MARIA WAGLAND / LONDON
A spate of corporate failures, loan defaults, falling values and disastrous financial results since 11 September have made investors think twice about funding airlines' capital acquisitions. Flight International looks at how the various sources of commercial aircraft finance - bank loans, capital markets, state export support and manufacturers' own finance schemes - are changing since the economic downturn and where future funding for aircraft will come from
After 11 September, the transport finance departments of major banks responsible for financing aircraft acquisitions immediately shut up shop and started to re-assess their asset risk exposure to airlines and the world commercial fleet.
A senior Hong Kong-based banker says: "After 11 September, we had to look at our exposure and insurance coverage, we were sending internal reports to our credit people, telling them not to panic."
Robert Morin, vice president of the transportation division, Export-Import Bank of the United States (Ex-Im Bank), points out that aircraft financing has not only been affected by the attacks on the USA, but also by recent airline bankruptcies. "In some respects, what has had a greater impact on the availability of aircraft finance has been the Swissair, Sabena, CityBird, Ansett and Midway bankruptcies. Some aviation financiers were surprised because they considered some of these European airlines too big to fail."
The failure of major carriers such as Ansett, Sabena and especially Swissair - an airline many considered a safe bet - also shook bankers. Peter Herman, head of transportation finance at the Bank of Japan says: "In a lot of institutions, the fact that Swissair went bankrupt has rattled them."
Battening down hatches
Though first reactions were to "batten down the hatches" as one banker put it, the major financing houses have been willing to continue financing aircraft purchases. Another senior banker says: "Banks were still trying in October, November and December [to do deals]. You see deals now carrying on in January and February."
However, some institutions are expected to put aircraft arrangements on hold while transport financing teams look at alternative asset-backed deals. The German regional banks, the Landesbanks, played an important role in aircraft financing in the last decade, but it is anticipated they will be the first to withdraw from the market.
One Asia-based banker says that banks new to aircraft financing are taking a conservative approach, but the ones who were there during the last downturn in the cycle are taking a more optimistic long-term view of the market. Another banker points out that some financial institutions may be refocusing their efforts "not because they want to get out of aircraft, but because there isn't any business".
Airlines had already begun to revise their delivery schedule before 11 September, forcing Airbus and Boeing to reduce delivery estimates. After the terrorist attacks, further deferrals were requested. Major carriers in the USA including American Airlines, Delta Air Lines and United Airlines have all deferred aircraft. European carriers such as Alitalia, Iberia, SAS and Virgin Atlantic are said to be discussing deferrals with manufacturers, and Asian carriers including Garuda, MAS and SIA have pushed back delivery dates.
As a result manufacturers have cut delivery estimates - Airbus forecasts 300 aircraft, and Boeing 380 for this year. They anticipate the delivery cycle bottoming out in 2002 and 2003. Banks are now adding the additional risk taken by financing aircraft under these market conditions into their margins, and are questioning when airline clients will show improvements in their cash flows, yields, and profit margins.
Besides higher pricing, many banks now demand airlines agree to stricter insurance requirements and tougher security conditions. Institutions are also very sensitive now over loan-to-value ratios, and are watching closely the residual values of the aircraft and airlines to which they are exposed - all of which makes life even harder for some carriers. A senior London banker says: "It will be difficult for second- and third-tier airlines to get financing."
Ian Hosier, global head of finance house Intesabci, says: "The continuing nervousness at bank credit committees regarding airlines means that active capacity is still pretty small, and few want to take underwriting positions.
"Therefore, we are not seeing any significant bidding competition at present. I think it will take some time for that to return, and it is also likely that former margin levels will not return, as they were almost certainly too low, having been kept there by an excessive appetite from some elements of the bank-loan market."
According to some lenders, pricing has become erratic since 11 September, with banks unsure how to price risk into their bids. In the recent bidding to finance 15 Boeing 737-800s for Australian carrier Qantas, according to one senior banker, the range in pricing was unusually wide: between 80 and 200 basis points over LIBOR (the "wholesale" loan rate used between banks). Barclays won the mandate for the $500 million US Ex-Im Bank-backed deal. The aircraft are being delivered over the first half of this year.
Traditionally, airlines went to banks for secured long-term debt to finance aircraft acquisitions. Although many US carriers have successfully tapped into the US capital markets to finance aircraft acquisitions by selling bonds secured against a pool of aircraft assets, only a few carriers outside the USA have taken that route. Financiers feel the time is ripe for carriers from other countries to follow the US lead, by raising money through Enhanced Equipment Trust Certificates (EETC) - bonds secured against some of the airline's aircraft.
Before 11 September, it was cheaper for airlines to take straight loans, giving them little reason to resort to capital markets. And popular Japanese and German tax-lease financing structures have now been dismantled: the Japanese and German leverage lease arrangements were attractive tax shelters for wealthy Japanese families and German private investors, who could pool smaller investments into a special purpose vehicle.
