Equipment leases were one of the first asset types to be securitized, beginning in 1985 with the securitization of Sperry Finance computer leases. Although still a relatively small niche within the asset-backed securities market, the investor base for lease-backed securities continues to grow as investors have become more comfortable with the asset class and have increased their exposure to equipment lease asset-backed securities (ABS). Heightened investor acceptance can be attributed to a number of factors, including increased market activity, larger deal sizes, a steady amount of issuance from larger, repeat issuers, and a desire by investors to diversify some of their holdings away from consumer-related ABS. The leased equipment is typically essential to the obligor's day-to-day operations, and the obligors are typically diversified in terms of both geographic and industry concentrations. Prepayment risk is minimized by the "hell-or-high-water" lease provisions that discourage prepayments. Several issuers often substitute new leases for prepaid leases, thereby helping to provide stability and the ultimate realization of the average life expected at the time of pricing. As the underlying leases are typically five to seven years in duration, the average life of transactions is in the two- to three-year range, and average life sensitivity to change in CPR assumptions is often minimal.
Equipment lease issuers frequently access both the public and private markets simultaneously in the same transaction by issuing the senior classes in the public market and subordinated classes via private placements. Often, there is a class that is rated AAA' that is split into a money market tranche and several other tranches with varying maturities. Requests for classes rated BB' and B' increased in 1999 after dropping considerably in the aftermath of the August 1998 bond market downturn but have declined more recently. In many cases, these below investment-grade-rated subordinated classes are held by the originator/issuer.
Through June 30 of this year, there was just over $5 billion of equipment lease-backed issuance. Most of the transaction volume this year has been attributable to public transactions from the larger issuers that have utilized the securitization market frequently over the last several years. These issuers include Case Credit Corp./New Holland, Copelco Capital, The CIT Group/Newcourt, Advanta Corp., IKON Office Solutions Inc., DVI Financial Services and SierraCities.com/First Sierra Financial Inc. Fitch anticipates that equipment lease ABS volume will decline slightly in 2000 relative to 1999 issuance. Many current issuers and potential issuers face a liquidity crunch that has curtailed issuance. Additionally, there have been several recent acquisitions of frequent equipment lease ABS issuers by well-capitalized banks that do not necessarily need to utilize securitization as a funding source.
Although Fitch has not noticed an across-the-board increase in defaults or delinquencies in the more than 100 equipment lease ABS transactions that are currently monitored, Fitch has noted a decline in the performance of transactions currently serviced by several issuers that were not well positioned to sustain the current liquidity crunch. The liquidity crunch, consolidation and a number of other developments in the leasing industry also pose challenges in the rating analysis of future transactions. Fitch also expects additional tiering among issuers as the securitization market becomes more selective in light of these developments in the equipment leasing industry.
Funding Crunch
The leasing industry is facing a funding crisis due to, amongst other things, rising interest rates, concerns about the impact of rising interest rates on portfolio performance, recent high profile bankruptcies or liquidations of several established lessors, and further consolidation of funding source banks. Many public lessors have also suffered large and often dramatic declines in their stock prices. Other lessors have scaled back their leasing activities or have pulled out entirely of certain leasing areas. Many smaller lessors, often in their growth stage and historically heavily reliant on securitization in the past, have been unable to raise funds in the asset-backed arena due to unattractive spreads and larger advance rates. These companies have been further hampered by their inability to access the debt or equity markets. Large stock devaluations, often triggered in part by lessors moving away from gain-on-sale accounting, have also prevented many public companies from completing secondary offerings. A number of lessors who relied heavily on gain-on-sale accounting in the past have also made the painful transition off of gain-on-sale accounting. Fitch expects that the liquidity crunch will curtail issuance in both the public and private markets.
Consolidation Continues
Economies of scale, cost reduction and increasing market share are primary drivers of consolidation in the leasing industry. One of the more prominent consolidations in the leasing industry took place in November of 1999 with CIT's purchase of Newcourt. UniCapital Corp. utilized a unique roll-up strategy by acquiring 14 small leasing firms with the proceeds of their IPO in May of 1998. More recently, several of the larger and frequent equipment lease ABS issuers, such as Copelco, Charter Financial and Fidelity Leasing, have been acquired by, respectively, Citigroup, Wells Fargo and European American Bank. It is uncertain as to whether or not these issuers will need to tap the ABS markets in light of the funding sources available to their new parents. As more banks increase their leasing activities and/or acquire leasing firms, smaller leasing firms can expect increased competition, particularly on the small-ticket front, and the amount of bank funding that has historically been available to smaller leasing firms may also be reduced. The depressed stock prices of many leasing firms also make them attractive acquisition candidates for larger leasing firms hoping to grow through consolidation.
Fitch anticipates that consolidation in the leasing industry will impact existing and future equipment lease securitizations in several ways. While consolidation will bring about more "diversified" portfolios, the rating analysis of these transactions may become more difficult as multiple and different reporting methods, performance histories reflecting various charge-off policies and recovery rates, underwriting standards and servicing procedures will need to be fully evaluated and incorporated into the rating analysis. The servicing of transactions may also be negatively impacted as back-office operations are disrupted due to layoffs or staff departures and to the consolidation and/or relocation of servicing operations.
Rating Approach
Fitch's analysis to determine credit enhancement levels focuses primarily on the originator's historical loss performance and industry performance, as well as an analysis of portfolio concentrations. Fitch will also incorporate quantitative factors into its analysis, including equipment type and equipment manufacturer/vendor concentrations and geographic and obligor industry concentrations, as well as portfolio seasoning. Qualitative factors include the strength and duration of origination sources, such as vendor programs and broker relationships, credit underwriting standards servicing and collection procedures, and changes in these standards and policies over time. Fitch will also assess the issuer/servicer's financial condition, management team, business plan and the rate and methods of historical portfolio growth. Fitch's criteria for rating equipment lease ABS also caps the rating of transactions by small first-time issuers to A'. Additionally, a hot backup servicer may be required for an issuer/servicer that do not meet certain equity dollar thresholds.
Historical portfolio performance is typically evaluated on a static pool basis in order to determine likely performance over the life of the transaction, including expected timing of losses. Charge-off policies are also evaluated as the timing of default and recovery recognition can affect cash flows to the pool. Factors that determine the amount of credit given to recoveries include the nature of the equipment being financed, the originator's UCC filing thresholds, historical recovery rates, and the strength of vendor programs and remarketing agreements. As more leasing companies, especially on the small-ticket side, increase their utilization of the Internet in their origination, underwriting and customer service areas, the integrity of information systems will also need to be further scrutinized.
