Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Thomas A. Zimmerman

Executive Director Head, ABS Research UBS Warburg

Asset-backed securities are securities backed by loans or receivables. The securitization of residential mortgage loans is by far the largest type of asset that has been securitized and these securities are covered in Chapters 14 and 15. The collateral includes standard residential mortgage loans, home equity loans, and manufactured housing loans. Securities backed by commercial mortgage loans, commercial mortgage-backed securities (CMBS), are covered in Chapter 16. For asset-backed securities not backed by real estate, the largest sector is securities backed by credit card receivables, covered in Chapter 18.

In this chapter, we discuss the basic features of asset-backed securities and the credit risks associated with investing in them. We then look at several types of asset-backed securities not backed by real estate or credit card receivables.

FEATURES OF AN ABS

Before we discuss the major types of asset-backed securities, let’s first look at the general features of the underlying collateral and the structure.

Credit Enhancement

All asset-backed securities are credit enhanced. This means that support is provided for one or more of the bondholders in the structure. Credit enhancement levels are determined relative to a target rating desired by the issuer for a security by each rating agency. There are two general types of credit enhancement structures: external and internal. We describe each type in Chapter 15.

Amortizing versus Nonamortizing Assets

The collateral for an ABS can be classified as either amortizing or non-amortizing assets. Amortizing assets are loans in which the borrower’s periodic payment consists of scheduled principal and interest payments over the life of the loan. The schedule for the repayment of the principal is called an amortization schedule. The standard residential mortgage loan falls into this category. Auto loans and closed-end home equity loans are amortizing assets. Any excess payment over the scheduled principal payment is called a prepayment.

In contrast to amortizing assets, nonamortizing assets do not have a schedule for the periodic payments that the individual borrower must make. Instead, a nonamortizing asset is one in which the borrower must make a minimum periodic payment. If that payment is less than the interest on the outstanding loan balance, the shortfall is added to the outstanding loan balance. If the periodic payment is greater than the interest on the outstanding loan balance, then the difference is applied to the reduction of the outstanding loan balance. There is no schedule of principal payments (i.e., no amortization schedule) for a nonamortizing asset. Consequently, the concept of a prepayment does not apply. Credit card receivables and open-end home equity loans are examples of nonamortizing assets.

For an amortizing asset, projection of the cash flows requires projecting prepayments. One factor that may affect prepayments is the prevailing level of interest rates relative to the interest rate on the loan. In projecting prepayments it is critical to determine the extent to which borrowers take advantage of a decline in interest rates below the loan rate in order to refinance the loan.

As with nonagency mortgage-backed securities (MBS) which are described in Chapter 15, modeling defaults for the collateral is critical in estimating the cash flows of an asset-backed security. Proceeds that are recovered in the event of a default of a loan prior to the scheduled principal repayment date of an amortizing asset represents a prepayment and are referred to as an involuntary prepayment. Projecting prepayments for amortizing assets requires an assumption of the default rate and the recovery rate. For a nonamortizing asset, while the concept of a prepayment does not exist, a projection of defaults is still necessary to project how much will be recovered and when.

The analysis of prepayments can be performed on a pool level or a loan level. In pool-level analysis it is assumed that all loans comprising the collateral are identical. For an amortizing asset, the amortization schedule is based on the gross weighted average coupon (GWAC) and weighted average maturity (WAM) for that single loan. Pool-level analysis is appropriate where the underlying loans are homogeneous. Loan-level analysis involves amortizing each loan (or group of homogeneous loans).

The maturity of an asset-backed security is not a meaningful parameter. Instead, the average life of the security is calculated. This measure is introduced in Chapter 14.

Fixed-Rate versus Floating-Rate

There are fixed-rate and floating-rate asset-backed securities. Floating-rate asset-backed securities are typically created where the underlying pool of loans or receivables pay a floating rate. The most common are securities backed by credit card receivables, home equity line of credit receivables, closed-end home equity loans with an adjustable rate, student loans, Small Business Administration loans, and trade receivables. With the use of derivative instruments, fixed-rate collateral also can be used to create a structure that has one or more floating-rate tranches. For example, there are automobile loan-backed securities with a fixed rate that can be pooled to create a structure with floating-rate tranches.

Passthrough versus Paythrough Structures

How a mortgage passthrough security is created is explained in Chapter 14. A pool of mortgage loans is used as collateral and certificates (securities) are issued with each certificate entitled to a pro rata share of the cash flow from the pool of mortgage loans. So, if a $100 million mortgage pool is the collateral for a passthrough security and 10,000 certificates are issued, then the holder of one certificate is entitled to 1/10,000 of the cash flow from the collateral.

The same type of structure, a passthrough structure, can be used for an asset-backed security deal. That is, each certificate holder is entitled to a pro rata share of the cash flow from the underlying pool of loans or receivables. For example, consider the following asset-backed security structure:

Each certificate holder of the senior tranche is entitled to receive 1/10,000 of the cash flow to be paid to the senior tranche from the collateral. Each certificate holder of the subordinated tranche is entitled to receive 1/1,000 of the cash flow to be paid to the subordinated tranche from the collateral.

How a passthrough security can be used to create a collateralized mortgage obligation (CMO) is also explained in Chapter 14. That is, passthrough securities are pooled and used as collateral for a CMO. Another name for a CMO structure is a paythrough structure. In the case of an ABS, the loans are either pooled and issued as a passthrough security or as a paythrough security. That is, unlike in the agency mortgage-backed securities market, a passthrough is not created first and then the passthrough is used to create a paythrough security. This is the same process as with a nonagency mortgage-backed security.

In a paythrough structure, the senior tranches can be simple sequential-pays, as described for CMOs in Chapter 14. Or, there could be a planned amortization class (PAC) structure with, say, senior tranche 1 being a short average life PAC, senior tranche 2 being a long average life tranche, and the other two senior tranches being support tranches.

