Methodology. Rating Canadian Equipment Finance Securitization Transactions

Transcription

1 Methodology Rating Canadian Equipment Finance Securitization Transactions october 2014 previous release: october 2013

2 CONTACT INFORMATION Tim O Neil Senior Vice President CDN ABS, Global Structured Finance toneil@dbrs.com Jamie Feehely Managing Director CDN Structured Finance, Global Structured Finance Tel jfeehely@dbrs.com DBRS is a full-service credit rating agency established in Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.

3 Rating Canadian Equipment Finance Securitization Transactions TABLE OF CONTENTS Scope and Limitations 4 Introduction 4 Originator Review 5 Company and Management 5 Controls and Compliance 5 Asset Origination 5 Underwriting 6 Technology 6 Pool Review 7 Portfolio Servicing Collections and Remarketing 7 Cash Management 7 Equipment Finance Receivable Contracts 8 Asset and Contract Review Eligibility Criteria 9 Contract Values and Terms 9 Portfolio Analysis Estimating Base Case Loss 10 Cash Flow Modelling 11 Prepayments 11 Residual Values 11 Large Obligor Analysis 12 Portfolio Termination Events Transaction Triggers 12 Other Structural Issues 12 Credit Enhancement Calculation and Composition 13 Forms of Credit Enhancement 14 Application of Stress Multiple and Concentration Limits 14 Historical Data 14 Seller/Servicer/Sponsor/Originator/Manufacturer Considerations 15 Structural Mitigants 15 3

4 Scope and Limitations DBRS evaluates both qualitative and quantitative factors when assigning ratings to a Canadian structured finance transaction. This methodology represents the current DBRS approach for rating equipment lease and loan securitizations issued in Canada with equipment collateral originated in Canada. It describes the DBRS approach to analysis, which includes (1) a focus on the quality of the originator/servicer, (2) evaluation of the collateral pool and (3) utilization of historically employed credit evaluation techniques. This report also outlines the asset class and discusses the methods DBRS typically employs when assessing a transaction and assigning a rating. It is important to note that the methods described herein may not be applicable in all cases. Further, this methodology is meant to provide guidance regarding the DBRS methods used in the sector and should not be interpreted with formulaic inflexibility, but understood in the context of the dynamic environment in which it is intended to be applied. Introduction Equipment loans and leases have been financed in the Canadian securitization market in the asset-backed commercial paper (ABCP) and term asset-backed securities (ABS) markets for a number of years. The underlying loans and leases are originated by captive finance companies associated with a manufacturer or third-party lenders secured by a wide variety of equipment types. While the financial obligations often include lease contracts, there is typically minimal exposure to residual value risk as the obligor is usually responsible for any shortfall upon remarketing of the equipment. Additionally, the lease contracts are usually structured as full payout leases such that there is little to no residual value risk for the customer, thereby eliminating the main difference in cash flow risk between lease and loan contracts. The underlying securitized assets range from small-ticket items such as office and technology equipment to medium- and large-ticket items from the transportation, agricultural or construction industries. Generally, the portfolios provide diversified collateral, although there may be an industry concentration for captive finance companies as the manufacturers tend to focus on a limited number of industries such as construction and/or agriculture. In most cases, the underlying equipment is used by corporate borrowers to generate revenue in their day-to-day business, which usually results in low delinquency rates. Losses also have historically been low in these transactions. Cash flow analysis for equipment transactions can also be different and sometimes includes seasonal and irregular payment streams depending on the industry and obligors included. In addition, because equipment securitization can encompass a wide variety of asset types from a number of different industries, remarketing channels are an important consideration in estimating the timing and recovery impact on cash flows. The following methodology details the DBRS rating approach for equipment securitization transactions. 4

