In the last Trains magazine, there was an article about BNSF and other railroads shelfing projects during the recession. The focus of the article seemed to be that the railroads wanted to see the direction of the economy before improving them-although I did not read the article as closely as I would have liked to, yet. Anyway, might another explanation be the difficulty in obtaining credit?
I had initially thought that the credit crunch had passed. However, I was in a mediation yesterday. My lawfirm obtained a $7,500,000 verdict against one of the larger steam ship companies. In the mediation, my pitch was there is an 8.5% post-judgment interest on the verdict, this is not the type of case that is reversed on appeal, and you guys should settle, as you are one of my lawfirm’s better investments.
Their response: go to Haties. Although we are paying 8.5% interest, right now you are the ONLY one lending us credit, we are going to drag this on as long as we possibly can regardless of the prospects for reversal on appeal.
Aside from wondering if I am ever going to settle a case in the next two years for this reason, this exchange left me wondering how many ROW improvement projects we are going to see. Even if a railraod can get the financing, might it be wiser for them to wait until it is cheaper?
On the other hand, with the cost of commodities (steel, concrete, gravel,…) a fraction of what it was last year, the railroads should be able to complete many more projects at lower costs. The only fly in this ointment is that now that stimulis money is kicking in, there are many road, building and infrastructure projects that are starting to use construction resources.
Steamship companies may be in the position that no one believes their recovery will be swift, so no one is betting on their futures.
Then again, the banks and investment houses did such a fine job of investing in recent years, we shouldn’t expect them to be making reasonable investments now.
Cost of credit isn’t necessarily the problem. Economics are a very complex issue with no one factor is independent and not influenced by everything else. The bailout provided banks with money that in theory was to be lent and stimulate the economy. Apparently every indication is that the banks are hoarding it so they don’t run out again. The government intrusion into their operations and the way they have operated in the past has them very leary about partnering with the feds and operating under basically do it or else intrusion. And before anybody say’s they need to have past operating practices checked it was the federal government that dictated the banks had to lend money with little or no equity to the people in trouble now or face severe penalties and Barney Frank has just proposed they do it again! Interest rates are remaining low for now (subject to risk) until the inflation hits. Obama’s plan to take over health care will put 1/6 of the gross national product into the hands of the government and will suck capital out of the markets for at least ten years. It may very well lead to very high costs for private industry to borrow when risk and lack of available funds are considered. It’s going to be a very bumpy ride for a long time
Most of these situations - esp. for railroads - are highly company-specific.
Your adversary was kind of unique - they’re in a position where they could use your client as an involuntary bank or lender for a 7.5 million line of credit at 8.5 per cent. If they can’t get the money to pay off that judgment elsewhere - like from a bank or their internal capital - at an effectively cheaper rate - or at all, if their credit rating is lousy - then that’s a short-term smart move, even though maybe a long-term dumb move with that high of an interest rate. In other words, where else cold they get that kid of a deal ? It’s kind of like using a revolving credit card to pay for a grocery bill - it’s going to cost a lot in interest, but keeping the cash and getting food right now in the immediate future is worth more than the additional interest expense at some indeterminate time down the road.
To illustrate with a personal example, I will often borrow the money for a big-ticket purchase, even if I have the cash to pay for it. Why do I do that ? Because if I pay cash, I’ve drawn down my cash reserves by that much - maybe a large amount, as for a house. If I need to get a loan later on, then the assets side of my balance sheet doesn’t look so attractive. But if I borrow the money, I’ve still got my cash - my credit and balance sheet still looks relatively good, and I can also still use the cash to pay the loan in installments, or to pay it off altogether in the future if I want. My net worth is essentially the same in either scenario, but I have more flexibility - and more total assets at my command - with a loan for the purchase, and keeping the cash still on hand. ‘Leverage’ - which results when the borrowed money is cheaper than your own or other money - is another good reason to use someone else’s money. So your adversary is able to just 'owe
Credit is still pretty tight out there. Take a look at the steamship line…no doubt their revenues are down considerably due to the global recession. If they are like other steamship lines, three years ago they were taking on new equipment as demand was high and the new equipment was much more fuel efficient.
Gabe, what do their financials look like? They might be in no position to make your payment.
Regarding the railroads, their carloadings are down 20%, perhaps even a bit more. Fixed costs remain the same and they are doing everything to keep variables under control. While capex does not fall under the category of variable costs, it is cash that is budgeted and must be generated by borrowing or FCF.
CSX reported their 2Q this week. Their revenue was down 25% vs 2Q 08. Expenses were down 27% vs 2Q08. Interestingly, their operating ratio for railroading improved from 74% to 71% for the quarter.
They were able to control their expenses quite well.
There will probably be another bankruptcy in the financial markets this week. CIT has not been given bailout $$$. CIT is big in retail lending and factoring, but also make loans to other businesses. How will this impact the credit markets? Who knows.
Gabe, you might want to see about a lien on one of those steamships.
The Class 1’s finance their work based on operating cash flow and carloadings. When these went down along withe the associated income, those projects got shelved.
There you go - the R-O-W improvement projects are funded internally to the company by the cash flow from carloadings and the resulting operating income [hopefully], not by credit from banks or others, and hence are not subject to a specific interest rate as charged by same.
Kind of like paying for building a new house by buying the materials and paying the general contractor and the trade sub-contractors with a portion out of each of your paychecks as available and needed, instead of taking out a mortgage and then having to pay back the bank with part of each paycheck. Meanwhile, you can still live in and use your old house or trailer next door, while the new one is being built - just like the railroad using the old existing facilities to earn the money to pay for the new ones.
