Asset-Backed Criteria Report Analysts Du Trieu +1 312 368-2091 du.trieu@fitchratings.com Ravi R. Gupta +1 312 368-2058 ravi.gupta@fitchratings.com Peter Manofsky +1 312 368-2068 peter.manofsky@fitchratings.com John H. Bella, Jr. +1 212 908-0243 john.bella@fitchratings.com Related Research Special-Purpose Vehicles in Structured Finance Transactions, June 13, 2006 SMARTView, May 3, 2007 The ABS Equipment Expo, Feb. 19, 2008 Inside Page Summary...1 Lease and Equipment Types...2 Structural Features...3 Legal Issues and Documentation...4 Rating Approach...4 Pool Characteristics...7 Portfolio Performance...8 Rating Methodologies Loss Approach and Obligor Concentration Approach...9 Cash Flow Analysis and Assumptions. 11 Credit Enhancement Components... 12 Evaluating a Proposed Structure A Hypothetical Example... 14 Performance Analytics... 15 Appendix I Operating Leases... 17 Appendix II Construction and Agricultural Equipment Loan Securitization... 18 Appendix III Residuals... 20 Appendix IV Historical Performance. 22 This report updates Fitch s existing criteria report titled Rating U.S. Equipment Lease and Loan Securitizations, dated May 31, 2007, and outlines Fitch s approach to rating securities backed by equipment lease and loan receivables. Rating Criteria for U.S. Equipment Lease and Loan Securitizations Summary The U.S. equipment lease and finance industry continues to play a significant role in the asset-backed term securitization market. Collateral supporting equipment transactions ranges from small ticket commercial equipment, such as copiers, to larger operating assets, such as aircraft and aircraft engines. Similar to the diversified collateral, issuers within the equipment leasing securitization market vary in size, with both small and large leasing companies playing an active role in the term securitization market. However, the equipment leasing sector has evolved since 2006, whereby the total issuance of $8.4 billion was evenly distributed between small ticket and large ticket (agricultural and construction) collateral-backed transactions. In 2007 there was a convergence whereby agricultural (AG) and construction (CE) collateral represented approximately 87% ($5.2 billion) of total issuance, compared with only $817 million in small ticket transactions. This trend has continued through first-quarter 2008 with $1.7 billion in issuance of AG/CE-backed transactions and zero issuance of small ticket transactions. Fitch Ratings views this change as positive because the issuers of AG/CE transactions are generally larger, better capitalized, and more financially stable companies, which are better suited to withstand an economic downturn. Similarly, the small ticket issuers that have been able to tap the securitization market are much more financially stable and better capitalized than their counterparts were in 2001, when small ticket issuance represented 60% of issuance volume. In conjunction with the change in issuer base and an improved economic cycle, transaction-specific performance has also improved since 2001, with reduced delinquency rates, loss severity, and loss volatility. Based on the ABS Equipment Expo, average delinquency rates for both the small ticket and heavy metal (AG and CE) portfolios have experienced significant declines in delinquency rates. The small ticket portfolio averaged 5.90% in 30-or-more-day delinquencies from 1998 2001, compared with 3.08% from 2002 through April 2008. Following a similar trend, the heavy metal portfolio averaged 1.09% in 60-or-more-day delinquencies from 1998 2001, compared with 0.54% from 2002 April 2008. Both the small ticket sector and the heavy metal sector benefited from the improved economy following 2001 and issuance from larger, better capitalized, and more financially stable issuers. (For additional historical performance commentary, see Appendix IV Historical Performance, page 22.) Due to the evolving nature of the equipment lease/loan securitization sector, Fitch continues to update its rating criteria to adjust for changes in the space. As a result, this report further details cash flow assumptions utilized in Fitch s proprietary cash flow model and the performance analytics process. Specifically, it explains Fitch s analytical process for rating equipment lease and loan transactions. Primary areas of analysis during the rating process include the following: The Financial Institutions (FI) group s assessment of issuer and or originator/servicer. Legal issues and documentation. www.fitchratings.com June 16, 2008
Originations, underwriting criteria, and portfolio servicing. Historical portfolio performance (managed portfolio and securitizations). Portfolio characteristics and concentrations. Obligor characteristics and concentrations. Loan and lease features. Manufacturer/vendor concentrations. Evaluating credit enhancement. Cash flow modeling. Performance analytics. Lease and Equipment Types Operating and Finance Leases Leases can be structured as operating or finance leases. In both instances, the lessor purchases the equipment and leases it under a contract, obligating the lessee to a set of scheduled payments. Payment streams can be structured on a monthly, quarterly, semiannual, or seasonal basis, reflecting the lessor s business needs and cash flow cycles. Full payout (or finance) leases are structured so that the net present value of lease payments cover at least 90% of the original equipment cost (for new equipment) or the fair market value (for used equipment). At the end of the lease term, the lessee is entitled to purchase the equipment at a nominal price, generally either the remaining fair market value of the equipment or 10% of the original equipment cost. Finance leases often terminate with a $1 buyout purchase option. The lessee is essentially purchasing the equipment on a monthly payment plan, because the lease term for new equipment covers at least 75% of the useful life of the equipment. In contrast, payments on operating leases cover only a portion of the equipment cost (less than 90%). The remaining value of the equipment is referred to as the residual. At the end of the lease term, methods of residual realization can vary; options include the lessee purchasing the equipment, the lessor selling the equipment in the secondary market, the lessor extending the lease to the original lessee, or the lessor re-leasing the equipment to a different lessee. Airplanes, railroad cars, and shipping containers are often under operating leases. Fitch s general approach to rating operating lease securitizations is summarized in Appendix I Operating Leases (see page 17). Prepayments Lease agreements may allow for early termination to upgrade equipment or, in the event the lessor has the opportunity to realize its residual value earlier. The required prepayment amount typically consists of the present value (often based on a predetermined discount rate) of all payments remaining due on the lease from the time of prepayment until the conclusion of the lease term, including any residual value and, possibly, a prepayment penalty. Equipment Classifications While several standards exist in the leasing industry, equipment portfolios are generally grouped into one of the following categories: Small ticket portfolios typically consist of equipment with an original cost of less than $100,000 and include office equipment, computers, and copiers. Small ticket leasing companies generally lease to a diverse group of obligors covering multiple industries, equipment types, and geographic locations. 2 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