It is important to emphasize that the senior-subordinated structure is a mechanism for redistributing credit risk from the senior tranche to the subordinated tranches and is referred to as credit tranching. When the senior tranche is carved up into tranches with different exposures to prepayment risk in a paythrough structure, prepayment risk can be transferred among the senior tranches as in a nonagency CMO. This is referred to as prepayment tranching or time tranching.

Optional Clean-Up Call Provisions

For asset-backed securities there is an optional clean-up call provision granted to the issuer. There are several types of clean-up call provisions.

In a percent of collateral call, the outstanding bonds can be called at par value if the outstanding collateral’s balance falls below a predetermined percent of the original collateral’s balance. This is the most common type of clean-up call provision for amortizing assets, and the predetermined level is typically 10%.

A percent of bonds clean-up call provision is similar to a percent of collateral call except that the percent that triggers the call is the percent of the amount of the bonds outstanding relative to the original amount of bonds issued. In structures where there is more than one type of collateral, such as in home equity loan-backed securities, a percent of tranche clean-up call provision is used.

A call on or after specified date operates just like a standard call provision for corporate, agency, and municipal securities. In a latter of percent or date call the outstanding bonds can be called if either (1) the collateral outstanding reaches a predetermined level before the specified call date or (2) the call date has been reached even if the collateral outstanding is above the predetermined level.

In an auction call, common in certain types of home equity loan-backed securities, at a certain date a call will be exercised if an auction results in the outstanding collateral being sold at a price greater than its par value. The premium over par value received from the auctioned collateral is retained by the trustee and eventually paid to the issuer through the residual.

In addition to the above clean-up call provisions, which permit the trustee to call the bonds, there may be an insurer call. Such a call permits the insurer to call the bonds if the collateral’s cumulative loss history reaches a predetermined level.

CREDIT RISKS ASSOCIATED WITH INVESTING IN ABS

In evaluating credit risk, the rating agencies focus on four areas:

• asset risks
• structural risks
• legal and regulatory considerations
• third parties to the structure

We discuss each area below.

Asset Risks

Evaluating asset risks involves the analysis of the credit quality of the collateral. The rating agencies will look at the underlying borrower’s ability to pay and the borrower’s equity in the asset. The latter will be a key determinant as to whether the underlying borrower will default or sell the asset and pay off a loan. The rating agencies will look at the experience of the originators of the underlying loans and will assess whether the loans underlying a specific transaction have the same characteristics as the experience reported by the issuer.

The concentration of loans is examined. The underlying principle of asset securitization is that a large number of borrowers in a pool will reduce the credit risk via diversification. If there are a few borrowers in the pool that are significant in size relative to the entire pool balance, this diversification benefit can be lost, resulting in a higher level of default risk. This risk is called concentration risk. In such instances, rating agencies will set concentration limits on the amount or percentage of receivables from any one borrower. If the concentration limit at issuance is exceeded, the issue will receive a lower credit rating than if the concentration limit was not exceeded. If after issuance the concentration limit is exceeded, the issue may be downgraded.

The rating agencies will use statistical analysis to assess the most likely loss to an investor in an ABS tranche due to the performance of the collateral. The rating agencies will analyze various scenarios, and from the results of these scenarios they can determine an expected (or weight average) loss for the investor in a tranche and the variability of the loss.

Structural Risks

As explained earlier in this chapter, the payment structure of an asset-backed deal can be either a passthrough or paythrough structure. The former simply has one senior tranche and the cash flow is distributed on a pro rata basis to the bondholders. In a paythrough structure, the senior tranche is divided into more than one tranche and there are payment rules as to how the cash flows from the collateral are to be distributed amongst the senior tranches.

The decision as to whether a passthrough or paythrough structure is used is made by the issuer. Once selected, the rating agencies examine the extent to which the cash flow from the collateral can satisfy all of the obligations of the ABS deal. The cash flow of the underlying collateral is interest and principal repayment. The cash flow payments that must be made are interest and principal to investors, servicing fees, and any other expenses for which the issuer is liable. The rating companies analyze the structure to test whether the collateral’s cash flows match the payments that must be made to satisfy the issuer’s obligations. This requires that the rating agency make assumptions about losses and delinquencies and consider various interest rate scenarios after taking into consideration credit enhancements.

In considering the structure, the rating agencies will consider (1) the loss allocation (how losses will be allocated to the tranches in the structure), (2) the cash flow allocation (i.e., in a paythrough structure the priority rules for the distribution of principal and interest), (3) the interest rate spread between the interest earned on the collateral and the interest paid to the tranches plus the servicing fee, (4) the potential for a trigger event to occur that will cause the rapid amortization of a deal, and (5) how credit enhancement may change over time.

Legal Structure

A corporation issuing an ABS seeks a rating on the securities it issues that is higher than its own corporate rating. This is done by using the underlying loans as collateral for a debt instrument rather than the general credit of the issuer. Typically, however, the corporate entity (i.e., seller of the collateral) retains some interest in the collateral. For example, the corporate entity can retain a subordinated tranche. Because the corporate entity retains an interest, rating companies want to be assured that a bankruptcy of that corporate entity will not allow the issuer’s creditors access to the collateral. That is, there is concern that a bankruptcy court could redirect the collateral’s cash flows or the collateral itself from the security holders in an ABS transaction to the creditors of the corporate entity if it became bankrupt.

To solve this problem, a bankruptcy-remote special-purpose vehicle (SPV) is formed. The issuer of the asset-backed security is then the SPV. Legal opinion is needed stating that in the event of bankruptcy of the seller of the collateral, counsel does not believe that a bankruptcy court will consolidate the collateral sold with the assets of the seller.

The SPV is set up as a wholly owned subsidiary of the seller of the collateral. Although it is a wholly owned subsidiary, it is established in such a way that it is treated as a third-party entity relative to the seller of the collateral. The collateral is sold to the SPV, which, in turn, resells the collateral to the trust. The trust holds the collateral on behalf of the investors. The SPV holds the interest retained by the seller of the collateral.

