The Russian Response to the Commercial Airplane Sanctions

 I have Blogged about the sanctions and the now the Russian response to the sanctions, It would be how I figured how it would go, anybody that deals with commercial aviation and the reams of paperwork to maintain the "Airworthiness Certification" of an airplane, what the sanctions are going to mean, when you mix parts you have to have a paper trail, basically what is called a "8130" paperwork attached to the part to say that the part is a good part from a good source and if there is a bunch of parts that have no paper attached to it, it basically will raise questions of the "Airworthiness" of that airplane, and sure it can fly inside Russia, but if there are doubts to the Russian Authorities allowing unsafe airplanes to fly, then it can cause problems with them flying outside Russia.

Until just a few weeks ago, Russian airlines were reliable business partners for the global aircraft leasing industry. The Russian sector was one of the least affected by the COVID-19 pandemic because its large domestic market recovered faster than elsewhere. But since President Vladimir Putin started a war in Ukraine, lessors have been facing an unheard-of scenario: a total loss of more than 500 of their aircraft.

• Hundreds of leased aircraft are likely to be kept in Russia
• Lessors prepare for total-loss scenario
• Contingency insurance coverage might apply

European Union sanctions imposed in response to Russia’s invasion of Ukraine require lessors to cut ties with Russian operators by March 28. But stopping sales of parts or new aircraft—which the sanctions also require—is far easier than trying to repossess assets in customers’ hands. The Russian government has indicated that it is willing to go to extremes to protect the fleets of its airlines, including confiscating or “nationalizing” aircraft that are owned by lessors. A draft law published March 10 establishes a government commission to determine whether aircraft can be returned to lessors and decrees that lease payments be made in rubles rather than U.S.-dollars for the rest of 2022, shielding operators from a further plunge of the Russian currency.

The unfolding drama is likely to redefine the commercial aircraft leasing market, which could exclude Russian customers for a very long time.

“If we have continued risk of nationalization, nobody in their right mind would take that risk,” says the CEO of one large lessor with a substantial fleet operating in Russia, speaking on the condition of anonymity. He says it is hard to see an inflection point, even far into the future, that would allow the industry to return. “What is the definition of: ‘It is over’?” he asks.

What the Russian transport ministry calls “nationalization” amounts to illegally taking possession of leased aircraft against the will of their owners and very likely without making purchase payments. Should the government proceed with the plans, “Russia will be an uninvestable country for a long time,” says Agency Partners analyst Sash Tusa.

The country, having opened up to Western suppliers and lessors just about 30 years ago, had turned into a good aviation market, buoyed by growth in both domestic and international flying and demand for replacements for aging Soviet-era aircraft. While some lessors took a relatively cautious approach to Russia, others were comfortable doing business there. Russian airlines depended on leasing to a large degree, given their precarious financial state after the breakup of the Soviet Union. At the end of 2021, domestic traffic was 20% above 2019 levels—partly because many Russians still could not fly abroad due to COVID-19-related travel restrictions—whereas globally domestic traffic was down 20%.

The Aviation Week Network Fleet Discovery database shows that Russian airlines lease more than 600 large transport aircraft—those certified for 19 or more seats—from lessors based outside Russia. At least 100 more aircraft belong to lessors with Russian roots and subsidiaries based outside the country. Many aircraft are leased through Irish affiliates, as is standard industry practice, and so are subject to EU sanctions. In some cases, determining the status of a leased aircraft is impossible without knowledge of contractual details.

By absolute numbers, AerCap, based in Dublin, Ireland, is the most exposed, with close to 150 of its aircraft operating in Russia (see chart). SMBC Aviation Capital has 36, Air Lease Corp. 32, BOC Aviation 24 and DAE Capital 22. For the largest international lessors to Russian airlines, the exposure is around 7% of their portfolio, which the CEOs of two of those lessors independently described as “manageable.”

How painful would the consequences be if repossessions cannot be made, access to the assets is permanently lost, or their value declines so much over time that they become complete write-offs? These are more than theoretical questions; they are likely scenarios for which the industry has to prepare as Russia tries to keep its air domestic transport industry going amid Western sanctions.

