August 22, 2016
Lockheed Martin’s billion-dollar cash advance is by now big news—or not so big news against the backdrop of a bigger program. As Defense News and others reported over a week ago, the Pentagon recently sent its contractor the money it needed to keep the Joint Strike Fighter production line running—just without a signed contract and in advance of final terms and pricing. On Defense-Aerospace, Giovanni de Briganti was scandalized that the buyer would accede so quickly to financing its supplier, “as if managing contractor cash flow was a governmental responsibility.” After all, in 2015, Lockheed generated cash from operations of $1.5 billion, and this year the company admits that the reimbursed billion will mostly maintain its hefty dividends to shareholders. So why is this not so scandalous? The answer is that industry and government are joined inextricably in the economic enterprises of defense, so the long-term consequences of opportunistic behavior need repeated remediation.

Let’s start with the immediate problem: $1.5 billion is about all the cash the company tends to keep on hand. Following my argument in an on this past Sunday’s Defense News TV (on WJLA Washington DC), when one program suddenly needs $1.0 billion, two-thirds the corporate treasury empties. Certainly, Lockheed’s management could have told its shareholders to wait on that dividend. In theory, the Pentagon could have told management to borrow the money on short payback terms. Either eventuality, however, would have sent a strong signal. A billion dollars is easier to get from the government than from a syndicate of banks, and if the government isn’t willing, those banks might question the surety of the program. Cancellation rumors regarding the F-35 are rare, but not wholly unbelievable, so borrowing costs would appropriately rise. To update the old adage, pas d’argent, pas d’avion, so Lockheed would return to the table seeking to recoup those costs as a cost of doing business. Thus, whoever is responsible, the cash management problem is not trivial.

It’s notable that those low interest rates embed a longer-term problem. Higher rates would be bad for the indebted governments who are Lockheed’s customers, as higher rates consume more cash for current obligations. As Richard Dobbs and Susan Lund of the McKinsey Global Institute calculated in 2013, one effect of low post-recession rates was to save the US government $900 billion in borrowing costs—about half again an entire annual defense budget. But higher interest rates may be good for many contractors, at least those with large pension responsibilities. Increases in rates decrease the present value of the bonds acquired to fund future obligations. (If this seems counterintuitive, “rates up, prices down” is the business school mnemonic.) The problem has been acute with the bottoming out of the price of money. As Jill Aitoro for Washington Business Journal back in 2013 as well, for every 25 basis point increase in the discount rate, Lockheed’s pension expense drops by $145 million.

The next year, Lockheed froze its defined-benefit pension plan, and like so many other companies, shifted new employees to defined contribution retirement plans. The problem was getting acute, for Jeff Clabaugh wrote then for Washington Business Journal, “defense contractors often carry the heaviest pension loads among US companies.” But why not? Defined-benefits are long-term debt, and Lockheed’s deal with the government is a very long-term affair. As Yossef Spiegel of Tel Aviv University wrote in “The Role of Debt in Procurement Contracts” (Journal of Economics and Management Strategy, 1996), each “partner is locked into the relationship, [so] each party has an incentive to behave opportunistically by demanding as large a share as possible” of the gains. Citing J. Ronald Fox’s Arming America: How the US Buys Weapons (Harvard University Press, 1974), Spiegel similarly noted the historical point that “defense contractors who are exposed to the risk of opportunistic behavior by the Department of Defense have debt-equity ratios that are twice as high as those of firms in general industries.” While these debt levels have decreased relatively since the end of the Cold War, the pension liabilities may have taken their place. And citing Bill Kovacic’s “Commitments in Regulation: Defense Contracting and Extensions to Price Caps” (Public Contract Law Journal, 1992), Spiegel further notes that one “case in point” of just how extreme things used to get “is the $500 million unilateral price increase that Lockheed received from the DoD for the C-5A program in 1971 when the firm was on the verge of bankruptcy.”

Ah, Lockheed. The company was bound to attract some opprobrium for a late-night delivery of a thousand shopping bags of C-notes. Of course, nothing quite like that happened, for whatever the current commentary, there’s a long literature on the efficient arrangements in contracting for exquisite systems. The Joint Strike Fighter program may qualify as a big deal, costing perhaps a trillion dollars over fifty years, or whatever scary numbers pundits repeat. As the interest-and-pensions problem indicates, the economics of that program are themselves embedded in the macroeconomics of government spending and borrowing. In this single instance, the governments’ negotiators could have played hardball, withholding the cash last month until a contract was signed at a suitably low price. Instead, the government chose to preserve the relationship, as its own rules have foreseen. After all, the Pentagon’s large “undefinitized” payment to its largest contractor is thoroughly covered by subpart 217.74 of the Defense Federal Acquisition Regulations Supplement (DFARS). There may have been other issues worth fighting over, but an overnight loan was a reasonable step in a multi-decade program.

James Hasik is a senior fellow at the Brent Scowcroft Center on International Security.

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