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Although the events of 11 September sent a tremor through aircraft financing market, the bankruptcies that followed had a worse effect. Banks got their finger badly burned and are likely to be wary in future

When global aviation suffers, as it clearly is now, the aircraft financing market is never far behind. "Life is tough at the moment," says Peter Barker, Bank of Scotland's head of aerospace finance. "All stock analysts talk about is how much exposure the banks have to the airline sector, which is causing them to be more circumspect in going forward."

While the events of 11 September had an immediate impact on the global airline industry, it was the bankruptcies, soon after, of such well-known names as Ansett, Sabena and Swissair that may have a more lasting effect on the aerospace banking sector, and, significantly, the demise of both Sabena and Swissair finally dispelled the myth that a European government would never allow a national carrier to fail.

Swissair's fall, in particular, gave rise to bad feeling among lenders, according to Richard Davies, head of aerospace with the Bank of Tokyo/Mitsubishi (BOT/M). He says that in restructuring prior to the bankruptcy, the Swissair board took some questionable steps, including the immediate sale of the Crossair subsidiary, and transfer of aircraft and all flight operations to the regional carrier, which had been earmarked to become the "new" Swissair.

These actions had the effect of reducing Swissair's value, and were highly detrimental for the banks, nearly all of which are now facing heavy losses. Furthermore, the government-sponsored injection of new capital was also into Crossair, and has done nothing to help the position of the creditors of Swissair, the banks and bondholders. US Export-Import Bank (Exim) head of transportation Robert Morin believes that "these bankruptcies have made commercial banks very cautious, and they are unlikely to do the same volume of business as in the past".

The US leveraged-lease market was already feeling the slowdown in available funds before 11 September. Although long-term debt had been plentiful, there was a noticeable squeeze on equity investment as many regional banks withdrew from aircraft leasing when they consolidated into larger banking groups. Today, the reverse holds true. The biggest obstacle facing an airline seeking US leveraged-lease financing is not the 20% equity, but the 80% debt portion. According to Bank of Scotland's Peter Barker: "The distribution of debt has almost evaporated now that syndication is no longer possible. Instead, airlines will have to look to more bilateral deals, meaning bigger deals will be harder to close."

Since the terrorist attacks in the USA, lending banks have either pulled out or are "sitting it out" for the moment, according to Chris Partridge, vice-president at Deutsche Bank. Although many aircraft scheduled for delivery in the first half of 2002 have prior financing commitments in place, Partridge believes that, for some carriers, the real crunch will come in the middle of this year. In times of uncertainty, lenders typically reassess their loan-to-value ratios, placing greater emphasis on security and higher debt margins, to reflect greater risk. Also, banks will give preference to airlines with good credit, and to proven, successful aircraft.

Joseph Motta, vice-president at State Street Bank, says: "It is difficult to place a valuation on the asset itself, and very difficult to predict what the fair market value of a particular jet will be when aircraft values have fallen an average of 20-30% for some larger commercial jets, and 10-20% for some regional aircraft."

Investment on hold

Motta says his company is in "observation mode", having temporarily put its investment business on hold. "We have not been able to place a transaction since 11 September that would get the agreement of the credit committee," he says. He adds that, "when State Street does return to the market, the focus of its equity investments is likely to be the regional jet sector which, in the present environment, looks most attractive." He points to the fact that regional affiliates of the US majors have been less affected by the reduction in US passenger traffic - but also believes there may be more financial enhancements from regional manufacturers to ensure that deals go through.

If US lenders seem traumatised by recent events, then Japan, the second largest tax-lease market, has been even worse affected. While 11 September brought a sense of uncertainty, the bankruptcies of Sabena and Swissair had a greater impact, as they had been big users of Japanese tax leases.