Mid-ticket portfolios contain equipment with an original cost between $100,000 and $500,000. Common equipment types are graphics, printing, and commercial and industrial equipment. Large ticket portfolios involve equipment that costs in excess of $500,000. Large ticket equipment pools, including large computer systems, magnetic resonance imaging (MRI), and other medical equipment, often involve substantial residual values. Agriculture (AG) and construction (CE) related equipment loans typically range from $25,000 $100,000 and have accounted for an increasing component of overall equipment issuance over the past few years. (For additional information on this segment of the equipment industry, see Appendix II Construction and Agricultural Equipment Loan Securitization, page 18.) Operating lease portfolios are typically composed of leases on transportation-related equipment such as aircraft, railcars, and shipping containers. (For additional information on this segment of the equipment industry, see Appendix I Operating Leases, page 17.) Eligibility Criteria The transaction documents for a securitization contain eligibility criteria for equipment leases and loans to be included in a securitization. Typical criteria for leases are as follows: At least the first payment has been made. The lease/loan contains no receivable more than 30 days past due at closing. The lessee has not been involved in bankruptcy proceedings. The lease/loan contains hell or high water, triple net, and noncancelable provisions. The lease is assignable. Structural Features Prefunding Accounts In transactions with prefunding accounts, a portion of the proceeds from the sale of the securities is deposited into a prefunding account at closing. These funds are then used to acquire additional equipment lease/loan receivables within a specific period, typically 90 days. Any remaining funds in the account at the end of this period are used to pay down the outstanding principal amount of the securities. Additionally, Fitch reviews collateral characteristics following the end of each prefunding period and expects concentrations to be comparable with closing concentrations and characteristics. A seller must demonstrate its ability to generate sufficient volume to support a prefunding account without jeopardizing credit policies. As a result, prefunding accounts for first-time issuers are rare. Fitch has noted prefunded accounts in the range of 15% 30% of the collateral balance for more established issuers. A capitalized interest account supplements transactions with prefunding accounts. This account serves to compensate investors for the negative carry attributable to cash in the prefunding account earning a lower yield than that of the notes issued. The capitalized interest account is typically funded by proceeds from the securities issued at closing. Any funds remaining in the account at the end of the prefunding period are returned to the issuer. Revolving Periods A revolving structure extends the term of a transaction with a revolving period that generally lasts from nine to 24 months. During a revolving period, investors receive only Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 3
interest payments, with all principal payment collections used to fund new equipment lease/loan receivable purchases. An amortization period follows in which all lease/loan collections pay interest and principal to investors. Leases/loans to be added during the revolving period are subject to eligibility criteria to maintain certain pool collateral characteristics and concentration limits. Additionally, early amortization triggers tied to portfolio performance and the originator s financial condition are structured to protect investors and maintain the integrity of the portfolio s original characteristics. Legal Issues and Documentation Equipment securitizations are structured to isolate the equipment leases or loans (collectively, contracts) from bankruptcy or insolvency risks of the other entities involved in the transaction (the originator/seller). This is typically accomplished by the originator/seller transferring the equipment contracts either directly or indirectly, depending on the chosen structure and the type of entity making the transfer by means of a true sale or series of true sales to one or more bankruptcy-remote entities, one of which will ultimately issue the asset-backed securities (ABS) to investors. Such transfers may take the form of a pledge in which one bankruptcy-remote transferor grants a first-priority perfected security interest in favor of a bankruptcy-remote transferee. Furthermore, if the bankruptcy-remote issuer is issuing debt securities, those debt securities should be secured by the grant of a first-priority perfected security interest from the bankruptcy-remote issuer to the indenture trustee for the benefit of the debtholders. (For more information, see Fitch Research on Special-Purpose Vehicles in Structured Finance Transactions, dated June 13, 2006, available on Fitch s web site www.fitchratings.com.) Fitch expects transaction counsel to opine on the nature of the various transfers in the transaction and the risk that an SPE would be consolidated with its parent in a bankruptcy of its parent. Regarding transfers from the sellers and/or originators of the equipment contracts to an SPE (together with all the transfers in-between), the legal opinions address whether the transfer would be treated as a true sale in the event of the bankruptcy of the transferor. Additionally, opinions should address whether various pledges create first-priority perfected security interests in the pledged assets. Finally, Fitch expects that the legal opinions address the tax status of the issuer in the transaction. Rating Approach Seller/Servicer Financial Strength Review Potential securitizations undergo a process to evaluate the financial strength of the seller/servicer. To complete this preliminary assessment, Fitch typically requests, at a minimum, the following: A detailed term sheet outlining the transaction structure. Stratifications of pool characteristics (i.e. equipment types, geographic, and obligor concentrations). Five years of historical portfolio performance on a gross default and net loss static basis. If available, prior securitization performance on a gross default and net loss basis and delinquency performance. Personal and professional background information on the servicer s principals and executive management. Three years of audited financial statements. 4 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
During the review process, Fitch works with its FI and Corporate Finance groups to analyze a potential servicer s financial strength and long-term servicing viability. Additionally, any unique structural or legal issues are discussed with Fitch s legal department. The ABS and FI groups interaction begins during a transaction s initial review and extends throughout its life. For unrated issuers, FI reviews are similar to its analyses for rated companies. Each issuer is analyzed using a set of qualitative and quantitative factors based on publicly available information and other data provided to Fitch. These reviews allow Fitch to assess the benefits and concerns surrounding ABS from an unsecured perspective and help measure securitizations potential effect on unsecured ratings. Servicer On-Site Visit Fitch conducts an on-site review of the transaction s originator and/or servicer. This review allows Fitch to gain an understanding of the organization s formation; executive management structure, experience, objectives, and strategy; competitive position; origination, underwriting, and servicing policies; portfolio performance; and funding capabilities. In the case of a repeat issuer, on-site reviews are performed annually, which allows Fitch to keep apprised of any significant changes to the issuer s overall business plan. Originations Fitch commits a part of its review to an examination of an originator s origination methods. Typically, leases/loans are originated directly by the lessor through vendor programs and/or third-party brokers. As a result, Fitch expects the originator to conduct various initial and periodic background checks on vendors and brokers. The background check should include a review of their financial condition, bank and trade credit references, length of time in business, and the quality of their customer service programs. Additionally, Fitch may also conduct background checks and review broker and vendor agreements to assess the level of recourse or equipment remarketing arrangements, if any. Furthermore, Fitch expects the originator to conduct periodic reviews on the delinquency and chargeoff performance of leases/loans originated by each vendor and broker. Procedures should also be in place to terminate vendor and broker relationships, if performance warrants. The extent of an originator s experience in originating and soliciting new accounts is critical. Changes in the underlying nature and type of origination concentrations can suggest potential problems. An originator needs appropriately experienced personnel prior to entering niche markets or markets requiring enhanced servicing capabilities. Due to limited performance data, issuers in most cases will exclude loans originated in new or niche markets from securitizations. Underwriting The quality and consistency of underwriting policies and processes are critical to the performance of equipment lease/loan receivables. The underwriting staff should consist of experienced underwriters with strong lease finance backgrounds. Lending authority should be designated by underwriter experience. Fitch expects each lease/loan applicant to be subject to a full credit review, including an examination of trade references, bank and credit bureau reports, past payment history for repeat customers, and financial statements. Additionally, lease/loan terms should be reviewed by the originator to ensure compliance with the underwriting guidelines. Fitch reviews credit approval/rejection ratios (and corresponding reasons) to check that adequate thresholds are in place. For originators that use a credit-scoring system, the methodology is reviewed by Fitch, including all inputs and assumptions. Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 5
