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Securitization

Deutsche Bank@
Global Markets Research

October 13, 2006


Guide to Pooled Aircraft Lease
Securitizations
Grounded after 9/11, liquidity returns
Table of Contents • Following some very difficult years after September 11, 2001, the airline industry has
recently been benefiting from strong global demand for air travel, helped by relatively
Introduction ..................... 3 healthy global economic conditions. These improved underlying fundamentals have
helped resurrect the market for ABS backed by aircraft leases. New issuance activity
Underlying aircraft
has picked up, and liquidity has also improved in the secondary market.
market trends .................. 4
• Many airlines have been successful in trimming their labor costs. However, the
The lessees ................... 10 operating environment for commercial airlines is still very difficult, and recent savings
Aircraft valuation achieved in labor costs in some cases have been more than offset by high fuel prices.
factors............................ 14 Additionally, the industry remains vulnerable to unpredictable events such as terrorism,
health scares (e.g. SARS), etc.
Aircraft ABS lessors
and historical issuance .. 18 • This article will focus on ABS backed by pools of aircraft operating leases, sometimes
referred to as “pooled aircraft lease ABS.” This asset class offers relatively short (3-5
Aircraft ABS structures year) average lives, with floating-rate coupons. Post 9/11, senior classes have been
and cashflow ................. 22 offered with surety wraps, with yields more typical of CDOs and home equity ABS.
Relative value ................ 27 However, given the highly cyclical nature of air travel and the potential for negative
industry-wide events, we believe a cautious stance is still appropriate for this asset
Conclusion ..................... 29 class.

Katie Reeves
Director
(212) 250-2507
katie.reeves@db.com

IMPORTANT: All prices are those current at the end of the previous trading session
unless otherwise indicated. Prices are sourced from local exchanges via Reuters,
Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject
Karen Weaver, CFA companies.
Managing Director Deutsche Bank does and seeks to do business with companies covered in its research
Global Head of Securitization reports. Thus, investors should be aware that the firm may have a conflict of interest
Research and Regional Head that could affect the objectivity of this report.
of Research for the
Investors should consider this report as only a single factor in making their investment
Americas
decision.
Independent, third-party research (IR) on certain companies covered by DBSI's
research is available to customers of DBSI in the United States at no cost. Customers
David Folkerts-Landau can access this IR at http://gm.db.com, or call 1-877-208-6300 to request that a copy
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Global Markets Research
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
October 13, 2006 Guide to Pooled Aircraft Lease Securitizations Deutsche Bank@

Pooled Aircraft Lease Securitization

Introduction

The pooled aircraft lease securitization market dates back to the early 1990s, but it
has had an erratic history. Issuance of ABS backed by commercial aircraft leases, and
its acceptance by investors, grew steadily throughout the 1990’s until the events of
September 11, 2001 stopped the asset class in its tracks. Aircraft values and lease
rates fell, impacting cash flow on many aircraft deals issued prior to 9/11. Issuance
ground to a halt, and there were downgrades. However, over the past several years,
demand for air travel has returned to its pre-9/11 levels, and the market for aircraft is
much more balanced in terms of supply and demand. The aircraft leasing industry is
enjoying a resurgence, and the pooled aircraft lease securitization market is once
again active and healthy. Lessors are finding a ready market when leases expire and
aircraft need to be re-leased, and lease rates have risen accordingly. However, the
operating environment for most commercial airlines is still difficult. Fuel prices are
still near all-time highs, rapidly eclipsing labor costs as the largest operating expense
for many airlines. Today, two major U.S. airlines, Northwest and Delta, are operating
under bankruptcy, in a Chapter 11 reorganization status.

Over time, “aircraft “Aircraft securitization” has over time picked up a variety of different financing
securitization” has structures on a continuum ranging from corporate credit to structured credit. Early
included ETCs, EETCs, issuance was dominated by structures that were largely linked to the credit of the
and pooled aircraft lease airlines. Equipment Trust Certificates (ETCs) are bonds issued to finance a single
ABS aircraft, or multiple aircraft from the same airline. Enhanced Equipment Trust
Certificates (EETCs) are like ETCs in that they finance aircraft from a single airline, but
they also include structural enhancements such as liquidity facilities. In both ETCs
and EETCs, the airline itself manages the aircraft (rather than a lessor), and there is
typically a rating dependency on the airline’s corporate rating. In addition to ETCs and
EETCs, there have also been repackagings of previously-issued ETCs and EETCs.
The EETC market dried up significantly after 2001, and, according to Standard &
Poor’s (S&P), there has not been a new EETC deal issued since 2004.

The ETC and EETC structures are on the “corporate” end of the financing spectrum
in that they are a transaction issued by a single airline, and the credit is tied into the
health of that airline. This primer will focus on the segment of “aircraft securitization”
that is furthest along the continuum toward structured credit, namely, pooled aircraft
lease securitizations. (Hereafter, we will shorten the label “pooled aircraft lease
securitizations” to “aircraft ABS” for this category of deals, and to distinguish these
transactions from the ETC or EETC markets. These are ABS backed by a pool of
aircraft and related leases, entered into by a single leasing company acting as lessor
(who initiates the securitization) and multiple airlines.1 The lessors that undertake
such transactions purchase aircraft either directly from manufacturers such as Boeing
or Airbus, or in the secondary market from airlines, other lessors, or other holders of
aircraft, and then lease or re-lease them to the airlines. In aircraft ABS, the leases and
the aircraft themselves are the collateral. In a given pool there are generally a large
number of airline lessees from regions around the world obligated to make lease
payments on a variety of different types of aircraft.

1
There have been a number of ABS transactions backed by aircraft financed for “general aviation”
purposes rather than commercial airline use (for example, corporate jets). While there have been
securitizations backed by corporate aircraft, these will not be the focus of this primer. Unless otherwise
stated, this article will refer to ABS linked to commercial passenger (rather than corporate, or cargo)
aircraft.

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

In order to better understand the health of the aircraft lease market, we begin with
an overview of the recent history and trends in the underlying aircraft market.

Trends and Recent History of the Underlying Aircraft Market

Lengthy manufacture, Before delving into the details of aircraft valuation and leasing, it is important to
order, and delivery time understand some dynamics of the air travel industry, which affect worldwide
frames make it difficult demand for and supply of aircraft. The long manufacturing time frame for new planes
for supply and demand (12–18 months), and an additional period for the manufacturer to determine which
to be perfectly balanced actual aircraft goes to which airline, and to deliver the aircraft, results in a consistent
in the aircraft market mismatch between supply and demand for aircraft. When placing orders for new
aircraft with manufacturers, the purchasers (lessors, airlines, etc.) have to come up
with a view of where they believe the market will be several years hence, when the
ordered plane is actually delivered. Given an historic correlation between aircraft
demand and GDP, economic forecasts tend to be a large part of the exercise. With
that said, it is easy to see how an exogenous shock like September 11 could result in
a dramatic imbalance between supply and demand, that can take several years to
correct itself.

Airlines’ operating results provide one indication of how well they are navigating this
competitive climate. The airlines have their own language for reporting operating
results. Some of the most common measures are shown below:

Operating statistics reported by airlines

The following measures are tracked and reported by airlines to illustrate capacity, profitability, and efficiency of
their operations.

Revenue Passenger Kilometre (RPK) – One passenger flown one kilometre. Measures air traffic volume.

Available Seat Kilometre (ASK) – One seat flown one kilometre. Measures capacity of an airline.

Cost per Available Seat Kilometre (CASK) – The cost of an airline to fly one available seat kilometer..

Revenue per Available Seat Kilometre (RASK) – The revenue generated from one available seat kilometer.

Load Factor – How much of the available capacity (both in terms of seats and kilometres flown) is being utilized. A
measure of efficiency for passenger aircraft, this is the ratio of RPKs to ASKs.

Breakeven Load Factor – The minimum load factor required for an airline to break even. This is calculated by
dividing total operating costs by total revenue, and multiplying that by the load factor. When costs are higher, the
airlines need more seats filled with passengers, flying longer distances, all else equal.

Source: The Airline Monitor *For many of these measures, “mile” is substituted for “kilometre” for U.S.-based companies.

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Demand for Travel

Globally, economic Globally, the single most important long-run driver of commercial air travel is global
conditions drive long- economic conditions. Over the short-run, however, events such as 9/11 can have a
run travel trends; one-off severe impact (more often than not, negative) on demand, even in the face of an
events can impact otherwise improving worldwide economy. World health threats (SARS, avian
demand shorter term, influenza, etc.) are other examples of events that fall into this category. While these
however statements hold true globally, over both the long-run and the short-run, demand for
travel is also heavily affected by regional factors. The individual economies and
regulatory climates for aviation in the regions where aircraft are being leased and
operated shape travel trends more locally.

