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Structured Finance

Asset-Backed

Special Report

Rating Guidelines for Franchise Loan Securitizations

Asset-Backed Securities Sandra Claghorn (212) 908-0615 sclaghorn@fitchibca.com

Alyssa Irving (212) 908-0733 airving@fitchibca.com

Kevin Duignan (212) 908-0630 kduignan@fitchibca.com

Commercial Mortgage-Backed Securities

Dan Chambers (212) 908-0782

Susan Merrick (212) 908-0725

dchambers@fitchibca.com

smerrick@fitchibca.com

Summary Franchise loans are cash flow-based loans originated by commercial finance companies to franchise operators. In this specialized market, the credit rationale for a franchise loan combines aspects of commercial lending and mortgage lending, measuring creditworthiness based on free cash flow generated by the operation, the borrower, and the property. Thus, Fitch IBCA’s rating analysis follows a similar pattern, combining aspects of both traditional asset-backed securities (ABS) analysis and commercial mortgage-backed securities (CMBS) analysis. This report outlines Fitch IBCA’s rating ap- proach for franchise loan securitizations, highlighting Fitch IBCA’s loan default and recovery model (LDRM), which was developed as a joint effort be- tween the ABS and CMBS groups.

The franchise loan securitization market has developed into a viable part of the fixed-income market, with 1998 year-to-date issuance of approximately $3 billion. Al- though franchise loan securitizations are typically seen as a new asset class, small private placement transac- tions were completed in the early to mid-1990s. The first franchise loans to be securitized were made exclu- sively to operators of quick service restaurants (QSRs). However, in the past year, loans to auto service centers, gas stations, convenience stores, auto dealerships, and car washes have emerged in securitizations, and Fitch IBCA expects continued expansion of concept types. Some of the original participants in this market are now established lenders to this sector, while several well capitalized new entrants have emerged, and start-

ups with substantial financial resources continue to be announced.

Prior to the entry of specialty finance companies, fran- chise operators borrowed almost exclusively from com- mercial banks. However, based on the unique factors associated with chainstore operations, specialty fran- chise lenders offered franchisees fixed-rate, 15- to 20- year loans, as opposed to floating-rate, seven-year loans offered by the banks. As franchise operators continue to grow and consolidate, Fitch IBCA expects specialty franchise lenders to continue to enter the market and disintermediate banks in supplying capital to this sec- tor. As growth and change in the franchise market continues, investors, rating agencies, and lenders need to be wary of the risk of overinvestment and overlever- age and to begin focusing on a consistent credit standard in this market.

Since many franchise operators are not rated entities, Fitch IBCA’s LDRM analyzes each loan in the pool based on factors that infer conditional expected default frequency. These factors include fixed-charge coverage ratio (FCCR), concept strength, number of units under management for each borrower, and the borrower’s op- erating experience. In addition, the LDRM takes into consideration the type of collateral (i.e. fee-simple mortgages, ground leases, and enterprise loans) and other factors in determining likely recovery values for each loan in the pool. Fitch IBCA views the single most important factor for estimating defaults and recoveries in franchise loan securitizations to be the FCCR.

October 30, 1998

www.fitchibca.com

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