In June 2006, almost a year before the current market correction began to unfold this past July with the collapse of the subprime mortgage market, we reported that credit was still plentiful and markets were liquid as well as resilient and forgiving. Clearly, the correction is altering that situation. Where will it take the equipment leasing and finance industry? And is it a journey to be feared or welcomed?

We asked some leading executives in the equipment leasing industry to share their thoughts on how their marketplace has been evolving this summer — and where it might be headed over the next year.

Where Is This Market Heading?
Laird Boulden is president and founder of RBS Asset Finance, a Chicago-based upper-middle market leasing company with $5.3 billion in assets. Boulden is hardly surprised by what he sees in today’s market.

“The economy isn’t bad, but it’s been too good for too long,” says Boulden, “And the longer the good times lasted, the more you felt that some sort of correction was overdue.” While many are focusing on the collapse of the subprime mortgage market and the potential ripple effect on consumer credit and spending, Boulden points to several less prominent indicators, like dropping levels of freight tonnage hauled by rail and weak revenue numbers starting to appear in the trucking industry, as potentially significant signs of where the overall economy could be heading.

“Rail and trucking are two pretty good indicators for the future because if somebody has produced something, they have to get it to market,” he explains. “I think the next 12 months are going to be an interesting ride.”

“It really is going to be a roller coaster ride,” says Martin Cox, a 27-year veteran with Chase Equipment Leasing, in Dallas. “I think our economy is so interconnected now that it’s increasingly hard to predict how this correction is going to progress. It could reach all over the place.”

For Doug Bowers, trying to discern concrete signs of the correction’s impact has not been easy. In fact, Bowers admits that he has not yet seen signs of it occurring. As president of Bank of America Leasing, in Charlotte, NC, the largest bank-owned leasing company in the United States, he has a unique vantage point on the current situation.

“I don’t have any grand crystal ball,” Bowers admits. “But I will say that, to date, the impact to us has been very modest.” Bowers focuses on following his bank’s customer base by providing it with equipment financing solutions. He reports that customers who have equipment on order and financing in place are moving forward with their transactions, and Bank of America Leasing is continuing to finance them. Other large bank-owned leasing companies are also reduced to speculating on the potential impact of the correction because they have not yet seen concrete evidence of it impacting them.

Mark Trollinger and Spence Hamrick serve as managing directors and co-heads of Wachovia Equipment Finance, the second-largest U.S. bank-owned leasing company, in Charlotte. Like Bowers, they focus on supporting the equipment leasing needs of their bank’s customers. Trollinger, who focuses on the execution side of Wachovia’s leasing business, acknowledges that changes are coming to the marketplace — but that’s not necessarily a cause for concern.

“Obviously, we’ve got a bubble that we’ve got to work through here,” he says, “But overall I think this correction is going to be fairly healthy for us.” Trollinger points to the fact that Wachovia’s size and customer diversification have served to insulate it from the immediate effects of the current correction.

Hamrick, who guides the origination side of Wachovia’s leasing business, shares his partner’s view that the effects have thus far been localized.

“It’s a little bit like dropping a pebble in a pond — the further out you get from the epicenter, the less impact there is,” says Hamrick. “Some people in our industry are going to be closer to that epicenter than others.”

Hamrick predicts a slowdown from the current GDP growth rate of 3.5% to somewhere around 2.8%. He also feels that the slowdown will remain focused primarily around the housing sector. “As you look outside of housing, things aren’t as dire. Aircraft and marine spending is still going to be good, and software and technology equipment will be strong — probably in excess of the GDP growth rate,” he notes.

For Paul Larkins, understanding how the correction got started might help predict where it will end. “We were wondering what it would take to cause a correction,” he says. “Now we know.”

Larkins has spent more than 25 years in the banking and finance business, including the past 14 with Key Equipment Finance, in Superior, CO, where he currently serves as president and CEO, overseeing the company’s $14 billion portfolio in the U.S. and 26 foreign countries.

“Liquidity coming out of the subprime mortgage market was the spark that lit the fuse,” he explains. “The resulting shockwave has gone from locking capital markets to limiting liquidity to actually creating a yield curve, which we haven’t had in a long time,” he says, laughing.

Maybe it takes a disaster in one sector of the economy to help restore order in another.

