5 B.1 Doug Runte - video notes ISTAT on aircraft funding PDF

Preview

Summary

video notes ISTAT on aircraft funding...

Description

1 5 B.1 – Doug Runte video – Aircraft Funding Doug Runte talks about the evolution of aircraft financing. Mr. Runte, CFA is the current Treasurer of ISTAT and a very experienced and knowledgeable investment banker. Dr. Guzhva: Hi, I'm doctor Vitaly Guzhva, Finance professor at Embry-Riddle Aeronautical University, College of Business, Daytona Beach campus and this is a video series for ISTAT University, where we discuss relevant topics with industry professionals relevant to aircraft leasing and finance. Today we have Doug Runte, CFA who works with the Deutsche Bank. Doug, can you please introduce yourself and say what you do at deutsche bank. Doug: Of course and thank you very much for the opportunity, to be here today. ISTAT University is a very important program, we are very glad to support it, and I am happy to be part of it in a very small way. By way of background, I cover the aircraft finance sector of Deutsche Bank on the debt side. I have been at Deutsche Bank for approximately five years. I have always been involved in the fixed income side of the business. I started out more than a few years ago as you might be able to tell from my gray hair, in fixed income research for a predecessor firm that is now Citigroup. I covered a wide range of industries everything from autos to auto suppliers to aerospace to basic industries. However, one of the sectors I have always had the opportunity to cover in great detail, is transportation and as the sector has grown and its capital markets have become a more and more important part of aviation finance. I have increasingly directed and focused my efforts at aircraft finance. So I started out on Wall Street doing fixed income research and a broad variety of sectors focused on aviation, put a little bit of time off for a business degree, which perhaps we can talk about later versus a CFA and came back after business school back into Wall Street working in research covering aviation. For me it is a great opportunity as a research professional of Wall Street you have a wonderful opportunity you get to talk to some of the smartest, most interesting people in the business. Everything from leasing company CEOs, Airline CEOs, CFOs, investors who are investing in the business on a fixed income in the equity side. It is just a fascinating opportunity to be in touch with the industry from a variety of viewpoints. Dr. Guzhva: Yeah, you mentioned CFA and I know lots of our students they're pursuing CFA, some of them like level two candidates. Can you please discuss a little bit if it helps you in this business and at what degree it would sound? Doug: Well, first I would say is the CFA is a lot of work, so be prepared when you're taking the first step that you do take the step, be all in or not at all, but I do find it very valuable or when I was doing

2 it in particular I found it very valuable. It is a great way to increase your skillset. It's a great educational program with a lot of self learning obviously, and it's also an important credential, especially in the international community the non-US community. It is a sign that you have developed a level of expertise and understanding in financial analysis. I have both the CFA and CFA Charter holder and an MBA. I did the CFA Charter holder first and then an MBA. I find them two different but complementary programs. MBA is broader, tends to provide you with a broader range of skills and learning CFA obviously it's quite focused on finance. Dr. Guzhva: What's your relationship with ISTAT so you've been involved with ISTAT for a long time. Doug: I've been attending ISTAT conferences for well over a decade. I could remember the days when ISTAT was quite small, a couple of hundred people maybe. I have been involved as a speaker for quite a few years as well and five years ago I ran for the ISTAT board, made it to the board and I've been serving as a member of the board since that time. For three years now, I have been treasurer of ISTAT and I have been privileged to watch the growth and expansion of ISTAT continue. We had a lot of illustrious predecessors on the ISTAT board that built an incredibly strong foundation and we're very much standing on their shoulders but ISTAT over the last few years has grown enormously and one of the things we're especially proud of and very mindful of, is our “obligation”. It is probably not the right word to use because we love doing it. Obligation sounds like a burden, but our obligation and our desire to help people into the business, we all love the business very much we like sharing our information and our knowledge we'd like to pass that on and things like ISTAT-U and your University and videos like this, it's all an opportunity for us to to give back to an industry that we really love. Dr. Guzhva: We really appreciate it & our students appreciate it. We have some students here & this is the best thing about the program that they watch the video that help them. Doug: Yeah, I think one of the highlights of the gala dinner or even just casual interactions are at the conference when you have an opportunity to run into a student run into someone who's looking at something with fresh eyes, new eyes, maybe with a level of enthusiasm that occasionally after 28 meetings and a day and a half maybe, I find myself getting a little bit tired and then you remind yourself just what a wonderful opportunity we have. At an opportunity to sit, not very long ago with the CEO of one of the largest aircraft lessors in the world, spend an hour in them talking about the industry, I mean what a remarkable opportunity and I would like to be able to share that so thank

