in Capital Markets , Investor Briefings , Aviation Banks and Lenders
Friday 18 November 2016
Will Dodd-Frank force lessors to keep more skin in the game?
On Christmas Eve 2016 Section 941 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act will come into effect. Dodd-Frank requires originators of aircraft asset-backed securities (ABS) to retain at least 5% of the residual risk. But not all lawyers are sure whether classic aircraft ABS deals will fall within the purview of the new regulations, and the US Securities and Exchange Commission (SEC) is yet to make an interpretation of the rule in practice.
ABS transactions have experienced a resurgence in the past three years after securitisiations suffered a fall from grace following the 2008 financial crisis. In 2016 there have been five aircraft ABS offerings to date from leasing firms which include Aergen, Apollo, Blackbird Capital, and Castlelake.
The Ishka View is that Dodd-Frank will not hamper lessors from signing new ABS deals. Even lessors looking to sell the equity portion of the ABS deal should, in theory, be able to circumvent the new act by adopting a loan format ABS. But the uncertainty over the rules, and whether aircraft ABS qualify or not as a self-liquidating asset, will have a chilling effect on any lessors looking to sell ABS E-notes.
Skin-in-the-game aims to reduce moral hazard
The amended Section 941, also known as the skin-in-the-game clause, requires originators to retain a minimum 5% portion of the risk in order to “provide securitisers an incentive to monitor and ensure the quality of the securitised assets.”
Securitisation is a convenient method of financing aircraft leases and loans. The usual transaction involves a lessor or lender, also known as an originator, selling leases to a special purpose vehicle (SPV) that finances the purchase by issuing securities which are backed by the cash flow from the aircraft leases or loans. The benefits are manifest. For an investor, the SPV is a bankruptcy remote entity that protects them against the risk of the originator folding. While for a lessor, an ABS is an off-balance sheet solution that is often better rated, and better priced than commercial debt.
Moreover, the lessor gets the cash up front. But, regulators argue, the ‘originate to distribute model,’ provides little incentive for originators to concern themselves with the strength of the underlying asset or loan. The amended section 941 is designed to ally the interests between originator and investor by forcing originators to keep a 5% stake in the asset risk.
In aviation, the mismatch is particularly acute when lessors sell equity notes (E-notes) in what is known as an equity disposition ABS transaction. Here a lessor disposes of all residual risk. This could pose a problem for lessors who want an outright sale as they may have to retain some risks on their balance sheets. However, there is some legal confusion over whether the new rules will even apply to traditional aircraft ABS deals.
Is an aircraft ABS a self-liquidating financial asset?
An ABS is defined as a “a fixed-income or other security collateralized by any type of self-liquidating asset (including a loan, a lease, or other secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset.” However, the term self-liquidating financial assets is not actually defined and is open to interpretation.
“It is not entirely free from doubt that these transactions do not fall within the ambit of the new rules. Because the assets cannot be considered self-liquidating assets,” says Zarrah Segal, a partner at Clifford Chance. “There is nothing clear on it and the SEC has yet to interpret a definition of the exchange act.” Even if an operating lease is considered as a self-liquidating financial asset, the reliance on cash from aircraft sales and releasing throughout the life of a traditional aircraft ABS is likely to disqualify these securities from falling under the new rules. This is because a lessor often remains the servicer on an aircraft portfolio even if it sells its E-notes. Consequently, it retains an economic interest in the performance of the assets after a sale and averts the moral hazard that regulators are concerned about.
Can Dodd-Frank be circumvented?
On the first reading, no. The rule specifically forbids originators from sidestepping the risk-retention requirement through hedging or transferring the credit risk. However, an originator may wish to stick to a loan format in order to avoid the hassle.
“Before an SEC ruling can be made there will have to be more of a consensus among lawyers that non-retention does not apply and wait for a challenge,” says Segal. I am not sure where that challenge will come from, but you can simply avoid all the mental gymnastics by doing it in the loan format instead.”
The rules are not designed to regulate loans; they are designed specifically for asset-backed securities. And the rule exempts a narrow class of collateralised loan obligations (CLOs) where, alongside other things, the lead arrangers retain at least 5% of the underlying loans.
There appears to be a legal consensus about the acceptability of loan-based solution. According to Segal, recent deals from Castlelake and Aergen have adopted this model. However, James Pascale, a partner at Millbank, urges caution, and adds that regulators might take the view that these deals, while legal, would not be in the spirit that the regulation was intended to be implemented: that is to make securitisation safer.
Ishka View
Dodd-Frank is unlikely to dampen demand for aviation asset-backed securities (ABS). Most of the issuers continue to access the ABS market as a means of raising cheap debt, as opposed to achieving a true sale of aircraft assets. The ABS market continues to be popular among lessors which cannot yet access the unsecured bond market to raise funds. Lawyers suggest that aircraft ABS deals can be structured to navigate around the risk retention restrictions.
One of the restrictions remains the relatively few numbers of investors with sufficient technical expertise to perform the necessary due diligence on the assets. Only a handful of investors are willing to invest in aircraft ABS E-notes at present. Lessors looking to sell aviation E-notes may struggle to find willing buyers given the uncertainty over the new Act. The Ishka View is that Dodd-Frank is likely to have a chilling effect on the sale of aircraft ABS E-notes.
One big question hanging over the implementation of the Act is whether Dodd-Frank could be over turned or not. In May 2016, Donald Trump pledged to “completely dismantle” all the Dodd-Frank legislation enacted by the Obama administration. It is too early to tell what the President-elect will decide to do. Trump could easily change his mind, or instead allow senior Republicans permission to chip away at the Act.
Please Note: The views expressed do not constitute investment advice. We accept no liability to recipients acting independently on its contents in respect of any losses, including, but not limited to profits, income, revenue or commercial opportunities.
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