Last year when AIN took a close look at the aviation finance industry, the prevailing sentiment among industry insiders was that if you were looking for money to finance a business jet, the money would find you. At the time, many of the aircraft finance divisions still felt they were relatively insulated from their mortgage brethren, even within the same company.
At the same time, the price of oil, hovering above $100 a barrel on its way to a peak of nearly $150, was beginning to have an effect on the number of flight hours, as operators felt the pain of paying $8 or more for a gallon of jet fuel. A recent report from UBS Investment Research found 2008’s business jet flight activity was down 9 percent through the end of October as compared with last year, with declines of 18 percent in August and 13 percent in September.
Nonetheless, business aircraft sales remained brisk. Cessna’s business jet order backlog increased by more than $4 billion in 2007, while Gulfstream–which reported record results last year–expected even better numbers this year despite the looming financial worries. As the financial institutions wrote off billions of dollars in sub-prime mortgage losses, liquidity began to tighten.
Even though the scent of economic distress was in the air, few Monday-morning quarterbacks could admit to correctly predicting the degree of chaos that struck Wall Street this year. Chastened economic sage and former Federal Reserve chairman Alan Greenspan testified to the House Committee on Oversight and Government Reform, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”
The foundations of some venerable money houses began to crumble, and first to fall was investment bank Bear Stearns in March, which was quickly absorbed by JP Morgan Chase; in September Lehman Brothers fell into Barclays’ hands. Just days later, Bank of America agreed to purchase Merrill Lynch, while Morgan Stanley sold one-fifth of its equity to Japan’s Mitsubishi UFJ Financial Group. Capital lending institution National City was purchased by PNC Bank, while banks such as Washington Mutual and Wachovia were swallowed up by JP Morgan Chase and Wells Fargo, respectively.
After Congress passed the emergency $700 billion bailout plan in early October, intended to “immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States,” there have been some indications that the $250 billion thus far disbursed to financial institutions such as Goldman Sachs and Bank of America has had an effect in restoring liquidity to the finance market. A report from the British Bankers Association showed the three-month U.S. dollar London interbank offered rate (Libor–the rate at which banks offer to lend money to each other, and a key index for the basis of other loans) fell at the beginning of last month to its lowest rate in nearly two months.
All of this activity and consolidation has narrowed the sources of financing for customers interested in buying business aircraft. “The recent economic crisis has caused significant changes in the finance market as sources of finance have pulled out entirely from the market, severely cut back their activity, or been acquired by another financial institution and no longer exist,” said Michael Amalfitano, Bank of America’s managing director, executive head of corporate aircraft finance. “At those sources that remain, financing terms are more conservatively structured to allow lenders and lessors to protect their investment,” he added.
Among lenders, the theme this year seems to be what a difference a year makes. “A year ago you didn’t have to do anything; the money found you,” said Allen Qualey, president of 1st Source Bank’s specialty finance group. “This year the market is much tighter; there’s still money to be had, but it’s going to be more expensive.”
A Federal Reserve Bank survey of finance industry senior loan officials released last month bears out that opinion. The survey found that roughly 75 percent of foreign respondents and about 40 percent of domestic respondents noted that a deterioration in their bank’s current or expected capital position had contributed to a move toward more stringent lending policies over the past three months. Eighty-five percent of domestic banks reported having tightened lending standards on commercial and industrial loans to large and middle-market firms over the past three months, and all of the banks in the survey said that they had increased spreads of loan rates over their cost of funds on C&I loans to large and middle-market firms, up from roughly 80 percent in the July survey.
Other economic factors are affecting the availability of funds for business aircraft loans. According to Adam Warner, president of Key Equipment Finance, “Interest rates are higher, too, “about 100 basis points [1 percent] higher than just three or four months ago and 200 basis points higher than at this time last year.” That has trickled down to the rate offered to customers, observed Carlsbad, Calif.-based aircraft broker Chuck Collins. “The people who are loaning now are loaning on variable-rate money as opposed to fixed-rate money. Fixed rate is expensive by today’s standards. We can still get loans with variable rates that are priced 130 basis points over Libor. That’s for credit-worthy customers, obviously.”
Such changes in the lending arena have caused some to see differences in the loan options their customers are pursuing. “The economic crisis has contributed to a 75-percent increase in the number of requests for our asset-based loan product,” explained Wayne Starling, senior vice president for sales and marketing at PNC Aviation Finance. “This type of loan requires 20 percent down in cash, but enables the buyer to borrow against the value of select aircraft (up to 80 percent loan to value) with reduced disclosure obligations. Asset-based loans do not require the borrower to put up other valuable assets as collateral, freeing up borrowing capacity for other uses. This is an excellent option for cash buyers because it allows them to spend their capital elsewhere, instead of leaving it parked on the tarmac.”
