 2006, 16 aircraft in 2007, and 20 planes 
annually over the 2008-2011 period. The Air Force will use each 
aircraft for 6 years and pay the Trust an average of $126 million a 
plane, in 2002 dollars, during that period. At the conclusion of each 
6-year period, the Air Force can return the aircraft to the Trust or 
purchase them for a price to be set when the contract is signed. The 
Air Force currently estimates the purchase price at an average of $35 
million per plane in 2002 dollars. Thus, according to its estimate, the 
Air Force will pay an average of $161 million per plane to lease and 
then purchase the tankers.\1\ The Air Force has not negotiated to 
purchase the planes directly, but on the basis of the leasing 
arrangement, CBO estimates that given multiyear procurement authority, 
the service could negotiate a contract for 100 tankers at an average 
price of $131 million per plane in 2002 dollars.
---------------------------------------------------------------------------
    \1\ Payments under the Air Force's proposal are based on a 
negotiated purchase price of $131 million in 2002 dollars. Payments 
will be adjusted for inflation using a combination of the Employment 
Cost Index and the Industrial Commodities Index.
---------------------------------------------------------------------------
    The Air Force will be able to terminate the deal prior to the 
completion of the contract by notifying the Trust one year in advance. 
However, that termination would be costly because the Air Force would 
have to make an additional payment equal to an annual lease payment on 
each aircraft and would have to reimburse the Trust for any additional 
costs that resulted from the decision to terminate.

                FINANCING ARRANGEMENTS FOR THE PROPOSAL

    Boeing and the Air Force have established the special-purpose 
entity to execute the leasing arrangement and to finance the 
acquisition of the aircraft. Under the financing plan established by 
the Air Force and Boeing, the Trust will buy 100 KC-767A tankers from 
Boeing at an estimated average price of $131 million per aircraft (in 
2002 dollars) and will borrow money to make progress payments to Boeing 
during the construction period for each group of aircraft.
    As Boeing completes construction of each group of tanker aircraft, 
the Trust will issue bonds in the commercial bond market. Boeing and 
the Air Force estimate that the proceeds from the bonds will need to 
equal $138.4 million per aircraft (in 2002 dollars), enough to pay 
Boeing for the remainder that it is owed for the aircraft, repay the 
principal on the construction loans, and pay interest on the 
construction loans, which the Air Force estimates at an average of $7.4 
million per aircraft.
    Press reports indicate that there will be three classes of bonds. 
The Trust, which will technically own the aircraft, will use the Air 
Force's annual lease payments to pay principal and interest on two of 
the three classes of bonds. If the aircraft are sold at the end of the 
lease term, the proceeds will be used to pay off principal and interest 
on the last class of bonds. The price the Air Force may pay to acquire 
title to the tankers will be established for all 100 planes at the time 
the contract is awarded. That amount will be equal to the principal and 
interest owed on the third class of bonds. Under the terms of the 
agreement, if the Air Force should choose to forgo purchasing the 
aircraft and the aircraft are then sold to another purchaser for more 
than the amount owed on the bonds, any profits from the sale will be 
returned to the U.S. Treasury.
    According to the Air Force and Boeing, the credit rating on the 
bonds will be based on the strength of the cash flow from the Air 
Force, rather than on Boeing's credit rating. For that reason, the Air 
Force expects that the Trust will be able to issue bonds at interest 
rates that are only slightly greater than Treasury rates. Interest 
rates on the bonds must compensate investors for the risk that the Air 
Force might terminate the contract early or might decline to purchase 
the aircraft at the end of the lease. CBO believes that the small risk 
premium estimated by the Air Force on borrowing by the special-purpose 
entity indicates that the Air Force assumes the market will perceive 
the debt as being backed by the Federal Government. (See Figure 1 for a 
graphic display of the financing arrangements.)

                     THE RESULTS OF CBO'S ANALYSIS

    CBO reviewed the information contained in the Air Force report, 
sections of the proposed contract, and the economic analysis prepared 
to support the Air Force's decision to lease. CBO found that the 
financing plan envisioned for acquiring the tankers constitutes Federal 
borrowing and spending under standard government accounting 
principles.\2\ CBO also concludes that the proposal does not meet the 
conditions for an operating lease described in OMB Circular A-11 and 
thus does not comply with the terms of section 8159 of the Department 
of Defense Appropriations Act, 2002. While the Air Force acknowledges 
that acquiring the aircraft with this financing method is more 
expensive than purchasing them outright, its estimate of the extra 
cost--at $150 million--is much less than CBO's analysis indicates. CBO 
concludes that the Air Force would pay $1.3 billion to $2 billion 
(expressed in net present value terms) more to lease and then purchase 
the tankers than it would to purchase them outright.
---------------------------------------------------------------------------
    \2\ The 1967 Report of the President's Commission on Budget 
Concepts suggests a broad definition of Federal budget activities, with 
a few narrow exclusions. It observes that ``providing for national 
security . . . obviously constitutes activities of the Federal 
Government which should clearly be in the budget.'' Consistent with 
other recommendations by the Commission, CBO believes that when the 
government owns a significant part of an entity's assets or exercises 
substantial control over the entity's operations, that entity should be 
included in the Federal budget.
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The Tanker Financing Plan Constitutes Federal Borrowing and Spending
    In its report to Congress, the Air Force indicates that the 
administration will record the tanker contract as an operating lease in 
the Federal budget once the contract is signed. Consequently, 
obligations and outlays will be recorded on a year-by-year basis, 
reflecting the lease payments due each year to the Trust. CBO believes 
that recording the transaction as such would be at odds with standard 
government accounting principles because the proposed financing 
constitutes Federal borrowing and spending. Therefore, the borrowing, 
resulting aircraft purchases, and interest payments by the special-
purpose entity established specifically for this purpose should be 
recorded in the budget at the time the Trust makes those transactions.
    The proposed contract between Boeing and the Air Force, as well as 
the financing arrangement, clearly indicates that the KC-767A USAF 
Tanker Statutory Trust 2003-1 exists solely to borrow money on behalf 
of the Federal Government to allow the Air Force to acquire an asset 
that has been built to its unique specifications. The borrowing 
activities of the special-purpose entity will be directed by a 
financing committee composed of the Air Force, Boeing, and the lease 
administrator. (The Air Force has asked Boeing to serve as the lease 
administrator.) Under the operating guidelines for the financing 
committee, the Air Force must approve all of the terms and conditions 
for the financing plan and must review and approve all financing 
documents.\3\ CBO concludes that the actions of that committee will be 
explicitly controlled by the Air Force.
---------------------------------------------------------------------------
    \3\ Boeing provided CBO with a summary of the operating guidelines 
for the financing committee. It is available upon request.
---------------------------------------------------------------------------
    Because the government will both direct and benefit from the 
Trust's financing activities (see Figure 2), the Trust will be acting 
on behalf of the government. Therefore, its borrowing and spending 
should be treated as Federal borrowing and spending and recorded 
appropriately in the budget.\4\ The parties to the lease portion of the 
contract are the Air Force and the Trust. Since the Trust is an 
instrument of the government, the government will effectively be buying 
the aircraft (via the Trust) and then leasing them to itself. To 
accurately reflect the nature of that arrangement, the Federal budget 
should report the transactions between the Trust and Boeing, and 
between the Trust and its bondholders, not the essentially 
intragovernmental transfers between the Trust and the Air Force. Thus, 
when the Trust pays Boeing for the aircraft, those payments should be 
reflected as Federal outlays. Subsequent interest payments on the 
Trust's borrowing should also be reflected as outlays when those 
payments are made. (Federal borrowing is not counted as a governmental 
receipt, and the repayment of principal is not counted as an outlay.)
---------------------------------------------------------------------------
    \4\ The Universal Service Fund is another example of a Federal 
program administered by a private agency for the Federal Government. 
The Universal Service Access Company (USAC), an independent 
organization that is regulated by the Federal Communications 
Commission, collects ``contributions'' from telecommunications service 
providers and makes payments to other service providers to ensure 
universal access to telecommunications services. Even though the 
collections and disbursements are not handled by the Treasury, USAC's 
transactions are included in the Federal budget. In 2002, the agent 
recorded revenue collections of $5.5 billion and expenditures of $5.1 
billion in the Federal budget.
---------------------------------------------------------------------------
      
    
    
      
    Table 1 displays how that budget authority and the associated 
outlays should be recorded in the budget compared with how CBO believes 
the department might reflect the contract in the budget. The table also 
shows CBO's estimate of the cost to purchase the tankers directly using 
traditional procurement methods. For budget purposes, all amounts are 
shown in current dollars.
    The two budgetary treatments of the financing plan differ 
substantially. If the proposed transaction is recorded as a purchase, 
budget authority over the first 5 years would total $17.3 billion, and 
outlays would sum to $10.1 billion. If the transaction is recorded as 
an operating lease, only $1.5 billion in budget authority would be 
shown over the first 5 years, and outlays during that period would also 
total only $1.5 billion, because most of the aircraft would not be 
available for leasing until 2009.
      
    
    
      
    In total, by CBO's estimates, acquiring the tankers through a lease 
would cost $21.5 billion over the next 14 years. In contrast, CBO 
estimates, a direct purchase of 100 tankers would cost $15.9 billion 
over the same period--but with all of the outlays recorded by the end 
of 2011.
    Budget authority and outlays for the Air Force's proposed lease 
have two components: the purchase price of the aircraft and the 
interest costs from the financing arrangement. (Those costs include the 
additional expense of borrowing money at rates that exceed Treasury's 
normal borrowing rates.) If the Air Force's proposal is recorded in the 
budget as a purchase, the purchase price of the aircraft would appear 
in the first few years when the planes were being constructed, and 
interest would be recorded annually as the lease payments were made. Of 
the $21.5 billion shown in Table 1, $17.1 billion is for the purchase 
price of the aircraft, while budget authority for the imputed interest 
would total $4 billion over the 2006-2017 period. The remaining $0.4 
billion would pay for insurance and other lease costs. Outlays for the 
purchase price, which would occur over the 2004-2011 period, would 
reflect progress payments during the construction period and final 
payments when the planes were delivered. Outlays for imputed interest 
charges would coincide with lease payments and would equal the annual 
budget authority for those charges.
    Alternatively, if one chooses not to view the special-purpose 
entity as an instrument of the government, CBO concludes the 
arrangement should be reflected in the budget as a lease-purchase, not 
an operating lease as suggested by the Air Force and Boeing. In that 
case, the budgetary treatment would be similar to that of the financing 
plan treated as a purchase (shown in Table 1).\5\
---------------------------------------------------------------------------
    \5\ For a more in-depth discussion, see Congressional Budget 
Office, The Budgetary Treatment of Leases and Public/Private Ventures 
(February 2003).
---------------------------------------------------------------------------
The Proposal Does Not Meet the Criteria for an Operating Lease
    After reviewing the details of the proposal, CBO concludes that it 
does not meet the conditions for an operating lease described in OMB 
Circular A-11 and thus does not comply with the terms of section 8159 
of the Department of Defense Appropriations Act, 2002.
    To comply with section 8159 and to be treated as an operating lease 
in the budget, the lease must meet the following six criteria:

         The asset must be a general-purpose asset, not built 
        to unique government specifications.
         There must be a private-sector market for the asset.
         The present value of the lease payments cannot exceed 
        90 percent of the asset's fair market value at the start of the 
        lease.
         The lease cannot contain a bargain-price purchase 
        option.
         Ownership of the asset must remain with the lessor.
         The lease term cannot exceed 75 percent of the asset's 
        useful life.

