Will a few bad apples spoil the apple cart? This cliche may be an appropriate metaphor when discussing securitization and the small ticket sector of the equipment leasing industry. In the past, the industry has periodically endured the trial of some members falling into severe financial distress, often resulting in bankruptcy. Reasons for such distress have varied from the relatively mundane such as poor credit underwriting or bad financial management, to the outrageous, such as the creation of fictitious receivables seen in the 1996 Bennett Funding collapse. These untimely events have led to some form of re-evaluation by the industry's funding sources, often leaving those without funding diversity in the midst of a credit crunch. In turn, this further exasperates the problem for the struggling firms and may even spill over to create problems for stable companies. As history has a tendency to repeat itself, the last couple of years have not been without its headlines for the equipment finance industry.
Those Who Live By The Sword, Die By The Sword
Since 1998, Standard & Poor's counts at least six severely distressed situations which have resulted in bankruptcy, liquidation or substantial creditor oversight. While, the causes contributing to such crises are somewhat unique to each lessor, they are also variations of a single theme - the changed macro environment of the industry. When the industry's main barrier to entry - access to capital - was lowered, fast growing new entrants swept through heightening competition. This caused the typical trickle down effects of steadily increasing vendor and broker expectations (and less loyalty) and steadily decreasing pricing. As bigger suddenly became better, volume growth was the strategic goal.
Underpinning all of this were very accommodating debt and equity capital markets. Added to this were the much talked about gain-on-sale accounting tactics which fuelled equity investors appetite for earnings, but also masked true profit margins. But just as many of the troubled lessors were spawned by such a market environment, they are now being sacrificed by it's new order. As the equity markets changed focus, many lessors took the positive step of moving away from gain on sale. However, it became apparent that a few lessors' gain-on-sale costs could not be supported by on balance sheet revenue recognition. In some cases, the losses violated bank covenants and/or triggers in mono-line insured securitizations. The result was clear: capital was and continues to be less available and more expensive. For some players, the world had changed.
Every Cloud Has A Silver Lining
The recent upheaval, which has resulted in an industry consolidation and shake-out, may be a blessing in disguise. Standard & Poor's believes that a corner has been turned. Although the cost of capital remains higher than it was a couple of years ago, there are anecdotal signs that lease pricing is beginning to stabilize and that lessors are becoming more focused on properly aligned cost structures. Consolidation and the move away from gain on sale accounting has lessened origination pressure, providing lessors the luxury to either re-evaluate pricing or exit unprofitable niches.
What this means for investors of equipment-backed paper is hopefully a more stable line-up of issuers. However, it is unlikely the tiering between large and small issuers will go away. Furthermore, recent events have tested securitization structures and provided the market with some case studies. Most have held up satisfactorily, and servicer transitions have successfully been implemented, albeit with some bumps along the road. Standard & Poor's has yet to downgrade an equipment lease securitization for performance-related reasons, though admittedly many of the recent troubled deals have purposefully benefited from a full bond insurance wrap - where the insurers have played key roles in administering the deals.
Not Out Of The Woods Yet...
The one important wild card that could alter the perception of the industry is, of course the economy. Solid collateral performance has been the overriding positive characteristic of the industry and more specifically, securitization of equipment finance receivables. While other asset finance sectors, namely sub-prime consumer finance, experienced similar credit crunches and shakeouts, poor collateral performance also played an important role in the demise of many sub-prime lenders. Clearly, asset performance is directly correlated to the general health of the economy which has been good for several years. When an economic downturn occurs, lessor's underwriting skills will be directly tested much like the last few years were a test of lessors' business models and financial management.
In general, collateral performance in Standard & Poor's rated equipment finance securitizations have been in line with expectations. While there have been individual cases of loss and delinquency spikes in certain pools, none have been so severe to warrant any type of rating action. Nonetheless, the reasons behind the increases validate the need for the securitization market to perhaps refocus on important structural areas that have been diluted over time - servicing transition plans and the relationship between historical data and transaction eligibility criteria. Most of the performance deterioration relative to expected losses have been either (1)due to the combining of servicing platforms for issuers that merged, or (2) isolated credit problems, often euphemised as "administrative delinquency" related to specific vendor programs or other large concentrations.
Planning upfront for the potential transition of a servicer deserves more attention and thought, particularly when dealing with smaller, thinly capitalized servicers. Size and structure of servicing fees, upfront testing and conversion feasibility of systems and even trustee control of collections are all elements that can greatly enhance the administration of a problem deal. In addition, eligibility criteria limiting various concentrations at the vendor, broker and obligor level may be necessary to ensure historical data is a proper proxy of future performance. With the niche focus of the vendor finance and strong desire to enter into new vendor relationships, applicability of historical data may be questionable.
For now, problems in the market's lower end appear to be fading and a period of stability may be in the offing, so long as the economy stays steady. While lessons can be drawn from the recent events, overall collateral performance has remained in check and securitization structures have worked. With the wide ranging credit profile of the sector's issuers and the niche focus of commercial finance, equipment-backed securitization has something to offer throughout the risk spectrum, depending on investors' tolerance.