Riding the storm

Germany's national carrier, Lufthansa, was hit hard by the September 11 terrorist attacks. The airline's chief risk officer talks to Gareth Gore about how the shock event brought about sweeping changes to its liquidity risk management

It was a stark reminder of the scars the events of September 11, 2001 had left on the airline industry that, on the second anniversary of the attacks, Germany's national carrier, Lufthansa, considered it necessary to cancel four of its eight daily flights between Germany and the US due to low passenger numbers.

The past six years have been the most difficult period of the sector's 98-year history. Global airline stocks lost 58% of their value in the two-year period to March 2003 as September 11, the outbreak of the severe acute respiratory syndrome (Sars) in Asia, the invasion of Iraq, soaring oil prices and countless flight security scares each took their toll.

Within months of the attacks, national carriers such as the Belgian airline Sabena and Switzerland's Swissair - companies that had been flying since the 1920s and 1930s - disappeared from the industry after massive financial collapses. Such was the crisis in North America that, by the end of 2005, more than half the total airline seats in the whole of the US belonged to companies that were officially bankrupt.

Lufthansa escaped relatively unscathed. Unlike rivals Air France and British Airways, whose businesses were focused heavily on transatlantic flights, only 15% of the German carrier's sales were linked to the badly hit North American routes. With much of the industry still running heavy losses, Lufthansa returned to the black in 2004 with net profits of EUR404 million after just two years of losses.

It was during that period that the airline decided to implement a massive overhaul of its risk management processes. It had already been hedging volatility in fuel prices since 1990, but the months following September 11 had illustrated some fundamental vulnerabilities - not least, solvency and a rapidly falling share price. By the time of the invasion of Iraq in March 2003, the airline's stock had hit a 10-year low of EUR6.74 - a 74.6% fall in the company's market value in just two years.

"The airline business has always been a very volatile one," says Walter Schmidt-Cording, the airline's head of liquidity and risk management in Frankfurt. "But the extraordinary shocks we experienced, such as 9/11 and Sars, made us more aware of the sensitivity of our business market, and we decided very quickly that we needed some kind of liquidity buffer for the strategic stability of the business."

Volatility of the airline industry relative to general equities during the past six years highlights the sector's inability to withstand successive shocks relative to the rest of the economy. In the days following the September 11 attacks, airlines stocks as measured by the Bloomberg World Airline Index dropped by 31% compared with a 12% fall for the FTSE All World Index (see figure 1).

Lufthansa's board was becoming concerned this vulnerability might pose serious difficulties were the company to make a large strategic purchase or expand its fleet during a difficult period for the sector. In the months following the terrorist attacks, it approved the creation of a EUR2 billion liquidity reserve - to be funded by successive bond issues - that would bolster the balance sheet of the company in such an event.

"Beyond the risk buffer, it is a way to support the credit judgement of the rating agencies and strengthen our ability to raise cash at favourable rates," says Schmidt-Cording. Until British Airways was upgraded to BBB- last month, Lufthansa had been the only European airline with an investment-grade rating, managing to keep its Standard & Poor's BBB rating throughout the difficult period. "It's a lot easier to raise credit with an investment-grade rating," adds Schmidt-Cording.

Over the course of 2004 and 2005, the cash was arranged into three separate liquidity buckets of overnight to six months, two to five years and greater than five years to reflect how quickly the business might need the cash. Initially, the funds were invested in more liquid and less volatile assets such as bonds and other fixed-income securities to ensure the corporate could readily have access to cash over different time periods. But in 2005, the airline decided to overhaul its portfolio to better manage market and correlation risks and to further optimise returns.

The board sets strict guidelines as to what assets the company can invest in and the level of risk the firm can take on. "We have very conservative guidelines about how to invest the money, such as no foreign currencies and no equities (unless with capital guarantee)," says Schmidt-Cording.

Nonetheless, the firm underwent in-depth analysis to assess how its portfolio would perform under different market conditions. The results of the portfolio analysis identified an optimum asset allocation, comprising fixed income, hedge funds, credit products, asset-backed securities and equities. At this stage, the bank approached a number of investment banks in Germany to discuss their needs.

"Lufthansa is known for coming up with very specific requirements," says Andreas Kosse, a director in the alternative investments department at HSBC Trinkaus and Burkhardt in Dusseldorf. The entity, a private bank in which HSBC owns a 78.6% share, was chosen to put together a EUR130 million 15-year capital-guaranteed equity note for the airline.

The product was one of a number of constant proportion portfolio insurance (CPPI) notes the airline invested in at that time. These structures are designed to guarantee 100% of investors' capital at maturity by dynamically allocating assets between a non-risky (usually fixed income) and risky (for instance, equities) assets. But for the airline, CPPI had an added benefit: capital-protected notes could also be wrapped in a Schuldscheindarlehen format, a semi-securitised bank loan.

"We can put the Schuldscheindarlehen straight on to the balance sheet as one transaction," says Schmidt-Cording. In accounting terms, the investment is considered a loan to the bank that pays back a guaranteed coupon. "That means each separate investment doesn't have to be split into its different components on the balance sheet, so it's a lot easier for us. We always used a similar structure," he adds.

Strict requirements

But such were the strict requirements of Lufthansa in terms of the required structure, underlying and coupon payments that the bank had to create a unique product for the transaction. In addition, Lufthansa had already chosen an investment manager - Frankfurt-based Helaba - to manage the equity portfolio (consisting of Eurostoxx 50 shares) underlying the note.

To create a CPPI structure for this dynamic underlying (Helaba constantly rebalances the portfolio), HSBC Trinkaus issued a Schuldscheindarlehen referenced to a total return swap transaction conducted with HSBC in London. The swap is linked to a CPPI index created by the investment bank, which is essentially a dynamic portfolio of HSBC's investment in the Helaba fund, together with a basket of fixed-income securities. Lufthansa can request a coupon at any time, so a call option is built into the swap between the private and investment bank to cover this. At present, 75% of the fund's assets are invested in equities, while 25% is in fixed-income securities.

So far the fund has returned 25% in mark-to-market terms. "During that time, there were quite a few days when we saw a lot of volatility in the equity markets," says Kosse. "But even through this, the allocation to the risky asset has been very stable." The airline had wanted to have 100% in the risky asset, but 75% was deemed the best the bank could offer while simultaneously guaranteeing the capital under current market conditions.

The benefits of the liquidity reserve will perhaps only become apparent during the next major crisis for the industry, but Schmidt-Cording says the airline has already begun to reap the benefits of its extensive fuel hedging programme. Implemented in 1990, Lufthansa is the only airline over the past 15 years to have continuously hedged the price of fuel. Its strategy of hedging up to 90% of its planned fuel requirement on a revolving basis over a period of 24 months into the future using Brent collars has made a net contribution to the airline's balance sheet of EUR1.5 billion over the past 16 years.

Following September 11, the company also decided to link 85% of its debts to variable rates through interest rate swaps. However, Schmidt-Cording admits this is proving expensive in the high rate environment. "The study will be actualised every two to three years and adjusted if necessary," he says.