Emirates Airlines’ Deal with

the Export–Import Bank

Janani Thiagarajan / Carl Covelli / Drew Hacker

FIN695A

ISTAT U Case 4

“Teamwork makes a dream work.”

- Anonymous

Table of Contents

1 Export Credit Agencies

2 Special Purpose Vehicles and Enhanced Equipment Trust Certificates

3 The Role of an SPC in the Emirates Case

4 Ex-Im Bank Loan and Subsidy Calculations

5 Sensitivity Analysis

6 ECAs vs. EETCs

7 SPVs and EETCs: A Competitive Advantage?

8 ECA Direct Lending vs. Loan Guarantees

9 Final Remarks

1 Export Credit Agencies

An export credit agency (ECA) is a conduit through which a number of countries

encourage the export of their goods and services. The primary financial services of an ECA

include direct loans, guarantees, and insurance. An ECA’s objective is to contribute to its

country’s employment by ensuring a steady outflow of exports to foreign buyers with

“reasonable assurance of repayment.”1 ECAs mitigate the risks of financing weaker credits in the

overseas and emerging markets, as well as provide an additional source of funding to diversify

risks of financing.2 ECAs are not meant to compete with private capital; rather, ECAs “address

market failures that dampen export levels.”3

More than 19 ECAs exist worldwide. The largest ECAs include China, Germany, South

Korea, and the United States.4

1 Shayerah Ilias Akhtar, “Export-Import Bank,” Congressional Research Service, June 30, 2014, p. i. 2 Akhtar, p. 18 3 Akhtar, p. i 4 Akhtar, p. 40

Figure 1

OECD new medium-

and long-term official

export credit support

volumes1

The United States’ ECA is called the Export-Import Bank of the United States (“the Bank” or

“Ex-Im”), and its transactions are “backed by the full faith and credit of the U.S. government.”5

According to the Ex-Im’s 2015 Annual Report:6

● Ex-Im supports 109,000 American jobs.

● Ex-Im supported $17 billion in exports at no cost to American taxpayers.

● Ex-Im supported more than $3.1 billion of exports from U.S. small businesses.

● Nearly 90% of transactions directly supported U.S. small businesses.

● Ex-Im Bank had a default rate of 0.235% as of Sept. 30, 2015.

● Remitted $431.6 million to the U.S. Treasury for debt reduction.

Both the private and public sectors hold a range of views of the Ex-Im bank. Proponents

of the Ex-Im bank believe it plays “an important role in certain niches” where U.S. exporters or

commercial banks need additional assurance of a foreign buyer's ability to repay a loan.7 Critics,

on the other hand, recognize the private sector as the leading source of export finance, and

deduce that the Ex-Im bank misuses “taxpayer funds for private benefit, whether for large or

small businesses, and contends that the private sector is more efficient in financing exports.”8

One of the United States’ largest exporters that understands the importance of the Ex-Im

bank is Boeing--the “sole U.S. producer and exporter of wide-body jets.”9 Wide-body jets

composed about $32 billion of Ex-Im bank financial exposure as of March 31, 2014, representing

“about 28% of Ex-Im bank’s total financial exposure.”10 India, the United Arab Emirates, and

South Korea each received over $3 billion in U.S. Ex-Im bank authorizations between 2004 and

2013. Boeing competes head-to-head with Airbus--an aircraft producer and exporter from

France, Germany, Spain, and the United Kingdom--who also receives significant ECA support.

Between 2008 and 2013, “European ECAs supported deliveries of 821 Airbus large commercial

aircraft.”1112 In comparison, the Ex-Im bank “supported deliveries of 789 Boeing large

commercial aircraft” during this time.

