22.01.2009 - MDM Comment: Why FLC defaulted and will it be rescued?

Moody’s yesterday announced a multi-notch downgrade of Finance Leasing Company, to Caa3 from Ba3. As part of its justification for the downgrade, Moody’s said “the action reflects FLC’s inability to pay coupons on its public debt”. The rating agency indicates that mismanagement could have been one of the reasons behind the default.

As we understand, FLC missed interest payments on both its USD100 mn 2011, 9.25% CLN issue and the USD150 mn 2013, 10% LPN issue. Both coupons were due in December 2008.

FLC is a subsidiary of United Aircraft Corporation (NR), the state conglomerate that controls Russia’s major assets in the aircraft-building industry. FLC had been receiving regular cash equity injections from the federal government, and had in excess of RUB10 bn of capital vs. RUB24 bn of assets as of its last reporting date – a strong balance sheet for a financial institution. Given its profile and status, we (as well as Moody’s and many investors) were surprised to see FLC defaulting.

Moody’s attributes FLC’s insolvency to inadequate liquidity management, as well as a significant deterioration in asset quality as a result of both troubled airlines defaulting on lease contracts and significant corporate governance issues materially affecting the company's assets.

Based on conversations with Moody’s and UAC, we believe the “corporate governance issues” and “inadequate liquidity management” in effect mean that FLC invested a significant part of its balance sheet into certain assets of a non-core nature (unrelated to the aircraft leasing mandate), which are illiquid in current circumstances and perhaps even have extremely low recovery values. These actions may actually qualify as serious mistakes or abuse on behalf of FLC’s management.

Now the key question is whether UAC or the government bail-out FLC and save its creditors or will let the company go bankrupt.

Most investors and analysts including ourselves, when examining FLC prior to bond issuance, were confident in state support under a stress-scenario. But in this particular situation, arrival of support is far less certain. First, we believe this is likely a case of abuse/fraud. Second, UAC says it effectively gained control of FLC only in 2H08 by receiving a majority on its board of directors (and, in fact, many powers remained in the management’s hands), so UAC may try to distance itself from the troubled company. Finally, in current conditions the government is already rather ‘stretched’ in terms of available resources and has to be selective in its bailout activities. In these circumstances a state rescue for FLC is not a given.

That said, we still think that chances are material (perhaps a 40-50% probability) that the government will decide to avoid possible damage to its reputation and will end up throwing to FLC the USD250m it would need to repay the notes (they all can be claimed for accelerated redemption). The easiest way to do this would be to use the balance sheet of a large state-controlled bank. We are hearing rumors that a decision on whether to do this has not been made yet, but that discussions are ongoing.

22.01.2009 14:45