"Thanks for your ideas and advice over the last few years"D.M.
"You are one of the most interesting, talented writers I know"A.G.
"I look forward to your emails. They are among the very few that pass my screen."J.C.
"The world needs more of voices like yours"B.W.
"I don't know anyone else that writes like you, shares market points of view like you, and makes things seem personal and approachable!"J.C.
"Thanks for your ideas and advice over the last few years."D.M.
Fly, Don't Buy Airlines or Why Big Banks Make Dumb Loans
If I’ve learned anything over the years, it’s that people don’t learn. Recently, I talked to my cousin who is an executive with a Russian airline company. In our discussion he mentioned that his company just received semi-unsecured loans (all planes are leased so they are not used as a collateral) from western banks at 10% a year. Though it sounds like a good rate in today’s interest rate environment, it is an airline and it is in Russia.
Why would somebody ever give a loan or buy airline bonds of any country? I can understand buying distressed bonds or maybe a stock as a trade. Not my kind of thing, but I can respect that. But a buyer (an investor) of fully priced (at par or close) airline bonds usually intends to hold them to their maturity, or for a long time. It is well documented that the airline industry as a whole has lost money over its cumulative existence. Thus, uneconomical, low fares that consumers have been enjoying over the years were subsidized by bond and equity investors. This is great for consumers, not so good for providers of capital. I almost want to say “Fly, don’t buy.”
One could argue, “but wait, Southwest (LUV) and Virgin have done well.” And maybe this is where the answer is, at least in part. We look at these very rare success stories and think that this time is different and the industry can reinvent itself and start making money. It’s rarely different.
Or maybe the answer lies in our forgetfulness? We forget that the deck (the industry structure) is stacked against us, that for every Southwest and Virgin there are dozen airlines that went through several bankruptcies, at least once. We look at glamorous, sophisticated, electronics-laden airplanes and forget that this is a very cyclical, capital intensive (planes cost hundreds of millions of dollars), low return on capital, highly unionized, debt burdened industry that is exposed to the gyrations of commodity prices. And to top it all, the industry has marginal pricing power and surprisingly low barriers to entry (i.e. new entrants compete with major airlines on one route at a time, it is similar to a death by one thousand cuts. Virgin Air was started with just couple million dollars and leased planes).
Russian airlines are even worse as they are forced to compete with a semi-government and thus not-for-economic-profit entity – Aeroflot. Also, the Russian government is predictably unpredictable. One day it may decide that it wants to control the airline industry and suddenly we’ll discover that airlines were ruining the environment, not paying taxes, scratching runways or whatever else it’ll need to say to justify ripping off equity and bond holders. It did this with many BP PLC (BP) and Royal Dutch Shell (RDS-A) holders a few months ago, so why would this time would be any different?
I suggest the rating agencies rethink their rating scale to accomodate for airline bonds: (A) – High Quality, (B) – Investment Grade, (C) – Junk, (FBJ) – Far Below Junk – domestic airline bonds, and finally in the Nuclear Waste (NW) category – Russian Airline bonds.
Why are banks not seeing this and what happened to risk (credit) spreads? My cousin mentioned that several large Russian oil companies just received loans from American and western banks (i.e. Citigroup (C), Goldman Sachs (GS), Barclays (BCS)) at or around Libor plus 25-50 basic points. Let me put it into perspective, this about 1% premium to risk (default) free US Treasury bills. In other words banks are thinking that Russian oil companies are just a bit riskier (1%) than the US Government – the entity that can print money, raise taxes and has nuclear weapons. Is this another case of selective amnesia, similar to sub-prime lending? Will they think it’s not a problem until suddenly (it is always sudden for them) it becomes one? Did banks forget about Russia’s near death experience of the late 90s or the Yukos debacle from 2004?
Lending at a slight premium to a risk free rate made very little economic sense. Any rational entity would have been better off taking the money and buying higher yielding (much higher quality), AAA rated U.S. corporate bonds. But see, big (money center) banks are in the business of making loans. To be more precise, they are in the business of making dumb loans. When the global economy is roaring, all loans are good loans, the risk is a four-letter word that only a few can spell.
As a man with a hammer is looking for a nail, a banker armed with cheap funds is looking to make loans and generate fees. Every time a recession shows its ugly face, the “dumb” loans float to the surface and huge write offs are taken, shareholder equity is lost. During the last recession of 2001, big banks were writing off billions in loans made to South America. In the next recession it will be Russian loans.
Again, why would western banks give loans to Russian airlines that never generated positive cash flows (and probably never will) or Russian oil companies at an almost risk free rate? The answers are very simple: global liquidity and syndication.
An abundance of global liquidity coupled with low interest rates has compressed spreads between investments of various risks. Investors hungry for any yield are garbling up bonds of any risk just to increase the yield of the portfolio. Also, more and more large loans are syndicated among dozen of banks, the risk is assumed to be diversified away. Syndication sounds great in theory, but it increases the system risk as it breeds indifference and a lot of bad loans – just wait a year or two.
I am the CEO at IMA, which is anything but your average investment firm. (Why? Get our company brochure here, or simply visit our website).
In a brief moment of senility, Forbes magazine called me “the new Benjamin Graham.”
I’ve written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. (I’m working on a third - you can read a chapter from it, titled “The 6 Commandments of Value Investing” here).
And if you prefer listening, audio versions of my articles are published weekly at investor.fm.