Bank-Owned Equipment Financing: Powerful Forces Influencing the Marketplace
by Scott Kiley July/August 2016
Fifth Third Equipment Finance’s Scott Kiley discusses seven powerful forces influencing bank-owned equipment finance companies, including the increasing market power of trillionaire banks, the oil and gas industry, the growth of alternative financing sources, risk assessment versus pricing and the corporate aircraft market.
Today’s bank-owned equipment financing marketplace looks a lot different than it did in the past. These seven powerful forces are influencing the market today:
Trillionaire Banks’ Market Power Continues to Grow
These “too-big-to-fail” banks are also known as “tough to beat on big deals” in today’s equipment financing space. Over the last few years, the equipment financing units of the trillionaire banks (Bank of America, JP Morgan Chase and Wells Fargo) have exerted their power to increase market share and control many of the larger transactions. Their power comes from the sheer size of their balance sheets and in their massive level of deposits. They have demonstrated a willingness to use their balance sheet strength by committing huge hold positions for individual credits to take a deal off the street and determine later if a syndication strategy is necessary.
On the flip side, international banking regulators are focused on forcing the largest banks to hold even higher levels of capital than the regional and independent banks that will require their business units, including their equipment finance groups, to generate even higher returns. This may lessen their competitive advantage in the next few years. In addition, even large companies see the benefit of developing strong relationships with multiple banks. I’ve seen many cases where a trillionaire bank leads a company’s senior credit facility, but a regional bank equipment finance company may have a larger share of the company’s equipment financing wallet.
Oil and Gas Industry Downturn Will Hurt
The steep drop in the price of a barrel of oil from $120 to as low as $30 has been a double whammy on our industry. The explosive growth in U.S. oil and gas production resulted in a ton of capital expenditures, and our industry happily obliged the industry with as much equipment financing capital as needed. A herd mentality often exists within the bank leasing community, which directs origination efforts to the hot industries of the day. With an unhealthy focus on growth for growth’s sake, it’s easy to understand targeting industries where more deals exist.
Without proper portfolio strategies to manage exposure to each industry and asset class, it’s easy to unintentionally become overexposed in these areas and stretch on deal terms and conditions in order to gain or maintain market share. On the contrary, if an organization doesn’t remain active in the hot industries, it’s difficult to meet increasing volume goals and easy to be criticized for being too conservative. This “follow the herd” behavior seems perfectly logical in the midst of a bubble, but having a disciplined and consistent portfolio approach to avoid overexposure in certain industries or asset classes has proven to be the best long-term strategy for consistent earnings.
Commoditization of Risk Assessment vs. the Variability of Pricing Methodologies and Required Deal Returns Among Bank Lessors
As bank regulators seem focused on commoditizing how banks assess and manage credit risks, a startling development in the last few years has been the proliferation of different pricing methodologies and the ways required returns can vary significantly among bank lessors. The “commoditization” of risk assessment is the implementation by all banks of similar ratings systems. There are now probability of default (PD) ratings, loss given default (LGD) ratings and, to some extent, facility ratings that take into account term, amortization and other structural components of a transaction.
While one can debate the ability of these ratings systems to predict future losses accurately and whether they result in a dilution of the importance of human judgment, there is no debate that regulators and internal compliance folks are fully committed to these systems. In addition, regulators have driven organiza2016tions to develop more robust and granular portfolio metrics — including industry, geographic and collateral concentrations — that more accurately identify and monitor highly-leveraged transactions. I believe the development of these in-depth portfolio management techniques has been positive for the industry.
Pricing methodologies deployed by bank lessors vary widely, ranging from models that measure ROE, ROA, profitability NPV, spread over cost of funds, spread over swap rates (comp term or average life) and risk adjusted return on capital (RAROC). These methodologies can be materially affected by the benefit assigned to depreciation deductions (amplified by bonus depreciation) and the tax rates assumed. How your pricing model on leases incorporates potential residual upside can be another important factor.
