Dodd-Frank Proposed Risk Retention Rule Concerns For Equipment Finance ExplainedBy Richard Henderson, President Equipment, Engine Financial Services Company, LLC
The risk retention rule which was proposed in April 2011 under the Dodd-Frank Act would require lenders to retain 5% of the loss risk for all debt obligations pooled into securities. While the rule was proposed primarily to target the residential mortgage backed securities (MBS or RMBS) and collateralized debt obligations (CDO) markets, the entire securitization market could be affected, including equipment finance related asset backed securities (ABS). The rule would impose unnecessary and inappropriate restrictions on the asset class and ultimately cause a ripple effect that would further restrict access to capital for American businesses and municipalities.
Why should we be concerned?
Equipment finance companies and America’s businesses and municipalities, in particular small to mid size businesses are already suffering from lack of access to capital due to fallout from the recent economic crisis. Any further restriction to their access to the capital they need to run their businesses will only prolong an already painfully slow recovery. Additionally, the reality is that the additional pressures the Dodd-Frank Act risk retention rule, as proposed, would place on equipment finance companies would surly force a significant number of such companies out of business. This in turn will result in even less access to capital for U.S. businesses that drive our economy and therefore any U.S. economic recovery we can hope to have in the future.
Why are the capital markets so important to equipment finance companies?
The business of providing equipment financing services is highly capital intensive. Simply put, an equipment finance company fronts the capital required for the end-user or “operator” to acquire essential equipment for use in creating goods and services for consumption. This “fronting” is exchanged for committed cash-flow from the ensuing rental stream payable to the equipment finance company for the term of the lease and generally secured by a first priority lien and security interest in the underlying equipment. For most equipment finance companies, the only meaningful return on equity comes at the end of the term when equipment is either turned in and remarketed or sold to the lessee. In order to extract an adequate return on equity to justify being in the equipment finance business at all, finance companies typically must utilize a significant amount of leverage.
The ABS market has been an essential source of capital for equipment finance companies. In an ABS transaction, a pool of receivables (future cash flow from equipment rental payments) is created and converted into a security backed by this cash flow and often residual positions which is then sold to institutional investors. These arrangements have been very appealing historically to investors due to the stability and predictability of the investments which are credit enhanced by a duly rated entity (generally a bank) and to equipment finance companies due to the relatively low cost of capital achieved by accessing the capital markets. The lower cost of capital achieved by accessing capital via the securitization market has been essential for equipment finance companies to keep their pricing competitive while ensuring adequate returns.
So how did we get here?
Having just gone through one of the worst financial market meltdowns in history, there has been a lot of finger-pointing and blame going around as well as an aggressive and politically charged movement to prevent another such crisis from occurring. Right or wrong, much of this blame has fallen on the MBS and CDO markets. This has caused an inappropriate “guilt by association” problem for the broader securitization market including the historically stable performing receivables pools of equipment finance companies.
Why are equipment finance asset backed securities different?
There are a variety of reasons for the stability of the equipment finance related securities as contrasted with other asset backed securities, in particular MBSs and CDOs. For example, the equipment finance industry has a long history and proven track record of consistent and strong underwriting (including conservative underlying asset valuations) and appropriate risk-based pricing. Additionally, in the ABS structure as applied to the equipment finance industry, pools of leases are originated and held to term by the equipment finance company (securitizer). Receivables and the underlying equipment form collateral for what amounts to a borrowing base in a revolving asset based loan facility (ABL), providing continued access to capital for the equipment finance company for the term of the arrangement. The advance rate against aggregated principal balance collateral is typically 90-95%, thus creating an over collateralized pool of assets with first loss risk retention of 5-10% at all times, not including residual risk which theoretically increases the risk retention.
What are the specific concerns?
There is concern that under the proposed regulations, this form of securitizer risk retention (overcollateralization) would not be recognized as acceptable and additional risk retention could be required in the form of structures generally avoided. Equipment residual value should be included in that overcollateralization model. Additionally, the Dodd-Frank risk retention rule proposal raises concerns about the possibility that securitizers of equipment ABS would be required to deposit all proceeds from cash-flow into multiple collection accounts, similar to the MBS format of separate principal and interest buckets unlike the “unitary waterfall” approach that is appropriate for a rental stream that is not comprised of principal and interest. Further, this provides a problem related to cash flow from regular rent payments, default recoveries, prepayments, asset dispositions in to a single collection account.
Any effort to improve confidence in the stability of the capital markets should be applauded. The concern among those of us in the equipment leasing and finance industry centers mostly around inappropriate lack of specificity and attention paid to the time-tested and proven structure and risk retention protocols in of the ABS collateralized by equipment leases and finance agreements. Whether intentional or just an oversight, the Dodd-Frank risk retention rule, as proposed, could cause serious harm to our industry and serve to seriously hamstring an already slow recovery from the Great Recession.