Airlines lose $40B from 2001 to 2005 / derivatives
10/2/2005
Jubak's Journal
Airlines and the epidemic of risk
Take a look at how broke airlines buy expensive airplanes, and you learn a little about derivatives and the risk that is endangering global markets.
By Jim Jubak
Like a broken record, Federal Reserve Chairman Alan Greenspan goes on and on about risk. Too many borrowers, lenders, consumers, bankers, bond investors, stock investors, hedge funds and pension funds are taking on more risk than they should. And the end, when it comes, won't be pretty.
To understand this epidemic of risk, why it is such a danger to the global financial markets -- and us -- and why the Fed can't do much about it except jawbone, you can try to master the details of the $8.4 trillion market for something called credit derivatives. Or you can answer one simple question about the airline industry.
The question: So how do these guys keep buying planes?
You'd figure that with four major U.S. airlines in bankruptcy, the two big plane makers would see some drop-off in sales. But no. Even though its customers in the global airline industry are on schedule to lose $8 billion this year, both Boeing (BA, news, msgs) and Airbus are headed toward what could be a record year.
The airlines are bleeding red ink, so they don't have the cash to buy planes. And why would anybody in their right minds lend money to an industry that lost billions this year, will lose more next year and, in its history, has lost more money than it has made? (The $40 billion the U.S. airline industry is projected to have lost from 2001 to 2005 more than wipes out the $18 billion it earnings from 1938 through 2000.).
Answer that and you'll be a long way toward understanding why investors who believe the Fed can guarantee the safety of the financial system are fooling themselves. And why so many investors and lenders -- from banks to insurance companies to pension funds to Wall Street investment houses to hedge funds -- are taking on more risk than is good for them.
Delta swings the axe
Let's get the conventional business-type answers out of the way quickly. Folks aren't lending the airlines -- particularly the U.S. airlines -- money because the carriers have come up with brilliant strategies for cutting costs and making higher profits. Or because they've figured out new sources of long-term profit.
Take a look at the plan that Delta Air Lines (DAL, news, msgs) outlined when it filed for bankruptcy protection on Sept. 14. It's more of the medicine that hasn't worked so far: pay cuts of up to 15% for workers and executives, and massive layoffs.
Fewer and less-well-paid workers will handle a smaller and simpler route system and fleet. Delta will reduce its domestic seat capacity by 15% to 20%, while adding 25% to its capacity on international routes for a net drop of about 7% to 10% in capacity. And the company will use bankruptcy proceedings to reduce the number of different kinds of planes that it flies to seven from the current 11.
Even before its bankruptcy filing, Delta had cut the cost -- excluding fuel -- of flying one seat one mile to the lowest among major carriers.
See the problem? Low cost -- if you exclude fuel. Lowest cost among the majors -- when the price competition is coming from new low-cost, few-frills airlines. Fewer types of planes in the fleet -- but still seven, compared to the one in the Southwest Airlines (LUV, news, msgs) fleet. Less domestic capacity -- but a still-unwieldy route system that combines hubs and point-to-point flights. Growth to come from international routes where low-fare airlines have little presence -- for now.
Nothing here is a permanent fix. And if Delta's plan works, AMR Corp.'s (AMR, news, msgs) American Airlines, and Continental Airlines (CAL, news, msgs) will almost certainly have to file for bankruptcy in order to compete.
Unlikely lessors
Here's where the airline bankruptcy story intersects with Alan Greenspan's worries about too much risk-taking by investors.
Thanks to the Delta bankruptcy filing (and those of Northwest and UAL and US Airways Group (UAIRQ, news, msgs), we now know some of the names of companies willing to lend companies with these track records and balance sheets money for planes. Delta, like most airlines these days, doesn't actually buy its planes; it leases them. Third parties put up the purchase price and then get a stream of cash payments (and tax breaks from depreciation) -- unless the airline can't pay, of course -- over the life of the lease.
A number of companies that lent money to Delta this way have told investors to expect a hit to earnings if they have to write down the value of these leases. The list includes some surprising names. On Sept. 14, Walt Disney Co. (DIS, news, msgs) said it might have to write off $100 million in Delta leases. Other companies issuing similar warnings include Electronic Data Systems (EDS, news, msgs), with $26 million at stake, and AT&T (T, news, msgs), with $71 million.