3 you for this opportunity. Dr. Guzhva: Thank you. So now let's move to our topic so we would like to discuss across finance of capital markets sure can you please enlighten us a little bit how Airlines and leasing companies make decisions on how to finance large purchases with aircraft. Doug: That is very good question and it has both a long complicated answer and probably a shorter simpler answer, which is a bit of a gross simplification at a very simple level. Treasurers, CFOs and ultimately CEOs are looking for the most attractive, cheapest, long-term source of funding that they can find and an aggregate basis to fund their business. What that means is they are looking for targets of opportunity, places where they can find capital available on a risk-adjusted basis, that's more actively priced relative to elsewhere. Capital markets is just one tool that they can potentially access and within capital markets they are obviously as well perhaps talk about different avenues to access the capital markets. So, a treasurer ultimately has a number of different levels that he can pull, a number of different avenues or opportunities that he can draw upon to raise funds. But ultimately it comes down to the cheapest form of capital at least cost in terms of more than just interest cost to the company, with another caveat, I suppose from that no one wants to put or should put their eggs in one basket as you are not always moving from space to space to constantly get the cheapest form of finance and ignoring everything else. I think most thoughtful treasurers and CFO's would look to diversify to stay in contact with all sorts of markets so that when one market becomes more expensive or even potentially closes, like we saw in 2008, that your friends in other places that you can approach, markets that are familiar with you that you can access, so I think thoughtful treasurers keep their hands on lots of different thought forms of financing. Dr. Guzhva: But we would like to stay with Capital Markets discussion right now and can you talk about the evolution, you know you have been in the industry for a while, so what did you see all the time new products were developed. Doug: Sure, I think probably the biggest development for aircraft finance in the capital markets was probably the EETC. A Genesis of the EETC was in the mid1990s, 1995 arguably perhaps 1994 depending upon which banker you talked to, about which deal came first. But in the mid-1990s, the EETC product came about and it has since become kind of the benchmark of capital markets issuance for Airlines to finance their new and re-finance their old aircraft. EETC is developed in a way, because airlines in aggregate around the world and particularly in the 1990s, in the United States were sub-investment grade companies, well sub-investment-grade in many cases B and even CCC rated airlines and a capital intensive industry that required lots of big shiny pieces of metal that

