The franchise loan industry experienced its share of indigestion in 2001, as collateral performance industry-wide continues to decline. Delinquencies and defaults have risen and losses have begun to flow through to investors. As part of Fitch's continued focus on the franchise industry, an index was constructed to aggregate the performance of all deals and monitor the industry as a whole by both issuer and vintage.
To be included in the index a deal must have been closed no earlier than 1996, have been sold into the public or 144A market and contain mostly QSR and C&G loans. Currently, 37 transactions are entered into the index. The index is run on a quarterly basis and tests the following industry vital signs: current collateral and securities outstanding; cumulative and monthly losses; and both the number of borrowers and dollar amount of loans that are either delinquent greater than 60 days and/or defaulted.
The third quarter of 2001 saw delinquencies fall dramatically, from just over $300 million at the end of the second quarter to about $125 million at the end of the third quarter. While many would like to believe this drop signals the bottoming out' of the market, that conclusion may prove presumptuous. Instead, expected softening in the economy will maintain the pressure on franchisees as stores struggle to stay above water.
A look at defaults over the last twelve months will reveal that the current level of defaults has more than quadrupled from $200 million in September 2000 to over $900 million in September 2001. Similarly, there was a quadrupling of borrowers in default from 42 in September 2000 to over 180 in September 2001.
Although at the end of 1Q01 50% of the then-current defaults were concentrated in one issuer, the end of the second quarter saw defaults not only rise but diversify throughout several issuers. The natural maturation of any market is sure to include rising delinquency and default curves as the collateral matures through its "peak loss" period or experiences some growing pains. Fitch believes that the industry's sustainable or expected loss rates should be far below the 12% of the collateral that has already defaulted in their first three years.
It should also be pointed out that high losses were anticipated to a certain extent. Despite only 50 basis points of loss for the industry prior to 1996, these deals were consistently structured with between 20% and 30% enhancement at the AAA level.
Factors that Fitch believed contributed to this poor performance are:
*Increased competition among lenders leading to aggressive underwriting.
*Inaccurate or unsupported valuations.
*Inconsistent FCCR calculations.
*Reliance on pro-forma data.
*Sharp sales declines. (Taco Bell, Burger King)
*Volatility of gas prices.
Fitch is currently tracking nearly 300 instances of default and has observed 90 workouts throughout its transactions. These workouts are classified into two primary groups, liquidations and restructures, and are monitored for the impact to the trust only. The recovery rates are calculated as the sum of all recoveries received on the loan net of any principal and interest advances, protective advances, legal fees, and any other expense of the trust related to the loan, divided by the principal balance of the loan at recovery or if not available, the most recently reported balance.
An attempt to view recovery rates by collateral type was made. However, this proved to be somewhat of a challenge since recoveries for an entire borrower are aggregated and not always reported on a property by property basis. To overcome this issue, Fitch has grouped the liquidations by primary collateral type. For a collateral type to be deemed primary there must be at least a two-to-one ratio of that type of collateral to all others.
The fee simple is the largest of the four categories, with 28 liquidations observed to date. Cumulatively these loans have recovered at 60% while the average recovery rate has been just over 70%.
Due to the relatively high number of observations for this collateral type, these loans have been further broken down into small, (less than $1 million) medium (between $1 million and $10 million ) and large (over $10 million). This breakdown by size has uncovered an interesting finding. The larger the loan, the smaller the recovery.
The large loans liquidated thus far have recovered on average just over 50%, while the medium-sized loans have yielded an average recovery of over 65% and the small loans have seen average recoveries of 85%. While there are many factors in the level of recovery, Fitch believes this pattern to be primarily the result of two of those factors. The first is the simple rule of supply and demand, which dictates that the larger the loan the smaller the market with the ability to purchase that loan (or access to the shrinking pool of lenders willing to finance the purchase) and, consequently, the smaller the premium willing to be paid for it.
The second reason can be traced back to underwriting. Since the impression that the incidence of aggressive underwriting and overvaluation are problematic if not rampant, it is conceivable that potential buyers or lenders may believe these miscalculations became exaggerated in the larger loans as the unit level loans were rolled up.
Liquidations of leasehold (groundlease, leasehold mortgage) loans have proven to be the most volatile with recovery rates ranging from 0 to 100%. Of the 23 observations reported, only six have recovered better than 50%, while 10 have recovered 0% and a total of seven recovered less than 50%. The average recovery is only about 30%.
In many instances the low recovery rates can be attributed to a lack of hard asset value in loans. Without owning the land, the only asset of material value is the building. Since this loan defaulted it is reasonable to assume that not all maintenance was performed as any excess funds were likely used to make loan payments, which could impact the building's condition.
Restructures have been used less frequently as a method of workout, as only 19 have been observed to date. It seems that restructures are the workout of choice for larger loans as the average balance of a restructured loan is well over $10 million.
This is consistent with the recovery theory of large loans. With a relatively small market to sell to, often the maximum recovery can be obtained by working with the borrower to restructure the loan. The types of restructures seen so far have included a combination of an interest-only periods, extended amortization, partial principal write-down, the creation of balloon payments and the bifurcation of loans into senior and subordinate tranches. Restructured loans have produced the highest recovery rates (76% on average) but not without challenges. The restructure of loans often creates liquidity concerns (usually expressed as an interest shortfall) for bondholders.
Unlike a liquidation where the trust receives proceeds from which it repays advances, a restructure normally has no proceeds flowing into the trust, and advances are recouped in the order prescribed by the deal's governing documents. Typically, this means the servicer is repaid prior to investor distributions from trust collections, which will short interest payments to subordinate classes. Of the 19 loans restructured, 5 have already returned to delinquent or defaulted status a second time, with one undergoing a second restructure and 3 requiring liquidation. While many of these restructures have only occurred in the last nine months, it remains to be seen how valid this workout option will prove to be. This method of workout may ultimately just delay the inevitable.
It's also important to remember that this asset class is extremely concentrated, with the top ten borrowers comprising on average between 60% and 70% of a given pool and single loans representing as much as 12 to 15% of the pool. This reality and the volatility of recoveries have already led to downgrades of investment grade and non-investment grade bonds often by a full letter grade or more. In the placement of classes on Rating Watch, Fitch has attempted to identify to investors those situations in which large obligors are in distress or a significant portion of the pool is otherwise impaired.
Fitch's continued diligence in the monitoring of these transactions has resulted in a series of downgrades across five issuers. As of October 12, 2001 Fitch has taken nearly 70 rating actions on 15 different deals.
The franchise lending industry has experienced a pronounced tiering of its issuers. Issuers seem to fall into one of four categories: 1) Large and in charge (FFCA now with GE, CNL, ACC now with Wells Fargo, MSDW). 2) Down but not out. (Amresco, Atherton). 3) Barely hanging on (Captec, Peachtree). 4) Gone but not forgotten (EMAC, FMAC, CSFC, GACC). The turmoil in the industry has supplied many lessons learned for issuers, rating agencies and investors alike and while little if anything can be done to aid the existing deals, future deals should prove structurally superior and demonstrate stronger performance.