These are old-fashioned leases. Disney's investment dates back to the early 1990s, the company says, and Electronic Data Systems made its investment in 1988. Kind of quaint, actually. These lease deals date back to a time when airlines actually made money, and the companies have had a good ride out of the investments. It's too bad that the leases finally didn't work out. You pays your money and you takes your chances.
Risk, sliced and diced
Well, at least you used to. Instead of these old-fashioned relatively straightforward leases, airlines these days rely on something called "enhanced equipment trust certificates." These are bonds, backed by pools of aircraft.
Any single bond issuance is divided into what are called tranches. Often, individual tranches come with different yields and different risk profiles. Specific investors can pick through the tranches to find one that matches their demand for yield and their tolerance for risk.
But the change from something as old-fashioned as a lease on an actual airplane to a derivative that represents a share of a pool of aircraft doesn't stop there. In the old days an investor like Disney was stuck with the risk of the investment it had just made. Today the investor in enhanced equipment trust certificates can sell part of that risk to another investor.
That's done with another derivative called a collateralized debt obligation, or CDO. The buyer of a CDO is buying insurance against Delta or any other debtor defaulting on its obligations. The seller of the CDO is hoping that the debtor will not default and that the seller will be able to pocket the price of the CDO.
And you can sell a CDO if your risk tolerance changes, then buy another to fit your current needs.
Once upon a time, this was a tiny market, with banks arranging these contracts for a large investor such as an insurance company. Now, banks such as JP Morgan Chase (JPM, news, msgs) or Citibank (C, news, msgs) create CDOs for a wide range of investors. And those investors then trade these CDOs with each other, as they're estimation or appetite for risk changes. Today there are $8.4 trillion (yes, that's trillion with a T) in credit derivative contracts outstanding. That's up from just $919 billion at the end of 2001.
Passing the buck
What are the takeaways here?
First, note that this is a huge financial market -- and the market for credit derivatives is just one part of the much larger market for derivatives of all kinds. For reference, the entire U.S. money supply (measured by M3, the widest definition of money) at the end of August was $9.9 trillion. The size of the credit derivatives market as of end of June 2005 was $12.4 trillion, up 128% in a year, according to the International Swaps and Derivatives Association. It's no wonder that the Federal Reserve has less clout than it did when this derivative money supply was a mere $919 billion.
Second, note what the credit derivatives market actually buys and sells: risk. Want a little more risk? Sell a contract guaranteeing someone else against default. Less risk? Buy a contract guaranteeing you against loss.
Third, note how this market changes the way that an investor treats risk. In the old days, Disney, or the bank or insurer that put together the lease, did due diligence on the creditworthiness of the airline making the lease payment. Getting that creditworthiness right was all that guaranteed you against loss, and you made sure that you were getting paid enough to compensate for the risk you were taking.
Now, thanks to derivatives, investors have a second kind of guarantee: they can buy insurance against the default of the bond issuer. Now that doesn't mean that all companies that buy and sell in the credit derivatives have stopped doing due diligence. But the ability to buy and sell risk is a powerful incentive to stop worrying about the fundamental risk of the original creditor. This is going on right now in the home mortgage and home-equity loan market. Some of the biggest mortgage lenders continue to offer interest-only or other risky mortgages to customers with marginal credit and then shed that risk by packaging the loans and selling them to investors who, in turn, sell their risk in the derivatives market. (More on this in a future column.)
The no-worries worry
In this system, no one really needs to worry about the risk of the loan they've made, the mortgage they've extended or the bond they've bought. They can lay off that risk on someone else -- for a price -- in the derivatives market.
The problem, of course, is that this system only works until it doesn't. Because derivative contracts are frequently bought and sold by the original purchaser, it's hard to tell who is now guaranteeing whom against loss. That's not a minor point if a big debtor goes into default and the guarantor doesn't have deep pockets to pay out on the guarantee. The derivatives market is not very efficient -- in June there was a backlog of 13 days before trades were completed, according to the International Swaps and Derivatives Association. Nor is it transparent -- since derivative contracts are still relatively hand-crafted it is hard to price them. So the market is not very good at detecting and pricing imbalances.
The greatest danger is a very human one: complacency. Since the derivatives market lets investors control risk, they stop worrying about taking on more risk. And that, as we all know from experience, creates an accident just waiting to happen. Which is exactly what Alan Greenspan is worried about.
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