Relief at a Return to Rationality
Rick Remiker agrees that a return to a more rational, empirical credit-evaluation process might be a silver lining in the dark clouds on the economic horizon. Remiker serves as managing director and group head of Merrill Lynch Capital in Chicago. “I could best sum up my thoughts on the current correction with the old adage, ‘Be careful what you ask for,’ he says. “Most of us in the industry have been eagerly waiting for some event to cause a market correction and tighten up some of the unprecedented liquidity that’s been out there.”

Other leasing industry executives, like Daniel McKew, president and CEO of SunTrust Leasing Corporation, are also welcoming the prospect of change — and the restoration of some sense of order to credit and pricing.

“I’ve been in this industry 24 years, and I’ve seen many corrections and adjustments,” says McKew. “And while it’s unclear as to the depth of this current correction, the credit adjustment side of this has been long overdue — and very much necessary.”

For David Merrill, a correction is more than just necessary. Merrill who is senior vice president and director of commercial leasing for Fifth Third Leasing, in Cincinnati, OH, says he sees some solid opportunities for the leasing industry in the current climate of change.

“The economy is uncertain at best, and, traditionally, when the economy is uncertain, the leasing industry does well,” he explains. “Conventional bank loans dry up for smaller borrowers first, and then tightened market conditions move up to some of the larger corporate borrowers.”

Merrill says he’s already starting to see this progression occur at Fifth Third, and some of his smaller borrowers are moving to the leasing product. “We think it will have a positive impact on our business,” he concludes.

Some, like Remiker, are finding comfort in the prospect of a return to past patterns. “I think we’re in for a bit more normal economic environment. For the past three or four years, the entire lending community has been operating in an unprecedentedly strong environment — with minimal credit losses or problems,” says Remiker. “While we’re not in for a complete reversal of that, we are probably headed back toward a more normalized credit environment.”

A more “normalized” credit environment is simply one in which there’s some correspondence between risk and reward, according to many leasing industry leaders.

“We have felt that the risk/reward equation was getting a little bit out of balance,” says Wachovia’s Hamrick. “There has been so much liquidity within the market that you had a lot of dollars chasing a relatively static number of capital expenditures.” Hamrick believes the current correction is probably healthy for the overall business community — and especially for improving the risk/reward equation.

Larkins concurs: “There’s certainly going to be a more thoughtful approach to risk and reward — which has been missing of late,” he says. In fact, Larkins feels that risk is already being scrutinized more carefully. “There’s not a risk manager in the world today who’s not looking carefully at the spectrum of current events and asking, ‘What’s going to happen next, and should we be lending into this environment?’” He remains hopeful that credit and pricing will regain a more rational foundation as LIBOR and treasuries move back toward some semblance of parallel movement.

For Merrill of Fifth Third, a return to order has already begun — and he’s welcoming it. “We’re seeing a return to swap-based pricing indices as opposed to treasuries. Spreads are starting to firm up,” he notes. “Overall, the good news is that the credit correction has not impacted our industry directly, but the fact that it has finally come to the surface means it’s going to help pricing.”

Chase’s Cox is similarly optimistic that any short-term pain will improve the long-term health of the credit and pricing markets. He sees the correction as “…an opportunity to move the risk/reward ratio back to where it probably always should have been.” But he’s less certain that the changes that have occurred to the equipment leasing market itself will allow a more rational risk/reward equation to have a major positive effect on the industry. That’s because the problems might be more systemic, Cox says.

“I don’t know that we’ll ever get back to ‘historically normal’ pricing because I think there has been a fundamental, permanent reduction in the profitability of equipment finance,” Cox says. “Let’s face it: because a lot of the mystery has been taken out of the [equipment finance] product over the years, it has become more of a commodity. Lessees and borrowers have become so much sharper and do much more comparison shopping,” he explains.

And while a savvier customer might be the leasing industry’s emerging challenge, it would be a welcome one — if logic and balance were restored to the risk/reward equation, says Boulden of RBS. He saw the same aggressive behavior in lessors that has been exhibited by many financing sources in the marketplace just prior to the start of the correction.

“Everybody knew that the terms and conditions were essentially ignoring any logical risk/reward equation, and we were all suffering from the excess liquidity,” he notes. Many in equipment finance were questioning why they were even bothering to try to close transactions, Boulden says. “Lenders and lessors were feeling that they weren’t bringing any real value to the deal. They had been totally commoditized and the market was very liquid. I don’t think that anybody in this business feels like their place is one of just calling up a potential customer to give a rate quote.

“There was little room to add value because there was so much irrational behavior,” Boulden concludes.

