Structured Finance

International Criteria Report Future Flow Securitization Rating Methodology

Analysts „ Summary Gregory Kabance Future flow securitization became popular in emerging markets in the +1 312 368-2052 1990s as a mechanism to reduce sovereign-related risk and provide [email protected] more attractive access to international capital markets for the strongest of emerging-market issuers. A future flow transaction is a Samuel Fox securitization of a company’s future and existing receivables that are +1 312 606-2307 [email protected] due from offshore obligors. These transactions capture cash flows out of the emerging-market country and place investors in a relatively Mark Salgado senior credit position. From a practical standpoint, the physical control +1 312 368-2080 by as third party of cash flows also benefits investors by reducing any [email protected] willingness-to-pay issues. In addition, future flow securitizations mitigate many of the sovereign risks associated with an emerging- Wasif Kazi market borrower. +44 20 7862-4168 [email protected] Future flow securitization has grown in emerging markets over the past Dr. Stefan Bund 15 years, primarily in response to the search for lower cost funding by +44 20 7417 3544 companies that generate hard currency flows. While many of these [email protected] issuers historically relied upon bank debt and straight capital-market bond debt, the volatility and risk perception within emerging markets Wit Solberg pushed these entities toward future flow securitizations. Future flow +852 2263-9922 investments have consistently proven themselves to investors, and over [email protected] the years they have successfully mitigated a variety of the risks associated with emerging-market investments. Related Research • Criteria Report, “Rating Future Flow Transactions and Recovery Rates,” Annual Emerging-Market Issuance Feb. 15, 2006. Emerging-Market Issuance Emerging-Market Future Flow

(US$ Mil.) 12,000

10,000

8,000

6,000

4,000

2,000

0

4 5 96 9 1 05 199 19 1997 1998 199 2000 200 2002 2003 2004 20 91–9 19

February 15, 2006 www.fitchratings.com

Structured Finance

Emerging-Market Future Flow Issuance by Latin America contributed only $2.9 billion to the Country/Region year’s total. It was Turkey, with future flow issuance (US$ Mil.) from six different banks producing approximately Argentina Brazil $5.5 billion that produced the most. 3,560 Caribbean Chile 11,628 432 200 Noteworthy, in the past five years, political risk Central insured (PRI) transactions have also become popular. Colombia America In 2001 and 2002, PRI transactions were 1,492 2,020 approximately 50% of the total issuance. In 2003 and 2004, these numbers declined, although PRI retains a Asia Mexico material presence. For the long run, Fitch Ratings 4,926 expects future flow to continue to dominate 18,377 emerging-market structured finance.

Russia and Venezuela Until 2001, Mexico had always been the dominating Eastern 3,349 country for future flow issuance. Prior to Turkey’s Europe explosion in 2005, Brazil had taken over as the 1,775 Peru Turkey primary source for future flow paper. This is Africa 778 11,149 explained, for the most part, in the countries’ relative 1,900 sovereign ratings. Mexican issuers, because they are domiciled in an investment-grade country, are less in Future flow issuance remains the most popular type need of the structural protections provided by future of structured transaction rated in emerging-market flow. Brazil (and Turkey in 2005) on the other hand, countries over the past 15 years. Interestingly, 2005 which has been resting in the ‘B’ and ‘BB’ rating was the highest issuance year for the asset class with categories since 2001, represents a “sweet spot” close to $10 billion in total volume. Latin America where future flow is useful in mitigating sovereign- has traditionally been the strongest producer of future related risks and opens access to international capital flow volume. Issuers such as Mexico’s Petróleos markets for strong companies. Mexicanos (Pemex), who in 1996 placed US$6.0 billion and Venezuela’s PDVSA Finance Ltd While Mexico, Brazil, and Turkey could be considered placement of $3.4 billion, have enhanced Latin the historical heavyweights, there has also been a America’s volume over the years. In 2005 however, significant amount of issuance out of other countries.

Emerging-Market Future Flow Issuance by Asset (US$ Mil.)

1991–2001 2002–2005

Credit Card Ex port Ex port Remittances/ Receiv ables Receiv ables Receiv ables Div ersified 5,287 6,769 22,803 Pay ment Rights Airline 13,007 Receiv ables Credit Card 611 Receiv ables Other 5,120 Remittances/ 1,712 Other, 110 Div ersified Airline Telephone Pay ment Rights Receiv ables Receiv ables 5,371 266 530

Future Flow Securitization Rating Methodology 2

Structured Finance

Typical Future Flow Transaction Structure transaction’s structure mitigates many sovereign risks by keeping the cash flow offshore until the investors

Receivables are paid. If certain events occur (trigger events), the Payment structures typically trap all cash flows going through Obligors Trust the collection account to accelerate amortization of the notes. In some cases, only a portion of excess Principal and flows are captured during early amortization events Interest in order to avert a liquidity crisis for an issuer. Future Future Product Receivables Ratings of future flow transactions are tied to the Collections Investors credit quality of the originator, which is typically Over Principal and Interest measured by its local currency issuer default rating Offshore (IDR). In some cases, it is possible for a transaction’s Local Country IDR to be rated higher than the company’s local currency IDR after considering the company’s ability Originator to continue operating beyond a general default and generate receivables for the duration of the deal. The going concern assessment (GCA) addresses these Argentina has produced more than $3.5 billion, although issues. Achieving a rating at the GCA level is a limited amounts since the 2001 financing crisis. Top tier twofold concept. The company must not only banks from various Central American countries have continue to generate these receivables by producing issued financial remittance future flows. Recently, and delivering the product, but the collections from Indonesia returned to the future flow market with a the receivables must also be legally protected through $600 million securitization of coal exports. Finally, a true sale structure. In some cases, transactions are Eastern Europe and Russia have shown significant rated above the issuing company’s local currency potential for strong future flow candidates. IDR but below the GCA. This analysis is explained in more detail in the Rating Future Flow Transactions The types of assets securitized by these future flow section on page 6 of this report. securitizations have varied over the years. The most common flow being securitized previously stemmed „ Description of Future Flows from export receivables. Over the past 15 years and There are two general types of future flow through 2005, there has been approximately US$54.2 securitizations: financial future flows backed by billion in future flow export receivables transactions. banks’ generation of hard currency flows and Since 2002, financial remittances have become the corporate-related transactions typically involving most popular future flow asset class, with US$13.2 export receipts of one form or another. Financial billion of remittances/diversified payment rights flows include credit card vouchers, electronic (DPR) securitizations. DPR transactions are closely (typically SWIFT-related payments, including MT- followed by credit card receivables, which have 100s and MT-200s) and paper remittances. totaled US$5.4 billion since 2002. Corporate-related transactions typically involve airline ticket receivables, telephone net settlements A future flow transaction securitizes the cash flow and, the most prevalent, export receivables originating from a specific business line of a bank or transactions, which are backed by products such as company that produces goods or services for foreign oil, gas, steel, iron ore, soybean, paper and pulp, obligors. The structure of the future flow transaction aluminum, coffee and chemicals. is designed to collect cash flows in a dedicated offshore collection account. The cash flows come A bank or company based in an emerging market from a variety of sources, including foreign importers securitizes existing and future receivables related to making payments on receivables, international credit offshore cash flows (usually in a stable foreign card companies making settlement payments to local currency) and receives the proceeds of the debt banks and international banks making remittance issuance denominated in the same currency. The cash transfers to local banks. All cash flows pass through flows originate from a specific line of business in the offshore collection account, and the excess flows which the bank/company has a strong history of are returned to the originating entity only after participation and which is expected to continue for periodic debt-service payments are made. The

