Aircraft leasing company flying into rough skies.

The legal and financial troubles that have engulfed American International Group Inc. have trickled down to the insurance giant's prosperous Century City-based aircraft finance unit, the No. 1 player in aircraft leasing.

AIG's International Lease Finance Corp. unit is expected to have a tough time navigating Wall Street's fickle credit markets due to the accounting improprieties uncovered after the departure of AIG's former chief executive, Maurice R. "Hank" Greenberg.

In the past few weeks, every major credit ratings agency has downgraded AIG, affecting some $26 billion of the company's senior debt. Last month, Fitch Ratings put International Lease Finance on "ratings watch negative," after AIG delayed the filing of its annual report, while Standard & Poor's placed the aircraft lease company's corporate credit and senior unsecured debt ratings on "CreditWatch negative," citing AIG's negative ratings.

In the short-term, the credit downgrades will make borrowing more expensive for International Lease Finance, which was founded in 1983 by Steven UdvarHazy, the son of Hungarian immigrants, and his two partners--the father-son team of Leslie Gonda, a Hungarian Holocaust survivor, and his son, Louis Gonda.

International Lease Finance, which owns a fleet of more than 800 commercial aircraft, has relied heavily on its relationship with AIG and the clout the insurer once brought to the capital markets. That alliance helped International Lease Finance leapfrog ahead of its closest competitor in revenues, General Electric Co.'s GE Capital Aviation Services (though the GE unit leases more planes worldwide). The two companies also have different strengths: International Lease Finance excels in the foreign market, while GE's unit dominates the domestic sector.

While analysts and government regulators are only beginning to pick apart the complex interactions between AIG and its various financial and insurance units, questions have been raised about transactions between International Lease Finance and General Re Co., the reinsurance unit of Berkshire Hathaway, which is run by billionaire Warren Buffett.

The New York Times. citing an unidentified senior executive of AIG, reported last month that International Lease Finance purchased an insurance policy from General Re that had the effect of reducing International Lease Finance's debt by hundreds of millions of dollars while also guaranteeing to General Re that it would not incur any losses on the insurance.

New York Attorney General Eliot Spitzer and other government regulators are looking closely at insurance transactions to see whether they transfer risk: if the seller of the insurance does not incur risk and the transaction simply masks a financial problem for the buyer, it is not considered a legitimate insurance deal.

Last week. the FBI said it has been looking for nearly a year into problems of accounting and other corporate fraud schemes at insurers.

International Lease Finance officials were traveling last week and were not available for comment. Officials from AIG and General Re did not return telephone calls for comment.

AIG's investment

Greenberg's departure and the resulting tumult at AIG have clearly raised more questions regarding International Lease Finance than can be answered.

Since 1990, when it purchased International Lease Finance for $1.3 billion, AIG has provided as much as $900 million of equity capital to support the growth of its aircraft leasing unit. The unit. in turn. pays dividends upstream thai account for as much as 10 percent of AIG's earnings, according to analysts' reports and Securities and Exchange Commission filings.

International Lease Finance also provides tax benefits to AIG that totaled $2.6 billion in 2004. Those benefits are expected to be phased out by 2007 under new tax rules.

Last year, International Lease Finance reported a slight decline in net income to $502 million from $506.3 million in 2003. Revenue rose 8 percent to $3.3 billion. Lease margins, a key indicator of performance in aircraft leasing, fell to 19.2 percent last year from 21.7 percent in 2003 and 23.2 percent in 2001.

With Greenberg gone, along with former AIG Chief Financial Officer Howard Smith, International Lease Finance now has two new AIG executives on its board. However, strong ties to Greenberg remain.

International Lease Finance's top three executives--Udvar-Hazy, its chairman and chief executive; Vice Chairman and Chief Financial Officer Alan Lund, and President and Chief Operating Officer John Plueger--continue to receive a portion of their pay from Starr International Inc., the private organization still headed by Greenberg that controls roughly 12 percent of AIG's shares.

Last year, Starr gave $2.1 million in deferred pay to Udvar-Hazy, and $716,412 in deferred pay to both Lund and Plueger, according to SEC filings. Some of the founders' net worth is tied up in AIG stock that is controlled by Start International.

Martin Sullivan, AIG's new president and chief executive, automatically gained Greenberg's board seat at International Lease Finance. He will eventually have to make strategic decisions about the aircraft leasing unit, analysts say--though it is unclear whether the unit would ever extricate itself from AIG. Julie Sackman, ILFC's executive vice president, general counsel and secretary, was named a director in March, replacing Smith.

Regulators have been highly critical of AIG and its relationship with Starr. They claim Greenberg created an unusual arrangement in which an outside private company controls tens of millions in incentive and bonus pay to AIG executives--at no cost to AIG. Moreover, Greenberg uses his control of Starr as leverage to dole out bonuses to favored AIG executives, including those at International Lease Finance.

Complex deals

As regulators are discovering, AIG's various operating units appear to be structured specifically for their complexity--making it difficult for credit and insurance analysts, let alone shareholders, to fully understand the purpose of many transactions.

Analysts have expressed some concern about two securitizations that International Lease Finance sold in 2003 and 2004. In those deals, portfolios of 34 and 37 aircraft were pooled together and sold for $1 billion each to affiliates of AIG. International Lease Finance manages the portfolios and received management fees of $10.2 million from AIG in 2004.

The aircraft leasing unit also executed $1.8 billion in trades through yet another AIG unit, AIG Financial Products Corp.

The biggest problem apparently involves the purchase of so-called "residual value insurance policies"--essentially insurance that serves as a buffer against a drop in the value of aircraft. Insurance analysts say such policies can be written to improperly ensure that both the purchaser and the insurer do not suffer losses. Last year, International Lease Finance paid $4.7 million to AIG for insurance policies.

The aircraft lease unit's own corporate structure is complex as well.

The unit is a subsidiary of AIG through two other AIG units, AIG Capital Corp., its capital markets unit, and National Union Fire Insurance Co. of Pittsburgh, a reinsurer based in New York.

International Lease Finance paid cash dividends to those two entities of $35.5 million in 2004, $49 million in 2003 and $26 million in 2002, according to SEC filings. The lease finance unit, like most AIG subsidiaries, is subject to "cost sharing agreements" with AIG that include pension costs, certain senior management compensation and costs for various corporate services, none of which are fully explained in SEC filings.

Philip Baggaley at S&P said AIG "has been particularly valuable in International Lease Finance's weathering the downturn in global aviation over the past several years."

Philip Walker, the Fitch analyst who put International Lease Finance on a negative ratings watch, called the credit downgrades "collateral damage" from AIG's turmoil. Thanks to a rebound in the struggling global airline industry, AIG's troubles may have less of an impact on International Lease Finance, he said.

"We're entering a different part of the cycle and the sector has really improved over the last two years," Walker said.

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