Mudchicken is right, fixed facility investment is almost always financed out of operating cash flows, which is a combination of depreciation and earnings. Railroads have had a hard time selling equity for about a century and long debt for almost as long. The NS bond sale to finance CR purchase being the major exception. Most of the big 7 +/- can sell short term notes which is how a lot of the recent stock buy backs have been funded. See financial notes of recent annual reports of BNSF and UP for example.
Selling 5 year notes to finance a 30 year project is a bad match in terms of duration. I looked at BNSF earlier today to see what debt they actually sold 1Q this year. Answer is nothing. They do have a $1 Billion standby line of credit that you can read about however. They have not drawn anything down on it.
The real “problem”, as Mudchicken says, is that traffic and revenue are both down. In another section of this website there is a blurb by Fred Frailey that says BNSF transcon traffic is down from 100 trains per day to about 65. BNSF has been trying to push 100 trains a day over a line that in some places does not have the capacity to reliably handle that volume. That makes everyone’s day too exciting. With traffic down to 65, that takes a lot of pressure off. No rational railroad manager is going to invest in fixed plant that he does not desperately need. Remember, the industy has been capital starved for a century. In that environment companies and individuals who have been/are not VERY carefull about ALL investments are rapidly and effectively selected against.
I believe this kind of arrangement is called a ‘carry trade’, and that a lot of banks and investors got burned by it over the last couple of years. Typically, they had loaned out money on 30-year mortgages at fixed rates, but had not tied down a corrresponding amount of money for the same time frame, at the usual slightly lower rate [to cover their expenses and profit, etc.].
Instead, they were able to borrow money at such lower rates by doing things such as issuing CDs, but for much shorter terms. They were able to roll-over or refinance or revolve those short-term borrowings/ CDs - still at the low rates - for an extended period, so they thought that would go on forever. Well, like all good things it came to an end, and the short-term loan/ CD rates went up, and they started to lose money on the mortgages - ‘buying high and selling low’ is essentially what they got caught up in. Obviously that led to losses, and there was no real way out - any borrowings/ CDs at that point to cover their previous long-term mortgage loan commitments was still going to be more expensive, and likely to lock them into that bad deal for an even longer period. So that’s a small part of the financial industry’s meltdown over the past couple of years.
In the railroad context, a railroad would typically approve and build a project with the expectation that the borrowed money to pay for it would cost a certain fixed percentage rate for the entire duration of the economic life - or at least the financial loan’s life - of the project. That would be like the benchmark or minimum threshold rate of return against which to measure the project’s savings or increased revenues, and returns, etc. But if the financing is not obtained and tied down for that same time period at the b
If you are as old as I am you will also remember the S&L debacle cuased by borrowing short and lending long.
In fact, the railroad will do a Net Present Value based on a minimum hurdle rate. I am not on the inside but would expect it to be at least 15%. If the project has a positive NPV financial theory says you should make the investment.
Regardless of the source of funds the real question is “Can I get enough money to finance all the projects that have a positive NPV”. For the last 100 years the answer has been NO because the carrier’s earnings have been insufficient to let them sell either long term debt or equity. The railroad will thus do the projects that it has to do as a matter of law, safety, and good investments in that order until it runs out of money. Most Class I carriers leave a lot of good projects on the table. Fixed facility investments will always be done last because they are sunk the moment they are done.
This is an interesting discussion which lends well to the CN/Hunter Harrison thread. Mac, you nailed it on how railroads (or other companies) determine what gets done. If the numbers dont crunch out, the project doesnt get done.
That is the interesting aspect to corporate balance sheets and debt/equity structures. Determining the cost of capital and then applying it to projects is fascinating. Throw in the handling of free cash flow:
projects
dividend payments
expansion of plant
purchase of (investment in) new companies
stock repurchase
Paul…carry trade applies to private equity groups that carry their net earnings on the books in order to be taxed at capital gains (and much lower taxes) rather than reporting it as net income, which would be taxed at a much higher rate. It never made much sense to me as to why it was taxed at CG rate rather than income and nothing I read made me understand why. It was simply a tax break given to private equity groups.
[#offtopic] Yes, I’m old enough to remember that one, too - to be clear, of the late 1980s / early 1990s time frame, so that we’re on the same historical page. But my understanding was that was caused by someone or some entity in the Bush I [Sr.] administration essentially arbitrarily deciding that the S&L’s had to suddenly increase their capital reserves for outstanding loans by a substantial amount - kind of like a sudden upping of the ante. Of course, being almost entirely ‘loaned out’ to maximize earnings through full deployment and utilization of their available funds, many didn’t have and couldn’t raise that amount of capital funds quickly - so almost overnight they became technically insolvent or impaired, even though the actual assets and liabilities on their balance sheets hadn’t changed much. I nother words, the rules were changed on them in the middle of the game. As a result, they had to seek salvation/ shelter/ bailout through mergers, sales, or the Federal govt.'s bailout of them at the time. At the time I was working for and with several people who were closely connected to and involved in the real estate development and banking businesses, though often on opposite sides of the table. Nevertheless, they were all of the opinion that it was an artificially caused and wholly unnecessary disaster. If you have a different understanding or reference, I’d be interested in learning more about it.
What I think is notable about the causes of the present debacle is the utter lack of invovlvement by the legal system - other than maybe drafting the underlying documentation, and of course now the after-the-fact clean-up of the resulting messes and jailing of some of those responsible, etc. Think ab