Future Flow Securitization Rating Methodology 3

Structured Finance the foreseeable future, or at least for the life of the on a letter of credit, cash against documents or cash structured deal. In the majority of structures, the against goods basis. bank/company sells its rights to the future flow to an offshore special-purpose vehicle (SPV), which The importer’s bank then sends payment to the transfers its rights to an offshore trust. The trust exporter’s local bank’s nostro account, located at a issues debt securities backed by future cash flows and correspondent bank in the importer’s country. This is remits the sale proceeds to the SPV, which in turn the cash flow that is sold into the securitization. The passes them back to the originating bank/company. correspondent bank signs a notice and acknowledgment (N&A) agreement to pay into the Because noteholders have access to payments on the offshore trust account rather than directly to the local receivables before they return to the country in which bank. Cash is used to pay principal and interest on the the issuer is located, Fitch believes they will not be debt securities, while any remainder is released to the directly subject to convertibility and transfer risks. originator. (Please see Appendix 2 on page 17. In Thus, the ratings of these transactions are not strictly addition, for a more thorough description of this asset constrained by the foreign currency rating of the host class, please see Fitch’s criteria report, “Diversified country (the sovereign ceiling). However, all Payment Rights Criteria,” dated Nov. 5, 2002, and sovereign risks are not mitigated by the structure, and available on Fitch’s Web site at transaction ratings are still constrained by certain www.fitchratings.com.) inherent political and economic risks of an emerging- market country. These risks can arise from such Paper Remittances events as government instability, civil unrest or a Paper remittances are physical checks usually coming natural disaster. from one of three categories: remittances sent by family members abroad to a relative in the emerging- Financial Future Flow market country who then deposits or cashes the check Financial future flow transactions are typically issued at the local bank; travelers in an emerging market by banks and secured by the offshore cash flows who use checks to pay local merchants or cash the generated through the banks’ various lines of checks at the bank; and payments made from abroad business. for the export of goods and services. Types of checks include personal checks, business checks, money Remittances orders, travelers’ checks or other instruments drawn Electronic Remittances on foreign financial institutions. In an electronic remittance securitization, the future cash flows represent payments sent by entities from In a paper remittances securitization, the future cash foreign countries to beneficiaries in an emerging- flows are receivables related to the check-clearing market country. Importers, companies, individuals process due from foreign banks to emerging-market and other entities in the foreign country send banks. The company that issues debt securities payments for goods and services, investments and through an offshore SPV is a local bank in an other transfers to various entities within the emerging-market country that processes the check emerging-market country. An emerging-market bank and receives the foreign currency payment. can issue debt securities backed by its expected future flow of electronic remittance transactions The checks are processed at the local bank and then (often SWIFT MT100 payment orders). sent for clearing to banks in foreign countries. In a check remittance securitization, the clearing banks in Trade Payment Rights: One important subset of the foreign countries sign N&A agreements electronic remittances is the trade payment rights committing themselves to direct the cash from the securitization. These future flows result from cleared checks to the offshore trust account rather payments made by importers to an emerging-market than returning it directly to the local bank. Cash is exporter through each of the entities’ international used to pay principal and interest on the debt banks. The company that issues debt securities securities, while any remainder is released to the through an offshore SPV is a local emerging-market local bank. (Please see Appendix 3 on page 18.) bank. Exporters in the emerging-market country send goods to importers in a foreign country. The importer International Credit Card Receivables arranges payment for the goods in foreign currency In a typical credit card receivables transaction, a foreign traveler creates a voucher (or electronic

Future Flow Securitization Rating Methodology 4

Structured Finance message) when he or she pays with a credit card for mechanisms. Such an event occurred in El Salvador goods or services in an emerging-market country. in the 1980s as part of a government effort to force The merchant in the emerging market presents the all of the hard currency flows back into the country. voucher, or the electronic message is sent, to a local These risks are further discussed in the Sovereign bank. This bank pays the merchant the amount of the Risk section on page 9. voucher in local currency and forwards the voucher to Visa or MasterCard for authorization and Future Export Receivables settlement in U.S. dollars. The processing bank’s Future flow export receivables transactions are right to receive future receivables from Visa and/or secured by receivables due on sales from exports to MasterCard is the security for this type of transaction. foreign obligors or through an established exchange. (Please see Appendix 4 on page 19.) A typical export receivables future flow transaction occurs when a company in an emerging-market Sovereign Risks Associated with Financial country produces a specific export (i.e., steel, oil or Future Flows aluminum) and sells its product to customers The sovereign risks of each financial future flow (obligors) in foreign countries. The obligors, through transaction vary depending on its specific N&A agreements, commit themselves to make their characteristics. For instance, certain remittances and payments to dedicated bank accounts with an credit card transactions do not involve the transfer of offshore trust. The trust then retains funds for the goods and services across borders; therefore, they are transaction’s debt service and sends any excess back less likely to be affected by export controls. to the originating company. The cash flow from the Conversely, trade payment rights transactions are obligors to the offshore trust is the flow securitized in susceptible to these types of controls. Furthermore, this transaction. remittances that are related to capital flows are highly susceptible to downturns within the sovereign Legal variations within the structures exist, and each environment. can have rating implications. Differences are established in the definition of the asset, whether by Of the financial future flow transactions, credit card receivables or product. Differences also exist receivables are the most susceptible to turmoil in the regarding the strength of a claim on an asset, most local sovereign environment, which can be twofold. importantly whether it has been sold into the trust or First, tourism and business-related flows can drop only pledged. Some examples of structural variations due to civil unrest or deterioration in economic include secured export notes, forward sales of conditions. Second, as purchases are made onshore product and outright sales of future receivables. and many goods and services are priced in local currency, these receivables are more susceptible to Future export receivables transactions are also unique devaluation. This second effect is somewhat from financial future flow securitizations in that there mitigated by an increase in inflation and the fact that is a very broad variety of potential assets, and each some goods and services (i.e., hotels) are repriced can bring specific advantages and/or disadvantages to into dollars. the table. Whether it is a pipeline with negligible offtake and redirection risk or a pure commodity with Fitch believes remittances have a higher diversion a healthy spot market, the credit profile of an export risk than credit card related flows. These transactions receivables securitization encompasses a wider range are more susceptible to diversion risk, as the of issues. (Please see Appendix 5 on page 20.) remittances could be diverted from the banks participating in the transaction. This risk is more „ Other Future Flow Asset Classes apparent in a remittance transaction since there are a In addition to those mentioned previously, several variety of potential correspondent banks, whereas a other types of future flow securitizations have been credit card deal only has a limited number of completed. Unique attributes for two examples, potential obligors. Additionally, the paper remittance future flow securitizations of telephone net settlement subset (i.e., personal checks) is even more susceptible payments and airline ticket receivables, are described to diversion risk, as the local government could insert in greater detail in Appendix 6 and 7 at the end of itself into the check-clearing process to ensure that all this report. remittances ultimately flow through the central bank and, thus, frustrate the offshore collection