For the airline industry, the terrorist attacks of September 11, 2001 could hardly have
come at a worse time, as demand was already dampened by a mild economic
recession. Over the past few years, however, demand for travel has rebounded.
According to Avitas,2 after having grown just 0.9% in 2003, global air traffic grew
14.0% in 2004. Avitas saw a slightly slower growth rate in 2005, of 7.7%. The two
major commercial aircraft manufacturers, Boeing and Airbus, also conduct their own
annual industry analyses with comparable statistics. While the Available Seat
Kilometers (ASKs) and Revenue Passenger Kilometers (RPKs) data (prepared by
Airbus) in Figure 1, is only through 2004, it shows the impact of 9/11, and the
subsequent rebound in travel:

Figure 1: The last several years have seen a rebound in demand for travel

Source: Airbus Global Market Forecast, ICAO, Airbus estimates

Looking forward, Avitas, Boeing, and Airbus all have published projections for air
travel looking about twenty years into the future. The chart below shows both
historical global travel activity, as well as the long-term outlook globally for air travel,
smoothed for short term trends, as reported by Boeing.

2
Avitas is an aviation consulting firm, which, among other services, performs aircraft appraisals. Each year
Avitas publishes a “Global Outlook for Air Transportation,” which can be found at http://www.avitas.com.

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

Figure 2: Boeing projects world air travel to grow faster than GDP globally

Source: Boeing Market Outlook. Note: Cargo growth rate measured in Revenue Tonne Kilometres (RTKs)

Boeing and Airbus are As the chart above shows, while Boeing is assuming a long-term global GDP growth
each forecasting long- rate of 3.1%, the company is forecasting demand for air travel to increase at a faster
term demand for aircraft pace. Boeing is looking to regions that have the most potential for modernization in
to outpace GDP growth their economies and liberalization in their travel regulations to lead the growth. The
report specifically cites northeast Asia, South America, and parts of Europe as likely
to experience the most growth in air traffic in excess of their GDP over the forecast
period.3 Airbus publishes a similar market outlook, projecting demand going out to
2023.4 Airbus projects that passenger air traffic (which is the segment most
represented in aircraft lease ABS) will grow 5.3% annually, slightly faster than the
4.9% annual growth in passenger traffic forecasted by Boeing. Airbus is projecting
freighter/cargo traffic to increase 5.9% annually to 2023, slightly lower than the 6.1%
forecasted by Boeing for freighter/cargo traffic.

Similar to the projections provided by Boeing and Airbus, Avitas was predicting global
air traffic to grow at an average annual rate of 4.7% between 2005 and 2024. The
expectation for above-average growth in both passenger and cargo traffic from the
Asia/Pacific region can be seen in the charts below:

3
See page 7, Boeing Current Market Outlook 2005.
4
Airbus Global Market Forecast, 2004-2023, http://www.airbus.com.

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Figure 3: For passenger air travel, the Asia/Pacific region is forecasted to see
the fastest growth (Passenger Traffic Forecast Annual Growth Rates (%))

25

20

15

10

0
2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024

United States Europe Asia/Pacific Other World

Source: Avitas report, 2005 Global Outlook for Air Transportation

Figure 4: The Asia/Pacific region is also forecasted to lead growth for cargo
traffic (Cargo Traffic Forecast Annual Growth Rates (%))

16

14

12

10

0
2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024
United States Europe Asia/Pacific Other World

Source: Avitas report, 2005 Global Outlook for Air Transportation

Demand also varies widely by aircraft type. Most aircraft ABS are collateralized by
leases on passenger (rather than cargo) aircraft. Passenger aircraft may be
“widebody” (300+ seats), or “narrowbody” (100-229 seats) jets5. Demand for bigger
or smaller aircraft depends in part on the type of routes that can be flown with each
type, as well as cost efficiency. Additionally, liquidity is bolstered for a particular
model when a large number of airlines want to use it, supporting demand. In the
widebody category, the two major manufacturers have taken very different views on
what will drive demand in coming years. Airbus believes that airlines will strive to
obtain further improvements in operating efficiency, carrying larger numbers of
passengers through large hub airports, for less expensive fares. Boeing, on the other
hand, believes that airlines will support growth through more diverse point-to-point

5
There is also another category of smaller planes, regional jets.

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

route systems (rather than relying on the traditional aircraft hub cities). This strategy
would make use of smaller widebody aircraft between secondary international city
pairs, as opposed to larger hub airports. This has recently led Boeing and Airbus to
develop the B787 (relatively smaller aircraft) and the A380 (relatively bigger aircraft),
respectively. With that said, Boeing also continues to produce large aircraft (the
B747, for example), and Airbus continues to produce smaller aircraft (the A330, for
example).

Figure 5: The A330 is a popular model in flight (and in securitization pools) today; the A380 and B787
models are the most recent large commercial passenger aircraft to be developed

Airbus A330-300 Airbus A380 Boeing 787-8

Source: Wikipedia

Useful lives for most Compared to passenger use, aircraft used for cargo/freight generally have a longer
passenger aircraft range useful life (35 years, versus 25-30 years for most passenger aircraft), because cargo
from between 25-30 aircraft tend to have lower utilization rates than passenger aircraft. This is also
years; cargo aircraft can because freighter operations are more able to cope with less reliable, older aircraft,
usually be flown for 5-10 while a passenger airline cannot afford the negative stigma associated with poor
years longer “dispatch reliability” metrics (on-time statistics, etc.). “Passenger-to-freighter”
conversion programs6 offered by the manufacturers or other companies certified to
carry out such conversions, can extend the life of an aircraft, and are seen as a
valuable option for aircraft owners.

Supply of Aircraft

The global stock of In commercial aviation, the existing stock of aircraft worldwide is typically described
aircraft consists of in terms of the “world commercial aircraft fleet.” Aircraft come from a number of
previously-delivered different sources. Brand new aircraft come into the world fleet when manufacturers
aircraft, new deliveries make deliveries of newly-built planes, fulfilling orders placed years earlier, in many
and aircraft in storage cases. Boeing and Airbus7 both regularly provide data on their orders and deliveries.
According to the most recent Airbus numbers, the manufacturer delivered 378
aircraft in 2005, up from 320 in 2004. Boeing delivered 290 in 2005, up slightly from
285 in 2004, and is projecting 395 deliveries for 2006. These numbers may soon
increase, however, given a record number of orders for aircraft received in 2005.
Boeing received 1002 new orders, up dramatically from the 272 and 239 orders
received in 2004 and 2003, respectively. Airbus had 1111 new orders in 2005, also
up dramatically from the 370 and 284 orders received in 2004 and 2003, respectively.
However, most of the world commercial aircraft fleet is older, existing aircraft. The
stock of existing aircraft is very fluid, with planes moving from airline to airline as
they are bought or sold, and/or as leases expire and lessors remarket the planes.

6
Such a program must be certified by the FAA or other relevant government authority that such
conversion can occur.
7
Boeing and Airbus currently are a duopoly in the market for large commercial passenger aircraft.

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Aircraft may be At any given time, some percentage of the world commercial aircraft fleet will be
“parked” (temporarily or parked. Lease rate changes, higher operating costs and the availability of more
permanently) when they efficient models can all lead an airline to store an aircraft, either temporarily or
become uneconomical permanently. Such aircraft on the ground may be put back in service if the dynamics
to service and fly shift, and the economics make sense (including the cost of reactivation). According
to Avitas, in April 2005, there were approximately 1,100 commercial aircraft in
storage. The fate of the current stock of such parked aircraft has been a hot topic
lately. Many believe that the likelihood that such aircraft will ultimately be put back
into service is much lower than would have been the case several years ago. Today,
airlines have been parking older planes that are coming up on regular “maintenance
events”. Such scheduled maintenance is performed every several years, and ends
up being a significant capital expenditure. Rather than paying for the upkeep for the
older, less fuel-efficient planes, airlines have been parking them, and flying newer,
more fuel-efficient aircraft.

The world fleet can be broken down several ways, and the two manufacturers, and
Avitas, all use slightly different categories. The data shown in Figure 6, below, is
provided by Avitas, which breaks down the world fleet between narrowbody,
widebody, and regional jet aircraft8. As shown in Figure 6, a little more than half of
the world fleet today is comprised of narrowbody aircraft, a trend which is expected
to persist.

Figure 6: Narrowbody aircraft comprise more than half of the existing world
aircraft fleet

25,000

20,000
Number of aircraft

15,000

10,000

5,000

0
2004 2005 2006 2007 2008 2009 2010

Narrowbody Widebody Regional Jet

Source: Avitas report, 2005 Global Outlook for Air Transportation

Boeing provides similar data, but breaks down the fleet by regional jets, single-aisle
aircraft, twin-aisle aircraft and aircraft at least as large as the Boeing 747. (All single-
aisle aircraft can be considered “narrowbody”, and all twin-aisle aircraft, and the
“747 and larger” category used by Avitas, can be considered “widebody”.) As
shown in Figure 7, Boeing is forecasting in its market outlook a near doubling of the
world fleet by 2024. Further, Boeing projects that by 2024, the share of very large
aircraft (for example, Boeing 747’s) will decline from 6% to 4% of the total, while
midsize twin-aisle planes will increase from 18% to 22%.

