Lease funding in an unpredictable and volatile environment
Innovation in lease funding is growing exponentially and there are a myriad of products available.
Latest posts by Derek Soper (see all)
- An evolving trajectory for leasing and asset finance - December 2, 2013
- Leasing in a changing landscape - December 2, 2013
- The evolution of leasing's commercial framework - December 2, 2013
Introduction from Executive Producer JO DAVIS
A core part of the leasing industry is making sure that, for lessors, adequate funds are available when required to finance both day-to-day working capital and the underlying leasing and asset finance transactions. Innovation in this area is growing exponentially and there are a myriad of products available. In this piece, part the Leasing Fundamentals series that explores the past, present and future of leasing, Derek Soper, Chairman of IAA-Advisory and of the Leasing Foundation, explores issues including the management of risk and the sources of funding including bank, money market loans and commercial paper. This piece is core reading for anyone wanting to understand the complexities of modern-day leasing.”
Who should be interested in this?
New entrants to the leasing and asset finance industry, industry commentators, anyone wanting to understand the context of modern-day leasing
Lease funding in an unpredictable and volatile environment
The financial management of companies involved in the provision of asset finance has rapidly become more sophisticated in line with growing competition and volatile environment. Whereas only relatively recently the finance director, controller or company accountant would monitor the cash and bank relationships within the lessor company as part of his or her overall duties, this has now been replaced by specific treasury expertise provided either by employing permanent staff or by a treasury function within the parent company.
With regard to a lessor’s liquidity management, the aim is to ensure that adequate funds are available when required to finance both day-to-day working capital and, of course, the underlying leasing and asset finance transactions.
Regularly updated cash flow forecasting is particularly important. This may often extend to as far as 10 years and beyond in the case of companies involved in medium-and long-term financing. With interest rate exposure management in mind, this may also involve some form of “bank type” gap management reporting, to aid identification and help develop strategies to manage the risks associated with asset/liability mismatches. The importance of the forecasting time horizon cannot be overemphasized – too short a time frame and significant funding requirements may be missed with possibly severe refunding cost consequences.
The rapid advancement in recent years of information technology has greatly aided these types of analyses both in terms of accuracy and also in the continuous timely production of management data.
Up until relatively recently the emphasis within leasing organisations has been generally towards passive management of balance sheet asset/liability mismatches. Development of new systems has accelerated in recent years and with the advent of Basle II the whole subject of cash flow and capital adequacy has at last been taken very seriously. It is clear that the advent of Basle III will have further constricting effects on the internal management of risk within the banking sector, thus affecting the leasing industry. The development of more sophisticated information systems is allowing more effective balance sheet planning and control and in future lessors will increasingly view their funding operations as an integral part of their attempts to achieve competitive advantage alongside issues such as a product development and marketing skills.
Among larger leasing organisations and particularly the banks, there has been a steady trend towards an increasingly centralised treasury function. The more progressive operations are becoming more accustomed to using a wider variety of market instruments and systems and these changes will undoubtedly be reflected in their attitudes to treasury risk and the opportunities to develop consolidated risk management functions, making full use of both internal and external resources.
As with other forms of risk, lessors need to develop a strategy to ensure they are protected. This involves defining the risks associated with balance sheet and funding policy; monitoring the various risks and, where possible, predicting them in advance; developing a policy to reduce risk; and informing operational management of this policy.
A lessor’s funding and risk management controls, in their simplest form, may be viewed as a netting operation whereby all revenues (rentals) and loans (intra-group flows) are channelled through the treasury or finance department often located at the group HQ (Bank) or company head office (Manufacturer). The principal behind netting is that company or group exposures are controlled and minimized by the netting centre before residual exposures are hedged in the external markets. This results in all risks being transferred to the centre and handled as a net group or company exposure.
One of the major advantages of centralising funding and risk management operations are the economies of scale derived from netting effects, so reducing the number of external hedging transactions required to manage the lessor’s business. The costs associated with hedging can be markedly reduced by indentifying opportunities for matching both cash flows, assets and liabilities.