5 Originator Review The transaction process includes a review of the originator of the loan and lease contracts and includes a review of the financial health of the originator which may or may not carry a public rating for it or its parent. If there is no public rating available on the seller or its parent, the DBRS corporate ratings group may be engaged to conduct such a review. Reviews of the management structure and experience of the originator and its corporate strategy are also conducted. These reviews are undertaken to determine the company s capabilities and experience as a servicer and its ability to originate and underwrite assets in a consistent manner as well as on the collection processes. In addition, if the originator is also the conduit sponsor as is the case in many ABS transactions it should meet the recommended criteria set out for ABCP conduit sponsors in the DBRS methodology Legal Criteria for Canadian Structured Finance. Company and Management DBRS believes that no origination operation can be successful without a strong seasoned management team that possesses demonstrated expertise in the product(s) they are originating. As a result, DBRS views favourably those originators whose management team possesses greater than ten years of industry experience. Additionally, DBRS believes the participation of the credit risk management, quality control, legal and compliance departments in the origination and underwriting process is important in order to identify and mitigate risk. Furthermore, adequate capacity and resources to handle fluctuations in equipment lease volume are of importance. Controls and Compliance DBRS believes internal assessments and quality control reviews are important in recognizing procedural errors that may not be easily detectable. These reviews can be used to identify trends, training opportunities and exception practices. Frequent checks can assist management in quickly instituting changes to areas needing improvement as well as benchmarking those results to performance. In addition to the aforementioned reviews, a monitoring process should be in place to ensure that the originator is in compliance with all applicable laws, rules and regulations and that all employees in customer-facing positions are appropriately trained. Minimal or no repurchases because of breaches of representations and warranties are considered, as is the existence of robust procedures for vendor selection and oversight. Additionally, strong controls for managing potential conflicts of interest associated with parties to a transaction are important. Asset Origination The pools of assets tend to differ based on the type of originator: captive finance company or third-party financial institution. Captive finance companies typically have a portfolio of loans and leases that reflect both the equipment manufactured by their parent companies and the industries that use the equipment. These portfolios tend to have performance histories that reflect the financial health of the industries they serve and are more homogeneous in nature. The obligors are often long-term users of that particular brand of equipment and have demonstrated brand loyalty, providing consistency in the portfolio performance. Third-party finance companies tend to have portfolios that reflect a more diversified obligor and equipment base. Usually, they will have several niches that they service, such as a particular geographic region, small- or medium-sized business operators or a specialized business line such as medical professionals. There is generally no concentration in a specific brand of equipment financed, although third-party finance companies may have concentration in certain types of equipment such as transport trucks. The overall performance is less tied to the financial health of a specific industry and reflects the overall economic performance of the segments they serve as well as the credit underwriting policies of the originator. 5

6 Asset origination channels effectively fall into two categories: in-house or purchased through a broker network. While both channels have their advantages, DBRS considers an in-house network to have more consistent and conservative practices than a broker network. This is in part because of the company s ability to oversee all facets of the process and in part because of the compensation framework associated with a broker. For some specialized equipment or specific geographic locations, DBRS will accept brokeroriginated assets on a comparable basis if the company has re-underwritten the obligations. Underwriting The underwriting practices are reviewed with a focus on policies and procedures in place to provide for a consistent quality of financing over time as demonstrated in the historical performance. The procedures usually include documented policies and procedures for the receipt and handling of applications; review of financial materials, including credit scoring and the appropriate legal documents required to support the financing; and a first priority security interest in the underlying equipment. Application approval generally includes predetermined authority levels commensurate with the exposure for the loan or lease. Technology Technology resources are an integral component of the originator review process. While DBRS does not subscribe to specific systems architecture, in reviewing the originator, DBRS considers whether adequate systems controls, consumer privacy protection and backup procedures, including disaster recovery and business continuity plans, are in place. Furthermore, originators must ensure that any offshore vendors are monitored and a backup plan is in place to ensure minimal downtime. 6

