If you double-dip your chip, “That’s like putting your whole mouth in the dip!”
A scene from one of television’s most iconic comedy series Seinfeld turns out to be apt advice at a time of Covid. You really do not want to poison the whole serving of dip, and should be exercising a higher degree of care when investing and financing aircraft. Which brings us to another kind of “DIP” or “liquidity facility” as it is known in the finance world.
A “DIP/liquidity” facility is a credit enhancement for structured finance vehicles like asset backed securities (ABS) and enhanced equipment trust certificates (EETC). It is basically an overdraft facility, there as a safety net to allow financiers to the structure some relief from the perils of lessees (airlines) not paying rents on time. It helps avert a sudden void in cashflows; interest payments, allows time to enable restructuring. This feature is helpful whether you are the investor in an EETC, ABS, or any other lending structure but what it can also represent false hope by simply postponing the inevitable.
In the world of aircraft finance, EETCs (sponsored by lessees) and ABSs (sponsored by lessors) have been a cheap, efficient and popular way to finance aircraft, especially older aircraft, with tens of billions invested in the sector. With the abundance of cheap financing, many were completed by the capital markets and mostly new institutional investors. These structures were possibly too successful as rates dropped and covenants/terms became more generous for the sponsors to the detriment of investors. You cannot just blame the sponsors, but rather the eternal search for more yield by investors in a low/negative rate environment. EETCs have seldomly defaulted and the airlines utilizing them have always elected to keep the assets, even when going through Chapter 11 restructuring. That trend held true until the recent wave of airline defaults and restructurings, particularly the LATAM Airlines restructuring. LATAM exemplified the non-U.S. airlines taking advantage of what was some of the most favorable financing in the industry. LATAM has rejected modern, highly prized assets.
What if the delay in enforcement is just a pause before the abyss? It amounts to piling on more debt by drawing down on overdraft facilities when there is really no hope. A statistic that should concern everyone in the industry is that aviation is said to be a $750 billion industry that is now borrowing $300 billion per year. There is no doubt there has been a fall in the market values of aircraft, with the larger movement skewed towards older technology, but that does not mean new technology is unaffected. What if values continue to fall and overdraft facilities are just creating the illusion of normality with the potential for greater losses some years down the road?
When overdraft facilities are in use, it is a warning sign for the debt holders. While helpful to the B and C junior noteholders, it is an annoying delaying tool for the A noteholders, who are more protected and want to get out. In the event of additional troubles, preemptive measures are not taken until the structure procedures are exhausted, which means the aircraft will incur parking, maintenance and storage fees, while aircraft values depreciate, missing potential opportunities to capture the remaining value.
The nature of the debt structure, with numerous creditor classes, means renegotiation is difficult or impossible, entrenched in legal and contractual procedures. The investors are not all equal, and their concerns are different and with more filings, I sense the desperation building up. Continuing on this current path, some noteholders will be wiped out or lose a substantial part of their investment, which was unfathomable until recently. This is not an untrodden path like structured products (mortgage-backed securities) during the financial crisis and pre-2000 vintage aviation structured products.
The lower noteholders can buy out the parties with superior rankings in most structures, but if they invested to receive a 6% coupon on their B tranche are they really going to invest millions more for 3% to 4% returns. In addition, a majority is needed to agree and that may not be as straightforward an exercise as it may sound. It is unclear under what time frame investors are able to realize, normalize the investment through the environmental improvements. To add to the dilemma, if it is a case like the LATAM EETC, where the airline has rejected the aircraft, there are other costs to recouping the investments, particularly reconfiguration and ongoing maintenance.
The A noteholder is high in the pecking order of cashflows, the inevitable delay is just another annoyance and further expense. They are receiving interest through borrowed facilities, but for how long and what about all the additional costs piling up? That bank paying the interest, who usually has a right to be super-senior, will soon be calling the shots, while all other noteholders become more junior and farther from the value gained in any asset sale. I hear investors talk of no problems, but these structures were not designed to catch up an additional 18 months of interest payments. It is not free money!
People may shrug their shoulders and argue that the values of the underlying assets in a EETC or ABS are conservative and eventually only the equity and lowest notes will be prejudiced. History shows that in aviation, as with other asset classes, even liquid investments are difficult to exit in a falling market. In a prolonged market rout, DIP facilities represent the proverbial can being kicked down the road and people continue living a fantasy because of the continued support from more borrowings.
If I were a lender, I would be reading my legal documents, as I would want to know what additional risks I am now obliged to take. Are there valuation provisions triggering an event of a default? Values are not near the levels when these transactions were consummated. Will the aircraft market recover, and when? I would say without a doubt that they will, as I believe in the resiliency of aviation, but the question is when, and what will be left for investors when all the debts are paid.