Future Flow Securitization Rating Methodology 5

Structured Finance

„ Rating Future Flow Transactions company is crucial to the economy of the host Future flow ratings are assigned transaction-specific country or to a powerful economic interest, and/or the IDRs. The process employs a comprehensive rating cash flow generating business in question is procedure when considering future flow transactions. profitable and desirable. Similar to U.S. bankruptcy The structured analysis procedure uses a experience, the originating entity in question might multidisciplinary approach led by Fitch’s Structured be worth much more as a going concern rather than Finance team and involving Fitch’s Sovereign group, in some form of liquidation proceedings. Some Corporates/Bank group and Legal department. The historical examples of companies that have continued rating incorporates an analysis of the probability of operating after a default are companies with the originator producing and delivering a specific monopoly status, top-tier banks, large or state-run product to certain obligors and the assurance that companies, capital-intensive companies with limited- these obligors will remit the cash flows due from the use assets, airline carriers with flag carrier status and receivables into an offshore collection account. Fitch companies operating in a uncertain bankruptcy analyzes the transaction’s ability to legally protect the regime with limited creditor rights. future flow investors from other creditors and the potential of sovereign interference. The analysis The GCA indicates the ability of an entity to continue considers the following factors: operations of a particular line of business as a going concern, despite financial difficulties. For example, • The local currency IDR of the originator; in a credit card receivables transaction, a bank may • The GCA of the originator; have defaulted on its general obligations and bonds; • The product; however, the bank remains functioning and continues to process credit card vouchers, as this is one of the • The obligor; more profitable and valuable parts of its overall • Sovereign risk; operations. For a corporate deal such as an airline • Structural features; and ticket securitization, an airline may default on • Legal analysis. loans/bonds and certain leases but most likely will continue to fly its profitable routes and, therefore, The Going Concern Assessment of the generate the ticket receipts that fuel the cash flows of Originator the securitization. A future flow transaction is not an existing asset securitization. Timely payment on bonds depends The GCA generally acts as a cap for the completely on the continued generation of the securitization’s IDR. However, it is important to note receivable. An exporter must continue to export that the going concern analysis applies on two levels. and/or a bank must continue to process financial While it serves as a general assessment on the flows in order for collateral to be generated. This performance risk of a company, it must also address methodology assumes the ability to generate flows is the strength of the business line being securitized. A highly correlated with financial solvency. transaction rating will be capped at the weaker of the Operational and financial risks, general credit quality two. In the majority of cases, the line being and, thus, the local currency IDR are excellent securitized typically represents a strategic line of proxies for the future generation risk profile of a business. Fitch looks at the importance of the product company. However, the local currency IDR of an within the company, including the profitability of the originator may not be the cap to the transaction’s business line, and whether it produces direct income, rating. Many companies could be in default on their float income, cross-selling opportunities or valuable debt but continue to operate and generate receivables, foreign exchange. In the majority of the export and the structure could legally protect investors’ receivables transactions, the product being exported interest in cash flows. In order to capture this element represents a significant portion of the company’s in a future flow transaction, Fitch uses the GCA. overall sales. From a bank’s perspective, the cash flows generated from remittances and credit cards While the company’s local currency IDR is a good represent only a subset of overall operations; starting point when assessing the performance risk of however, these cash flows are significant contributors an entity, Fitch has seen a number of cases in which to the bank’s foreign-exchange receipts. Furthermore, companies or banks defaulted on debt, yet continued while the processing of international credit cards is to operate specific, securitized business lines. The neither capital intensive nor the primary business line motivation for this is likely to be that a bank or of a bank, it is generally profitable, an important

Future Flow Securitization Rating Methodology 6

Structured Finance source of foreign currency and, most importantly, an During periods of acute sovereign stress and/or integral part of the overall credit card issuing and default, history has shown that governments may acquiring business. override a bank’s normal operations by taking actions that may include instituting bank holidays, limiting Some export receivables transactions have delivery savings deposit withdrawals, freezing bank deposits risk; in certain circumstances there is a risk that while and confiscating deposits and savings accounts the company continues to produce the product, it through forced conversion into new government stops exporting the product and, therefore, stops securities. Such actions are generally intended to generating export receivables. Fitch has seen this stem the loss of confidence in a banking system and situation manifest itself when there is a change in prevent the collapse of the payment chain that could domestic supply or demand, work stoppage in the follow a consequent run on a system’s deposits. In local market, issues relating to the exporting port such cases, the resulting restrictions on depositors facility and/or coercion by the sovereign government. and/or creditors would give rise to a local currency default by the banks affected, further reinforcing the Finally, in certain circumstances, the securitization’s reason for the rating link between banks and IDR has been lower than the GCA for reasons sovereigns. beyond the originator’s or the specific product line’s performance risk. The reasons are typically based on Despite technical defaults that could result from potential for sovereign interference or disruption in government-imposed restrictions, it is common that the delivery of the product to the export market. Fitch most top-tier banks will continue to operate, as their performs a detailed analysis on the risks involved performance is crucial to the maintenance of the with a transaction to determine the potential for payment chain that allows day-to-day commerce to sovereign diversion (see the Sovereign Risk section continue. Fitch has analyzed banks’ abilities to on page 9). operate during a sovereign default in various countries, including recent situations in Russia, Bank Versus Corporate Approach Argentina and Ecuador. For these reasons, the GCAs While the overall analysis to determine the of the top-tier banks have historically exceeded the performance risk and assign the GCAs to both banks local currency IDRs of the banks by 1–6 notches. The and corporates is quite similar, the difference number of notches a bank’s GCA can be rated above between a bank’s local currency IDR and its GCA the local currency rating of the sovereign depends on and a corporate’s local currency IDR and its GCA a variety of factors, including asset quality, business can be significant. The differences are generally mix, market share and franchise, risk management, explained in Fitch’s methodologies regarding credit policies and procedures, ownership structure corporate and bank local currency ratings. and the bank’s intrinsic financial strength.