    CBO has concluded that the arrangement between Boeing and the Air 
Force fails to meet the first four of these criteria and complies with 
the letter but not the spirit of the fifth.
    The Lease Must Be For a General-Purpose Asset. Operating leases 
must be for a general-purpose asset, not one that is built to the 
unique specifications of the government. An aerial refueling tanker is 
not a general-purpose asset. Although the tanker is based on Boeing's 
commercial 767-200 model, the Air Force has specified several 
significant modifications such as auxiliary fuel tanks, a refueling 
boom, a refueling receptacle, more powerful generators, and heavier 
wiring to accommodate unique military requirements. The tanker's aerial 
refueling capability serves a uniquely governmental purpose.
    There Must Be a Private-Sector Market. A private-sector market must 
exist for any asset obtained through an operating lease. The Air Force 
and Boeing assert that the lease meets this criterion because Boeing 
has offered the tanker, called the Global Tanking and Transport 
Aircraft (GTTA), for public sale. However, the only customers for the 
GTTA so far are the U.S. Air Force, the government of Japan, and the 
government of Italy, all of which plan to use the aircraft to refuel 
their military aircraft. Boeing states that there are a number of 
private companies that might purchase GTTA aircraft--Omega Air and the 
Tanker and Transport Service Company Ltd., in particular. CBO does not 
believe that those companies would buy more than a few of the tankers.
    Boeing also points out that some long-haul commercial air carriers 
may be interested in acquiring the capability for aerial refueling, but 
none currently employs the technique. CBO believes it unlikely that 
aerial refueling would make economic sense for commercial 
transportation companies because they already have access to 
groundbased refueling services at airfields worldwide. Finally, while 
Boeing cites many potential customers for the freighter capability 
inherent in the tanker, how many of the 100 tankers reconfigured as 
freighters the private market would be able to absorb is unclear.
    There are only about two dozen outstanding orders for all Boeing 
767 variants. The KC-767A is derived from the Boeing 767-200C variant, 
for which Boeing has no commercial orders. In fact, according to 
Boeing, the last delivery of any commercial version of 767-200 aircraft 
occurred in 2002, and Boeing has no future orders because it now 
produces 767 models that are superior to the 767-200. Thus, while there 
may be a private-sector market for a few of the aircraft that the 
government is acquiring, there is no evidence of such a market for 100 
tanker aircraft.
    Lease Payments May Not Exceed 90 Percent of the Fair Market Value. 
To qualify as an operating lease, the net present value of the lease 
payments may not exceed 90 percent of the fair market value of the 
aircraft. The Air Force report indicates that the lease payments under 
the proposed financing arrangement will account for 89.9 percent of the 
fair market value of the aircraft, which the Air Force calculates at 
$138.4 million (in 2002 dollars) when the cost of the construction loan 
financing ($7.4 million per aircraft) is included. CBO believes that 
including the cost of that financing as part of the aircraft's fair 
market value is inappropriate because that cost is additional to any 
interest that would be capitalized in the price of the aircraft in the 
purchase option. When the financing cost is excluded from the 
calculation, the net present value of the lease payments accounts for 
93 percent of the fair market value.
    CBO also notes that, even using the Air Force's methodology, there 
is a significant possibility that the threshold of 90 percent of the 
fair market value could be exceeded for at least some of the groups of 
leased tankers. The lease payments are based on the Air Force's 
estimate of bond interest rates. If the rates for Treasury bonds are 
higher than the predicted value used by the Air Force, or if the spread 
on the interest rates for the bonds issued by the Trust is greater than 
predicted, lease payments will increase accordingly. Since the Air 
Force already estimates that the present value of the lease payments 
will be 89.9 percent of the fair market value, it has no margin for 
error on its estimate of interest rates.
    The Lease Cannot Contain a Bargain-Price Purchase Option. The lease 
cannot contain an option to purchase the aircraft at a bargain price. 
The agreement gives the Air Force the option to purchase the aircraft 
at any time during or at the end of the lease. The Air Force estimates 
that it could purchase the aircraft at the end of the lease for an 
average $35 million apiece (in 2002 dollars), or 28 percent of the cost 
to purchase new tankers. Since the aircraft should last at least 30 
years, the aircraft should have 80 percent or more of their life 
expectancy remaining after 6 years. While it is difficult to establish 
the fair market value of used tanker aircraft, CBO believes that paying 
28 percent of the cost of a new tanker for a used aircraft with 80 
percent of its life left constitutes a bargain purchase price.
    Ownership Must Remain With the Lessor. Under the operating lease, 
ownership must remain with the lessor, and title may not transfer to 
the government at or shortly after the end of the lease term. CBO 
believes the Trust is an instrument of the government, given the level 
of control the government exercises over its operations. Thus, the 
Trust is effectively purchasing the tankers for the government.
    However, if one chooses not to view the Trust as an instrument of 
the government, the financing arrangement technically complies with 
this criterion since the purchase option is contingent upon subsequent 
authorization and appropriation by Congress. It seems clear for several 
reasons, however, that the Air Force fully intends to acquire the 
tankers during or at the end of the lease term.
    First, the Air Force and Boeing plan to negotiate a purchase price 
for each group of planes when the contract is awarded. The Air Force 
has the right of first refusal on the disposal of the aircraft at the 
end of the 6-year term. The Air Force has also stated its intention to 
earmark funds to purchase the aircraft.
    Second, senior Department of Defense officials have stated on 
several occasions that the department has a long-term requirement for 
tankers and that the department plans to replace the entire fleet of 
KC-135 aircraft over the next 30 years. It seems implausible that the 
Air Force would return the 100 leased tankers to the Trust since the 
Air Force plans to retire 68 KC-135E tanker aircraft over the 2004-2006 
period regardless of whether the lease is approved and will retire all 
131 KC-135E aircraft by 2008 if the lease is approved. Moreover, it 
would have to accept a significant reduction in its aerial refueling 
capability if it chose not to purchase (or continue to lease) the KC-
767 tankers at the end of the 6-year term.
    Finally, the Air Force's basing plan for the tankers includes more 
than $600 million in construction projects to support the permanent 
basing of the aircraft. Spending those funds would be uneconomical if 
the Air Force was seriously considering returning the aircraft at the 
end of the lease term.

The Proposed Financing Approach Is More Costly Than an Outright 
        Purchase
    The proposed financing arrangement to acquire the tanker aircraft 
is significantly more expensive than an outright purchase by the 
government because of the anticipated interest rates (which are higher 
than U.S. Treasury rates) and other costs that are unique to the 
leasing option. By CBO's estimates, total costs for a direct purchase, 
including the estimated costs for self-insurance, would be about $16 
billion (see Table 2). The Air Force reports that it will pay $17 
billion to lease the aircraft for 6 years and more than $4 billion to 
purchase them at the end of the lease term. Those payments include the 
interest expense on borrowing by the special-purpose entity. The Air 
Force will also pay about $400 million for insurance and other expenses 
related to the lease transactions. Thus, the Air Force estimates that 
the costs of acquiring the aircraft under the financing arrangement 
will total almost $22 billion in current dollars. On a present value 
basis, the leasing approach would cost $1.3 billion more than an 
outright purchase, CBO estimates. (The administration uses a 
discounting methodology specified in OMB Circular A-94, Guidelines and 
Discount Rates for Benefit-Cost Analysis of Federal Programs, which, 
CBO estimates, would result in a greater cost difference of $2 billion 
relative to a purchase.)
      
    
    
      
The Air Force's Economic Analysis Understates the Cost Difference
    In its report to Congress, the Air Force indicates that leasing 100 
air-refueling aircraft will cost $150 million more than an outright 
purchase in net present value terms (see Table 3). CBO's analysis 
indicates that the estimate significantly understates the additional 
cost associated with the Air Force's plan. The Air Force, in fact, does 
not rule out that possibility, stating that ``had Congress chosen 
instead to provide multiyear procurement authority and had the 
Department of Defense been able to accommodate that execution while 
preserving program stability, the [net present value] could favor 
purchase by up to $1.9 billion.'' \6\ The Air Force's report notes that 
this type of analysis is ``highly sensitive to the underlying 
assumptions'' but that ``in no case approved by OMB did the financial 
analysis indicate that the net present value of the lease option as 
being less than that of a traditional purchase.''
---------------------------------------------------------------------------
    \6\ The Air Force appears to attribute the large difference to the 
effects of multiyear procurement alone. In fact, CBO's analysis 
indicates that the assumption of multiyear procurement accounts for 
only $970 million of the $1.9 billion difference.
---------------------------------------------------------------------------
      
    
    