Third-Party Providers

In an ABS deal there are several third parties involved. These include third-party credit enhancers, the servicer, a trustee, issuer’s counsel, a guaranteed investment contract provider (this entity insures the reinvestment rate on investable funds), and accountants. The rating agency will investigate all third-party providers. For the thirty-party enhancers, the rating agencies will perform a credit analysis of their ability to pay.

All loans must be serviced. Servicing involves collecting payments from borrowers, notifying borrowers who may be delinquent, and, when necessary, recovering and disposing of the collateral if the borrower does not make loan repayments by a specified time. These responsibilities are fulfilled by a third party to an ABS transaction, the servicer. Moreover, while still viewed as a “third party” in many asset-backed securities transactions, the servicer is likely to be the originator of the loans used as the collateral.

In addition to the administration of the loan portfolio as just described, the servicer is responsible for distributing the proceeds collected from the borrowers to the different bondholders in an ABS transaction according to the payment priorities. Where there are floating-rate securities in the transaction, the servicer will determine the interest rate for the period. The servicer may also be responsible for advancing payments when there are delinquencies in payments (that are likely to be collected in the future), resulting in a temporary shortfall in the payments that must be made to the bondholders.

The role of the servicer is critical in an ABS transaction. Therefore, rating agencies look at the ability of a servicer to perform all the activities that a servicer will be responsible for before they assign a rating to the bonds in a transaction. For example, the following factors are reviewed when evaluating servicers: servicing history, experience, underwriting standard for loan originations, servicing capabilities, human resources, financial condition, and growth/competition/business environment. Based on its analysis, a rating agency determines whether the servicer is acceptable or unacceptable. Transactions including the latter are not rated, or the rating agency may require a backup servicer if there is a concern about the ability of a servicer to perform.

Remember that the issuer is not a corporation with employees. It simply has loans and receivables. The servicer therefore plays an important role in ensuring that the payments are made to the bondholders.

REVIEW OF SEVERAL NON-REAL ESTATE ABS

The list of non-real estate assets that have been securitized continues to grow. Below we restrict our discussion to a few asset types that have been securitized—auto loan-backed securities, student-loan backed securities, SBA-loan backed securities, aircraft ABS, franchise-loan backed securities, and rate reduction bonds.

Auto Loan-Backed Securities

Auto loan-backed securities represent one of the oldest and most familiar sectors of the ABS market. A key factor in the appeal of auto ABS securities is the historically strong credit quality of the underlying collateral. Of the most active sectors in the ABS arena—autos, credit cards, home equity loans (HELs)—autos are generally considered to have the strongest credit quality (that is, before credit enhancement brings virtually all senior securities across sectors to a triple-A rating).

Auto ABS are issued by:

1. the financial subsidiaries of auto manufacturers (domestic and foreign)
2. commercial banks
3. independent finance companies and small financial institutions specializing in auto loans

The auto loan market has traditionally played a major role in the ABS universe, representing about 16% of the outstanding ABS market. Since 1999 there has been explosive growth in this sector attributed largely to the “prime market”—specifically, to loans originated by the Big Three auto company part of that market. Other parts of the prime auto loan sector also had strong increases, with Japanese captive finance companies leading the way.

Prime auto loans are of fundamentally high credit quality for the following reasons. First, they are a secured form of lending (credit cards are unsecured lending). Second, they begin to repay principal immediately through amortization (credit cards require only a minimum payment). Third, they are short-term in nature (HELs have 15–30 year maturities). Finally, for the most part, major issuers of auto loans have tended to follow reasonably prudent underwriting standards.

Unlike the sub-prime mortgage industry, there is less consistency on what actually constitutes various categories of prime and sub-prime auto loans. According to Moody’s, the prime market is composed of issuers typically having cumulative losses (on a static pool basis) of less than 3%; near-prime issuers that have cumulative losses of 3–7%; and sub-prime issuers with losses exceeding 7%.

Cash Flows and Prepayments

The cash flow for auto loan-backed securities consists of regularly scheduled monthly loan payments (interest and scheduled principal repayments) and any prepayments. For securities backed by auto loans, prepayments result from

• sales and trade-ins requiring full payoff of the loan
• repossession and subsequent resale of the automobile
• loss or destruction of the vehicle
• payoff of the loan with cash to save on the interest cost
• refinancing of the loan at a lower interest cost

While refinancings may be a major reason for prepayments of mortgage loans, they are of minor importance for automobile loans. Moreover, the interest rates for automobile loans underlying some deals are substantially below market rates since they are offered by manufacturers as part of a sales promotion.

Prepayments for auto loan-backed securities are measured in terms of the absolute prepayment speed (ABS). The ABS measure is the monthly prepayment expressed as a percentage of the original collateral amount. As explained in Chapter 14, the single monthly mortality rate (SMM) is a monthly conditional prepayment rate (CPR) that expresses prepayments based on the prior month’s balance.

Structures

There are auto loan-backed deals that are passthrough structures and pay-through structures. In the typical passthrough structure there is a senior tranche and a subordinate tranche. There is also an interest-only class. While more deals are structured as passthroughs, this structure is typically used for smaller deals. Larger deals usually have a paythrough structure.

Since inception of the grantor trust passthrough in the mid-1980s through late-1999, only a few innovations have been introduced into this sector. These included an owner’s trust structure (which permitted tranching), the securitization of non-prime loans, and the use of auto leases as collateral. Other than those few developments, the sector was, for the most part, relatively boring and predictable. Investors came to appreciate that this area was dominated by the “Big Three” auto makers, offered low credit losses, and represented a safe, liquid part of the short end of the ABS maturity spectrum.

However, several interesting developments in 2000 and 2001 made the auto sector somewhat less steady. First was the introduction of a soft bullet in late-1999, a structure that had been the norm in credit cards for many years. Second was the shift towards greater floating-rate issuance, a sharp contrast to the long-term convention of fixed-rate auto ABS. The final change was use of an initial revolving period, which extends the average life of the securities.

Although none of these structural changes are revolutionary, on balance they represent a major change in the auto sector. This is important, because the greater diversity of security types has attracted a wider range of investors. Below we examine these relatively new features.