In most cases, Fitch historically has capped an In the case of corporate ratings, the local currency emerging-market bank’s local currency IDR at the IDRs are also constrained by the sovereign ratings, local currency rating of the sovereign. Bank ratings but to a much lesser degree than banks, and may be are typically linked to the sovereign, as these rated above the local currency rating of the sovereign institutions are highly correlated and intertwined with by several notches. The degree to which the corporate a country’s economy. The banking system facilitates local currency IDRs are constrained by the sovereign a country’s payment system and supports a majority depends on many factors, including type of business, of the economic transactions. Emerging-market industry position, dependence on the local economy, banks in particular often hold large amounts of product destination, cost structure, exposure to government securities and are highly regulated; thus, regulation, ownership structure and financial these banks are subject to the direct actions taken by strength. Local currency IDRs are also influenced by their regulators. Recently, Fitch has published a company’s debt profile, which includes exceptions to this rule and the banks that are denomination of debt, average life, debt mix (i.e., strongest, largest and most likely to receive some capital market debt versus bank debt), etc. As a type of external support (i.e., from a foreign parent) result, the degree to which the local currency rating have been rated higher than the local currency of the of a corporate is linked to the local currency rating of sovereign. However, exceptions are few and do not the sovereign is dependant on a diverse set of facts create wide gaps between the ratings of banks and and circumstances. Also, unlike the banks, corporates those of their sovereigns. tend to be less exposed to government intervention

Future Flow Securitization Rating Methodology 7

Structured Finance that would cause or force a local currency default, as For the majority of private-sector corporates, Fitch described in the preceding paragraphs. has not significantly differentiated between secured local currency IDR and GCAs. The risk of financial During periods of acute sovereign stress and/or default and liquidation are inherently linked for many default, the domestic economy of a sovereign can of these entities. Reflecting Fitch’s rationale for substantially contract, local currency can experience allowing the corporate local currency IDRs to exceed sharp devaluation and inflation can run rampant, the sovereign local currency ratings and assigning forcing the government to impose price controls on bank GCAs at a somewhat related level, future flow certain goods and services. The financial markets and IDRs for top-tier banks and corporates, remain quite banking system undoubtedly would be disrupted in similar. this environment, limiting financial liquidity. Clearly, these stress scenarios would create a difficult State-Owned Companies operating environment for all corporates, but the Future flow transactions can also involve state-owned effect would vary by type of company. Exporters, for companies, and Fitch’s approach to these entities example, likely would do significantly better than differs from privately owned companies. Similar to companies more dependant on the local economy. banks, in most circumstances Fitch either caps or Exporters generally compete on a global basis and closely links the local currency IDRs of state-owned actually benefit from devaluation due to their higher companies to the sovereign ratings of the country. levels of revenue in hard currencies, such as U.S. Many times, their ownership is embodied into law dollars or euros. Thus, devaluation would lower their and, in some cases, the national constitution. State- cost structure and reduce the burden of their local owned entities, which may give the appearance of currency debt obligations relative to their hard independent and autonomous management, are currency denominated cash flows. Fitch believes significantly influenced by a government’s current these entities have a high degree of insulation from administration and are staffed with governmental the government and, thus, their local currency IDRs appointees. The influence of policymakers can also can exceed the local currency rating of the sovereign affect these companies’ operating plans and by 1–6 notches. Therefore, like the banks, the GCAs strategies, capital-investment plans and financial of the top exporting corporates have also historically policies. In addition, a government’s willingness exceeded the local currency IDRs of the sovereign by and/or constitutional ability to differentiate between 1–6 notches. its local currency sovereign obligations and its state- owned enterprise obligations can sometimes be In contrast to exporters, companies dependent on the difficult during a sovereign debt restructuring. local economy, such as food retailers, are more likely to be exposed to recessionary pressures of sovereign Fitch’s GCAs of state-owned entities will often environment. One food retailer may perform better exceed the local currency IDR of the company by than a similar food retailer in the same market if one several notches. This is because liquidation scenarios of the companies has a majority of its debt in are less conceivable, as these state-owned enterprises dollars/euros and the other does not or if one of the are often large, strategic assets and may represent a companies has very little debt and is better substantial portion of a government’s revenues or capitalized than the other entity. fiscal receipts. Many times the companies produce resources that are critically important to the A third type of company is a regulated entity. The economy, such as energy, oil or public services. link to the sovereign is much greater here due to the Additionally, these companies are often exporters and high level of state regulation, dependence on local generate a significant portion of a country’s hard economic conditions and the government’s ability to currency, giving the sovereign a huge incentive to impose price restrictions to control inflation. continue producing and exporting. While the GCA Assuming clear law and regulations enforced by a levels might be well-above the local currency IDR of reasonably independent regulatory commission, high the state-owned company, Fitch often caps the capital-investment needs in the sector, conservative transaction rating before it reaches the level of the financials and foreign sponsor support, a regulated GCA, as Fitch believes state-owned companies are entity can be rated a few notches higher than the local more susceptible to sovereign interference. currency rating of the sovereign.

Future Flow Securitization Rating Methodology 8

Structured Finance

The Product exporters, whose obligors are numerous and In rating an originating company and a future flow diversified. These transactions must have sufficient transaction, attributes of the product itself are taken overcollateralization to compensate for any potential into consideration. The product should have a stable volatility in the flow of obligors. Other enhancements or increasing demand profile and produce a that mitigate potential obligor risk are letters of credit consistent cash flow. There should be a low and insurance. possibility of product obsolescence and a large, stable international market. The breadth and depth of the Sovereign Risk client base and the duration of customer relationships A defining attribute of future flow transactions is are also important. Similarly, the availability of their ability to be rated above the sovereign ceiling. substitute products and an assessment of customer For this to be achieved, several sovereign risks must switching costs are also considered. Analysts look at be mitigated by the structure. These risks include the competitive environment, and any advantages the transfer, convertibility, devaluations and, to some company has are recognized (i.e., technology or degree, nationalization and expropriation. geographical positioning). Finally, Fitch considers the potential risk of product diversion and payment If there is a shortage of foreign exchange in the redirection. emerging-market country, any controls on transfer or conversion of foreign exchange should be mitigated Fitch also considers the price volatility of the product in a structured future flow transaction, as payments involved. Price risk is usually addressed by from the obligors are collected offshore. Foreign- dedicating excess receivables to the transaction exchange risk is mitigated by using sales contracts (overcollateralization). Alternatively, long-term sales denominated in hard currency, typically U.S. dollars contracts can be used to ensure minimum volumes of or euros. If the N&A agreements are broad enough in receivables at certain prices. nature, the structured transaction can also mitigate against certain forms of nationalization and Financial future flow transactions do not have price expropriation. When determining the foreign risk but have exchange-rate risk instead. Prices of currency rating of the future flow transaction, Fitch goods and services within a country rise and fall in decides whether the structure properly protects relation to the volatility of the exchange rate. In both investors from these various risks. financial and export receivable transactions, stress tests are employed using historical data to provide When a sovereign is in default, it not only restricts ample overcollateralization. the transfer and converting of foreign exchange, but it often forbids entities from keeping cash flows The Obligors offshore. Moreover, exporters are often directed to The obligors of export receivables transactions are remit receipts back into the country. Fitch analyzes purchasers of the product that are generating the these risks when determining the foreign currency receivables. The obligor for a financial future flow rating of the future flow transaction. Because the transaction is the clearing/correspondent entity, such structures are designed to keep cash flows offshore, it as Visa in a credit card transaction or Citibank in a is important to ensure that even during sovereign diversified payment rights transaction. The obligor stress, it is difficult to redirect these export proceeds profile should be commensurate with the back to the sovereign. Fitch analyzes redirection risk transaction’s rating. The obligors in a securitization by looking at both the incentives and the ease/ability involving a small number of customers should enter with which a government could interfere with the into long-term, noncancelable sales contracts and transaction. have a senior unsecured credit rating at least equal to that of the transaction. The obligors of a Incentive—Coverage/Debt Size securitization involving multiple customers are Fitch measures incentives by looking at the size and analyzed carefully, but not all obligors need to be total amount of future flow debt within the country, rated higher than the transaction. However, as well as the amount of foreign-exchange receipts overcollateralization and/or obligor substitution involved for the particular transaction. While Fitch mechanisms can be used to support transaction relies on overcollateralization to mitigate volume and ratings. Securitizations that capture an originator’s price risk, we also believe it is an important element entire customer base typically involve commodity in mitigating the incentive for government

