March 2010 Bright Fundamentals Once the Fog of Economic Uncertainty Lifts The global financial system has navigated uncharted waters since the financial crisis fully took hold in 2007. At the core was a loss of investor confidence over the intrinsic value of a broad array of financial assets. Confidence was undermined in significant part by the recursive relationship that had developed between (rising) asset prices and the real economy. In particular, rising asset prices accounted for ever-increasing growth in consumer spending, which in turn drove further increases in asset prices, and so on until the music stopped. This feedback loop of ever-rising asset prices was induced, directly and indirectly, by a variety of factors. The mass-popularization of phenomena such as online trading accounts and aggressive consumer lending products directly fostered a climate of speculative activity in the financial and real estate markets. Indirectly, the current generation’s lack of first-hand experience of suffering through a significant and extended economic downturn fostered an appetite for excessive risk-taking. Against the backdrop of a broadly troubled financial system the aviation finance sector has remained a virtual safe haven. This contrast is perhaps best seen by comparing the relative strength of the commercial aircraft operating leasing sector to the financial extremis experienced by many of the financial institutions that own such leasing companies. Similarly, though public data is only partially available, it would appear that loans secured by commercial aircraft have performed well relative to many subsectors of the commercial credit markets. However, the lack of global liquidity has had its impact on aviation finance—notably a significant curtailment of commercial bank lending activity and a temporary lack of access to new issuance in the public capital markets. These factors have led to concerns about “funding gaps” arising in connection with financing of new aircraft deliveries, as well as to worries about a collapsing of aircraft residual values due to global air carriers shedding large portions of their in-service fleets and order books to circumvent liquidity shortfalls. However, these concerns have yet to come to pass and it is increasingly likely that the aircraft finance sector will prove resilient once the economy and financial sector further recover owing to a unique combination of fundamentals.
The global utility and fungible nature of commercial aircraft is well acknowledged. This is of benefit to the asset-based financier because an aircraft can be re-deployed into regions of the world exhibiting greatest demand. However, what is perhaps of greater significance in the “new normal” economy is the fact that global assets such as commercial aircraft are buoyed by the unprecedented growth dynamics of emerging markets such as China and India. Under the “new normal” economic scenario a number of mature Western economies including the U.S. are at increased risk of economic underperformance over the near term due to ongoing deleveraging by consumers and the financial sector, high fiscal deficits and aging demographics. However, the growth dynamics for air travel associated with the burgeoning middle classes in the major population centers of the world such as China and India should far outweigh any negative shadow cast by exhausted consumers in economies such as the U.S. Supply fundamentals for commercial aircraft are also beneficial for the asset-based financier. Though barriers to entry into the commercial airline sector are low, the barriers to becoming a global aircraft manufacturer are quite the opposite. These barriers extend well beyond the ability to engineer a machine that is superior to what can be produced by the industry incumbents. The barriers also include the ability to provide global aftermarket support such as training, access to spare parts and the like. They also encompass solving the chicken-and-egg problem of aircraft financiers that are increasingly particular about financing only the most popular or “liquid” aircraft types. Such barriers further include overcoming the frictions associated with introducing a new aircraft type into an air carrier that has an infrastructure built around incumbent types . The enormous barriers coupled with a limited number of aircraft manufacturers generally results in a rational supply of new aircraft coming into the marketplace based on projected long-term growth in air travel. By way of contrast, a lower-barrier sector such as cargo vessel manufacturing has resulted in a situation of literally dozens of new shipyards competing for market share. This results in the potential for highly unpredictable and unjustifiable changes in supply such as the 25% increase in bulk carrier vessel capacity incurred in 2009. This increase was far in excess of long-term growth rates in demand and occurred at a time when the U.S. and Europe were in recession. SkyWorks’ proprietary analysis of aircraft trading values shows that trading prices are interdependent upon relative growth rates in supply and demand. Hence the aforementioned situation where supply growth is severely out of synch with underlying demand levels can result in extreme volatility for asset values. The duopolistic competitive situation of large aircraft manufacturing on the other hand should not generally result in supply increases that grossly exceed long-term growth in underlying demand. As such, the prohibitive barriers to entry in the commercial aircraft manufacturing sector are of benefit to the aircraft financier. This should outweigh any impact attributable to the generally weak state of finances for many commercial airlines provided that a lease or secured loan is conservatively structured. A further fundamental in support of aircraft finance relates to the intrinsic nature of commercial aircraft. In particular, commercial aircraft receive favorable tax advantages in many jurisdictions, and also have an embedded inflation hedge. The tax advantages are generally attributable to the fact that the economic life of a commercial aircraft typically spans two to three decades whereas it can often be depreciated for tax purposes in less than ten years. This results in the opportunity for an owner of such an asset to receive a significant deferral in taxable income. Inflation protection arises from the fact that aircraft have significant inputs of raw materials and labor, each of which will customarily increase with general inflation. History has shown this effect with highly inflationary periods resulting in higher than average increases in both selling prices of new aircraft as well as residual values of used aircraft. Given that the state of the market is such that a lessor can generally use “uninflated” residual value assumptions when calculating required rental rates, there is virtually a free inflation hedge currently embedded in this asset class. These two intrinsic fundamentals are very timely when considering that a number of the developed economies are pursuing extraordinarily aggressive monetary policies to avoid entering a deflationary spiral. At the same time many of these nations are mounting unprecedented fiscal deficits. The monetary phenomenon that is underway is causing increasing concern about the specter of inflation being unleashed. Likewise, the current fiscal deficits that are being compounded by rising entitlements and decreasing tax receipts due to aging demographics portend substantial increases in marginal tax rates for the wealthy in the near future. A comparison of current times to recent U.S. economic history perhaps draws greatest parallel to the 1970’s. That era represented a golden age for aircraft leasing, as inflation protection and tax shelter were highly valued investment attributes. Given the parallels to such period that may be forming we may even see the re-birth of a broad tax-based aircraft leasing market
Though much uncertainty persists throughout the global economic and financial system including the potential for further increases in oil prices and the need for the aircraft manufacturers to carefully weigh production targets , the current dynamics of the “new normal” favor the aircraft finance sector. Although the airline sector itself still has yet to establish broad and consistent profitability, the aircraft finance sector already made a shift from a credit-based market to an asset-based market during the previous downturn. The asset-based orientation for the aircraft finance sector has in turn resulted in relatively limited distress heretofore in the most recent downturn. Provided the economic recovery continues to gain strength, it is likely that market observers will look back and see that the aircraft finance sector performed notably well through a period of unprecedented economic and financial challenges. This favorable track record combined with the attractive fundamentals discussed hereunder portends a resilient aircraft finance market to come in the near future. Click Here To Download This Article In PDF Format 1. Excluding loans guaranteed by export-credit agencies. 2. It should not be entirely surprising that the negative savings rate in the U.S. was unsustainable. 3. For example, the ability to use pilots interchangeably on aircraft that share a “common type rating”. 4. Source: SSY Consultancy & Research Ltd. 5. Aviation is of course subject to large short-term fluctuations in demand from time to time that will generally result in fluctuations of aircraft trading prices; however, it does not face large swings in supply that would further exacerbate asset price volatility. 6. Although few competitors in large aircraft manufacturing results in a rational supply environment, a counterpoint is that such manufacturers must be cautious in setting production rates as it is difficult to make large reductions in production output due to unique supply chain complexity. 7. This is evidenced by the fact that maximum terms for secured aircraft loans provided by commercial bank lenders have shortened to a maximum of 10-12 years on average.
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