7 Pool Review In its review of equipment pools, DBRS employs static pool and obligor concentration analysis, focusing on delinquency, default and loss performance of the originator s historic portfolios. Generally, DBRS looks for five to ten years of historic portfolio information given the longer duration of receivables contracts in some types of equipment financing that may be included in the portfolio. The objective is to complete an analysis through an economic cycle to understand what the performance of the obligations might look like during the life of the securitization transaction. When determining expected asset pool performance, DBRS reviews multiple vintages to capture the portfolio performance volatility that can occur through origination and operational changes as well as the impact of external economic forces. Portfolio Servicing Collections and Remarketing DBRS reviews the collection process and procedures that the originator employs for accounts that are past due. The processes should reflect the nature of the client base and the observed performance history of the portfolio. Although not as prevalent as with consumer obligations, the use of pre-authorized payments allows for better management of the payment stream and a reduction in early-stage delinquencies as payments are made automatically without the need for the obligor to initiate them. For industries with a more seasonal payment structure such as agriculture, pre-authorized payments are generally not used. The past-due collections process is especially important for reducing the default levels and, when combined with the remarketing efforts, for reducing net losses given default. Equipment originators generally have dedicated teams of collectors demonstrating experience commensurate with the severity of the defaults with which they are dealing. Often, firms will employ separate early-stage default and late-stage default teams, reflecting the differences in collection techniques required as an account ages. These efforts are typically supported by a framework of management reporting to allow appropriate analysis of the portfolio and monitoring of the performance in a timely manner. The remarketing strategy and network is reviewed at the originator level as the underlying assets and process will differ for each issuer. There are also differences between captive finance companies and third-party finance companies driven by the more focused equipment line and the existence of an affiliated dealer network that provides a ready-made first source for remarketing available to captive finance companies. Remarketing is less important for assets that have little to no recovery value assumed in the underwriting process, such as technology and office equipment. Historical data is expected by asset types that are to be included in the rated transaction. Cash Management Similar to other structured finance transactions, cash management is reviewed and commingling of funds collected from securitized assets is based on the rating of the seller/servicer. Consistent with DBRS s Legal Criteria for Canadian Structured Finance, transactions sellers/servicers rated investment grade meet the criteria to commingle securitized funds with their non-securitized funds. For non-investment-grade servicers, other mitigants such as the use of lock boxes, more frequent reporting and daily remittance of cash to accounts controlled by the trust are often employed. In addition, a backup servicer may be engaged from the outset of the transaction. The classifications range from a cold backup servicer, which has minimal day-to-day responsibilities, to a hot backup servicer, which is actively involved in monitoring and reviewing the portfolio in parallel with the regular servicer. 7

8 Equipment Finance Receivable Contracts Equipment finance receivables are underwritten using loan and lease contracts. In loan contracts, the ownership of the equipment is transferred to the obligor with full repayment of the principal required by an agreed-upon date with no exposure to any residual value by the finance company. Leases, however, can be underwritten as capital leases or operating leases. The key difference relates to the residual value exposure that operating leases create for the seller/servicer. In Canadian equipment securitization transactions, most obligations are either loans or capital leases. When capital leases are securitized, the lessee is usually responsible for any residual value loss on the equipment upon remarketing and must pay the finance company for any shortfall, with no residual value exposure on leases taken in the transaction. This is similar to a loan, where the obligor is responsible for full repayment of the advance, with no consideration for any value change in the underlying equipment. In this manner, the finance company and, hence, the securitization structure is insulated from residual value risk of the equipment. Some transactions incorporate a small number of operating leases as part of a larger portfolio; however, any residual value exposure must be incorporated into the risk assessment of the transaction. As a result of the similar profile of both capital leases and loans, the cash flow analysis does not differentiate between the two unless the historic loss performance indicates a difference in the credit profile and performance of one or the other type of financing. The structural framework supporting the transaction is reviewed to ensure that the transfer of the loans and leases meets the legal requirements for being treated as bankruptcy remote from the finance company. This allows the transaction to be rated on the basis of the expected performance of the asset pool and the structure without being affected by the credit rating of the finance company itself. Legal documents are reviewed by DBRS prior to closing and should be supported by legal opinions to ensure that the transaction is both bankruptcy remote from the finance company and considered to be a true sale of the assets. For more specific details on the legal requirements, please see DBRS s Legal Criteria for Canadian Structured Finance. 8

