Airline finance officers need to brace for some unpleasant surprises this year as the European sovereign debt crisis and new regulations continue to cripple bank lending to the sector, and could force more financiers to withdraw funding entirely, amid fears of a fresh credit crunch.
Airlines, no doubt, will pay more to borrow capital in this tighter environment, but the major concern is the availability of liquidity, not its cost. Unlike the 2007-2009 recession, airlines will not only endure tougher conditions in their search to obtain funding, but they must also plan on banks pulling out of committed aircraft dealings - a movement that, unfortunately, is already taking place.
In a break from the past, airlines will find less comfort in export credit agency financings, as these dealings, becoming pricier under new regulations, also rely on bank funding. Airlines could see financial guarantees dry up come May, should Congress fail to lift the US Ex-Im Bank's funding limits.
As in previous years, the manufacturers, operating lessors, capital markets and private equity/hedge funds will provide financing. But all talk about a possible "funding gap" stems almost exclusively from the commercial banking market. This is the source of restricted capital that has airlines and manufacturers concerned as it bankrolls almost all other sources of aviation funding as well.
This liquidity squeeze, unfortunately, coincides with more expensive aircraft financing bills at the manufacturers. The total bill for deliveries scheduled this year will jump to $95 mbllion, up from $77 billion in 2011. This will increase to $106 billion in 2013, according to Boeing's latest forecast.
Boeing anticipates aviation bank financing will slip to 21% of all aircraft deliveries this year from 25% in 2011. However, that figure could prove optimistic as European banks and sovereign nations take drastic steps to try and repair the finance markets and prevent an impending credit crunch.
European banks, which have been the cornerstone of aviation lending in recent years, are scaling back their activities and restructuring operations to meet new financing guidelines imposed by the banking authorities. By June, eurozone commercial banks need to adjust their balance sheets so they meet core tier one capital of at least 9% of risk-weighted assets, as determined by the European Banking Authority (EBA). An additional €114.7 billion ($150 billion) of extra capital will be needed to reach the new standard, says the EBA.
Banks must also reduce risk-weighted assets in order to comply with tier one capital requirements set under the Basel III accord by 2019 - a new global regulatory standard that addresses shortfalls in financial regulation revealed by the previous crisis.
So, lenders such as Societe Generale, BNP Paribas and Royal Bank of Scotland, which have been reliable sources of aircraft funding and leasing in recent years, are now peddling their aviation exposure to interested buyers to contract their credit supply and to comply with these new liquidity ratios. In fact, since spring 2011, various German, French and other European banks have retreated from the aviation finance market. The question remains whether this pullback will be permanent.
While these financiers are busy trying to sell off aviation exposure, they are also closing their door to new business and during a time of increased deliveries.
Ray Sisson, chief executive of lessor AWAS, believes the aviation finance market faces more pressure than in the last recession in its effort to raise liquidity. "The situation now is much worse because [in 2007-2009] we were in recession, which was part of the cycle. We all knew [the recession] was coming," he says. "But, now, we are in the upturn, so the industry should be making money, but instead we have banks leaving the industry."
The sovereign debt crisis has also resulted in a shortage of US dollars, the dominant currency of aviation. This, too, has forced financiers to sell aviation paper and assets to ease their exposure of the greenback.
Banking sources indicate American Airlines' Chapter 11 filing has further dampened the existing appetite for airline credits as banks can no longer push potentially risky asset classes past their stricter credit committees.
Add in IATA's latest industry forecast, which expects collective profits to halve this year to $3.5 billion, and lending into this sector becomes even more difficult to justify at many banks, particularly those of which are under pressure at the parent level. "If I know aviation is tipped to lose money, can I responsibly lend money into this sector?" says a German financier. "These are the questions European banks must now ask themselves and perhaps never did so thoroughly before."
Also, concerns of overproduction at the aircraft manufacturers are calling into question the long-term attractiveness of aviation assets in a tighter banking environment, the banker warns. "Capital is precious and banks are being more precious about capital every day. Is putting liquidity into a market that is possibly in oversupply a smart move?"