Future Flow Securitization Rating Methodology 9

Structured Finance interference. If a transaction has debt-service credit card vouchers, the customer base is very coverage of 10 times (x), then only 10% of the narrow and it is difficult to deliver this product to any foreign exchange is being collected offshore and the other customers. If the product is gold or any other rest is returned to the originating company. type of worldwide commodity, the number of Conversely, if an entity has debt-service coverage of potential buyers is enormous, and it would be only 1.25x, then 80% of the cash flow is collected impossible to get all potential customers to sign N&A offshore. Therefore, even if price and volume risks agreements. Finally, Fitch believes structured are removed, Fitch would like to see additional transactions are much more susceptible to coverage to decrease a sovereign’s incentives to product/customer redirection/diversion when the interfere in the transaction. originating entity is state owned. In most cases, these state-owned companies act as a direct arm of the Similarly, Fitch analyzes the sovereign’s total future sovereign, and the potential for interference is flow debt relative to a sovereign’s other debt. Fitch therefore greater. looks at these debt levels and the overall debt profile when determining the total number of notches the Fitch’s foreign currency rating for a transaction transaction can be rated above a sovereign’s foreign considers the structure’s ability to protect against the currency rating. various sovereign redirection/diversion risks. If the structure does not offer sufficient protections, Fitch Sovereign Redirection/Diversion differentiates the rating on the transaction. Such A sovereign’s or company’s ability to redirect circumstances might cause the foreign currency exports or the proceeds from these exports can be rating of a transaction to be below the GCA rating of classified as payment redirection/diversion risk or the originator. product/customer redirection/diversion risk. Fitch believes payment redirection/diversion risk is Structured future flow transactions inherently tend to mitigated by the N&A agreements signed by the discourage sovereign interference in various ways. obligors of the transaction. The N&A agreement is Historically, emerging-market governments have useful, because it effectively binds an obligor to the exempted third-party contracts because of fear that transaction by creating recourse in the event the interference could limit international trade. Also, the obligor participates in the diversion. It is important debt-service payments of a transaction should be a that these N&A agreements are broad in nature so fairly small part of a company’s foreign-exchange that they encompass a variety of circumstances. The earnings potential and liabilities. A company should, agreement should broadly identify the receivables so if it keeps producing at high coverage levels, that there is no question the customer should make consistently receive high returns even after the debt- payments to the transaction’s offshore collection service payments are made. In this scenario, the account. Additionally, the strongest N&A agreements government has little incentive to interfere in the contain successor language so that the obligors transaction. continue to pay into trustee-administered accounts, even if there is some type of change in control. The There are other sovereign risks that are unique to a stronger the language in these agreements, the more country and could interfere with the originator’s difficult it is for the sovereign or company to force ability to generate receivables. These risks include the customers to redirect payments. nationalization of a company or industry, creeping expropriation, domestic hyperinflation, civil unrest, Product/customer redirection/diversion is when an terrorism, and/or labor disturbances. Fitch limits the entity sells its product to customers that have not degree to which transactions are rated above the signed N&A agreements. By directing the product to sovereign ceiling to an extent dependent on all of the customers outside the structure, the sovereign can rating factors described herein. reclaim the foreign exchange that might have been lost due to the offshore collection account Structural Features mechanisms. The potential of this risk typically Depending on the structure of the transaction, the varies depending on the type of product, which originator may transfer the receivables either directly determines the potential customer base and also the to the trust or through an offshore SPV. Fitch reviews total number of customers who have signed N&A the structure to ensure it provides adequate security agreements. For instance, if the product is very for investors. The specifics of this review are specific, such as crude oil, auto parts or international

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Structured Finance

discussed in the Legal Considerations section on page Emerging-Market Legal Environment 12. The majority of future flow transactions are structured relying on the local sale of the Debt-Service Coverage Ratios underlying receivables. While Fitch requires a The debt-service coverage ratios (DSCRs) for a proper sale when rating transactions above the future flow transaction vary significantly depending originator’s default risk, we also recognize that on a variety of characteristics present in the specific many emerging-market legal systems have transaction. Fitch typically measures the DSCR as the relatively weak bankruptcy regimes. In practice, receivables for a specific period of time divided by many emerging-market bankruptcy regimes are the maximum debt service over the life of the deal for characterized by weak creditor rights. These that specific period of time (i.e., quarterly flow over weaknesses often allow the originating entity to maximum quarterly debt service). For the calculation, maintain normal operations and control the Fitch typically reviews the last three years of majority of the restructuring proceedings. While receivables, normalizing for any abnormal these weaknesses may be detrimental to the circumstances. In addition, Fitch considers the effects majority of the originating entities’ creditors, this of seasonality when analyzing these levels. The weakness can work to the benefit of the future DSCRs offer protections for a variety of issues, flow creditors. Future flow transactions including price fluctuations, volume fluctuations, significantly reduce the willingness-to-pay issue; credit quality of the obligor base and volatility of therefore, the originator is essentially forced to interest rates. Fitch also believes the level of DSCRs pay future flow creditors, even during provides differing incentives for the potential for reorganization or restructuring proceedings. Fitch interference by the originator or the sovereign. has seen this play out when an originating entity has been in default with the majority of its The Debt-Service Coverage Ratios table on page 15 creditors; however, the entity continued to shows standard minimum ranges for a ‘BBB’-rated operate, and the future flow transaction survived. transaction. Depending on the rating level sought, The rating requirement of a proper sale, coupled these ranges are adjusted upward or downward. The with a realistic understanding of bankruptcy ranges remain broad, as the individual characteristics proceedings, can be considered a “belts and of a specific transaction dictate the exact level of suspenders” type approach. coverage. able to restructure all other obligations, repair its Relative Size of Debt balance sheet and return to financial stability without Given the right circumstances, and if the transaction prejudice to the future flow securitization. The higher is structured properly, Fitch will rate a future flow the proportion of future flow debt, the closer the transaction above the local currency IDR and up to rating on the transaction is to the unsecured local the GCA of the originator. An integral part of making currency IDR of the originator. Also important to the a rating differentiation between the local currency debt profile analysis is the future flow creditors’ legal IDR and the transaction rating is the relative size of protections and how well these creditors are protected the future flow debt in relation to the company’s from actions by the company’s other creditors. overall debt profile. For the transaction to be rated at the GCA or the local currency level, the amount When evaluating the ratio of secured to overall debt being securitized should be small and have strong for corporate issuers, Fitch considers 10% small security in relation to the company’s other enough to allow securitization ratings at 2–3 notches outstanding debt obligations. In this case, Fitch will over the local currency IDR of the company. A ratio analyze the originating entity’s overall debt profile of 10%–50% is considered average and would allow and determine the strengths and weaknesses the for ratings 1–2 notches over the company’s local various forms of debt have in relation to each other. currency IDR. Anything greater than 50% is In the majority of cases, the future flow debt is considered relatively large, and the methodology considered senior to the other forms of debt, as it would not likely allow the structured IDR or GCA typically controls a vital source of the originator’s ratings to differ from the company’s IDR. For top-tier revenues and reduces any issues related with banks, given that their GCA could significantly willingness to pay. Similarly, if senior secured debt is exceed their IDR and the fact that future flow debt relatively small, the company is more likely to be tends to be a relatively small portion (less than 10%)

