Advice for lessees and lessors: watch those rates! - interest rate increases - Column

Railway Age, Jan, 1995 by Anthony Kruglinski

The best way to cope with

long-term inter- est rate fluctua- tion is to try to remember how you behaved per- sonally the last time you went shopping for a home mortgage in a hot market.

Did you act or fail to act at any point m the process because you felt rates were likely to improve or worsen in the near term? Most important, whatever you decided to do, do you feel you made the correct decision, in retrospect?

You didn't know it at the time, but you were also developing, or refining, your ability to make the right decision in regard to any rail equipment financing that may be in your future. And if you're a funder, you may have a personal understanding of what your railroad borrower or lessee is going through as he or she is getting ready to throw the dice in what's really an inter- est rate game of chance.

This writer has been a participant and observer for over a decade in the work- ings of the fixed-rate, long-term funding system that supports the borrowing and leasing needs of railcar and locomotive users. I've seen high rates, low rates, and rate movements of all types. Never have I seen the level of rate concern that current- ly pervades the debt and leasing markets. Providers and users of long-term fixed rate money are handling their rate negotia- tions as if they were juggling fine, trea- sured family heirloom crystal. Nothing is taken for granted. No one is willing to "hold" (the funders) or "float" (the bor- rowers or lessees) the rate assigned to their deals for longer than a few days without some kind of additional compen- sation or protection.

Everyone knows when the next Feder- al Reserve meeting to review rates is scheduled. And everyone has already made their best guess on what the Fed will do. Lessors, lenders, and railroaders have become Fed watchers and rate seers. Why? Remember the last time you figured out what a quarter of 1% meant on your home mortgage? The calculation is almost as easy and the result much more dramatic

when you're analyzing the cost of the same 25 basis point (100 basis points is 1%) movement in millions (or tens of mil- lions) of dollars in railcars and locomo- tives.

And while long-term, fixed-rate equip- ment money is somewhat different from long-term mortgage money, they're both driven by rate movements in long-term federal debt obligations. For this reason, if you've paid half a mind to the upward climb that 15-year, 25-year and 30-year mortgage rates have gone through in the last 12 months, you also have an in-depth understanding of the climate in the long-term equipment funding marketplace.

With few exceptions, most railroads and operating lessors regularly consider long-term finance leasing as an alternative to straight debt financing or a cash pur- chase when it comes time to belly up to the bar and pay today's higher prices for new railcars and locomotives. Railcars and locomotives are long lived assets, the

acquisition cost of which can be readily determined and locked in place with a long-term finance lease. When properly structured, such lease financing can mimic the "control" aspects of ownership (including purchase options), yet offer the off-balance sheet accounting of an operat- ing lease.

And thanks, in part, to a dissatisfaction with investment opportunities in the air- plane lease market (airlines are still in credit disfavor), railroad equipment lease deals are in hot demand by lessors. Hot demand and a tight market are translating into some of the lowest lease rates seen in years--but not as low as last year's rates.

Why? Most lessors fund their long-term needs in some long-term market. Those that don't (for instance, banks with a mix of their own short-, medium-, and

long-term deposits) look at the long-term debt market to price the risk and reward of any mismatch in their funding.

So, if I'm a profitable industrial or institutional funder seeking a tax shelter, without my own source of long-term funds, I have to borrow when I make my long4erm investment in purchasing rail- cars or locomotives for lease. For this rea- son, I'm as concerned as a long-term lender when I quote a lease rate for 15 or 20 years. If long-term debt rates move upward, and if I (as lessor) haven't locked in the source of my funds (and the rate for them), I'm in a world of hurt.

Interest and lease rates are higher than last year and the market is sending out predictions of yet further rate increases. Assuming that I buy into this analysis, what are my options? First, I can look for lessors willing to do my deal at a locked future rate. Why would anyone do this? Because they have their own long-term, stable source of funds (like an insurance company), or because they feel rates will fall before the funding date.

Or, I can seek a lessor willing to engage in an interest rate swap or other derivative transaction to protect himself against rising rates. I know I'll probably be paying a higher rate to compensate the lessor for taking the risk that interest rates fall. My lessor has to pay compensation to the swap "counter party" who protected him against a rate increase, but I'll still get my locked rate.