Financial services firms are very aware of the problems economic downcycles can cause but, for aviation bankers, the aviation industry is more robust than ever before, which is attracting new investors into the commercial and capital markets all seeking aviation assets to help boost yields.
Ten years ago, the global financial crisis hit and the aviation sector was impacted by a lack of access to funds to pay for aircraft and engine deliveries, a spike in fuel costs and falling passenger numbers. During the following year, unable to access the bank market, airlines and aircraft owners resorted to ECA financing and sought new sources of equity investment to keep funding their deliveries.
One of the defining characteristics of the aviation financing market is its ability to continually innovate to find more efficient and suitable funding products and structures to fulfil the demand for ever more sources to fund aircraft deliveries, portfolio purchases and corporate expansion. Despite the economic pressures and indeed because of the ultra-low interest rate environment, which endures today, aviation financiers quickly created innovative ways to tap into new sources of liquidity. This gave renewed prominence to the capital markets and structured products for aviation assets that attracted new investors into the space – particularly for leasing company credits – as they searched for yield and stable returns.
Today, the aviation banking market is experiencing other challenges: fierce competition, an abundance of liquidity pushing down margins and loosening covenants as well as regulatory changes that threaten to distort the market significantly. The extended closure of the export credit agencies (ECAs) for Airbus and Boeing aircraft has impacted airlines specifically, which have turned to lessors and banks for assistance.
Despite the current challenges, as the pace of new aircraft deliveries accelerates, banks and the capital markets are more in demand than ever. The aviation financing market remains relatively stable and continues to offer a wide variety of financing options for lessors and airlines. Leasing companies are increasingly using the capital markets to raise unsecured debt, although the commercial bank markets are easy to access and remain competitive and are often less complex and less expensive than more structured debt and equity products. Airlines too are awash with liquidity and can access affordable bank debt easily and demand favourable terms, which is not great news for banks scrambling for reasonable returns.
“We are optimistic on the sources of financing for borrowers,” says one European banker, “but we are pessimistic on returns given margin/spread compression.” His team is seeking higher returns by focusing on riskier borrowers but ensuring the addition of stronger covenants, as well as offering more bridge loans and other high margin backstops as capital markets take outs, which also has been a popular measure in recent years.
That spirit of innovation has continued in 2017 driven by the export credit vacuum, which accelerated the launch of the first insurance-backed funding products from Marsh’s Aircraft Finance Insurance Consortium (AFIC).
Despite the benign environment, some bankers are calling the top of the cycle for aviation financing. “We are probably at a peak in term of funding liquidity,” says Bertrand Dehouck, managing director – head of aviation EMEA at BNP Paribas. “The question marks are how long we stay at the peak; are we entering an unusually prolonged phase at peak thanks to the massive liquidity brought in by central banks. A credit event could accelerate a retrenchment on the liquidity front. [The current situation] might not have translated fully into a peak of asset values; we anticipate liquidity to tighten before asset values soften.”
Another European banker agrees that the market is facing over-liquidity in debt and equity markets, arguing that this is unsustainable since investors “will be disappointed in that the return on equity they were expecting will unlikely be met”.
Dehouck predicts that the market is nearing a peak in terms of the covenant-light transactions, with excessive structural flexibility to the benefit of borrowers, which has defined many deals of late. “We would anticipate this flexibility and such favourable terms to gradually reduce in a 2019-2020 horizon.”
Arnaud Fiscel, head of transportation at Bank of China in London, sees a natural market correction building. “One can sense some of the ingredients we observed back in late 2006 / early 2007 with excess liquidity, further exacerbated by relatively low fuel price and interest rates,” he says. “The aviation market is undoubtedly growing and offering solid opportunities for investors; one may however question whether the macroeconomic environment can sustain steep, prolonged increases in air traffic, or whether the recently observed capacity boost is momentarily outpacing the actual growth in demand. While we can legitimately remain very optimistic on aviation and its strong long-term prospects, aviation remains a cyclical industry and one can never exclude some short term adjustment.”
Other experienced financiers don’t see a correction on the horizon at all – although such comments are usually tempered by the caveat that most bankers didn’t see the collapse of Bear Sterns on the horizon either. The banking market and the aviation market are in a sustained period of growth and despite interest rates inching up with inflation – which benefits asset-backed financing as values rise – there are no clear signs yet that the situation is changing but the boom in liquidity gives some the sense that a correction must be building. The trick is to monitor the signs and insulate long term financing deals for the worst.