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Structured Finance of total liabilities, transaction ratings greater than 3 described in the Legal Considerations section below, notches over the issuer’s IDR can be considered. the agreements strengthen certificateholders’ rights to the receivables in the event of a bankruptcy. Collections Collection procedures should be structured so that Legal Considerations receivables are directed by the trustee to fund When completing our legal review for cross-border, periodic debt service with excess collections remitted emerging-market future flow securitizations, Fitch back to the originator. Typically, procedures specify uses both international and local counsel. One of the that the trustee will retain all or a majority of flows key elements in Fitch’s legal analysis of cross-border, for accelerated amortization under certain trigger future flow transactions concerns the rights of the events. The receivables must be denominated in the trust in the receivables. Legal opinions are typically same currency as the transaction to eliminate rendered by counsel in the originator’s jurisdiction, exchange-rate risk. If the currency denominations are any offshore location in which a special-purpose different, Fitch will stress these different cash flows. entity (SPE) is located and the jurisdiction in which Floating-rate issues should have swaps, caps or the trust is located. They address two principal issues: overcollateralization, which mitigate interest rate and the first priority of the trust’s secured rights in the basis risks. Some transactions have a reserve account, receivables and potential interference with or delays which would be adequate to provide liquidity in the in the exercise of those rights, particularly in the case of a temporary disruption in collections or event of the insolvency of the originator. In production. transactions rated no higher than the originator’s local currency IDR, timing delays in the event of the Triggers originator’s insolvency are not a significant legal Specified event triggers that either accelerate issue, because that performance risk has already been amortization of the transaction or obligate the fully factored into the rating. originator to repurchase receivables are generally required. Accelerated amortization triggers require However, in transactions rated higher than the the trustee to trap all cash generated from the originator’s local currency rating, insolvency-related receivables on certain specified events. Such events delays must be addressed not only from the point of can include deterioration in the volume of view of the originator’s own jurisdiction but also in receivables, breeches of covenants and/or light of the fact that section 109 of the U.S. representations and warranties of the originator or Bankruptcy Code (the code) defines a debtor as government action that adversely affects the including any entity that has property in the United transaction. While these triggers provide a certain States. Thus, any originator with property in the degree of negotiating power for creditors, in most United States may be subject to the automatic stay cases they do not serve the purpose of immediately provisions of the code. Collections on the receivables prepaying the transaction. If all cash flows were in the U.S. account held by the trustee may be trapped, this would cause an extraordinary liquidity considered property of the originator for U.S. event that could further destroy the company’s bankruptcy purposes, even if their transfer is production capabilities. More commonly, Fitch has nominally described as a sale, because the seen these triggers act as an early warning signal in characteristics of that “sale” are typically not strong transactions and, as a matter of negotiation, the future enough for U.S. counsel to opine that it be held to be flow investors have typically allowed some of these a sale by a U.S. bankruptcy court. One of the reasons captured funds to go back to the originating entity. for this is that the trust must be structured so as to Thus, it is common and acceptable to see these avoid entity-level taxation. trigger events only capture a portion of the collections, rather than 100%. There are three methods that have been used in Fitch- related transactions to address U.S. bankruptcy Notice and Acknowledgements issues. The most common method in transactions Finally, Fitch views the execution of irrevocable Fitch has rated higher than the originator’s local N&A agreements by the obligors as significant currency rating is a structure that incorporates a local enhancements to all the structures. These agreements true sale to an offshore SPE, with the SPE being the help reduce the risk of sovereign redirection of transferor to the U.S. trust. Although the second payments to the central bank. In addition, as further transfer may be viewed as financing for bankruptcy purposes, a bankruptcy filing should not occur,

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Structured Finance because bankruptcy-remote SPEs should not have the obligor and has fulfilled all other applicable any other creditors. This is the same for similarly obligations. structured domestic transactions. • The receivables (a) meet any applicable concentration limit requirements and (b) are no A second method has been used when the originator is more than a certain number of days delinquent. exempt from the code. This exemption is available to • The receivables are an “account” or “general certain foreign banks. Unlike U.S. banks, which are intangible” under U.S. law (if U.S. law is generally exempt from the code, foreign banks are only relevant to the transaction). exempt from most provisions of the code if they are • Prior to sale, the originator has good title to the engaged in the business of banking in the United States. receivables, free and clear of any adverse claim, If reliance is in place on this exemption, Fitch expects and the applicable sale agreement has constituted U.S. counsel to opine as to its applicability. Also, the a valid transfer of all of the originator’s rights, transaction documents must contain covenants to notify title and interest in the receivables. Fitch if the foreign bank ceases the U.S. operations that • The receivables were created in accordance with initially allowed for the exemption. and do not contravene any laws, rules or regulations applicable thereto, or contract A third option is to locate the trust account in a between the originator and the obligor, and no jurisdiction that does not have an automatic stay or party to any related contract is in violation of any comparable delay risk. The jurisdiction of the such law, rule or regulation. Cayman Islands has been typically used for these • No procedures or investigations are pending or transactions. In such a case, Fitch expects transaction threatened that would adversely affect the counsel in that jurisdiction to confirm in their legal payment or enforceability of the receivables. opinion the absences of these legal processes. Many • No right of rescission, offset, setoff, recoupment, future flow transactions have reserve accounts that defense or counterclaim with respect to payment are typically held in U.S. bank accounts. As these of amounts due under the receivables exist, and funds ultimately will be remitted back to the neither the receivables nor the related contract originator, they could be susceptible to a stay by a has been satisfied, subordinated or rescinded; in U.S. bankruptcy judge if creditors or debtors file addition, the originator has no knowledge that at within the United States. Fitch believes a letter of the time of sale of the receivables, the credit payable to the SPV would mitigate this risk obligations thereunder would not be paid in full. and, therefore, provide liquidity to the transaction, • Such receivables are the legal, valid and binding which offers greater protection to investors in the obligation of the obligor and are enforceable in event of an insolvency proceeding. accordance with their terms. • The related obligor on the receivables has Due to the nature of future flow transactions, which received notice and has agreed to send payments often involve the assignment of all of an originator’s directly to the relevant trust account. receivables from specific obligors, representations and warranties for individual receivables may be less This latter requirement—that notice be sent to the significant than they would be in a fixed-pool obligors—serves three functions. First, it informs transaction or a revolving structure that is fully obligors that payments are to be made directly to an collateralized by existing receivables. This is because account held for the benefit of investors (typically in a future flow transaction is rated based on the the United States or other jurisdiction in which the originator’s ability to generate a specified level of trustee is located) rather than being remitted to the cash flow from the particular asset type over a certain originator in its home country. Second, it may be period of time. helpful to the true sale analysis (if such analysis is relevant in the particular transaction) that as many Nonetheless, Fitch generally expects (subject to parties as possible are advised of the originator’s modification in appropriate circumstances) the intent that the transaction be considered a sale. Third, following representations and warranties in the in certain circumstances, notice may be necessary to transaction documents: perfect the interest of the trustee in the receivables under the Uniform Commercial Code (UCC) by • The originator has submitted all necessary advising the obligor that the receivables have been documentation for payment of the receivables to sold or pledged (the UCC applies not only to pledges