Already, some airlines have been hit with painful market disruption clauses, which can be invoked when financiers are experiencing exceptional difficulty in raising funds, or if they are paying materially more for interbank deposits. This has resulted in airlines paying much higher interest rates on aircraft financings than they originally anticipated, or banks pulling out of the deals altogether.
In one recent case, a European bank used a market disruption clause on a Boeing 777 delivery heading to a top-tier credit airline, forcing another bank to step into the deal just two weeks before the aircraft was due to fly.
In this situation, "at least another banker was still able to take on more risk", notes a financier, "in the future, given the turmoil in Europe, that might not be the case. If that happens on a more widespread basis, Airbus and Boeing could see their vendor financing swell in a short period of time."
Another banking source adds: "These clauses will only increase going forward. In fact, I understand a clause was invoked on a European flag carrier just a few weeks back."
Banks are having extreme difficulty funding themselves in the long-term money markets, says former AerCap chief executive Klaus Heinemann, who now heads HH Capital. "Just because an airline gets a guarantee from a bank for financing does not mean that airlines will actually get funding in this environment." Robert Martin, BOC Aviation's chief executive, believes aircraft funding will continue to be on tap for airlines in 2012-2013 but agrees with other financiers that this money will come at a higher cost as financial sources continue to come under pressure.
"As we expressed in 2008, we don't see a gap because export credit agencies, operating lessors and ultimately manufacturers will step up to fund the order book," says Martin. "There will, however, be an upward pricing effect on the available capital from these sources as the crisis unfolds."
He adds the bond markets in Singapore, Hong Kong and the USA "are still alive and providing funds" and there is reasonable liquidity in the Japanese financing market "though focused on a few players".
Capital markets, while much talked about, are very much a US-focused finance solution. Many financiers doubt the capital markets will take up a meaningful chunk of the commercial bank shortfall. Public market financing, which accounted for 5% of aircraft financings in 2011, will jump to 10% in 2012, according to Boeing's latest forecast.
However, a German banker points out the limitations: "The capital markets rely on credit ratings. This is fine for US airlines, but it is not in the DNA of European and Asian airlines to have credit ratings, so I don't see the capital markets doubling in size next year. Perhaps an increase, but not 10%."
With fewer bank sources available for aircraft financing, pricing on deals has been on a steady increase and will continue to rise to reflect the stricter financing environment. Pricing for good credit airlines with new aircraft is up 50 basis points "and climbing" compared with six months ago due to increased funding costs at the banks, says a Japanese financier.
"The cost of financing for a tier-one airline credit with a brand new asset is around the 250 basis point mark, whereas a second-tier airline would price around 280-320 basis points for the same asset," he says. "That move north will continue as funding costs continue to creep and the number of lenders grows leaner." But aviation's liquidity squeeze could find some relief from those banks that are left standing. These banks realise the potential upside of having a lending presence in the wake of increased deliveries.
Behind closed doors, financiers are busily searching for alternative plans to raise funding to increase their aviation lending activities. "If an aviation bank can find the funds, the market is a paradise for them. They can call the shots. But, again, finding the funds is the problem," notes a European banker.
One example is Norddeutsche Landesbank, which is looking to raise €500 million in long-term funding, through the German Pfandbrief market. Initially, the Pfandbrief will be issued in euros, but NordLB considers this a potential instrument for the highly coveted US dollar as well.
Typically used in real estate and shipping, Pfandbrief is a Moody's Investors Service-rated German bank debenture that is collateralised by long-term assets, in this case, "solid aircraft types", explains Harald Brauns, NordLB's head of aviation finance.
In the first half of this year, NordLB will begin issuances out of its aircraft covered bond programme called "Flugzeugpfandbrief". The programme is governed by the German Pfandbrief Act and regulated by German law. A portfolio of aircraft financing transactions with their underlying cash flows and collateral would support this transaction.NordLB hopes to repeat regular issuances out of the bond programme, once it is launched.