While underwriting methods may vary drastically among leasing companies, Fitch focuses on the consistent implementation and monitoring of stated underwriting policies and procedures. Any exceptions to the underwriting criteria should be fully documented. Such exceptions to credit policy are a concern, since they can be an indicator of possible portfolio deterioration. Additionally, internal and external audit processes are expected to be in place to ensure compliance with policies and procedures. This is especially important if underwriting is decentralized. During the review of underwriting procedures, Fitch also assesses the historical experience of past originations, underwriting criteria changes, and the originator s objectives for portfolio growth and performance. Portfolio Servicing The ability to service equipment lease/loan receivables properly and in a timely manner directly affects the quality and performance of a transaction. Fitch evaluates the servicer s ability to perform customer service duties as well as the tracking of billing and collections, repossessions and remarketings, receipts, nonpayments, insurance, taxes, Uniform Commercial Code (UCC) filings, and all dialogue with accounts. The servicer must also have the ability to produce monthly investor reports detailing portfolio performance, as is required by the transaction documents. As effective servicing provides the cash flow needed in a securitization, Fitch examines a servicer s billing and collections policies and processes. Fitch evaluates staffing adequacy and turnover, the experience of collections personnel, and management s commitment to the ongoing improvement of servicing capabilities. Sufficient accounts-to-collector ratios are key, while servicing capacity should be available to support any expected portfolio growth. Personnel resources are evaluated, and an effective and efficient training system should be in place. Backup Servicing As the ability to service equipment lease receivables properly and in a timely manner directly affects the quality and performance of a securitization, Fitch examines the servicing and backup servicing arrangements within an equipment lease ABS transaction. In the past several years, the number of servicing transfers, as well as the difficulties accompanying these transfers, has contributed to Fitch s increasing emphasis on the financial condition and credit quality of the servicer when assigning ratings to new equipment lease ABS transactions. The initial assessment of a transaction s servicer is performed in conjunction with Fitch s FI group. This review consists of, among other things, an analysis of the servicer s audited annual and quarterly financial statements and the availability of alternative funding sources outside of securitization; the company s competitive market position; and the overall financial flexibility of the servicer. The FI group s assessment of the company may affect the ABS group s analysis and the rating of any transaction. A backup servicing arrangement may be appropriate if Fitch has concerns about the servicer s ability to manage its assets and collections. Grounds for servicer concern include the addition of more specialized equipment in the securitization pool, limited system capabilities, brief servicing experience, or a weak capital structure. Fitch typically assesses a backup servicer s ability via an on-site review. For those transactions in which the trustee is the named backup servicer, Fitch assesses the trustee s ability to service the pool and/or subcontract the servicing to a third party. Furthermore, Fitch reviews the backup servicing agreement to understand the backup servicers responsibilities. To facilitate a transition to the backup servicer, the backup servicer is typically a party to the transaction s underlying legal documents. A backup servicing agreement generally outlines key aspects, such as the frequency of data tape receipt and the speed with which the backup servicer assumes full servicing responsibilities in the event that a transfer is necessary. In certain cases, a documented servicer transition plan may be in place corresponding with the transaction s close. Fitch also assesses the fee structure in the backup servicing agreement for market competitiveness and will incorporate the fee, typically higher than the fee structure of the original servicer, when analyzing break-even cash flow runs used in evaluating credit-enhancement levels. 6 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
Fitch also evaluates the servicer s data processing systems, as such systems play a vital role in the servicing process. Fitch assesses system capabilities in terms of functionality, flexibility, maintenance, security, life span, management, and investor reporting. Fitch also examines a servicer s tested disaster recovery plans. Copies of all files are expected to be kept in fireproof cabinets, and daily off-site backup of all data processing systems occurs. In the event of a disaster, a proper recovery plan should be able to establish a minimal servicing platform within 24 48 hours. A securitization s performance relies on the quality of the servicing platform. If Fitch believes the servicer demonstrates weakness in any of the aforementioned responsibilities or the overall servicing platform is inadequate, Fitch will incorporate the higher end of stress multiples and obligor ranges utilized to evaluate the proposed transaction s loss coverages (see tables, page 10). Pool Characteristics Collateral Evaluation Fitch s evaluation of pool characteristics begins with an examination of the collateral. Common collateral types securitized to date are computers, transportation, medical, telecommunications, and office equipment. Fitch makes distinctions among these collateral classifications, as the nature of the equipment will have implications on Fitch s loss proxy determination and assessment of the transaction s structure. For example, a distinction will be made between the various types of printing equipment. Copier machines are generally deemed small ticket items and tend to depreciate relatively quickly, given constantly evolving technology. Meanwhile, printing presses are typically deemed mid-ticket items and tend to retain a significant amount of their value over time. These distinctions will have implications on the timing and incidence of default as well as the timing and size of recoveries when cash flows are stressed. Historically, stronger collateral pools consist of equipment that is less specialized, retains value, and has a longer useful life. Obligor Diversification In its analysis of portfolio risk, Fitch examines existing obligor concentrations. Concentration issues are commonly found in pools of large ticket equipment or pools with multiple leases/loans to a single obligor. Additional credit enhancement is often provided if any single nonrated or noninvestment-grade obligor makes up more than 1% of a portfolio. A pool consisting of significant obligor concentrations (assuming minimal net losses) often results in the application of Fitch s obligor concentration approach to derive credit enhancement (see Obligor Concentration Approach, page 10). Geographic Concentrations Geographic diversification in securitized portfolios can mitigate the default risk associated with any regional economic downturn or natural disaster. During the rating process, Fitch analyzes the portfolio to determine if higher-than-normal concentrations will result in additional portfolio risk. Generally, a geographically diversified pool consists of no more than 15% of leases/loans originated in any one state, however, higher-than-average geographic concentrations for securitized portfolios are common in larger states such as New York and California. As a result, Fitch s cumulative net loss proxy may be increased to mitigate any additional risk posed by geographic concentrations. Additionally, higher stress multiples or obligor coverages may be incorporated to further offset the geographic concentration risk Equipment Type and Manufacturer Diversification The type of equipment, the risk of technological obsolescence, and the number of equipment manufacturers may affect the ability to re-lease or sell repossessed Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 7