Lessees Are Cautious, Not Fearful
If most lessors and lenders are cautiously optimistic, how are lessees and borrowers reacting to the current uncertainties? According to many leasing industry leaders, their customers appear largely unfazed by the correction.

“We’re up in originations,” says Chase’s Cox. “We have not seen any hesitancy among our customers to ink new deals.” Boulden shares this sentiment, although he is quick to add that, “We’re still early in the game, and a lot of [our customers’] decisions are longer-term decisions.”

While Fifth Third’s Merrill has seen some of his company’s smaller customers opt to hold off on their capital expenditure decisions, he reports that his larger clients appear unaffected.

“Our [lease] pipelines are still strong,” says Wachovia’s Trollinger. “In our business, we’re financing equipment that is really essential for our customers to have in order to continue their operations and stay in business.” Outside of clients who are closely related to the housing market, he has seen no hesitancy among his customers to book new deals, although he and Hamrick have detected a renewed sense of caution in clients undertaking non-essential capital expenditures.

“I think they’re just being more thoughtful,” says Hamrick. “Today, they’re making absolutely sure that the right dollars are being spent on the right assets at the right time. But they’re going to spend them.”

New lease activity remains relatively robust for Merrill Lynch and SunTrust, as well, according to Remiker and McKew. “While we’re seeing some evidence of companies that have discretionary CAPEX postponing or delaying their decisions to acquire equipment, those that have existing needs for revenue-producing or labor-saving equipment are moving forward to acquire the capital equipment they need to run their business,” Remiker says. McKew adds, “While our business in the commercial sector was down a little bit early in the year, it has since come back.”

But at least one leasing company has seen a shift in its customers’ behavior, according to Larkins, of Key Equipment Finance. “We have seen clients worldwide suddenly slow down their equipment acquisition plans,” Larkins says, and he attributes it to the ripple effect hinging on consumer spending. According to Larkins, “Prudent businesses are looking to see where this correction lands before they keep investing in their plant or capacity or transportation.”

Exorcising the Twin Demons Behind Margin Compression
Equipment leasing executives have complained loudly and often about the twin burdens of seemingly limitless liquidity and easy credit during the market expansion leading up to this year’s correction. As recently as this past spring, Monitor 100 executives polled identified the most common consequence of high liquidity and easy credit — margin compression — as the number one challenge facing their industry.

Will the current market correction effectively reduce liquidity and tighten credit, thereby eliminating these burdens and expanding margins back to more realistic — and profitable — spreads?

Wachovia’s Hamrick thinks so. “Another term for easing margin compression is just getting a fair return for the risk that you’re taking,” he explains. “And that’s been out of balance in the recent past across a broad array of capital markets, not just in the leasing sector.” Hamrick says that the correction has already helped ease margin compression in the corporate debt public markets, and he feels confident it’s going to eventually have a positive effect on the leasing industry.

Merrill is similarly optimistic: “We’re just starting to see a turnaround in margins. We have a long way to go, but I think this is a sustainable trend and margins will start to recover now.” He notes that there wasn’t much spread differential between lower-rated and higher-rated credits, and he’s welcoming a return to a more traditional view of pricing relative to risk.

Bank of America’s Bowers knows the problem has been real. “If you were to stop the clock today and compare where we are today with where we were three years ago or so, you would see that we are like any other wholesale lender: we have experienced significant margin compression,” he says.

And deal structure should not be overlooked as a contributor to compressed margins either, says Merrill. “We’re seeing a renewed emphasis on structural return. Taking bigger balloons or higher residuals, or making larger advances, are no longer being given away for free. We’re now asking to be paid for the additional risk being put into these kinds of transactions,” he says.

Wachovia’s Trollinger agrees that aggressive deal structures are a significant contributor to compressed margins. “They almost go hand in hand,” he says.

So how long will it take to see healthier margins? “It’s like turning a huge ship; it takes a couple of miles,” says McKew. “It takes time.”

“In the short term, margins are probably going to get worse,” warns Larkins, “because you’ve got a lot of LIBOR-based funding and a lot of treasury-based pricing — and they’re not moving together.” He goes on to explain that every borrower, from AA to unrated, is paying a risk premium for their money — and those risk premiums have widened dramatically in the past 30 days.

Larkins predicts that because the consequent increased cost of funds cannot all be passed along to lessees, margins will continue to compress in the near term followed by a steady return toward improved margins. “Rationality, risk premiums, a yield curve will all help. This is an 18-month process; it’s going to take a while,” he explains.

