The year 2000 was a turbulent one for the franchise loan industry. Difficult market conditions for the sector were a result of substantial credit problems in some franchise loan pools. The credit deterioration and ratings volatility in franchise deals in 2000 were not broad-based, but were generally concentrated in pools sponsored by Bay View Franchise Mortgage Acceptance Corporation (FMAC) and Global Franchise Trust. Problems for large borrowers and resulting losses created significant ratings volatility for some transactions for those issuers.
The primary culprit in the credit deterioration was large acquisition "business value" or "enterprise" loans.1 Competitive pressures in the franchise lending market in the late-1990s led some lenders to advance substantial amounts of cash to borrowers with little or no equity. Ample availability of cash gave an incentive for some operators to expand beyond their means and managerial capabilities. With this substantial leverage, sales declines due to systemwide franchisor troubles, or problems resulting from managing additional units, made some borrowers vulnerable and led to loan defaults. With no hard collateral, recoveries on some business value loans were low, leading to large losses.
Rosy prospects quickly fade in 2000
The outlook for the franchise sector was rosy at the start of 2000. Credit performance of securitized franchise pools had been stellar, with few problem loans across securitized pools. With the prospect of a healthy national economy, 2000 was set for record issuance.
However, the promise of a solid year for the franchise loan industry faded quickly. The first sign of problems occurred in January 2000 when Olajuwon Holdings Inc. (OHI) filed for Chapter 11 bankruptcy protection. OHI was a large operator of Denny's units and was a large concentration (approximately 15%) of Global Franchise Trust 1998-1. The OHI operations deteriorated rapidly and in May 2000, a bankruptcy court approved a sale of the collateral. The collateral was business value and the resulting recoveries were minimal. Based on the OHI default, securities issued in the Global Franchise Trust 1998-1 were downgraded from Aa2 to A3, A2 to Ba2, and Baa3 to B2.
FMAC also experienced turbulence in May 2000. Two FMAC transactions, 1997-C and 1998-A, not rated by Moody's, were affected by writedowns of business value loans. Perkins operator Reading Restaurants, Inc., a large business value 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.
As the year progressed, FMAC's performance deteriorated substantially. In September 2000, Bay View Bank announced that it would shut down FMAC's lending operations. The difficult year in the franchise industry was topped off by the dramatic deterioration of FMAC's 1996-B transaction, not rated by Moody's. The transaction ran aground due to the default of the largest borrower of the pool, Midland Foods, which was originated by CS First Boston Mortgage Capital Corp. and purchased by FMAC. Midland's default resulted in interest shortfalls for senior and subordinate classes.
In October 2000, securities issued by Peachtree Franchise Finance were placed on review for possible downgrade by Moody's. The ratings action was due to the deteriorating performance of the second largest borrower in the pool, which comprised approximately 10% of the pool. The borrower is a Burger King franchisee, with loan proceeds used to acquire units. The collateral for the loan is a leasehold interest, leading to significant uncertainty regarding recoveries on the loan.
With such turmoil, it is easy to dwell on the negatives and ignore the favorable credit performance of some franchise deals. Some lenders had little or no problems in 2000 while others experienced bumps in the road in 2000, but were able to work out the problems:
AMRESCO defaults and delinquencies have been very low. However, in late 2000, loans from four borrowers (particularly Duke & Long) that are common to several AMRESCO deals experienced problems leading to increased delinquencies in securitized pools, with some pools having delinquencies ranging from 10%-16%. However, AMRESCO expects substantial recoveries from these four large borrowers due to the fee simple collateral supporting the loans.
Atherton securitizations continued to perform well in 2000. Atherton's VFCT 1994, VFCT 1996, and 1998-A securitizations have not suffered a delinquency or a loss, while their VFCT 1993, AFC 1994, and 1997-A deals have net losses of less than 2% with limited delinquencies as of December 2000. The Atherton 1999-A transaction has two delinquent borrowers (both 90+) that account for 13% of the pool principal balance as of December 2000. Atherton expects recoveries on the two loans to exceed 90%.