equipment. Consequently, any concentrations of equipment types or manufacturers may affect the overall credit quality of the portfolio. As a result, Fitch s cumulative net loss proxy may be increased and higher stress multiples or obligor coverages may be incorporated to mitigate this additional risk. Fitch reviews the essential-use nature of the equipment and the size of the secondary market for such equipment. Additionally, Fitch inquires whether a capable third-party service company could continue to maintain and service the equipment in the event of a manufacturer bankruptcy. Portfolios of specialized equipment, such as MRIs, require extensive industry analysis to make assumptions on the future value and uses of the equipment. Portfolio Performance Delinquencies Delinquencies can be an indicator of the current and future quality of a transaction s cash flow. Fitch expects a servicer s delinquency reporting to be divided into aging categories. The analysis of these delinquency buckets, typically arranged into 30 60 days past due, 61 90 days past due, and 91 or more days past due, supports the tracking of delinquency trends. These trends are not only useful in gauging portfolio deterioration and potential defaults but also assist in the evaluation of performance-related triggers commonly found in lease/loan securitizations. Defaults In equipment leasing transactions, Fitch looks to historical portfolio performance on a static basis (cumulative gross default and net losses) as an indicator of future performance. For purposes of securitization, defaults are typically defined as the earliest of an actual default and 120 or 180 days delinquent. Static loss data reference leases/loans originated during a specific period and track the performance of such leases/loans over time. Fitch prefers cumulative static pool data on portfolios of fully paid out leases/loans. This cumulative static pool data is used to calculate Fitch s base case proxy. Alternatively, annual loss performance is a less effective predictor, as it can be skewed by portfolio growth. Additionally, some issuers recognize losses partially upon repossession of the equipment or chargeoff. The remaining loss will then be recognized when the contract is liquidated through sale or other disposition. Fitch s cumulative net loss proxy may be increased and higher stress multiples or obligor coverages may be incorporated if adequate default performance data is not provided. Recoveries Similar to its evaluation of losses, Fitch reviews historical portfolio recovery performance on a static and annual basis. However, given that timing delays between losses and recoveries could exist, Fitch strongly prefers at least five years of static recovery data. During its analysis, Fitch examines the actual level of historical recoveries as well as the time and method by which recoveries are realized (i.e. sale or re-leasing). Based on this analysis, Fitch may allocate recovery credit to adjust our base case proxy. For an investment-grade servicer, Fitch evaluates asset management operations, remarketing channels, and vendor relationships to determine the appropriate recovery levels. For an unrated or below-investment-grade servicer, Fitch relies on recovery rates based on the cost and types of equipment. In such a case, higher recovery credit may be given for equipment that tends to retain value (i.e. construction and agricultural equipment, printing presses, and certain types of medical equipment) than for equipment heavily subjected to obsolescence risk or depreciation (i.e. personal computers and furniture, fixtures, and other equipment). Typically, Fitch gives no 8 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
credit for recoveries on small ticket lease/loan pools, with possible exceptions made for servicers with consistent historical experience. Ultimately the level of recovery credit is dependent on historical performance and the adequacy of the performance data. As a result, Fitch s cumulative net loss proxy may be increased and higher stress multiples or obligor coverages may be incorporated if adequate recovery performance data is not provided. Rating Methodologies Loss Approach and Obligor Concentration Approach Fitch incorporates a twofold analysis when analyzing a proposed structure and evaluating credit enhancement levels: a loss approach and an obligor concentration approach. Most frequently, Fitch analyzes proposed credit-enhancement levels using a loss approach in which an expected base case net loss rate (expected gross defaults less expected recoveries) is stressed by a factor reflective of the assigned rating. Alternatively, Fitch exercises an obligor concentration approach when encountering an issuer with low historical default and net loss rates or for pools with large obligor concentrations. A simple approach of applying a stress multiple to the low historical base case, usually in the single basis point to lower teens range, would result in very low credit enhancement levels. Furthermore, if an underlying pool is comprised of large obligor concentrations, a stress multiple approach cannot fully account for large obligor risk. Subsequently, Fitch analyzes break-even cash flow runs to determine the level of expected cumulative losses the proposed structure can withstand or to cover the default of certain top obligors over the life of the transaction. The level of enhancement will not necessarily correlate with the stressed cumulative net losses or top obligors as of the deal closing date. Several factors influence the amount of credit enhancement available to support the stressed net losses or obligor coverages over the life of the transaction. These factors include the following: A transaction s payment priority (pro rata compared with sequential). Cash reserve mechanics (i.e. the level of initial funding, timing to reach required reserve amount reserve floors, and stepdown mechanics). The loss timing, prepayment, and delinquency assumptions incorporated into the cash flow model. Changes in obligor concentrations over time. Additionally, qualitative factors such as originations, underwriting, servicing, collateral, and pool concentrations, are incorporated into Fitch s analysis of expected and stressed loss rates. Loss Approach Under the loss approach, the amount of available credit enhancement must sustain a portfolio s expected level of stressed net losses. The first step in reviewing the adequate level of credit enhancement is to determine a base case net loss proxy based on a review of the servicer s historical gross default and recovery performance. In deriving a base case net loss proxy, Fitch first determines an expected gross default rate. This gross default rate may then be adjusted to reflect expected recoveries and seasoning. The nature of the equipment, strong historical performance evidenced by quality servicing, and financial strength of the issuer may determine whether Fitch gives credit for recoveries. Fitch s base case net loss proxy may also be adjusted for seasoning credit. Fitch considers the timing and consistency of static net losses when reviewing a Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 9