Some U.S. airlines, however, have been critical of the Ex-Im bank. Between 2011 and

2014, Delta Air Lines, Hawaiian Airlines, and the Airline Pilots Association continuously debated

the economic impact of the Ex-Im bank in regards to its “financing for Boeing aircraft exports to

5 Akhtar,p. i 6 Lawton King, “Ex-Im bank Bank Releases it FY 2015 Annual Report,” Export-Import Bank of the United States, Jan. 14, 2016, http://www.Ex-Im bank.gov/news/Ex-Im bank-bank-releases-its-fy-2015-annual-report. 7 Akhtar,p. 18. 8 Akhtar, p. i-ii 9 Kimberly Gianopoulos, “Export-Import Bank: Information on Export Credit Agency Financing Support for Wide-Body Jets,” U.S. Government Accountability Office, p. 6. 10 Gianopoulos, p. 2. 11 Gianopoulos, p. 2 12 Gianopoulos, p. 15

India and other countries [which had] resulted in an oversupply of seats that has had an adverse

effect on their businesses.”13 The Ex-Im bank held that “in the absence of Ex-Im bank financing, a

foreign aircraft manufacturer may win the deal over a U.S. aircraft manufacturer,” while the

critics believed that the Ex-Im bank provided foreign airlines “more favorable financing terms

than were available to U.S. airlines.”14 Ultimately, no lawsuits have been concluded, and the U.S.

airlines (like foreign carriers using the Ex-Im bank) continue to use “government-backed export

financing for its purchases of airplanes, such as from Canada’s Bombardier Inc. or Brazil’s

Embraer S.A.”15

2 Special Purpose Vehicles and Enhanced Equipment Trust Certificates

After the economic crisis in 2009, many banks became wary of lending loans in general

and hence Government backed ECAs had to step in with a different business model in-order to

ease aircraft transactions. As per the proposed new business plan, the airline is to set up a

special purpose vehicle (SPV)--or special purpose entity (SPE) as it is referred to in Europe--

whose only purpose is to own the aircraft. In this case, Amal Ltd. was a special purpose company

(SPC) which issued bonds to investors and then used the cash from these bonds to buy aircraft

through a sale and leaseback strategy. The airline then makes lease payments to the SPC, and

the SPC passes these on to the investors as the bond coupon payments.

An EETC, on the other hand, is a commercial financing structure available for aircraft

acquisitions by/for U.S. airlines. Enhanced equipment trust certificates are hybrid forms of

equipment trust certificates that are backed by aircraft assets. Similar to more basic ETCs, the

airline sets up a trust and this trust issues certificates to investors. The capital raised is then used

for buying the aircraft asset and is then leased to the airline either on an operating lease or on a

finance lease. Although very similar, this is different from SPVs whereby investors can provide

financing directly through the capital markets, as opposed to loan financing provided by the

banks. The structure involves a senior tranche which is subscribed by investors along with

another junior tranche subscribed by the airline for equity participation. The structure is

premised on § 1110 of the U.S. Bankruptcy Code and the airline’s participation enhances the

credit quality of the security thereby significantly decreasing the risk to creditors of U.S. airlines

which in turn allows the creditors to provide more favorable financing terms. This provides

13 Akhtar, p. 31 14 Akhtar, p. 31 15 Akhtar, p. 31

significant cost advantages to U.S. airlines when compared to the creditors of foreign airlines

which lack equivalent securitization.16

3 The Role of an SPC in the Emirates Case

In broad terms, the deal might look unattractive at a first glance because of the amount

of moving parts that structure the arrangement and the depth of responsibility each party took

on to push the deal through. We, however, support it. Emirates’ request to buy the three aircraft

from Boeing came at the worst time possible, so their transaction took a unique approach to

compensate. The financial oceans which had been full of money prior to the meltdown in the

late ‘00s were now dry and Wall Street’s belt had tightened to the point where nobody was

lending for prospects with such a risk profile.

Morin and the rest of Credit Agricole CIB (Credit Agricole hereon), as well as Goldman

Sachs in the United States, needed to make an ECA-financed deal work like a traditional bank

market collateralized debt structure and run it through the capital markets while still upholding

the default obligations of each party. They did this by helping Emirates and Amal Ltd. distribute

several different rounds of promissory notes for successive debt issuances with similar

characteristics to enhanced equipment trust certificates (EETC), gain a government guarantee

for a temporary bank loan by Credit Agricole, and paying off their initial notes to Goldman Sachs.

