As traditional tax-leveraged lease markets learn to live with more restrictive tax regulations in Japan and Germany, airlines are increasingly looking toward new structures in the capital markets as well as traditional export credit finance

If one factor above others has dominated the headlines in aircraft financing over the past couple of years, it is the decline of the cross-border tax-lease market. The tax-leveraged lease had helped to fund a major slice of aircraft deals over more than a decade. Yet accounting changes by national tax authorities in Japan and German have since effectively killed off the benefits of the tax-leveraged lease in its two key markets and so closed the door on billions in financing.

It is true that airlines are hardly likely to find themselves short of alternatives. The capital markets are increasingly taking up the slack left by the demise of the tax lease, with securitised deals due to grow in double digits. Nations on both sides of the Atlantic also continue to back sales by their respective airliner manufacturers through export credit support. However, deal arrangers are still keen to push new alternatives on the tax-lease theme, although the success of their efforts thus far has been patchy at best.

The Japanese operating lease (JOL) is being marketed to foreign carriers as the successor to the Japanese leveraged lease (JLL). As a true operating lease structure, the JOL has been around for many years, but with a narrower investor base: namely, investors seeking to avoid inheritance tax. Richard Davies, head of aerospace at the Bank of Tokyo/Mitsubishi, says that "these investors tend to invest in used and nearly new aircraft with 5-7 year tenders and real asset risk at the back end. It is a very limited investor base."

New leveraged leases

With the demise of the JLL, arrangers have attempted to structure JOLs in such a way that they take on some of the characteristics of the old JLL and, in that way, attract equity from the JLL market. They have had limited success with a half dozen narrow-body financings closing each month, but this volume of activity still falls short of the JLL in its heyday. Davies reckons that around$1-2 billion worth of JOLs could be done each year, but this is still a small proportion of Japan's total investor base, estimated at $10-12 billion. He adds that last year his own bank closed JOLs on six narrow-body aircraft for European carriers, including Iberia Airlines, Sabena Airlines, and Transavia. Other carriers that have sourced JOLs to finance new aircraft acquisitions include Flightlease, Go, Maersk Air and SAS.

The JOL market is expected to remain fairly limited for several reasons. First, Japanese investors prefer placing equity into known airline names, such as the large flag carriers and their subsidiaries, or in airlines that have previously sourced JLLs.

Second, foreign carriers may be barred from using JLL structures, but Japanese carriers are not. So if Japan Airlines or All Nippon Airlines take new aircraft in a given year, they will likely use a JLL. Equity that might have gone into a JOL would probably be diverted to the less risky JLL market.

Third, although a couple of Airbus wide-bodies (A330/A340s) have been financed in Japan, JOL investors have shown a distinct preference for narrow-bodies, such as Airbus A320s and Boeing 737 and 757s, because they are easier to remarket. Finally, as with any new financing product, tax and accounting rules have yet to be clarified and arrangers are careful not to publicise too many deals and so attract the scrutiny of Japan's National Tax Authority.

The German leveraged lease market has followed a similar pattern after the introduction, two years ago, of a German income tax act that disallowed tax shelter deals where tax yields are twice as high as pre-tax yields. A grandfather clause enabled a number of German leveraged lease deals to proceed after the tax act was passed, as long as the aircraft were delivered before the final deadline at the end of 2000. Hence, German arrangers and financial institutions focused all of their energies last year on finalising a number of these grandfathered deals, including an Airbus A330 for Airtours, an A300-600F for United Parcel Services and an A340 for Iberia.

The German Operating Lease (GOL) is touted as the new alternative to the GLL, but with the exception of a few private GOL deals, this market sector has been slow in getting off the ground.

Angela Hasenfuss of Deutsche Bank says "the German investor market will absorb the last of the GLL tax deals first, then look at the GOL deals." As in the case of the JOL, it will take time to convince German investors to go from a level of no asset risk to some asset risk. Paul Steinhardt, chief executive of Deutsche Structured Finance, says that as investors got comfortable with the longer, 10-year lease terms of GLLs, the shorter terms of operating leases may have proved difficult to accept.

German alternative

German banks marketing the GOL suggest that this product will appeal mainly to European carriers, especially those known to the German investment community from earlier GLL deals. European carriers will also appreciate the ability to denominate their GOL financing in euros. As in the case of the JOL, airlines will find it easier to finance new or, relatively new, narrow-body aircraft, such as the 737NG or A320.