pool s seasoning. This analysis focuses on the nature and shape of a servicer s net loss curve. After incorporating recoveries and seasoning, the adjusted base case Stress Multiple Ranges net loss proxy is stressed by a Rating Category Stress Multiple (x) multiple corresponding to the rating. AAA 4.50 6.00 For example, for an A rating, a base AA 4.00 5.00 case net loss proxy of 5% would A 3.00 4.00 suggest the securitized portfolio BBB 2.00 3.00 BB 1.50 2.50 must withstand 15% of cumulative B 1.00 1.75 net losses. The table above shows Fitch s standard stress multiples. Stress multiples on the higher end are utilized if factors such as minimal historical performance data from a less established issuer, volatile loss performance, and significant concentrations (equipment, geographic, and industry, etc.) are present. Conversely, for a well established issuer with abundant static pool data with consistent and low historical loss levels and diversified pools, the lower-tier stress multiples would be incorporated into Fitch s analysis. Obligor Concentration Approach When an underlying lease/loan pool exhibits large obligor concentrations or when the servicer s historical default and loss rates are low, Fitch reviews proposed credit-enhancement levels based on certain top obligor concentrations. Obligor coverage by rating category is reflected in the table below. Obligor coverage is based on several qualitative and quantitative factors, including the pool s characteristics (e.g. equipment types, obligor industries, geographic concentrations, etc.), the amount and consistency of performance data, and changes in origination focus. A first-time securitizer often warrants higher obligor coverage. The obligor coverages incorporated in Fitch s analysis will be adjusted based on these qualitative factors. Fitch begins by reviewing the top 10 obligors included in a securitized Top Obligor Coverage Ranges pool at closing. Fitch will request the Rating Category No. of Obligors credit summaries of the top 10 AAA Top 5.0 6.0 obligors. Fitch examines such AA Top 4.0 5.0 summaries for the depth and history A Top 3.0 4.0 of the relationship with the servicer, BBB Top 2.0 3.0 BB Top 1.5 2.0 the obligor s financial strength and B Top 1.0 1.5 length of time in business, the nature of the collateral, residual exposures, and the obligor s overall exposure to the servicer. To the extent, in Fitch s determination, that the analysis of these top obligors results in incremental risk, creditenhancement levels above the stress multiples listed in the table above may be warranted. Furthermore, Fitch examines the top 10 obligors as a percentage of the aggregate pool balance at quarterly intervals over the life of the leases/loans. The composition of the original top 10 obligors may change over time. For this reason, Fitch requests credit summaries on additional obligors if significant new concentrations arise at any of these intervals. Fitch reviews cash flow model runs to assess whether the level of credit enhancement provided can sustain the default of certain top obligors as of the closing date as well as at quarterly intervals throughout a transaction. Mechanisms that adjust cash 10 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
reserve floors and switch bond payment priorities are crucial implements to ensure that the level of credit enhancement available at any time is sufficient to cover the top obligors. This is especially critical near the tail end of the transaction, as individual obligor concentrations as a percentage of the aggregate pool balance may increase dramatically. Cash Flow Analysis and Assumptions An important part of Fitch s quantitative review of an equipment lease/loan transaction centers on cash flow modeling, which is a critical step in evaluating credit enhancement levels. All transactions are modeled utilizing Fitch s proprietary equipment lease and loan cashflow model, which replicates the transaction payment priority, liabilities, triggers, related pool characteristics, and credit enhancement levels. Base case assumptions are determined by analyzing historical performance data provided by the issuers and collected by industry resources. The base assumptions are then stressed to determine whether cash flows generated by the underlying collateral and credit enhancement are appropriate for the given rating level. The following sections outline many of the assumptions and various stresses Fitch models for any given equipment lease/loan transaction. Transaction Structure and Mechanics Fitch s proprietary cash flow model incorporates standard inputs such as the transaction s payment priority, application of servicing and trustee fees, trigger mechanics, and pricing assumptions. Generally, equipment transactions incorporate either a sequential or pro rata payment priority. A transaction may also include various performance-related triggers, which can shift the payment priority or allow for credit enhancement components such as the reserve account or overcollateralization (O/C) to increase or decrease if defined performance metrics are met. Furthermore, Fitch models interest on interest unless the transaction is specifically structured to allow for bond writeoffs, which is seldom seen in today s equipment securitization space. Additionally, Fitch models each transaction to the maturity dates of the bonds and not the optional call date of the bonds. Servicing Fee Fitch will incorporate the servicing fee that has been established in the transaction documents, which is typically allocated at the top of the payment priority. A higher servicing fee, generally the backup servicer fee, may be incorporated for noninvestment grade servicers. Delinquency Rate Based on historical delinquency rates on both the managed portfolio and securitization basis, Fitch will typically apply delinquency stresses assuming that a percentage of the portfolio remains delinquent, which ultimately reduces the available excess spread to the transaction. The delinquency rate stress ranges from 0.10% 0.25%, depending on the rating category and collateral type. The delinquency rate stress is added on top of the standard servicing fee to reduce the amount of excess spread at the top of the payment priority. Default Timing Curves The default timing curves incorporated in the cash flow model are issuer specific and derived from the issuer s historical performance data. Fitch reviews both static pool gross defaults and net losses to determine the historical default timing of the issuer s portfolio. This analysis yields the base default curve, which is the loss curve the securitization is expected to experience. Historically, equipment lease/loan Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 11
securitizations have experienced front-loaded gross defaults and net losses, whereby these securitizations experienced approximately 30% 40% of lifetime cumulative losses in the first year after closing. In addition to the base default curve, Fitch will model various default timing assumptions to test the sensitivity of the proposed structure. The default timing curves range from evenly distributed losses, back-end loss distribution, and further front-loaded loss scenarios. Prepayment Speeds Prepayments can materially affect the expected cash flows of a securitization by reducing the security s average life and lowering the excess spread generated by the collateral. As a result, Fitch reviews an issuer s historical prepayment experience on both the managed portfolio and securitization basis, if available, to derive a base prepayment rate. In addition to the base prepayment rate, additional prepayment assumptions are utilized to analyze the sensitivity of the structure and the level of excess spread the transaction will benefit from under various prepayment speeds. Fitch models prepayments using a constant prepayment rate (CPR) assumption. Recovery Rates and Recovery Lag Similar to other stresses, recovery credit is applied to the cash flows if historical performance data suggest credit is warranted. The amount of recovery credit can vary dramatically and is dependent on factors such as credit quality of the servicer and the cost and types of equipment. Equipment types such as construction, agricultural equipment, and printing presses have historically experienced high recovery rates, whereas small ticket collateral such as personal computers and furniture and fixtures have much lower recovery rates. Similar to recovery rates, recovery lag varies significantly based on collateral type. Historically, the more expensive and larger equipment types have experienced longer delays in recovery, due to the longer repossession and remarketing process. Recovery rate credit ranges from 10% 50%, while recovery lags have ranged from three to six months. Furthermore, both recovery credit and recovery lags may vary depending on the rating category. Residuals In many cases, soft credit enhancement such as residual realizations can comprise upwards of 40% of total credit enhancement. As a result, Fitch applies a haircut to the residuals. Credit to residuals will only be given if sufficient historical data is provided, generally five or more years of performance data. Ideally, historical residual realization data should include realization rates by equipment type and realization method. Based on the historical performance data, Fitch will apply various haircuts to the actual credit that is given to residuals at each specific rating category. Residual haircuts range from 30% 90% depending on the rating category and historical realization rates (see Appendix III, page 20). Excess Spread The availability of excess spread as credit enhancement relies on the continued performance of both the collateral and the servicer. Fitch will incorporate a delinquency stress that reduces the available excess spread that will benefit the transaction. In addition to the delinquency stress, various default timing stresses are incorporated to stress the availability of excess spread at different points through the transaction s life. Finally, Fitch may haircut the amount of excess spread available according to the rating category while taking into account the financial wherewithal of the transaction s servicer. Credit Enhancement Components In addition to its review of credit enhancement levels, Fitch evaluates the composition of such credit enhancement. The primary forms of credit enhancement incorporated in 12 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