“If people are disciplined in the way they finance the industry, in the way they structure deals for debt and equity investors, and retain a longer-term view rather than trying to churn cash out, his positive cycle could run for a while more,” says Srinivasan.
Many in aviation are keeping a close eye on OEM production rates, which could alter the delicate supply and demand balance and put downward pressure on asset values, but most are confident in the abilities of the OEMs to manage this on a longer-term basis. “The wise folks within the industry in the leasing community and the OEMs are taking a longer-term view and are fairly nimble in trying to control production rates and manage it to a point where it is sustainable over a longer period,” adds Srinivasan.
Major defaults are an obvious trigger o reducing the overall liquidity levels in the market although the five major airline insolvencies in 2017 has not impacted liquidity levels for the moment, despite many of the aircraft concerned being encumbered in ABS vehicles as servicers worked hard to re-lease those aircraft with seemingly minimal fuss.
For mid-life aircraft investments, one of the first indications of a correction may be seen in the capital markets.
“A big part of the vibrancy in the mid-life and older aircraft market is the health of the capital markets and leasing companies’ ability to sell mid-life and older planes into the ABS market,” says Matt Little, partner and head of business development & capital markets at Castlelake. “Any volatility in the health of the capital markets is a big driver that may lead to a repricing of risk in the mid-life and older aircraft space.”
Financiers as well as airlines also keep a sharp eye on oil prices as potential triggers for a downturn scenario since a significant increase in the jet fuel price could accelerate a drop in market value of older aircraft securing loans.
Rising interest rates could cause pressure on liquidity but many aviation bankers and leasing executives are phlegmatic on this issue. “The US and the world remains in a prolonged low interest rate environment,” says Srinivasan,” and I don’t see rates going significantly high or spiking any time soon… [The] prolonged low interest rate environment is part of the reason there is more capital coming into the sector.”
That excess capital chasing the same assets is what is causing the fiercely competitive financing environment. Cheap money, largely from new investors and capital sources that are willing to forgo the usual basic securities – fair return, covenants – is driving down returns and increasing the risk exposure for inexperienced investors piling into aviation.
“There are banks who are prepared to do bilateral loans to airlines at levels that are too tempting,” says Hollahan. “That’s a threat that our business model has faced, which will only increase as there are more and more banks emerging, particularly in Asia, that want to lend money to the airlines at very, very, low returns.”
The allure of the robust aviation market has forced some banks that have not traditionally played in the industry in the past or for a long period of time to build new teams and increase their activities in the sector, putting even more pressure on returns.
Some of the more mature aviation financiers are pulling back from the scramble, in some cases resisting the allure of large deals in order to retain balance sheet and risk-return discipline. Best practices include prudently structuring deals and avoiding too aggressive loan profiles and too high debt balloons (especially for non-recourse loans).
“With a buoyant market and ample liquidity, discipline is key,” says Fiscel. “It is usually wiser to let an opportunity go when some key structural aspects are not met; seasoned longstanding aviation players will know when to stand out”
He adds: “Although the bank is fully dedicated to aviation, transactions must meet certain criteria and remain within some key parameters, such as loan-to-value and amortising profile.”
The Mizhuo team is also retaining a disciplined approach, which can be difficult in the current environment: “We are trying to be smart in a fiercely competitive environment, so we don’t stretch ourselves and do the wrong thing, which can be the catalyst to something big happening,” says Srinivasan. “We still need to be productive and do deals but we are trying to pick the right players and not fall victim to peer pressure of following the herd into a deal that doesn’t look or feel right.”
Some financing structures are becoming ever more complex and are heavily structured – particularly for some widebody deals that attract new investors – which is concerning Fiscel. “New investor pockets are being tapped for more complicated, more innovative structures on less liquid - yet still good - aircraft,” he says. “Although intellectually rewarding, some of the most sophisticated structures are being paired with less sophisticated investor resources, which might present some challenges, were those transactions to unwind early.”
In general, most of the financiers that contributed to this survey do not see the threat of a downturn as a negative for their business, indeed, they see it as an opportunity to serve their clients more effectively.
“As a banker able to offer a wide range of financing and advisory solutions to cope with the cyclicality of the business, there is no need for the industry to be too stable and financing to become too commoditised,” says one banker. “In the up and down of the cycle in the long run, you will recognise the professional bankers which will be supporting their clients during the difficult times.”
Already under pressure from the fiercely competitive operating environment, European banks have been preparing for the full impact of the implementation of the Basel Committee on Banking Supervision’s Basel III capital requirements reforms including expanded requirements (often referred to as Basel IV), which were finalised on December 7, 2017. Despite lobbying efforts from the industry, notably the Aviation Working Group (AWG), to force an exception for aircraft financing being 100% risk weighted in a bank’s capital requirement calculation, this has not been heeded in the final text.
