As of mid year 2000, volume in the franchise sector of the asset backed market has fallen relative to 1998 and 1999 with issuance topping the one billion mark. The lack of issuance has been partially driven by ratings' action on four of the 50+ franchise securitizations along with choppy capital markets within the private placement sector. The franchise sector was highly competitive through 1997 and 1998 causing some lenders to compromise their credit standards through concessions on interest rate, security (collateral) and covenants. Ultimately, this will lead to a tiering among franchise originators. Lenders that maintained their underwriting discipline will rise to the top of the tiering scale and continue to provide good underwriting for loans supporting future securitizations. In fact, some issuers such as Franchise Finance Corp. of America and American Commercial Capital have announced strategic alliances with large commercial banks to increase the liquidity of their originations. Fitch anticipates that more franchise lenders will follow a similar path as interest rates rise and the securitization market becomes more selective.
Recent rating actions by Fitch, within the franchise sector on FMAC 1997-C, FMAC 1998-A, FMAC 1998-B and Global Franchise Trust (GAFCo) 1998-1, were taken due to realized losses or the potential for large borrower concentration losses within each of the pools. These actions are not necessarily an indication that franchise paper is following the deteriorating performance witnessed in the home equity and sub prime auto sectors.
One commonality among workouts is that the ability to affect healthy recoveries by a special servicer is directly related to the underwriting standards of the originator. Lenders that utilized strong collateral combined with the appropriate covenants gave their workout team better tools to affect higher recoveries and reduce net losses to bondholders. The following are some of the anecdotal, yet significant, observations by Fitch regarding recently defaulted borrowers:
*In some cases, the lender did not require covenants linking debt of a subsidiary to its parent company which may have led the special servicer to affect higher recoveries. Ultimately, the lack of any "upstream" covenants leaves special servicers at a disadvantage while negotiating with the borrower or the bankruptcy courts. If the collateral in the underlying subsidiary is significantly impaired, the special servicer may have no recourse to the parent company in recovering the impairment caused by negligence.
*Some operators were financial buyers that sought returns on an investment as opposed to managing a business for the long term. These operators tended to have a minimal amount of operating experience, which eventually led to declining sales and profitability.
*Forced liquidations in bankruptcy typically result in a sale based upon collateral value (land, building and equipment) as the cash flow or business value is impaired. In cases of leasehold collateral, only below market lease agreements provide any "equity" or incentive to potential buyers. In either case, the new operator may have to negotiate a new lease agreement with the landlord prior to assuming the sites.
*In cases where the special servicer was able to foreclose upon the collateral and avoid bankruptcy courts, temporary management teams can be utilized to restore operations and the business value of the company. In some cases, a competent management team can restore business value, service debt and assist the special servicer in avoiding extreme losses. This affirms the notion that management plays a large part in maintaining cash flow within a viable brand.
*In some cases, borrowers did not maintain an appropriate level of capital expenditures. The lack of capital expenditures resulted in an offset (reduction) to the valuation of the collateral. In some instances, the franchisor would not allow the special servicer to bring in a management team unless a significant amount of capital expenditures were used to bring the units up to the franchisor's standards. Without the capital expenditures, the franchisor could remove its brand name from the units, which would further impair the collateral value.
*Sales taxes and/or property taxes were left unpaid prior to default, creating senior liens that could lower recoveries.
*In the months prior to default, borrowers stretched their operating accounts and working capital to their maximum to maintain debt service.
*Personal guarantees do assist the special servicer in demanding cooperation from the borrower.
Fitch believes that franchise lending still needs a level of standardization regarding covenants imposed by the lender and the calculation of fixed charge coverage ratios (FCCRs). In addition, servicers need to provide greater detail to the marketplace as a pool seasons and certain borrowers prepay and change the composition of the pool. Reporting standards such as updating FCCRs and collateral composition are a must for servicers. For problem loans, special servicers should be able to provide periodic reports on delinquent or defaulted borrowers to identify the problem at hand and the intended resolution by the special servicer.
Currently, the market has a level of uncertainty with franchise paper that is primarily driven by the scarcity of information regarding the current strength of each pool. A majority of the franchise pools are performing well as not all originators have waning performance. Fitch believes the franchise sector in general is a sector that can show good performance if underwritten with good collateral, covenants and a reasonable degree of leverage. However, Fitch will use the recently gathered data from all franchise loan defaults to complement Fitch's default and recovery assumptions in modeling credit enhancement. This loan level analysis combined with an in depth review of the originator's and servicer's capabilities will provide investors with the most complete and accurate assessment of a transaction's risk profile.