equipment lease and loan securitizations with internal credit enhancement are reserve accounts, subordination and overcollateralization, excess spread, and residuals. Typically, Fitch classifies credit-enhancement elements into two main categories, hard and soft, recognizing that not all forms offer noteholders equitable protection. While looking at both the hard/soft ratios of overall credit enhancement, Fitch takes into consideration the percentage of overall credit enhancement carried by excess spread and residuals. Reserve Account Most equipment lease and loan securitizations utilize reserve accounts, which are typically funded with an initial deposit and may trap excess spread up to a required target amount. Reserve accounts are useful for meeting transaction expenses and providing liquidity, which may be strained during periods of high delinquencies and losses or on the back end when fewer loans remain outstanding. In addition to the target amount, reserves are often structured with minimum amounts (floors), which are often expressed as a dollar amount or percentage of the initial collateral balance. As the reserve account reaches its floor, it will maintain that minimum balance and, as such, grow as a percentage of the outstanding collateral balance. The use of these floor mechanisms will boost available credit enhancement as the transaction delevers. Subordination/Overcollateralization Subordination and overcollateralization are typical forms of credit enhancement found in equipment ABS and provide credit support for more senior tranches through cash flow subordination dictated through the payment priority. If collections from the underlying collateral are insufficient to make scheduled payments, funds otherwise payable to the issuer or to junior noteholders are used to pay senior noteholders. O/C, considered the first-loss piece, consists of an ownership interest in the receivables and is often retained by the sponsor. There is typically no coupon expense associated with O/C. Subordinate tranches typically have coupon expenses and, therefore, will result in less cash for senior bonds than O/C. Both generally will offer less credit protection than a cash reserve account, since they depend on asset performance and available collections. Excess Spread In certain transactions, excess spread (generally, the interest rate spread between the weighted-average coupon of the notes issued plus the servicing fee and the interest rate at which the underlying collateral payments are discounted) is available as an additional form of credit enhancement support. Unlike hard enhancement, soft enhancement, such as excess spread, may be harder to quantify upon the initial rating of the transaction. This uncertainty is due to several factors, such as delinquency and default rates, that can significantly affect the amount and timing of when this enhancement is available. Fitch reviews the relative mix of hard and soft enhancement available on a rating-specific basis. Hard enhancement will generally make up a higher percentage of overall enhancement available for classes with higher ratings. Residuals Small ticket equipment securitizations may benefit from residual realizations as an additional form of credit enhancement. Residual realizations are the cash flows on the sale of a piece of equipment following lease maturity. The residuals are monetized and sold to the ABS trust, providing additional soft credit enhancement. Credit to residual realizations will be applied on a case-by-case basis and only if historical data is available for review. Furthermore, the level of credit for residuals will vary depending on historical residual performance data and rating category (see Appendix III Residuals, page 20). Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 13
Evaluating a Proposed Structure A Hypothetical Example Assumptions ABC Leasing Co. (ABC), an independent small ticket leasing company, approaches Fitch for a rating on its first equipment lease securitization. Fitch s FI group assigns ABC a BB issuer default rating based on a review of its financial statements. Additionally, the ABS group has completed its on-site review of ABC and believes the company s servicing and underwriting standards are adequate. ABC s pool is sufficiently diversified, no significant obligor concentrations exist, and all legal documentation incorporates Fitch s criteria. The portfolio is made up of computers, fax machines, photocopiers, office equipment, and communication/telephone systems. Based on the aforementioned FI rating and the fact that ABC is a first-time issuer with a diversified portfolio and credible static pool loss history, among other things, the ABS group is able to move forward with the rating process. (For more on the financial strength of seller/servicers, see page 4.) Calculation The first step in evaluating a proposed structure is a review of ABC s historical gross default and net loss performance. Given the small ticket nature of the equipment in this hypothetical portfolio, historical recovery rates have been minimal. Consequently, Fitch assumes there will be no recoveries on defaulted leases and will focus on historical gross default data to derive a base case loss proxy. Based on its review of ABC s static default data, historical performance and pool characteristics (i.e. equipment, obligor, industry, geographic concentrations, etc.), Fitch derives a 5% base case loss proxy (5% of the pool balance will ultimately default). In this example, it is also assumed the portfolio has 12 months of seasoning as of the deal s closing date. A timing analysis of ABC s static default data reflects that, historically, about 40% of all defaults occur in the first year after origination. Under the assumption that some of ABC s expected defaults have already taken place, Fitch is able to give partial credit for seasoning. By applying a 50% haircut to ABC s loss curve experience, Fitch adjusts the base case loss proxy accordingly. The calculation is as follows: the base case proxy of 5% times one minus the haircut (50%) times the credit for loss curve seasoning (40%), resulting in a 4.00% seasoning adjusted cumulative net loss rate. This credit to seasoning is based on an analysis of ABC s historical loss timing and the volatility of its losses. The adjusted base case cumulative loss rate is then stressed by the appropriate multiple to derive a stressed cumulative loss rate for an A scenario. The portfolio characteristics and other quantitative and qualitative factors warrant a stress factor multiple of 3.5x for the A scenario. It should be noted that a higher initial multiple was incorporated as ABC is a first-time issuer with some history of volatility in its static pool performance. Based on the stress factor multiple (3.5x ) and Fitch s base case loss proxy of 4.00%, the stressed cumulative net loss rate is 14.00%. Finally, Fitch analyzes several break-even cash flow runs that Derivation of Cumulative Net Loss Proxy (%) Recovery Rate Analysis Base Case Cumulative Gross Default Rate (CGD) 5.00 Credit to Recoveries 0.00 Base Case Cumulative Net Loss Rate 5.00 Calculation for Recovery Credit: [CGD x Recovery Rate x (1 Haircut)] [5.00% x 0.00% x (1 0.00%)] = 0.00 Seasoning Credit Analysis Base Case Cumulative Gross Default Rate (CGD) 5.00 Credit to Seasoning 1.00 Seasoned Cumulative Net Loss Rate 4.00 Calculation for Seasoning Credit: [CGD x Loss Curve Seasoning x (1 Haircut)] [5.00% x 40.00% (1 0.50)] = 1.00 Stressed Cumulative Loss Rate Analysis Seasoned Cumulative Net Loss Rate 4.00 Stress Factor (x) 3.50 Stressed Cumulative Net Loss Rate 14.00 Note: Numbers may not add due to rounding. 14 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