9 Asset and Contract Review Eligibility Criteria The eligibility criteria are important when reviewing revolving transactions. To ensure that the securitized pool is similar in nature to the analyzed portfolio, securitization transactions set out eligibility criteria in the legal documents, covering such issues as maximum term, advance rate and payment frequency for the loan or lease; obligor and equipment concentrations; number of contracts with balloon payments; and the amount of residual value exposure in the portfolio. Enhancement proposals are evaluated based on the parameters outlined in the eligibility criteria for each transaction. While many types of assets are long lived and maintain significant value during their useful life, the terms of equipment financing for securitization purposes should not exceed the useful life of the equipment and, in many cases, the terms will be shorter. It is expected that the entire portfolio would not be composed solely of longer-term financings as this introduces a greater period of uncertainty around factors that may affect the performance of the underlying assets. For those segments of the pool with longer maturities, an adjustment will be made to the base-case loss assumptions to incorporate the higher degree of risk. Particular focus for longer-term contracts are the loan-to-value and useful life of the equipment. Used equipment is acceptable as collateral, but only for those asset types with longer useful lives with levels restricted for assets that do not retain significant value over time. Most Canadian equipment portfolios are geographically diversified. A portfolio will usually have larger exposures to the provinces in which the industries using the equipment operate. For example, it is typical for a portfolio to have a larger exposure to Ontario and Québec as both provinces have strong industrial and agricultural bases serviced by equipment finance companies. In addition, if a finance company covers the agriculture industry, higher levels of exposure to Alberta, Saskatchewan or Manitoba would be normal. This geographic diversification is important as it usually tempers the severity of economic downturns experienced by one region with more positive performance in another. Contract Values and Terms The financed amount of the equipment should not exceed 100% of the all-in cost, including retail purchase price, taxes and a reasonable commission as a percentage of the purchase price. Soft costs such as computer cables, installation costs and other supplies should be identified separately and make up only a very small portion of the total amount funded. Advance rates greater than the initial price of the equipment are considered riskier since the assets do not benefit from the same potential recovery from the equipment should it be necessary to liquidate it in a default scenario. Similarly, there should be no monetization of future interest flows in the transaction. As in auto loan contracts, contract term, annual percentage rate (APR) and depreciation have an impact on how quickly a contract reaches positive equity, thus reducing loss exposure. As shown in the graphs below, the sooner that positive equity is achieved, the sooner expected losses decline as the obligor has an equity interest to protect and the equipment can be remarketed to repay the outstanding obligation. There are a number of factors that affect this timing, including the following: Required down payment levels. Term of the financing, with longer-term financing requiring longer repayment periods. Depreciation profile of the equipment. Available remarketing channels. Specialized or seasonal use of the equipment. 9

10 Short-Term Long-Term Value ($) Equity Positive Value ($) Equity Positive Time (Months) Time (Months) Funded Amount Equipment Value Funded Amount Equipment Value Source: DBRS. The above graphs are intended to illustrate the different profiles of short-term and long-term financing. As expected, short-term financing typically becomes equity positive (i.e., the resale value exceeds the outstanding funding) at a much earlier date than in long-term financing. Again, this analysis is important when there is recovery credit assumed on the underlying equipment, which is typically not the case for technology and office equipment. The contract between the obligor and the finance company should be standard among the obligors for each type of financing and material amendments to the documents should not affect any securitized transactions. The contract must allow for the sale and assignment of the interests in the cash flows and ownership interest in the equipment, under appropriate circumstances and within legal requirements, to a third party, such as a trust, that then uses this ownership interest to support the issuance of asset-backed notes. Portfolio Analysis Estimating Base Case Loss Each transaction begins with a historic review of the performance of pools of loans and leases of the seller/servicer by origination period this is known as a static pool analysis. This static pool analysis enables DBRS to review the performance of the assets through various economic cycles and monitor the impact of changes in underwriting and collections practices. This information is gathered for the different types of assets funded by the originator to enable the development of an expected base-case loss for the securitized pool based on the portfolio composition. If gross loss levels instead of net loss levels are provided, the analysis will incorporate the value of the underlying equipment and the time frame for its disposal. DBRS reviews the history of the performance before assigning appropriate stress levels to the recovery value of the assets. Ranges for both the expected recovery rate and timing lag on asset recovery are used, depending on the desired ratings threshold. The table below summarizes the normal stresses used to determine the base-case loss scenario when employing gross loss numbers. 10

