Equity Defeasance Parties:
Will The Real AAA Please Stand Up
Our firm recently assisted in an effort to structurally upgrade an Equity Defeasance Party which had fallen below the documentation requirements for continued participation in a Leasehold Transaction. The documentation was clear as to the steps to be taken in the event of a downgrade; however, the implementation was a more complicated issue.
Typical transaction documentation requires that the non-complying Defeasance Party be replaced with a complying party, as defined by the transaction documentation. The critical issue faced in the transaction was the breakage costs.
The selection of an Equity Defeasance Party should be clearly understood by all parties as to its long term affects on a transaction. A Defeasance Party can be a corporation, bank, insurance company, etc. to whom an equity party (lessor) or lender has entrusted a present value sum of money at a defined interest rate for usually long periods of time (15 years or greater). That present value sum will grow to equal a future value obligation of a lessee/borrower. The Defeasance structure is utilized to assist in the tax efficiency, credit strengthening or the removal from an obligor's balance sheet, of a large future purchase obligation or balloon loan repayment. The Defeasance Obligation has taken the technical name of a Guaranteed Investment Contract (GIC), Payment Undertaking Agreement (PUA) etc.
The Defeasance Party is important and should carry a true AAA rating as one does not wish to be concerned with this party's credit rating, as most transactions that utilize a defeasance structure will have other structural complication that are, in some manner, utilizing a defeasance structure to simplify the transaction or relieve credit weakness in a transaction participant. The structural issues may be centered around the international cross boarder nature of the transaction itself or the international credit nature of the lessee/borrower etc.
Given the falling interest rate environment over the last year or two, the original defeasance rate carried a higher coupon than would be available in today's market; therefore, breakage costs would be substantial. To avoid these substantial breakage costs, the alternative considered was to attain a "credit wrap" for the downgraded party. Easier said than done.
The objective was to attain a "credit wrap" (enhancement) for a recently down graded party that would be:
1) long term in duration (15 years or greater) and
2) have substantial single issuer exposure,
became an art versus a science. The considered "conventional market", the monoline credit enhancement insurer, presented challenges in that:
1) Single issue "wraps" are not the norm, unless structured so from the inception of the transaction;

2) Term is an issue. Leaseholds, OFSCs etc. are long term in nature (greater than 15 years); and

3) The large single issuer exposure customary in the lease finance markets are considered large by this market.
These challenges, plus the issue of understanding the nature of these Leasehold and Defeasance products, are not faced in the normal course of business for the monoline insurers. Securitizations are their market: issues are medium term financings, credit exposures are diversified and issues are rather homogenized in nature.
The intense rating agency portfolio scrutiny placed on these monolines, especially for a recently downgraded large single issue, makes execution difficult at best. A further downgrade of the newly "enhanced" issue, or the specter of further "event risk", could cause the insurer to incur further capital charge assessments, the ultimate nightmare for the any general purpose insurance or monoline insurance entity.
The alternative market available to our firm was the credit swap derivative market. This market is:
  • Not yet a mature market with great liquidity or depth,

  • The pricing is volatile,

  • Long term (greater than seven/ten years) availability is thin and

  • The size of trades is relatively small compared to the demands of a Leasehold Transaction.
The solution will be time consuming and absorb finite resources for which there will be no consummate reward for the original placement agent or ultimate equity participant, who viewed the original Equity Defeasance Party as a "AAA risk free" entity.
All this leads our firm to recommend that when selecting an Equity Defeasance Party.............. chose carefully.
Defeasance Parties
The three most common defeasance alternatives are:
1) direct US government treasury obligations,

2) obligations issued by AAA rated insurance companies, and

3) Derivative Products Companies (DPCs). These alternatives present increased rate alternatives/benefits which enhance transaction yields. They also present increased exposure in their structural and credit aspects to either the AAA insurance company or the DPC.
The use of direct US Government Treasury obligations speaks for itself, the use of US government agency or agency guaranteed issues may require a bit more due diligence. The credit and structural makeup of AAA rated insurance companies is well documented. What is the insurance company's:
  • Loss ratio;

  • How well reserved is the insurer;

  • How highly leveraged is the balance sheet;

  • What are the quality of the insurer's earnings;