It all seems sort of magical that the different pieces synthesized correctly and the deal

was successful. We are of the opinion that Morin’s deal structure was a good idea because when

the bank markets shriveled up during the late ‘00s credit collapse, the export credit agencies,

including the United States’ Export Import Bank (Ex-Im), were the only sources of financing

available.17 Emirates created Amal Ltd. solely to acquire and retain the paperwork for the three

Boeing aircraft because the SPC’s obligations would be distinct from Emirates’ interests and

would continue operating even if its parent airline could not stay afloat. SPCs and similar entities

have been instrumental in securitization for property-based financial products over the last thirty

years.18 Amal Ltd., however, was formed during a delicate time period immediately following the

subprime mortgage crisis - the financial services industry still had bad memories from Enron’s

SPC cave-in and it was just unearthed that Lehman Brothers had gone down a similar path with

16 “Delta air lines, Inc. V. Export‐ Import bank of the United States,” Export-Import Bank of the United States, June 18, 2013, http://www.exim.gov/sites/default/files/newsreleases/Option_2_Memo-OGC-11-22-13-accessible.pdf 17 "Aircraft Funding - Debt, Equity & the Capital Markets." Lecture. 18 Gosrani, Nishnma, and Andrew Gray. The next Chapter: Creating an Understanding of Special Purpose Vehicles. Report. PricewaterhouseCoopers LLP, 2011.

mortgage-backed securities.19 Despite SPCs having negative associations as islands for

companies to clean up their balance sheets and dump their debt, Amal Ltd. was critical in

assisting Emirates’ acquisition of the three Boeing 777s. After Amal Ltd. purchased the aircraft by

way of debt securities, they used the aircraft as collateral for the notes they issued and the

lenders only evaluated the creditworthiness of the collateral and not the credit quality of the

corporation which allowed for low costs.20 As a final note, the Cayman Islands, where Amal Ltd.

was based, is historically a popular spot for SPCs and the like because incorporated entities enjoy

a tax holiday, where they pay little to no taxes, for their first 20 years of operation.21

The necessity for government backed public debt originates in the Emirates deal’s basic

outline. Morin and his team at Credit Agricole were running a traditional bank market

transaction through a nontraditional forum - the capital markets. These markets are designed to

house the issuances of medium- to long-term debt and equity instruments and are only

accessible to corporations, institutional investors, and similar private entities.22 The Ex-Im bank

was also in a special situation because it had to guarantee Amal Ltd.’s promissory note on a short

term loan from Credit Agricole which was used in the interim to finance a portion of the bundle

of 777s. The investment banks required that the Ex-Im bank act as the guarantor for the bank

note Amal Ltd. held for Credit Agricole because Amal Ltd. was not “connected” to Emirates,

which meant that the loan was nonrecourse to Emirates and the only assets that Credit Agricole

could seize if Amal Ltd. went under were the three aircraft acting as collateral. Since the Ex-Im

bank’s guarantee would essentially be government-backed, subject to the same credentials as

virtually risk free Treasury bills, the risk of the securities was quite low. 23Accordingly, the Ex-Im

bank promised to cover the debts owed by Amal Ltd. in the case of default; the associated risk

involved with this possibility seemed low enough to the Ex-Im bank that they only charged a

marginal exposure fee - less than 1% of the total of the debt offerings by Amal Ltd. valued at

over $400 million.24

We are of the opinion that Morin and the rest of Credit Agricole’s deal was brilliant and

agree it was the best solution for Emirates. Short of using EETCs as the financial products, this

structure worked well. GE Capital outlines two different types of common debt structures for

aircraft financing deals, where a deal like Credit Agricole’s is described as an “investor loan.” In

this example, however, they have the SPC paying a mortgage to the creditor rather than an

outright purchase loan being repaid. The chart is displayed in Figure 2 on the following page.

19 Gosrani and Gray, p. 2 20 Gosrani and Gray, p. 7 21 Gosrani and Gray, p. 8 22 "Capital Markets." Investopedia. Accessed April 4, 2016. 23 “Government Security.” Investopedia. Accessed April 4, 2016. 24 Foley, C. Fritz, and Matthew S. Johnson. The Export-Import Bank of the United States. Publication no. 9-211-032. Harvard Business School, 2010.

4 Ex-Im Bank Loan Guarantee and Subsidy Calculations

Without Market Risk

The cost for EXIM to provide the loan guarantee is equivalent to the difference between

the cost of the risk free loan and the risky loan. The risk free loan is equal to the present value of

expected payments exclusive of the estimated default costs, while the risky loan corresponds to

the present value of expected payments inclusive of default costs.