“There will be no repossessions,” says one leasing company CEO. “The state-owned companies are not cooperating. The private ones pretend to but do nothing.” Why? “There are implications for airlines that don’t hold the [official] line,” another executive says. In other words: Even if an airline wanted to adhere to international law, it has no choice but to break it because of government orders.

 

“A couple dozen [aircraft] have come out [of Russia],” Bloomberg Intelligence analyst George Ferguson says he has heard. “I think if you don’t have your airplane out now, you’re not going to get it, because the Russians are hiding them.” And even if ultimately some aircraft are returned, they likely will be complete write-offs.

“[The airlines] are probably taking parts off some of the airplanes to keep the others flying,” Ferguson says. “You are going to have parts mixed and mingled, which makes it difficult to keep the record straight. It’s a really bad situation for the lessors.”

“In our view, it is unrealistic for lessors to repossess aircraft within a month because more than 80% of the planes are narrowbody and regional jets that are unlikely to leave Russia for a neutral jurisdiction,” Scope Ratings analyst Dierk Brandenburg writes. “Russia’s aviation legislator has banned international flights with foreign--leased planes from this week. Even under normal circumstances, we would have expected repossessions in Russia to take up to six months.”

“[Given] current airspace and border closures, we question whether any aircraft will exit” Russia, J.P. Morgan Chase analysts write in a March 3 research note issued after an investor conference it hosted. “We don’t believe Russia will simply allow Aeroflot or S7, for example, to fly aircraft out of the country to Western jurisdictions simply because leases have been canceled.”

Avolon was one of very few lessors able to repossess aircraft from Russian carriers: It took possession of a Boeing 737-800 on lease to Aeroflot subsidiary Podeba when the aircraft was in Istanbul on Feb. 27.

On March 5, Russia’s Federal Air Transport Agency (Rosaviatsiya) recommended that local carriers with aircraft leased from foreign companies and registered in foreign registers suspend all international passenger and cargo services. The ban for outbound flights took effect on March 6; return flights were stopped starting March 8.

The largest Russian airlines—including Aeroflot and its low-cost subsidiary Pobeda, Ural Airlines, charter carriers Azur Air and Nordwind—responded on March 5 by saying they would cut international operations beginning March 8. S7 and Smartavia announced similar measures ahead of Rosaviatsiya’s recommendation.

Aeroflot is still operating flights beyond Russia’s borders only to Belarus, Moscow’s ally in the war in Ukraine. Red Wings announced it would still fly to Armenia and Uzbekistan using Russian-made Superjet 100 regional jets leased from Russian lessors. All-Superjet operator Azimuth flies to Armenia, Azerbaijan and Turkey. Azur Air planned to use only Russian-registered Boeing 767s and 757s for international flights after March 8. Utair is continuing international services for the time being, too, as it owns about 40% of its fleet, including 18 Boeing 737-500s and six Boeing 737-400s, and has moved three of them into the Russian register.

With repossessions feasible only when leased aircraft are outside Russia, maintenance shops are moving into the spotlight as well. One lessor told J.P. Morgan chase analysts that it had four Russian customer airframes in heavy checks outside the country.

Lessors not subject to sanctions still face significant hurdles. Broad sanctions are limiting Russia’s access to the global financial system, making routine payments difficult, if not impossible.However, one of the main lessors active in Russia said its monthly lease rates had been paid in U.S. dollars the week of Feb. 28.

The payments are unlikely to continue. “[The] suspension of certain Russian banks’ access to SWIFT, the universally used international bank messaging system that facilitates interbank transfers, could disrupt rent and loan payments owed lessors by their Russia-based airline customers,” Moody’s writes in a March 4 research note.

“[While] some Russian airlines may be able to remit lease payments through China, the ability to move U.S. dollars directly from Russia appears [to be] next to impossible,” J.P. Morgan Chase states.

“The initial financial impact to aircraft lessors will be disruptions to their revenues and operating cash flows as near-term payments from Russian airline customers due in March are not likely to be received,” write DRBS Morningstar analysts. “Longer-term, the absence of rental revenue from these aircraft creates an additional headwind to the lessors’ ability to restore their revenue generation to pre-pandemic levels, as revenues remain constrained by rent deferrals granted to airlines looking to navigate the impact of the pandemic.”