11 Credit for Recoveries AAA AA A BBB BB or less Recovery credit 50% 66% 75% 80% to 85% 90% to 100% Recovery lag (in months) 4 to 5 3 to 4 2 to to 2 DBRS is conservative when reviewing static loss information in an attempt to capture results under various economic situations. Cash Flow Modelling For each transaction, a pool cut is received that provides the details of the proposed pool of assets to be sold. This will generally include scheduled cash flows from the loan and lease payments; terms of the underlying obligations; timing of any seasonal, balloon or residual payments due from the obligor; types of assets financed (e.g., new versus used equipment); largest ten obligor exposures by name; geographic breakdown; industry breakdown; and the interest generated on the outstanding loans and leases. Subvented (i.e., below market) interest rates are much less common in equipment financing than in the consumer-based auto finance industry. Interest payments are important in the monthly cash flow of the transaction and can form part of the credit enhancement available to prevent noteholder losses in the form of excess spread. The pool also affects the base-case loss estimate as factors such as seasoning, industry concentrations and performance, tenor of the loan or lease, model type or new versus used composition and recovery levels are all considered. From this analysis, a projected base-case loss curve is derived based on the expected performance of the securitized pool over the life of the assets and provides an estimated cumulative loss level. This base-case estimate is applied in the quantitative cash flow model analysis of the amount and composition of the credit enhancement to assess whether the proposed transaction structure meets the requested rating threshold. Similar to DBRS s Rating Canadian Auto Retail Loan and Lease Securitizations, a discount rate may be applied to each of the contracts in the proposed pool to generate additional yield. The discount rate applied should be the higher of the APR in the secured contracts and the rate chosen to generate additional yield for the portfolio. Prepayments A review of the originator s historical prepayment experience provides the basis for determining the extent to which incorporating prepayment assumptions in the cash modelling is necessary. If historical experience demonstrates a consistent level of prepayments, then a prepayment rate will be assumed in the analysis. Additional scenarios may be tested to ensure that the proposed transaction structure can support various prepayment speeds should future prepayment rates deviate from historical experience. Residual Values To the extent that residual values constitute a significant portion of the overall collateral in a securitization transaction, the residual value of equipment can provide credit support to a transaction; however, reliance on credit support from residual values may be limited because of relatively high variability of the proceeds at the end of a lease. DBRS reviews the experience of the servicer in setting and realizing residual values when incorporating it into the cash flow analysis. In order to receive credit for any proceeds from the residual values, the servicer would be expected to have significant detail on historical residual realizations. The servicer s accounting and depreciation policies are also reviewed and compared with actual residual realizations. 11