As of December 2000, CNL's 1998-1 transaction had not experienced a default or a delinquency. For the CNL 1999-1 deal, 6.55% of the December 2000 pool balance was delinquent past 30 days. One large borrower that was forced into bankruptcy by another lender comprised 5.94% of the balance.
Enterprise Mortgage Acceptance Corp. (EMAC), primarily a gas and convenience store lender, has experienced limited problem loans in their three securitizations. In EMAC's 1998-1 transaction, loans totaling 1.28% of the original principal balance of the pool have reached the foreclosure/bankruptcy/REO status and, as of December 2000, the 30+ delinquency rate was only 0.13%. In the EMAC 1999-1 deal, 1.71% of the original principal balance has reached foreclosure/bankruptcy/REO status while the delinquency rate was 0.90%. Delinquencies for EMAC 2000-1 were 1.64% as of December 2000.
Franchise Finance Corporation of America (FFCA) has experienced limited losses to date on their securitized pools. As of December 2000, FFCA 1996C-1 and 1997-1 have no delinquencies, while the FFCA 1998-1, 1999-1, and 1999-2 deals have 60+ delinquency rates of 2.9%, 1.4%, and 3.9%, respectively. Excluding loans in which FFCA expects full recovery, delinquencies fall to 0%, 0.2%, and 1.6% for the three deals, respectively.
Auto dealer lenders Capital Automotive REIT and Falcon Financial have not had a delinquency or a default in their transactions. Capital Automotive REIT completed one deal in 1999 and Falcon Financial was in the market in 1999 and 2000.
Outlook for 2001
The problems of 2000 will have a dramatic impact on the franchise lending sector:
Going forward, franchise pools are unlikely to have large exposures to any single business value borrower.2 Although lenders will extend business value loans, such loans either be smaller in size or will be cross-collateralized with other loans backed by fee simple units from the same borrower. However, large borrower concentrations in loans with solid real estate collateral will continue; in fact, the market may see some ABS deals supported by a single credit-worthy borrower with substantial real estate collateral.
Measures that shed light on the degree of real estate collateral will receive much attention in the analysis of franchise pools. Items of focus include real estate based appraisals of the units under consideration and the loan amount per fee simple unit. These measures will likely gain favor over loan-to-value ratios based on business value appraisals, which can be extremely volatile.
With the exception of FMAC and Deutsche Bank franchise loan origination affiliate Global Alliance Finance Company (which shut down lending operations in September 2000 and mid-1999, respectively) the franchise market has avoided the consolidations and downsizings that have been prominent in other segments of the ABS market, such as home equities, manufactured housing, and subprime autos. Due to lack of profitability resulting from an abundance of lenders, 2001 may see a reduction in the number of franchise lenders due to mergers and exits from the industry.
The difficulties of some franchisors will continue in 2001 and some loans tied to those concepts will be under stress.
Large operators that experienced problems in 2000 include Duke & Long, Midland Foods, OHI, Reading Restaurants, and Westwind Group. We anticipate more delinquencies and defaults for some highly leveraged large borrowers in 2001.
Given the problems in this sector, more senior classes will be insured by Aaa-rated monoline insurance providers.
Given the uncertainty in the industry, issuance in 2001 will likely be flat-to-lower relative to previous years. The market will favor creditworthy lenders (or lenders tied to financially sound parents) that have solid underwriting standards and real estate collateral for larger borrowers in case a problem occurs.
1 Business value loans (also referred to as enterprise loans or space leases) are present in most franchise loan securitizations. A business value borrower does not own land or the related building but rather leases the space and the unit from a landlord; collateral supporting the loan consists of the right to occupy the units rather than real estate. Fee simple loans (the borrower owns the land and the building on which the franchise business is operated), ground lease loans (the borrower owns the building and leases the ground below the building), and equipment loans generally comprise the remainder of collateral categories in franchise pools.
2 Examples of large business value exposures include FMAC 1996-B, which contained an enterprise loan to Midland Foods originated by an affiliate of CS First Boston and purchased by FMAC comprising 45% of the pool. Global Franchise Trust 1998-1 had a 15% exposure to OHI, which was backed primarily by business value. Taken to the extreme, GAFCO 1998-1 consisted of one borrower backed primarily by business value.