The DRBS analysts further note: “More importantly, we see the lessors as facing an elevated risk of noteworthy impairments to the value of the aircraft on lease in Russia. Should the aircraft become stranded in Russia with the lessors having no ability to regain possession of the aircraft, then the lessors will likely have to write down the value of the aircraft to a low recovery value that reflects collateral such as letters of credit and maintenance reserves that serve as security as well as any potential insurance proceeds.”

If Russian airlines refuse to return leased aircraft after March 28, a portfolio of more than 500 aircraft worth well in excess of $10 billion would be in limbo, according to Scope Ratings estimates. As a consequence, one industry CEO forecasts that lessors will file claims with their insurers for a total loss of affected aircraft. “It is complicated, and there will be years of litigation over this, as some insurers will reject the claims,” the leasing industry executive says. “I’m concerned about how the insurance market will absorb this.”

Aircraft insurance arrangements usually are complex, but lessors typically require airlines to “carry those types of insurance that are customary in the air transportation industry, including comprehensive liability insurance, aircraft all-risk hull insurance, and war-risk insurance covering risks such as hijacking, terrorism (but excluding coverage for weapons of mass destruction and nuclear events), confiscation, expropriation, seizure, and nationalization,” Air Lease Corp. writes in its most recent annual report.

In Russia, airlines are obliged to insure aircraft locally, and most lessors also have contingency coverage for individual aircraft or parts of their fleets where the risk of relying only on airline-managed policies is considered too high. That is the case for most of the Russia-based fleet, according to one insurance industry expert. The contingency policies cover everything or only certain aspects, including war risk or confiscation.

Whether lessors can expect to recover damages through the contingency arrangements is not yet clear. No claims have been filed so far. Plus, the policies are typically handled on the London insurance market, and the UK, unlike the EU, has not yet published the details of its Russia sanctions, which will determine whether the financial impact is covered or not. “A lot of people are very nervous,” an insurance official says. He also expects premiums to rise substantially in the future as insurance companies reassess risk profiles.

“Due to sanctions, many insurance companies have canceled coverage or may contest future claims, but certain lessors moved aircraft to their contingent/possession insurance policies,” Fitch Ratings writes. “Russian aircraft are insured in Russia, but the value of these policies is uncertain, if [of] any value at all. Individual insurance and umbrella policies with contingency clauses intend to cover ‘act of war’ events, and these policies could potentially cover the current aircraft market value under certain terms. . . . Any policy payouts may take time.”

Another concern is that the West’s major aircraft and engine manufacturers have ceased aftermarket support for Russian operators, either voluntarily or due to sanctions. Without access to around-the-clock technical support, spare parts sales and foreign airframe and engine maintenance services, Russian airlines planning to operate Airbus, ATR, Boeing, Bombardier (MHI RJ Aviation) or Embraer aircraft for any length of time seemingly face an uphill struggle.

Two-thirds of the 1,259 aircraft in Russian scheduled and nonscheduled services were built by Airbus, ATR, Boeing, Bombardier (MHI RJ Aviation) or Embraer. Lost access to international markets and a drop in booming domestic demand will create excess capacity—and open the door for parts cannibalization within subfleets. But long-term operations without support probably will require securing parts on the black market, similar to the way airlines in targeted countries such as Iran evade Western sanctions to keep their Airbus and Boeing aircraft flying. Iran, of course, is a much smaller market by comparison, and far fewer aircraft have had to be sustained.

Russia is already preparing for an environment without OEM support. The transport ministry published a draft government decree on March 5 that automatically extends until Sept. 1 expired airworthiness certificates for foreign-made aircraft registered in Russia. The same measure is suggested for aircraft on foreign registers that are operated in Russia under the Chicago Convention Article 83 bis. Crews can operate these aircraft based on a document issued by the Russian authorities without approval by the country of registration, according to the provision.

The ministry also will allow Russian airlines to use operating and maintenance manuals for foreign-made aircraft without support and updates from the OEMs. The draft decree is open for public consideration until March 28.