Economic Influences That Can Negatively Term Paper

Why does GE finance poorly-rated airlines with its aircraft financing? GE benefits in three ways: (1) its lower cost of capital than the airlines means that it can charge a risk premium, and make more money on the airline debt, (2) it sells aircraft engines and, more critically, spare parts, which are the biggest long-term source of revenue for the company, and (3) the loans are well-collateralized. Even in a bankruptcy procedure, the airlines have relatively little recourse to the assets, and GE would be free to sell or lease the airlines to others. Other leasing companies, while they don't have GE's aircraft engine business, are able to lure tax-advantaged investors (offshore, those receiving tax credits, others) who also give them a lower cost of capital; their expertise in leasing and selling planes, as well as their leverage in pricing negotiations with the major airframe manufacturers gives them an advantage that an individual airline may not have.

The ironic result of their leveraged finances and higher cost per seat mile is that they (1) cannot afford the newest, most fuel-efficient planes, (2) cannot afford to hedge their future fuel costs to the same extent as their low-cost competitors, and (3) make less money in good times (and lose more in bad times) than their low-cost competitors.

In a freely-functioning economic system, the legacy airlines would have merged or gone out of business at a faster rate than they have done up to now. Indeed, from 2001 to 2004 the U.S. airline industry lost $32 billion, or $13 on each passenger flown during that four-year period (Winston)the elements that have kept them in business include governmental factors, such as not allowing foreign airlines to own over 25% of U.S. airlines (thus making economies of international scale more difficult) and the disallowance of 'fifth freedoms,' which would allow a non-U.S. flag carrier to pick up paying passengers in one U.S. city and drop them off in another U.S. city.

A further factor which keeps the number of competitors at a high level are liberal U.S. bankruptcy laws. By shielding the bankrupt airlines from many of their liabilities, including pensions and, to a more limited degree, their leasing obligations, they allow the legacy, bankrupt airlines to compete on a lower-cost basis than their status before filing for bankruptcy and after emerging from bankruptcy.

Additional economic influences which can affect the industry negatively include the global cost of oil, which increases the fuel expenses for airlines. The increase in demand in large, newly-emerging economies such as China and India has combined with a relatively stable supply to push up overall oil prices to or near $100 per barrel, an increase of 50% in the past 5 years. These price increases can be expected to continue to increase as supply remains relatively static and global demand increases. The net result is that those airlines in the U.S. which can afford more fuel-efficient planes and have lower costs per seat mile will continue to widen their advantage against the legacy airlines. Hedging, while a source of short-term profits (see Southwest Airlines, which claimed over $700 million in profits in 2007 due to fuel hedging (Mandaro)).

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Mackinac. Price Elasticity of Demand. Economic. Mackinac: Mackinac Center for Public Policy, 1997.

Mandaro, L. "Southwest surges on traffic comeback." CBS Marketwatch 18 October 2007: n.p.

Waters, WG, Oum, TH and Yong, JS. "Concepts of Price elasticities of Transport Demand and Recent Empirical Estimates - an Interpretative Survey." Journal of Transport Economics and Policy (1992): n.p.

Winston, C and Morrison, SA. What's Wrong with the…