The View from the City: Where will the Money come from in 2012?

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Despite a relatively strong performance of the passenger market during 2011, we can be less confident about the outlook for 2012. While in many regions, the industry, seems relatively well organized and looks capable of achieving a positive financial result, there are also factors beyond the control of the airlines that could change the picture completely. Already today it is obvious that increasing oil prices are hurting the industry, but there are more clouds on the horizon.

Against this fluid background, airlines and lessors will have to fund a record number of deliveries this year and next. In 2012 alone between $80 billion and $95 billion will have to be found. Meanwhile, a significant number of aviation banks have left the industry and those remaining are frugal in deploying capital outside their core clients, or for deals for new aircraft and with "prime" signatures. New money is chasing the same deals. The visitor lounges of Lufthansa, Ryanair and Singapore Airlines are crowded with bankers thrilled with the prospect of lending their balance sheet, sometimes at a price lower than their own marginal cost of borrowing (names available upon request).

However, for the vast majority of airlines and lessors, it is a struggle to find a banker willing to make its balance sheet available and not just by offering advisory business. Those eternal optimists who believe that "100 basis points (bps) will solve everything" unfortunately will be proven wrong: in this "new world", as it is the risk guy who is firmly sitting in the driver's seat in most credit committees of global institutions. Throwing in a little sweetener will do nothing to change his mind

Some rain dancers are also trying to squeeze some liquidity from the capital markets. No-one is not disputing the macro-economic trend here: borrowers need to become "issuers" and dis-intermediate that part of the banking system that has failed to provide constant and predictable access to capital. For four years now, at each conference, polite organizers invite experienced and talented investment bankers to tell us about the beauty of the capital markets, but they do not actually exist outside of the USA.

The Emirates Airline issuance actually proves the point that only a very limited number of airlines can actually raise money on the strength of their own credit and not the credit of the export credit agencies (ECAs)! According to Goldman Sachs, $23 billion was sourced from the capital markets between October 2010 and October 2011.

Checking the profile of each issuer, one can see that $2.6 billion, or a mere 11%, were non US issuers, while the US-Export Import Bank represented another $820 million. In other words, 80% of the capital markets activity during that period is related to US issuers. No offence to those deploying huge talent and technology in this segment but the verdict is clear: investors always prefer to invest within the depth and the sophistication of the US market, which is second to none.

Is the situation different for lessors? Not really, and some are privately admitting that "unsecured" capital market money with dozens of covenants is hugely more cumbersome than a solid traditional secured bank facility with someone you can actually "talk to" if things get tough.

Shall we fear for the "funding gap" then? Surely not. The ECAs will do their duties, as they have done in the past. Whether or not they will provide or support more or less than 35% of the deliveries in 2012 is an interesting debate that will better be left to the panels at ISTAT. The fact is that banks, original equipment manufacturers (OEM) as well as airlines and lessors used to consider the ECAs as a systemic back-stop financier for any financing of any quantity of aircraft. For a multi-billion dollar industry like commercial aviation isn't this worrying? Recently, the Norwegian's chief financial officer was asked by the Financial Times how their recent and massive order is going to be financed. Thee answer came with no surprise to most: 'export credit agencies'. Oh dear! We would love to hear more from Washington, Paris, London or Berlin on that statement...

The key question remains: what can be told of an industry that consistently relies on public support to cover more than a quarter of its annual sale? "Bubble" is a silly word in Hamburg, Toulouse and Seattle and we rather speak in terms of the need to "protect jobs" and defend "national interest". Can we exclude that at one point in time gravity will prevail, perhaps brutally triggered by a major default or a change in the political climate? While the watchtower crews and skyline-managers have done an admirable job so far, aren't the OEM's playing with fire when they implement another ambitious increase in production rates, especially on the narrowbody front?

Some would make the valid point that "over-ordering is not over-manufacturing". In an ideal world, this is indeed correct, but such a world assumes that each of the leading OEMs will always display rationale behaviour when it comes to production rates... But when this is about "losing" or "gaining" market share, will sanity prevail?

Perhaps the widening difference in lease rate between the A320 and the 737 is telling us something?

While the power of the OEMs ensures that the spotlight is always on financing new deliveries, we all know that the maximum tension will never be seen there, for the reasons just explained above. Thus, the story gets much different when it comes to financing second hand aircraft...

In that market, because of a lack of political lobbying power, the ECAs are no "white knights" and the OEMs remain particularly aloof to the problem as an aircraft produced and sold disappears forever from their radar screen. But for lessors, chasing money to finance "the second lease" or airlines, willing to dispose of old equipment, the prospects are depressing: banks willing to finance old equipment are less than five, and lessors find themselves hiding their old assets in large portfolios to attract some interest. The result could be further negative volatility of values in the second-hand market, mostly for narrowbodies, much deeper and quicker than the slow ramp-up of new programmes could normally suggest.

In Dublin, AWAS' chief executive officer Ray Sisson publicly warned that prices on old equipment were "falling off the cliff" Indeed, the lack of liquidity is not the sole party to blame in that situation but certainly contribute to what is not yet - but could become: a downward spiral of equipment values.

To end up on a more positive note, let me share what I believe is one of the next challenges for the finance markets and that being concentration. The platitude is that mergers of airlines create large entities, while regulators impose 'single borrower limits' and that, for many banks, will prove to be another limiting factor to deploy capital.

But this phenomenon is also likely to take its toll when watching the structure of current orderbooks. According to DVB Research, a total of 17 Airbus and Boeing customers have orders in excess of 100 aircraft each. Airbus has two orders in excess of 225 aircraft each and Boeing's top two customers have orders in excess of 350 aircraft each. To complicate matters, none of the six larger orders at Boeing or Airbus, except one, is US-based with access to the capital markets. When it comes to finance these deliveries, directly or through sale and leasebacks, many financiers, including the ECAs, may find themselves reaching their limits. What would happen then to these mega-orders?

Any reason for optimism?

If any, it will not come from the debt side but rather, as we have seen for three years now, from the equity side: the magic of printing money, sorry I meant quantitative easing, is such that money is still abundant and return expectations are falling. New entrants realise that a "10-ish" return on investment - or even lower - based on a moveable asset and predictable cash flows is an excellent risk reward in today's market. Smart bankers and arrangers are selling aviation investment much beyond the traditional JOLCO and KG markets, and this works well. Recent transactions have opened up doors of the London public markets and we are well aware of some imminent attempts to enter others.

This massive injection of new money with lower return expectations, as well as underperforming residual values has massive implications for the existing platforms. Watch that space carefully.

Overall, when it comes to the search for money, and leverage in particular, we believe the industry needs to admit the challenges it faces more than searching for the current toolbox it already has. By just focusing on the short-term issues, either selling another 225 new aircraft or setting up another initial public offering, the medium to long-term prospects don't get much better. But who knows, hard work and some luck will do, perhaps.

Article contibuted by Bertrand Grabowski, member of the board of managing directors, DVB Bank SE.