8
Regional jets seat approximately 35-100 passengers, and are not a significant part of most aircraft ABS
pools. Narrowbody aircraft typically seat 100 – 229 passengers. Widebody jets are the largest commercial
passenger aircraft.

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Figure 7: Boeing projects that the size of the world fleet will more than
double by 2024

2004 2024
16,800 airplanes 35,300 airplanes
747 and larger, 6% 747 and larger, 4%
Regional jets, 15%
Twin-aisle, 18% Regional jets, 16%
Twin-aisle, 22%

Single-aisle, 61%

Single-aisle, 58%

Source: Boeing Market Outlook

The Lessees and their Operating Environment

A typical aircraft ABS For commercial aircraft leases, the lessees are the many national and regional
deal will include aircraft commercial airlines around the world. That being the case, the financial health and
leased by 20-50 airlines operating environment of the airline lessees is a critical factor impacting the
performance of these lease ABS transactions. In a typical aircraft ABS deal, there is a
large number (20-50) of lessees, from all over the world. However, even with that
number of lessees, it is easy to see how bankruptcy or default by just one airline
could be damaging to an ABS pool. To mitigate this risk, pooled lease ABS structures
will typically include a number of different concentration limits. One of these will
specify that no single airline can account for more than a certain percentage of a total
pool. While this constrains the lessor’s ability to remarket an aircraft to different
airlines, it does benefit investors.

Concentration limits (by There are also concentration limits on the geographic regions where the airlines are
airline and geographic based. In recent years, the North American airlines have suffered disproportionately
region, for example) are versus their competitors abroad. Currently Delta and Northwest Airlines are each in
included in aircraft ABS the midst of Ch. 11 bankruptcy reorganizations, and United and US Air only emerged
structures from their own reorganizations in early 2006 and late 2005, respectively. The
bankruptcy filings have only been the most visible manifestations of the widespread
financial woes of the U.S. “legacy” airlines. In May 2005, Standard & Poor’s
published a review of its EETC ratings related to the large U.S. airlines, commenting
that “the factors most likely to trigger bankruptcy in the near term —high fuel prices,
price competition, possibly renewed terrorism—are industry-wide threats that would
affect many airlines at once.” (And, while that report focused on the U.S. airlines,
many of the concerns could impact airlines worldwide.)

As an example of actual lessee concentrations in aircraft ABS transactions, in a 2005


transaction, Aviation Capital Group Trust III (ACG III), Series 2005-1, there were 45
lessees in the initial pool, and the top 5 initial lessees accounted for just under 25%
of the initial pool value. Fitch included the concentration limits by lessee, country,

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and geographic region for ACG III, Series 2005-1, in a December 19, 2005 presale
report, as shown in the table below:

Figure 8: ACG III, Series 2005-1 Transaction Concentration Limits (%)


Lessee
Single Lessee rated BBB or higher 15
Other Single Lessee (lower rated) 10
Five largest lessees 35
Country
United States 25
Countries rated BBB or better 20
Other Single Countries 10
Undesignated Countries 5
Geographic
Developed European Region 55
North America 25
Developed Pacific 35
Emerging Asia 55
Emerging Europe and Middle East Region 35
Latin America 25
Undesignated 10
Source: FitchRatings

Understanding today’s environment by comparing to the years


immediately post-9/11

Post-9/11, demand for To better understand today’s operating environment, it is instructive to look at what
air travel fell, and supply happened to the aviation market in response to 9/11. Lease rates, (what lessors can
of aircraft built up, charge lessees), are one gauge of values in the market. Even before 9/11, the
causing lease rates to aviation market was grappling with declining lease rates, caused by the overall
fall economic downturn. But the terrorist attacks of 9/11 caused values for many aircraft
models to collapse further, which soon showed up in lease rates.

However, not all aircraft values suffered to the same degree after 9/11. Figure 9
shows typical monthly lease rates, as provided by the International Bureau of
Aviation (IBA). The four models shown were selected to demonstrate how differently
lease rates for different models from the same manufacturer (Boeing) performed.
While the 737s (a very popular medium-range narrowbody aircraft) held up relatively
well, the 767-300ER (a less popular extended-range widebody aircraft) was an
example of an aircraft for which lease rates dropped more. In an audio update that
Fitch conducted in January 20039, the rating agency estimated that deterioration in
market values post-9/11 were running from 30%-70% versus pre-9/11 levels.

9
Aircraft Leasing: Update/Outlook Teleconference Transcript – 1/16/2003, Fitchratings

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Figure 9: Pos - 9/11, lease rates for some aircraft models suffered more than
others

Average Typical Monthly Lease Rental


$600,000

$500,000

$400,000

$327,000
$300,000 $295,150

$200,000
$173,450
$144,550
$100,000

$0
2000 2001 2002 2003 2004 2005 2006

757-200 737-300 767-300ER 737-800

For Models 757-200, 737-300, and 767-300ER, data is for aircraft delivered in 1990. Data for the 737-800 is for
aircraft delivered in 2000.
Source: International Bureau of Aviation, www.ibagroup.com

With many travelers loathe to board aircraft, supply of parked aircraft piled up, just as
aircraft orders placed with manufacturers in earlier years became available for
delivery. Given this extreme imbalance in the market, lessees were able to extract
significant concessions from lessors. In many cases lessees found themselves
unable to make existing lease payments, and it was not uncommon for existing
leases to get renegotiated. (Lessors were left with little option not to.) Airlines under
Chapter 11 bankruptcy protection in some cases got permission from the bankruptcy
courts to return aircraft to the lessors. Even where lessees were able to meet their
existing obligations, as lease maturity dates came due, lessees would negotiate
dramatically lower lease rates to extend. While the new lease rates were in some
cases not enough for lessors to cover associated financing costs, renegotiating with
existing lessees at least gave lessors some cash flow. Many parties that financed the
aircraft for the lessors were burnt and many lenders (banks, insurance companies)
exited the sector.

Fuel costs are quickly However, the industry worked through that period, and demand for air travel has
approaching labor costs grown rapidly over the past several years. In addition to increased revenue, major
as the number one U.S. airlines have also been trying to increase profitability by cutting labor and
airline operating operating costs. However, maintaining profitability has still been difficult, in no small
expense part because of fuel costs. Historically labor costs have been the largest operating
cost for a typical airline. As shown in Figure 10, however, fuel costs are a rapidly
increasing share of costs:

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Figure 10: Fuel costs have almost surpassed labor-related costs as the
greatest expense for airlines

Source: May 2006 Air Transport Association analysis of Energy Information Administration data

The impact of rising crude oil prices on the airlines has been compounded by the
additional cost to refine crude oil into usable jet fuel, a cost which has also been
rising. This incremental amount, known as the “crack spread,” has helped push jet
fuel costs to record highs (see Figure 11). Many of the jet fuel refinery operations are
located on the Gulf Coast, and were severely impacted by Hurricane Katrina in 2005.
Airlines have been coping with rising fuel costs in a number of ways. Many airlines
have hedging programs to mitigate the effect of fuel increases. The industry has
been able to pass some of the higher fuel costs on to passengers. And, longer-term,
the airlines are moving toward more fuel-efficient aircraft.

Figure 11: Record crude oil prices have been accompanied by increased
costs of refining jet fuel

$100
Average Price ($ per Barrel)

$80

$60

$40

$20

$0
1990 1993 1996 1999 2002 2005 YTD
Benchmark Crude Oil Jet Fuel Crack Spread Sept 06

* West Texas Intermediate (WTI)


Source: May 2006 Air Transport Association analysis of Energy Information Administration data

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Actual load factors have Partially as a result of rising fuel costs (as well as lower airfares), the breakeven load
increased but still fall factor, which measures the level of aircraft utilization needed to turn a profit, has
short of break-even load increased dramatically. Prior to 2001, the airline industry’s load factors were
factors consistently higher than where they needed to be on a breakeven basis. But, as
shown in Figure 12 below, beginning in 2001, the breakeven load factor increased
significantly. Even though efficiency gains have also caused actual load factors to
increase, actual levels are still below what is required to break even.

Figure 12: Airlines have increased load factors, but still fall short of what is
required on a break-even basis.
Passenger Load Factor (%)—Majors and Nationals
85%
82.8

80%
77.5

75%

70%

65%

60%
1995 1997 1999 2001 2003 2005
Actual Breakeven

Source: May 2006 Air Transport Association analysis of Energy Information Administration data

Aircraft Valuation Factors

Cash flows for aircraft ABS come from lease payments made by the airlines to the
lessors, as well as proceeds from any related aircraft disposals. As such, aircraft
values and lease terms dictate the available cashflow in this asset class.