Boulden of RBS sees signs of an easing of margins underway already. “Better rates are already starting to creep into the market. Margins across the board are starting to go up,” he says. And he thinks he knows where to look to explain why. “I think we’re in the earlier stages of an upswing [in margins] because the bank relationship managers we know are already getting higher margins on their new revolvers — anywhere from 10 to 50 basis points,” Boulden says.

He also feels that liquidity is going get scarcer in certain markets: “There’s going to be a flight to safety. We’ve already seen that; that’s why treasuries dropped so much,” he explains. “And we’ve only seen the first wave; the next wave will occur when the third quarter results come out, and then there’s going to be a flight to quality.”

Cox, too, feels certain that margin compression should begin to ease up. “I definitely think it is the logical, natural and, probably, gradual outcome of what we are seeing underway with the current correction,” he says.

With better margins comes a subtle shift in leverage, says Boulden. “The pendulum is swinging fairly quickly from the borrower or lessee having the upper hand to the lender or lessor starting to have the upper hand,” he explains. “For so long, [the lender or lessor] had no leverage whatsoever on terms, conditions or margins. Those days seem to be behind us now, and I expect financing sources to be more disciplined and selective,” he says.

Tapping the Opportunities in Today’s Challenges: A Look Ahead
If there are indeed opportunities in challenges, the equipment leasing industry faces no shortage of options for success and growth — not only from the current correction underway but also through applying the core values that have sustained the industry through similarly turbulent times in the past.

“I think the leasing industry is still a very vibrant and strong one,” says McKew. “All of us in it have done a very good job of diversifying ourselves within our own organizations. That’s why we’ve survived the past ten years. And if we continue to do a good job, we’ll survive another ten years.”

McKew feels it might be valuable to compare the names of the top 20 leasing companies listed in The Monitor 100 ten or 15 years ago to those listed today: “I’ll bet they’re completely different,” he says. The ability to adapt to meet rapidly evolving challenges and opportunities has always been a hallmark of success in the industry, McKew says.

Longevity is most often associated with a commitment to recognizing the opportunity inherent in change. “I’m very optimistic about the opportunities that are ahead of us for growth in the equipment financing industry,” says Key’s Larkins. “I’m very encouraged by the efforts of Ken Bentsen and the ELFA team that has brought a fresh focus to advocating on behalf of its membership.” Larkins credits the ELA’s transformation into the ELFA and subsequent repositioning as a significant factor in strengthening the stature of the equipment financing industry.

For Chase’s Cox, his industry’s transformation has been inevitable — and will be critical to meeting the changing needs of lessees and borrowers in the future. “What’s going to be the role of a stand-alone equipment finance company within a bank 15 years from now?” he asks. “Eventually, the skill sets are going to be so similar to banking skill sets that there really won’t be much difference.”

The transformation is already well underway, according to some. “ELFA has appropriately recognized that we are a capital formation industry, and we’re beginning to be understood as that,” says Larkins. McKew concurs: “People within our industry are now saying, ‘We are an equipment financing company, not just a leasing company.’”

Regardless of whether one is a lender or a lessor, Bank of America’s Bowers finds cause for optimism in the capability of the industry to continually adapt to market needs. “As long as the economy generally holds up and as long as we continue to have positive CAPEX spending, I remain optimistic,” he says. He also gives credit to the people who have shaped the industry and risen to its challenges to find opportunities.

“I’ve got enormous respect for the people in this industry,” says Bowers. “They’re a very entrepreneurial, smart group of professionals. It seems to me that we always find a way. That mantra has always played out for Bank of America and has, by and large, always played out for the equipment finance industry. We always seem to find our way, and that’s encouraging.”

“I’m encouraged by the youth and the interest in our industry, but it has to be kindled. We have to work at finding new talent from Generation Y and making our businesses attractive to them,” Larkins says. “I don’t think there’s any one challenge or opportunity,” says Fifth Third’s Merrill; “I think the key is watching the market closely enough to identify the challenges and create products and solutions that satisfy our clients’ requirements and create opportunity for our franchise.”

SunTrust’s McKew perhaps has the surest advice for these unsure times: “You can’t predict the future, but you can predict that discipline will win out in the long term.”

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Stephen J. McCabe has written on credit management strategies, financing training for sales professionals, and management techniques for today’s leasing industry in recent issues of the Monitor and ELT. McCabe is a writer for Susan Carol Associates, public relations specialists in equipment leasing and e-commerce (www.scapr.com).