Ironically, while regulators have been pushing for banks to be more consistent when assessing and monitoring credit risk, there now seems to be a wider variation in how each bank prices transactions and determines minimum acceptable economic returns. Each bank has developed its own “sausage grinder” to assess the economics of a deal, but it’s equally important that the pricing model takes current market pricing into account (the syndication team is the best source for this information) to confirm that the economic requirements will achieve the desired level of asset growth and profitability. Corporate Aircraft Financing Market: Vastly Different Than 10 Years Ago
Do you remember when a 65% residual at 10 years on a large cabin aircraft lease was the market norm? Well, those days are long gone, and I honestly don’t see them coming back any time soon. The significant residual impairments and losses realized by every major corporate aircraft lessor will be hard to forget and will keep a lid on residual values for many years to come. Every bubble eventually bursts, and it’s important that we learn the lessons from a period of severe asset devaluation.
The residuals assumed on corporate aircraft as a percentage of cost are higher than almost every other asset class, with rail being the only comparable one. Because aircraft costs are so high, the resulting dollar residual positions both on an individual asset basis and on a portfolio basis can result in concentration issues very quickly. Supply and demand dynamics ultimately drive all asset values and with such a high starting point, the drop in aircraft values can be dramatic and expose a portfolio’s concentration to this asset class in a draconian manner.
One favorable structuring trend I am seeing recently in aircraft leases is the elimination of the early buy-out (EBO) options to the lessee. Offering an EBO option alters the risk reward proposition of a lease by leaving the lessor with all of the downside risk while virtually eliminating the possibility of realizing the upside reward potential that was assumed when setting the residual.
Growth in Alternative Financing Sources
Will the recent growth in the number of alternative financing sources be considered addition by subtraction? The GE Capital divestiture represents the largest subtraction of dollars committed by a non-bank “alternative” to the asset-based finance marketplace. While many in Washington believe the Dodd Frank regulations and GE Capital’s SIFI designation are helping to rein in excessive risk taking, GE concluded that acceptable returns could no longer be made in the asset-based financing market due to increased regulatory scrutiny and compliance costs without having access to low cost bank deposits.
This subtraction of a major non-bank financing source has spawned the creation of many new smaller alternative financing sources and an attempt by banks to fill this void. Many questions remain, and it’s too early to tell if these players will fill the vacuum created by GE Capital’s exit. Will companies with less than stellar financial metrics continue to have access to reasonably priced credit to fund their growth? Will the heavily regulated banks be able to meet the financing needs of “B” and lower-rated credits while also meeting internal and external credit and regulatory compliance requirements? Will the new alternative financing sources entering this space prove to be reliable and longterm players?
Direct Origination Marketplace vs. Capital Markets
The divide is widening between how a transaction is structured and priced when it is being bid to retain or bid with a partial or full syndication strategy. If a CFO has a $100 million equipment financing need for the year, one option is to break it up among several lessors and drive everyone to price aggressively to win a piece of the business, which most likely will be retained. This takes a lot of time and energy on the part of the CFO and his team, so a different strategy often deployed is to award the entire transaction to one lessor, knowing that it will have to be priced a little higher to clear the market.
The efficiency of negotiating with one lessor and agreeing on one master lease as well as relying on one servicer can be appealing to some companies. Buy shops also demonstrate the variability in pricing requirements among bank lessors, and this presents challenges to syndicators trying to provide an accurate market read on a transaction. This variability makes it more difficult for a syndicator to price and structure large transactions that involve a syndication strategy with confidence in such a way to clear the market.
Equipment Finance Portfolios: A Unique Advantage in a Bank’s Commercial Book
The equipment finance portfolios at most banks represent a significant percentage of the longer tenor fixed-rate assets of the total commercial book. This should rightfully be viewed as a sound asset/liability management strategy and a way to play the yield curve. In 2009 through 2012, many bank lessors did not want to book many longer-term leases (i.e., longer than eight years) because the prevailing wisdom was that rates were going to rise. Well, rates didn’t rise and haven’t risen since. How many banks wish they had a larger percentage of some of those higher-yielding long-tenor lease assets in their books right now? These are also the type of earning assets that decrease the run-off rate and provide portfolio sale gain opportunities with shorter remaining terms and attractive buy rates.
Scott Nelson, Chief Digital Officer, Tamarack Consulting
While it is too early to define the new normal, one thing we can say for sure is that the rule “past performance does not guarantee future returns” has never been more true. Scott Nelson explores how real-time data can reflect a customer’s current financial health and reduce uncertainty about the future.