Asset Values and Liquidity

A well documented, well structured and well maintained secured lease or equipment loan transaction is like money in the bank. With the velocity in the movement of finance lease and loan receivables, lenders and lessors should focus more time, energy and resources toward their asset management departments as a means to ensure the value of these assets to the maximum extent possible throughout the term of the financing agreement.

We at R.V.I. Associates are presented with and asked to structure asset value protection on numerous assets in numerous financing transactions. The basic issues in providing coverage are, however, always the same: what is the asset, how well documented are the equipment maintenance and equipment return provisions. Will the lender or lessor have the same asset at the termination of the financing agreement as it had at the origination of the transaction? For assets subject to a securitization transaction the due diligence process that a lender or lessor undergoes is a most sobering experience. It is a process that will bring to light the importance of asset management. What this article will focus on is the role that residual value insurance can play in the maximization of the untapped profits and liquidity in a lender's or lessor's portfolio.

Residual Value Insurance as a Financial Tool

Broadly stated, residual value insurance is a tool to achieve one or all of the following objectives: 1) to arbitrage accounting standards; 2) to utilize R.V.I.'s asset knowledge in achieving a level of asset risk pricing and protection for a lender or lessor entering a new market, or 3) to create liquidity in one's portfolio. The specific goals and applications of residual value insurance are 1) to assist either a lender or lessor to achieve capital lease accounting treatment for the lessor's income recognition; 2) to assist a borrower or lessee to achieve operating lease accounting treatment for their financing; 3) to assist either a lender or lessor in a securitization transaction to gain sale accounting treatment for maximum income recognition and balance sheet presentation, or 4) to turn balloon payments or booked residual values into financial receivables.

During the last recession many lenders were made aware that asset values can and do fluctuate. The role of residual value insurance is to provide coverage in the event of severe drops in the value of relatively liquid assets. This residual value or balloon-payment coverage, especially when offered by an insurance company with an investment grade rating, is most frequently required by lenders, credit committees, accountant, or regulators. When residual value underwriters provide a hundred dollar guarantee for a five dollar insurance premium, they cannot afford to be wrong, as there will be no two or three dollar losses. Losses will either be zero or they will be ten to fifteen dollars, and they will hit all insured assets at the same time. People who insure aircraft against accidents can compute actuarial probabilities of occurrence, but we know too well that when residual values go down, they all go down together. The Residual Value Insurance Law of Large Numbers is that "LARGE NUMBERS HURT MORE THAN SMALL NUMBERS."

Residual value insurance underwriters, therefore, are avid students of market lows. In a 1983 underwriting, a 1971 Swissair 747-200 was insured for $15.5 million. At lease termination, the insured's remarketing agent was unable to find a bid higher than $13.5 million, so the residual value insurers elected to pay the full insured amount and take title to this asset. This plane was later sold for $16.5 million. By December, 1987, this plane was again sold at a value of $28 million. When the then owner again sold the plane in 1990, the market had appreciated to $40 million, a 42% climb in value in three years. By 1994, the value of the plane had dropped to approximately $18 million to $20 million at best.

The trick of residual value underwriting, whether as an insurer, as an investor or as a lender, is identifying the point at which a bedrock value turns into a speculative value. The ex-Swissair 747 passed its twenty-third birthday in March but probably has another decade of operation ahead of it. Its 1994 value of $18 million to $20 million is, with eight years of inflation removed, $15 million in 1983 dollars, which is just a little more than it sold for in early 1984. Bedrock value then was $15 million, and the bedrock value now is approximately $18 million. For this aircraft or any asset, as well as for every other technologically current asset, there is a "base value" which, in constant dollar terms, declines over time like any other depreciation curve. Above this base figure is the variable layer within which the asset value fluctuates in accordance with market cycles. As used by forecasters, "probable value" should be the arithmetic mean of the cyclical value (a trend line).

The goal of both the lessor's asset management department and the residual value insurance underwriter is to book or insure values within the "base value" layer. The distance from the top of the layer will vary with the predictability of values for an asset, which is in turn effected by such factors as:

An asset's age (volatility increases toward the end of the product life cycle); The thinness of the asset's market (747's are more volatile that 737's); The degree of specialization in the configuration of the asset, and he finance term in the transaction (crystal balls are clearer at two years than at ten).

Premium Levels

A residual value insurance premium is composed of two elements: 1) a risk charge and 2) a capacity charge. The risk charge is determined in accordance with the distance between the "base line" and the amount of insurance requested. The determination is made in this manner in the event that the consensus of forecasters, pundits and oracles used by the underwriters is wrong. The risk is still only at the top of the "base value" band. The risk charge, therefore, decreases exponentially as the sum insured moves below the top line of the "base value" band. The capacity charge reflects the fact than an insurer can only issue a finite amount of insurance, and each dollar insured consumes one dollar of its capacity for each year of the entire policy term.

Product Application

One aim of residual value insurance is to assist lenders and lessors subject to accounting standards such as FASB 13, SSAP 21 or any of the other IAS 17 lease capitalization rules to achieve a lease finance/capital lease accounting even though the lessee is "booking" the transaction as an operating lease. From a lessor's standpoint, residual value insurance qualifies as a third-party residual guarantee and is included within "minimum lease rentals" when calculating if the minimum lease rentals exceed 90% of equipment value. For a lessee subject to similar accounting standards, residual value insurance is utilized to accord a lessee "off-balance sheet" operating lease accounting for a loan or lease financing.

A second use of residual value insurance also provides a rated guarantee instead of asset risk at the end of the term of a lease or balloon-note financing. As a result, an insured lease or balloon note is a ratable transaction which can be based upon credit alone and, therefore, can be financed by a lender's fixed-income department instead of the equipment finance department.

Product Goals

Residual value insurance is a financial product which can pay for itself when used correctly, as a lease or loan with a rated balloon should be able to be financed more inexpensively than a lease or loan with a walk-away option. As stated earlier, some of the uses of residual value insurance are: 1) to enable lessors to achieve maximum income recognition and balance sheet treatment in a lease or loan transaction; 2) to enable a lessee or borrower to achieve its preferred accounting treatment in the execution of an asset-based financing; 3) to assist securitized transactions to achieve sale accounting treatment, and 4) to assist specific stand-alone transactions in creating the maximum liquidity in equipment residual values and balloon payments.

These goals can only be achieved when a lender or lessor has devoted the proper resources to the management and maintenance of its portfolio of asset-based loans, be they an auto fleet, transportation equipment, commercial equipment or real estate.

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Thomas A. Orofino is a Managing Partner of Collateral Guaranty LLC Westport Ct (203.227.7080). He is responsible for the marketing and product design of residual value insurance products and services worldwide. Mr. Orofino is a graduate of Villanova University where he earned his BA in Economics.