Another European bank is using multi-currency aircraft loan structures to get around the squeeze on long-term US dollar funding to the eurozone. The bank is offering a "euro-backed fully amortising loan with the balloon portion, or the aircraft metal risk", in US dollars as "this is still the currency of aircraft financing", says the banker.
"This works for us due to the difficulties in obtaining US dollars and it works very well for European airlines. But, it also makes sense for non-European airlines, as the metal exposure is in dollars, and also for those carriers with an intercontinental approach with euro exposure," the banker says.
Even if banks do raise more money and expand their lending arms, there is no denying there will be an overall reduction in bank funding this year. But, what will make the next 12-24 months particularly difficult for airlines is the impact reduced bank funding will have on export credit transactions.
Export credit agency guarantees cover 85% of an aircraft financing, so a further 15% still needs to come from the airline or the commercial bank market. "Banks are scaling back on lending, so airlines can no longer walk up to the ECAs cap in hand and expect support. These deals are no longer 'no hassle, zero risk' transactions," says a banker. "Funds must be allocated for the best deals and some banks do not see the benefit of ECA deals in a tighter environment."
Due to sovereign downgrades and pricey bank funding, ECA deals now cost more for banks to put together and the returns "tend to be marginal", says the banker. "Also, there is the time and personnel commitment and both are limited these days. But like debt financings, ECA pricing is also going up, so more banks are becoming interested in this space again," he says.
Still ECAs, according to Boeing, are tipped to remain the single biggest funder to the industry at 30%, or $29 billion, this year.
Airlines will also be forced to pay more to obtain ECA credit under the new Aircraft Sector Understanding (ASU), which entered force in February 2011 but will not take full effect until 2013 when grandfather clauses run out.
ECA-supported deals have been available to airlines and lessors for as little as 25 basis points - a quarter of a percent - above the London interbank offered rate (Libor) for US Ex-Im Bank deals, and under 50 basis points for European transactions.
Upfront fees on loans under the 2007 ASU range from 4% to 7.5%, depending on the credit rating of the customer. Under the revised ASU, even the most creditworthy will pay 7.72% up front. Alternatively, they could pay Libor plus 137 basis points yearly over the typical 12-year term.
However, if times are tough, perhaps governments will relax the current costly regulation? This will do little to help the situation, says a banker. "The problem is not the cost of money, it is whether the funds will be available at all. If the export credit agencies increase their cover and the ASU rules are pushed out, or changed, is irrelevant."
Furthermore, the US Ex-Im Bank, often referred to as "Boeing's bank" because of the frequent use of this source of funding to finance Boeing aircraft worldwide, may run out of funds by May, according to a new research note issued by Credit Suisse's aerospace analyst team on the last business day of 2011.
"The US Ex-Im Bank may have to halt operations unless Congress raises its $100 billion 'exposure cap', which runs through May 2012," Credit Suisse writes.
"The current law limits the amount of credit exposure the bank can hold and it has been funding new projects faster than old loans are being repaid."
Credit Suisse writes that Ex-Im has $90 billion in commitments, and is expected to hit the $100 billion cap within a few months. Boeing and General Electric, among others, are urging Congress to raise the limit to $140 billion, says Credit Suisse.
But Credit Suisse also notes that some US airlines oppose the raise, charging the lending could subsidise foreign competitors. Delta Air Lines has been particularly vocal on this point and spurred US carrier body Airlines for America to sue to halt financings. The Obama administration supports raising the limit, Credit Suisse says.
But even with a crumbling financial system and tougher regulation, fears of white tails piling up in the desert are surprisingly limited.
As one European bank sums up the sentiment: "True, there is no exact game plan for our financing dilemma, and it will be painful, but know this: We are talking aviation, not about a charity or research. In some form, money will be found and the deals that need to will get done."
Additional reporting by Scott Hamilton