      
    Multiyear Procurement. For the lease, the Air Force and Boeing 
negotiated a price for the aircraft as delivered to the Trust on the 
basis of the assumption that the Air Force would ultimately lease and 
acquire 100 airplanes. That assumption allows Boeing to make 
investments in facilities and equipment that will reduce the total 
costs of production. It also allows Boeing to purchase parts and 
components in large quantities to get price breaks from suppliers. For 
its analysis of the purchase option, however, the Air Force assumed 
that each lot of aircraft would be bought on an annual basis (that is, 
with no assurances of subsequent purchases). Thus, no price breaks or 
production efficiencies were included in the estimated purchase prices.
    For the purchase option, the Air Force increased the price of each 
aircraft by 7.4 percent relative to the price that it used for the 
lease. CBO believes that estimating the purchase cost under the 
assumption that a multiyear contract would be granted is warranted 
because, under section 8159, Congress has already granted authority for 
the lease and would likely grant such authority for an acquisition 
program of that size. The Air Force's statement that it did not assume 
a multiyear procurement in its analysis of a purchase because it did 
not currently have that authority is inconsistent with its budgetary 
practices for other major acquisition programs. The department does not 
currently have multiyear procurement authority for either the F-22 
fighter or the Joint Strike Fighter programs but assumes multiyear 
procurement in estimating the future purchase costs of those aircraft.
    CBO estimates that the cost to acquire 100 KC-767A tankers under 
the proposed financing arrangement would exceed the cost of purchasing 
the aircraft under a multiyear contract by $1.1 billion (expressed in 
net present value terms), an increase of $970 million relative to the 
Air Force's results. Although Congress has already granted multiyear 
authority for the lease, in traditional procurement programs, that 
authority is frequently provided after several years of production 
prove that the program is stable. If Congress waited until the third 
lot to grant the authority, then, by CBO's estimates, the lease would 
cost $920 million more than the purchase, an increase of $765 million 
relative to the Air Force's estimate.
    Inflation of Progress Payments. The Air Force's method for applying 
inflation to progress payments is another factor that affects the 
purchase price in its analysis. During the construction period, a 
contractor is continually paying for materials and labor. If the 
government paid the contractor for the full price of the asset at the 
time of delivery, the contractor would have to borrow money to cover 
those expenses and include the full costs of that borrowing in the 
purchase price. Progress payments reimburse the contractor for the 
costs the company incurs during the construction period and reduce the 
requirement for the contractor to borrow the money to cover expenses--
resulting in a lower purchase price for the government. The government 
usually limits progress payments to a percentage of the actual costs 
incurred at the time the request for payment is made.
    In its analysis of the cost of a straightforward purchase, the Air 
Force estimated progress payments as a percentage of the tanker's 
price, which it inflated to the year of delivery. CBO believes that 
that method overstates both the amount of the progress payments and the 
total cost of the aircraft since inflation would affect the cost of 
material and labor only up to the time those costs were paid. The 
method also conflicts with the DOD Comptroller's guidance on inflation, 
which calls for inflating costs to the year the order is made, using an 
inflation index that takes into account the fact that outlays will 
occur incrementally between the date the order is placed and the date 
the asset is delivered. CBO estimates that if the cost of progress 
payments were inflated only to the time those costs were paid, then the 
cost of the leasing arrangement would exceed the cost of a 
straightforward purchase by an additional $640 million (in net present 
value terms).
    Schedule for Progress Payments. The schedule for making those 
progress payments is also a factor that affects the purchase price in 
the Air Force's analysis. For the option of purchasing the aircraft, 
the Air Force assumed that progress payments would begin approximately 
4 years before the aircraft were delivered. The assumed payment 
schedule seems protracted for several reasons. First, the schedule is 
longer than that of other major aircraft procurement programs. For 
example, the budget for the C-17 transport program provides advance 
procurement funding just 2 years before the delivery date. Other 
procurement programs, like that for the F-22 fighter, assume that the 
majority of the progress payments are made over 3 years.
    Second, the Air Force's aircraft procurement programs spend, on 
average, about 90 percent of budget authority within 3 years after 
appropriation. In contrast, the progress-payment schedule that the Air 
Force used in calculating the costs of purchasing tankers would expend 
only 75 percent of budget authority in 3 years, with the last 25 
percent of the payments in the fourth year. That progress-payment 
schedule does not appear to reflect the Air Force and Boeing's plan to 
deliver the first KC-767A tanker approximately 34 months after lease 
approval and to deliver subsequent aircraft on an even faster schedule.
    Using a 4-year progress payment schedule increases the cost of the 
purchase option in net present value terms because it brings forward a 
large portion of the payments into a period in which the discount 
factors have less impact. The method appears to conflict with the 
Department of Defense's Financial Management Regulation, which limits 
progress payments to a percentage of incurred costs, because it would 
make payments before work commences. Using a 3-year schedule for 
progress payments (one more in line with historical outlay rates for 
procuring aircraft) would defer some payments for 1 year relative to 
the schedule used in the Air Force analysis and would reduce the cost 
of the purchase by about $210 million in net present value terms.
    Discount Rates and Interaction Among The Factors. The results of 
any economic analysis are sensitive to changes in the discount rate 
selected. Changes in the discount rate also affect the costs associated 
with assumptions made about multiyear procurement and progress 
payments. CBO has calculated the present value of cash flows associated 
with the planned acquisition of tanker aircraft by discounting the 
estimated cash flow for each year using the interest rate on a 
marketable zero-coupon Treasury security with the same maturity from 
the date of disbursement as that cash flow. That method--often referred 
to as the ``basket of zeros'' discounting approach--is used by both CBO 
and OMB for calculating estimates of loan subsidies under the Federal 
Credit Reform Act. Although the tanker acquisition plan does not 
explicitly involve a direct loan or Federal loan guarantee, the 
financing of tankers would result in a series of annual cash flows that 
have to be matched by the trust's borrowing (on behalf of the 
government). Using the basket of zeros to discount that stream of cash 
flows most accurately reflects the time value of money. Under CBO's 
approach, the acquisition plan would cost about $1.3 billion more--in 
present value terms--than an outright purchase would.
    In contrast, the Air Force's analysis relied on the simplified 
discounting method provided in OMB Circular A-94, which advises using a 
single discount rate (as opposed to the ``basket of zeros''). In 
implementing the guidelines, the Air Force used a 9-year Treasury rate, 
based on a 3-year construction period and a 6-year lease term, to 
discount the lease payments. CBO estimates that this assumption would 
result in an additional cost to leasing of $1.7 billion.
    However, CBO believes that if a single discount rate is used, the 
relevant period of analysis should be 6 years, since the Trust will 
issue bonds that mature in no more than 6 years. CBO estimates that 
using the administration's method with a single 6-year discount rate 
would yield an even larger present value difference--a greater cost of 
about $2 billion for the Air Force's plan.

                          OTHER CONSIDERATIONS

Termination Liability
    Under the terms of the agreement, the Air Force can terminate the 
lease prior to the completion of the lease term for its convenience. 
However, exercising that option would be expensive for the Air Force 
because of the requirement to pay penalty payments, unamortized costs 
of the development of the tankers, and additional costs that would 
arise from its decision to terminate. If it terminates the lease, the 
Air Force might take delivery of the tankers under construction, make 1 
year's lease payment, and within a year, return them to the Trust along 
with the penalty payment. Alternatively, it might choose to pay Boeing 
for the costs of work performed before the decision to terminate. CBO 
estimates that termination liability could be as high as $5 billion to 
$7 billion in some years. Under the authority in section 8117 of the 
Department of Defense Appropriations Act, 2003, the Air Force does not 
intend to set aside budget authority to cover this contingency and 
therefore would need an appropriation from Congress to do so. Given the 
potential size of the liability and the fact that the Air Force does 
not intend to budget for it, CBO believes it is extremely unlikely that 
the Air Force will terminate the lease.

The Long-Term Affordability of Leasing and Then Purchasing Tankers
    The Air Force states that its primary reason for choosing this 
financing arrangement is the favorable budgetary treatment that it will 
receive. This treatment would allow the service to get the tankers 
today without displacing other programs from its budget. However, the 
budget will eventually have to reflect the Air Force's decision to 
acquire the tankers. When those obligations are eventually recorded, 
mostly over the 2008-2017 period, they will create additional budgetary 
pressure in those years.
    The Air Force report acknowledges that the lease is a more costly 
method to acquire the tankers, but the Air Force believes that its 
decision to pursue the method is justified by lower up-front costs. 
Total costs to the government are higher under the lease (almost $5.7 
billion in current dollars, according to CBO's estimate), however, so 
rather than eliminating difficult budgetary decisions, the lease merely 
postpones them.
    There is no reason to believe that the Air Force itself will have 
more budgetary flexibility 10 years from now than it has today. In 
2012, for example, the Air Force will be making lease payments on the 
tankers that were delivered over the 2007-2011 period--about $2.9 
billion (in current dollars) a year in payments. It will also have to 
begin purchasing the leased tankers at an estimated cost of $4.4 
billion over the 2012-2017 period. Finally, the Air Force will have to 
decide how to replace the rest of its KC-135 fleet. Should the Air 
Force choose to buy more than 100 KC-767s, it would need to start 
purchasing those additional tankers in 2011 to keep the Boeing 767-200 
production line in operation. Procuring 20 tankers annually would cost 
about $3 billion each year in current dollars, CBO estimates. Designing 
and building a new tanker would probably cost more and taker longer.
    But the Air Force will not just be buying tankers with its aircraft 
procurement funds over this period. Other Air Force programs will 
require significant sums also. According to the administration's 
published plans and cost estimates, by 2012 the Air Force will be 
buying 110 Joint Strike Fighters annually at a cost of almost $7 
billion per year. Together, those two programs would consume about 70 
percent of estimated funding for procuring aircraft. Thus, CBO 
concludes that the Air Force will likely be faced with making difficult 
budgetary decisions over the longer term also.

    Chairman Warner. Dr. Nelson.

STATEMENT OF J. RICHARD NELSON, PH.D., ASSISTANT DIRECTOR, COST 
 ANALYSIS AND RESEARCH DIVISION, INSTITUTE FOR DEFENSE ANALYSES

    Dr. Nelson. Thank you. Mr. Chairman and members of the 
committee: I am pleased to come before you today to talk about 
IDA's estimate for the unit purchase price of the KC-767A 
tanker/combi aircraft. I will present a summary in the interest 
of time.
    Before beginning, however, and with all due respect to the 
committee, I need to clarify an impression I was getting from 
some remarks this morning. I testified for this work, IDA, 
yesterday and for the record I did not testify for or against 
the lease, and I do not intend today to testify for or against 
the lease. I am here to testify on the unit direct purchase 
price estimate for 100 KC-767A tanker/combi aircraft.
    In January 2003 the IDA was tasked by the Office of the 
Under Secretary of Defense, Acquisition, Technology, and 
Logistics, and the Office of the Director, Program Analysis and 
Evaluation, to estimate the unit purchase price for the KC-767A 
tanker/combi aircraft. The tanker/combi designation which we 
examined indicates that the aircraft can serve as an air 
refueling tanker or carry freight or carry passengers or 
combine freight and passengers, and that is the configuration 
that we assessed.
    The objective of our task was to estimate the unit purchase 
price for the 100 KC-767A aircraft. We did not investigate the 
condition of the KC-135E/R fleet or the requirement for a 
tanker replacement, and we were not asked to evaluate any other 
aspect of the proposed acquisition nor address provisions of 
the lease, the financing, suitability of leasing, or any 
alternatives for that proposal. The unit purchase price for the 
aircraft is what we addressed and that is what I am prepared to 
discuss.
    Our methodology and data sources are as follows. To 
estimate the KC-767A tanker/combi purchase price, we separated 
the acquisition into several segments that included the basic 
767-200ER, the enhanced features that the Air Force required 
from other Boeing 767 family members, the combi modifications 
for freight and passenger or combined, the auxiliary fuel tank, 
and the other USAF-unique modifications pertaining to the 
tanker and the avionics equipment that the Air Force needed. We 
also looked at the development cost for the program.
    The proposed KC-767A program would use FAR Part 12 
guidelines written for the acquisition or lease of commercial 
items. The establishment of a reasonable price under these 
rules would normally rely largely on prices for the same or 
similar items in the commercial marketplace. The market for 
larger tanker aircraft is of course limited and of little value 
for rigorous determination of reasonable prices under such 
conditions.
    Consequently, while our analysis made use of commercial 
pricing wherever possible, we relied on traditional cost 
analysis techniques where estimation by commercial pricing was 
not practical. Our analysis relied on data from a variety of 
public sources, some of whom you have heard today, including 
other sources and the analysis of consultant organizations 
familiar with the airline industry hired by IDA, internal IDA 
proprietary data and models, data supplied by Boeing, data 
provided by other aerospace suppliers who supply to Boeing, and 
data supplied by the USAF.
    Chairman Warner. We are assuming that you pursued a very 
careful methodology and that is in your statement. We are quite 
interested in receiving your conclusions.
    Dr. Nelson. We feel the evolution of the task through the 
time period from January to May is a methodologically 
conservative approach. We estimate, summarized according to the 
segments in the final testimony--there is a table that will 
show the breakdown. We believe that $120.7 million is a 
reasonable unit purchase price for the proposed 100 KC-767A 
aircraft.
    [The prepared statement of Dr. Nelson follows:]

              Prepared Statement by Dr. J. Richard Nelson

    Mr. Chairman and members of the committee, I am pleased to come 
before you today to talk about IDA's estimate of the purchase price of 
the KC-767A Tanker/Combi Aircraft.

