After having just closed this summer, Frans 2003 plc - an equipment enhanced trust certificates (EETC) transaction backed by payments from Air France - saw its unwrapped class B securities come under pressure. This came after reports last week of a possible merger between the French airline and Dutch carrier KLM.

Merger talks between the two airlines are still being ironed out but Moody's Investors Services and Fitch Ratings, which rated the deal, are closely following the developing situation.

"So far we've had different reactions from the two agencies - but both will focus on the legal corporate structure of the alliance," said a source at Credit Lyonnais who worked on the EETC transaction earlier this year. "But we expect the review will take some time, primarily because, for the time being, the alliance is just being talked about. Before it manifests into anything permanent, it will need to receive the proper stamp of approval from the authorities to move ahead."

How much time that could take is still subject to varying speculation. On the one hand, market sources say that the merger talks right now are short on detail about the structure. But on the other hand, if the merger results in Air France having to increase its dividend to the new holding company, it could jeopardize the company's existing corporate rating (the corporate rating for Air France is not public).

"This is mitigated to some extent by the holding company's results being a consolidated picture," said analysts at Fitch. "Thus, if its dividend payout ratio is fixed, the dividend payment would fluctuate accordingly. But if the holding company's management wanted to maintain its dividend when KLM was underperforming then Air France would be under pressure to increase its payout." This type of cash leakage could harm the corporate rating of Air France.

Reviewing EETCs

EETCs are not technically securitizations; the deals are structured and secured by aircraft, and often sold to the same investors that buy pooled aircraft lease securitizations. One primary difference between EETCs and aircraft lease deals is that aircraft lease securitizations are backed by payments from multiple obligors. In contrast, EETCs have only one obligor. As a result, (EETCs) deals might be more vulnerable to continued ratings action because the debt is supported by payments from a single airline and rating methodology links the EETC credit worthiness to the rating of the underlying airline. The rating agencies prefer to assess these transactions via a combined effort of the structured finance and corporate finance groups.

According to Moody's, the risk transferred to the credit-linked notes in the transaction is affected by whether the airline which owns the aircraft has gone bankrupt or has refused to pay amounts due to the credit default swap servicer. Another potential drag on the rating would be a drop in value of the aircraft, so that it is insufficient to repay the outstanding financing on the aircraft. Only if both situations occur at once is there a loss determined that must be covered by the available credit enhancement.

However, if the airline were in default, the servicer would react by putting the aircraft for sale. After one year, if the sale has not been completed, the collateral value will be the aircraft's base value. Moody's defines the base value as "the price the aircraft gets in a liquid market between a willing buyer and seller and not the fire-sale price which might be obtainable in the current market." Three independent appraisers determine this base value.

Under the Frans 2003 structure, only one of the three tranches is susceptible to the potential knockdown of Air France's corporate rating. This is because the class A1 and A2 notes have their triple-A ratings backed by a monoline guarantee, whereas the class B notes - rated single-A - are unwrapped. Moody's preliminary reaction last week was to place the Class B notes under review for downgrade and say that the proposed business combination of the two airlines could alter Air France's ability to meet its obligations under the transaction documents.

Despite highlighting the same risk exposure, Fitch last week entertained a more optimistic approach and said that - like Moody's -it will continue to review how the business structure develops within the alliance. The rating agency did not immediately see this as adversely affecting the corporate rating of Air France, thus affirming the ratings of Frans 2003. Analysts at Fitch reviewing the transaction said that there is credit-linkage to the corporate rating and, at the moment, it is important to follow what business plan that merger would yield. Air France does not intend to guarantee or support the creditors of KLM and the funding of Air France will be ring-fenced from that of KLM.

Due to the relative newness of the transaction, the agency had not undertaken a review of its performance in terms of the underlying collateral, nor in terms of aircraft values or in foreign exchange since closing. "We have had a few questions from investors but nothing of great importance," said the source at Credit Lyonnais. The source added that the bank and other industry players tended to agree with Fitch's approach because of the limited details released so far with regards to how the alliance would play out.

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