Both Deutsche Structured Finance and Deutsche Bank concede that development of the GOL market will not happen overnight and, perhaps, will never even approach the size of the GLL market, which in 1998 accounted forc7 billion ($6.6 billion) worth of aircraft deals. DSF is one of the few German financial institutions to have its own GOL structure for aircraft in place since 1997 for which it has placed c700m in the German private equity market. By contrast, Steinhardt does not expect to see more than c500 million to c1 billion of GOL aircraft financings in the near term, with the figure perhaps rising to c2 billion in three year's time.

On the other side of the Atlantic, the US leveraged lease market continues to finance many aircraft each year for American carriers. Unlike its Japanese and German counterparts, the US leveraged lease has not had to face an onslaught of unfavourable tax changes. In recent months, however, arrangers have complained of the difficulty in sourcing equity for leveraged leases.

JPMorgan managing director Hossein Amir-Aslani concedes that it is a shrinking market, largely due to bank consolidation. Traditionally, US regional banks have been the major providers of equity to the US leveraged lease market, but it is these same banks that are most susceptible to take-overs by larger banks. The problem with consolidation, says Amir-Aslani, is that when you combine the investment exposure of the newly merged bank groups, you quickly hit the internal limit on exposure.

The other providers of US leveraged lease equity tend to be the big corporations, such as Philip Morris or General Electric. But the problem here, says one industry source, is that they prefer to do large volume transactions, and not single aircraft deals. They also expect a yield premium, and may charge as many as 100 basis points higher than the cost of equity from most regional banks.

The Foreign Sales Corporation is another US tax lease structure. Designed to facilitate exports of US-manufactured products such as Boeing aircraft. There are two types of FSC: the Commission-FSC (C-FSC), which is primarily used by US carriers to lease aircraft they operate overseas; and the Ownership-FSC (O-FSC), which can be used to lease aircraft to non- US carriers.

At this stage, the FSC is limited to a niche product role for the airlines, with only a handful completed each year for foreign carriers. Last year, less than a dozen O-FSCs were used to finance Boeing aircraft for Qantas, Lufthansa and Cargolux, partly because it was successfully challenged by the European Union Government in 1998 as an illegal subsidy. New replacement legislation was only signed into law days before last November's US election.

According to Ray Simon, a partner with the law firm Watson, Farley & Williams, "as the legislation is brand new and no notices or regulations have been issued, arrangers are still in a planning mode." Nevertheless, he explains that the traditional FSC equity providers - typically US banks - are still interested in pursuing future transactions. A fair number of arrangers are looking at the new regime to replicate the benefits of the former O-FSC structures. A number of new transactions is expected in the first quarter of this year.


With the tax-lease in decline, airlines are instead turning to capital markets to source their long-term funding. And they are turning to securitised transactions in particular. Last year, $12.5 billion worth of aircraft-related securitisations were closed. Enhanced Equipment Trust Certificates (EETC) led the field, with $6.5 billion worth of transactions, up from $5.3 billion in 1999.

Tom Cahill, managing director at Morgan Stanley Dean Witter, expects the EETC market to continue to see annual growth of 20%. The main factor driving the US EETC market has been the low cost of funding, especially for carriers rated below investment grade. A BB/Ba2-rated carrier, for example, can expect an EETC-raised loan to cost around 150 basis points less than if it borrowed on a senior secured basis from a bank. Hossein Amir-Aslani, managing director at JPMorgan, says that US carriers now fund most of their aircraft through EETCs and tend to use traditional bank financing only short-term.

Low funding costs

Airlines such as US Airways, United , Midway, Continental Airlines, Federal Express, AirTran Airways and American Eagle have all sourced finance in the EETC market. Even the better rated carriers that typically self-finance their fleet renewal and expansion programmes, are turning to the product, not just for the low funding costs but also for the amount they can source in one transaction. Last year's debut by Delta Air Lines into the EETC market was telling. The carrier pulled off a $1.5 billion issue covering 44 aircraft making it the largest such airline financing. Yet Cahill says investor demand was so high that the issue was four times oversubscribed.

While the evidence suggests that investors have a huge appetite for airline EETCs, they are also becoming more knowledgeable about the risks involved. Cahill says the abundance of investor interest in aircraft securitisations has led to the beginnings of tiered transactions. "Investors grade the transactions into a one, two or three; a kind of ranking whereby they can distinguish between the quality of the portfolio and the service and, in turn, price these differences. In other words, fair compensation for the risk involved," says Cahill.

As the securitisation market matures, more innovative structures will be developed to better meet the airlines' needs. Cahill cites the example of last year's $800 million EETC for United. "There was a mismatch between the floating rate leases on six Boeing 757s and the fixed rate debt, yet the transaction still met Section 1110 [US bankruptcy protection] rules, was AAA rated and the mismatch was bridged with a swap that did not cost anything. In the past the airline would have had to pay a premium for this swap," he says.