  • What is the quality of the investment portfolio as this is the true measure of the insurer's liquidity and a strong driver in its ability to meet policy claims.
The remainder of this article will focus on the structural aspects of Derivative Product Company (DPC).
The use of Derivative Products Companies (DPC) is a recent phenomena as is the Leasehold or Service Contract transaction. The first DPC was created in 1985 by Prudential Global Funding. The next by AIG Financial Products in 1987. The importance of counterparty credit risk was driven home by the 1990 bankruptcy of Drexel Burnham Lambert. The Structured DPCs were created between 1991 and 1995.
Derivative Products Companies (DPC) are segmented into one of three corporate entities:
1) A Continuing Vehicle,

2) A Termination Vehicle or

3) A Guaranteed Structure.
In the Continuing and Termination structures the DPC is the counterparty. The Guaranteed entity, in general has, the parent as the counterparty with the DPC guaranteeing the parent/sponsor.
The ultimate risks in the DPC entities are: 1) credit risk and 2) market risk (rate movement, currency movements etc.).
The two most common vehicles are the Continuing Vehicle and the Termination Vehicle. The difference between these two entities lies in the manner in which they are unwound in the event pre-agreed upon "trigger" events occur: the DPC or parent/sponsor default, downgrades of the DPC or parent/sponsor.
The use of these DPC vehicles are heavily reliant on their Sponsor/Parent organizations. In general, for every derivative contract they enter into, they enter into, or must enter into, a mirror transaction with the sponsor/parent. This is how DPC are insulated from the market risk - this market risk is passed on to the sponsor/parent. The credit risk cannot fully be "mirrored" into the parent/sponsor and is mitigated through econometric credit models which dictate the credit reserves required for the swap portfolio on a daily basis.
This raises the questions of what happens if the parent/sponsor or DPC encounters financial stress. If certain trigger events related to the sponsor/parent or DPC occur, the Continuing Vehicle DPC ceases to write new business and its management is handed over to a third party and hopefully the swap portfolio is liquidated over time in an orderly manner. In the event of a "trigger" event for a Termination Vehicle, the Termination Vehicle is terminated, swap positions are "valued" and the portfolio is terminated. A "trigger" event in either the DPC or parent/sponsor leading to the DPC no longer being a AAA rated entity may occur if the parent/sponsor is unable to post required collateral the mirror transactions. Given the capital base and collateral requirements, however, the DPC should not have a problem honoring its obligations. While it appears these DPCs may deserve their AAA ratings, from a default perspective, they do not (in our firm's opinion) deserve them when it comes to workout risk or what we call "brain damage" risk. On page 29 of the Federal Reserve Bank of New York Economic Policy Review (April 1996) article on DPCs ("Risk Management by Structured Derivative Product Companies"), it states:
"Even when derivative customers value an intermediary's triple-A rating, they may not regard a structured DPC's rating as the equal of other triple-A ratings. The DPC's rating may be differently regarded because the workout risk of such a DPC corresponds more closely to the parent's typically single-A rating."
While the DPCs themselves may have parent company "mirror" safeguards and the Equity Defeasance Contracts have safeguards, such as collateral requirements or replacement mechanics in the event of downgrades, no one really wishes to exercise those remedies. As we understand the DPC structures, the risk of having to workout the equity defeasance contract is based upon the credit of the parent/sponsor. From historical data published by S&P, an "A" credit is 2.2 times more likely to default on a debt obligation over a 15 year period than a "AAA" credit. We assume that both lessors and lessees would prefer to not have to analyze the equity defeasance parties and contracts between closing and the purchase option date and would find such a workout to be, at a minimum inconvenient. There also may be an issue related to the fact that if the parent/sponsor does have financial problems, the Equity Defeasance Contract is likely to be the last DPC obligation outstanding since most conventional derivative contracts are less than 10 years in duration.
Our firm realizes that the ultimate decision concerning how to handle the equity defeasance in a transaction is made by the lessor and lessee and that there are numerous trade-offs. We want to make sure that you and your clients understand the differences between entities such as DPCs and true AAA rated insurance companies when making these decisions. Understanding the nature and structure of a AAA rated DPC may be as difficult as understanding the Leasehold or Service Contract Transaction itself.
* * *

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.