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There is a proverb in my home state of Louisiana that says, “When you’re up to your waist in alligators, it’s hard to remember that your prime objective is to drain the swamp.” The chief financial officers at rail-car leasing companies must think they’re in much the same predicament today as the hapless fellow in the swamp, with cash flow problems caused by terminating leases diverting attention from the need to properly manage risk.
In good times, leasing reps often view risk management as a deal killer; the wishes of their customers for low rates and flexible terms often are at odds with their company’s need for high rates and long-term contracts with fixed terms. Leasing companies that have managed to balance these conflicting interests in the past will experience less damage to their income statements during the present downturn than those that haven’t.
And in the future, it is more than likely that leasing companies will tighten up on credit terms and lease conditions. Lease contracts also will be less “customer friendly” — i.e., we’ll see higher rates, longer terms, less forgiveness in defaults, more return obligations — than in the past.
Risk management is not something that can be ignored during economic downturns — especially when it appears that lessees’ wishes coincide with the company’s needs. For example, competition and a huge car surplus puts pressure on leasing companies to lower their rates; at the same time, economic uncertainties force railroads and shippers to limit the commitments they’re willing to make in lease contracts.
For lessors who think the recession will be over next year, low rates for a short term appear to be a perfect solution to today’s problems.
But if the recession lasts beyond 2010, those short-term contracts will only compound the problems for leases that are scheduled to terminate down the road. Instead of just a fraction of leases in the portfolio coming up for renewal, a majority of them may have to be addressed all at once.
Risk management involves more than just the timing of lease renewals. Customer credit, asset diversification and corporate debt loads are other considerations that also top the list in less economically distressing times.
Poor credit ratings sometimes are overlooked when there are large numbers of surplus cars incurring high storage costs, but bankrupt or cash-starved lessees can tie up equipment and/or raise maintenance costs by not properly repairing the cars or using them improperly. Sometimes, leases with companies with poor credit cost more than the lost revenue and storage costs that’d come with doing the deal in the first place.
Leasing companies with diversified portfolios of many car types and ages usually fare better during economic slumps than those with only a few types of cars and age profiles, and this is true even in the current recession. Although there are surplus quantities of every car type, some are more abundant than others and lease rates for these car types have fallen faster and will take longer to recover than the rates for cars that have only recently become surplus.
Leasing companies with manageable or low debt loads may find opportunities to address any problems they may perceive in the composition of their equipment portfolio, especially if the recession drags on for a couple of years.
Highly leveraged leasing companies may have to reduce their debts by selling some or all of their equipment. This type of industry consolidation has happened before; creative destruction is one of the constants of the rail-car leasing industry. During the last severe downturn in the early 1980s, most of the newcomers to the industry failed and many of today’s leasing companies either arose to take their place or added their assets to their own fleets.
Just as fighting alligators has separated the strong from the weak in the Bayou State, so too will this recession change the lineup of rail-car leasing companies. In a few years, the industry may look entirely different than it does today, with new entrants to the industry, old companies that have greatly increased their share of the market and tombstones for companies that have left the field.
The industry will survive and prosper once again, and those companies that manage their risks well will earn the
returns that justify investing in rail-car assets.
Toby Kolstad has been in the railroad industry for more than 30 years, with stints at Illinois Central Gulf Railroad, Denver & Rio Grande Western Railroad, a car builder and lessor. Currently a consultant on rail-car matters and president of Rail Theory Forecasts L.L.C.