Typically lenders are asking customers to “put some skin in the game,” according to Starling. “Many of those that are still lending are tightening credit, pulling back from doing 100 percent loan to value and requiring more for down payment. They are also shortening the amortization period from 20 years to 15 years.”
Too Many Cooks Spoil the Pie
As the business aviation industry experienced its latest boom, dating back several years, it may have found itself a victim of its own success as many lenders rushed to fill the need for financing clients. “More and more banks were coming to the party because it was a good, stable lending place,” Doug Reinarz, senior vice president at Chase Business Aircraft Finance and president of the National Aircraft Finance Association, told AIN. “Having a stable asset that you are lending on for the most part very good credit, that’s a great place to be. Banks like that, finance companies like that, especially when you are able to differentiate your borrower pool a little bit and have high-net-worth individuals and some companies and maybe a little bit of charter operators and maybe a broker or two; you get a wider spectrum of borrowers.”
Having that many participants in the business aircraft finance market sparked intense competition, flooding the market with capital, which in turn caused
the lending rates to decrease. “Clearly a year ago you had some very aggressive liberal things happening because of the number of players and because of the easy access to capital that was present, and that was making [borrowing] too easy and making terms and conditions too flexible,” said Reinarz. “There will
be stories written later about folks who acquired airplanes who frankly shouldn’t have.”
That overarching drive to “close the deal,” which analysts began to notice in 2005, drew some similarities to the sub-prime debacle that clobbered real estate and Wall Street. “You were seeing aircraft loans to high-net-worth individuals or even private companies that were getting priced at the levels of say Libor plus 50 or Libor plus 70, and these individuals or private companies were by no means household names or by no means hyper-high credit quality,” said Reinarz. “These types of transaction were getting pricing that had historically been reserved for [customer credit ratings of] double As or triple As. If you go back over time and look at where double As and triple As historically have borrowed, it would be in that very low rate range. We had driven down to that range our rates for clients that didn’t meet those criteria.”
Due to the very low rates–resulting in narrowing profit margins–combined with tighter capital as a result of the financial meltdown, many of the newcomers to business aircraft financing are now taking a much more cautious approach, according to many in the industry. “What we are seeing now is that many of the lenders that were in aircraft financing or offering aircraft financing have either withdrawn or changed their approach to aircraft lending,” said Greg Renna, senior vice president of Webster Bank subsidiary Center Capital’s general aviation division. Lenders that might have offered a full gamut of financing options are pulling back slightly, concentrating on one facet of the business. For example, “We’re seeing some of the lenders out there now maybe just operating lease structures, others that were lending for all brands of aircraft now lending only for one manufacturer’s line of aircraft, so there are many variations now.”
That hunkering down means the aircraft financing landscape has changed dramatically since last year, according to Reinarz. “I would have guessed [that at this time last year] there were probably 25 serious larger-end aircraft finance shops. Today there are probably five or six that are active.”
Many experienced members of the aircraft finance industry have seen this type of cycle before. “When markets are good, new players come in that don’t really understand the industry but obviously see it as an opportunity. As soon as you have a slight downturn, they tend to back-pedal fast, scuttle back into the woodwork and disappear again. In an historic view of, say, 15 years you can see a cycle of the number of financiers increasing and, with a slight downturn, contracting again,” said business aviation consultant Mark Wooller of the UK-based International Bureau of Aviation Group.
By some accounts, that change is already having a deleterious effect on customers contemplating aircraft purchases. “Financing is spotty; there are some who are not doing it and some that are,” said aircraft broker Collins. “If my client has a banking relationship and was counting on doing it with them, then obviously if that institution is out of the business it’s a showstopper for us. If I can persuade him to go out to the open market, there are institutions that are [offering financing]. There are some that are stopping, not by saying, ‘We’re not going to make loans anymore,’ but by quoting rates that are commercially unacceptable.”
According to the Federal Reserve Bank survey of senior loan officers, among banks that reported an increase in demand for loans, nearly all domestic respondents reported that customer borrowing had shifted to their bank from other bank or non-bank sources because these other sources had become less attractive. “Early this year, there were too many lenders/brokers and too much money chasing too few deals,” said PNC’s Starling. “In the last 90 days that has changed. Today, a borrower might call his current lender or bank for a loan only to be told that they are not lending at this time. Brokers also are encountering difficulties in finding a bank that will buy loans from them. Money is available, but it is harder to qualify for a loan and much more expensive to borrow.”