The macroeconomic considerations mentioned above heavily impact supply and


demand for commercial air travel globally. However, in reality, the market for aircraft
is very region-specific, and even model-specific. At the most granular level, the
popularity of a given aircraft type/model will depend on:

• The routes that can be flown with the planes (for example, international or
regional)

• Plane layout (number of seats and configuration)

• Performance measures such as direct operating cost

• Engine make/model and level of noise compliance

• Number, type, and location of lessees using the aircraft

• Number of aircraft that are grounded (and, of those, what percentage is


considered likely to be put back into service at some point)

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• Any “replacement technologies” that are on the horizon (i.e. competing,


newer plane models set to become available)

• Number of the aircraft that are still scheduled to be delivered from the
manufacturer in coming years, and

• Maintenance status

Fuel efficiency and Several characteristics of today’s market will make an aircraft model more or less
operational efficiency popular. For flying shorter routes, some of the newer models are expected to retain
will cause a specific their value well, for several reasons. First, they are more fuel-efficient than bigger
aircraft model to be widebody jets. Another big reason is operational efficiency. Airlines today want to be
more or less valuable able to fly a lot of different, sometimes short, nonstop routes, in response to traveler
than another demand. In order to achieve high load factors, they need to be able to fill up their
aircraft. The smaller, more fuel-efficient jets make this possible. Examples of models
that fall into this category, and that are in use by many airlines, are the A320 series
manufactured by Airbus, and the Boeing “Next Generation” single-aisle models,
such as the 737s.

However, the ability to fly long international routes efficiently will also continue to be
important. Here airlines want still fuel-efficient, but spacious, aircraft. Models that
fall into this category include the A330 and the Boeing 777. The issue of
“replacement technology” referenced above is a very real one in today’s long-haul
market. The new Boeing 787 “dreamliners” are expected to begin delivery in 2008.
Airbus’ competing model, the newly re-designed A350, is still in development, but is
expected to begin delivery in 2012. In addition, the double-decker “superjumbo”
A380s are expected to start delivery next year. Many such new models are
expected to offer significant cost and operational efficiencies in the long-haul,
widebody market. On the opposite end of the spectrum, Boeing 727s and DC-10s
are examples of aircraft that are now out-of-production, and are relatively cost-
inefficient.

Appraisals

Aircraft values are Manufacturers will generally sell new planes based on a discounted list price,
assessed in the inflation-adjusted for what can be a multi-year production/delivery time frame. This
secondary market using list price will also be adjusted for market conditions. In the secondary market,
base value or market appraisals are used. Aircraft appraisals generally are one of two types, either a “base
value appraisals value” (or “maintenance-adjusted base value”) appraisal, or a “market value” (or
“maintenance-adjusted market value”) appraisal. In base value appraisals, aircraft
value is assessed with the assumption of a stable market based on balanced supply
and demand factors. By comparison, a market value appraisal adjusts for the
competitive climate of the aircraft buyers and lessees at the time of the appraisal. In
most securitizations, base value appraisals are obtained for all aircraft prior to the
transaction closing date. Base values are generally performed without physically
inspecting the plane, and instead rely on other information obtained. The fact that
market conditions (which do not factor into base value appraisals) have been so weak
up until very recently has likely resulted in base values for many types of aircraft
coming in somewhat higher than where those aircraft would likely have sold for on
the open market. Base value appraisals are used in securitizations because they are
viewed as steady state indicators of long-term value, whereas market value
appraisals can be very volatile.

In a typical ABS transaction, appraisals are obtained from three or four different
appraisers, and an average is calculated. For example, in the ACG III, Series 2005-1

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

transaction, base value appraisals were conducted by Aircraft Information Services,


Inc; AVITAS, Inc.; BACK Aviation Solutions; and BK Associates, Inc. prior to closing.
The total of the appraisals for the pool of 74 aircraft summed together in that
transaction was $2.27 billion (this was the average of the appraisals from the four
different providers).10 As a point of reference (and unrelated to that specific
securitization), Boeing and Airbus show list prices for individual new commercial
aircraft in 2006 ranging from about $50 million to $300 million, depending on model,
size and configuration.

Aircraft Leases and Valuation

Operating Leases

Aircraft operating leases The vast majority of leases seen in commercial aircraft ABS transactions are
have relatively short operating leases11 between the lessor and an airline. For the lessee’s part, the
terms (three to ten obligations under an operating lease are treated as an operating expense, but the
years); responsibility for lease does not show up as an asset or liability on the balance sheet. Compared to
maintenance and capital leases, operating leases result in less debt showing up on an airline’s balance
operating expenses sheet, all else equal. Operating leases also allow airlines to acquire the use of aircraft
usually lies with the without a significant upfront outlay of capital. As with any depreciating asset, there is
lessee a tax benefit associated with depreciation expense; in an operating lease these tax
benefits accrue to the lessor (as owner). Most aircraft leases today are structured as
“triple-net” leases, meaning that the lessee also covers all operating expenses
(including fuel, taxes, insurance, operations (airline crew), etc.), and is responsible for
keeping the aircraft well maintained. The lease terms are generally significantly
shorter (most lease terms are three to ten years) than the useful life of the related
aircraft (25-30 years). Because of this fact, the mechanics of re-leasing, re-deploying,
or disposing of aircraft at the end of their existing leases is an important aspect of
aircraft ABS credit quality.

10
See Presale Report Aviation Capital Group Trust III Series 2005-1 Notes, FitchRatings. December 19,
2005.
11
In an operating lease, the lessee makes lease payments to the lessor for a period of time and gains use
of the property (aircraft) for that period of time only, at which point possession reverts back to the lessor.
Residual risk is borne by the lessor. By contrast, a financial (or capital) lease is structured to be more like a
purchase of the aircraft by the lessee. FASB accounting guidelines require that at least one of the
following is present in order for a lease to be considered a finance/capital lease (otherwise the lease is an
operating lease): 1) lease term greater than 75% of the asset’s useful life, 2) ownership of the asset is
transferred at the end of the lease term, 3) present value of the lease payments is greater than 90% of the
asset’s value, or 4) there is an option in the lease whereby the lessee could purchase the lease for less
than fair market value. Capital leases generally have a longer term (closer to the useful life of the asset),
than do operating leases.

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Aircraft maintenance requirements stem from normal ongoing (wear-and-tear) usage, as


well as (less predictable) government safety regulations

All aircraft must be maintained throughout their lives; each model and each airline will have its own requirements
about what parts and systems need to be updated or repaired according to what specific schedules. Airframe
maintenance typically occurs every five to ten years, and can cost between about $1 million and $5 million each
time, depending on the aircraft, its age, and the airline. Separately, engines have their own scheduled maintenance
programs. For “mature” engines (those at least several years old), maintenance occurs every two to four years,
with the cost ranging from $700,000 to $4 million each time, depending on the engine type and utilization. In
addition to predictable maintenance requirements that result from normal usage, aircraft-specific maintenance
requirements may be issued at any time to address specific safety issues. In the U.S., the Federal Aviation
Administration (FAA) issues these detailed maintenance requirements, known as “airworthiness directives” (ADs).
According to the offering document for the ACG III, Series 2005-1 aircraft ABS transaction, recent ADs have
mandated modifications for collision avoidance systems, airborne wind shear avoidance systems, noise
abatement, as well as requirements for increased inspections.

In aircraft operating leases, the lessees are generally obligated to cover maintenance expenses. Provisions vary in
the leases, however. In many cases, the lessees are required to pay periodic (usually monthly) “maintenance
reserve” payments. Such maintenance reserve payments may be paid along with, or included in, the monthly
lease payments. These go into a trust account, and when maintenance is required, the reserves are tapped.
However, if the reserves are not adequate to cover the cost of the maintenance, any shortfall is made up by the
lessee. At the end of the lease, any unused maintenance reserves go to the lessor. In cases where a lease does
not require ongoing maintenance payments, adjustment payments at the end of a lease are usually required, to the
extent that the aircraft needs maintenance when it is returned. (Here the lessor is essentially relying on the credit
of the lessees.) When this kind of lease is included in an aircraft ABS deal, a liquidity facility or some other type of
structural enhancement is typically sized to cover exposure to the lessee for maintenance expense.

Source: Deutsche Bank, ACG III, Series 2005-1 offering document

Setting Lease Rates

List prices and appraisals are two good sources of aircraft values. However, aircraft
are bought and sold infrequently, and appraisal values can lag true market
conditions. Because aircraft operating leases have relatively short terms, lease rates
often provide a more current picture of market conditions than list prices or
appraised values. Lease rates are set when new aircraft are leased for the first time,
or when existing leases come up for renewal or are renegotiated, reflecting then-
current market dynamics. However, even lease rates will somewhat lag market
fundamentals, since, at any given time some aircraft will be under lease terms
negotiated several years earlier.