The anticipated impact of the capital requirements in the aircraft sector is a 3.5x to 6x increase in Tier 1 capital requirements on secured aircraft loans. If implemented, this would require the banking industry to raise $17bn to $34bn in new Tier 1 capital to support the existing aircraft loan banking books and sustain the bank market share in new aircraft delivery financing in 2017-2020.
By not recognizing the historically low risk of aircraft collateral, AWG argues that secured aircraft loans are at a drastic risk-return profile disadvantage relative to higher risk unsecured corporate loans and secured loans with other types of collateral that historically realized higher loss given default rates (LGDs). Within the aircraft sector, lower risk aircraft loans are at a disadvantage relative to higher risk loans (e.g. low LTV vs. high LTV loans).
The consequences will likely include: reduced capital availability to secured aircraft lending; a reduction in the size of low-risk aircraft loan portfolios on banking books via possible asset sales; and an overall increase in bank portfolio risk through re-allocating capital away from secured aircraft lending towards riskier unsecured lending and riskier types of collateral. AWG argues that some aircraft financing may shift towards unregulated shadow banking entities, while secured aircraft financing that remains in banks may shift to riskier terms and borrowers to capture higher margins to compensate for increased regulatory capital costs.
The dynamic of the existing commercial bank market will change in the coming years as Basel IV begins to impact European banks, increasing their cost of capital significantly, especially those that are operating with advanced capital models (IRB).
“Basel IV will definitely change our business and will lead to more distribution outside the traditional aviation banks, which will face an increase in capital allocation against long-term secured aircraft loans and more pressure to do cross-selling in capital markets and advisory (fee business),” says one banker. “New debt platforms will attract more and more alternative sources of funds such as pension funds, insurance companies, infrastructure funds and others.”
The Basel Committee is pushing for European regulators to implement Basel III reforms by January 2022, but the proposals have been in motion for so long now, banks have had a long time to investigate the impact on their business, even if they are not yet manoeuvring to comply.
“One would’ve thought with [Basel III] being imminent many of the European banks would be pulling back in terms of lending but ironically they haven’t,” says Srinivasan. “In fact, they’re still lending significant amounts.” But, he adds that they are continuing with more structured and heavily syndicated deals that have become the norm for commercial banks since the financial crisis as they sought to reduce their balance sheet exposures for long-term debt. During that time many of the active European banks in Germany, the UK and even France, closed their books and some pulled out of aviation finance altogether. Some have slipped back into the market with revitalised strategies to act more as structuring arrangers rather than balance sheet lenders, which will continue after 2022 but perhaps even on a more reduced scale.
While in the long run, US and Asian banks, and others outside of Europe, may benefit from the implementation of Basel III since they can continue to offer their balance sheet for aviation debt, many are united in the opinion that the changes are wrong given the low default rate of this industry. Regulatory change has transformed the banking industry over the past decade and it continues to do so and yet banks and financial institutions have and will find ways to adapt. “Our business is in constant change and requires a regular adaptation and we do not expect this to change,” says Dehouck.
One observer points out the irony that with Basel III in place, “regulated institutions will try to take as much risk as possible as their credit/risk teams permit,” that goes against the spirit with which the rules were introduced in the first place.
After Basel III is in place, the importance of the capital markets will be even further enhanced. This should compel more airlines and leasing companies to seek a corporate credit rating. “The industry would benefit from a larger number of airlines in Asia and the Middle East to be rated in order to offer more opportunities of diversification through the capital markets,” says one banker.
Unlike lessors, few banks – other than DVB that funds older aircraft – take residual value risk on aircraft assets as they prefer to take credit risk on the airline or lessor and restrict financing to new aircraft. For secured portfolio financing transactions, the residual value risk is taken by the investors. Nevertheless, most bankers consider a 25-year depreciation curve for new technology aircraft as acceptable, but for older aircraft, they say, historical depreciation levels probably should be increased.
“Some aircraft are scrapped earlier than 25 years of age because there are not owned by operators but by pure financial investors which see a better exit (ROE) in phasing out the aircraft and parting it out but this does not mean that the said aircraft could not have been operated by an airline for a longer term so we might say there is a distinction to be drawn between “useful life” for an airline and “financial life” for investors.”