Richard Davies at BOT/M describes the level of Japanese equity exposure as "substantial", saying this is the first time Japanese investors in these structures face the possibility of losses. He explains that equity investors had been well protected in early Japanese vehicles. But in some of the country's more recent operating-lease structures - which call for a greater level of risk, commensurate with the return - investors would find themselves more exposed.

A handful of Japanese operating-lease transactions have closed since 11 September, though they did feature pre-committed equity. Gilles Dealtry, vice- president at Deutsche Bank, says he is not sure when Japanese investors will return to the market, as they are considered very conservative and unlikely to commit to new deals until they see an upturn in yields and traffic. "Don't expect too many deals to be done in the next couple of months," he says, "although a few might close just before the Japanese financial year-end on 31 March".

Japanese return?

If they do come back, the expectation is that Japanese investors will favour participation in Japanese leveraged-lease structures with their own carriers, All Nippon Airways and Japan Airlines. Both airlines are scheduled to take a mix of narrowbody and widebody aircraft from Boeing and Airbus this year. Nor is BOT/M's Davies too hopeful about the level of business in 2002 for non-Japanese carriers. "If we do just half of last year's lease activity [approximately $2 billion], then I would be quite pleased," he says.

The German operating-lease structure, which succeeded the popular German leveraged lease (GLL), never got the chance to fulfill its promise last year - nor is it likely to come of age in this. Dr Klaus Wolf, managing director of German Operating Aircraft Leasing (GOAL) describes the problem as one of bad timing : "It is best to place a German operating lease (GOL) typically in the last quarter of the year, when German equity investors have a better idea of their tax position," he says. "Unfortunately, this time-frame coincided with the events of 11 September."

In the end, GOAL managed to close GOLs on four Bombardier CRJ-200s to Eurowings in the fourth quarter last year, thanks to pre-committed debt and equity coming from one of its parents: KG Allgemeine Bank. "It will be difficult to predict what the potential level of German tax-lease activity will be this year based on the limited level of business closed in 2001," says Wolf. "Lufthansa Group has a number of new aircraft deliveries scheduled for this year - but whether they can be placed on a German tax-lease structure is still anyone's guess."

Wei Guo, director of Deutsche Structured Finance, echoes these sentiments: "The GOL - unlike the GLL - requires true residual-value risk to be taken by the investor, which even in the best of times can be a hard sell. Coupled with this is the absence of debt, now that most German banks have pulled back from the aircraft financing sector."

However, Guo thinks this is only a temporary phenomenon and that, by year-end, German investors will return to the market. He harkens back to the pre-11 September market, when the product was gaining acceptance by equity investors, and producing lots of healthy competition among the lease finance arrangers.

As tax-lease and debt sources dry up, airlines may consider the capital markets as the next best alternative for financing new deliveries. Even those carriers which had access to lending at very attractive rates prior to 11 September, will revisit the Enhanced Equipment Trust Certificates (EETC) product, through which an airline uses its aircraft as backing to raise debt in the capital markets.

Liquidity boost

It was encouraging that two major EETC transactions closed post-11 September: a three-part $1.6 billion issue for American Airlines, and one to first-time issuer Southwest Airlines, which used the $614 million it raised to boost liquidity. As a top-rated carrier, Southwest had never before expressed interest in the EETC product. However, in view of increasing debt spreads in the aftermath of 11 September, the difference in margins between debt raised in the capital market as opposed to other sources was much less, making the EETC a more attractive option.

Tom Cahill, managing director of Morgan Stanley, says he would not be surprised if airlines take a greater interest in the capital markets, but says the determining factor will be an airline's ability to "execute" these issues in today's difficult circumstances. "Flag carriers, such as Lufthansa or Air France, could execute [an issue] in this market if they wanted to, but weaker credits will not," adds Cahill.

As for the US airlines, he says there are only four carriers that could raise capital today: American, Delta Air Lines, Southwest and United. However, he questions whether it makes sense for these carriers - which collectively have close to $15 billion in unencumbered assets - to do more EETCs at today's higher spreads. As for the carriers that really need the cash - America West and US Airways - their downgrading by the rating agencies will make any new issues a difficult sell to investors.