incorporate additional assumptions, such as loss timing, increased delinquencies, and elevated servicing fees, among others. Additionally, Fitch reviews the composition of the credit-enhancement structure, analyzing hard versus soft ratios, to evaluate the mix and cumulative enhancement levels. Performance Analytics After an equipment leasing/loan transaction closes, performance is monitored throughout its life and ratings on the various classes may be raised, lowered, or withdrawn as Fitch sees appropriate. Servicer remittance reports for equipment transactions are typically distributed on a monthly basis. Fitch reviews the monthly reports, and pertinent performance metrics are captured in an in-house database. The database tracks performance metrics such as note amortization, collateral balance, available credit enhancement, delinquencies, defaults, recoveries, losses, prepayments, and residual realizations, among others. The data is then compared with initial expectations, prior securitizations, and industry averages. An upgrade of the initial rating may be warranted if actual loss performance is inside of initial base case expectations and available credit enhancement has continued to increase. Conversely, if loss performance is greater than anticipated and available credit enhancement is less than expected, a downgrade of the initial rating may be warranted. If any metric should display negative performance outside of expectations, Fitch will contact the servicer for further quantitative and qualitative information. All transactions are reviewed once a month after comparing the remittance report data against various Fitch internal algorithms, or a screener, that provides recommendations on which transactions should be reviewed for upgrade or downgrade. This process is described in further detail below. Fitch may elect to review transactions at any point should significant performance events occur or credit concerns regarding parties to the transaction arise. Monthly Review Process Step 1: Input Monthly Performance Data Utilizing an in-house database, Fitch inputs data included in monthly servicer remittance reports for each transaction, and performance is reviewed by a surveillance analyst. Step 2: Screener Review A screener is then generated through the use of algorithms specific to equipment leasing/loans transactions. Based on the levels of amortization, loss rates, and available credit enhancement, the screener will recommend that certain classes be reviewed for potential upgrade or downgrade or that no rating action is required. The performance of each transaction and the screener output is reviewed and discussed in a screener committee, which then decides which classes will be given a SMARTView date (meaning no in-depth review is necessary at that time) and which classes will be placed Under Analysis (meaning the transaction requires an in-depth review, which will generally be completed within a 30-day window). For more details on SMARTView, see Fitch Research on SMARTView, dated May 3, 2007, and available on Fitch s web site at www.fitchratings.com. Step 3: Committee and Rating Action Commentary For transactions placed Under Analysis by the screener review, Fitch compiles all data necessary to complete an in-depth review. This data may come from monthly remittance reports or be provided by the servicer. Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 15
Performance on the transaction to date may be compared with initial expectations, prior securitizations, and/or industry averages. Cash flow runs are completed using an in-house amortizing lease and loan cash flow model. These cash flow runs incorporate the current collateral pool characteristics and transaction structure as well as various assumptions on future losses, recoveries, delinquencies, and prepayments. Using the aforementioned data and analysis, the rating committee decides on each bond s rating. The primary and surveillance analyst subsequently issues a Rating Action Commentary with the final rating actions. 16 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
Appendix I Operating Leases Operating lease securitizations have primarily consisted of railcar and shipping container leases. Due to the nature of the underlying collateral in these transactions, most of the securitizations completed to date have been further enhanced by insurance policies provided by a monoline insurer. Fitch s analysis of these transactions takes into consideration additional factors due to the unique aspects of these types of leases and the underlying collateral. Typically, operating leases are full-service leases in which the lessor is obligated to provide an array of services on the equipment, including inspection, maintenance/repair, assistance in complying with federal regulations, support in responding to emergency leaks and spills, and payment of property taxes relating to the leases, among other things. The analysis of these transactions is also further complicated by the fact that the economic life of the underlying collateral is considerably longer that the lease terms. Key variables stressed in Fitch s cash flow analysis of operating lease securitizations include the following: Utilization and Rental Rates Fitch develops stressed utilization and rental rates based on historical averages and standard deviations of those averages. This analysis, however, also takes into consideration several factors, including lease rate cyclicality, the lessor s remarketing history and abilities, and residual and appraised value assumptions. Fitch will also incorporate stressed timing lags between changes in rental rates and utilization rates. Maintenance Expenses, Renewal Rates, and Inflation Adjustments Maintenance expenses on operating assets increase over time as the assets age, and, as such, Fitch projects rising maintenance costs. Stresses on the maintenance costs will also be affected by the accessibility of the maintenance providers. Renewal rates are assessed based on the lessor s pricing and extension history, the leasing history between the lessor and lessee, and the likelihood of renewal with the original lessee. Fitch assumes the original lessees do not renew and incorporates a remarketing lag time into our analysis of expected cash flows. Annual inflation rates are also typically applied to all nominal variables. Market Cyclicality Fitch reviews industrywide and issuer-specific rental rates and incorporates stresses reflecting this cyclicality. Typically, Fitch assumes alternating periods of several years, each reflecting steady-state and then stressed economic conditions. Management and Servicing Fees Fitch expects the defined management and servicing fees to be consistent with current market rates. Fitch s stress analysis assumes that a servicing transfer occurs and transaction cash flows will be negatively affected by above-market rates. Potential market participants would be more inclined to assume servicing responsibilities for a transaction if the compensation was above the current market rate. Due to the specialized nature of the underlying collateral, it is often important to incorporate a named backup servicer as a party to the transaction s documents. Lessee Concentrations Should the operating lease pool contain significant lessee concentrations, Fitch will apply a lessee stress by fair market value of the leased assets in addition to a stress via concentration by annual rental amounts. Fitch looks for the structure to withstand the default of certain top obligors over the life of the transaction. Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 17
