Evaluating credit enhancement floors in equipment ABS.

• Author: Gibson, Lang

First Union [Securities.sup.*]

Since late 1997, the majority of equipment asset-backed securities (ABS) have been structured with credit enhancement (C/E) floors instead of the credit triggers used in previous deals. We see this change as a positive for the transparency of the equipment ABS market, as floors are easier to understand than credit triggers for most investors.

In a typical equipment ABS deal, pro rata payment of the senior and subordinated classes will revert to sequential payment if the C/E floors are hit. If the floors are hit, the senior bonds must be paid off before the more junior bonds, at which point the junior bonds are paid off sequentially among themselves. However, there is normally ample credit enhancement to pay off the junior tranches in full-- the cash flows are simply delayed if the G/E floor is hit. The purpose is to protect the more senior note holders if credit enhancement levels decline significantly.

1. INTRODUCTION

   Since late 1997, the majority of equipment asset-backed securities (ABS) have been structured with credit enhancement (C/E) floors instead of the credit triggers used in previous deals. We see this change as a positive for the transparency of the equipment ABS market, as floors are easier to understand than credit triggers for most investors. Furthermore, unlike credit triggers, C/E floors have the following benefits:

   * Absolute minimum enhancement levels, which reduce "tail-end risk" if defaults toward the end of the deal cause cash flow volatility

   * Incorporation of the benefits of triggers into a less complicated structure

   * Irreversible, so once floors are hit there is no risk for senior note holders that floor structural protection will disappear

   In a typical equipment ABS deal, pro rata payment of the senior and subordinated classes will revert to sequential payment if the C/E floors are hit. If the floors are hit, the senior bonds must be paid off before the more junior bonds, at which point the junior bonds are paid off sequentially among themselves. However, there is normally ample credit enhancement to pay off the junior tranches in full--the cash flows are simply delayed if the C/E floor is hit. The purpose is to protect the more senior note holders if credit enhancement levels decline significantly.

   This article covers the following topics:

   * Overview of the C/E floor structure

   * Equipment ABS structural payment description

   * Historical loss stability of equipment ABS collateral

   * Credit stress tests for mezzanine and subordinated equipment bonds

2. OVERVIEW OF THE C/E FLOOR STRUCTURE

   As equipment ABS is a comparatively less commoditized asset class, it has benefitted from the innovation of simpler structures. C/E floors are less complex than the credit triggers structured into other ABS classes, which exhibit entrenched structuring standards. For instance, it is more difficult for auto ABS, which have been commoditized for many years, to overhaul structural standards already firmly accepted by the market by replacing triggers with C/E floors.

   We have discussed credit triggers in depth in two research reports, Credit-Sensitive Asset-Backed Securities (ABS): Performance, Risk...