Therefore, the calculations reveal:

This loan guarantee of over -$3.9 million reveals that the EXIM bank is going to make money

from this transaction (that is, if Amal does not default on its loan).

Figure 2

Commonplace debt structures

displayed on GE Capital’s PK

AirFinance website.1

Risk free loan = risky loan - loan guarantee

$413, 735,523 = $409,755,789.31 - loan guarantee

Loan guarantee = -$3,979,733.69

With this loan guarantee, we calculated the subsidy that the U.S. government provided to EXIM:

Last, using the subsidy and risk free loan values, the loan value can be calculated by:

If you take the difference between the Loan Value of $396,020,266.30 and the original

Loan Amount of $400,000,000.00, you arrive at the amount prescribed by the Loan Guarantee of

$3,979,733.69. According to this, with fees and risk costs all-inclusive in the government

subsidized package, the Ex-Im bank reaped close to $10 million in pure profit. An interesting

facet of the agreement is how the investment bank syndicate, which included Credit Agricole

Securities and Goldman Sachs, wrote the Ex-Im bank’s guarantee fee into the loan bundle. This

illustrates the occurrence of a “negative subsidy,” because the Ex-Im bank was still receiving

coverage from the U.S. government for the associated fees, but was instead able to use them for

their own gain.

With Market Risk

Using the Capital Asset Pricing Model (CAPM), the discount rate inclusive of market risk is equal

to:

Loan guarantee = fee + subsidy

-$3,979,733.69 = $13,735,523 + subsidy

Subsidy = -$17,715,256.69

Subsidy = loan value - risk free loan

-$17,715,256.69 = loan value - $413,735,523

Loan value = $396,020,266.30

Discount rate inclusive of market risk = risk free rate + beta * market risk premium

= 3.465% + 0.2 * (5%)

= 4.465%

Using this discount rate, we found the new loan guarantee:

The loan guarantee increased from -$3,979,733.69 with a risk-free discount rate to

-$3,830,652.51 with a discount rate inclusive of market risk. As a result, the subsidy and the loan

value also change as a result of the additional market risk:

Last, using the subsidy and risk free (inclusive of market risk) loan values, the loan value can be

calculated by:

We do not believe that Ex-Im should use the discount rate inclusive of the market risk because

ECA’s are government-backed; therefore, like government bonds, it requires the risk-free rate.

Risk free loan = risky loan - loan guarantee

$391,723,573.18 = $387,892,920.67 - loan guarantee

Loan guarantee = -$3,830,652.51

Loan guarantee = fee + subsidy

-$3,830,652.51 = $13,735,523 + subsidy

Subsidy = -$17,566,175.51

Subsidy = loan value - risk free loan

-$17,566,175.51 = loan value - $391,723,573.18

Loan value = $374,157,397.70

5 Sensitivity Analysis

We conducted the sensitivity analysis at absolute extremes. Based on research about historical

probabilities of default, we are currently sitting at 0.235%. This became our minimum value, with

our most likely value at 3% as per the case, and rounded off our inputs at 6% as the maximum,

basing our decision off of the possibility of another upcoming financial crisis as we approach the

standard recession cycle.

Our anticipated expected default loss ranged from 0 to 100% centered on the view that, in some

cases, like we have seen recently with foreign airlines seizing assets they did not own during

bankruptcy, some debtors don’t pay. Though extreme, this is supported because not receiving an

aircraft back is, in essence, the same as not getting paid. The case outlined that the industry

average predicts insolvency in the final quarter of year 4, and anticipates such an event by

shielding the possibility with a payout of $4.5 million. Our analysis described that there was a

95% chance that expected default loss would be less than $1.3 million, with the 95th-percentile

of outcomes containing a loss of more than $15 million.

We made the following input assumptions:

Risk free yield: We took the daily average for a period of 20 years before the 2009 economic crisis as our minimum possible value and for the maximum possible value, we took the 20 year daily average for the second quarter of 2009.

Probability of default: Their current probability of default is less than one percent and hence our chosen minimum value is 0%. During the past economic crisis, their default probability was 3% and we feel that, if there is one more severe world economic crisis, then there is a good chance that their numbers jump to +3% from the previous crisis and hence our choice of maximum possible value is 6%.

Loss given Default: our loss given default ranges from a minimum value of 0% (risk free) to 100% (when everything including the aircraft is lost).