Soft Bullets

Perhaps the most interesting innovation was the introduction of the soft bullet structure. Since the inception of auto ABS in the mid1980s, auto ABS have been structured with amortizing principal payments. This cash flow structure of the security mirrors the underlying payments on the collateral, which typically are 4- to 5-year amortizing loans. Although the owner trust structure allowed for prioritization of cash flows across different classes, the amortization of principal had not been dealt with until 2001.

Source: Moody’s Investor Service.

The Capital Auto Receivables Asset Trust (CARAT) 1999-2 issue by GMAC in August 1999 marked the first time that investors were able to buy auto loan ABS with a soft bullet maturity. Exhibit 17.1 presents the details of the different classes from that deal. This structure was able to offer soft bullet classes instead of amortizing classes, because it included a new type of security that could (1) absorb the amortizing principal cash flows prior to the bullet date and (2) provide the cash flow to meet the bullet principal payment at maturity.

In the CARAT structure, this security was christened a “variable pay term note” (VPTN). At origination, the deal contained a VPTN-1 class that received all principal payments until class A-1 targeted final maturity date, at which point the VPTN-1 class would be paid down. At that point the trust would issue a new VPTN-2 class, the proceeds from which would be used to pay down the A1 class. During the next period, principal payments would go to pay down the VPTN-2 class. On the maturity date of the A2 class, a new class, VPTN-3, would be issued; the proceeds would pay off the A2 bullet class. This process of creating new variable notes and paying them down continues until all the bullet securities are paid off.

Beginning with the CARAT 2000-2 deal, GMAC modified its soft bullet structure by using a single variable pay note rather than a series of notes. At the maturity date of each bullet class, the VTPN in this revised structure is increased by the amount needed to pay off the bullet class. Then the enlarged variable pay note is paid down until the next bullet maturity date.

Ford’s soft bullet deals utilized a structure similar to that in the early CARAT deals. The first such Ford deal, Ford 2000-B, was issued in April 2000.

Source: Moody’s Investor Service.

Since the initial CARAT soft bullet deal, the use of the soft bullet structure has been irregular. So far, only GMAC (via CARAT deals) and Ford have used the structure. Ford used it on three deals in 2000: Ford Credit Auto Owner Trusts 2000-B, 2000-D, and 2000-F. Ford has not revisited the soft bullet structure as of this writing. On the other hand, GMAC has used it exclusively since the initial CARAT 1999-2.

Floating-Rate Autos

The second major change in the auto sector was the increased issuance of floaters. In response to the volatile environment for corporates in 2001 and early 2002, the auto ABS market experienced a dramatic increase in floater issuance. Until that time, auto loans were almost exclusively a fixed-rate product. Floating-rate issuance in 2000 accounted for only 4.3% of total auto ABS issuance. In the first half of 2001, however, that percentage shot up to 25.5%.

An example of a floating-rate auto loan ABS is the Toyota Motor Credit of May 2001 (Toyota Auto Receivables 2001-B Owner Trust), the first auto deal entirely comprised of floating-rate tranches.¹ This $1.5 billion issue was divided into four tranches, three of which were sold publicly. The fourth tranche, a $418 million money-market class, was placed privately. Details of this issue are presented in Exhibit 17.2.

Revolving Period

Another recent innovation, introduced in the Ford 2000-F deal, is an initial revolving period during which the securities receive no principal payments. Instead, during this time, collateral payments are used to purchase additional receivables. After the revolving period ends, the securities pay down in sequential order. The revolving period in this deal added 1.5 years to the average life of each class. We can see this in Exhibit 17.3, which compares average lives of Ford 2000-F tranches with those from Ford 2000-D, a deal typical of other Ford soft bullet deals. The advantage to investors is that they can purchase an auto ABS with a longer average life than found in other auto deals. However to our knowledge, this is the only public auto deal using this technique, which suggests that demand for this structure was not great enough to encourage a follow-up deal.²

Student Loan-Backed Securities

Student loans are made to cover college cost (undergraduate, graduate, and professional programs such as medical school and law school) and tuition for a wide range of vocational and trade schools. Securities backed by student loans are popularly referred to as SLABS (student loan asset-backed securities).

The student loans that have been most commonly securitized are those that are made under the Federal Family Education Loan Program (FFELP). Under this program, the government makes loans to students via private lenders. The decision by private lenders to extend a loan to a student is not based on the applicant’s ability to repay the loan. If a default of a loan occurs and the loan has been properly serviced, then the government will guarantee up to 98% of the principal plus accrued interest.

Loans that are not part of a government guarantee program are called alternative loans. These loans are basically consumer loans, and the lender’s decision to extend an alternative loan will be based on the ability of the applicant to repay the loan. Alternative loans have been securitized.

Congress created Fannie Mae and Freddie Mac to provide liquidity in the mortgage market by allowing these government-sponsored enterprises to buy mortgage loans in the secondary market. Congress created the Student Loan Marketing Association (Sallie Mae) as a government-sponsored enterprise to purchase student loans in the secondary market and to securitize pools of student loans. Sallie Mae is the major issuer of SLABS, and its issues are viewed as the benchmark issues. Other entities that issue SLABS are either traditional corporate entities (e.g., the Money Store and PNC Bank) or nonprofit organizations (Michigan Higher Education Loan Authority and the California Educational Facilities Authority). The SLABS of the latter typically are issued as tax-exempt securities and therefore trade in the municipal market.

Collateral

There are different types of student loans under the FFELP, including subsidized and unsubsidized Stafford loans, Parental Loans for Undergraduate Students (PLUS), and Supplemental Loans to Students (SLS). These loans involve three periods with respect to the borrower’s payments—deferment period, grace period, and loan repayment period. Typically, student loans work as follows. While a student is in school, no payments are made by the student on the loan. This is the deferment period. Upon leaving school, the student is extended a grace period of usually 6 months when no payments on the loan must be made. After this period, payments are made on the loan by the borrower.

