Journal: Lockheed Mark to Market Pentagon Style

03 Economy, 10 Security
Chuck Spinney

“Mark to Market” is (or was?) an accounting standard  that required financial institutions to value their assets at their current market value.  Thus a stock portfolio would be valued at an amount determined by the stock market, if the stock holder sold all his assets in that market.

Last Spring, when the government was contemplating its plan to rescue the big banks, it settled on the idea of using taxpayer money to purchase or guarantee the so-called toxic assets of the large “investment” banks and their insurers (e.g., collateralized debt obligations and credit default swaps).  The banks lobbied furiously against the mark to market rule, because the toxic assets could not be sold in a market that was frozen, and under the rule, they would be valued a fraction (somewhere between 0% and 60%) of their original purchase prices.  Under mark to market, the banks would take a bath or even become insolvent.  So, they concocted a new concept of “fair value,” which came close to reimbursing them at cost, thus implying the capitalist market was inherently unfair.  The Federal Government ended up guaranteeing the debt at taxpayer expense, thus securing an American economic system that guarantees private profits at the expense of public losses for the privileged entities on Wall Street.

But don't blame the banks for this kind of system.  They are only doing what is natural when one is working with the best government money can buy.  In fact, the American political economy has many ways of guaranteeing private profits with public subsidies of what should be private losses.

For example, the latest scam in the Military – Industrial – Congressional Complex (MICC) is the so-called “Buy to Budget” formula for the hugely expensive and deeply troubled F-35 Joint Strike Fighter.

This formula was just gleefully endorsed in the attached email recently sent to the F-35's Stakeholders.  The author, Charles T. Burbage, is the executive vice president of Lockheed Martin Aeronautics Company and general manager of the F-35 Joint Strike Fighter (JSF) Program Integration.  Burbage is responsible for ensuring that all of the F-35's requirements are fulfilled for both the program’s U.S. and its international customers, as well as its industrial partners around the world.  And the email makes clear Burbage is licking his chops at the MICC's latest coup.

It is pretty easy to understand why Burbage is so gleeful.  Defense contractors operate in a “cost-plus” economy, where profits are a negotiated percentage of costs.  If costs rise, profits rise.  The Pentagon just approved another higher cost estimate for the F-35 and a reduced production quantity.  That is clearly good, but Burbage is confident the future looks even rosier.  The reasons for his confidence in Lockheed's rosy scenario becomes clear when “Buy to Budget” is viewed in this context of the MICC's political economy.

“Buy to Budget” increases the incentive to grow costs even faster and thereby increase profits even more over the long term.   The rosy scenario results when costs continue to grow, and smaller numbers of F-35s will be purchased each future year, all financed within a given budget level.  The lower F-35 production rates will exacerbate the aging crisis of the F-16s, A-10s, F-18s, and AV-8s that the F-35 is supposed to replace.  But the average age of these airplanes is already far greater that they were designed for, so the political/bureaucratic pressure to increase the production rate of the F-35 will be enormous.

Moreover, Burbage knows the Pentagon does not want any alternatives to the F-35.  This rising political/bureaucratic pressure caused by the aging inventories will therefore lead to loud calls for higher F-35 budgets, and larger budgets will provide a larger space in which to “Buy to Budget” by jacking up costs further.  Thus, the deadly cycle of cost growth, decreasing production rates, aging inventories, and higher profitability will reinforce itself again, in what is the political-economic equivalent of a perpetual motion machine.

At a program acquisition cost already exceeding $300 billion, and a total life cycle cost approaching one trillion dollars (which no doubt will include lots of follow-on maintenance contracts for Lockheed), the F-35 is solidly on track to be the all time record breaker in high cost programs, in which continual production cutbacks will finance a never ending honey pot for Lockheed.  Moreover, the Pentagon just signaled its increased commitment to the importance of the program by elevating its government program manager (Burbage's uniformed equivalent) from a two star to a three star general officer, in this case a vice admiral in the Navy — which means more high level meetings in bigger offices, more cocktail parties, and more of the pomp and circumstance that are the perks of working in the MICC, not to mention even greater high-powered efforts in the Pentagon to save face by continuing business as usual.  That the F-35's foreign partners like Great Britain and the Netherlands will help to foot the ever increasing bill is merely icing on the cake.

