The Strategic Rail Authority (SRA) has unleashed proposals for a new U.K. rail sector franchise policy, redefining the degree of government backing in deals from this arena. Consequences for securitizations of rolling stock options are still unclear, but market sources say this funding source will remain a viable funding option. According to a Fitch Ratings report earlier this month, the timing of this new franchise policy indicates that the market will see at least one deal before the end of the year.
Although the SRA earlier this year published a strategic plan reiterating a 10-year target of 50% growth in passenger rail services and 80% growth in freight services, it also publicly stated that its main objective is to ensure that the current network runs economically and efficiently. Concerns have arisen, however. What the SRA considers to be economic and efficient might translate into slower growth rates. For ABS deals today, the scaling back of growth targets could affect rolling stock demands and lease rates, Fitch said.
The SRA reported that the cost of operating existing franchises has run substantially above bid levels; this, combined with a leveling off of revenue, has caused a number of franchises to lose their economic viability. As a result, the SRA has had to provide a level of financial support above those projected in the initial franchise agreements.
Four of the six ABS deals that Fitch has rated rely on cash flows originally supported by a contractual government undertaking to support part of the lease payments in the event of a train operating company (TOC) default. These original deals all securitized "hell or high water" leases; even if the rolling stock were not available the TOC lessees would still have to pay the rental costs.
Given these spiraling costs for TOCs and the SRA being forced to pay out higher-than-expected subsidies, the agency has set out in its Franchise Policy Statement (October 2002) ways of reducing TOC fixed costs and reallocating risk within the rail industry. This includes shifting the cost of rolling stock failure from TOCs to rolling stock companies, or ROSCOS (the lessors in these transactions) and train manufacturers.
The suggestion is that future leases would include a performance aspect, meaning that lessees would pay reduced rental if rolling stock does not perform. "Given the level of SRA financial support for franchisees, the franchise policy statement recognized that it was questionable to what extent risk has really been transferred to the private sector," reports Fitch. "Whilst it was envisaged that the overall subsidy pay to train operating companies fell each year from privatization to 2001, overall subsidy levels rose in 2002."
The SRA has stated that the provisions of the leases must demonstrate value for money, and that future support of the leases will be linked to asset performance and asset condition. From a financial point of view, increasing operating risk on the train operating company level would make future deals less economically viable because they would have to add the risk of non-performance to already low profit levels.
The Franchise Policy Statement is an implicit acknowledgement that the split of the cake was not equitable at privatization - some unreasonable operating risks (including those related to infrastructure and rolling stock failure) were left with the TOCs, said analysts at Fitch. "At this point it's really probably only the ROSCOs that have been profitable," explained one source. "If the lessors (the ROSCOs) take rolling stock performance risk to a greater degree, they may push up lease rates to compensate. For investors in any future rolling stock securitizations, this may mean that lease rentals become less predictable and more volatile."
In the original deals, there was a high level of government support via hard contractual guarantees of lease rentals, or via soft guarantees wherein the SRA has an option to step into all (but not some) leases on TOC default. Although it's not entirely clear what the new SRA measures involve, it could mean that investors will have to take on more risks should the SRA base its support for lease rentals in the event of TOC default on the adequate performance of rolling stock. As a result, the agency would have to further stress the cash flow, which means that the advance rate [i.e. the amount of debt which could be raised for a certain amount of expected lease rental] would be lower than when the fuller SRA guarantees existed.
But the analysis would be contingent on what form the securitized leases took. "Part of the reasoning behind the timing of this report is that we feel that there will be more activity in this sector, but we're not sure what future structures are going to look like," said one analyst. "We wanted to highlight to investors the changes afoot in the industry and the new risk parameters they may have to consider in future deals. In addition, we wanted to update investors in existing transactions on the performance of these deals and whether they are likely to be affected by recent policy changes. On the whole, we believe that existing transactions are likely to withstand these changes."
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