Last year was another growth year for asset-backed activity, with a total of $9.5 billion in issues, and another $5.4 billion in securitisations. With the current market in "disarray", Cahill says that he is unable to forecast the level of EETC activity this year, but is fairly certain that, "it won't come close to lastyear's total. At this stage, the most I can see getting done is one or two transactions."

Export credit demand

Historically, the demand for export credit agency (ECA) supported loans has increased in times of airline crisis. For example, during both the industry downturn in 1992/93 and the Asian airline downturn in 1998/99, Exim reported a sharp rise in its aviation-related loans. Exim's Robert Morin predicts that the current disequilibrium in the financial markets will create a similar demand for ECA support. "A portion of the business we do at Exim is counter-cyclical. In other words, we will see an increase in business when commercial banks reduce their lending to the aviation sector."

In the year to 30 September 2001, Exim extended $2.6 billion of loan guarantees for 53 aircraft to 12 airlines in 11 different countries, and Morin believes this figure could easily rise over the next year to $3-4 billion. "As commercial banks reduce their volume of business, airlines will be looking for an assured source of financing," says Morin. "We also expect to see requests from airlines that traditionally have not used ECA support."

The UK's Export Credit Guarantee Department (ECGD), which supports loans for the UK portion of Airbus aircraft, reported its second busiest year in 2000/01, with $2.5 billion in guarantees for 87 aircraft. Since 11 September, ECGD has supported eight transactions - some of these to airlines that have not used ECA support for a while, including Cathay Pacific and Scandinavian Airlines. However, unlike Exim, ECGD is hedging its bets for the moment, and expects to support a slightly lower volume of business in 2001/2.

No longer considered as the "finance of last resort", ECA-supported products have proven to be innovative and cost-effective. Last year, JP Morgan/Chase Manhattan developed a new adjustable floating-rate note structure that tapped new funding sources for an Exim-guaranteed loan to Hainan Airlines. This was followed by the development of a similar Exim-guaranteed product from Citibank which was used to finance five widebody Boeing aircraft to Korean Airlines, and eight Boeing 737NGs for GATX that were leased to South African Airways. In Europe, the three ECAs (ECGD, COFACE and Hermes) supported an Islamic lease structure used to finance an Airbus A330 to Emirates.

Tailor-made finance

Also, foreign currency denominated loans that enable airlines better to match their revenues to expenses are increasingly popular. Last year, Exim backed a euro-denominated loan to Royal Air Maroc, and - together with ECGD - supported a yen-denominated financing for two Rolls-Royce-powered Boeing 777-300s for Thai Airways International. Morin expects the trend to incorporate ECA support into new, innovative structures to continue. "Airlines are looking for more tailor-made products and not just the off-the-shelf product traditionally offered by ECAs. When it comes to aircraft finance, it is no longer 'one size fits all'."

Deutsche Bank's Chris Partridge believes not all is gloom and doom. He says the supply-demand curve for debt may be presently out of alignment, but probably not for long, as many of the world's largest carriers and biggest users of debt have already taken steps tocancel or defer orders.

Also taking up the slack are the large operating lease companies, such as Boullioun, GE Capital Aviation Services, International Lease Finance Corporation and Singapore Aircraft Leasing Enterprise, all of which have been doing sale-leasebacks on newdeliveries to airlines. As for the higher debt margins, the current low interest rates takes the sting out of steepermargins, so that the overall cost of debt is probably no higher than pre-11 September levels.

"There have been down-cycles before, and there will be more again, but the market does come back up," says Partridge. Perhaps the one bright spot on the horizon is the huge replacement cycle looming, as airlines replace the oldest aircraft in their fleet, from the most aged Boeing 737s and 747s to MD-80s and McDonnell Douglas DC-9s. n