Prepayments typically occur due to defaults or loan consolidation. Even if there is no loss of principal faced by the investor when defaults occur, the investor is still exposed to contraction risk. This is the risk that the investor must reinvest the proceeds at a lower spread and, in the case of a bond purchased at a premium, the premium will be lost. Studies have shown student loan prepayments are insensitive to the level of interest rates. Consolidation of a loan occurs when the student who has loans over several years combines them into a single loan. The proceeds from the consolidation are distributed to the original lender and, in turn, distributed to the bondholders.

Structures

Structures on student loan floaters have experienced more than the usual amount of change since 2000. The reason for this is quite simple. The underlying collateral—student loans—is exclusively indexed to 3-month Treasury bills, while a large percentage of securities are issued as LIBOR floaters. This creates an inherent mismatch between the collateral and the securities.

Issuers have dealt with the mismatch in a variety of ways. Some issued Treasury bill floaters which eliminate the mismatch, others issued hedged or unhedged LIBOR floaters, while others switched back and forth between the two. Recently, some have issued both Treasury and LIBOR floaters in the same transaction.³

Exhibit 17.4 lists the main structural permutations from which issuers can chose. They can issue securities linked to Treasury bills. If they chose this route, there is minimal mismatch risk because the coupon on the bonds will rise and fall in line with the index on the collateral. Such floaters are essentially capless, although typically they do contain a “student loan rate” cap for liquidity management purposes.

Investors who prefer LIBOR-indexed assets, and who want to invest in student loan floaters from such an issuer, are forced to enter into an interest rate swap outside the deal. The other issuance selection is to issue LIBOR floaters. When no cap protection is provided, the bonds have an available funds cap (i.e., a student loan rate cap). This cap is generally defined as the monthly or quarterly cash flow from the student loan rate, less servicing and administration fees. The student loan rate is a weighted average of the various types of loans in a particular deal plus the rates on the special allowance supplement (SAP) payments.

If LIBOR spiked relative to the 3-month Treasury bill rate, or if bills dropped in a flight to quality, it is possible there would be insufficient funds available to meet bond interest payments. In such structures, it is typical to have a make-up or carryover provision. Once the index on the collateral rises (or the coupon on the bonds falls) sufficiently, the increased cash flow is used to make up the interest carryover amount. While it is conceivable that the spread between Treasuries and LIBOR could widen and stay permanently at a level that the shortfall might never be recouped, this is a highly unlikely event based on historical experience.

It is important to bear in mind that when an ABS structure contains a basis mismatch, it is not only the investor, but the issuer that bears a risk. Student loan deals (like deals in many other ABS classes) have excess spread, i.e., roughly the difference between the net coupon on the collateral and the coupon on the bonds.

In mortgage-related ABS, the excess spread is much larger than in the student loan sector, and is used to absorb monthly losses. Since losses in federally guaranteed student loans are relatively small, the vast majority of the excess spread flows back to the issuer. Hence, the Treasury bill/LIBOR basis risk is of major concern to issuers. When an issuer incorporates a swap in the deal, it not only reduces the risk to the investor (by eliminating the effect of an available funds cap) but reduces risk to the issuer, as well, by protecting a level of excess spread. When a cap is purchased, it is primarily for the benefit of the investor, because the cap only comes into play once the excess spread in the deal has been effectively reduced to zero.

The indices used on private and public student loan ABS transactions since the earliest deals in 1993 have shifted over time (even though throughout this period, the index on the underlying loans was always 3month Treasury bills). During 1993–1995, most issuers, with the notable exception of Sallie Mae, used 1-month LIBOR, which indicated strong investor preference for LIBOR floaters. By contrast, from Sallie Mae’s first deal in late 1995-on, that issuer chose to issue Treasury bill floaters to minimize interest rate risk.

In 1999, Congress changed the formula for the special allowance supplement (SAP) paid to banks that originate student loans. Student loan rates are capped. If interest rates increase to a point where the student loan rate is capped out, the Education Department supplements the students’ payments to the lending bank. Traditionally, these SAP payments, like the student loan rate, were indexed to the 3-month Treasury-bill rate. Under the new formula, SAP payments on newly originated loans are indexed to 3-month commercial paper. Since SAP payments can represent a sizeable amount of the cash flow in a student loan deal, and commercial paper is highly correlated to LIBOR, this change reduces the “natural” mismatch between student loan collateral and student loan ABS.

SBA Loan-Backed Securities

The Small Business Administration (SBA) is an agency of the U.S. government empowered to guarantee loans made by approved SBA lenders to qualified borrowers. The loans are backed by the full faith and credit of the U.S. government. Most SBA loans are variable-rate loans where the reference rate is the prime rate. The rate on the loan is reset monthly on the first of the month or quarterly on the first of January, April, July, and October. SBA regulations specify the maximum coupon allowable in the secondary market. Newly originated loans have maturities between 5 and 25 years.

The Small Business Secondary Market Improvement Act passed in 1984 permitted the pooling of SBA loans. When pooled, the underlying loans must have similar terms and features. The maturities typically used for pooling loans are 7, 10, 15, 20, and 25 years. Loans without caps are not pooled with loans that have caps.

Most variable-rate SBA loans make monthly payments consisting of interest and principal repayment. The amount of the monthly payment for an individual loan is determined as follows. Given the coupon formula of the prime rate plus the loan’s quoted margin, the interest rate is determined for each loan. Given the interest rate, a level payment amortization schedule is determined. This level payment is paid until the coupon rate is reset.

The monthly cash flow that the investor in an SBA-backed security receives consists of:

• the coupon interest based on the coupon rate set for the period
• the scheduled principal repayment (i.e., scheduled amortization)
• prepayments

Prepayments for SBA-backed securities are measured in terms of CPR. Voluntary prepayments can be made by the borrower without any penalty. There are several factors contributing to the prepayment speed of a pool of SBA loans. A factor affecting prepayments is the maturity date of the loan. It has been found that the fastest speeds on SBA loans and pools occur for shorter maturities. The purpose of the loan also affects prepayments. There are loans for working capital purposes and loans to finance real estate construction or acquisition. It has been observed that SBA pools with maturities of 10 years or less made for working capital purposes tend to prepay at the fastest speed. In contrast, loans backed by real estate that are long maturities tend to prepay at a slow speed. All other factors constant, pools that have capped loans tend to prepay more slowly than pools of uncapped loans.