To determine a monthly lease rate, the transaction parties must take a view on
where the aircraft’s value will be at the end of the lease term (its residual value).12
This will be driven by assumptions about depreciation, which in turn are driven by
factors such as the liquidity of the aircraft, the aircraft’s age, its assumed useful life
and an inflation/growth variable. (ABS transactions are structured based on cashflow
assumptions relating to these variables. This will be discussed more in a later
section.) The lessor will strive to set the monthly lease rate high enough to cover
depreciation and other expenses, with some margin of profit.

12
Such an assumption is often referred to as an “asset decline” assumption.

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

Aircraft ABS Lessors and Historical Issuance Activity

While aircraft ABS have been issued since the early 1990s, it is still by no means an
on–the–run asset class. Issuance generally has run “hot and cold” with demand for
airline travel, and issuance (and credit performance) were particularly marked by the
events of September 11, 2001.

In terms of lessors executing these transactions, a few names dominate the list.
Lessors with ABS outstanding include:

• AerCap Aviation Solutions – (Formerly debis AirFinance) Now owned by


privately-held Cerberus Capital Management, AerCap manages a portfolio of
aircraft through purchasing, leasing, and trading activity. According to its
website, AerCap has a “modern fleet of 220 commercial aircraft across a
wide range of types, and more than 80 new A320 family aircraft on order”.
Aercap issued the $1 billion “Aircraft Lease Securitization 2005-1” in August
2005. Prior to that deal, Aercap’s previous securitization was a $1 billion
“AerCo Ltd” securitization in 1998. In April 2006, the company announced
the closing of a $1 billion warehouse facility to finance new aircraft. See
www.aercap.com for more information.

• Aircastle Advisor – Aircastle is a commercial aviation finance company that


was formed in 2004 by Fortress Investment Group. The company went
public in August 2006, and trades under the NYSE ticker ‘AYR’. Aircastle
focuses on acquiring, owning and leasing commercial aircraft worldwide. The
company is based in Stamford, CT, and also has offices in Dublin and
Singapore. According to its website, Fortress Investment Group is a global
alternative investment and asset management firm founded in 1998 with
approximately $21 billion in equity capital under management. Aircastle
issued its first term ABS transaction, ACS 2006-1 Pass Through Trust, in
June 2006. See www.aircastle.com for more information.

• Aviation Capital Group (ACG) – Wholly-owned by Pacific LifeCorp (A3/A/A),


Aviation Capital Group bought Boullioun Aviation Services in 2005, adding
$5 billion to the ACG portfolio. According to its website, ACG acquires and
leases commercial jets (focusing on narrowbody aircraft) to more than 90
airlines in 42 different countries, and currently owns and manages 200+
aircraft. ACG has issued three securitizations (in 2000, 2003, and 2005),
totaling $3.6 billion. The $1.86 billion ACG III, Series 2005-1 transaction was
its most recent deal, pricing in December, 2005. See
www.aviationcapital.com for more information.

• GE – GE (Aaa/AAA/AAA) is active in both commercial and corporate aircraft


leasing. Its commercial business is conducted through GE Commercial
Finance Aviation Services (GECAS). Its corporate business is conducted
through the Corporate Aircraft division of GE Commercial Finance. GE has
recently been a particularly active securitizer of its corporate aircraft lease
portfolio, coming to market annually since 2003. GE purchased a large
corporate aircraft portfolio from CIT in 2005. See www.gecas.com for more
information.

• International Lease Finance Corporation (ILFC) – ILFC is a wholly-owned


subsidiary of AIG, Inc. (Aa2/AA/AA). ILFC is the lessor for the Castle Trust
ABS program and also serves as a back-up servicer for the ACG
securitizations. According to its website, ILFC is the largest lessor in the

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world as measured by fleet value ($40+ billion) and has a fleet of more than
800 aircraft. In addition to leasing aircraft, ILFC also provides fleet
management and aircraft remarketing services to third parties. See
www.ilfc.com for more information.

• Pegasus Aviation – Pegasus was founded in 1988, and, according to its


website, has a fleet of 195 passenger and cargo aircraft. A November 2005
article in Air Finance Journal puts the value of its fleet at that time at
$4.6 billion.13 In addition to leasing services, Pegasus also remarkets aircraft
and arranges other types of aircraft financing for end users. Pegasus issued
four securitizations from 1997 to 2001, through the Pegasus Aviation Lease
Securitization (“PALS”) ABS platform. Oaktree Capital Management is a
leading investor in Pegasus. Historically Pegasus had a strategy of
purchasing older aircraft and leasing them to small carriers, but has recently
stepped up purchases of new models, including the Boeing “Next
Generation” 737 series. See www.pegasusaviation.com for more
information.

The following chart shows annual issuance of rated, capital markets14 pooled aircraft
lease deals (including corporate aircraft deals, but excluding repackagings of
previously-issued transactions), over the past 10 years:

Figure 13: Aircraft ABS Issuance – Quieted by 9/11, but staging a comeback

$6,000 4
2 8
$5,000
$US (millions)

$4,000 4 4
6
4
$3,000

$2,000
1
$1,000 2 1 1

$0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Note: Number of transactions indicated above each column. Excludes ETC, EETC, and repackagings of previously-
issued transactions.
Source: Deutsche Bank

The single transaction shown above for 2006 is somewhat misleading in terms of it
being a measure of financing activity. Over the last two years, there has been a
relative shift from rated, capital markets issuance to the (unrated) bank markets. The
bank market has allowed issuers to pursue acquisition financing of aircraft portfolios,
as well as access term or warehouse financing of existing portfolios. The bank
market deals have typically been unrated, but structured to an implied triple-B level.
This market has allowed issuers more flexibility in terms of structure, and the ability
to manage their portfolios more precisely. (In a bank deal, issuers will frequently be

13
Air Finance Journal, The New Pegasus, Victoria Pennington, November 2005.
14
As opposed to unrated deals offered in the bank markets.

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

allowed to buy or sell a limited number of aircraft, subject to specified eligibility and
performance conditions, and maintaining concentration limits).

A bleak ratings history for early aircraft ABS deals

Since September 11, 2001 the aircraft ABS sector has had the unenviable distinction of being one of the most
downgraded asset classes. As shown below, as a percentage of total ABS downgrades, aircraft ABS accounted for
26% of all downgrade activity in 2006, the highest percentage ever. (See chart below). This is a high percentage
for a segment of the market that has never made up more than 1% of ABS new issue volume. Most of these
downgrades were the direct result of September 11, and all were a function of collateral performance as opposed
to, for example, the downgrade of a swap counterparty or other third party. After 9/11, weaker demand for travel
overall pressured lease rates. In some cases lessees defaulted. In others, aircraft leases were renegotiated at very
low lease rates, or aircraft were re-leased to new lessees at rates much lower than what was assumed when the
transactions were first modeled.

30% $25,000
Percent of total ABS downgrades

25%
$20,000

Downgrades ($000s)
20%
$15,000
15%
10.74%
$10,000
10%

$5,000
5% $5,714.1

0% $0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Aircraft as a % of total ABS downgrades (due to collateral/servicer performance)


Aircraft ABS downgrades (due to collateral/servicer performance, in $000s)

The damage extended to the structured product CDO sector. To add collateral diversification and pick up yield,
many of the early structured product CDOs invested in aircraft ABS, which along with weak performance in
manufactured housing, franchise loan, and mutual fund fee ABS, ultimately wound up causing the downgrades of
many of those CDOs.

Source: Deutsche Bank

Recent Aircraft ABS Issuance

So far in 2006 there has been just one transaction, ACS 2006-1 Pass Through Trust.
In 2005 there were four pooled aircraft lease deals issued, one of which was backed
by corporate aircraft loans (GE Equipment Corporate Aircraft Trust, Series 2005-1).
Two of the 2005 deals, Aircraft Lease Securitization Ltd., and Aviation Capital Group
(ACG) III, Series 2005-1, were backed by commercial leases on large commercial jet
aircraft, while a third, RASPRO Class G Pass Through Trust 2005-1, was backed by
leases on smaller regional aircraft. Highlights of the 2005 and 2006 commercial
aircraft lease transactions, all of which were done on a 144A basis, are shown below:

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Figure 14: Summary of Recent Aircraft ABS


ACS ACG III, Aircraft Lease RASPRO Class G Pass
2006-1 Series 2005-1 Securitisation Ltd Through Trust 2005-1
Servicer Aircastle Advisor Aviation Capital Group AerCap Group (f/k/a debis Bombardier Services Corp.
AirFinance)
Pricing Date 6/2/2006 12/28/2005 8/31/2005 9/15/05
Bloomberg Ticker ACST ACAP AERLS RPRO