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Structured Finance of accounts and general intangibles but also to sales account or general intangible for money due, the of accounts). security interest of the trustee may be perfected by notice. This method of perfection may be the only If the assignor of the receivables is located in a one relevant under the UCC in circumstances where jurisdiction outside the United States or Canada and the assignor’s home country does not have a filing the receivables are properly characterized as an system, and U.S. filings cannot be made because the assignor does not have a U.S. office.

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Structured Finance

Debt-Service Coverage Ratios

Commodity Exports 5x–6x Price Risk High Volume Risk Medium Obligor Risk Low Sovereign/Corporate Redirection Medium/High

Commodity Exports with Price Hedge 3x–4x Price Risk Low Volume Risk Medium/High Obligor Risk Low Sovereign/Corporate Redirection Medium/High

Commodity Exports with Supply Agreement 3x–4x Price Risk High Volume Risk Low Obligor Risk Low Sovereign/Corporate Redirection Medium/High

Specialized Exports 4x–5x Price Risk Medium Volume Risk Medium Obligor Risk Medium Sovereign/Corporate Redirection Low

Telephone Net Settlements 3x–5x Tariff Regime and Potential Volatility Varies Volume Fluctuation Incoming/Outgoing Low Local Competition Varies Obligor Risk Varies Sovereign/Corporate Redirection Low

Airline Ticket Receivables 3x–5x Price Risk Medium Volume Risk/Cut in Routes Varies Obligor Risk Low Sovereign/Corporate Redirection Medium/High

Paper (Checks) Remittances 10x–15x Volume Risk Medium/High Obligor Risk Low Sovereign/Corporate Redirection High

Electronic Remittances (Diversified Payment Rights) 10x–15x Volume Risk (Depends on Remittance Type) Workers’ Remittances Low Trade Receivables Medium Capital Inflows High Devaluation Exposure Low Obligor Risk Low Sovereign/Corporate Redirection Medium

Credit Card Receivables 4x–5x Volume Risk Medium Devaluation Exposure Medium/High Obligor Risk Low Sovereign/Corporate Redirection Low

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„ Appendix 1: Case Study of Future Flows of Credit Cards: Bank Internasional Indonesia (BII)

Indonesian Crisis (1997–2001) In August 1997, the Indonesian government first devalued the rupiah, which had been at 2,383 to the dollar at year-end 1996. The devaluation began slowly, but as the Asian financial crisis gripped the country, the rupiah hit levels of more than 10,000–17,000 to the dollar throughout 1998. Then, interest rates sharply climbed, companies with unhedged foreign currency liabilities became insolvent and social unrest increased. Yet, the economy appeared to defy political gravity during 2000 with 4.3% growth, its highest level since the start of the crisis. However, by the end of 2000, political turmoil had begun to translate into exchange-rate depreciation, rising inflation and higher interest rates. Relations with the International Monetary Fund (IMF) went from bad to worse, and disbursements under the current program ceased from December 2000 until late 2001. Nonetheless, higher oil prices helped Indonesia to attain a record account surplus in 2000, pushing international reserves up to US$28 billion. Bank Internasional Receivables Trust The Bank Internasional Indonesia (BII) securitization of future credit card vouchers closed in July 1997 with debt-service coverage of roughly 4.2 times (x). The transaction was based on the bank’s ability to continue generating credit card vouchers in order to repay the debt. Soon after the close, the rupiah began to lose value, and total cash flows decreased by roughly 50% by January 1998. Unlike the Mexican peso in 1994, the rupiah did not stabilize but instead continued to devalue. The cash flows experienced additional decreases as social unrest broke out in May 1998, and the transaction bottomed out in midyear 1998, with coverages only 2.0x the maximum debt service. Flows rebounded slightly during the latter portion of the year due to rising inflation and temporary strengthening of the rupiah, which prompted local merchants to increase prices. Despite this tentative stabilization, the overall political uncertainty and the deep recession caused a severe decline in tourism and business travel, the primary sources of incoming cash flows for the credit card receivables transaction. Yet, the overall coverage level continued to increase after 1998. Coverages averaged 2.65x maximum debt service for the 12 months ending April 2000 and 3.40x for the 12 months ending April 2001. The exchange rate has stabilized somewhat around 9,000 rupiah to the dollar since 2001, due to greater political stability with the appointment of Megawati as the new president.

More recently, the Bali bombing of October 2002 placed further stress on the transaction as foreign tourists avoided Bali and Indonesia in the weeks and months following this event. Prior to the bombing, debt-service coverage peaked at 4.32x in September and dipped slightly in October to 4.17x. It subsequently plummeted to a low of 2.17x maximum debt service in December. The coverage level improved in the first month of 2003 to 2.7x maximum debt service. Fitch continues to follow this transaction very closely and will update investors on any material developments. The stress experienced in Indonesia highlights the volatility emerging markets may experience but bolsters Fitch’s belief that future flow transactions must have high levels of debt-service coverage to achieve investment-grade ratings.

