:: September 2008 Letter ::


Dear Fellow Distressed Debt Fans,

The funny thing about finance is how durable it sounds. Words like “mechanism,” “instrument,” “securitized,” “structured,” and “vehicle” all connote security, tangibility, and hardness. Combine a few of these terms and you create phrases like “Structured Investment Vehicle (SIV)” which sound even more reassuringly solid, as though you’d find them in a hardware store. Unfortunately, recent events imply that this flimsy beaten-up paper is more truthfully termed “Vehicle of Assets Poorly Obligated and Rearranged (VAPOR).”

Aircraft finance isn’t immune from this amusing rift between hard words and soft reality. Enhanced Equipment Trust Certificates (EETCs) were a durable-sounding early casualty of the credit crunch. Yet strangely, aircraft finance is in respectable shape. Having just bought a house, I’m acutely aware of what a hassle it is to get a mortgage, yet financing a plane is still relatively easy. This difference between aviation and the rest of the world is in the headlines. ILFC, the biggest jet financier and customer, is trying to detach from dysfunctional parent company AIG like a starship breaking away from an exploding space dock. ILFC continues to enjoy strong revenues and profits. The second biggest lessor, GECAS, has retained its AAA credit rating. The other lessors are reporting strong results too.

Due largely to this distinction between aircraft finance and every other type of finance on the planet, our beloved jetliner market continues to do okay…for now. There are five reasons why:

The first is that the end users are doing unexpectedly well. Sure, IATA forecasts $5.2 billion in airline losses, but these losses are confined to a few US carriers. Most of the world’s big carriers are in decent shape, and 90+% of the backlog is for non-US carriers. There’s talk of profits in 2009, especially since fuel is down. Sure, thirtysomething carriers have gone bankrupt. So has DayJet, but that means nothing (incidentally — POGO IPO. Worst. Financial initials. Ever.). You shouldn’t draw larger economic meaning from marginal players exiting the business. In fact, the airline biz might finally see creative destruction.

Second, no matter how much capacity gets cut (and those cuts are a major reason for the airlines’ improving health), people have to fly (at least people other than the low-fare price-hypersensitive types that the fare hikes got rid of). Traffic ain’t great, and front-cabin traffic will get hit as businesses tighten their belts, but the world travel market won’t suffer anything worse than a cyclical dip. There’s still a connection between long-term economic growth and travel demand. Also, fuel may have dropped, but it’s still much higher than a year ago, so new jets look great. Replacing old jets with new ones can save enough in fuel and maintenance to pay the lease payments on the new jets.

Third: forecasters who predicted an airline financing crisis were exactly right—airlines needed external capital to buy planes. But the money guys were there for them, creating a reasonably strong industry financing their airline customers. It’s the law of unintended happy consequences.

Reasons four and five relate to the aircraft. Fourth, manufacturers have done their best to design planes that appeal to a broad market. If an airline drops capacity (or is wiped out), these increasingly generic planes will fit in with other fleets. Fifth, the Capetown Convention makes it easier for financiers to repossess aircraft. The fourth factor, by the way, hurts aircraft that appeal to a much smaller niche market, such as the A340 or 777-200LR. Despite the A380’s limited customer base and modest order book, it’s not in danger because most of its customers are in good financial shape. Also, finance concerns account for some, but not all, of the reasons CSeries orders have stalled. The money guys can’t gauge its market appeal.

In short, aircraft finance involves a tangible asset that can generate revenue and can be moved to any market that needs it. For all the money still floating out there in the world, jetliners are almost a safe haven, rather like defense company equities. The assets causing the credit meltdown, by contrast, are murky, intangible grab bags sliced and diced beyond recognition. Much of it involves collections of house mortgages. Houses are immobile, relatively customized, and often non-revenue generating.

All told, we do not regard the credit crunch as an exogenous shock that precipitates a sudden bust cycle. In fact, the industry has a few finance layers to cushion us if traditional financiers falter. The world’s cash-rich sovereign wealth funds haven’t gotten heavily into this market yet. The Mid East funds are particularly interested in aviation (an ILFC acquisition would give a Mid East player instant aviation superpower status). The manufacturers are only starting to bulk up their finance arms. Then there are our government pals, Europe’s ECA and the US’s Ex-Im bank. Key Airbus customer Air Asia just announced that it wants ECA help with financing A320s for its expansion. I don’t know why European and US taxpayers would want to fund airline service elsewhere, but the taxpayer is expected to fund everything else these days, so why not foreign airlines?

Should you be worried? Hell yes, for many reasons. The credit crunch could turn crunchier. Those backstop capital sources — governments and OEMs — aren’t necessarily safe if the liquidity crisis gets worse. If ILFC doesn’t find a new home or some kind of other financial solution in the first quarter of 2009, a chill would hit the market. The decelerating BRIC markets could cancel some orders, particularly for the more dubious players (i.e., Kingfisher). Airliner retirements will rise so utilization and discretionary spending will drop, hurting the spares, MRO and refurb markets.

Other aviation markets, aside from rotorcraft and military aircraft, look grim. Regional aircraft have fewer customers and a greater reliance on North America. Both of those are bad. Smaller RJs are financially radioactive. They’ve already been buried, but external financing requirements mean we may need to exhume them, shoot them and bury them again. Then there are business jets, which have less in common with jetliners and more in common with McMansions. It’s a smaller, much more fragmented user base, most of the jets don’t generate revenue, and the products are more varied and customer-specific. Private jets are also easy targets for cost-cutters — Sarah Palin’s strongest (and only coherent) message involved selling the Alaska Government business jet. In short, I’m worried. Teal is revising its business aircraft forecast downward with a production peak now in 2009.

But the good news is that jetliner finance is holding. Will this last? Watch what happens with ILFC, a good arbiter of jetliner finance health. But for now, I believe the finance glass is half full, not half empty. It might be a cracked and leaky glass, but it’s definitely half full.

Since my retirement date has moved to the 12th of Never, it’s back to my day job. September Teal Aircraft reports: a new Eclipse report, plus updates of the Rafale, F-2, AH-1, HondaJet, Avanti, Tiger, Super Puma, and Mirage F1. Have a great month.

Yours, Until Our Mechanisms Are Structurally Securitized,
Richard Aboulafia


© Richard Aboulafia 1997-2006, All rights reserved.
  ~  Last updated on January 08, 2006