Dehouck says: “We continue to believe that there is no material change in the useful life of an aircraft from an operator perspective. But from an investor perspective the conclusion is somewhat inside of that. Because there are more and more financial investors involved in this asset class, the resultant is therefore a perception of a shortening of the life of an aircraft.”
There is evidence that the rating agencies are increasingly taking a view that an aircraft’s useful life is closer to 22 years than 25 when rating secured aircraft transactions. “If you assume the useful life is 25 years,” says Srinivasan, “the debt amortization schedules are being set to low 20s, so there are some measures already in play to address that risk. There are operators out there that are much better at sweating an asset and can extend its useful life but there seems to be more of a conservative view about the future where lenders as well as rating agencies and investors are sort of converging around that 22 year number.”
One of the main drivers in pushing down useful life of aircraft is the loss of the African secondary market, whose airlines have progressively been buying new aircraft with the support of the ECAs, which leaves little demand for 10-15 year aircraft in that region today. However, some flag carriers do tend to operate aircraft for longer than that especially those with strong maintenance, in-house capabilities.”
Michel Dembinski, Head of Aviation in the Structured Finance Office EMEA at MUFG, says that for lessors, the issue is less about useful economic life than how the book value tracks (or not) the trading value of the aircraft. “The 25 years depreciation does not allow for this,” he says, “leading to potential impairments, and hinders trading of aircraft: both have a detrimental effect on the profitability of the lessors.”
The concept of a “single-use aircraft” has been discussed recently, with aircraft purchase prices being so low for some operators that replacement seems a more economical option than a D check but respondents think that this approach is unsustainable, especially since the business models of the OEMs, particularly engine OEMs, are more focused on selling aftersales services than new aircraft and engines.
In summary, while there can be factors justifying an increase or decrease in the rate of depreciation, most respondents agree that the 25 year depreciation policy for new technology aircraft is reasonable.
Valuing assets accurately for sale and secured transactions has been, and is, a hotly debated subject. One of the problems is the paucity of publicly available market data for appraisers to access to be able to accurately value aircraft. Survey respondents were asked if they thought greater transparency would be beneficial for the entire industry. Some responded that it would be helpful but that it was unlikely to happen. Others said that it would never happen and would be of limited benefit if it did, calling out the heightened transparency in ship trading which does not reduce volatility and so has little benefit.
“The best proxy for aircraft value is to obtain a precise “Maintenance Adjusted CMV” by two reputable appraiser firms,” said one banker.
Larger lessors benefit from sales data that appraisers will never have, or at least not immediately, but are essential to the smooth running of secured debt transactions, which are rated by the credit rating agencies based on appraised values. “While we recognise that appraisers have an important role to play in this process, they do as good a job as they can do, given the information that they have, which I don’t think is enough. We have to build in buffers, lower them on the values, and use our own judgment, to take into account the fact that they can be wrong a lot,” says one US banker.
Respondents generally agree that more transparency on lease rates and sale prices would benefit the market, as well as the appraiser values, but it would be difficult because every lease is different – return conditions, maintenance reserves and security deposits can create or destroy value. If there was more transparency, deeper and more mature capital markets would be created but few believe this would be possible.
Financial institutions are undergoing a period of accelerated change as financial technology (fintech) disruptors encroach on market share in the commercial lending market particularly. Internally, more and more financial processes are being digitalised and automated as banks find ways to become more efficient, regulatory compliant and meet rising customer demands. However, advanced technologies such as distributed ledgers (blockchain), artificial intelligence and machine learning, are yet to impact aviation finance in a meaningful way, according to the survey respondents.
“Technology has a place in everything,” says Srinivasan. “It makes processes more efficient, but this is a relationship business, a human business – that touch and feel is required when you are figuring out if this is the right partner to work with… There’s only so much you can do with technology.”
Although crowd funding has been used for financing small aircraft and by some lessors to raise operating capital (see Lessor section), respondents doubt this lending avenue will ever represent a significant share of the annual $140bn needed to finance the aircraft deliveries of aircraft. “Long term lending still requires judgment from seasoned professionals,” says one banker, although he does see some fintech debt platforms being set up that could attract institutional sources, which is funded with lower administrative costs that could consequently decrease the overall cost of lending.
Other bankers are more positive about the developments in financial technology and less positive about the current level of adoption by aviation banks. “Aviation needs to be pulled out of the dark ages,” says one banker. “Some 90% of new aircraft financing is fairly plain vanilla and should be done online. Aviation bankers should be worried, it’s inevitable.” Others see the need for significant continued investment in technology “to industrialise processes that can help to increase the scale of the franchise.”