                              INTRODUCTION

    In January 2003, the Institute for Defense Analyses (IDA) was 
tasked by the Office of the Under Secretary of Defense Acquisition 
Technology and Logistics and the Office of the Director, Program 
Analysis and Evaluation to estimate the purchase price of the KC-767A 
Tanker/Combi aircraft. The Tanker/Combi designation indicates that the 
aircraft can serve as an air-refueling tanker or carry freight or carry 
passengers or combine freight and passengers.
Description of Proposed Aircraft as Assessed by IDA
    The KC-767A Tanker/Combi aircraft is to be based upon the 
commercial B767-200ER. Modifications would include the addition of 
features available on other Boeing 767 models, as well as changes 
required for the military application. In the tanker role, total fuel 
capacity is to be just over 200,000 pounds, including up to 41,000 
pounds carried in added auxiliary fuel tanks. The KC-767A would have 
the capability to perform refueling by both the hose/drogue and boom 
methods (not simultaneously) from the aircraft centerline and would 
also be able to receive fuel from other tanker aircraft. The cabin of 
the KC-767A is to be convertible to three configurations. In the 
passenger configuration, the KC-767A would accommodate up to 190 
passengers and 10 crewmembers. The freight configuration would allow 
carriage of up to 19 cargo pallets and 10 crewmembers. The combination 
(so-called ``Combi'') configuration is to have the capacity for 
simultaneous carriage up to 10 pallets, 10 crewmembers, and 70 
passengers.

                    OBJECTIVE AND SCOPE OF THE TASK

    The objective of the IDA task was to estimate a unit purchase price 
for 100 KC-767A aircraft. We did not investigate the condition of the 
KC-135E/R fleet or the requirement for a tanker replacement. We were 
not asked to evaluate any other aspect of the proposed acquisition and 
therefore did not address provisions of the lease, financing, 
suitability of leasing, or any alternatives to this proposal. 
Consequently, the purchase price for the fleet of KC-767A aircraft is 
what I am prepared to discuss today.

                      METHODOLOGY AND DATA SOURCES

    To estimate the KC-767A Tanker/Combi purchase price, we separated 
the acquisition into several segments:

         Basic 767-200E/R--the commercial aircraft upon which 
        the KC-767A design would be based.
         Enhanced B767 Features--the features from other B767 
        models that would be added to the basic B767-200E/R design to 
        build toward the KC-767A.
         Combi Modifications--the modifications to the B767-
        200E/R that would allow the carriage of passengers, freight, or 
        both simultaneously.
         Auxiliary Fuel Tanks--the lower fuselage fuel tanks, 
        pumps, and installation materials required for additional fuel 
        capacity in the KC-767A.
         Tanker and Other USAF-Unique Modifications--the 
        changes required to give the KC-767A its refueling, fuel-
        receiving, and military-unique capabilities.
         Development Costs--the investment required to create 
        and certify the KC-767A design.

    The proposed KC-767A program would use FAR Part 12 guidelines 
written for the acquisition or lease of commercial items. Under these 
guidelines, the contractor is not required to provide cost estimates, 
or any other data not normally supplied to commercial customers. The 
establishment of a reasonable price under these rules would normally 
rely largely on prices for the same or similar items in the commercial 
marketplace. However, the KC-767A Tanker/Combi aircraft acquisition 
involves modifications that do not easily lend themselves to this 
approach, particularly in the area of military aerial refueling 
capability. The market for large tanker aircraft is limited and of 
little value for rigorous determination of reasonable prices. 
Consequently, while our analysis made use of commercial pricing 
wherever possible, we relied on traditional cost analysis techniques 
where estimation by commercial pricing was not practical.
    Our analysis relied on data from a variety of public sources, 
including other government sources, the analyses of consultant 
organizations hired by IDA, internal IDA proprietary data and models, 
data supplied by Boeing, data provided by other aerospace suppliers, 
and data supplied by the USAF.

                              TASK RESULTS

    The analysis examined the proposed aircraft in detail, and 
incorporated information provided by Boeing during and after briefings 
at their facility in Wichita, Kansas. We feel that the evolution of our 
task through the January to May time period has resulted in a 
methodologically conservative approach that has produced a high quality 
unit price estimate. We also performed an internal rate of return (IRR) 
analysis on an estimate of Boeing's initial investment and found that 
our price estimate would provide Boeing with an attractive IRR for the 
time-period, and considering the risks involved. We believe that $120.7 
million is a reasonable unit purchase price estimate for the proposed 
100 KC-767A aircraft. Our estimate is summarized in the following table 
according to the segments identified in the methodology.

                             SUMMARY OF KC-767A TANKER/COMBI PURCHASE PRICE ANALYSIS
                                            [In millions of dollars]
----------------------------------------------------------------------------------------------------------------
                                           IDA Unit Price
           Taxonomy Element               Estimate (Fiscal        Primary Analysis        Primary Data Sources
                                             Year 2002)               Technique
----------------------------------------------------------------------------------------------------------------
Basic B767-200ER......................                  72.1  Commercial Pricing......  Consultants, Department
                                                                                         of Transportation data
Enhanced B767-200ER Features..........                   1.6  Commercial Pricing......  Consultants, Boeing,
                                                                                         USAF data, IDA models,
                                                                                         vendor quotes
Combi Modifications...................                   9.5  Commercial Pricing......  Consultants, public data
Auxiliary Fuel Tanks..................                   6.3  Cost analysis...........  Vendor quotes, IDA
                                                                                         models
Tanker and Other Modifications........                  20.3  Cost analysis...........  IDA models, USAF, Boeing
Development Costs.....................                  10.9  Cost analysis...........  USAF, IDA models
                                       ----------------------
  Total...............................                 120.7
----------------------------------------------------------------------------------------------------------------

    Mr. Chairman and members of the committee: Due to the proprietary 
information agreement that IDA has signed with The Boeing Company, I 
cannot divulge any proprietary data that we have obtained under this 
agreement. IDA and the OSD sponsors have provided a redacted version of 
our report, and the privileged information version can be read in the 
Pentagon.
    Mr. Chairman and members of the committee: Thank you for your 
attention. I am available for comments/questions.

