US Airways' bankruptcy filing could set a new precedent for enhanced equipment trust certificates (EETCs), as the structure has yet to be tested in bankruptcy court. However, certain investors, specifically the G class certificate holders, benefit from third party liquidity.

Additionally, all the US Airways EETC bonds have Section 1110 protection, which means the airline has 60 days to decide if it will continue to make payments on the notes or return the equipment (aircraft in this case). The situation, however, could get dicey. Factors such as declining aircraft resale values and the absence of legal precedent are at the forefront.

At the very least, complex airline restructurings can take years to wind through bankruptcy court, and there are many hurdles along the way. It's unclear yet how the EETCs will be treated in bankruptcy, and holders are bracing themselves for what might be a not-so-pleasant outcome.

What's in it for

EETC holders?

With Section 1110 protection, if US Airways doesn't make payments due, it will be required to liquidate the planes to pay the debt. "Because there is a lot of volatility in old aircraft values, it will be a real challenge to do that in this market," said Joel Denney, an airline analyst at US Bancorp Piper Jaffray. "This will be a good test of the structure to test how it performs in a liquidation situation."

Certainly, the collateral will be a major factor in the restructuring. While there is no concern about having to test the Section 1110 code on the aircraft that remain as part of the fleet, there will be pressure on the equipment that will be put out to pasture, said John Addeo, an investor at Mass Financial Servicers.

"It may be the creditors will have to claim the aircraft and that's a cumbersome problem; my sense from 5,000 feet is that it could get messy," he said.

The value of the EETCs will depend on the value of the collateral backing them. If EETC holders learn that the equipment they have as collateral is worth little, the cost of capital for airlines will skyrocket.

"If the belief has been that [investors] would always be paid with EETCs and that no longer is true, the cost of capital will go up even more than it is right now and justifiably so, because no one will finance these airplanes," said Arthur Calavritinos, portfolio manager of the John Hancock High Yield Fund. "If you're an insurance company holding a plane that's no good and you bought it with 20-to-30 year money, you're not going to be too happy when you have a big position in these planes and they've become obsolete. The validity and efficacy of the EETCs will definitely be tested in this case."

As it is, the airline industry has been down in the dumps for a while, and its situation was worsened after Sept. 11. If it's determined that the collateral backing EETCs is worthless, no one will want to buy the notes.

"This is more serious than people think - this industry affects more industries than most. You have to consider those who supply parts to aviation or make alloys and the job creation is huge, so repercussions to the economy are a really big deal," Calavritinos said.

The extra "E"

The extra "e" for "enhancement," the financial liquidity provider that backs the notes, is also an issue, and investors need to see how it holds up in bankruptcy court.

Ideally, the financial liquidity provider guarantor should repurchase the bonds at par immediately, but that will not happen because of the structure of the notes. Only the triple-A rated G tranches would be entitled to that.

The second best scenario would be one in which US Airways doesn't make the payments but the liquidity provider honors interest and principal payment on the airline's behalf.

The insurer would guarantee the recovery of interest and principal payment on G tranches. According to a holder of US Airways EETC notes, the likely outcome is that the liquidity provider will make the next three coupon payments, depending on the tranche, but if US Airways decides during bankruptcy proceedings that it doesn't want the aircraft and "kicks" them back, debtholders would be stuck with them. If they're worth less than the debt, investors would still be losing out. It would be more like a loan that has to be paid back because, in bankruptcy court, the lender would be in line ahead of the bondholder, sources said.

Still, a majority of the EETCs have aircraft that US Airways will continue to fly and in that case, the airline will have to continue to make payments on them - although perhaps not on a timely basis.

"You will expect that they'll pay on the EETCs of the aircraft they want to continue flying, and I expect they will," Denney said.

US Airways has secured DIP financing to get the company through the restructuring period and the goal is to get rid of old collateral to be more efficient and keep those that fit better with their revised route network.

It is a wait-and-see situation now, but the market will know in roughly 60 days what will be decided. "We'll know which aircraft they want to keep and those they'll reject. They might keep some of the Boeings but we don't know; they may need more than just the Airbuses to continue their operation," said Betsy Snyder, an airline analyst at Standard & Poor's. "It depends on what the holders of the debt are willing to give up; they're either stuck with [the planes] parked not getting anything from them, or US Airways with them and not getting what they were getting before," she said.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.