Their tax structure replacements required more asset risk. The Japanese Operating Lease has been tested over the past few years, but the German equivalent has not yet got off the ground.
A Dublin-based source says that, since 11 September, Japanese private investors may no longer favour aircraft: "The Japanese loved the European flag carriers, but then Swissair happened. There was a push in 2001 from aircraft to shipping assets." In shipping, Japanese investors tend to prefer Japanese shipbuilders.
Morgan Stanley Dean Witter is an EETC specialist, and was the lead bank on an issue of EETCs for Spanish carrier Iberia - the only European EETC issue so far. Managing director Tom Cahill says: "In the last three months, the pricing [of capital markets and commercial banks] has been relatively on par. It will be interesting to see if this happens over the next year."
Cahill says the capital markets' appetite has survived the crisis: "Post-11 September there were people willing to invest in the EETC market. Although limited, there was some liquidity and you would have been able to invest in high-level credit carriers such as Northwest, Continental, American Airlines and Delta. If you are an investor you want to buy in the bad times.
"Total issuing levels will be down dramatically [in 2002]. It is not that the investors are unwilling, it is the issuers who are deferring their aircraft deliveries." Last year the market saw $10.2 billion worth of EETCs, but this year only $3-4 billion is anticipated.
The capital markets were tested in September with three separate EETC offerings from American, Delta and Southwest. American had first planned a $2 billion four-tranche offering. After 11 September, it was reduced to $1.4 billion in two tranches, with the third and fourth added a month later to a total of $1.9 billion. Delta's EETC was priced before 11 September, but closed on 18 September, with wider margins (representing higher perceived risk) as a result.
The Southwest deal was truly a post-11 September EETC, says Cahill. It was a two-tranche $600 million offering, but has been sold successfully.
Cahill believes more carriers will see the capital markets as an alternative to their traditional sources of financing, such as the banks. "Unless existing bank ties were in place, there is no way an airline can get bank debt unless there is good collateral and covenants given," he says.
Despite the portents for a shaky 2002, many banks are still hopeful the market will recover by 2002/3, believing that airlines are better-placed now than in the last cycle.
Carriers had begun preparing for downturn before 11 September, but, they have been taking drastic cost-cutting measures since by reducing staff numbers and capacity, and streamlining their business plans accordingly.
Higher margins on commercial lending are expected to lead to more requests for government export support. Export credit agencies (ECAs) have usually been seen as a last resort for airlines, particularly for riskier developing-world carriers.
ECAs are preparing for more applications for support this year. These agencies normally guarantee the financing for 85% of the aircraft's value, with the remainder coming from commercial banking loans or the airline's own equity. Countries belonging to the Organisation for Economic Co-operation and Development agreed these terms as part of the large aircraft sector understanding (LASU).
US Ex-Im Bank's Robert Morin notes that, historically, airlines have turned to government export credit support during difficult periods. For example, at the end of the Asian crisis in the late 1990s, Ex-Im Bank's aircraft finance support reached record levels. Morin says: "In fiscal year [FY] 1999, just as the Asian crisis was subsiding, Ex-Im Bank issued $6.3 billion in loan guarantees supporting $7 billion of US aircraft exports." There was a similar increase in demand for government export credit support after the Gulf War, he adds.
Morin says airlines from the group of eight industrialised countries (G8) that would normally look to the commercial market for loans may now find it necessary to turn to government export credit support. Under current market conditions, it may be too expensive or difficult for carriers from the G8 countries to source the funds. He says: "Traditional sources of capital are no longer available, or are available only on very expensive terms."
Morin says: "Before 11 September, and the Sabena and Swissair bankruptcies, I was estimating Ex-Im Bank would do $3-3.5 billion in authorisations during FY2002, which would support the export of around $3.5-4 billion of aircraft. That was the projection over the past summer. Today, I think we will be at the higher end of the range, with authorisations supporting $4-5 billion of aircraft exports."
In Europe, the same is expected for European ECAs: France's Coface, Germany's Hermes and the UK's Export Credit Guarantee Department (ECGD). Jens Schnoor, aircraft financing co-ordinator for legal issues and international relations at Hermes, says: "We have been told by Airbus that we will see customers that we haven't seen in the past: customers that are now unable to get commercial financing. This is a tendency that was already envisioned at the end of 2001."
Schnoor adds that 2002 estimates remain unclear. Hermes says that it and the other two ECAs provided one third of support for the 328 aircraft delivered by Airbus last year, with Hermes' share amounting to DM3 billion. The remainder of the support was split between Coface and ECGD. "We will meet with Airbus in the first quarter for a forecast on 2002," Schnoor says, estimating ECAs will probably continue to provide a third of aircraft sales support, but figures remain unclear.