Any centralised risk management function must have the ability to identify future exposures and recognise matching opportunities. The fundamental tool for the construction of an internal risk management function is an effective cash and exposure forecasting system based on a forward date ladder. This is the prerequisite of effecting planning, risk evaluation and management. For a company wishing to establish a centralised risk management function this will involve developing a detailed forecasting system that identifies all cash flows and exposures by expected timing and likely amount. This means that adequate systems must be in place for operating departments to report their present expected future funding requirements.
Reporting requirements should lay down the levels of risk that must be reported and the timing of the report. The priority given to certain risk reporting will depend on the company’s own definition of its risk management decision as to what exposure it is prepared to tolerate at the operating level. It is highly likely that banks will manage these risks on behalf of all their subsidiary activities and less and less leasing activity will be managed separately from a central treasury.
Interest rate exposure: the lessor’s perspective
Because of the nature of many asset finance products and industry conventions the lessor may well be faced with a number of interest rate exposure risks which require identification monitoring and controlling. These may include any or all of the following:
Position or mismatch risk. This arises because of the potential losses that may be incurred due to both size (implied capital) and maturity mismatches with regard to leasing assets and funding liabilities.
Reinvestment risk. This arises in cases where assets (leases, hire-purchase contracts etc) and funding (liabilities) are mismatched with regard to interest-compounding periods. An example of this would be a hire-purchase agreement paying monthly rentals (monthly interest compounding) funded by loan finance requiring interest payment on an annual basis (annual compounding).
Basic risk. This arises in cases where the reference interest basis differs between assets and liabilities (e.g. LIBOR, Base Rate, CP, etc)
Termination Risk. Where asset (lease, instalment-purchase, etc) maturities vary from that originally envisaged, loss may arise where termination sums reinvested will not generate enough income to immunize the associated funding liabilities. A lessor faces greatest risk of losses from this type of exposure where periods of rapidly falling interest rates coincide with significant lease terminations, particularly where no provision is available within customer documentation under which breakage cost can be recovered.
The sources of funds that are potentially available to a lessor may be summarised as follows:
1. Bank facilities.
2. Money market loans (a) term loans; (b) structured
3. Sales and/or purchases of cash flows
4. Acceptance credits
5. Securitized lease receivable.
6. Commercial paper
7. Lease finance
This source of funds is important particularly with regard to day-to-day management of bank current accounts and possible very short term liquidity problems due to rental collection or other value date shortfalls.
It is an extremely risky method of funding a fixed lease because of the risk of (a) the overdraft facility being withdrawn and (b) losses due to unhedged upward movements in term interest rates.
Funding fixed rate leasing in this way is tantamount to deciding to back falling period interest rates in the short term e.g. in expectation of base rate cuts.
Money Market Loans
Term loans are probably the most common source of funds for the lessor. Here lessors are able to draw on funds for fixed periods from banks who will charge lessors cost of funds based on one of the main indexes such as the London Interbank Offered Rate (LIBOR). This is a reasonably flexible source of funds since the funding period can be anything from overnight money to two years. Beyond two years, swap financing is probably more reliable and efficient with regard to price, although longer term loans are not unknown.
Leasing and asset finance transactions characteristically involve complex implied capital repayment profiles. Amortizing structures, balloon payments and complex cash flows are common. The problem of portfolio asset liability mismatches with regard to capital and interest payment profiles can sometimes be minimized via structured funding. Certain specialist funders will provide tailored loan funding which closely mirrors the lessor’s exposure with regard to a particular leasing transaction. The cost of funds is derived from a blend of rates weighted depending on the capital repayment profile, the appropriate interest rate term structure and possibly the differing ‘risk’ structures within the overall mix.
Sales and/or Purchases of Cash Flows
In a similar manner to structured funding, some specialist funders will buy or sell lessor’s cash flows – effectively the net present value of an income or payment stream based on the appropriate interest rate term structure. This can prove useful not only for individual transactions but also for net cash flows generated by a portfolio of leases, thus crystallizing their value.