    Chairman Warner. You said reasonable unit price for 
purchase.
    Dr. Nelson. Yes, sir.
    Chairman Warner. You meant that vice lease. So I mean, you 
carefully used the word ``purchase.''
    Dr. Nelson. Yes, sir, right.
    IDA has executed a proprietary information agreement with 
Boeing. Boeing has given IDA permission to discuss proprietary 
information in a closed hearing if needed. IDA and the OSD 
sponsors have provided a redacted version of our report and the 
privileged information version can be read in the Pentagon.
    Thank you for your attention. I am available for your 
questions.
    Chairman Warner. Thank you.
    We will proceed to questions. First, Dr. Curtin, you said 
you did not have--I think you made effort, but did not 
receive--facts to support, ``the urgency to proceed along these 
lines,'' vice to go through a normal procurement process.
    Mr. Curtin. Yes, sir. We got the same kind of answers that 
you got from the panel this morning, that, yes, there are 
corrosion problems and, sure, it is always better to have a 
shiny new plane than an old one. But the real urgency----
    Chairman Warner. The threat of some block----
    Mr. Curtin. Nothing specific. There is nothing that anybody 
can say is going to happen.
    Chairman Warner. I made reference to an earlier KC-135 
study on which presumably the Air Force relied in its judgment 
with budget submissions to Congress, and the Secretary said, we 
just felt it was all wrong. Did you ever look at that analysis?
    Mr. Curtin. Yes, and we have been using that. The Air Force 
pointed us to that when we first started looking at tankers as 
a well-documented study, and I was not aware that there is 
anything more current than that, that had gone into that 
detail.
    Chairman Warner. In your own professional judgment, was it 
a carefully prepared study and was it of value?
    Mr. Curtin. It looked to us like a very valuable study, 
yes, sir. It was a joint study with Boeing and Air Force 
personnel involved.
    Chairman Warner. That answers my question.
    Quickly, Mr. Sunshine, what impact might this transaction, 
if it is approved by Congress, have on the other military 
departments in the annual allocation of budgets in those out 
years where this bow wave is due to occur?
    Mr. Sunshine. This transaction pushes the need for 
budgetary resources from the next 2 years out into future 
years.
    Chairman Warner. That is correct.
    Mr. Sunshine. So it eases pressures in the next few years.
    Chairman Warner. On one military department.
    Mr. Sunshine. Or on the whole Defense Department. Congress 
has to make those tradeoffs.
    Chairman Warner. But each year the Secretary of Defense 
sits down with the service secretaries, service chiefs, and 
works through--you know all about it, the Program Objective 
Memorandum (POM) process, what do you need. Then finally those 
numbers are struck for the military departments, and by and 
large service secretaries and service chiefs work within that 
framework in the Department. It is salute and march off. That 
is the way that building runs.
    But this thing is a very skillful, really a Hail Mary pass, 
an end run around that process. Then the Air Force is stuck 
with this thing in the out years, and the Secretary, he cannot 
just ignore it. Therefore, it seems to me it is going to 
impinge on that annual allocation between the three military 
departments. Am I correct?
    Mr. Sunshine. That is correct, it is a ``pay me now or pay 
me later'' or a ``pay me something now or pay me more later'' 
proposal.
    Chairman Warner. But I do not see this as a little, narrow 
Air Force problem, unless the Secretary of Defense said, you 
are going to have to eat all of this and go into your budget, 
in which case then there are going to be serious perturbations 
in other items.
    Mr. Sunshine. That is correct. CBO recently did an analysis 
on long-term defense needs, and the pressures are not going to 
diminish as we get out into those later years.
    Chairman Warner. Let me ask first Mr. Curtin and then the 
same question to Mr. Sunshine and Dr. Nelson, if you care to 
opine. I am concerned that if this matter is approved as 
submitted to this committee and three others it will establish 
a precedent and we can see a reoccurrence of this type of end 
run, I call it a Hail Mary pass, around the budget process in 
the out years.
    Having had some modest experience with shipbuilding 
acquisition, I would love to get a hold of this thing and start 
building some Navy ships on this program. Believe me, I would 
throw the all-time Hail Mary that will go over and through the 
end zone. But there would be an obligation on the people in the 
military departments: Hey, the Air Force won out; let us give 
it a try.
    Is this wild speculation?
    Mr. Curtin. No, I think you are exactly on point there. The 
enticing part of this lease is pushing it back to the out years 
and it is somebody else's problem down the road.
    Chairman Warner. We will have three-star tours in the 
Pentagon, got the distinguished Pentagon service, go on back to 
industry. Hey, I have been there, done that.
    What do you think, Mr. Sunshine?
    Mr. Sunshine. I agree. I think it is a very legitimate 
fear.
    Chairman Warner. Thank you.
    Dr. Nelson?
    Dr. Nelson. Very definitely there is a difficulty there 
with long-term implications that are not anywhere near known at 
this time.
    Chairman Warner. Now, lastly. I assume full responsibility 
for this, without any adequate consultation with colleagues. 
But again having some experience with the Department of 
Defense, and I try, as well as all of the members of this 
committee and others, to keep abreast of military problems and 
so forth, we are in a bind, I think, because of--I am not 
pointing fingers for any reason, but mismanagement, 
miscalculation, by previous Air Force secretaries or something, 
not addressing this problem. I will just say that for the 
record.
    What do we do at this juncture? We have three committees of 
Congress that have approved this. We are the holdouts. As I 
said, I am very impressed with the thoroughness with which this 
committee is performing its responsibility. Is there any merit 
in asking them to come back with a 25 buy to help alleviate the 
pressures on Boeing----
    Senator McCain. A 25 lease.
    Chairman Warner. A 25-unit lease, aircraft unit lease. Then 
try and require the Department to accept this emergency fix and 
move into the orderly procurement process. Do you think that 
has any merit, Mr. Curtin?
    Mr. Curtin. I was intrigued when you raised that earlier, 
Mr. Chairman.
    Chairman Warner. I am sure there is intrigue in the back 
halls right now figuring it out.
    Mr. Curtin. Yes, there is, exactly. My sense is that the 
Air Force and DOD have invested so much time and energy in this 
lease that they are pretty well focused on that and they are 
not thinking about alternatives like that. But I think that is 
probably exactly what is needed, is let us really think through 
the need and how urgent it is, what we can do in the short term 
versus long term, what we can do that is fiscally responsible. 
I think it is worth a look at it.
    The other thing you could do, and I am raising this not as 
a GAO recommendation, but it is one that we have talked about, 
is that there is a provision in the lease agreement here that 
the Air Force can buy these out before the end of the lease. If 
you feel we need to start on replacing this fleet, you could 
begin with the lease, get the production line running, and buy 
yourself some time that way to rejigger the budget over the 
next couple years, to do the studies they need to do, and you 
may have only leased the first 20 or 30 at that point and you 
can make a buy decision at that point. That is another option.
    Chairman Warner. There is only so much we can do, given the 
constraints of the very short period of time.
    Mr. Curtin. Yes.
    Chairman Warner. But I am concerned when the final 
questions were propounded here by my colleagues the Secretary 
of the Air Force said: ``We have to figure out that this thing 
is going to work, if it is mission-capable to the expectations 
that we have of this aircraft.'' I am sitting back here saying 
to myself: Whoa, there is really some front-end work on this 
thing that either has not been done or could not have been 
done, and I have to explore that.
    So I am just trying to look at something that might take 
the pressure off Congress, the pressure off the Air Force, to 
begin to address the needs, and take a 25-unit buy and try it, 
lease.
    Mr. Curtin. It strikes me that this is really----
    Chairman Warner. Not buy. I said ``lease''. I am trying to 
move quickly so I can give you gentlemen time.
    Mr. Curtin. This is a very----
    Chairman Warner. In other words, lease just 25 aircraft.
    Mr. Curtin. It strikes me that this is a very substantial 
decision and I think the members of the committee have been 
asking all the right questions. I have the sense that the 
administration pretty much thought that they had a clear 
direction to go in a leasing direction and they really did not 
fully explore the other options for getting the aircraft 
quickly.
    I do not know, I do not have the expertise myself to judge 
what those other options are. But it seems to me very 
worthwhile to explore what other options we have for getting 
either some or all of those aircraft quickly, assuming that 
there is a need to have them.
    Chairman Warner. It is predicated on the basis, that they 
desperately need to do this. Lease 25 now and then go into the 
normal procurement cycle.
    Mr. Curtin. Actually, Mr. Chairman, I do not mean to 
interrupt you, but that is actually pretty close to a proposal 
we raised at a hearing earlier this summer with the House Armed 
Services Committee. We have not explored that in detail, but we 
did raise the option of just leasing a first portion to buy 
yourself a few years to do the AOA that should have been done.
    So yes. I thought you were talking purchase the first 25--
--
    Chairman Warner. No, I misspoke in trying to move along 
quickly.
    Mr. Curtin. Leasing 25, I think that is----
    Chairman Warner. Clearly I said in my initial statement 
that, let us look at a 25-unit lease program at this juncture.
    Mr. Curtin. I think it makes a lot of sense, yes.
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    Chairman Warner. Now, Senator Levin.
    Senator Levin. Thank you, Mr. Chairman.
    The CBO wrote in August that the tanker lease fails to meet 
four of the six criteria, as has been indicated here this 
morning, that are required in OMB Circular A-11. It stated that 
the recording lease payments on a year-to-year basis would, 
``be at odds with standard government accounting principles.'' 
I think you said the same thing here this morning, Mr. 
Sunshine.
    You indicated in that letter and here today, that purchase 
costs should be recorded as Federal expenditures at the time 
the aircraft are delivered.
    However, I am told that if this lease is approved by this 
committee and goes into effect that CBO would then plan to 
score it as an operating lease despite what you have told us 
here; and that you would record the lease payments on a year-
to-year basis. I have trouble understanding that. Is that true, 
first of all?
    Mr. Sunshine. There is a difference between the scoring of 
legislation when legislation is being considered or being 
enacted and the actual budget implementation. This authority, 
if the committee approves this, will have been provided and 
there will in fact be no legislation for CBO to score. What 
will happen is this: the Defense Department will get 
appropriations for 2004 and later for 2005 and so on, and the 
administration will decide how it is going to record the 
obligations it makes for this transaction against the budget 
authority that is provided. It has indicated that it is going 
to record obligations under the criteria for an operating 
lease, not as if the transaction is a purchase.
    Senator Levin. You are saying prospectively it should not 
be scored that way, but when you get down to scoring you are 
going to score it that way?
    Mr. Sunshine. It has moved from the legislative arena, 
where we do scoring of bills, to the budget implementation 
arena, where ultimately OMB decides how to record actions 
actually in the budget itself.
    Senator Levin. If OMB decides to proceed that way, you 
would not disagree with them at that time?
    Mr. Sunshine. If OMB says that outlays in fiscal year 2004 
are $2 point whatever trillion, CBO is not going to say, well, 
no, they are not really $2 point something trillion; they are 
more than that. Once we get to the point of actual budget 
implementation, that is in the domain of the administration. We 
have told you how we think they should do it, but the time at 
which the budget is implemented is beyond the point where we 
can do something about that.
    Senator Levin. Dr. Nelson, you have indicated that you have 
determined that $120.7 million would be a reasonable unit 
purchase price for the aircraft. The Air Force, however, is 
stating that the unit price that they have negotiated, upon 
which they base either a purchase or a lease, is $138 million. 
The GAO has said that the actual price is going to be $173 
million per aircraft if, as expected, the Air Force exercises 
its option to purchase the aircraft at the end of the lease.
    Now, I am not here talking about the $1 point plus billion 
difference which has been described to us by the OMB Deputy 
Director this morning. I think we finally have taken that range 
of $150 million to $1.9 billion and, at least as far as my 
thinking is concerned, I am going to assume it is about $1 
billion plus in additional costs on an apples to apples basis, 
using net present value, if we lease instead of purchase in the 
ordinary course.
    But that $1.1 billion does not include what Dr. Nelson has 
said should be the cost of this plane in his best judgment, 
which is $120.7 million a unit, versus the price which has been 
negotiated, which is $138 million per unit. Are you with me so 
far?
    Mr. Curtin. I think so.
    Senator Levin. So let me ask both of you, because this is 
no longer a question for you. You have done your work. You have 
given us your best estimate. It is $120.7 million and that is 
what we have to go on. Is what I have said accurate, Mr. 
Curtin, that there is also then a difference between that 
negotiated price per unit and what Dr. Nelson has said should 
be the reasonable price of the purchase?
    Mr. Curtin. Yes. As far as I can tell, you have described 
it pretty well. The reason the price--the $131 million is the 
starting point versus the $120.7 million, and you add on 
interest and you add on the price or the cost of paying the 
final residual value afterwards. So yes, it is $120 million 
versus----
    Senator Levin. But the interest and the residual value 
piece is included in the $1.1 billion, if I am correct; is that 
correct or not? You know what I am saying?
    Mr. Curtin. Yes, I think that is probably a good way of 
looking at it.
    Senator Levin. Which is the net present value difference.
    Mr. Curtin. Yes, that is fine, that is a good way.
    Senator Levin. So I want to remove those items because we 
have already included those in the difference in net present 
value between purchase versus lease, which is the $1 billion 
plus.
    Now I want to talk about something in addition to that 
which we are now being confronted with, which is that if Dr. 
Nelson's projections are correct that this should cost us $120 
million per plane if we were just buying it right now, that the 
negotiated price upon which that lease is based or the purchase 
would be based is approximately $17 million more per plane than 
it, ``should'' be based on his assessment of what parts cost 
and inflation and the cost of labor and everything else that I 
assume goes into whatever proposal he made.
    Mr. Curtin. Yes, I think that is right on, yes.
    Senator Levin. All right. What is their explanation for 
that? I do not know whether you have talked to the Air Force 
about that or to the OMB about that.
    I do not think that was in your domain, was it, Dr. Nelson, 
or was it, to ask them, how come you have negotiated $138 
million when you say it should be----
    Dr. Nelson. We were not part of the negotiation process.
    Senator Levin. Then let me ask the CBO, then the GAO. My 
time is up.
    Just quickly, have you raised that question with the Air 
Force?
    Mr. Curtin. This whole IDA situation, it took us a long 
time before we finally got a copy of the IDA report and we were 
not sure whether the Air Force was ever going to actually give 
us that or not. So we were not able to get into much detail on 
that. But I think there was testimony yesterday at the Commerce 
Committee hearing from Secretary Roche, who said, yes, they had 
that, but it was advice, and they came up with a different 
number. They used that as part of their bargaining, but they 
did not use that number.
    Senator Levin. All right. Mr. Sunshine?
    Mr. Sunshine. That is not an area that we have explored.
    Dr. Nelson. If I might, our role was to provide our best 
information--objective, independent--to our sponsors. Our 
sponsors were USD AT&L, and OSD PA&E. But we did have meetings 
with Air Force on issues of difference. We tried resolving data 
and sources, interpretation of data, analogies application, as 
best we could. But we were not part of the final negotiation.
    Senator Levin. Thank you.
    Mr. Chairman, if there is an urgent requirement here it 
seems to me we ought to try to find a way to meet it. I think 
we have to meet it in a way which is direct, straightforward, 
does not shift costs, more costs yet, to the future, that does 
not create this conflict in the future where huge amounts of 
money are going to be needed for the refueling tankers that are 
going to have to be purchased after this first 100. That is 
going to be a huge part of the Air Force budget, creates the 
problem which the chairman has talked about in terms of the 
overall budget.
    I am willing to consider meeting an urgent requirement if 
that is what is concluded. But I think we have to do it in a 
way which is much more responsible, much more straightforward 
in terms of the present cost, and avoid hiding costs and avoid 
this uneven playing field which has been so very clearly 
described this morning by our witness.
    Thank you.
    Chairman Warner. Thank you, Senator. We will work together 
on that.
    Senator McCain.
    Senator McCain. Thank you, Mr. Chairman, and I thank you 
and Senator Levin. Obviously, there is some thinking out loud 
going on here, and I would like to say that I think that both 
the chairman and the ranking member have come up with at least 
a concept that I think we ought to pursue.
    I also would emphasize, and I think that my friends would 
agree, we do need an AOA. This may not be the best way to go. 
We need an intense study as to how serious these corrosion 
problems are, so that that would give us a better idea of the 
urgency and the schedule that is necessary for the replacement 
of the existing tanker fleet. I think both of those have to be 
key elements of any proposal or scheme that the chairman, the 
ranking member, and others may come up with.
    But I do think that what the chairman has said is really 
something worth pursuing seriously. I appreciate Mr. Curtin's 
view that this might be on the surface of it--I know it is not 
an official position of yours, but it might be an option worthy 
of pursuit.
    Would you agree it might be worth looking at, Mr. Sunshine?
    Mr. Sunshine. Yes, I think we ought to explore ways, the 
various alternatives we have, for getting the airplanes 
quickly.
    Senator McCain. Dr. Nelson, I want to apologize if I 
misportrayed your position. I guess what I was trying to say is 
that the best estimate of cost per airplane that IDA could come 
up with was $120 million per copy and the Air Force's version 
is considerably more under the lease proposal. So I would like 
to correct the record if I misportrayed any of your position.
    Does that take care of that?
    Dr. Nelson. Thank you very much, Senator.
    Senator McCain. Thank you, Dr. Nelson. I know that you are 
in a difficult position here and I appreciate that.
    Let me just discuss for 1 additional minute this issue of 
the lease-purchase. Mr. Curtin and Mr. Sunshine, if this were a 
lease-purchase it would be illegal, right?
    Mr. Curtin. It would not be an operating lease, yes. It 
could not fit under the current rules for an operating lease.
    Senator McCain. Right. But under the present setup we are 
going to pay 90 percent of the price of the airplane over a 6-
year period, which has a lifespan of 30, 40 years roughly. So 
it would be almost insane to pay 90 percent of the cost of an 
airplane over the first 6 years of its, say, 30-year life--that 
is a conservative estimate--and then not purchase it. That 
would be the worst kind of economics that anybody could 
consider.
    So really, it walks like a duck and it quacks like a duck, 
and everybody knows that they are not only talking about 100, 
they are talking about 200, in some cases 400 or 500 more. So I 
guess that that is a disturbing kind of element here in this 
whole scenario, because I think all of us on the committee 
would feel better by saying, as in response to previous 
questioning, we intend to buy it, this is the best way that we 
can do it without disturbing the Air Force's budget and their 
other priorities. I can understand that argument. I may not 
agree with it.
    But I would just like your comments on, would it make any 
sense whatsoever to pay 90 percent of the cost of anything that 
has a 30- or 40-year life period and then not purchase it at 
the end of that period of time? Mr. Curtin?
    Mr. Curtin. No. I think that is the point I made in my 
opening remarks, is that you have really thrown money down the 
drain if you turn those planes back after 6 years, because they 
do have a long life. If they are not the right plane, you have 
spent an awful lot of money on the wrong plane already, so 
turning them back at that point does not accomplish much.
    You are acquiring these for their full life cycle.
    Mr. Sunshine. It is not that the need is a temporary need. 
The need is a permanent need, and it is probably a growing 
need. You do not have anything to replace them with if you turn 
them back after 6 years, and you have just exacerbated the 
problem. So if someone comes along 5 years into the lease and 
says let us do an analysis and let us decide whether it is 
worth keeping these aircraft or not, the analysis almost 
certainly has to conclude that we have to keep them because we 
have already paid for most of them.
    Senator McCain. I thank you, Mr. Chairman. I thank the 
witnesses.
    Chairman Warner. This has been very helpful testimony, 
gentlemen, and I commend each of you. I thank my ranking member 
and you, Senator McCain, you have spent a lot of time on this 
issue, and this committee. I am just very impressed with the 
depth, the sincerity, the commitment, and the attendance we had 
today to address this important issue.
    So I will consult with my ranking member and members of the 
committee and we will probably have further statements on 
behalf of the committee as to our procedures we are going to 
follow as we address our responsibility under this request.
    Senator McCain, I did get from the Inspector General a 
reply. It tracks pretty well what you had said, with no 
reference to the word ``criminal'' at this point in time. I 
will place this into the record. I will actually read it for 
those who are following the hearing: ``Dear Chairman Warner: 
You have inquired as to whether or not I am investigating 
someone in connection with the Air Force tanker proposal.
    First of all, it is Inspector General policy generally not 
to comment publicly on the incidents of ongoing investigative 
activities. However, when others have already publicly 
commented on the IG investigative activities''--and there has 
been some press coverage and so forth--``in an inaccurate 
manner, it is appropriate and sometimes necessary for the 
Inspector General to set the public record straight.''
    ``As indicated to you''--that is Warner--``yesterday, my 
investigative staff has received information from another 
Senator's staff that we are currently reviewing to determine 
whether or not we should open an investigation. Procedurally, 
we are still conducting a `preliminary inquiry', which is 
standard operating procedure for my staff on the receipt of any 
such information. We may or may not determine to open an 
investigation. In the course of this preliminary inquiry, we 
determine whether the information is credible, whether it 
alleges violation of a prescribed standard, and whether the 
information is sufficient to enable a focused investigation. 
Although we generally hope to complete preliminary inquiries 
within 10 days, that aspirational standard depends upon the 
complexity and quantity of the information we are reviewing.''
    ``The enclosed memorandum, dated May 1, 2003, describes our 
standard operating procedures,'' and so forth.
    That is in response.
    [The information referred to follows:]
      
