Aircraft ABS shielded from Boeing 737 Max problems? Not so simple
Leasing has fueled the takeoff of the airline industry over the last 50 years, helping carriers around the world meet rising demand for travel and upgrade their fleets to become more fuel efficient. Planes are expensive; leasing gives airlines, particularly smaller carriers or those looking to expand quickly, an attractive alternative to making big, upfront investments.
Events like the grounding of the Boeing Max put some stress on this business model. The financial burden falls almost exclusively on the airlines, so much so that some weaker airlines could eventually face financial difficulties because of liabilities to lessors. In the most extreme scenario, this could affect their ability to make timely lease payments on other kinds of aircraft — including some that have been securitized.
Aircraft operating leases are typically what are known as “hell or high water” leases, meaning that lease payments must continue irrespective of any difficulties the lessee may encounter. So the aircraft lessors’ revenues are protected for the full term of the lease, generally up to 12 years. While hell-or-high-water leases cannot be canceled, if an aircraft is grounded for a prolonged period—typically more than six months—the airline is obligated to pay the a sum intended to make the lessor whole, usually within 120 days. Only when the lessor receives full payment is the lease is terminated.
Airlines have an “unconditional obligation” to continue lease payments on Max aircraft during the grounding, DBRS analyst David Laterza said on a webinar held in March. He said this obligation could pressure a carrier’s financial performance, resulting in “potential credit issues for the lessors including rising delinquencies or deferred lease payments.”
While airlines typically carry insurance-loss coverage for third-party liability claims or damage as part of a leasing arrangement, Kroll Bond Rating Agency does not believe the grounding would qualify as a claim. “Therefore, airlines with exposure to 737 Max aircraft could face earnings pressure, which is potentially credit negative depending on the extent of their exposure,” it stated in a report published the same month.
Even if this risk is remote, and there are still relatively few Max aircraft on lease, the prospect of making lease payments on planes that they cannot fly over an extended period of time is creating tension between lessors and lessees, market observers say.
Phil Seymour, chief executive of the International Bureau of Aviation, a U.K. consultancy, says airlines are likely to be negotiating for some leeway from leasing companies in the event of a prolonged grounding. “Obviously, lessors already have equipment placed with airlines, and those airlines will be requesting some sort of alleviation of not having to pay the lease rentals even though technically and legally they will still be liable for those lease payments,” he said. “I suspect there are conversations going on among airlines and lessors and correspondingly with Boeing over those commitments.”
However, such concessions from lessors would be unprecedented, analysts say.
Buy or lease, the grounding of Boeing’s 737 Max passenger planes has unquestionably been a costly exercise for airlines. Each day that their Max fleets are parked, airlines are losing $150,000 in direct costs per plane, according to the IBA. That tally includes expenses for storing the jets at major airports, paying for staffing costs for idled Max-trained flight crews, and re-routing and/or compensating passengers for routes changed or canceled.
Then there’s the cost of financing the jets. At an average monthly cost of $360,000, airlines leasing a next-generation Max 8 plane must shell out $12,000 a day, according to the IBA.
Fortunately there are still relatively few Max aircraft on lease, let alone in a securitization. A total of 37 737 Max aircraft, 34 of which have been delivered, are currently in five outstanding enhanced equipment trust certificates, or EETCs, a kind of sale-and-leaseback arrangement, according to Deutsche Bank. However, EETC investors are pretty well insulated from the impact of the grounding of these planes. In a March 12 report, Douglas Runte, an aircraft debt analyst and managing director at the bank, said these deals have several indenture provisions that insulate investors from the financial impact of regulatory action.
For aircraft already delivered, EETC indenture language requires principal and interest payments to continue for outstanding EETC issues “regardless of the operating status of the aircraft” or until a loss is declared, when a par call on the notes would occur, Deutsche Bank’s report states.
EETC agreements also establish the steps for an airline to return a plane deemed not flightworthy, usually a six-month time frame during which EETC payments also continue. (Airlines can delay this return schedule up to two years if it’s working toward introducing the plane into service.)
An airplane returned to a manufacturer would be followed by a pro rata call of the EETC deal at par to refund certificate investors, the report states.
Even for the 4,596 of Max jets on back order awaiting delivery, regulatory and transactional protections will also limit exposure for airlines and aircraft lease/EETC investors in the event of a long-term grounding or an actual ban of the jet. It is “inconceivable that an airline would accept delivery of an aircraft that could not be flown,” the report states. “In the event that scheduled delivery had to be delayed, the indenture provisions allow for some period of time between the original expected delivery date of the aircraft and when it is ultimately delivered.”
Carriers’ first recourse is likely to seek compensation from Boeing. Industry observers believe airlines received reimbursements from Boeing over the five-month grounding of approximately 50 787 Dreamliner series in 2013 due to a series of electrical problems related to on-board lithium-ion batteries. (None of the Dreamliner incidents included fatalities, but one of the events was an in-flight fire that forced an emergency landing for an All Nippon Airways flight in Japan.) Details on these types of undisclosed arrangements are usually held tightly to the vest by the airline and the manufacturer, however.