Appendix II Construction and Agricultural Equipment Loan Securitization While Fitch s rating approach to CE and AG equipment loan securitizations is essentially similar to that used for equipment lease deals, the analysis is affected by several unique factors that receive additional scrutiny during the rating process. Fitch s analysis of these loans is refined by considering the mix of CE and AG equipment and the combination of new and used equipment in the pool being securitized. Additionally, the size, duration, and loan eligibility requirements of any prefunding amount, which may be up to 35% of the underlying collateral, are factored into Fitch s analysis. CE and AG equipment loan transactions are also reviewed in conjunction with Fitch s Corporate Finance and FI groups, which provide additional insight into industry and issuer-specific concerns and strengths that can affect a transaction s performance. Performance Factors CE and AG equipment are generally considered as essential use, as they are needed by the obligor to produce revenue. Consequently, loan performance as it pertains to delinquencies and defaults is affected by several factors. For CE loans, these include the general state of the economy, interest rates, housing starts, and government and private construction appropriations, all of which influence the demand for CE equipment. For example, a prolonged economic downturn will usually result in higher delinquencies and higher repossessions. Likewise, recovery rates and the time to recover on repossessed equipment (and therefore the losses experienced by a transaction) are more sensitive to which point in the economic cycle the equipment repossession takes place. Recovery rates on CE equipment loans are inherently affected by the nature and usage of the underlying equipment itself, as CE equipment tends to depreciate faster relative to AG equipment. Fitch also considers obligor, geographic, and equipment-type diversity, which can help mitigate the risk of regional economic downturns. AG equipment loan performance is affected by, among other things, commodity prices, government price supports, weather, and crop yields. Since AG equipment loan performance is not as correlated with economic conditions as CE equipment loan performance is, AG equipment pools generally tend to have less variable and lower default rates. Net losses in these pools also tend to be lower, as recoveries on repossessed AG equipment tend to be higher than those on CE equipment because AG equipment generally tends to retain its value better over time. Weather-related occurrences, such as floods, droughts, and other natural disasters, may also significantly affect AG equipment loan performance; however, geographic diversity and, to a lesser degree, government aid in the event of such disasters help mitigate this risk. Cash Flow Variability While most AG loans have monthly payment terms, quarterly, semiannual, and annual payment terms are also common, as the terms are often tied to the timing of expected cash flows from harvests. CE equipment loans typically have monthly payment terms but may have skip months during the winter, when the ability to generate cash flows from construction work is limited due to weather. Consequently, the seasonality of monthly cash flows in a transaction and its effect on the transaction s ability to make required monthly interest and principal payments are assessed during the rating process. Role of Dealerships The major manufacturers generally have extensive dealership networks. These dealer relationships are generally long-term (and often exclusive) arrangements with independent dealerships. The underlying collateral in CE and AG equipment loan securitizations is 18 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008
typically originated initially through the dealerships, which usually have entered into a retail financing agreement that allows them to sell financing contracts and/or leases to the manufacturer s captive finance company (if the financing agreements are in compliance with the captive s underwriting guidelines). Dealerships are subject to periodic financial review, and the agreements may be terminated due to, among other things, a lack of volume or a violation of dealer responsibilities in the retail financing agreement. The size and strength of a manufacturer s dealership network affect portfolio performance in several ways, as the dealerships assist in the collection process. Local dealerships are often aware of an obligor s financial difficulties, particularly in smaller, close-knit rural communities. Dealerships often augment the collection process through personal visits to the obligor and assist in developing collection strategies specific to an obligor and that obligor s financial situation. Obligors that are experiencing financial difficulties will typically return the equipment to the dealer. Recently, dealer consolidation has helped increase the strength of the dealership networks. Equipment Descriptions Agricultural equipment generally includes tractors, combines, cotton pickers, soil management equipment, planting and seeding equipment, hay and forage equipment, crop care equipment (e.g., sprayers and irrigation) and small telescopic handlers. Construction equipment generally includes excavators, backhoes, wheel loaders, skid steer loaders, tractor loaders, trenchers, horizontal directional drilling equipment, telescopic handlers, forklifts, compaction equipment, crawlers and cranes. Role of Excess Spread Excess spread is often a significant component of overall credit enhancement in CE and AG equipment loan transactions. Fitch s review includes an analysis of cash flow models under several default timing scenarios, including front-end loaded timing. This better reflects the effect of a loss of expected excess spread. The annual percentage rate (APR) distribution is also analyzed to assess the effect on excess spread if high APR receivables default or prepay faster than historical rates. Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008 19
Appendix III Residuals As the equipment ABS market becomes increasingly dominated by the securitization of larger balance finance leases and loans and the number of issuers of conventional equipment lease products continues to shrink, the residual component of equipment ABS has changed to follow suit. Once monetized, equipment residuals sold to an ABS trust in Credit to Residuals Rating Category Residual Credit Range (%) AAA 30.0 50.0 AA 40.0 60.0 A 50.0 70.0 BBB 60.0 80.0 BB 70.0 90.0 B 80.0 90.0 recent transactions typically serve only as an additional form of credit enhancement. As such, credit to residuals will be reviewed on a case-by-case basis. Throughout the process, Fitch s analysis focuses on three primary factors: the determination of booked residual values; the method of realization; and the consistency and volatility of historical realization rates. For lease pools for which the lessor has substantial realization history, if credit is warranted, residuals sold to the trust may be used as a supplementary form of credit enhancement. Proceeds from residual realizations are then available to cover monthly interest and principal payment shortfalls or to replenish the cash reserve account to its specified balance. Fitch examines residual booking policies for consistency and conservatism. Stratifications by equipment type and the size of the booked residuals as a percentage of the original equipment cost are central to Fitch s residual analysis. Fitch reviews residual pool stratifications for any equipment type, equipment manufacturer/vendor, obligor, or geographic concentration. If large manufacturer/vendor concentrations exist, Fitch investigates the financial strength of such entities, as they may be relied upon for remarketing assistance and/or loss recourse. Additionally, Fitch takes into consideration the risk of technological obsolescence, the essentiality of the equipment for the lessee s day-to-day operations, and the existence and strength of any manufacturer/vendor support programs. In the case of specialized equipment, the extent to which third parties are available to provide basic service and maintenance on the equipment is assessed. The size of the secondary market for equipment types, as well as de-installation and refurbishing costs, affect the timeliness and rate at which residuals are realized. When analyzing historical residual realization rates, Fitch focuses on realization methods. Typically, residuals are realized in one of the following four ways: the exercise of the purchase option by the original lessee; month-to-month lease extensions to the original lessee; re-leasing the equipment to a new lessee; or the remarketing and sale of the equipment in the secondary market. Historical rates at which equipment is either sold or re-leased back to the original lessee may decrease the reliance on remarketing the equipment to realize residuals. Based on this analysis, Fitch determines a haircut on the amount of credit assigned to the booked residuals. The size of the haircut varies by rating level and takes into account the rate at which residuals are booked. The amount of credit given to residuals is also affected by Fitch s expected default rates at each rating level. Residuals on defaulted leases may not be realized, since the underlying equipment may be sold and the cash proceeds recognized as a recovery on the defaulted lease. Often, residuals are trapped in a residual reserve account until a predetermined requirement is met. Trapping can either be structured to start immediately after the 20 Rating Criteria for U.S. Equipment Lease and Loan Securitizations June 16, 2008