Aircraft ABS

Aircraft financing has gone through an evolution over the past several years. It started with mainly bank financing, then moved to equipment trust certificates (ETCs), then to enhanced ETCs (EETCs), and finally to aircraft ABS. Today, both EETCs and aircraft ABS are widely used.

EETCs are corporate bonds that share some of the features of structured products, such as credit tranching and liquidity facilities. Aircraft ABS differ from EETCs in that they are not corporate bonds, and they are backed by leases to a number of airlines instead being tied to a single airline. The rating of aircraft ABS is based on the cash flow from the pool of aircraft leases or loans and the collateral value of that aircraft, not on the rating of lessee airlines.

One of the major characteristics that set aircraft ABS apart from other forms of aircraft financing is their diversification. ETCs and EETCs finance aircraft from a single airline. An aircraft ABS is usually backed by leases from a number of different airlines, located in a number of different countries and flying a variety of aircraft types. This diversification is a major attraction for investors. In essence, they are investing in a portfolio of airlines and aircraft types rather than a single airline—as in the case of an airline corporate bond. Diversification also is one of the main criteria that rating agencies look for in an aircraft securitization. The greater the diversification, the higher the credit rating, all else being equal.

Aircraft Leasing

Although there are various forms of financing that might appear in an aircraft ABS deal—including operating leases, financing leases, loans, or mortgages—to date, the vast majority of the collateral in aircraft deals has been operating leases. In fact, all of the largest deals have been issued by aircraft leasing companies. This does not mean that a diversified finance company or an airline itself might not at some point bring a lease-backed or other aircraft ABS deal. It just means that so far, aircraft ABS have been mainly the province of leasing companies. Airlines, on the other hand, are active issuers of EETCs.

Aircraft leasing differs from general equipment leasing in that the useful life of an aircraft is much longer than most pieces of industrial or commercial equipment. In a typical equipment lease deal, cash flow from a particular lease on a particular piece of equipment only contributes to the ABS deal for the life of the lease. There is no assumption that the lease will be renewed. In aircraft leasing, the equipment usually has an original useful life of 20+ years, but leases run for only around 4–5 years. This means that the aircraft will have to be re-leased on expiration of the original leases. Hence, in the rating agencies’ review, there’s a great deal of focus on the risks associated with re-leasing the aircraft.

The risk of being able to put the plane back out on an attractive lease can be broken down into three components: (1) the time it takes to release the craft, (2) the lease rate, and (3) the lease term. Factors that can affect re-leasing include:

• General health of the economy—Although there is a long-term, secular rise in both passenger and freight miles flown, the airline industry is well known for its sharp cyclical swings, and it typically experiences sharp declines during recessions.
• Health of the airline industry—Periods of overbuilding (which there have been) can create sharp declines in aircraft values and lease rates.
• Obsolescence—Older aircraft run the risk of becoming technically (or legislatively) obsolete. The older the aircraft, in general, the more difficult it is to obtain high lease rates on renewal.
• Type of aircraft—Today, wide-body aircraft are less in demand than are narrow-bodied craft. This is partly from the recession in Asia as of this writing. Most of the Pacific fleet are wide-bodies; and with the decline of demand, a surplus developed. Some aircraft are more desirable for freighters than others. For example, in the air freight business, some McDonnell Douglas aircraft are viewed as virtually indestructible and valuable because they can fly (almost) indefinitely.

Servicing

Servicing is important in many ABS sectors, but it is crucial in a lease-backed aircraft deal, especially when the craft must be re-marketed when their lease terms expire before the term of the aircraft ABS. It is the servicer’s responsibility to re-lease the aircraft. To fulfill that function in a timely and efficient manner, the servicer must be both well-established and well-regarded by the industry.

As Moody’s states, the servicer “should have a large and diverse presence in the global aircraft marketplace in terms of the number of aircraft controlled. Market share drives the ability of a servicer to meet aircraft market demand and deal with distressed airlines.”⁴

The servicer is also the key to maintaining value of the aircraft, through monitoring usage of the craft by lessees. If a lessee is not maintaining an aircraft properly, it is the servicer’s responsibility to correct that situation. Because of servicers’ vital role to the securitization, the rating agencies spend a great deal of effort ascertaining how well a servicer is likely to perform.

Defaults

In addition to the risk from needing to re-lease craft, rating agencies are also concerned about possible defaults. Because of protections under Section 1110 of the U.S. bankruptcy code, and international statutes that favor aircraft creditors, there is relatively little risk of losing an aircraft. There are, however, repossession costs, plus the loss of revenues during the time it takes to repossess and restore the aircraft to generating lease income.

The rating agencies will “stress” an aircraft financing by assuming a default rate, a period of time, and cost for repossessing the aircraft. A major input into base default assumptions is the credit rating of airline lessees. For this part of the review, the ABS rating analyst relies on the corporate rating of the airline.

While there is little risk of not recovering the aircraft in event of a default, the rating agencies do carefully review the legal and political risks that the aircraft may be exposed to, and evaluate the ease with which the aircraft can be repossessed in the event of a default, especially if any of the lessees are in developing countries.

Enhancement Levels

In aircraft ABS, as in every other ABS sector, the rating agencies attempt to set enhancement levels that are consistent across asset types. That is, the risk of not receiving interest or principal in an aircraft deal rated a particular credit level should be the same as in a credit card or home equity deal (or, for that matter, even for a corporate bond) of the same rating. The total enhancement ranges from 34% to 47%.

Since the early deals, there has been a change in enhancement levels. Early deals depended largely on the sale of aircraft to meet principal payments on the bonds. Since then, the aircraft ABS relied more on lease revenue. Since lease revenue is more robust than sales revenue, the enhancement levels have declined. To understand why a “sales” deal requires more enhancement than a “lease” deal, consider the following. If an aircraft is sold during a recession, the deal suffers that entire decline in market value. On the other hand, if a lease rate declines during a recession, the deal sustains only the loss on the re-lease rate.