Commercial paper is an unsecured promissory note with a fixed maturity. The lessor promises to pay the investor a fixed amount on some future date but pledges no assets, only his or her liquidity status and established earning power, to guarantee the promise. Typically rates on commercial paper, like those on bills, are quoted on a discount basis. However, commercial paper in interest-bearing form is known, simplifying calculations for the investor. The majority of investors in commercial paper are large institutions such as pension and insurance funds. The largest and most developed market for this type of security is in the US where commercial paper is a much used alternative to short-term bank borrowing. Being securitized debt as opposed to say non-transferable bank loans, commercial paper can be bought and sold by investors.
Lessors can obtain funding for specific leases by means of head-lease or “back to back” lease funding. This may be an exactly matched structure or may, in certain situations, be mismatched because of particular circumstances.
The Bond Market
Recently a number of lessors have accessed the bond markets, pledging lease receivables as security in the process. The rates have proved competitive and it is thought that this access to funding for lessors will grow in importance.
Accessing the derivatives markets
Although these products have been marked as one of the causes of the credit crisis; in particular the sub-prime mortgage products sold in huge amounts by the investment banks and the investment arms of the major banking groups; they are nevertheless destined to stabilise and initiative products will continue to help create ‘risk’ hedging.
Initially, before considering hedging techniques, it is very important that the lessor has a firm view as to its objectives with regard to risk exposure. The control and management of funding costs will have not only major implications with regard to the company’s equity exposure, composed of the market value of assets (leases) and liabilities (funding), but also may impact directly on the lessor’s ability to use funding and treasury management as a source of competitive advantage. This will be particularly true of those companies who take a portfolio view of their funding and cash management activity.
There are three main types of derivative instruments available which will in effect guarantee a future cost of funds for a specific period. These are:
1. Exchange-traded futures contracts
2. Forward rate agreements
3. Interest rate swaps.
Exchange-traded futures contracts
A financial futures contract is simply a binding agreement to buy or sell a financial instrument during a specified month or day in the future for the traded price agreed by the parties when entering the contract,
Futures contracts cover one interest period only (although in some cases futures strips can be executed i.e. covering consecutive time periods).
Forward rate agreements The forward rate agreement (FRA) is a simple and flexible contract between two parties under which an interest rate is agreed for a period commencing at a future date. The difference between the FRA rate and the actual market rate for that period is discounted and settled as a cash payment. These instruments are very similar to the three-month exchange-traded futures deposit/loan contracts. However, these products are marketed by banks directly to customers (over-counter or OTC). The main advantages of these products are the tailored nature of the agreement that the lessor can negotiate with the bank, and the lack of margin and valuation calls, characteristic of exchange-traded futures. There is no cash movement of the principal amount. An FRA covers one interest period only, although of course a whole strip of FRAs covering a number of successive interest periods can be executed at the same time.
Interest rate swaps An interest rate swap is a transaction in which two parties agree to make periodic payments to each other, calculated on the basis of specified interest rates and a specified principal amount. For example, a lessor may enter into an agreement with a bank whereby it makes payments based on a fixed agreed rate of interest for the life of the swap, while it receives payments based on some floating rate basis (LIBOR, commercial paper rate, etc) for the life of the swap. An interest rate swap may therefore be used by the lessor to transform one type of asset or liability/interest obligation into another. The swap represents a very powerful risk management and funding tool enable a swap participant to tailor its asset and liability position with respect to a given interest rate structure, costs of borrowing, risk profiles and exposure. Closely related to the FRA product, interest rate swaps are available generally for periods varying from 1 to 10 years but transactions up to 25 years are not unknown. Swaps are currently available in a very large number of currencies. Whereas an FRA covers one interest period only, a swap covers a series of interest periods typically at semi-annual intervals over a number of years.
From relatively small beginnings, interest-rate based derivative products have gown to represent an invaluable toolbox to the asset and liability managers of leasing companies. Instruments such as swaps and options neatly complement one another – a swap provides for certainty while an option allows a manager to control uncertain events and the associated exposure. Very active markets already exist for many of the options described here, and the depth and innovation is growing exponentially. Some of the myriad of products now being offered have been outlined. No attempt however has been made to provide an exhaustive list of available instruments and it is very important that individual treasurers of lessors work closely with their bankers and funders so that their particular requirements are adequately satisfied.