Airplanes and Basle and credit—oh my! - Financial Edge - Basle Accord and equipment leasing risk

Railway Age, May, 2003 by Anthony Kruglinski

What do the state of the U.S. airline industry and a Swiss city on the Rhine have to do with coal cars and locomotives? A lot, if you're looking to finance those coal cars and locos in today's tax leasing marketplace.

Why? If you or your financial advisor have been in the tax-affected leasing marketplace in the last weeks and months, you may have learned more than you ever thought you wanted to know about the troubles of America's airlines. A funny thing happens when large banks, insurance companies, and industrials that invest in tax leases as lessors to manage their own tax positions are faced with bankrupt airlines: intense dissatisfaction. They wind up essentially throwing the keys to the planes on the owner/lessors' desks, as they don't need fleets of commercial jets and have few, if any, places to redeploy them. The lessors are no longer getting rent. And the planes' value is less than the amount of the unpaid debt in most transactions. This, in turn, means the lessors' option to pay off the debt to get clear title to the planes is usually not a good economic choice.

What do the lessors then do? They pick up the keys to the planes and toss them on the desks of the lenders who put the debt in the original leveraged lease transactions. That's right: The lessors essentially write off their investments and walk away. This ruins the days of the various credit and investment executives who signed off on the lessors' equity investments and the lenders' debt placements in these transactions to begin with.

What happens to the next guy with a capital equipment need seeking financing for a 20-year tax lease? in more and more cases, these potential lessees are finding out that that the lessors' lights may be on and the lessors' leasing professionals may indeed be at their desks--but that the front door is suspiciously locked (or the price of a key is inordinately high!).

It gets worse. Not only are a number of traditional U.S. tax lessors having to deal with the fallout from the nation's airline credit problems, they're also having to deal with an international financial regulatory initiative: the "Basle Accords." While Basle (where the international meetings took place) is at present only a statement of principles and purposes designed to be the basis for the evolution of safer worldwide banking and lending laws, it's something looming on the horizons of all U.S. lessors. Why? One of the things Basle has done is to set, as an international financial goal, the accurate evaluation of financial risks being taken by lenders and lessors and the proper allocation of risk capital to various risks being undertaken.

How do Basle and U.S. commercial airline problems relate to each other? One view is that all long-term (15 to 20-plus years) equipment lease transactions may be inherently more risky than had been thought, simply because of the inability of a lessor/owner to accurately evaluate any risk that far out in the future. And if a 20-year airplane finance lease has proven to be surprisingly risky, why not view similarly long rail deals in the same light? And (here's where it all ties together), if long-term finance leasing is more risky than originally thought, perhaps, under Basle, greater amounts of equity capital should be allocated to doing such risky business. If this were to be done, the skinny investment yields (in some cases 5% or less, if everything goes right with residual assumptions) that tax lessors put up with to obtain the tax benefits of equipment ownership under long-term leveraged leases will drop to levels that are barely visible.

Clearly, the view expressed above would be cataclysmic to the U.S. finance leasing industry. It could, if carried to its logical conclusion, shorten lease terms and cause rents to dramatically increase. Ouch!

On the other hand, you should be saying about now, "Hey, what proof is there that a locomotive leased to a Class I railroad under a 20-year leveraged lease presents the same risks to an investing lessor as a 737 leased to a bankrupt airline?"

And, at least in this writer s view, you would be right in pointing that out. Certainly, the record built during the last 20-plus years would support a claim that rail leasing is not in any sense risky. But, having said this, neither you, nor I, are on the investment and credit committees of our favorite finance lessors and equipment lenders. And it's those guys whose days are being ruined by airplanes and Basle and credit--oh my!

Tony Kruglinski welcomes comments and controversy via e-mail at: thruglinshi@railfin.com.