Spreading the Spreads
Another effect of the intense competition in the market was an unnatural manipulation of the credit spreads. “This competition for deals did drive the spreads to a low point that we had never experienced,” said Starling. “Many of these loans barely met the profitability model.” Bank of America’s Amalfitano agreed. “That competition resulted in compressed spreads and poorly structured transactions, including over advances on loans, interest-only structures, and limited and non-recourse financing. To make matters worse, the aircraft being financed have been selling at premium pricing often in excess of the original cost.”
Most of the lenders who spoke to AIN believe the spreads will increase in the coming years, tipping back in favor of the lenders. “I think what you are going to see for the foreseeable future is a much better spread for banks, with less compression, because the big banks that drive the pricing all have various issues they are dealing with, and with all the write-offs that are being taken in various areas, they need to offset that some way, and this is one of the few areas they have,” said Qualey of 1st Source Bank. “When you look at banking for the next year, all of us are going to pay a lot higher premium to the Federal Deposit Insurance Corporation than we have because we have to pay for the other banks that failed, and obviously we have to pass that on.” Wells Fargo Equipment Finance v-p Dick Ramsden believes that well capitalized lenders, while fewer in number, will continue to offer competitive rates while “thinly capitalized lenders have to put a high premium on their capital and they have increased their spreads dramatically.”
With the lenders being less aggressive overall, most believe the law of supply and demand will become more evident as aircraft purchasers scramble for financing. For example, Mary Schwartz, global head of aircraft finance for Citi Global Wealth Management, explained, “With balance sheet restrictions, bad earnings reports and capital not readily available for lending, there are fewer lenders searching for deals, spreads have increased dramatically, and terms are not as advantageous as they were a year ago. This has become more apparent in the last two months. We believe that this will continue for at least another year and possibly longer.” RBS Asset president Marc Paulhus agrees with that prediction. “I expect next year that there won’t be as much compression to no compression, where you will actually have commensurate returns for the appropriate risk.”
The Effect on Older Aircraft
With the used business jet inventory currently at an all-time high, the days of their selling at prices above those of new aircraft seem–at least for the near future–to be done. According to statistics from Jetnet, as of October 2,600 jets were on the market, a 47-percent increase from the same month two years ago.
With such growth, lenders not surprisingly are keeping a close eye on pre-owned aircraft values, as well as factoring in other considerations such as costs associated with the possible resale of repossessed aircraft (see “When the axe falls” on page 22). “It’s not purely just looking at the value today and saying OK, what’s the bank’s or financier’s exposure?” said Wooller of aviation finance advisory firm International Bureau of Aviation Group. “It’s also saying actually this could take us six, nine, 12 months to sell, so what are the storage costs that we then have to amortize into our overall exposure before we actually dispose of the aircraft. It follows suit that if, quarter-on-quarter, the trend is going down the two extremes are moving in opposite directions. Your security value is going down, and maintenance and storage costs are driving your exposure up. It’s a nasty equation if a financier gets his numbers wrong.”
Concerns about such equations have caused many lenders to scrutinize more closely the type and age of aircraft they will finance. One rule of thumb currently in play seems to be to avoid deals where the age of the aircraft plus the term of
the loan exceeds 25 years. “It is reasonable to expect that older jets–20 years and older–will be difficult to finance as the experienced aviation lenders all remember the significant deterioration in turbine values of older aircraft in our last industry recession, which began in the fourth quarter of 2000,” said Bob Kent, president of Scope Aircraft Finance.
“Some lenders do not finance older aircraft because in a slow economy, with aircraft values declining, older aircraft values drop first and take the longest to come back,” said PNC’s Starling. “You might have a low-time older aircraft that is in excellent condition, but if 20 percent of the fleet is for sale, [the lender if necessary] will not be able to get top dollar and [the airplane can be expected] to take much longer to sell.”
Older aircraft also might not include the latest in upgrades, generally making them the least attractive to buyers and therefore also unappealing to a lender that might someday find itself owning them, explained Center Capital’s Renna. “One must consider the costs of upgrading an aircraft to operate in today’s airspace and compete with features in later-model aircraft. Add to that a major maintenance event, and you could very likely have an aircraft that’s simply not worth the investment. As a lender you must always put yourself in a position of possibly remarketing an aircraft, and a prudent lender does not want to go to the market with an inferior, older aircraft.”