Franchise-Loan Backed Securities

Franchise loan securities are a hybrid between the commercial mortgage-backed securities (CMBS) and ABS markets. They are often backed by real estate, as in CMBS, but the deal structures are more akin to ABS. Also, franchise loans resemble Small Business Administration (SBA) loans and collateralized debt obligations (CDOs) more than they do consumer loan-backed ABS securities. Greater reliance is placed on examining each franchise loan within the pool than on using aggregate statistics. In a pool of 100 to 200 loans (typical franchise loan group sizing) each loan is significant. By contrast within the consumer sector, any individual loan from a pool of 10,000 loans (as in home equity deals) does not represent as large a percentage, thus is not considered quite as important.

Franchise loans are similar to SBA loans in average size, maturity, and end use. But whereas most SBA loans are floating-rate loans indexed to the prime rate, most securitized franchise loans are fixed-rate; if they are floating, they are likely to be LIBOR-linked.

Franchise loans are used to fund working capital, expansion, acquisitions, and renovation of existing franchise facilities.

The typical securitized deal borrower owns a large number of units, as opposed to being a small individual owner of a single franchise unit. However, individual loans are usually made on a single unit, secured either by the real estate, the building, or the equipment in the franchise.

The consolidation within the industry and the emergence of large operators of numerous franchise units have improved industry credit performance. A company owning 10 to 100 units is in a better position to weather a financial setback than is the owner of a single franchise location.

Loans can be either fixed or floating rate, and are typically closed-end, fully amortizing with maturities of 7 to 20 years. If secured by equipment, maturities range from 7 to 10 years. If they are secured by real estate, maturities usually extend 15 to 20 years.

Security Characteristics

Because franchise loan collateral is relatively new to the ABS market, and deal size is small, most of these securitized packages have been issued as a 144A. Issuers also prefer the 144A execution for competitive reasons, because they are reluctant to publicly disclose details of their transactions.

Deals typically range from $100–$300 million, and are customarily backed by 150 to 200 loans. Average loan size is around $500,000, while individual loans may range from $15,000–$2,000,000.

Most deals are structured as sequential-pay bonds with a senior/subordinate credit enhancement. Prepayments can occur if a franchise unit closes or is acquired by another franchisor. However, few prepayments have been experienced within securitized deals as of this writing, and most loans carry steep prepayment penalties that effectively discourage rate refinancing. Those penalties often equal 1% of the original balance of the loan.

Major Sectors

The vast majority of franchise operations consist of three types of retail establishments: restaurants, specialty retail stores, and retail energy outlets. The restaurant category has three major subsectors: quick service restaurants (QSRs), casual restaurants, and family restaurants. Exhibit 17.5 shows some of the franchise “concepts” that fall within these categories.

A “concept” is simply another name for a particular franchise idea, since each franchise seeks to differentiate itself from its competitors. Hence, even though Burger King and Wendy’s are both QSRs specializing in sandwiches, their menu and style of service are sufficiently different that each has its own business/marketing plan—or “concept.” For example, Wendy’s has long promoted the “fresh” market, as the firm mandated fresh (not frozen) beef patties in their hamburgers, and helped pioneer the industry’s salad bars. Burger King is noted for its “flame broiled” burgers, as well as having it “your way.”

In addition to segmenting the industry by functional types, it is also segmented by credit grades. For example, Fitch developed a credit tiering system based on expected recoveries of defaulted loans. Tier I concepts have a much lower expected default level than Tier II concepts, etc. Many financial and operational variables go into these tiered ratings, including the number of outlets nationwide (larger, successful concepts benefit from better exposure, national advertising, etc.); concept “seasoning” (especially if it has weathered a recession); and viability in today’s competitive environment (yesterday’s darlings may have become oversaturated, or unable to respond to changing tastes or trends by revamping and updating).

Risk Considerations

There are several risk factors to be aware of when comparing franchise loan pools, and the following are some of the most important.

Number of Loans/Average Size

High concentrations of larger loans represent increased risk, just as in any other pool of securitized loans.

Loan-to-Value Ratio

LTVs can be based on either real estate or business values. It is important to determine which is being used in a particular deal in order to make a valid comparison with other franchise issues. Note that when business value is used to compute LTV, it is common for a nationally recognized accounting firm to provide the valuation estimate.

Fixed Charge Coverage Ratio

The fixed charge coverage ratio (FCCR) is calculated as follows:

Typical FCCRs range from 1.00–3.00, and average around 1.5. A deal with most unit FCCRs below 1.5 would be viewed as having greater risk than average, while one with most FCCRs above 1.5 would be perceived as having less risk than average.

Diversification

As in all ABS sectors, a primary risk factor is the degree of diversification. In a franchise loan deal, important areas for diversification include franchise owner, concept, and location.

A typical franchise pool includes loans to 10–15 franchisees, each having taken out loans on 5–20 individual units. A large concentration of loans to any single franchise operator might increase deal risk. However, such concentration is sometimes allowed, and rating agencies will not penalize extensively, if that particular franchisee has a very strong record and the individual franchise units have strong financials. It might even be better to have a high concentration of high quality loans than a more diverse pool of weaker credits.

Concept diversification is also important. Franchise loans extend for 10 to 20 years, and a profitable concept today may become unprofitable as the loans mature.

It is not as important that pooled loans include representation across several major sectors (such as more than one restaurant subsector, or loans from all three major groups). Many finance companies specialize in one or two segments of the industry, and know their area well. Thus a deal from only one of the major sectors does not add any measurable risk as long as there is diversification by franchisee and concept.

Geographical diversification is also important, as it reduces risk associated with regional economic recessions.