Our Results Summary:

We got some interesting results from our sensitivity analysis. With our input parameters we wanted to observe its effect on present value of expected payments, loan guarantee, subsidy, expected default loss and last but not the least their fee. These are our observations: Present Value of Expected Payments: As per our input assumptions, the sensitivity results

suggest that, the Ex-Im bank would receive a minimum payment of $389,411,400 (with maximum default on the fourth year) and maximum of $412,597,000 on the loan when there is no default.

Expected Default Loss: If there is a default on the fourth year, then the minimum default payment would be $32,811.04 and might go as high as $15,246,120.00.

Loan Guarantee: Consistent with Ex-Im’s assumptions, our loan guarantee remains as negative amount throughout our simulation. The minimum amount of loan guarantee would be negative $24,324,100 and maximum amount would be negative 1,138,530.00.

Subsidy: In line with the loan guarantee, subsidy also ranges from a negative $38,059,630.00 to a negative $14,874,050.00.

Fee: Interestingly, for the given loan amount, the fee is constant throughout the simulation at $13,735,520.

Our Result interpretation:

As per our results, the Ex-Im bank is definitely going to make a lot of money as they

expected. Even though we went with extreme values for our assumptions, the minimum present

value of expected future payments $389.4 million which is more than the actual present value of

$374.1 million (when taking market risk into account for the $400 million loan). Which explains

why they make negative subsidy (make more money than their cost incurred) with or without

default. Also, the calculation in our previous section reveals that that their risk amount or loan

guarantee of $3.9 million is the difference between agreed loan amount and the actual present

value. Since the risk is built into the loan, for a given loan amount the additional risk fee charged

($13.7 million in this case) is constant.

6 ECAs vs. EETCs

If Emirates did not use an ECA, they would need to get another form asset backed

securitization. EETC would have been the second best option for them. In-order to obtain a

comparable discount rate, we took the corporate investment grade bond yield in 2009 and used

it in CAPM equation.

Using this discount rate, we found the new loan guarantee:

The loan guarantee increased from -$3,979,733.69 to -$3,912,344.75, as explained above.

7 SPVs and EETCs: A Competitive Advantage?

The Ex-Im bank of the United States is an independent export credit agency of the U.S.

Federal Government. Many of the major industrialized countries have their own export credit

agencies. Ex‐Im bank and many ECAs from other countries work through the Organization for

Economic Cooperation and Development (OECD) as per established common set of guidelines

and arrangement for ECAs to follow in supporting exports from their home country.

EETC Discount rate = risk free rate + beta * (Market risk rate - Risk free rate)

EETC Discount rate = 3.465% + 0.2 * (5.7% - 3.465%)

Discount rate inclusive of market risk = 3.91%

Risk free loan = risky loan - loan guarantee

$403,683,007.90 = $399,770,663.15 - loan guarantee

Loan guarantee = -$3,912,344.75

Both the Ex‐Im bank (for Boeing) of US and European ECAs (for Airbus), participate in the

Aircraft Sector Understanding (ASU) previously called Large Aircraft Sector Understanding

(LASU). As far as aircraft financing is concerned, their aim is to provide financing with the most

favorable terms a Bank is permitted to provide and support.

There are many guidelines and requirements that need to be met before the ECA can

authorize an aircraft transaction. One of the major requirements is the ‘minimum risk fees’ that

needs to be charged. Under the 2011 ASU, which is currently in effect, the risk fee is indexed to a

number of private commercial financing rates. This minimum risk fee translates into financial

cost. The intention here is to match the overall financial cost of a transaction supported by an

ECA to the overall financial cost of a transaction in the private commercial markets without ECA

support. But, historically, for wide-bodied aircraft, the financial costs of an ECA‐supported

transaction has been less favorable to the other airlines than the financial costs of an equivalent

transaction for U.S. airlines due to aspects of both U.S. tax laws and U.S. bankruptcy law that

benefitted the parties to these transactions involving U.S. airlines. An example of this is shown

below in Figure 3.

The ASU also requires that the term of repayment be limited to 12 years and the

transaction cannot be structured with a bullet payment at the end of the loan term. Contrary to

this arrangement, many private commercial financing structures for purchasing large aircraft has

much longer repayment terms, and allows for variations in the amounts repaid throughout that

term. These factors tend to make private commercial financing more attractive than ECA

financing to U.S. based airlines.