4 needed to be replaced regularly and where you needed to buy new ones to grow. To do that as a CCC rated airline in the capital markets with an unsecured bond issue would impose a punitive borrowing cost on the airline that just simply wouldn't work. So the EETC was really developed as kind of a bargain between issuers who wanted cheaper finance, investors who wanted a reasonable likelihood of repayment at par, and what happened is EETC as a secured corporate bond, backed by airplanes, the airline's effectively giving a mortgage on the planes, the investor has a mortgage to type a security as collateral if necessary, and in exchange the investor is willing to accept a significantly lower interest rate versus what they would accept for an unsecured bonders issue. Even today, where spreads of Godin generally tighter versus what they were back then, it is 100s of basis points and 100s of basis points over billions of dollars has a significant impact on the bottom line and your ability to borrow. So EETCs started in 1995, with a few hundred million dollars of issuance and they grew very rapidly. By 2000, we had hit a peak issuance level of over ten billion dollars, with almost every US airline accessing the EETC market by the Euro hose in one way or another. After 2001, we had a bit of an issuance hibernation. Airlines had stopped ordering airplanes after 9/11. They didn't need the EETC product. But as they reentered the market for new airplanes EETCs once again became a very important arrow in their quiver and we have seen insurance rise once again. Dr. Guzhva: But mostly that will be issued by US airlines. Doug: Right correct very good point. Dr. Guzhva: But why do they use it internationally? Doug: That's a very good point. The EETC was developed in the US, in part because the US has a very favorable bankruptcy regime for secured aircraft credits. Section 1110, which we may have heard from other modules in this series, provides very important protections for creditors and you take Section 1110, put it into a EETC, and it provides investors with a very high degree of principal protection. What's interesting with EETC is that, if you look back over the history of EETCs, back to 1995, beginning in 2001 with 9/11, you can safely say I think that just about every plague known to job hit the US airline industry and throughout all of those plagues of 9/11, global traffic decline, eventually SAARS, high fuel price, global recession, 2008 financial crisis and the others were a pretty difficult decade for the airlines, the US airlines in particular. Through all of that, the EETC structure worked with 99.9% of senior tranches of EETCs, receiving full repayment. That is an extraordinary record for airlines that generally had ratings of B or CCC and many of whom after 9/11, went into Chapter 11 bankruptcy. So US investors liked the product. Globally, the EETC did enter the market in the early 90s, people tend to forget but Air France and Iberia, both the EETC's early on but then thankfully bank finance was generally available at cheaper rates. So most of the European airlines continued to access the bank markets. In recent years, and part based upon the development of the Cape Town treaty, we've seen more and more non-US Airlines access the market. I think they are

5 looking to the capital markets through international or non-US EETC's for a number of reasons. One reason is simply Scale. The corporate bond market, the US corporate bond market in particular is I would argue the largest liquid source of capital in the world. Aviation debt as large as it is as important as we think it is, a tiny drop in the gigantic ocean of corporate bond issuance. Therefore, there is a ready appetite in the Corporate Bond market for new products. There is an interest in exposure to aviation and there is a respect for the fact that the EETC product has worked so well. Moreover, with Cape Town, investors, bankers and issuers feel that there is the ability to extend the success of the US EETC market. I will say success for both Airlines and Investors to extend that success into the non-US market. I spoke we are going to see that continue for quite some time. Dr. Guzhva: So one of the biggest features to EETC is like bankruptcy-remote structure. So typically it's set up on the trust like Special Purpose Vehicle. So to me, kind of I don't know why Bank finances would be cheaper for international airlines than EETC that provides better protection. Doug: That is a good point. I think it is fair to say that in the past & perhaps to a certain degree now certain airlines globally are viewed, especially by their home market banks is something more akin to a pseudo sovereign credit, in many cases than an independent standalone airline that might be allowed to fail. So there's a halo effect of sorts for certain airlines globally where there are unsecured corporate bonds trade or would trade at levels significantly better than what their simple credit metrics might employ. So a BB rated airline, looking at its balance sheet might in fact be able to borrow significantly higher because of its importance to a certain country, because of its non independent ownership structure for a number of different reasons and banks would like to lend against airplanes. So that all led to a market where bank finance was often available to non-US airlines particularly European and Asian carriers at a cheaper price than a disinterested EETC industrial. Dr. Guzhva: So we discussed EETC and kind of evolution. Can you say something about ABS and financing for lessors? Doug: Yes, there are two major users of the capital markets for aviation related debt. One is the “Airlines”, which we just talked about through the EETC market. Just by way of Scale, there have been about 50 billion dollars of EETC s issued in the capital markets over the last six or seven years in addition to the 60 billion or so of EETC debt. We have unsecured airline debt issuance as well. Paralleling that world of airline related issuance we have the “Lessors”. Lessors also access the capital markets and they access it in a number of different ways. They will access it wherever possible through the unsecured corporate bond market where covenants are usually/fairly loose and give the bus or a great deal of flexibility without being handcuffed on how you can use, move, or

