Global Financial Crisis: aviation repercussions October 2008

It is sometimes very difficult to see beyond the doom and gloom in the depths of a crisis; and while the world’s media and governments threaten to panic consumers into a global recession the prospects for aviation are at best opaque.

The current financial crisis generates invidious comparisons with the worst crises of history — notably the '29 Wall Street crash and the resulting Great Depression of the 1930s. Like all past banking cycles however there are similarities but many more differences. The prime similarity with past cycles — and particularly that of ‘29-’33 — is a loss of confidence in and by financial institutions, to the point where many banks have stopped lending to each other. This in turn has lead to a severe lack of liquidity in the wholesale banking markets — and the important thing about liquidity is that you do not know how important it is until you do not have it. This loss of liquidity in turn feeds a lack of confidence, and widens its scope to include the retail markets, encouraging withdrawal of savings by individuals (and retail deposits form the primary bedrock of the financial system) from institutions deemed at risk of failure.

A further similarity — common to most cycles and not just the banking cycle — is likely to be that we enter a period of consolidation, dearth of innovation as the market participants retrench resulting in the likelihood of a prolonged period of expensive debt.

In the past decade the finance industry has fled headlong into creating obscure products, which appeared to remove risk, with (seemingly) high margins — most based on the very availability of cheap debt finance and the fallacious stupidity of borrowing short to lend long. Many of these products appear to have been based on an overoptimistic assessment of the pricing of risk; and many appear not to have been understood properly by the perpetrators themselves. Overcapacity — as in any industry — eventually leads to falling returns, and in a highly cyclical industry to deep losses.

One big difference with past cycles however is the financial reporting requirements of the new improved accounting standards to mark to market tradeable investments and liabilities. This consequently exacerbates the write–downs and losses but also has a negative spiral impact on the market values of the underlying instruments. It will take time — but the finance industry will recover and will find a new upward trend in its cycle (and go through the whole process again) — the real question for us all is how long.

The aviation industry is already reeling from the impact of the very high fuel prices and the consequent need to raise fares and the resulting weakness in demand. If we are indeed in for a prolonged global recession, then this demand environment will weaken further — requiring even more cut–backs in capacity and tightening of belts. It will undoubtedly also lead to further failures and help to accelerate consolidation.

This last upswing in the airline cycle has not been easy — and entering the downturn there are only a handful of carriers round the world with balance sheets (and importantly cash balances) strong enough to weather the difficulties.

In Europe in particular we are seeing the network legacy carriers already accelerating consolidation: with British Airways finally coming to the altar with Iberia, Lufthansa taking out SWISS and Brussels Airlines, and eyeing Austrian (while its call option on British Midland should mature this year). Air France–KLM may in the end link up with the new improved Alitalia (unless Lufthansa’s plans for Malpensa win the Northern League’s favour and it manages to sneak in) while also showing interest in Austrian.

All three of the majors are trying to consolidate further the transatlantic alliances — with the prospect that 90% of transatlantic services will shortly be provided by three ATI approved joint ventures of oneworld, SkyTeam and the Star Alliance. This consolidation process should make the surviving carriers stronger and more resilient in the next upturn.

In the short haul markets in Europe, meanwhile, Ryanair and easyJet should have the finances, staying power and persistence to continue to grow into the recession and the vacuum left as others cut back or fail. Ryanair has the particular benefit of being by far the lowest cost producer in what is a commodity market and, with easyJet, has the advantage of an order book of equipment on prices arranged in the depths of the last industry recession. Smaller carriers, and ones with less robust business models, and particularly those with less cash, may well fail.

Leasing fallout

One thing appears clear — although there may become aircraft available, there is now likely to be a dearth of capital, equity or debt, to finance them and allow start–ups by the kerosene–sniffing hopefuls to fulfil their dreams of making a small fortune out of running an airline.The greatest fallout from this crisis meanwhile is likely to be among the providers of finance to the industry, the aircraft market and particularly the aircraft leasing industry. It was inconceivable that AIG should fail — but as Charles Dodgson noted, "I can think of six impossible things before breakfast" and in the past few months those six have materialised as fact before lunch. AIG’s failure, and the US government’s bail out to allow the orderly winding up of its empire, will put ILFC in a precarious position.

ILFC is the world’s second largest aircraft leasing company behind GE Capital, with a beneficial interest in about 950 jet aircraft (6% of the world’s fleet) and manages or has subsidiary interest in a further 100 units. It also has some 160 aircraft on order, mostly weighted to Boeing. Its customer base is fairly well spread throughout the world and 90% of its fleet is placed with airlines outside the US.

It is also profitable: on revenues of $4.6bn in 2007 it generated net profits of $600m, and even in the first half of 2008 (when failed carriers ATA, Eos and Aloha in the US returned 16 aircraft) it saw revenues up by 12% to $2.5bn and net profits up by 48% to $364m. Although as a subsidiary of AIG the balance sheet probably doesn’t mean much, it appears to have some $30bn of debt on balance sheet supported by $42bn of net fixed assets. AIG acquired ILFC in 1990 — just before the industry recession of the early 1990s that managed to kill off GPA (or at least that pushed it into GE’s coffers) — but it has been run very effectively since then by the original founder Steven Udverhazy. As an aside it may (just) be relevant to point out that GPA, run by the late Tony Ryan, was the stable from which emerged both Ryanair’s CEO Michael O'Leary and Aer Lingus' new chair man Colm Barrington (who is also CEO of Babcock and Brown Air).

There will undoubtedly be some intra–group connections, although these should be relatively easy to unwind. In the short run however, ILFC could well suffer competitively from the downgrading of its parent’s debt ratings — let alone a likely deterioration in lease rates. It could perhaps be offered onto the equity markets in an IPO — after all it was there before in the '80s — but equity appetite, and particularly for the intricacies of the aircraft leasing business is likely to be poor.

Interested industry buyers a few months ago would have included AWAS, BBAM, Macquarie and RBS, but each now may have their own funding problems. As it is primarily the western banks who are suffering the most from the fall out of the credit crisis, it may be more likely to find a buyer in the Middle East or Asia. A more liquid contender could be Dubai Aerospace Enterprise — who only manages 49 aircraft, but last year at the Dubai air show announced a massive $27bn aircraft order for 200 planes — while there may be a solution for capital (as some of the major investment houses have found) in the Far East.

GECAS, meanwhile, the world’s largest aircraft lessor, also has its own funding problems. GE recently managed a $15bn capital raising exercise to cover underlying losses resulting from the credit crunch. At the moment it seems exceedingly unlikely that they or their leasing operation would encounter similar difficulties as seen by AIG. With 10% of the world’s jet fleet under its belt the consequences of that impossible thought as well would be unthinkable.

It is indeed incredible that either of the two major aircraft lessors could be brought down as part of this financial crisis. In the worst case there would be some serious further repercussions for the airline industry.

The order position at Boeing and Airbus would no doubt go back into the "pool" of delivery slots allowing others constrained by the current order backlog potentially to gain equipment earlier (if they can get the funding). Some airlines may take it as an opportunity to hand back equipment to the lessors, some to reshuffle fleet mix to try to reduce ownership costs, but it would create an overhang of 16% of the world’s jet fleet. The net effect could be to accelerate the downward pressure on lease rates, but also increase pressure on aircraft residual values, encourage further debt write downs at banks who lend to the industry and once again make it increasingly difficult for the majority of airlines to acquire equipment.