But while there are such considerations, many of the lenders interviewed still expressed a desire to examine deals on a case-by-case basis. GE Capital Solutions corporate aircraft president Dave Labrozzi said, “When asked to finance aircraft that are more than 20 years old, we tend to be more selective of the entity’s credit, and here our experience with such transactions has been very positive.”
Yet some feel the lenders’ caution is only part of the equation when it comes to hesitation on current used aircraft purchases. “I don’t think the road block is the loan. If someone really wants to do a deal, they can find the money,” said aircraft broker Collins. “The road block is that people really don’t want to do the deal right now. Everybody wants to buy at the bottom of the market, but with the volatility in the stock market and concerns about the economy, they’re not sure if the bottom has come.” He added, “The state of the marketplace has been horrible. The number of calls that I have been getting has been very low, but not because of the quality of my inventory. After this last crunch in the marketplace, when the Dow dropped 800 points, my call volume doubled, maybe tripled. I had a gentleman come look at my GIV yesterday, and I have a guy who I’m working with to put together a letter of intent on my Hawker 800SP. That leads me to believe that the bottom is here. The offers might be lower than I would like, but they are making offers.”
What Does the Future Hold?
The entire industry seems to agree that a slowdown is coming. At this year’s NBAA Convention, staged in October against a backdrop of financial uncertainty, no blockbuster orders–a mainstay of recent conventions–were announced, as sales slowed to a trickle. However, the market has changed since the last downturn in 2001 and this time OEMs are betting their extensive backlogs will see them through the rough times ahead. Nonetheless, they are beginning to prepare for the worst. Citing “very serious challenges facing the company due to the unprecedented worldwide economic decline,” Hawker Beechcraft last month announced it would be reducing its workforce by 5 percent, while Cessna chairman, president and CEO Jack Pelton informed employees that “changes to our 2009 production schedules, as well as reduced aircraft utilization, will result in a need to reduce our current workforce level.” The company will increase the number of Mustang deliveries and decrease production on some of the other Citation models next year.
Most of the lenders who spoke to AIN expressed belief that there could certainly be some changes ahead for the business aircraft industry after the surge seen in the last several years. “The market for new aircraft deliveries should remain quite strong through 2010 as the result of strong backlogs enjoyed by the major airframe manufacturers,” said Bank of America’s Amalfitano. “At the same time, new orders have already started to decline as a direct result of rising [used aircraft] inventories. In fact, inventories through the fall of 2008 are at a five-year high and until these inventories are reduced, new orders for business jets will be negatively impacted. Another concern of the OEMs will be the risk of order cancellations by customers unable to obtain financing.”
Labrozzi of GE Capital said, “Historically, there has been a high correlation between corporate profits and aircraft deliveries, so a decrease in additional new aircraft orders, given the current economic turmoil and related corporate profit reductions, is not unexpected. However, with backlogs at an all-time high, the OEMs are in a strong position. Having said that, used aircraft values, which–during the past two years–have exceeded new aircraft values for certain models, will undoubtedly be negatively impacted, and we’re already seeing this take place.”
“The market is not as strong as it was last year,” said Citibank’s Schwartz. “Inventory has increased, prices have come down and aircraft are remaining on the market longer. We see a softening that will negatively affect aircraft sales, which we believe will continue, at least into 2009. The strong backlogs, some out for three to five years, will help to sustain the market, even if 50 percent went away, which is unlikely, there will still be a backlog remaining.”
Some observers, such as RBS Asset Management’s Paulhus, think there will be a marked differentiation in any possible slowdown. “I don’t know that you will see that much turnover in corporate aircraft; I’m expecting a higher impact on the
high-net-worth individual, who has really driven the market. The corporation’s use of a jet is much different from a single individual’s use, whether he’s using it personally or professionally, and so with the impact that the economy has on some of these high-net-worth individuals, I think you will see a difference in these two markets that drive the corporate jet industry.”
“Aircraft are no different from anything else in terms of capital goods,” 1st Source Bank’s Qualey told AIN. “People are not buying cars, they’re not buying trucks, they’re not buying houses, they’re not buying airplanes, they’re not buying much of anything, but that’s a very short-lived phenomenon. It’s the health of the bottom line of the operating companies that drives aircraft purchases and liquidations. I do think the market is going to be a lot slower next year, just from what we are seeing in the way of trends.”