Total Size Offered $560 million $1.86 billion $1 billion $1.39b


Aircraft 40 commercial aircraft Commercial - 63% Boeing Commercial - 90% Airbus 65 regional jets
55% Boeing; 45% Airbus WA age – 4.8 years WA age - 8.2 yrs 5 turboprop aircraft
54.8% narrowbody planes 98.6% narrowbody planes 66.9% narrowbody planes WA age at closing –
no freighters 6.9% freighters 6.5 months
7.5% freighters
Lessees/Obligors 23 airlines in 19 countries 46 airlines in 28 countries 19 airlines in 16 countries 4 lessees total:
Largest lessee – USAir Largest lessee - Air Europa Largest lessee - Tombo Skywest (45.25%)
(16.3%) (6.1%) (13%)
Air Canada (25.8%)
top 3 lessees are 36% of 38% of the lessees are in
Mesa (23.3%)
pool Europe
Flybe (U.K.) (5.6%)

Leases Operating leases Operating leases Operating leases Capital/Finance leases for
WA remaining lease term: WA remaining lease term: WA remaining lease term: 47 of the aircraft; terms
4 years 3.8 years 2.6 yrs were expected to be
18.5 years (per S&P
73 leases; 1 of the aircraft
was off-lease at close Presale Report)

Initial triple-A LTV 54.8% 70.6% 54.2% (for Class G-1A) N/A
61.1% (for Class G-2A)
Other Credit FGIC wrap; liquidity facility Ambac, FGIC, and MBIA MBIA wrap; liquidity facility MBIA wrap for triple-As;
Enhancement from Calyon wraps; liquidity reserve and from Calyon, a division of airline rent reserve
Sources credit facility Credit Agricole (Aa2/AA- amount; supplemental
/AA) rental facility
Triple-A 4.5 yr: 1L+27 bp 6.4 yr: 1L+38 5.5 yr: 1L+40 6.2 yr: 3L+40
WAL/Pricing 7.8 yr: 1L+45

Source: Presale and New Issue reports from Moody’s, Standard & Poor’s, and FitchRatings; Transaction documents; Bloomberg

Since 9/11, triple-A The deals shown above differ from aircraft ABS issued prior to 9/11 in a number of
aircraft ABS have been ways. For one, the senior securities all have wraps, which was not the case in pre-
issued with surety 9/11 transactions. Additionally, the rating agencies tightened their criteria after they
wraps, and generally saw how badly values could be impacted by something like a terrorist attack. In a
structured to more 2003 Moody’s update (“Pooled Aircraft Securitization Update” (10/7/2003)), the
stringent rating criteria rating agency stated that transactions structured post-9/11 included additional credit
support and improved structural features versus those offered before September 11.
For the purposes of their stress runs, the agencies generally increased assumed
expenses associated with repossessions, and extended the assumed time it would
take to re-market planes when they come off lease. (We cover the rating agencies
approach in detail later in this article.)

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

Corporate Aircraft Lease ABS – Different Credit, Different Structures

While transactions backed by aircraft leased to commercial airlines make up the majority of the aircraft ABS sector,
there is also a niche comprised of loans for corporate aircraft. G.E. has been the most prolific recent issuer of
these transactions, through its “GE Equipment Corporate Aircraft Trust” (Bloomberg: GECAF) platform. The jets in
these pools are loaned (as opposed to leased) to companies or high net worth individuals, and are generally
smaller, with smaller related loan sizes. Whereas a commercial aircraft ABS deal may have only 20-50 individual
leased aircraft in their pools, corporate aircraft deals will usually have more than 100, with the result being a more
granular pool with respect to lessee risk. And unlike the Boeing and Airbus duopoly in commercial aircraft
manufacturing, there are more manufacturers of corporate aircraft, including Gulfstream, Falcon, and Challenger.
While the commercial aviation industry is extremely cyclical, and exposed to the commercial airline industry, the
“general aviation” sector (a catch-all term to include aircraft outside of the commercial sector or the military) is
more exposed to the credit of individual companies (or individuals), which can represent a wide range of industries.
Corporate aircraft typically will be used for far fewer hours in a given year than commercial aircraft. In a November
11, 2005 FitchRatings New Issue Report for GE Equipment Corporate Aircraft Trust, Series 2005-1, the rating
agency states that “although manufactured to the same rigorous Federal Aviation Administration standards,
corporate aircraft have a fraction of the utilization of commercial aircraft (400 hours per year for corporate versus
2,000 or more hours per year for commercial).* This tends to lead to longer useful lives, all else equal.

The credit quality of G.E.’s corporate aircraft portfolio has been excellent, with annual losses in the basis points. As
a result, this program’s ABS is generally offered without a wrap, and notes are offered to investors down the
capital structure (usually down to triple-B). For the last GE deal, GE Equipment Corporate Aircraft Trust, Series
2005-1, required credit enhancement (predominately in the form of subordination) for triple-A securities was
10.5%. A five-year triple-A class from the September 2005 G.E. transaction priced at L+26 bp, at a time when
wrapped commercial aircraft ABS of approximately the same tenor was pricing at spreads ranging from 35-40 bp
over LIBOR.

* See http://www.fitchratings.com.

Source: Deutsche Bank

Aircraft ABS Structures and Cashflow

There is wide variation in the legal structures seen for aircraft ABS deals. Very
generally, most feature a single ABS-issuing SPV that holds ownership interests in
many different plane-specific SPVs. These plane-specific entities may take the form
of LLC’s, grantor trusts, off-shore SPVs, or other types of entities. Usually there will
be some combination of several different types of aircraft-owning entities.

Cash Flow Distribution and Credit Enhancement

A typical number of leases and related aircraft for a large ABS transaction would be
between 40 and 80; if just one of the lessees defaults it can have a significant impact
on the transaction cashflow. For this reason, thorough credit analysis of any given
deal is a lease-by-lease, aircraft-by-aircraft exercise. For each lease, the initial lease
terms and aircraft types are considered, to determine initial monthly cashflow
coming in. Further assumptions then must be made (again, for each plane) about
when the plane will need to be re-leased, how long such a re-leasing process might
take, and the terms of such new leases in the future.

Aircraft ABS are amortizing transactions, with principal payments made as collections
come in. Principal payments are guided by several different schedules (minimum,

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scheduled, and supplemental15), established when the transaction is structured.


These schedules are derived from the assumptions about depreciation, and set so
that payments will reduce (or at least maintain) LTV levels as the transaction pays
down.

In addition to surety The most common structure in recent aircraft ABS transactions is to have a wrapped
wraps, aircraft ABS are senior, triple-A class, as well as a number of offered subordinate classes. Surety
also enhanced with wraps typically will cover timely payment of interest, and payment of bond principal
overcollateralization by the legal final maturity date, and may be drawn after other sources of liquidity and
credit enhancement are depleted. In addition to the surety wrap, additional
enhancement is provided in several forms. First, there is typically
overcollateralization. At the outset of a deal, loan-to-value (LTV) ratios for each class
are calculated, generally defined to be (for a given class):

Initial size of the class, added to the initial sizes of any classes equal to or
senior to that class

Divided by:

Initial appraised value of the aircraft pool, together with any class-specific
reserves available for the class in question, as well as for any classes equal
to or senior to it.

Initial LTVs for the senior wrapped classes in recent transactions have varied widely,
from, for example 54% for the triple-A Class G-1A of the 2005 Aircraft Lease
Securitization Ltd transaction, to 71% for the ACG III, Series 2005-1 transaction. In
the ACG deal, the $1.62 billion Class G also benefited from a $35 million liquidity
facility, and $25 million of cash reserves. Such liquidity amounts are standard in
these transactions, and are available to cover interest shortfalls and transaction
expenses. Any junior classes also generally benefit from their own class-specific
liquidity reserves.

Principal payment As mentioned above, aircraft ABS are typically structured around schedules of
schedules are set based principal payments derived based on assumptions about depreciation and future
on depreciation residual values. It is standard for transactions to specify an equation that produces a
assumptions depreciation curve for each aircraft in the portfolio, based on plane-specific inputs.
For each aircraft, the equation results in a depreciation factor for different points in
the aircraft’s life (ex: annually) which are then applied to the initial aircraft value in
order to determine an assumed residual value for each point in the future. These
aggregated depreciated values are the denominator (“value”) in the LTV ratios
calculated on an ongoing basis. The following depreciation curve equation was
specified in the ACG III, Series 2005-1 transaction, and gives a different factor for
each year of the aircraft’s life. Other recent aircraft ABS deals use close variants of
this equation.

15
These three different schedules are used in the ABS cashflow waterfall. For example, in the 2005 ACG
transaction, which had a senior Class G-1, and two subordinate classes, the B-1 and the C-1, the
schedules operated as follows: the subordinate notes do not receive any interest payments until at least
the Class G-1 minimum principal payment is made. Once that has been made, the subordinate notes can
be paid their interest, followed by their minimum principal payments. Following those payments, any
remaining cash can then be used to make scheduled principal payments (or, more precisely, the difference
between what was paid per the minimum schedule, and what would bring the payment up to the amount
specified in the “scheduled” schedule), again in sequential order. Lastly, if there is still remaining cash, the
supplemental principal payments can then be made, again in sequential order.