Control of Collateral

A key factor in the event of borrower (franchisee) default is control of the collateral. If a franchise loan is secured by a fee simple mortgage, the lender controls disposition of collateral in a bankruptcy. However, if that collateral is a leasehold interest (especially if the lessor is a third party and not the franchisor), the lender may not be able to control disposition in the event of default.

Rate Reduction Bonds

The concept of rate reduction bonds (RRBs)—also known as stranded costs or stranded assets—grew out of the movement to deregulate the electric utility industry and bring about a competitive market environment for electric power. Deregulating the electric utility market was complicated by large amounts of “stranded assets” already on the books of many electric utilities. These stranded assets were commitments that had been undertaken by utilities at an earlier time with the understanding that they would be recoverable in utility rates to be approved by the states’ utility commissions. However, in a competitive environment for electricity, these assets would likely become uneconomical, and utilities would no longer be assured that they could charge a high enough rate to recover the costs. To compensate investors of these utilities, a special tariff was proposed. This tariff, which would be collected over a specified period of time, would allow the utility to recover its stranded costs.

This tariff, which is commonly known as the competitive transition charge (or CTC), is created through legislation. State legislatures allow utilities to levy a fee, which is collected from their customers. Although there is an incremental fee to the consumer, the presumed benefit is that the utility can charge a lower rate as a result of deregulation. This reduction in rates would more than offset the competitive transition charge. In order to facilitate the securitization of these fees, legislation typically designates the revenue stream from these fees as a statutory property right. These rights may be sold to an SPV, which may then issue securities backed by future cash flows from the tariff.

The result is a structured security similar in many ways to other ABS products, but different in one critical aspect—the underlying asset in a RRB deal is created by legislation, which is not the case for other ABS products.

In the first quarter of 2001 there was a good deal of concern regarding RRBs. The sector came under intense scrutiny as a result of the financial problems experienced by California’s major utilities. Yet despite the bankruptcy motion filed by Pacific Gas and Electric (PG&E) in 2001—a bellwether issuer of RRBs—rating agencies maintained their triple-A ratings on California’s existing RRB issues. This is not the first time the RRB sector had found itself in turmoil. Over much of 1998, the sector was roiled by a movement in California to overturn the existing legislation which had been created specifically for RRB securitization. This put existing RRB issues in jeopardy; however, the ultimate result (voter initiative was defeated) proved to be positive for this product. The ability of this asset class to retain its rating despite a significant credit crisis at an underlying utility, as well as a serious challenge to the legislation that allows for the creation of these securities, speaks volumes for the soundness of the structures of RRB deals.

Structure

As noted previously, state regulatory authorities and/or state legislatures must take the first step in creating RRB issues. State regulatory commissions decide how much, if any, of a specific utility’s stranded assets will be recaptured via securitization. They will also decide upon an acceptable time frame and collection formula to be used to calculate the tariff (the CTC). When this legislation is finalized, the utility is free to proceed with the securitization process.

The basic structure of an RRB issue is straightforward. The utility sells its rights to future CTC cash flows to an SPV created for the sole purpose of purchasing these assets and issuing debt to finance this purchase. In most cases, the utility itself will act as the servicer since it collects the CTC payment from its customer base along with the typical electric utility bill. Upon issuance, the utility receives the proceeds of the securitization (less the fees associated with issuing a deal), effectively reimbursing the utility for its stranded costs immediately.

RRBs usually have a “true-up” mechanism. This mechanism allows the utility to recalculate the CTC on a periodic basis over the term of the deal. Because the CTC is initially calculated based on projections of utility usage and the ability of the servicer to collect revenues, actual collection experience may differ from initial projections. In most cases, the utility can re-examine actual collections, and if the variance is large enough (generally a 2% difference), the utility will be allowed to revise the CTC charge. This true-up mechanism provides cash flow stability as well as credit enhancement to the bondholder.

Enhancement Levels

Credit enhancement levels required by the rating agencies for RRB deals are very low relative to other ABS asset classes. Although exact amounts and forms of credit enhancement may vary by deal, most transactions require little credit enhancement because the underlying asset (the CTC) is a statutory asset and is not directly affected by economic factors or other exogenous variables. Furthermore, the true-up mechanism virtually assures cash-flow stability to the bondholder.

As an example, the Detroit Edison Securitization Funding 1 issued in March 2001 was structured with 0.50% initial cash enhancement (funded at closing) and 0.50% overcollateralization (to be funded in equal semiannual increments over the term of the transactions). This total of 1% credit enhancement is minuscule in comparison to credit cards (for example), which typically require credit enhancement in the 12%–15% range for large bank issuers.

Unique Risks

RRBs are subject to risks that are very different from those associated with more traditional structured products (e.g., credit cards, HELs, etc.). For example, risks involving underwriting standards do not exist in the RRB sector, since the underlying asset is an artificial construct. Underwriting standards are a critical factor in evaluating the credit of most other ABS. Also, factors that tend to affect the creditworthiness of many other ABS products—such as levels of consumer credit or the economic environment—generally do not have a direct effect RRBs. Instead, other unique factors must be considered when evaluating this sector. The most critical risks revolve around the legislative process and environment plus the long-term ability of the trust to collect future revenues to support the security’s cash flows.

In examining a specific RRB deal, several points must be considered.

• Is the CTC determined by legislation to be a property right? If the legislation defines the fee as a property right, then the utility may sell these rights to an SPV for securitization.
• Is the transfer considered a true sale? This determines actual ownership of the asset. A true sale safeguards the trust from future claims that may be made against the utility itself, and fully separates the assets from the utility (this true sale now allows for current California RRBs to maintain their triple-A ratings).
• Is the CTC irrevocable? Since the CTC is created by legislation, it is important to consider whether future legislation could challenge or modify the existing legislation. It is also wise to consider the overall legislative environment, to attempt quantifying the likelihood of any future challenge to existing legislation.
• Is the utility a good generator and servicer? Since the asset that securitizes an RRB deal is based on a future cash flow stream, the ability of a utility to generate and collect fees must be considered. Electric power is an essential service, so even utilities that find themselves in financial distress usually continue to generate power and collect fees (as is the case in California as of this writing).