While the EETC is now the debt market of choice for US carriers, its usage by non-US issuers has been virtually non-existent. Only Spain's Iberia Airlines has completed two issues - one in 1999 and a second last year. Cahill believes the reason for the EETC's slow progress outside of the USA is simple. "As long as European banks continue to lend at tight margins there is no real incentive for using the EETC," he says. It is not unusual for European banks to lend at just 20-25 basis points above Libor (the London Inter Bank Offer Rate).

Some would counter that the EETC product is priced too high for non-US carriers. JPMorgan's Amir-Aslani says that when his bank tried to arrange an EETC for an Asian carrier the cost was a prohibitive 100-125 basis points more expensive than an export credit-supported deal. Indeed, the absence of Section 1110 bankruptcy protection in many non-US jurisdictions will be factored into the risk and ultimately the pricing of the issue. Moreover, many non-US airlines simply lack that essential prerequisite to access the capital markets: a credit rating from one of the big three rating agencies.

Nevertheless, Cahill is optimistic that EETC fever will spread beyond the USA. "After the success of the second Iberia deal (arranged by Morgan Stanley Dean Witter), which included tax leases and was three times the size of the 1999 transaction, we expect more transactions to follow, possibly two next year from European airlines." n


Roughly one-third of all new syndicated loans used to finance aircraft purchases continue to be supported by the US and European export credit agencies (ECAs). The US Export-Import Bank (Ex-Im) provided $3.5 billion of export credit support for 63 aircraft supplied to 19 airlines in 15 countries during fiscal year 2000. Latest available data from Capital Data Loanware for the year to the end of November suggests that Europe's ECAs were at roughly half the US figures, having provided $1.6 billion of support for 21 Airbus aircraft. Agencies on both sides of the Atlantic expect a similar level of support in 2001.

European ECA support is typically provided in one of two ways for up to 12 years: fixed rate export finance (FREF) or pure cover. In recent years, FREF has been popular among Airbus customers, as it allows the airline to lock into a fixed interest rate as early as three years before delivery for an additional premium of 50 basis points. If market interest rates suddenly fall just before delivery, the airline can walk away from the deal with no penalty. However, this flexible option has proven costly to the European ECAs and may soon change.

In future, the lock-in period may be shortened to a date closer to delivery, or there may be an additional up-front fee to pay or a penalty for walking away.

If an airline seeks greater flexibility in rates, it will opt for pure cover. Airlines will secure finance at commercial rates on a fixed or floating basis, then the ECA would simply guarantee the lending bank against default on payment of principal or interest. For example, the airline could place that aircraft in an enhanced equipment trust certificate (EETC), something it cannot do under FREF. To date, however, neither Ex-Im Bank nor the European ECAs have been involved in an EETC structure.

Ex-Im Bank's head of transportation, Robert Morin, says that most of its support is as an Ex-Im Bank guarantee for 100% of the principal and interest of a loan. Because the Ex-Im Bank guarantee is backed by the full faith and credit of the US Government, the commercial banks have become increasingly aggressive in their terms. Most Ex-Im Bank-supported deals last year were priced at or just over Libor and a few transactions were even sub-Libor.

Many commercial banks involved in Ex-Im Bank-supported finance now access the capital markets to fund Ex-Im Bank guaranteed loans, and pass on the lower cost of funds to the customer. This is likely to sustain the attractiveness of such deals. Morin says: "Ex-Im Bank is very attuned to the airline's needs." In an effort to address cost volatility, it has developed the Jet Fuel Indexed Interest Rate, which links an airline's two major costs: fuel and interest rates. Last year three airlines included this option in their export finance package, says Morin. It establishes an inverse relation between the two costs, so that when fuel prices are up, the airline's interest rate will be decreased to offset the rise in fuel costs, or vice versa.

Extending the product

Cognisant of the airline's growing preference for capital market products, ECAs are studying the various ways they might get involved in extending the EETC product to non-US carriers. According to one ECA source, this could take the guise of some form of repossession cover similar to the protection afforded by the US Bankruptcy Law.

Airlines and manufacturers would also like to see the terms of export credit loans lengthened beyond the 12-year limit, but there has been little movement by the ECAs to directly address this issue. Rather, in certain circumstances, ECAs use mismatch or SOAR (Stretched Overall Amortisation Repayment) loans, whereby commercial lenders supplement an ECA-supported loan with a commercial loan to provide loan economics typically associated with a longer repayment term.

Such innovations may prompt questions over whether it is finally time to overhaul the rules of the large aircraft agreement under which the USA and Europe agreed limits on support for their airliner manufacturers. That was last reviewed in the mid-1980s.

Source: Airline Business