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Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

Depreciation factor = (1-(k*n))*(1+g)^n

n = age of aircraft in years from date of its manufacture or conversion,

r = 0.80, 0.85, 0.88, or 0.90, depending on the aircraft (0.80 is for aircraft considered
more liquid; .90 is for aircraft considered less liquid),

k = r/expected useful life (usually assumed to be 25 years for passenger aircraft, and
30 years for cargo aircraft), and

g = 0.02 (inflation rate)

For example, assuming a value of 0.80 for ‘r’, and a 25 year useful life, the
depreciation factor falls from .987 when the aircraft is one year old, to 0.328 when
the aircraft is 25 years old.

The depreciation factor in each period is used to derive an assumed depreciated


value of the aircraft at each point in time, using the following quotient:

Depreciation factor on the calculation date


Depreciation factor in effect when the ABS deal closed

Principal payment schedules then are followed to direct payments to bondholders


under a schedule that results in maintaining LTVs at sufficiently low levels.

Limitations on lessee Another form of structural credit enhancement is the set of concentration limits
size and rating, and applied to the aircraft pools, referenced earlier in the article. Because there are a
geographic regions, are relatively small number of assets and lessees in these pools, rating agency
also included in capital limitations on lessee (relative size, and rating), and countries/regions are also
markets aircraft ABS important. The requirement that such concentration limits be met is a constraint on
deals the lessor’s ability to remarket aircraft to new lessees upon expiration of a lease.
Experienced, well-regarded lessors will be better able to work with this constraint
than a less-experienced entity.

Coverage ratios also are sometimes included in the transactions. For example, the
ACS 2006-1 transaction made use of a debt service coverage ratio (“DSCR”) test. In
that transaction, the DSCR is defined to be the ratio of net revenues to net interest
expense and principal payments. If the DSCR falls to below 1.7x for two consecutive
months, anytime after month 34 of the transaction, then all incoming cash is used to
pay down the senior ABS. (Otherwise, some cashflow may be available for a junior
equity position included in the transaction.)

Interest Rate Hedging

Aircraft ABS transactions usually have floating-rate bond coupons, indexed to LIBOR.
These interest payments are made out of lease cash flow, which will vary over the
course of the transaction. ABS issuers usually hedge the interest rate risk partially or
completely through interest rate swaps or caps. As an example, the June 2006 ACS
transaction was structured with a 10-year interest rate swap. Moody’s stressed the
trust’s exposure to interest rates beyond ten years by assuming LIBOR increases 50
bp every six months from the closing date until LIBOR hits 7.5%.16 For an interest

16
Moody’s Investors Service, ACS 2006-1 Pass Through Trust Pre-Sale Report, May 31, 2006.

24 Global Markets Research


October 13, 2006 Guide to Pooled Aircraft Lease Securitizations Deutsche Bank@

rate swap, swap payments are made pari-passu with the interest payments to the
senior class.

Servicing/Remarketing

“Servicing” for aircraft Servicing for an aircraft ABS deal can be broken down between those responsibilities
ABS includes relating to administrative/cash management functions, and those tasks relating to
administrative duties as remarketing and repossessing aircraft. While the former could in theory be done by a
well as aircraft- large number of organizations, the latter requires very industry-specific expertise. In
remarketing tasks aircraft ABS, the entity that handles the aircraft marketing-related tasks (remarketing
agent) may or may not also be the same entity that handles the more administrative
functions. Aircraft ABS are subject to cashflow variability, even in a healthy
commercial aviation market, by virtue of the fact that many of the leases in the pools
will be shorter than the average lives of the associated ABS. When the initial leases
expire, and the aircraft need to be re-leased there is the risk that 1) the aircraft won’t
be successfully placed/re-leased, or 2) a new home will be found for the aircraft, but
at a lower lease rate than was the case in the original lease (or than was assumed by
the structurers and rating agencies for the transaction). This “re-leasing” risk is
assessed by looking at each individual aircraft and related lease in the pool. In each
ABS transaction, a “re-marketing” agent is listed, who may or may not also be the
lessor, who has the responsibility of re-leasing an aircraft when the initial lease
comes due. In the ACG III, Series 2005-1 deal, (according to Fitch) the lessor, in its
capacity as remarketing agent, “begins actively remarketing nine months prior to an
aircraft coming off lease.” In practice, in a good market, this period can be much
shorter. In ILFC’s 2006 first quarter 10Q the company cites a typical remarketing
time period today of two to three months.

There may also be a “monitoring agent,” who is tasked with monitoring how well
the remarketing agent is adhering to the terms of the remarketing agreement. As an
example, in the ACG III, Series 2005-1 transaction, Aviation Capital Group (unrated) is
the “remarketing and administrative agent,” Pacific Life Insurance Co.17 is the “cash
manager and servicing agent,” and Aircraft Monitoring Services is the monitoring
agent. In that transaction, according to a December 19, 2005 Fitch Presale Report,

“Aviation Capital may be replaced as the marketing agent by a majority of


policy providers if PLC fails to maintain an 80% ownership interest in
Aviation Capital, unless i) the loan-to-value ratio of class G-1 notes is less
than 35% and ii) Aviation Capital or its consolidated parent maintains a
minimum tangible net worth of $125 million and Aviation Capital and/or its
subsequent parent maintains a rating of at least ‘BBB’.”

In 2003, ACG issued its previous securitization, before it was wholly-owned by


Pacific Life. In that deal (Aviation Capital Group Trust II, Series 2003-1), ILFC, another
competing lessor, was the back-up servicer. Servicing and remarketing fees (which
may be fixed, variable, or some combination of both) are paid at the top of the
cashflow waterfall, before the senior class is paid interest.

17
Pacific Life Insurance Co. (aka PLC) owns 100% of ACG and is rated A3/A/A.

Global Markets Research 25


Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

Rating Agency Stress Scenarios

The rating agencies stress a number of variables that could impact available cashflow
for the bonds. Once variables are stressed, both S&P and Moody’s use a Monte
Carlo approach in rating aircraft ABS, generating thousands of different possible
cashflow paths, and assigning probabilities to come up with likely scenarios at
different rating categories. Some of the most important variables are described
below, with examples taken from S&P and Moody’s analyses of the most recently-
issued aircraft ABS transaction, ACS 2006-1 Pass-Through Trust (Fitch did not rate
the deal):

• Economic cycles – Assumptions about how the economy is going to


perform have a number of implications for aircraft ABS. In general the rating
agencies will assume that a number of downturns occur while the bonds are
outstanding. For the ACS triple-A class, S&P assumed that three different
depressions will occur, each lasting approximately 3-4 years.

• Airline default rates – The rating agencies also make assumptions about the
percentage of lessees that will default in the different depressions
referenced above. In the ACS transaction, based on the ratings of potential
lessees, Moody’s assumed a 63% cumulative lessee default rate over the
life of the transaction.

• Lease rates – The agencies assume that in each depression, lease rates
decline dramatically. For example, S&P assumes that lease rates decline by
30% to 50% for a triple-B cash flow stress, and 55% to 70% for a double-A
stress.

• Lease terms – The shorter the lease term for a given aircraft, the more
frequently that plane will need to be remarketed, and exposed to the
uncertainties of that process (remarketing time, new lease rate negotiations,
etc.). S&P assumed short lease terms, of three or four years, during the
different recessionary periods.

• Repossession – time off-lease due to repossession, and repossession


costs – The longer it takes to repossess and remarket an aircraft for which a
lessee has defaulted, the longer the period of time that the asset is not cash-
flowing. In the ACS transaction, S&P assumed 6-12 months for a double-A
stress, and 4-10 months for a triple-B stress. Further, S&P assumed it costs
between $750,000 to $1 million to repossess an aircraft. Moody’s looks at
both the cost of repossession, and the cost to then turn around and remarket
that aircraft, and, in the ACS transaction provides a range for their
assumption of between $1 million and $3.5 million (more for older, widebody
planes, less for newer, narrowbody planes).

• Aircraft useful lives and ending “scrap” values – A very typical assumed
average life for commercial passenger aircraft is 25 years. In the ACS
transaction, Moody’s assumed 26 years for some newer models (Boeing
737-700s and 737-800s, A320s, and A319s.) Moody’s further assumed a
minimum scrap value at the end of the planes’ useful lives, of between
$500,000 and $1,000,000.

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October 13, 2006 Guide to Pooled Aircraft Lease Securitizations Deutsche Bank@

Relative Value

Aircraft ABS has been enjoying a resurgence in terms of investor reception and
issuance activity when compared to the 2002-2004 time period. There has also been
a notable shift in the supply of capital to the aviation industry over the past 5-10
years. Whereas commercial banks and insurance companies were more active in the
sector prior to 9/11, the sharp downturn in 2001 caused many of these traditional
players to exit. In their place, hedge funds and investment banks have filled the void.

