On June 1, 2009, Dennis Rousseau gave a presentation on the Pre-Owned Market Perspective at the Aviation Professionals Conference.
We continue with the second of three in a series of posts.
Pre-Owned Market Perspective: Part II
In Part I of our perspective on the pre-owned market, we focused on the Dot-com bubble and the correlation of the Dow Jones Industrial Average to the selling prices of aircraft. There is some belief that the crash of the Dot-com era contributed to the current housing bubble. According to Yale economist Robert Spiller, “once stocks fell, real estate became the primary outlet for the speculative frenzy.” In 2005, consumers spent over $200 billion of the money that they pulled out of their home equity. The number of homes bought for investment jumped 50%.
In mid-2005 the Fed stated, “there’s a little ‘froth’ in the housing market”. Meanwhile, The Economist magazine, declared “the worldwide rise in house pricing is the biggest bubble in years.” As history has shown, a bubble is inevitably followed by a severe price decrease when the bubble bursts. In the case of real estate, the owner is left with negative equity. The home buyer psychology fits in with the model of a bubble; wishful thinking that assumes everything is going to be all right and that one must buy in at any cost because prices will keep going up. This is very similar to what happened during the Dot-com era and subsequently to aircraft sales.
In 2006, sales of existing homes began to fall, and inventories soared, resulting in the biggest housing slump in 40 years.
Yet business jets continued selling at ‘increased’ prices and, in many cases, for more than they cost new. Challenger 300s that had a new list price of 19.2M, were selling between for 23M and 25M on the used market. We lost site of a key fundamental in our business.
If we look at a trend analysis for the GV, it cost 39M new in 1999. By incorporating straight-line depreciation, we can generate a baseline value as depicted by the dark blue line. This base line value also accounts, on the + / – side for major maintenance events, such as a 96-month airframe inspection, engine overhauls, avionics upgrades and the like. We then factor in a confluence of economic and market factors to enable imputed value, as shown by the pink line. Yet market exuberance drove the selling price in 2007 to an exorbitant level far in excess of the cost of a new G550, only to return to some semblance of normalcy in 2008. This same trend report can also be used to determine buy / sell decisions.
In a 2007 interview on CNBC, Treasury Secretary Henry Paulson claimed the fallout of the subprime crash was largely contained due to the strongest global economy in decades. Many bankers believed their industry was protected from risk because of their use of sophisticated tools and algorithms. According to David Brooks in his NY Times Op-Ed on April 2, 2009, “when big events — like the rise of China — fundamentally altered the world economy, their tools were worse than useless.” We can correlate this to the pre-owned aircraft markets of 2007 where, especially for late model aircraft, there was on average a 2% spread between ask and selling price. Today we are seeing an average spread of 22%. Our markets, like many others, are in a state of confusion.
The current downturn is global, unlike the burst of the Dot-com bubble in 2001, and is multifaceted, encompassing banking, manufacturing, retailing and housing. It is also longer lasting. By the start of 2008, the industrialized world had entered into a recession attributed in part to reckless mortgage lending in the US.
On September 15, Lehman Brothers filed Chapter 11 with over $600B in debt, the 2nd largest failure of an investment bank. Washington Mutual, the largest S&L in the US, was the largest bank failure in financial history. The 2nd largest failure was Indy Mac in July. Shortly after, Secretary Paulson assured us saying, “it’s a safe, sound banking system. It’s is a very manageable situation.” There have been 34 bank failures so far this year compared with 25 in 2008 and 3 in 2007. The FDIC expects bank failures to cost $65B through 2013 with as many as 1,000 banks to go under.
Economists have expressed that this recession is the worst since the Great Depression and may not show signs of recovery until 2012. The unemployment rate, at 8.9% on June 1, has been increasing and in March alone over 740,000 jobs were lost bringing the total to 6 million since the start of this recession in Dec ‘07. This does not include part-time workers who cannot get full-time jobs. Factoring that in, the unemployment rate doubles to 12.5 million people or 15%. If layoffs continue at the current pace, unemployment could hit 20% by the end of the year. What does this mean to our industry? What’s the corollary between unemployment and business jet sales?
As depicted on the graph, when unemployment goes up, business jet sales go down. What will happen if the unemployment rate rises to 20%?
In March, the John Hancock Tower in Boston was auctioned for $660 million — half the amount paid 3 years ago. Some $270B in commercial property loans are coming due this year. It is likely many borrowers will not be able to refinance, similar to what happened to General Growth Properties, the nation’s 2nd largest mall owner, which became the largest US real estate bankruptcy in history. A large number of these mortgages were taken out in the mid-2000s, when prices were at record highs and the loan-to-value ratio was 90%. Now many have to be refinanced at a time when property values are dropping and the loan-to-value ratio is 60%.
There is real concern about upcoming losses from commercial real estate loans. Delinquency rates and defaults have more than doubled in 6 months and losses could hit $53B over the next 2 years for the nation’s major banks. This does not include local and regional lenders, who hold a large share of the $3.5 trillion in commercial property loans.
Of course, real estate, like business jets, is a cyclical business. Many of today’s troubled office markets were hurt in the recessions of 1990 and 2001 and production of new office space came to a halt. Within a few years, as the economy rebounded, the demand for office space grew and development began once again. This is very similar to what happened to business jet production over the last few years.
On Friday, we will post the conclusion in this series, Where Do We Go From Here? (Part III).