Aircraft lessors have taken delivery of 67 737 Max planes, according to Boeing sales date, but none to date have been financed in the asset-backed market. That’s to be expected, according to Deutsche Bank, since this model has only been delivered since 2017. “The typical aircraft ABS collateral pool consists of aircraft that are not newly delivered (and quite old),” the bank stated in a March report.
Kroll, DBRS and Fitch Ratings all confirmed that they do not currently rate any bonds backed by leases on 737 Max.
Lessors that have taken ordered and/or taken delivery of Max aircraft include GE Capital Aviation Services, Air Lease Corp. and Aviation Capital. None of the three firms responded to requests for interviews.
Even so, airlines that fly 737 Max them are included in ABS pools, though rating agencies are downplaying this risk, for now. “Smaller and financially weaker airlines with large exposure to Max aircraft could face disruption issues, including lost revenue and costs associated with sourcing replacement aircraft,” Fitch stated in a March 21 report. “These disruptions may worsen depending on the length of the grounding.”
Still, Fitch believes the risk of this causing airline defaults in ABS pools is limited. “In general, among the airlines flying the Max, those with the greatest exposure are larger and more financially stable,” the report states. “Further, we expect these airlines to pursue compensation from Boeing to offset costs incurred.”
In fact, the grounding of Boeing Max could result in higher valuations for alternate narrow-body models, at least temporarily, as airlines seek replacement aircraft. ABS pools rated by Fitch contain high concentrations (typically 60%-100%) of Airbus current engine option and Boeing next generation narrow-body aircraft. “If findings of ongoing investigations result in a prolonged grounding of Max aircraft, ABS transactions with near-term maturity or off lease narrow-body aircraft may benefit as on-lease aircraft are likely to be extended and off-lease aircraft placed quickly at favorable lease rates,” the report states. “This would help minimize downtime and costs while supporting ABS lease cash flows.”
Larger airlines would likely be able to absorb a long-term grounding of the Boeing Max. But smaller airlines, such as Icelandair that was operating six Max aircraft, “does not have the wherewithal to ensure that alternative aircraft are readily available such a substitution,” the DBRS report stated. “Its remaining fleet consists solely of older Boeing 757s.”
The demand is there for commercial aircraft, particular narrowbody planes of recent vintage. According to an April 4 report on single-aisle aircraft demand, DBRS analysts said fewer than 150 of 450 total aircraft available for lease have been built in the last decade (excluding 737 Max aircraft).
“Demand for many narrowbody aircraft types is very strong,” said Deutsche Bank’s Runte. “Planes that can be flown are being flown. Leases increasingly are being renewed rather than airplanes being returned back to lessors.”
For lessors themselves, the primary risk is from the halting of new deliveries. Of the nearly 5,000 Max on back-order, 1,000 are on order from leasing companies such as Avolon Aerospace, which is awaiting 102 Max planes, and Air Lease Corp., which has 92 Max planes on the way. Lessors cannot collect lease payments on planes that have not been delivered. And the longer they wait, the more revenue they forfeit on planes they have ordered but cannot put to work. Seymour said aircraft lessors have been counting the lost revenue ever since global aviation regulators grounded the Boeing Max on March 10. “If there are lessors out there thinking they would be [placing] 10 Max 8s in this quarter, and they can’t deliver those, they can’t earn that $300,000 to $360,000 a month,” per plane, he said.
Nevertheless Seymour believes that lessors are much better protected than the airlines themselves. The grounding “will be inconvenient, and maybe there’s a few hundred thousand dollars’ worth of costs toward them, but it’s not going to be tens of millions they’ve got to find in cash,” he said.
Where lessors may find relief, coincidentally, are from struggling airlines. Growing numbers of smaller airlines are going under, releasing from their fleets dozens of narrowbody planes after bankruptcy or liquidation. DBRS noted in its April report that 41 Airbus A320s and 17 Boeing 737NG models became available again for lease following the recent insolvency of four airlines (including 18 Airbus planes being surrendered from last week’s sudden demise of Wow Air).
Analysts are keeping an eye on India’s Jet Airways, as well. Lenders in that country are looking to fund a bailout of the struggling airline and provide a bridge loan to keep operations intact, but Reuters reported the interim loan has yet to fund an underwriter. DBRS noted in its report a potential Jet Airways insolvency could result in 79 narrowbody aircraft suddenly hitting the leasing market.
That could help fulfill demand for planes, particularly in the wake of the Max grounding. But could it be too many, creating an oversupply? “Market value and lease rate changes to the downside (in the case of oversupply of off-lease aircraft) could pressure cash flow,” the report stated. “Conversely, if demand persists or improves, or the 737 Max groundings are prolonged, positive value and lease rates for current single-aisles could improve performance.”