    
    
      
    
    
      
    
    
      
    
    
      
    Senator Levin. Mr. Chairman, I have a request to make if it 
is appropriate. We have this issue about the cost, the purchase 
price for the plane, and there is quite a difference here 
between $120 million and the $137 million which has been 
negotiated. The GAO has not had an opportunity to really look 
at the IDA analysis as I understand Mr. Curtin's testimony. I 
would like them to look at that analysis because as part of the 
approach which we have talked about and you outlined here I 
think we have to address that issue in some way.
    That is actually, I believe, a larger number than the $1 
point plus billion delta in the net present value approach. So 
I do think, if it is appropriate, Mr. Chairman, that we ask the 
GAO to give us a report on that narrow issue to supplement 
their testimony here today.
    Chairman Warner. I would suggest that a letter be prepared 
for our joint signatures and it will be sent out this 
afternoon.
    [The information referred to follows:]
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    
    
      
    Chairman Warner. I will be consulting with my colleague 
regarding my proposal where we look at a unit of 25 leased 
aircraft for the present time.
    Thank you very much. The hearing is concluded.
    [Questions for the record with answers supplied follow:]

             Questions Submitted by Senator James M. Inhofe

                        TANKER MAINTENANCE COSTS

    1. Senator Inhofe. Secretary Roche, can you explain the 767 
maintenance costs indicated in the July GAO report of $8 million?
    Secretary Roche. The GAO stated, ``The Air Force estimates that the 
maintenance agreement with Boeing will cost between $5 billion and $5.7 
billion during the lease period. It has negotiated an agreement with 
Boeing as part of the lease negotiations, covering all maintenance 
except flight-line maintenance to be done by Air Force mechanics. This 
represents an average of about $50 million per aircraft, with each 
aircraft being leased for 6 years, or over $8 million per year.''

    2. Senator Inhofe. Secretary Roche, how can the annual maintenance 
costs of a new aircraft be double the cost of the KC-135?
    Secretary Roche. It is not. Comparing the costs based on actual 
utilization planned, the KC-767 is much more cost effective. The 
support cost-per-flying hour (calendar year 2002 dollars) for the KC-
767 is $10,800 per hour. The support cost-per-flying-hour for the KC-
135E is $27,000 and $17,700 for the KC-135R. These are the estimated 
costs for operations in 2012 (expressed in calendar year 2002 dollars) 
when 100 KC-767s will be in the inventory. If the flying hours for KC-
135 were increased to 750 flying hours per year (the projected flying 
hour for the KC-767), the support cost-per-flying-hour for the KC-135E 
would be $16,300 and $10,600 for the KC-135R.

    3. Senator Inhofe. Secretary Roche, did the annual maintenance 
costs of the KC-135 mentioned in the GAO report include any one-time 
modifications such as the Pacer CRAG (Compass, Radar, and Global 
Positioning System)?
    Secretary Roche. The Air Force contacted the GAO analysts 
responsible for the July 2003 report. The GAO analysts advised that the 
costs mentioned in the July 2003 GAO report do include one time 
modification costs.

    4. Senator Inhofe. Secretary Roche, if the costs did include any 
one-time modification costs, what are the normal, annual maintenance 
costs of the KC-135E and KC-135R without the one-time costs?
    Secretary Roche. The aggregate data in the July 2003 GAO report is 
insufficient to answer this question. The annual operating costs 
referenced in the GAO report include the costs of personnel, unit level 
consumption and depot maintenance. After discussions with the 
responsible GAO analyst, we received some additional information used 
by the GAO to support the cost data referenced in their report. The 
additional GAO data shows that after removal of all avionics 
modifications, remaining fiscal year 2001 operating costs are $3.7 
million per aircraft for the KC-135D/E and $3.0 million per aircraft 
for the KC-135R/T. These costs are in constant year 2000 dollars.

                        TRAINING AND MAINTENANCE

    5. Senator Inhofe. Secretary Roche, in your testimony you said you 
would be back in November with a training and maintenance plan. What 
happens between now and November that would precipitate a training 
plan?
    Secretary Roche. A Training System Requirements Analysis (TSRA) was 
scheduled for completion in the late-November 2003 timeframe. The TSRA 
will provide a comprehensive analysis of our KC-767 training 
requirements, how training devices can best be utilized, and 
recommended locations for training activities. That activity, however, 
is currently suspended pending ``new start'' approval.

    6. Senator Inhofe. Secretary Roche, does the Air Force currently 
have a long-term, centralized training plan for the 767?
    Secretary Roche. Yes, KC-767 training is included in the lease 
contract with Boeing. As tanker fleet recapitalization continues beyond 
the initial 100 new tankers and should the decision be made to procure 
additional KC-767s, the Air Force will look again at the advantages of 
centralized training for the larger fleet. Boeing, as part of the 
training service, will provide the simulators and Boeing will own the 
simulators. The Government has the option to purchase the devices from 
Boeing at any time during the lease.
                                 ______
                                 
             Questions Submitted by Senator Elizabeth Dole

                           SPECIAL EQUIPMENT

    7. Senator Dole. Secretary Roche and Secretary Wynne, as part of 
the Boeing 767 tanker lease proposal, Boeing has designated many of the 
components and systems of this aircraft for foreign procurement as part 
of a foreign procurement offset plan. Arguably, some global tanker 
transport aircraft will be designed for foreign customers; however, 
these aircraft will not share the same special mission requirements as 
the KC-767. As part of the lease, has the Air Force imposed any special 
restrictions on Boeing for U.S. specific features such as auxiliary 
fuel systems and other special mission equipment?
    Secretary Roche. The Air Force has not directed Boeing to any 
particular U.S. subcontractor to fulfill a specific requirement such as 
the auxiliary fuel system or other special mission equipment. The Air 
Force typically does not give such direction thus avoiding the 
potential argument that the Government is guaranteeing subcontractor 
performance. The lease does, however, include DFARS 252.225-7001, Buy 
American Act and Balance of Payments Program and Boeing has certified 
that it is providing end products manufactured in the United States.
    Secretary Wynne. The Air Force has not required that Boeing fulfill 
a specific requirement such as the auxiliary fuel system or other 
special mission equipment only through domestic sources. The lease 
includes DFARS 252.225-7001, Buy American Act and Balance of Payments 
Program, and Boeing has certified that it is providing end products 
manufactured in the United States.

