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Tuesday
Jul222008

Leverage Detoxification: Banks and Airlines

With second quarter earnings releases in full swing and a four-letter word starting with “F” being used to describe the impact on the industry’s earnings at each and every carrier, the discussion turns to the what actions each and every carrier is taking to address the new macroeconomic reality. The unequivocal response for the industry’s carriers, with the exception of one I guess, is the level of capacity that will be taken out of the system beginning later this year.

The Banking Industry

Over the weekend, and in between 4 rounds of competitive golf in 95 degree heat and matching humidity, I was drawn to a series of articles in the July 28, 2008 copy of Business Week. Peter Coy wrote a piece entitled: The Credit Chokehold. Breaking the vicious cycle of tightening will take time, but how much? He writes how the cover story explains how each dollar of loan loss can force commercial and investment banks to reduce lending by $15 or more. He goes further to suggest, that by one estimate, mortgage-related losses alone could cause a trillion dollars in credit to vaporize”.

Think About All Network Industries – Not Just Banks

In the second Business Week story by David Henry and Matthew Goldstein: How Bad Will It Get?, ….the concept of leverage is raised. The authors write: “Traders, investors, bankers and economists are waking up to the possibility that Wall Street’s recovery from the worst financial disaster since the Great Depression could grind on for years. ……its aftermath will weigh on banks, other companies and consumers alike.”

“One thing is for sure: The new normal won’t be as fun as the recent past. Banks will be smaller and fewer. Capital will be harder to get for some consumers and companies”. The writers ask: Why hasn’t the healing begun? The answer lies in the mechanics of leverage, or borrowed money, which banks not only provide to customers but also use themselves. Leverage is a powerful but dangerous tool, intoxicating on the way up and devastating on the way down”.

The authors continue: "Banks live on the stuff [leverage]: When they post profits, they borrow money to make more loans and book still more profits. During the boom, bigger mortgage loans pumped home prices until people couldn’t handle the debt and the bubble burst. Then the banks, poorer from the losses, had to cut back their own borrowing, too. Now the damage is spreading. How far? Simplified, for every dollar of bank wealth lost, government-regulated commercial banks must eliminate some $10 of lending; for investment banks, the figure can be $30”.

The article includes a graphic demonstrating “The Leverage Multiplier.” Banks used borrowed money to amp returns in the good times.

1. By borrowing $15 for every $1 of capital – or leveraging up 15 times – an investment bank could turn $10 billion into a portfolio of $150 billion.

2. But leverage also amplifies losses. The authors describe when the value of a bank’s portfolio drops by 2%, or $3 billion, the bank loses 30% of its capital, cutting the original $10 billion to $7 billion.

3. Those losses have ramifications that go beyond the bank. If its leverage ratio remains the same, the firm may have to cut back its lending – in this case by $45 billion ($3 billion X 15). That tightening hurts the economy”.

Airlines: Struggling With Just How Much Capacity to Pull Down – For Many of the Same Reasons

The airline industry that lawmakers, communites, employees and other stakeholders have come to know was born of an industry addicted to leverage.

Whereas banks utilize financial leverage to improve returns, the airline industry employs operating leverage. Each node, or new city added to an airline’s map, benefits multiple other flights on that airline’s network by generating new traffic and revenue. Both of these industries are network industries and leverage is a critical component in sustaining existing, and generating new, scale economics.

As the Business Week piece suggests that traders, bankers and economists are waking up to the fact that the banking industry’s recovery could drag on for years - airline industry consumers, employees and communities of all sizes should be considering the same. The article suggests that the banking industry will be smaller and have fewer players. So too will the US and global airline industries. Air travel consumption will prove harder for many consumers going forward. And yes, there will be some dislocations from the air transportation system.

The leverage of capacity growth since deregulation has been both a powerful and dangerous tool for individual carriers. For the industry, it has been intoxicating on the way up as air travel has been made available to the masses. But we are about to experience some devastation on the way down as networks are deleveraged.

Wright Analysis Still Describes Hub Dynamics

The one thing readers will discover about Swelbar: I have advocated one position or another during a career and have done so with conviction. I have made my conclusions over the years with supporting analysis. In fact, the internet makes it impossible to hide from what you have done and said and honestly, that is good. In 2005, I was retained to assist American Airlines in its defense of the Wright Amendment.

Based on work done earlier in a career (the United-US Airways merger attempt in 2001), American asked for an analysis of what “could” happen to the DFW hub if AA were to match Southwest’s expected three frequencies per day into 15 of the largest US markets from Love Field? It was assumed that these 90 inbound and outbound flights would be operated at Love instead of DFW. The (Eclat Consulting’s findings at the time on this project where I was the lead) conclusion was that if American were to move those 90 operations from DFW to Love, an additional 279 flights at DFW would be negatively impacted. The analysis was a ”bottoms up” analysis of load factor impacts of all flights arriving or departing DFW based on the movement of these 90 operations.

Of course you can question whether all 279 would have been uneconomic as market prices were not considered. The analysis found that a 3:1 leverage ratio existed (one mainline flight from 15 large markets supports 3 other mainline and/or regional flights at DFW). It is not totally unreasonable. Moreover, we are about to witness in real time the delicate cutting of capacity that is being considered by each of the hub and spoke carriers.

I was attacked on the analysis of hub degradation then, but it applies to the industry’s decision to cut back capacity today. Wall Street is saying that 20% is the number that gives the industry pricing traction. I do not disagree. But isn’t it also about a 20% reduction within a carrier’s competitive footprint that matters? Why is it being suggested that each carrier pull down capacity approximating 20% that makes it right in the eyes of the Street?

I have been public in my analysis that the industry needs to be judicious in capacity cuts. There is a leverage ratio for airlines too. Competitor capacity cuts within each airline’s footprint need also to count toward that 20 percent. But Delta’s 20 percent is different than United’s 20 percent is different than American’s 20 percent. Right? By the actions already announced, just how much previous capacity will vaporize based on the deleveraging of the industry? Capital has vaporized and so too will existing capacity – or at least we hope.

The healing for the airline industry will only begin when a sustainably profitable model is found that benefits all stakeholders - and this time it will need to benefit shareholders too.

Congrats to United on a very nice earnings call earlier today.