ECAs in Europe have revised their support for carriers, removing a scheme that allowed borrowers to take advantage of lower commercial interest rates without penalty. This may help decide whether carriers go to the commercial banks, with the low interest rates available in the private sector, or turn to the ECAs for support.
Lenders and capital markets are still wary of airlines, but the picture is different for the airframe builders' financial arms. Both Airbus and Boeing have customer finance departments, and both see the downturn as an opportunity to build up their business. However, Boeing Capital Corporation and Airbus Customer Finance operate in very different ways.
Benôit Debains is senior vice president finance at Airbus, responsible for the company's customer finance business. Most of Airbus's financing is insurance against the customer being unable to pay on delivery - "not something we want to do all the time", he explains.
While some of Airbus's contracts are for cash down, the rest generally involve some degree of customer financing. So far, since 11 September, none of this second group of customers - generally smaller and less well-performing airlines - has had to take the financing option. But the larger airlines, who now find their balance sheets rather less favourable than expected, have been coming back to Airbus and asking for support, according to Debains.
Unquestionably, this trend is related to the overall health of the airline. When times are good and cash accounts full, airlines prefer to buy rather than lease - in order to benefit from favourable tax laws governing depreciation - and to buy for cash down rather than via financing deals. During downturns, leasing is more prevalent. The chief financial officer of Air France, Philippe Calavia, announced last year that the airline would aim to lease two-thirds of its fleet - doubling the normal proportion of leased aircraft – as "a temporary move to cope with the current uncertainty".
Airbus Finance does not intend to get involved in the leasing business itself. "I don't see it as a business development," Debains says. "We do not do operating leases, except sometimes on aircraft we take back in trade, and we don't lease new aircraft." Airbus prefers instead to "outsource the risk "by selling aircraft to independent lessors.
Nor does Debains plan to expand the financing business continuously - "in the long term, we will stay within our headroom. There is a temptation to keep financing in the good times, but we will refuse it. The traffic figures are coming back now, so external financing will return - and a senior secured loan to an airline seldom loses money even now."
Secured debt is set against specific assets of the borrower, and senior debt receives priority for repayment if the borrower goes into liquidation. So a senior secured loan is safest from the lender's point of view. While several credit agencies recently downgraded unsecured debt - which is not set against assets - of various airlines, including British Airways, to junk status (Flight International, 11 December 2001), secured debt ratings have remained high.
When traffic returns, Airbus Finance will probably follow its normal policy of selling off its debt to the capital markets. But this raises an interesting question: why should other lenders be willing to buy debt that they were unwilling to incur directly at the time? Or, to put it another way: why do manufacturers think it makes sense to make loans that the rest of the capital market regards as too risky?
Debains says: "The finance business gives us the ability to disagree with the financial markets at any given point in time. "In addition, the business is not just about generating returns for Airbus through financing deals.
A successful deal also keeps Airbus inventory down and allows it both to keep customers afloat and to keep them loyal to Airbus - all secondary benefits which would not apply to commercial lenders, and allow Airbus Customer Finance to enjoy a better risk/reward trade-off than another lender would have.
Debain's opposite number, Boeing Capital's head of aircraft finance Scott Scherer, agrees - at least on this point. "We will cover financing deals that the capital markets won't. For example we will supply a lower interest rate than the commercial market would offer."
Scherer is keen to contrast the Airbus operation, which is deliberately limited to financing buyers of its commercial airliners, with his own more wide-ranging business. "Our roles are to profitably grow the finance business, and to support Boeing's commercial airliner business. We were historically a support organisation, like Airbus [Customer Finance]".
However, Boeing Capital now operates much more independently of its parent company, raising its own debt on the capital markets, and supporting not only airliner sales, but projects involving other arms of Boeing.
A significant amount of its lending goes to support non-Boeing projects: while this, of course, does little immediate good for the parent company, it widens Boeing Capital's portfolio of risk, boosting its credit rating and making its own approaches to the capital markets easier.
"Boeing Capital changed because a finance firm can facilitate growth for Boeing," says Schering. Diversifying over the last few years has led Boeing away from its airliner business into military manufacturing, communications and space technology, as well as into the capital markets, in search of better growth - and this move has helped keep the company going despite the effects of 11 September.
Disagreeing with the capital markets, who, Scherer says, "have quarterly reporting and oversight boards and so they want to see quick returns", is also an option in the space business. The failure of the ambitious Iridium satellite communications network has soured investors on satellites, but Boeing Capital believes there is still money to be made.
"We're a buyer [of airline debt] right now", says Scherer. Without the pressure of the capital markets, and with a large parent company to supply capital, the manufacturer finance arms can afford to take a longer view.
And the temporary aversion to buying airline or space debt means that these long-term, high-risk investments are actually underpriced - another advantage for the organisations who choose to move into the sector.
Source: Flight International