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Issue Brief


Next Stop, Risky Junction: How a Federal Loan to the Dakota, Minnesota & Eastern Railroad Could Take Taxpayers for a Ride
NTU Issue Brief 159

October 19, 2006
By Chris Biggs By Andrew Moylan

What the nation's least populous state of Wyoming may lack in size, it makes up for in abundance of natural resources. Its Powder River Basin (PRB) contains some of the largest deposits of coal in the world and has supported many mining operations for decades. In order to supply the Midwest with this valuable energy source, the region relies on railroads to transport the coal from state to state. The Dakota, Minnesota and Eastern Railroad (DM&E) wants to join the elite class of carriers by tapping into this lucrative business opportunity. But as the South Dakota-based company tries to raise capital to expand its rail line service to the PRB, it is hoping American taxpayers, not private financiers, will ante up.

Through the Railroad Rehabilitation & Improvement Financing (RRIF) Program, DM&E has asked the Federal Railroad Administration (FRA) for a $2.5 billion loan to aid in the development of railways in four states. The plan includes a 262-mile extension into the PRB from a location in South Dakota and an upgrade of 600 miles of existing trackway. Originally Congress authorized the RRIF to issue loan guarantees only up to a total of $3 billion, but the maximum contribution level rose to $35 billion with the passage of the Transportation Bill in August 2005.[1]

There are many reasons why a federal loan to DM&E would be a poor deal for taxpayers.

First, the railroad is already heavily dependent on federal handouts. In early 2004, the company was granted a $233 million loan through the same RRIF program. Despite a spotty safety record, DM&E spent less than $40 million of the money for track repair, using the rest of the $194 million to refinance existing debt for railway acquisition and rehabilitation. None of the funds were applied to the PRB expansion project.[2]

RRIF's biggest loan to date was the $233 million one already doled out to DM&E; the new loan would be more than 10 times greater. A $2.5 billion loan would be 4.8 times the size of the total amount of guarantees currently administered through the RRIF program. In addition, the company's debt already makes up 45 percent of the RRIF's total holdings. If the new loan were to be approved, DM&E alone would represent a colossal 91 percent – $2.733 billion – of the new $3.017 billion portfolio.[3]

Second, there is an apparent conflict of interest that made the loan possible. Because FRA's total lending cap was set too low for DM&E to receive the necessary amount of federal aid for the PRB project, Senator John Thune quietly tacked on language to the Transportation Bill that raised the limit tenfold. This is not just a case of a Senator helping out a business from his home state. The connection is a bit more personal, as Thune happened to be a lobbyist for DM&E in the brief period between the end of his service in the House in 2003 and his election to the Senate in 2004.[4]

In the wake of the lobbying scandals involving the likes of Duke Cunningham and Bob Ney, the federal government ought to be taking proactive steps to reduce "rent-seeking" among special interests and elected officials. The lack of transparency in the legislative process, in combination with the massive, pork-laden bills that are routinely ground out of the flawed machinery, has rendered oversight on these relationships virtually impossible.

Third, rail service is already being provided out of the PRB by two larger and superior railroads who have invested private funds in most of their ventures. The government should not prop up a weak competitor in an already-served market with the help of taxpayer funds. Two so-called Class I railroads (classified by their larger revenues) already provide coal freight service out of the PRB: Burlington Northern Santa Fe (BNSF) Railway and the Union Pacific Railroad (UP). Without the use of taxpayer dollars, BNSF plans to invest $436 million this year to increase coal transport capacity. They make the case that the amount of the federal loan would be better served through the private markets, where investment in existing railways would gravitate towards reducing bottlenecks and improving capacity deficiencies.[5]

Fourth, DM&E will find it difficult to succeed in the PRB market. Independent reports have determined that the railroad will most likely be unable to compete with larger railroads or will be consolidated into a Class I competitor due to high debt and lack of infrastructure. Financial analysis by the investment firm UBS confirms that a federal loan to DM&E would not be a prudent strategy. The federal government may hope that giving DM&E access to the PRB may ultimately lower rates; however, UBS believes a third carrier competing in the market may not last long. The firm concludes that the two Class I stalwarts would crowd out DM&E using their pricing power:[6]

For example if the DM&E connects to one power plant for a utility, but the other four plants are served by BNSF, the Class I will likely discourage the utility giving business to the DM&E for one plant by threatening to hike on the other four. We therefore expect the DM&E to struggle initially to generate meaningful business…[7]