                             ECONOMIC BOOST

    8. Senator Dole. Secretary Roche and Secretary Wynne, if approved, 
this lease plan will provide a huge economic boost for Boeing. Berry 
Amendment provisions for military specific aircraft, if applied 
correctly in this deal, could also provide an economic boost for 
subsystem suppliers as well. What U.S. military-only modifications are 
being included in the creation of the KC-767 and how many of these 
systems are foreign produced?
    Secretary Roche. The Fiscal Year 2002 Supplemental Appropriations 
Act 107-206, Section 308, dated 12 Aug 2002, exempts the KC-767A Tanker 
Program from Berry Amendment application under Section 2533a of Title 
10 U.S.C. The KC-767A is a commercial tanker aircraft equipped to meet 
Air Force requirements. There are a very limited number of USAF 
specific military avionics components, and all are procured or are 
projected to be procured from domestic sources.
    Secretary Wynne. Section 308 of the 2002 Supplemental 
Appropriations Act, P.L. 107-206, exempts the KC-767A Tanker Program 
from the provisions of section 2533a of title 10, United States Code 
(commonly referred to as the Berry Amendment). The KC-767A is a 
commercial tanker aircraft equipped to meet the requirements of the 
USAF. There are very few pieces of military avionics specific to the 
requirements of the USAF, and all are procured or are projected to be 
procured from domestic sources.

    9. Senator Dole. Secretary Roche and Secretary Wynne, are 
comparable systems or materials made in the U.S.?
    Secretary Roche and Secretary Wynne. The 767 tanker is a 
commercially offered aircraft. All systems are procured from domestic 
sources or are projected to be procured from domestic sources.

    10. Senator Dole. Secretary Roche and Secretary Wynne, the Boeing 
767 tanker lease proposal brings to light a new aspect of weapons 
systems acquisition. This proposal continues the trend toward the use 
of commercial off-the-shelf (COTS) technology as a means of reducing 
often exorbitant research and development costs. The Berry Amendment 
requires the Department of Defense to purchase U.S. sourced and 
manufactured specialty metals, clothing, and textiles. This law, re-
codified by Congress in 2001, preserves the ``warm industrial base'' 
that provides the items our military needs in times of both war and 
peace. The 100 proposed airframes will be manufactured on the 
commercial line then modified to fill the specific military tanker 
mission. Technically, this lease plan bypasses the Berry Amendment 
specialty metals requirements due to the dual use of commercial and 
military manufacturing lines. Boeing has agreed to a deal with the 
House Armed Services Committee to purchase the same amount of American 
titanium in the proposed Air Force tanker lease deal as would have been 
required under traditional defense procurement guidelines. Has the Air 
Force written this agreement into the leasing contract?
    Secretary Roche. Section 308 of the Fiscal Year 2002 Supplemental 
Appropriations Act for Further Recovery From and Response to Terrorist 
Acts on the United States, P.L. 107-206, 116 Stat. 841, provides that 
10 U.S.C. 2533a (Berry Amendment) does not apply to the Boeing tanker 
lease. Therefore, the tanker lease properly does not include any 
clauses implementing the Berry Amendment. The Air Force was not party 
to any agreement between the House Armed Services Committee and Boeing 
nor is the Air Force clear on the terms of any such agreement. If 
Congress changes the application of the Berry Amendment to the tanker 
lease, the Air Force will negotiate changes to the lease to comply with 
the new law.
    Secretary Wynne. Section 308 of the 2002 Supplemental 
Appropriations Act, P.L. 107-206, 116 Stat. 841, provides that section 
2533a of title 10, United States Code (commonly referred to as the 
Berry Amendment) does not apply to the Boeing tanker lease. Therefore, 
the tanker lease properly does not include any clauses implementing the 
Berry Amendment. The Air Force was not party to the agreement between 
the House Armed Services Committee and Boeing, and thus has not 
memorialized the agreement as a requirement of the proposed lease 
contract.

    11. Senator Dole. Secretary Roche and Secretary Wynne, how does the 
Department of Defense plan to meet the Berry Amendment's requirements 
for other COTS items modified for military use?
    Secretary Roche. The Berry Amendment (10 U.S.C. 2533a) applies to 
both military and commercial items acquired with appropriated funds or 
funds otherwise made available to the Department. Nevertheless, many 
COTS items are manufactured without regard to Berry Amendment 
requirements. The Department will examine the feasibility of 
incorporating Berry Amendment compliant materials and components into 
COTS items manufactured for military use on a case-by-case basis. If 
the Air Force determines that it is not feasible to incorporate Berry 
Amendment compliant materials and components into the manufacturing 
process for these items, the Air Force will consider exercising the 
statutory authority to grant waivers in appropriate cases.
    Secretary Wynne. The Department will have to assess each COTS case 
independently. In anticipation of Congress' consideration of the 
National Defense Authorization Act for Fiscal Year 2004, we sent a 
legislative proposal to Congress, with the goal of clarifying and 
streamlining the requirements in section 2533a of title 10, United 
States Code (often referred to as the Berry Amendment). The House of 
Representatives and the Senate each passed its own version of the Act, 
and each version proposes changes to the Berry Amendment. The House 
version has additional provisions, including those dealing with machine 
tools and the requirement to procure specified items from manufacturers 
that are part of the national technology and industrial base. Because 
the resulting legislation will have a significant impact, the 
Department is keenly interested in the results of the work of the House 
and Senate conferees. We hope that whatever changes are enacted will 
result in a statute that can be efficiently applied and enforced, will 
protect the defense industrial base, and will be consistent with the 
principles established in negotiated agreements with our counterparts 
in other countries regarding mutual cooperation in defense procurement.
                                 ______
                                 
               Questions Submitted by Senator Carl Levin

                     USEFUL SERVICE LIFE REMAINING

    12. Senator Levin. Secretary Roche, as late as February 2001, the 
KC-135 Economic Service Life Study, found that ``the fleet is 
structurally viable to 2040,'' and that none of the KC-135Es and only 
six of the KC-135Rs would reach the end of their fatigue life (36,000 
hours and 39,000 hours, respectively) by 2040. Based on that 
assessment, the Air Force intended to: (1) continue to convert KC-135E 
aircraft to the KC-135R configuration; and (2) wait until 2013 to begin 
KC-135 replacement. What is your latest assessment of the fatigue life 
remaining for the KC-135E aircraft?
    Secretary Roche. Assessments of the KC-135 service life agree that 
fatigue alone will not be the driving factor for retirement; rather 
degradation of the aircraft structure due to corrosion is the life-
limiting factor. One of our greatest concerns is a potential fleet-wide 
grounding event that could emerge with little or no warning because of 
unknown unknowns in regards to what corrosion does to aircraft. The Air 
Force feels that we cannot accept the risk of unknown systematic 
failures that could ground the tanker fleet.

                        DISADVANTAGES OF LEASING

    13. Senator Levin. Director Kaplan, earlier this year, the CBO 
provided us with a report on the budgetary treatment of leases. In that 
report, CBO concludes that the use of long-term leases reduce the 
budget's ability to fully depict the Federal Government's financial 
commitments, undermine fiscal discipline by circumventing controls such 
as limits on deficits and caps on discretionary spending, and allow 
agencies to avoid facing the full costs of their purchasing decisions. 
Indeed, the Air Force has stated that the ``dominant reason'' for the 
lease approach is that it enables the Department to obtain tanker 
aircraft ``without requiring significant up front funding.'' Do you 
agree or disagree with CBO's conclusion that the use of long-term 
leases has the effect of undermining fiscal discipline by pushing costs 
off into outyear budgets?
    Director Kaplan. OMB agrees that leases can be abused in some 
instances in the way feared by CBO. When the Air Force first brought 
this proposal to OMB, we had a number of questions about it. Pursuant 
to congressional authorization, and after nearly 2 years of discussions 
that ultimately involved a reduction of over 12 percent in the price 
per plane, the administration decided to pursue a lease because of the 
price reduction and the advantages it provides for urgently 
recapitalizing the tanker fleet. The Boeing lease does not represent an 
endorsement of leasing as a preferred method for acquiring military 
equipment or other critical assets. OMB expects agencies to know the 
full costs of their programs, and to conduct the appropriate analyses 
under OMB Circulars A-11 and A-94. OMB will review any lease proposal 
to ensure that appropriate analyses have been conducted, and will 
approve such a proposal only when leasing is the most appropriate 
structure in light of all the circumstances.

    14. Senator Levin. Director Kaplan, what standards will you use to 
ensure that the Boeing lease does not become a precedent for other 
long-term leases of expensive capital equipment by the Department of 
Defense and other Federal agencies?
    Director Kaplan. As mentioned in the previous response, the Boeing 
lease is the result of exhaustive efforts to understand the 
implications of the transaction and to negotiate the best possible 
price. OMB will review any lease proposal to ensure that the agency has 
conducted appropriate analyses under OMB Circulars A-11 and A-94, and 
will approve such a proposal only when leasing is the most appropriate 
structure in light of all the circumstances. The Boeing lease does not 
represent an endorsement of leasing as a preferred method for acquiring 
military equipment or other critical assets. Instead, OMB anticipates 
that long-term leases of capital equipment will remain the exception 
rather than the rule.

                       URGENCY OF THE REQUIREMENT

    15. Senator Levin. Secretary Roche, whatever we believe about the 
various cost estimates, it is clear that the Air Force is willing to 
pay a premium to lease the KC-767 tankers. The Air Force states that it 
is willing to pay this premium because the urgency of obtaining new 
tanker aircraft overwhelms the added costs. However, the Air Force's 
most comprehensive study of its existing tanker fleet--the February 
2001 KC-135 Economic Service Life Study (ESLS)--concluded that ``the 
fleet is structurally viable to 2040'' and that although the cost of 
aircraft maintenance would increase significantly during that time, 
``there appears to be no run-away cost growth.'' On this basis, the Air 
Force planned to wait until 2013 to begin KC-135 replacement. Since the 
time of that study, the amount of time the KC-135 has spent in the 
depot has declined, the number of aircraft in the depot at any one time 
has declined, and the mission capable rates for the aircraft have 
increased. Also, in the fiscal year 2004 budget, the Air Force proposed 
reducing its tanker capacity by retiring more than 60 KC-135E tankers 
without any immediate replacement. This hardly seems to describe a 
situation so urgent that the Air Force must pay a premium to obtain new 
tankers early. During the hearing, you indicated that the ESLS was a 
faulty study. Could you provide the committee with the better studies 
upon which the Air Force based its decision that the requirement to 
replace the KC-135E tankers was so urgent as to require pursuing the 
leasing proposal now?
    Secretary Roche. The Deputy Secretary of Defense, in his 22 Sep 
2003 letters to Senators Warner and Levin, confirmed that structural 
degradation due to corrosion is the life-limiting factor. Our major 
concern is a potential fleet grounding event due to the unforeseen 
nature of corrosion. This would cripple global reach--we cannot accept 
the risk. This drives the Air Force to begin a rapid recapitalization 
of the aging KC-135 tanker fleet. Since the ESLS study release, average 
annual costs have increased by $250 million per year. The ``KC-135E 
Business Case Analysis,'' dated 1 May 2003, updates the cost 
projections of the ESLS. This document was provided to SASC staff on 18 
July 2003.

