Managing risk is a full time job - railroad financing - Column

Railway Age, Feb, 1996 by Anthony Kruglinski

Just the other day I was speaking to one of my friends in the banking community about the possibility of his bank funding an equipment transaction for what I would best describe as an "emerging" or "story" credit (a weak credit that is gaining respect in the financial community). The collateral was made up of railcars subject to Section 1168 bankruptcy protection and the railroad involved had negotiated a good price for the cars, which were of a type currently in short supply.

From this writer's perspective, the risk of actual loss in the transaction was minute. No matter what happened to the railroad in the future, the equipment collateral would clearly provide the ultimate way "out" for the bank.

My banker friend, Dick, saw it another way. He began the conversation by semiseriously asking me: "Do you think we're in this business to take risks?"

"Frankly, yes" I answered, "if you're fairly compensated for taking them."

Unfortunately, joking or not, Dick saw it from another perspective and because the railroad was not a strong enough credit, he offered to lend only up to the scrap value of the cars.

In any case, there's little doubt that risk and the management of risk is what we're all about in the railroad finance fraternity.

For instance, every lender to the rail segment evaluates the "risk" of involvement with the industry in general and specific "names" in particular every time a new transaction is proposed.

Unsecured lenders look at the risk of nonpayment. Secured lenders look at this risk, and also regularly at the value of the collateral they would use to make themselves whole in the event of a default.

Lessors must make many of the same decisions, as well as decisions as to whether they will be able to continue to lease the equipment at reasonable rates on a reoccurring basis (operating lessors) or whether at the end of a lease term the equipment will be worth more or less than the assumed residual (finance lessors).

Borrowers and lessees make their own evaluations of rail finance risk: Do I buy or lease? Do I do a deal now or wait until my credit is better? Or if I wait, will rates or equipment prices go up?

What we'd like to suggest to you, the reader, is that you take a few minutes to personally evaluate the way you and your company evaluate the risks you regularly take in the railroad financial marketplace. Why? First, it's always healthy to take a break during a long hike to check your bearings. Second, and most importantly, we think that the volatility of today's railroad equipment and rail finance markets makes it even more important to keep things in perspective through regular reality checks.

Some market "players" are already doing this. For instance, several large finance lessors that were major participants in the rail equipment finance lease marketplace in prior years have cut back on the amount of rail business that they're doing today. Is the rail segment suddenly more risky than it was a year or two ago? Certainly not. Are equipment values and likely residuals an issue? Perhaps, but probably not for deals involving new equipment.

These lessors have simply cut back because they can't get the return on their investment that they once received. Why? Frenetic market bidding has driven the returns down as more and more lessors compete for a finite pool of rail equipment requiring lease financing.

These lessors have determined that the reward the market is offering for their investment is not consistent with either the risks they would be taking over 15 or 20 years with the credit or the residual risks at the end of the deal.

Here's another thought: Railcars of all types are in short supply. Rental rates are up and lessors are attempting to lock up these higher rates for longer terms. (By the way, we have no problem with lessors taking advantage of commercial opportunities such as this.) On the other hand, if a railroad sees a particular type of equipment as in short supply and needs it, any lease offer at market rates may seem to be OK, even if the lessee is locked up for longer than it would otherwise want or if there is no option to ultimately control (purchase) the equipment.

True? Perhaps not. Especially if the lease is a net lease and the equipment being offered only on a multi-year lease will likely wear out in whole or part over the new, longer lease term! Pricing the risk of maintenance in this deal might give the lessee reason to rethink the true value of the reward of having it for the term.

Finally, let's return for a minute to the funders and their risk/reward decisions. As an advocate for the most efficient funding for rail equipment deals, I have trouble finding fault with cheap lease and loan rates. The rail industry gets this preferred rate treatment because, in today's finance markets, it's earned it. And today's low rates are also supporting the new equipment building industry that's so crucial to the rail industry's success.

But as rail finance vets will tell novices--rates will go up eventually. Whether driven by overall interest rate inflation, or the eventual rehabilitation of other markets--such as the airline segment--rates will go up.