The View from the City: Panic in Needle Park

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Some of you may remember this great movie from the early 70s, featuring Al Pacino, giving a disconcerting picture of heroin addicts in New York City's Verdi Square (a.k.a. "needle park"). The movie is about addiction, how it creates panic and how addicted are losing touch with reality, while embarked on a very dark journey to self destruction ....

Worryingly, this behaviour seems not too dissimilar to that of the financial markets, all addicted for years with cheap debt, since fall 2008. Because today, heroin is ... debt ! Over the summer-months this year, it became more and more obvious that despite some initial optimism in 2010, there was no "Happy End" in sight and that the sequel to the 2008 crisis could become even darker than the first part. Similar to 2008, it looks like we will once more see a macro script not too dissimilar to the adventures of the airfinance market in this new chapter of the movie.

On the Macro picture, star-player is Alan G. as the chief dealer, the one that flushed the system with liquidity in a way that did not mirror in any respect any real wealth creation : the trade balance of the USA for the past three decades remained in the red with the last positive figure dating back to ... 1975 ! The current gap for the USA is at a record 4% of GDP, about the same as China .... but with an opposite sign !

In the roles of deputy chief dealers working the Street, we can recognise the various investment banks that cleverly packaged toxic assets for easy consumption by the rest of the world, knowing perfectly well what they were doing, as evidenced by hearings in Congress (For those interested, go and see the minutes of the 27 April 2010 meeting in particular).

Plenty of actors that can play the role of the addicted, including most of the European Banks, poorly managed with incompetent leaders, many of them without a clear business model nor any ambition to provide added value to the rest of the economy but still desperate to become 'global players' and 'market makers'. Sadly without the talent, the culture or even the discipline.

With no franchise in hands, what do you do as an addicted banker without a clue? Well, in addition to 'Mortage Backed'-paper (that you don't really understand), you buy Greek or Irish bonds to boost your weak returns - and you rely on Moody's or S&P's 'opinion' as your alibi, after having disbanded your in-house team of economists for cost reasons. Subsequently, you hand the key of the safe to a bunch of bounty-hunters who will triple the size of your dealing rooms to develop trading without a client flow, and you christen it 'prop trading', so trendy .... In aviation finance and leasing, we have seen banks going nonsense too ....

Last, you decide to borrow short term on the US$ commercial papers markets to finance long term assets . Easy money made on the spread differential and - minor detail - on the assumption that the commercial paper market will remain liquid under all circumstances. Well, the devil once more is in such "details". Recent research from Barcap shows that the refinancing needs of Societé Generale, BNP and Credit Agricole over the next three months represent between 60% (Soc Gen.) and 50% (Crédit Agricole) of their total. For information, the similar short term refinancing need for HSBC and most of the German banks, including Deutsche Bank, is only in the range of 40%.

The plot thickens; the Greek issue - that should not be an issue - gets into the spotlight. The Greece GDP represents less than 3% of the total of the Euro zone and the total of Greek debt approximately 5 % of the total of the same. Total public debt of the Euro countries is 85% to GDP, 10 points lower than in the USA. What's really at stake is 'Corporate Governance' of Europe and not the size of public debt. However, markets - rightly or wrongly - see confidence collapse once more. Guess what happens: Panic!

Coming back to the airfinance script : Next year, approximately $77 billion of new equipment will be delivered (Boeing estimate), a record high, but only for a short period as 2013 estimate is close to $100 billion! Once again, the question is 'Where is the money coming from?' In the influential French newspaper 'les Echos', the challenge for French banks to refinance their US$ in relation to their aviation business portfolio was highlighted. While wrongly reporting that this little Gallic club was representing 31% of the total of aircraft finance volume (the real figure is probably at best around 20%, with half of it being 'commodity' Export Credit that can easily be taken over by US Banks), EADS shares plunged by 8% the same day, 22 September ....

While not panicking, it seems we are all becoming a little nervous. French banks, a cornerstone of aircraft finance, are selling a portion of their portfolio - starting with the easy part, Export Credit - while trying to exit some of their current mandates. With a nervous twitch around the mouth, they confidently claim that they will be back to business next year. Sure, but who these days would trust a banker?

What, if not? Capital markets are much talked about but haven't delivered close to a meaningful figure that could substitute a tiny portion of the ill fated French commercial bank market.

What's left is .... Export Credit! Again we are back to 2008/09 where public support saved the industry by filling up a funding gap that was reality, despite the denial of Airbus and Boeing. Except that with the new ASU rates, cost for most of the non-grandfathered issuers are going to double, and in all cases about the same price as commercial loans. Except also, that with an increase in the narrow-body production rates as forecasted by the two Big Brothers (and desperately needed for some positive cash-flow), total financing needs will not only be significant for next year, but also for the few years to come.

With the risk of a double dip now real and with key commercial banks having embarked in a severe - Basle III inspired - weight watcher programme to reduce their balance sheet, our industry is again confronted with one of those potential tensions that can have a devastating effect on the ability to raise finance. While sovereign risks are not so sovereign anymore, the ECA's will play the role of the Superhero once more and 'save the world' of new aircraft. The (re-) financing of second hand aircraft will probably be left out in the cold again, with the two Big Brothers remain totally aloof on that issue. To believe that the future will still be "a walk in the park" and all of this will not have any effect on used equipment values .... watch where you go, it may be "needle park".

Article contributed by Bertrand Grabowski, member of the Board of Managing Directors of DVB Bank SE