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Rating Guidelines for Franchise Loan Securitizations - page 3 / 8

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Key Borrower and Loan Factors

Default Fixed-Charge Coverage Ratio (Borrower) Concept Strength Units Under Management Operator Experience Unit Seasoning

Recovery Collateral Type Loan-to-Value Ratio Fixed-Charge Coverage Ratio (Unit)

contribution to aggregate pool losses. The LDRM uses data for a pool of franchise loans to compute a point esti- mate and a range for gross defaults and net losses. The net losses calculated by the model establish a range of credit enhancement for each desired rating level. In assigning final enhancement levels, Fitch IBCA takes into consid- eration various qualitative factors, such as structure, servicer, and legal analysis.

The key underlying assumption for in- terpreting the default and recovery es- timates that result from the LDRM is that all risk in the pool is systematic risk (i.e. default is due to measurable changes in the key variables and is not random nor based on hypothetical eco- nomic scenarios). This shared system- atic risk assumes that changes in the underlying credit factors have a similar, but not equivalent, absolute effect on every loan in the pool, placing a higher weighting on the value of FCCR and minimizing the effect of obligor con- centrations. This assumption is consis- tent with the notion that if any large concentration of loans in the pool is likely to default, the entire pool is sub- ject to default but not to the same de- gree. This approach also eliminates the burden of trying to model or specify how the volatility of loans within the

Rating Guidelines for Franchise Loan Securitizations

pool covary over time, or whether bor- rowers are correlated or uncorrelated.

Credit Factor Analysis The LDRM credit factor analysis ex- amines the pool on a loan-by-loan basis and then estimates a conditional ex- pected default frequency and a condi- tional expected recovery rate for each loan at every rating level. These loan- by-loan estimates are then aggregated to the pool level to calculate expected losses for the pool, which, in turn, are used to size the subordination levels.

defaults in franchise loan securitiza- tions is FCCR. Recovery is primarily a function of LTVs (which, in these cash flow-based loans, is roughly equivalent to the inverse of the unit FCCR) and the type of loan collateral that consti- tutes the pool. The recovery assump- tion regarding the specialized nature of the franchise location considers the uniqueness of the franchise’s building configuration, as well as the demon- strated sustainability and viability of the existing franchise in that location (i.e. traffic patterns, capture rate, and age of franchise in that location).

Conditional expected default fre- quency and conditional expected re- covery are estimated on a dollar and percentage of pool basis by applying a system of empirically derived weights and coefficients to the following pool characteristics: FCCR; unit seasoning (years); concept strength; management experience (years); number of units un- der management by any one obligor; loan-to-value ratio (LTV); and collateral type. These credit factors can be grouped into loan-level, borrower- level, and unit-level categories. Coeffi- cients used to adjust the baseline default and recovery level are inferred from an extensive sample of underwrit- ten franchise and small-business loans over a 15-year period. Hence, the sam- ple covers multiple business cycles.

The default and recovery estimates at each rating level depend on the rela- tionship among the individual charac- teristics of each loan. Fitch IBCA’s unconditional base case (‘BB’) assumes that all loans default at a 15% baseline rate and that the baseline recovery rate for defaulted loans is 40%. This base- line is then modified according to each individual loan credit factor to compute a conditional default and recovery amount for each loan within a given rating level.

Fitch IBCA believes that the single most important factor for estimating

The credit factor analysis infers default frequency from the interrelationship among key loan, borrower and unit fac- tors according to the coefficients, weights, and multipliers applied at each rating level. Fitch IBCA also esti- mates recovery based on the going con- cern value of the collateral backing each loan. Additionally, by examining the pool on a loan-by-loan basis, Fitch IBCA has the ability to assess the rela- tive contribution of each individual loan to the aggregate net losses for the pool.

Fixed-Charge Coverage Ratio

Fixed-charge coverage ratio (FCCR) equals the ratio of cash flow to fixed costs.

  • Analysis of the level of operating cash flow

  • Operating cash flow is a function of revenue vola- tility and cost structure

FCCR volatility is miti- gated by:

  • Revenue impact of con- cept strength and unit seasoning

  • Cost impact of borrower experience and units un- der management

Fitch IBCA, Inc.

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