Figure 3

Aircraft Sector

Understanding

chart showing the

cost increases

depending on credit

quality rating

8 ECA Direct Lending vs. Loan Guarantees

The Ex-Im bank decided to guarantee the loan from Credit Agricole for several reasons that were more attractive than lending the money directly. To the Ex-Im bank’s benefit, aircraft transactions came attached with fees that surpassed the costs to assist financing them and the bank was also being healthily subsidized by the government to the point where the Ex-Im bank was making money from the deal. This resulted in what is called a “negative subsidy”. The ability to make money in excess of their risk undertaking supported the Ex-Im bank’s decision which depended heavily on the subsidy they received. The government subsidy that the Ex-Im bank receives impacts the guarantee and transaction fees that the Ex-Im bank would then charge its security interest holders, in this case, Amal Ltd. The cost of the loan fees, which included additional items like the promissory note charge, was a little over $13 million coupled to the $400 million in debt issuances. Traditionally, the government subsidies for credit guarantees are often greater than they are for financing direct. In fiscal year 2007, student loans programs, associated with medium to high risk, were federally subsidized at 10% for guarantees and only 2% for direct loans.25

For any generic company in the marketplace, if the subsidy goes up, the fees decline, and vice versa should the subsidy dwindle. In airline finance, however, there are a few strings attached. An advantage of being the guarantor for Amal Ltd.’s loan rather than just hand out the capital is the benefit from government subsidies in good times. On the other hand, if Amal Ltd. found themselves stuck in the Cayman Islands with no money, the Ex-Im bank had signed on to come up with the rest of it. This is one of the major downsides of credit guarantees. Yet, through loan guarantees, the risk-sharing element established with profit-oriented intermediary banks generates an independent creditworthiness hurdle for borrowers and can provide a means of transparency across all parties involved.26

Apart from the negative subsidy benefit, as per the new ASU, Ex-Im will benefit more by their guarantees than by direct lending. This is because they are required to charge 142 basis points (bps) to 310bps for investment grade corporate bonds rated triple-A to C respectively. By one basis point, we mean one hundredth of a percent. 100 basis points mean one percent above the base yield percentage. So 310bps for the lowest possible grade investment would yield 3% above the nominal interest rate since those carry the most risk.

25 Lucas, Deborah, and Damien Moore. "Guaranteed versus Direct Lending: The Case of Student Loans." Measuring and Managing Federal Financial Risk, February 2010, 163-205. Accessed April 5, 2016. National Bureau of Economic Research. 26 Honohan, Patrick. "Partial Credit Guarantees: Principal and Practice." Journal of Financial Stability 6 (August 12, 2009): 1-9. Accessed April 5, 2016. Elsevier.

9 Final Remarks

Aviation is a famously cyclical industry and at the time of this writing we are in a period of euphoria. Supported by tremendous aircraft order backlogs, low oil price, and plenty of financial tools available to the airlines, things look pleasant for the industry. When the situation was grim back in 2009, the Ex-Im bank was able to step in temporarily to provide relief so banks could offer up debt products at competitive pricing. Since the global crisis, public debt and the capital markets have tended to be conservative with their funding while investors started to look towards safer government bonds. EETCs and similar financial products backed by government agencies, which were responsible for helping Emirates when no banks would, have gained significant investor interest in the wake of the meltdown.27 The Ex-Im bank is supposed to be utilized as a last resort, but the years since the crisis has seen ECA provided guarantees used as a one stop shop in the available funding source chain, even for airlines with exceptional credit like Emirates. The problem this creates is that the investment bank’s credit risk is no longer the airline but rather the government-backed risk from the ECA based on the collateral.28 The cost of funding is also on the rise.29 Though structurally complex, the Emirates deal with the Ex-Im bank was employed successfully and opened up a new portal of financial tools to an industry which was in desperate need of them. Only time will tell what funding options will be available to the airlines in the years to come.

27 Ali, Shamshad, and Neil Hampson. Aviation finance: Fasten your seatbelts. Report. Pricewaterhouse Coopers LLP, January 2013. 28 Ali, Shamshad, and Neil Hampson, p. 24 29 Ali, Shamshad, and Neil Hampson, p. 28