6 release some of your aircraft assets. They will also look to the secured corporate bond market where they can get a lower interest rate because they are borrowing on a secured basis. But with that security that they're giving, come some constraints. So lower the interest more constraints. Continuing down the spectrum, we have aircraft ABS where EETC's are issued by Airlines either US or international. Aircraft ABS is effectively issued by a lessor, someone who controls a pool of airplanes, who is looking for a way to either finance them economically or potentially even to sell all or a portion of the equity interest in the collateral pool. so aircraft ABS has had a more diversified background in terms of history than EETCS. I have mentioned earlier that EETC's has a historically exemplary recovery rate. Aircraft ABS has a somewhat more difficult history and you almost have to break the market into generations of aircraft ABS. There were earlier deals done pre 9/11 that were large in scale, lots of aircraft, diversified collateral tools with the onset of 9/11 where EETC did exceptionally well while some of the aircraft ABS deals actually most if not all of them perform poorly which was surprising because to some because EETC & aircraft ABS were often rated comparably, prior to 9/11. So, there was a divergence and relative performance so where EETCs did well and issuance resumed relatively quickly. Aircraft ABS in part, because of bad performance and because of investor memory is an experience, went into hibernation a lot longer and it took investors quite some time to get comfortable with the idea of coming back to the market. We can talk about reasons briefly for that poor performance because I think it's a an interesting contrast, near full recovery for EETCS across-the-board, punitive damage to the aircraft ABS investor on the other side. EETCs were issued by usually a single airline in almost every case for relatively new fleets that was a critically important part of an Airline’s fleet structure and when the airline went into bankruptcy and wanted to reorganize, it reorganized around its most attractive fleet that it wanted to keep and those were the EETC airplanes. So they were affirmed, even as other parts of the capital structure, particularly labor were deeply hurt and restructured in the bankruptcy but because the EETC had new collateral, good attractive airplanes, core to the fleet, it did very well. Aircraft abs were issued under a different ratings regimen, where a great deal of benefit was given to the issue in terms of its ultimate credit rating, to diversification. So in a simplistic example, the rating of an aircraft abs deal would benefit if you took a pool of 10 737-800 aircrafts, which I think we would all decide it's one of the best along with the A320 aircraft, to finance. Under the lot of the rating agency methodology, having those ten seven three seven eight hundreds would be a bad thing because it was too homogeneous. So the way you quote, improves the collateral pool is to add 737-300s 737300 freighters, diversify the pool in different ways in this manner similar to the way credit card pools are diversified. The problem is, in the aircraft market especially, diversification away from goodness is not a virtue now as we make a joke sometimes, that if you take a scoop of ice cream on a cone and you sprinkle some dirt on it to diversify it, it is far more likely to taste like dirt than ice cream and it is

7 definitely not a better ice-cream cone. So after that experience, where diversification which works quite well in credit card pools, doesn't work so well with aircraft and other lumpier assets, aircraft ABS pools became more thoughtfully designed. They started to be issued with better collateral, with more conservative structures and more conservative advance rates, simpler structures in many cases and those deals generally perform quite well in terms of cash flow that came into the deal relative to what was expected. So over the last few years, as investors have gotten more comfortable we have seen the aircraft ABS market to grow and I expect we are going to continue to see that. However, I do expect that aircraft abs will be a smaller part of the market because it is much more complicated. A EETC, when you put away all of the acronyms, the abbreviations, the complexities, the indentures, it is a secured corporate bond. I have an obligation of a company to repay me on a fixed schedule back buying a plane mortgage to put it simply. Aircraft ABS is different. It is more complicated. It has large pool of aircraft with leases that expire by design, before the expected final maturity of the bonds that requires you to do far more complex modeling in order to determine your expected cash flow and expected likelihood of recovery. With that said, it is doable, the investor base is growing, we are adding dozens of new investors each year to the product, but I think inherently, given the complexity, relative to a EETC it will always be a smaller part of the market. But it is an important tool for lessors. It is one of the arrows that they have in their quiver of accessing the capital markets to ensure that an avenue of capital raising is always open. Again never put your eggs in one basket, never take a guess that the bank market is going to be ope...