12 DBRS analyzes the data provided by the servicer and typically applies a stress to the anticipated residual value and incorporates the reduced residual proceeds into its stressed cash flow analysis based on the schedule of residual collections provided by the servicer. The magnitude of reduction within a given range for each rating level is dependent on the servicer s experience and residual realization track record as well as the amount, quality and consistency of the historical data. Large Obligor Analysis Lessee concentrations existing in the portfolio are reviewed by DBRS to determine if the potential for individual lessee or several large lessee payment defaults pose increased credit risk to a transaction. In many cases, the lower-rated tranches tend to be thinner, which when combined with sequential principal payment priority and an increasingly concentrated obligor base, may expose such tranches to increased back-ended obligor default risk. If lessee concentrations present an increased risk to a transaction, it is often appropriate to conduct additional analyses to determine whether the credit enhancement levels are sufficient to support the rating. For the lessee concentration risk analysis, DBRS typically uses its proprietary model DBRS Collateralized Loan Obligation (CLO) Asset Model to estimate losses in an ABS transaction s collateral pool at different statistical confidence intervals that correspond to a given rating level. The DBRS CLO Asset Model has several key inputs including collateral tenor, notional exposure, default probability (which is derived from the underlying obligor rating), expected recovery rate for each obligor exposure in a pool (net of estimated recovery expenses) and correlation assumptions among the obligors. Correlation is a function of the obligor industry mix in a collateral portfolio. For more discussion on DBRS s CLO Model, please refer to Rating Methodology for CLOs and CDOs of Large Corporate Credit. Portfolio Termination Events Transaction Triggers Termination events or transaction triggers proposed at the outset of the transaction are evaluated based on an analysis of the key metrics that correspond to the health of the securitized portfolio. The triggers should be set to ensure that poor performance does not erode the available enhancement, but still provide room for volatility in performance that is consistent with historical experience. In some cases, such as agricultural equipment, triggers are set based on pools that exhibit significantly different patterns on a seasonal basis. Examples of triggers from prior transactions include aging of the portfolio (delinquency) and loss performance of the portfolio (defaults). Usually, a termination event will result in the acceleration of the repayment of the notes by capturing all excess cash flow in the deal and applying it to the outstanding principal balance. Other Structural Issues Equipment finance transactions that include a mismatch between the funding basis of the underlying assets and that of the notes issued by the funding entity are expected to be hedged. For example, to the extent that a fixed-rate versus floating-rate mismatch exists, hedging arrangements are expected to be entered into to mitigate this exposure to the trust and ensure that the noteholders have access to the appropriate type of interest cash flow. A similar issue exists if there is a currency mismatch between the underlying finance obligations and the currency of the notes that fund the assets. In these cases, it is expected that the transaction comply with DBRS s Derivatives Criteria for Canadian Structured Finance methodology. 12

13 Credit Enhancement Calculation and Composition Credit enhancement levels are intended to protect noteholders from the loss of principal or interest throughout the life of the pool of assets that have been securitized. As described above, DBRS considers the performance history of the finance company s portfolio together with the pool being sold and any external factors that could affect performance when deriving a base-case loss curve. The base-case loss curve, therefore, may be adjusted from transaction to transaction to reflect different performance history, pool composition or other factors that are anticipated to affect the performance of the identified pool of equipment financing. The base-case loss curve is applied when modelling the monthly cash flows to review the impact of different scenarios on the performance of the pool and the proposed credit enhancement levels. DBRS employs a proprietary cash flow model for this purpose and considers different scenarios when evaluating whether the proposed level of credit enhancement is sufficient to warrant the assignment of the desired rating level. Consistent with other traditional assets, recommended credit enhancement levels contemplate coverage multiples of the base-case estimated loss based on the desired rating level for the rated notes (see the table below). Base-Case Coverage Levels Rating Level Minimum Coverage AAA 4.0x to 6.0x AA 3.0x to 5.0x A 2.5x to 3.5x BBB 2.25x to 3.0x The above table assumes that the pool of assets will have adequate diversification, especially as it pertains to obligor concentration levels. When considering obligor concentration levels, obligations of an obligor and its affiliates within the pool are analyzed on a combined basis rather than on the exposure to any one loan or lease. This reflects the fact that obligors are likely to default on all their obligations, not just one, if they experience financial distress. Consistent with other traditional assets, the minimum credit enhancement coverage of obligor concentrations based on the desired ratings levels is shown in the table below. Credit Enhancement Levels Obligor Rating Level Maximum Concentration as a Per Cent of Credit Enhancement AAA 100% AA 50% A 33% BBB 25% BB or less 16% 13