    16. Senator Levin. Secretary Roche, what new information has the 
Air Force obtained since February 2001 that has caused it to reverse 
its position and determine that it is urgent to begin fielding new 
tanker aircraft as soon as possible?
    Secretary Roche. The comprehensive report and briefing, ``KC-135E 
Business Case Analysis,'' dated 1 May 2003, documents the cost 
avoidance and strategy for retiring the KC-135E. This report and 
briefing was provided in July to SASC members and staff. In addition, 
the Air Force provided ``The KC-135 Aging Aircraft Story,'' dated 2 Aug 
2002.

                 SOLE-SOURCE LOGISTICS SUPPORT CONTRACT

    17. Senator Levin. Secretary Roche, most of our focus in the 
discussion in the hearing was related to the issue of the lease versus 
purchase comparisons of the proposed deal. However, the proposed 
agreement between Boeing and the Air Force also includes a sole-source 
logistics support contract of roughly $6 billion. Although Boeing is 
undoubtedly capable of providing this support, there appear to be other 
organizations in the public and private sectors that could have 
effectively competed for this work, had they been permitted to do so. 
Indeed, I understand that Boeing is not now providing logistics support 
for any of the 767s that it has sold in the commercial marketplace. 
Wouldn't the Air Force have been able to save a considerable amount of 
money if it had conducted a competition for logistics support, instead 
of awarding the contract on a sole-source basis to Boeing?
    Secretary Roche. Our contract terms with Boeing require them to 
cover the costs of parts obsolescence and diminishing manufacturing 
sources (for both green a/c and modification) to ensure aircraft 
availability. These are two areas that the original equipment 
manufacturer is best prepared to address due to their relationship with 
the vendor base and availability of data. In addition, for the tanker 
unique aspects of the KC-767, the data required for support is Boeing 
proprietary.

    18. Senator Levin. Secretary Roche, some Air Force officials have 
told us that some aspects of logistics support could not be awarded to 
a contractor without Boeing's approval, because of Boeing's proprietary 
data in the refueling system. If this is the case, couldn't the sole-
source award have been limited to those aspects of the system?
    Secretary Roche. Breaking the support of the aircraft into smaller 
``pieces'' would drive the cost for general and administrative support 
higher to carry multiple contractors. For these reasons, the Air Force 
justified a sole source justification and approval for the lease and 
support of the KC-767A tanker.

               BOEING'S ROLE IN DRAFTING THE REQUIREMENT

    19. Senator Levin. Secretary Roche, an article in U.S. News and 
World Report earlier this month states that the Air Force allowed 
Boeing to help draft the requirements for the tanker aircraft to be 
leased. The article states that an unnamed Pentagon panel later 
``chastised the Air Force for tailoring its requirements to the Boeing 
767 and concluded that the document `should not be written for a 
specific aircraft.' '' In fact, Senator McCain has provided us with a 
Boeing document in which company officials refer to an objective of 
``establish[ing] clearly defined requirements for the USAF tanker 
configuration that results in an affordable solution that meets the 
USAF mission needs and will prevent an [Analysis of Alternatives] from 
being conducted.'' Did Boeing in fact participate in drafting the Air 
Force's requirement for tanker aircraft? If so, isn't this inconsistent 
with DOD acquisition regulations?
    Secretary Roche. The Air Force did share the draft operational 
requirements document with Boeing as the legislation was being 
finalized (i.e. prior to Dec 2001). However, working with industry 
early in the acquisition process is encouraged by DOD acquisition 
regulations. In fact, according to the Chairman of the Joint Chiefs of 
Staff Memorandum 3170.01, ``The intent is to share capstone 
requirements documents with allies and industry wherever possible. 
Early collaboration should be encouraged wherever possible.''

                        LOGISTICS SUPPORT COSTS

    20. Senator Levin. Secretary Roche, Mr. Curtin's prepared testimony 
on page 16 states that the total operating and support cost including 
logistics support and flying hour costs for the KC-767 tanker fleet of 
100 aircraft would be $808 million in constant fiscal year 2002 
dollars, or $8.08 million per aircraft. The statement also quotes an 
Air Force prediction that the KC-135 fleet of 510 aircraft would 
require a total operating and support cost expenditure of roughly $3.5 
billion in fiscal year 2002 dollar terms, or an average of about $6.4 
million per aircraft per year. As I understand it, within that total 
KC-135 expenditure, the Air Force is predicting that the KC-135R 
aircraft would require roughly $2.7 billion, or $6.5 million per 
aircraft and the KC-135E aircraft would require $773 million or roughly 
$8.3 million per aircraft. I note that one of the reasons that the Air 
Force wants to retire the KC-135E aircraft is because they are 
expecting increasing maintenance costs. However, based on these 
estimates, it would not appear that the KC-767 logistics support costs 
will be greatly reduced from those of the current fleet of tankers. Do 
you have any reason to believe that operating and support costs for the 
KC-767 tanker will not increase over time?
    Secretary Roche. The Air Force has negotiated a fixed price 
contract for integrated fleet support for the duration of the KC-767 
lease. The cost per year in constant year dollars will remain static 
throughout this contract and will not increase. More importantly, the 
more capable KC-767 will fly twice as many hours as a KC-135 and thus 
will be less expensive to operate. The support cost per flying hour 
costs (calendar year 2002 dollars) for the KC-767 is $10,800 per hour. 
The support cost per flying hour for the KC-135E is $27,000 and $17,700 
for the KC-135R. These are the estimated costs for operations in 2012 
(expressed in calendar year 2002 dollars) when 100 KC-767s will be in 
the inventory. If the flying hours for KC-135 were increased to 750 
flying hours per year (the projected flying hour for the KC-767), the 
support cost-per-flying-hour for the KC-135E would be $16,300 and 
$10,600 for the KC-135R.

    21. Senator Levin. Secretary Roche, if the cost per year is already 
at roughly $8.1 million per aircraft per year for the KC-767, and as 
the Air Force points out, support costs for any aircraft are likely to 
grow over time, do you have any estimate of how these costs might 
increase beyond the current estimate in later years?
    Secretary Roche. The Air Force has negotiated a firm fixed price 
contract for integrated fleet support (IFS) for the duration of the KC-
767 lease. The cost per year in constant year dollars will remain 
static throughout this contract and will not increase. When this 
contract expires, the Air Force has many options for this IFS contract. 
They include competing the IFS contract and performing IFS by the 
government. The aircraft industry has made many corrosion prevention 
improvements in metallurgy as well as coatings over the years between 
KC-135 production and KC-767 production. We anticipate lower 
sustainment costs for the KC-767 as it ages compared to the KC-135.

                   LOGISTICS SUPPORT COST ASSUMPTIONS

    22. Senator Levin. Secretary Roche, all of the Air Force 
assumptions about the logistics support contract costs assume an annual 
flying hour total of 750 hours per aircraft. The Air Force is now 
flying the KC-135Es and KC-135Rs at a rate closer to 300-400 hours per 
year. I would note that one of the reasons that the Air Force has 
claimed that it needed to retire roughly half of the KC-135E fleet (68 
aircraft) in the Future Years Defense Program is that you do not have 
enough crews to keep up with the current flying hour program. Isn't 
this assumed utilization rate too optimistic for the KC-767?
    Secretary Roche. No, the KC-767 utilization rate is based on the 
planned crew ratio of 2.0 as compared to the current 1.3 crew ratio for 
the KC-135 fleet. As a result, the KC-767 is envisioned being used 
similar to the KC-10 and should fulfill the projected 750 hours per 
aircraft. 600 of the projected flight hours are required during 
peacetime to ensure adequate experience levels throughout the crew 
force. The additional 150 hours are provided for contingency 
operations.

    23. Senator Levin. Secretary Roche, what would be the cost 
difference in total support costs from assuming a more reasonable 400 
hours-per-year rate?
    Secretary Roche. Our warfighters established 750 flying hours per 
year as the expected utilization rate, in line with how AMC operates 
the KC-10. The IFS contract has the flexibility to adjust for changes 
in OPTEMPO scaling the level of support based on need. As such, fleet 
cost estimates provided by the KC-767 System Program Office for 100 KC-
767 operating at 400 annual flying hours is $679 million (calendar year 
2002 dollars) and at 750 annual flying hours is $808 million. Cost per 
flying hour for 400 annual flying hours is $17,000 while for 750 flying 
hours is $10,800.

                        LIFE CYCLE COST ANALYSES

    24. Senator Levin. Secretary Roche, in response to a question from 
Senator Reed during the hearing, you indicated that the Air Force had 
completed life cycle cost analyses of the tanker situation, presumably 
including life cycle costs of the current KC-135E force and of the 
proposed KC-767 force. Could you provide those analyses for the record?
    Secretary Roche. As I stated to Senator Reed during the hearing, 
the earlier we have these new aircraft in place, the more operational 
savings we will be able to realize. The support cost-per-flying-hour 
(calendar year 2002 dollars) for the KC-767 is $10,800 per hour. The 
support cost-per-flying-hour for the KC-135E is $27,000 and $17,700 for 
the KC-135R. These are the estimated costs for operations in 2012 
(expressed in calendar year 2002 dollars) when 100 KC-767s will be in 
the inventory. Cost avoidance of accelerating retirement of KC-135Es by 
5 years is $6.3 billion (then-year dollars). The details of this cost 
avoidance is included in the comprehensive report and briefing, ``KC-
135E Business Case Analysis,'' dated 1 May 2003. This report and 
briefing were provided in July to SASC members and staff. If the flying 
hours for KC-135 were increased to 750 flying hours per year (the 
projected flying hour for the KC-767), the support cost-per-flying-hour 
for the KC-135E would be $16,300 and $10,600 for the KC-135R.

                        PROFITS IN THE CONTRACT

    25. Senator Levin. Secretary Roche, a CRS report assesses that 
Boeing is making roughly 6 percent return on sales for its commercial 
sales of B-767 aircraft. The proposed Air Force leasing deal would cap 
Boeing profits at no more than 15 percent return on sales for the 
commercial aircraft (so-called ``green aircraft'') and 15 percent 
return on sales for the refueling modification. There may be some 
additional risk in modifying the aircraft to tanker configuration that 
would merit a potentially higher return, but why would the Air Force 
agree to pay a potential premium for an unmodified aircraft above what 
Boeing is apparently receiving on its commercial orders?
    Secretary Roche. Boeing has assumed tremendous risk in this program 
in both undertaking a firm fixed price development of $1.4 billion and 
in the first-time manufacturing of the tanker. Because of this high 
risk, a high ``potential'' reward is merited. Although it may be argued 
that the ``green'' component of the tanker is low risk and has been 
``assumed'' to deliver a 6-percent profit, it is important to recognize 
that we have both a profit cap and a most favored customer clause. 
Since the Air Force is getting the best, most favored price, Boeing's 
profit will be, at best, at the 6-percent level. The profit level is a 
cap and not a mandate of profit. By allowing a higher cap, we 
incentivize Boeing to be as efficient as possible so as to get a better 
price for future commercial 767 derivatives.

    [Whereupon, at 1:15 p.m., the committee adjourned.]

                                 
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