In the context of MICCs long-term survival, Burbage's gleeful endorsement of “Buy to Budget” reaches back to the end of the Cold War confirms the farsighted wisdom displayed William Anders, former CEO of General Dynamics (note: GD at that time owned the Fort Worth factory where Burbage now works and the F-35 is produced).  “Buy to Budget” is validation of the MICC business strategy that Anders spelled out in 1991.  Anders decided that General Dynamics (and by extension the Fort Worth factory, which he subsequently sold to Lockheed) was not going to diversify business operations into the non-defense commercial  manufacturing sector, even though the Cold War had just ended.  Anders said his decision was to increase his concentration in defense activities (a view widely shared and resulted in increased oligopolization of the industry, in an orgy of Pac Man gobbling up of defense companies by other defense companies during the early 1990s.  He said this decision to increase concentration was “not surprising,” because 80% of defense acquisitions in the non-defense sector failed. He then explained succinctly  why these acquisitions are always so unsuccessful: “Defense industry management teams generally have little commercial experience and market savvy,” and “Most have been cost-plus and mil spec trained.”  He concluded by saying, “In short, most don't bring a competitive advantage to non-defense business,” and  “Frankly, sword makers don't make good and affordable plowshares.” [1]

Of course, what Anders did not say is that sword makers also do not make good affordable swords.  But who cares when you live in a posh, post-cold-war marketplace like Burbage's,  where ever rising costs and profits are fueled by a user friendly Pentagon policy of “Buy to Budgets.”

[1] “Rationalizing America's Defense Industry: Renewing Investor Support for the Defense Industrial Base and Safeguarding National Security,” Keynote Address, Defense Week 12th Annual Congress, 30 October 1991, page 13.

Chuck Spinney

From: Burbage, Charles T
Sent: Wednesday, February 03, 2010 11:34 AM
Subject: Message to Stakeholders

Dear F-35 Stakeholders:   In our last letter we highlighted recent accomplishments of the program and some of the acquisition challenges facing us as we waited to see what the FY 2011 President’s Budget would hold for us.  As expected, the U.S. Administration showed strong support for the F-35 program.  In fact, Secretary Gates said, “The program is on track to become the backbone of U.S. air superiority for the next generation.”  The announced funding line of ~$11B in FY2011 validates that support, and while the program remains a top priority for the department, there were some adjustments made to the production profile, schedule and funding to ensure program success.

As anticipated, The Department of Defense in its budgeting process adopted the very conservative estimates of the Cost Assessment and Program Evaluation (CAPE) team’s recommendations. This more conservative approach was strongly endorsed by the 2009 Weapons System Acquisition Reform Act directed by the U.S. Congress, which introduced a new, higher-confidence budgeting process for this year.  In keeping with this new process, Secretary Gates specifically called out the plan to transfer some funds from procurement to research and development to reduce risk on the remaining SDD tasks. The primary focus for these funds will be on additional software test resources and the potential procurement of a fourth CV variant flight-sciences test airplane. The more conservative FY-11 procurement funding is now expected to fund 43 aircraft. As you are aware, this is a downward adjustment from the 52 aircraft previously planned for LRIP 5. The U.S. intends to adopt a “Buy to Budget” plan, which would allow the U.S. to procure more aircraft if the program continues to track to the affordability targets.  The Secretary also took specific actions to hold the program more accountable.  He directed an elevation of the level of the F-35 PEO to a three-star flag officer, based on the importance of the program to the Department of Defense.  For the contractor team, he also announced he was withholding the remaining $614M in SDD contract fee and would tie that fee to specific milestones to ensure completion of SDD tasks.

So what does all this mean?  In many respects it is good news.  These adjustments to the program ensure that we have adequate resources and time for the successful completion of SDD.  While these changes necessitated a change to the buy profile for the U.S., there is no plan to scale back the ultimate numbers of aircraft or change the Initial Operational Capability dates for the three U.S. military services or international delivery plans.  For our part, we plan to outperform the CAPE estimates and support the Buy to Budget strategy.

In closing, let us say that you have every reason to remain confident in the program.  The aircraft remains technically sound and we are rapidly gaining back production efficiencies that will allow us deliver desired capability on our promised schedule.  Lockheed Martin is vigorously pursuing the ongoing steep reductions in F-35 cost during Low-Rate Initial Production so that the government can buy more aircraft within the existing budget at a lower cost. Our team remains strong, and we greatly appreciate your continuing confidence in the program. We are committed to ensuring the acquisition objective of delivering a lethal, survivable, supportable and affordable air system for the U.S. Government, our eight international partners and future FMS countries.

Tom Burbage                           Dan Crowley

Phi Beta Iota: The Pentagon is long over-due for a total make-over that re-connects to both reality and integrity–integrity in requirements definition; integrity in acquisition management; integrity in operational test & evaluation; integrity in….the list is long.  Chuck has been focusing on “cost plus” as a national disease, and we agree–it's time the government learned how to do Statements of Work based on honest functional requirements and validated Required Operational Capabilities, etc etc etc.

See also:

Review: Defense Facts of Life–The Plans/Reality Mismatch

Review: Wastrels of Defense–How Congress Sabotages U.S. Security

2010: Human Intelligence (HUMINT) Trilogy Updated

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