14 Forms of Credit Enhancement The credit enhancement for an equipment securitization structure typically includes a combination of overcollateralization, cash reserves, subordinated notes (if a public transaction) and excess spread. In addition, other forms of enhancement such as letters of credit or guarantees will be considered in any proposal and are expected to be supported by an institution meeting the required ratings threshold as set out in DBRS s Legal Criteria for Canadian Structured Finance. The proposed level of enhancement will be evaluated based on the coverage levels indicated in the table above for the rating level desired. If applicable, the evaluation of the enhancement proposal will also mitigate obligor concentration risks by referencing the credit rating of the obligor to the recommended concentration limits noted in the table above. DBRS considers excess spread to be a component of credit enhancement and any credit assigned includes an analysis of a number of factors, including whether there is a specific mechanic in the transaction to prevent the release of any excess spread to the seller, the timing of losses, expected prepayment levels and the overall APR of the securitized pool. Similar to auto loan transactions, pools with low APRs are usually discounted to create some excess spread and, in these cases, limited credit can be granted to this amount. Conversely, transactions that have a significant amount of excess spread because of a high weighted-average APR can be given credit; however, the credit assigned in these cases requires additional analysis, including sensitivity analysis that stresses the portfolio assuming prepayments and losses occur on the contracts with the highest APR. Application of Stress Multiple and Concentration Limits The stress multiple and concentration limits protect the rated securities from much harsher and more stressful conditions than assumed within the base-case cash flow scenario. The stress multiple is compared with the historical volatility of net credit losses such that an issuer with more consistent historical data than the industry average may warrant the use of lower multiples within the ranges in the tables above for a given rating. The stress levels are applied to transactions on a case-by-case basis determined by, among other things: (1) The quality and availability of historical data, (2) Originator/seller/servicer and manufacturer considerations and (3) The transaction structure. Historical Data Consistent and lengthy historical data that covers at least one full economic cycle and includes all significant stratifications (new/used, contract term, credit score, residual value losses, etc.) of the proposed pool may warrant lower stress multiples; however, volatile and incomplete data sets may warrant higher stress multiples to account for the lack of historical data. An incomplete data set, for example, may include only limited data on extended term loans and may not include data over the entire term of the loan (i.e., only 36 months of data on 84-month or longer contract terms). In these cases, DBRS may use an industry comparable or other forecasting method as applicable to project net credit losses over the full term. Similarly, data sets which incorporate significant changes in credit underwriting standards may also warrant higher stress multiples as the data has not been generated using consistent underwriting standards. This consideration may also be represented through a change in the cumulative net loss assumption prior to applying the appropriate stress multiple. 14

15 Seller/Servicer/Sponsor/Originator/Manufacturer Considerations The Seller/Servicer/Sponsor/Originator of the transaction can and often does play an important role in the selection of appropriate stress levels. An investment-grade entity with a history of securitization, servicing assets, a well-tenured and experienced staff and a diversified obligor base may warrant lower stress levels. A new issuer, non-investment-grade entity, a highly concentrated portfolio or one where a replacement servicer is more likely to be required may warrant higher stress multiples. Lower stress multiples might be warranted if the manufacturer of the equipment in the transaction has a history of supporting the financing entity issuing the security, if there is very high perceived brand quality and if the manufacturer is of high credit quality (this is relevant to consider for warranties on equipment in the future). A poor quality manufacturer or group of manufacturers that is high credit risk may, however, warrant higher stress multiples to the extent that such considerations are not factored into the expected cumulative net loss. Structural Mitigants The transaction structure is also considered when assessing the stress multiples applied in a given transaction. If the structure includes appropriately structured early warning triggers on metrics such as losses and delinquencies, it may warrant lower stress multiples; however, if such triggers do not exist or are considered by DBRS to have been set at levels that are not meaningful, higher stress multiples may be applied. If credit enhancement is non-amortizing or has very high floor levels or if an investment-grade originator is required to repurchase defaulted assets, lower stress multiples may also be warranted; however, in the absence of these structural mechanics, higher stress multiples are likely more appropriate. 15

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