While a servicing downgrade does not necessarily indicate portfolio deterioration, systematic delinquencies and defaults in Franchise Mortgage Acceptance Corp.'s asset-backed securities are driving up the industry's weighted averages, creating what some participants are calling a "black cloud" over the franchise asset-backed securities market.

"I think the black cloud may be somewhat overstated," said one investment banker who works with franchise ABS. "Clearly there's a black cloud over FMAC, but I think people in the sector are trying to do their best to differentiate between what FMAC is doing and what others are doing."

One visible impact on franchise ABS is that most deals going forward will be wrapped. Franchise Finance Corporation of America's last deal, which priced in December, was insured by MBIA.

"I don't think that that's a phenomena that will be long-lived," the banker said. "I think it will last until people start to understand why FMAC pools performed the way they performed, and why the lending that other parties have done differs, and that other people's pools are not performing like FMAC's."

Last week Standard & Poor's Ratings Services lowered its rating on FMAC's servicing from above average to average, citing employee turnover as one factor.

However, sources are saying that there are other, equally severe problems associated with the portfolio, stemming from less-than-prudent underwriting and overleveraged loans. This, combined with the credit deterioration of several obligors, has negatively effected the recovery rates, those sources said.

FMAC's portfolio has significant exposure to Taco Bell and Burger King. Taco Bell, for instance, has suffered deterioration in customer sales due, in part, to product quality issues, according to published reports.

However, because a high percentage of FMAC loans were business-value loans, as opposed to loans against hard collateral, recoveries are more difficult, especially when the credit problems are related to branding issues.

"Some have said that there's just a limited amount of good loans out there, and the only way to do $1 billion a year is to walk down the credit spectrum," said an analyst who covers the franchise industry. "I talked to an issuer who said, in some deals, for example, they would be willing to advance $5 million, where FMAC was giving out, say, $11 million."

"They lent people more money than the competition was willing to lend, and that's how they got the deal," the investment banker said. "Investors began finding out the hard way that the recovery percentages that had been assumed were not coming to fruition, and that's basically because the lending was very much focussed on business value, where you had very little hard collateral."

Servicing vs. Underwriting

With FMAC, sources differ in their opinions on whether the problems are more attributable to the underwriting or servicing, but most agree it's some combination of both.

As S&P noted, there have been employee turnover problems at FMAC, most severe following the announcement by Bay View Capital, FMAC's parent company, that FMAC would end its origination business.

"If you're an employee, that's kind of a one-way ticket to nowhere," the investment banker said. "What are you going to do? You've got a portfolio that's going to liquidate or amortize on its own."

One source close to what's happening at FMAC said that the remaining servicing staff have little experience servicing franchise loan.

"The credit problems appear to be much higher than what is probably really the case," the source said.

However, Joseph Godley, a senior vice president at FMAC, disagreed.

"If anything, we've even added to our asset management group," he said. "Our group is made of experienced commercial workout individuals, and we have an individual who was a senior vice president at Old Kent Financial Corp."

Godley added that, while S&P lowered its rating on FMAC's servicing to "average," to his knowledge, FMAC might be the only S&P-rated franchise loan servicer with a rating as high as average.

"The deliquencies are from a concept level," Godley said. "We're experiencing delinquencies from a concentration of a few select concepts."

Regardless, it is rumored that, within the last two weeks, FMAC has retained an industry professional and his team to assist with the servicing. Ironically, this pro was originally with a potential buyer of the FMAC portfolio, and was hired on by FMAC after taking a look at the operation. The potential investor and FMAC were unable to come to terms, the source said, but FMAC retained the due diligence team.

FMAC's Godley did not comment on this rumor.

The Same Old Story

As the banker was suggesting, the FMAC performance data is an exception, when compared to other franchise issuers, such as FFCA or Enterprise Mortgage Acceptance Co. (see chart below).

"What's interesting is that what's happening in the franchise world is what we're finding in other sectors," said Paul McCarthy, an analyst at Fitch who has been following FMAC closely. McCarthy was referencing the recent default study Fitch released concerning ABS, MBS and CMBS.

"We've found that if you're going to drill down into each sector, you'll find that defaults are concentrated," he added. "Sometimes they're concentrated by industry, and sometimes by issuer. That's pretty identical to what we're seeing in franchise."

"FMAC is the ContiFinancial of the franchise loan industry," said one ABS research analyst. "People were saying, we won't do these loans, but FMAC will. That's what people were saying about Conti back then."

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