Issuance of securities backed by franchise loans dropped dramatically in the first half of 2000 over 1999. Only two securitizations were completed in the first half - Enterprise Mortgage Acceptance Corp. (EMAC) and Captec Financial Group - compared with over ten transactions in all of 1999. In addition, two regular issuers - Atherton Capital and Franchise Mortgage Acceptance Corp. (FMAC) - utilized the whole loan market in the second half in lieu of the securization market.

Two reasons led to the significant reduction in volume. First, the subordinate tranche market was weak (particularly for longer-term securities) in the first half of 2000 with historically wide spreads relative to treasuries. In most franchise loan securitizations, a commercial mortgage-backed securities-type structure is employed in which a trust issues securities ranging in ratings from triple-A to single-B. In a turbulent subordinate market, selling sub-investment grade classes is difficult at perceived reasonable interest rate levels, making securitzation uneconomical for some issuers.

A second hindrance to first half 2000 issuance was the credit problems of large business value or enterprise loans in several transactions. In a business value loan, the borrower does not own the land or building but rather leases the unit from a landlord. In Global Franchise Trust 1998-1, the trust will likely take a large writedown due to problems with a loan to a large operator of Denny's units. The borrower filed for Chapter 11 bankruptcy protection in January 2000. In May 2000, a bankruptcy court approved a sale of the collateral, resulting in minimal recoveries for the trust.

FMAC, a pioneer in the franchise loan industry, also experienced turbulence in the first half. Two FMAC transactions were affected by writedowns of business value loans: 1997-C and 1998-A. A large borrower that was common to both transactions experienced financial distress; in a sale of the bankruptcy estate, the trust recovered less than $1 million on the loans that totaled nearly $9.5 million. After repayment of servicing advances and other expenses to the special servicer, no recoveries were left to repay the trusts.

The problems in these transactions point to the risks inherent in business value loans. Because the collateral consists of the right to operate units and not ownership of the underlying land and building, recoveries on such loans can be very volatile. The typical method for recovery on such a loan is replacement of the operator and resulting assumption of the loan. If an alternative borrower cannot be put in place to assume the loans, the business value essentially evaporates, leading to little or no recoveries. While recoveries on most of the business value loans in franchise loan pools have been high (typically over 50% with 90% recoveries not uncommon) recent experience indicates that the lower bound on such loans is 0%.

A loan with a high business value relative to the loan amount should not provide substantial comfort for investors due to the volatility in business values; for example, the business value of the collateral supporting the largest loan (initially $29 million) in the Global Franchise Trust pool was appraised at $42 million by an accounting firm at the closing of the loan, resulting in an LTV of 69%. However, two years after the appraisal, the recovery on the loan was less than $5 million.

In contrast, loans supported by real estate will likely have a much lower level of recovery volatility, particularly in situations in which the real estate value is high relative to the loan amount. Recovery volatility is further reduced in situations in which the loan is supported by multiple units which are cross- defaulted and cross-collateralized; in a default, some units may have low recoveries, but shortfalls from these units will be countered by units with high recoveries.

Higher recoveries for real estate loans reflect the wider array of alternatives for the lender in the event of a borrower default. If the concept is not in distress, the option that most likely leads to the highest recovery is a sale of the unit to an operator in the same system and assumption of the related debt; in that case, little or no refitting of equipment or fixtures is necessary and a relatively seamless transfer is possible. If the concept is performing poorly, an operator in another concept can be put in place. Recoveries under this scenario will likely be lower than in the first case due to the cost of replacing the equipment, furniture, and fixtures. Typical costs for these items range between $50,000 to $200,000 per unit. Other franchisors or third-party vendors may be willing to assume or finance these costs at attractive rates to enhance market share. The third possible exit strategy is a conversion of the unit to an alternative use, most likely a retail operation. This option will lead to the lowest level of recoveries for a lender with real estate as collateral. However, for loans supported by multiple units, conversion of all of the units supporting the troubled loan to alternative uses is unlikely.

In contrast, the only workout strategy that will lead to significant recoveries for business value loans is strategy one, finding another operator in the same concept to assume the loan. Estoppels or non-disturbance agreements between the landlord and the lender may mitigate some of the risks of business value loans; these agreements generally call for notification of the lender by the landlord of delinquent lease payments and give the lender the opportunity to cure the delinquent lease payments while a substitute tenant can be put in place. However, even with estoppels or non-disturbance agreements, problems at the franchisor level may lead to reluctance on the part of other operators to step in as a tenant and assume the loan, leading to low recoveries on defaulted loans.

Furthermore, even if the franchisor is healthy, low recoveries will result if the franchisor does not cooperate in the workout process. For example, business value collateral evaporates if the franchisor does not allow the lender's designated operator to assume the franchise agreement and operate the stores. Franchisor reluctance to approve successor operators may also frustrate the workout process. Obviously, franchisor cooperation is also important for real estate loans; however, a lender with real estate has the option of selling the unit to an operator of another chain or converting the property to another use.

Investors should be aware that some real estate loans have a high business value component. Suppose that a $1 million loan is extended and supported by land and a building valued at $600,000. In this situation, higher expected recoveries can only be expected on the $600,000 appraised real estate component, with lower expected recoveries on the business value component, which is the excess of the loan amount relative to the real estate value. Thus, breakdowns of business value versus real estate in pool descriptions may be misleading.

However, recent problems with business value loans does not imply that this type of lending is dead. As noted earlier, the recovery experience for business value loans has been quite good, generally over 50%. An examination of the recovery history of business value loans indicates that the high recoveries have generally related to units tied to top-tier concepts. For top-tier concepts, the pool of operators willing to step in and assume the loan is larger. In contrast, business value loans tied to lower-tier concepts generally have lower recovery values. Some SBA loan pools have concentrations in these loans made to operators tied to third and fourth tier concepts; as it is generally difficult to find an operator willing to assume the units, recovery values are limited to sale of the furniture, fixtures, and equipment and tend to hover around 10%-30%.

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