Recent aircraft ABS have Investors looking at this asset class can find triple-A wrapped risk, offered at yields
offered wrapped triple-a comparable to unwrapped triple-A collateralized debt obligations (CDOs). For more
credit risk, at spreads yield, investors can look to unwrapped subordinates. Aircraft ABS is also one of the
comparable to few places in the ABS market that offers exposure to commercial obligors rather
unwrapped CDOs than to consumers. Recent deals have all been structured as floaters. The
transactions that have priced in late 2005 and 2006 came at a time when spreads for
most triple-A ABS were at or close to their all-time tights. The 2005 aircraft ABS
transactions shown in Figure 14 above saw their most senior wrapped triple-A
classes, which ranged in average life at pricing from between 5.5 and 6.4 years, price
at spreads of 38 – 40 bp over LIBOR,18 during the last four months of 2005. For some
context, during that period, 3-year triple-A unwrapped home equity ARM sequentials
were trading in a range of 21 bp to 26 bp over LIBOR; also, 10-year unwrapped
CMBS paper was trading between 26 bp and 31 bp over swaps. The CDO sector
also offers some more points of comparison. According to DB’s secondary market
data, unwrapped triple-A CDOs in various categories were trading at levels more
comparable to the aircraft ABS deal that priced late last year:

Figure 15: Wrapped triple-A aircraft ABS offers yields comparable to triple-A
CDO paper
CDO spread pick-up/(give-back)
Secondary market generic to triple-A wrapped 5.5 – 6.5
Triple-A CDO category and spreads [to LIBOR]; range from year aircraft ABS (assume L+39
WAL (all unwrapped) 9/1/05 to 12/31/05* bp)
HY CBOs – 7-year 34–39 bp (0-5 bp)
HY CLOs – 5-year 26 bp (13 bp)
HY CLOs – 6 year 42–44 bp 3-5 bp
ABS CBOs – 7 year 27–29 bp (10-12 bp)
IG CBOs – 5 year 34–38 bp (1-5 bp)
Wrapped Aircraft ABS –
5.5 year – 6.5 year 38–40 bp
* Spreads for aircraft are based on new issue pricing data
Source: Deutsche Bank

The only aircraft ABS to price so far in 2006 was the Aircastle transaction (ACST
2006-1) referenced above, which included a single, wrapped triple-A class. That
class, a 4.5 year, priced at L+27 bp, 11-13 bp tighter than the aircraft ABS that priced
in late 2005. However, the ABS market overall tightened in the first half of 2006. For
example, the 3-year triple-A unwrapped subprime MBS level that ranged from 21 bp
to 26 bp over LIBOR in late 2005 had tightened in to 15-16 bp over LIBOR by the
time the 2006 Aircastle deal priced. Nonetheless, the pick-up for aircraft ABS is still
attractive.

18
The benchmark for the RASPRO deal was 3-month LIBOR, rather than 1-month LIBOR.

Global Markets Research 27


Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

For investors looking for triple-digit spreads, and willing to go down the capital
structure, most aircraft ABS also include offerings of unwrapped subordinate paper.
While the most recent (Aircastle 2006-1) new deal did not include offered subs, most
other recent deals have. In late 2005, such aircraft subs rated triple-B were pricing at
levels of 325 – 375 bp over LIBOR, for 7-8 year WALs. The structures can vary
widely, and must be analyzed on a deal-by-deal basis. For example, in the 2005
Aviation Capital Group transaction (ACAP), the single-A Class B1 and triple-B Class
C1 are “deferrable interest” notes, and the ratings do not address timely payment of
interest, as is the norm for most senior ABS ratings. Most aircraft ABS are structured
with class-specific liquidity reserves to benefit the subordinates. Because most
aircraft ABS are structured to maintain LTVs for the senior class at a minimum level,
there is extension risk for subordinates in most structures to the extent that
collections of lease payments and payments related to aircraft dispositions are low
enough that payments to the subordinates are frozen for a period of time. Still, at a
pick-up of about 100 bp to where 5-year triple-B subprime mortgage ABS was trading
during Q4 2005, subprime aircraft ABS appeared to be generously priced. In the
secondary market, spreads for subprime mortgage subordinates have come in
dramatically in 2006, driven in large part by the CDO bid. Aircraft subordinates, by
contrast, are relatively unchanged. The pick-up today for 7-year unwrapped triple-B
aircraft ABS versus 5-year unwrapped triple-B subprime mortgage subordinates is
now more in the 150-200 bp range.

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October 13, 2006 Guide to Pooled Aircraft Lease Securitizations Deutsche Bank@

Conclusion

Aviation is a cyclical industry, and, by most measures, today is a good period in the
current cycle. Demand for air travel is high, in spite of periodic threats to security that
have popped up in the years since 9/11. Airlines are no longer faced with a glut of
aircraft, and lessors have generally not had to cut lease rates. The market generally is
in balance. The rating agencies tightened their criteria for rating aircraft ABS post-
9/11, and investors have returned to the market, attracted by the improved
fundamentals, relatively high yield compared to other asset classes, and, in some
cases, the credit of a surety wrapper. Liquidity has improved, with a number of
experienced lessors financing growth in their aircraft fleets by securitizing in either
capital market or bank market transactions.

However, the operating climate for airlines remains challenging. While several
airlines have succeeded in restructuring operating costs, including labor contracts,
the rise in fuel prices earlier this year weighs on the industry. Additionally, recent
“one-off” events such as the mid-summer terrorist scare highlight the ongoing risks.
Different aircraft models will enjoy different degrees of liquidity in any wide-scale
industry contraction. Investors should complete thorough due diligence when
evaluating aircraft ABS pools. Particularly to the extent that one is unwilling to rely
entirely on a surety bond provider, an aircraft-by-aircraft analysis is appropriate for
aircraft ABS securitization pools.

Global Markets Research 29


Deutsche Bank@ Guide to Pooled Aircraft Lease Securitizations October 13, 2006

Appendix 1
Additional Information Available upon Request

For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see
the most recently published company report or visit our global disclosure look-up page on our website at
http://gm.db.com.

Analyst Certification

This report covers more than one security or issuer and was prepared by more than one analyst. The views expressed
in this report accurately reflect the personal views of each contributor to this compendium report. In addition, each
contributor has not and will not receive any compensation for providing a specific recommendation or view in this
compendium report.

30 Global Markets Research


October 13, 2006 Guide to Pooled Aircraft Lease Securitizations Deutsche Bank@

Global Securitization Research


Analyst Coverage Telephone E-mail

Karen Weaver, CFA Global Head of Securitization Research and +1 (212) 250-3125 karen.weaver@db.com
Regional Head of Research for the Americas
ABS Strategy

North America
Anthony Thompson Head of US ABS and Global CDO Research +1 (212) 250-2087 anthony.thompson@db.com
Eugene Xu ABS Strategy +1 (212) 250-3129 eugene.xu@db.com
Richard Parkus CDOs/ABS Synthetics +1 (212) 250-6724 richard.parkus@db.com
Elen Callahan Securitization Generalist +1 (212) 250-8161 elen.callahan@db.com
Lily Lau Securitization Generalist +1 (212) 250-5360 lily.lau@db.com
Katie Reeves Securitization Generalist +1 (212) 250-2507 katie.reeves@db.com

Europe
Ganesh Rajendra, CFA Head of European Securitization Research +44 (207) 545-2082 ganesh.rajendra@db.com
Carole Bernard European Securitization +44 (207) 545-2569 carole.bernard@db.com
Ivan Påhlson-Möller European Securitization +44 (207) 547-2877 ivan.pahlson-moller@db.com

Australia
Philip Brown Australian Securitization +61 (2) 8258-3619 philip.brown@db.com

Japan
Yukio Egawa Japanese Securitization +81 (3) 5156-6163 yukio.egawa@db.com
Michiko Sakai Securitization Generalist +81 (3) 5156-6157 michiko.sakai@db.com

North America MBS


Amin Majidi Head of MBS Strategy +1 (212) 250-6156 amin.majidi@db.com
Victoria Averbukh Head of Structured MBS Research +1 (212) 250-8002 victoria.averbukh@db.com
Gregg Patruno Head of MBS Modeling +1 (212) 250-8824 gregg.patruno@db.com
Jiangtao Du Agency Pass-Throughs +1 (212) 250-4953 jiangtao.du@db.com
Nenad Ilincic MBS Modeling +1 (212) 250-6157 nenad.ilincic@db.com
Anish Lohokare MBS Strategy +1 (212) 250-2147 anish.lohokare@db.com
Adam Rothschild MBS Modeling +1 (212) 250-6499 adam.rothschild@db.com
Marc Silie MBS Strategy +1 (212) 250-6405 marc.silie@db.com
Enping Zhao MBS Modeling +1 (212) 250-0145 enping.zhao@db.com

Global Markets Research 31


Deutsche Bank Global Research

David Folkerts-Landau
Managing Director
Global Head of Research
London Tel: (44) 20 7545 5502
Stuart Parkinson Fergus Lynch
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