UBS goes on to question whether DM&E could even survive. Citing the company's large debt as one possible threat to its financial vitality, DM&E may eventually be gobbled up through acquisition by UP, BNSF, or another Class I carrier. In addition, DM&E's business strategy can also be questioned. DM&E serves only one major city directly, Minneapolis. UBS believes the company will be hindered by this lack of geographical diversification, ultimately affecting its marketing capabilities:[8]

The company will therefore require coal to be interchanged with other railroads in order to reach the bulk of potential customers. These interchanges would occur mostly at Chicago, which is 'congestion central' for North American railroads, and would mitigate the cost advantages of running unit trains. UP and BNSF clearly won't be willing to partner with the DM & E, so it will need to rely on the Eastern and Canadian rails for distribution.[9]

Fifth, the Bush Administration wants to terminate the RRIF program altogether. White House officials evaluated the merits of the railroad loan program and decided to terminate it from the proposed budget for Fiscal Year 2007. The Administration cites the fact that the government would be responsible for any unsecured losses in the event of a loan default as a validation for the program's cancellation. Also mentioned are recent changes in the Tax Code, which relieve the railroads of their tax liability on rail diesel fuel. The President's budget concludes, "there is no clear justification for the federal government to extend such favorable loan terms to private rail companies."[10]

Finally, the most compelling argument against granting the loan to DM&E is based on principle. Floating a taxpayer-backed "credit-line" to a private company is simply wrong. However, there will always be those who rationalize the need for the government to provide credit assistance to business in the instance of a "market failure" or a "compelling public interest." They often cite the success of the Chrysler Loan Guarantee Act which gave the almost-bankrupt carmaker $1.2 billion in 1980. Within three years, Chrysler was financially stable and had completely paid off its loan.[11] But Professors Walter Adams and James W. Brock understand the financial and social consequences created by the Chrysler precedent:

[T]he political economy of [big business] thus revolutionizes an ostensibly free enterprise society in a subtle but profoundly radical way. It privatizes profit while socializing losses – provided the latter are large enough. It thereby erodes the social role (and justification) of profit as an inducement for sound decision-making in the public interest. It is thus tantamount to socialism for the big and powerful.[12]

Adams and Brock's reasoning can also be applied to the DM&E loan. DM&E could not raise the capital for the PRB project from the private sector alone, so the firm asked the federal government to step in as a "partner." DM&E is in the position to receive federal aid because of the enormity of its goals and its political ties to Washington insiders. If the company fails to pay back the loan, American taxpayers will have to defray the costs of the deal. It defies logic to allow a company to pass the risk on to taxpayers while keeping the potential rewards for itself.

In an open economy, the market decides winners and losers. DM&E wants to tap into the lucrative PRB, but the private sector weighed the risk and chose not to invest. The federal government should not be the fall-back lender for a business that can't succeed in the real world. DM&E and its appeal for a federal loan is just another case of corporate welfare aided by high-level connections in which the American taxpayer is taken for a ride.

Notes

NTU has supported federal divestiture of assets and an end to taxpayer backing for various transportation programs, including the sale of Conrail and repeal of Amtrak subsidies.



[1] Steve Glischinski, "DM&E Takes a $2.5 Billion Step Toward Wyoming," Trains, February 2006.

[2] "DM&E Gets $233 Million Loan from FRA," Coal Outlook, January 12, 2004.

[3] "DM&E Loan Would Dwarf All Others, Combined," Knight Ridder/Tribune Business News, July 28, 2006.

[4] "Why Help DM&E Railroad Rochester?" Knight Ridder/Tribune Business News, September 24, 2006.

[5] John Gallagher, "BNSF, Mayo Fight DM&E," Traffic World, May 29, 2006.

[6] John Gallagher, "DM&E's Competition Squeeze," Traffic World, June 19, 2006.

[7] Ibid.

[8] Ibid.

[9] Ibid.

[10] U.S. Department of Transportation, Budget for Fiscal Year 2007, http://www.whitehouse.gov/omb/budget/fy2007/pdf/budget/transportation.pdf.

[11] Stephen Cooney and Brent D. Yacobucci, "U.S. Automotive Industry: Policy Overview and Recent History," Congressional Research Service Report for Congress, April 25, 2005.

[12] Walter Adams and James W. Brock, "Corporate Size and the Bailout Factor," Journal of Economic Issues, March 1987, pp. 61-85.