Bank Internasional Indonesia (BII) An additional lesson to learn from the Indonesian crisis is the importance of the originating bank and its role in the market. Prior to the 1997 economic crisis, BII was the country’s preeminent bank with good technology, a strong ATM network, innovative products and a deposit base in the mid- to upper class retail market. However, the bank’s lending operations were very focused on large corporations and, thus, it suffered huge losses during the crisis. BII experienced three bailouts by the government from 1999 to mid-2002, which resulted in a 94% government stake in the bank by the end of 2002. The structured transaction saw a number of downgrades over these years due to the decrease in flows and the deterioration in the credit quality of the bank. Debt-service coverages ceased to be a constraint to the rating and, rather, the bank’s then long-term foreign currency rating of ‘B–’ capped the transaction’s rating at ‘B–’. BII’s rating is based on the government’s ability and willingness to support it, which in the long run is not feasible due to the bank’s lack of systematic importance and the Indonesia’s stressed finances. However, BII’s future is increasingly optimistic. The bank’s objective now is to reorient its lending operations toward the consumer and small-medium enterprise markets. Also, despite issues leftover from the crisis that hinder the bank’s recuperation, such as BII’s lack of products and inadequate marketing and processing expertise, the credit card business remains strong. With a good technological base, sizeable branch network and presence among mid- to upper class retail depositors, BII should experience rapid growth.

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Structured Finance

„ Appendix 2

Trade Payment Rights

Pays transaction Sells future trade fee payment rights Exporter in Emerging-Market Bank in Emerging- Offshore SPV Country Market Country Sends payment Pays for future trade for goods payment rights Ships goods

Transfers Pays for future future Pays for goods Importer’s Bank in trade trade Importers in Foreign Country payment payment Foreign Country rights rights

Sends Sends trade payment excess rights funds cash

Emerging-Market Bank’s Correspondent Bank Located Offshore Trust Sends trade payment rights funds in Foreign Country

Issues Pays for bonds bonds Pays interest and principal Investors

SPV – Special-purpose vehicle.

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Structured Finance

„ Appendix 3

Remittances

Sells future credit card receivables Bank in Emerging-Market Offshore SPV Country Pays for future credit card receivables

Deposits foreign Credits currency- account for denominated deposit checks Transfers Pays for S en rights to rights to ds e future future xc Account holder in Emerging- es credit card credit card s ca receivables receivables Market Country sh

Submits checks

Clearing/Correspondent Offshore Trust Banks in Foreign Country

Issues Pays for bonds bonds Pays interest and principal Investors

SPV – Special-purpose vehicle.

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„ Appendix 4

International Credit Card Receivables

Sells future credit card receivables Bank in Emerging-Market Offshore SPV Country Pays for future credit card receivables Pays for Submits vouchers in credit card local vouchers currency Transfers Pays for Pays for goods and Foreign Business services with credit card rights to rights to Merchant in Emerging-Market People and future future credit card credit card Tourists Country receivables receivables Sells goods and services Petitions for Sends payment on excess vouchers cash Sends credit card receivables payment in foreign currency Foreign Credit Card Network Offshore Trust

Issues Pays for bonds bonds Pays interest and principal Investors

SPV – Special-purpose vehicle.

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Structured Finance

„ Appendix 5

Export Receivables

Exporting Sells receivables Company in Offshore SPV Emerging-Market Country Pays for receivables Pays Exports Transfers Pays for excess receivables receivables cash flows

Obligors Pays for exports (Designated Offshore Trust Customers)

Pays Issues interest securities Pays for and securities principal

Investors

SPV – Special-purpose vehicle.

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Structured Finance

„ Appendix 6: Future Flow Securitizations of Airline Ticket Receivables In airline ticket receivables securitizations, the future flow is a result of payments made on international ticket purchases. The hard currency proceeds from sales executed in the United States or other foreign jurisdictions are captured offshore by the structure prior to being remitted back to the airline. The majority of these sales are in cash or via credit cards and take place at foreign ticket offices of the airline, travel agents or over the Internet. Regardless of point of purchase, most tickets are arranged and settled through Airlines Reporting Corp. (ARC), a global system for all airlines that facilitates the transaction process between carriers and travelers.

In the case of cash purchases, ARC acts as a direct obligor and, having executed a notice and acknowledgment agreement, forwards all proceeds directly to the offshore trust. For credit card purchases, the corresponding voucher is forwarded by ARC to a clearing bank. The clearing bank then forwards the voucher to the card’s payment network (e.g., MasterCard International, Visa International or American Express Co.) who in turn is obligated to pay the receivable amount into the offshore trust.

The collateral is typically defined in terms of revenues generated from specific international routes and only from ticket sales taking place at foreign locations. In this regard, a structure ensures the creation of offshore cash flows, a key element to future flow transactions. In some cases, the collateral is not restricted to international routes but may include the strongest domestic routes as well. Cash flows, derived from domestic operations without offshore payment mechanisms, are generally constrained by the sovereign ceiling.

Key points of Fitch’s rating analysis include the following:

• The likelihood that the local airline will continue to remain in business, fly certain international routes and sell tickets in foreign countries. • Reliability of ARC and foreign credit card companies to meet payment obligations to the local airline. • Regulatory and competitive environment within the local country and for international routes.

Performance Risk and the Going Concern Assessment Similar to other future flow analyses, Fitch will make a going concern assessment for the originating airline, which is more a measure of commercial or operating risk rather than financial payment risk. The assessment is based on the fact that, in many countries, financial default for an airline will not lead to liquidation. Despite a default on general obligations, as long as the airline continues to fly the securitized international routes, receivables should be generated and controlled by the transaction’s structure. Fitch’s Corporates group, in conjunction with Fitch’s Sovereign group, examines financial statements, management experience, operating performance, potential sources of support, and country and industry outlooks to determine the airline’s local currency rating and going concern assessment. Future flow securitization ratings higher than the corporate rating are achieved only in cases where the going concern assessment exceeds the local currency of the corporate and a true sale structure is employed. Like all future flows, the true sale concept must be validated under local law, confirming that under all reorganization scenarios, as long as the receivable is generated, no other creditors or the company will have the ability to interfere with securitized cash flows.

Receivables Generation Risk A major issue in rating an airline ticket receivables securitization is whether the airline will be able to continue producing the cash flows necessary to meet timely debt-service obligations. While the going concern assessment addresses the ability of the airline to stay in business, it does not ensure the airline will maintain the eligible international routes generating the receivables. To determine whether the cash flows sold will continue to be generated, Fitch considers the historical stability of cash flows, the outlook for the flows and the importance of the routes being sold to the country, the industry and the airline’s operations. During a time of stress, the airline should still be projected to generate the cash flows that are being sold into the securitization.

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„ Appendix 6: Future Flow Securitizations of Airline Ticket Receivables (cont’d) Fundamental to Fitch’s analysis is an assessment of the relative importance and sustainability of the eligible routes. Typically, international passenger routes are among the most profitable of an airline’s overall operations (although this is sometimes supplemented, if not driven by, accompanying cargo operations). This is significant, given that airlines allocate aircraft and resources to the most profitable routes. During periods of stress, when the airline could be forced to scale back operation, these routes should be among the last affected. In many securitizations, there is recourse to the originator and/or debt covenants obligating the originator to maintain the business lines or core operating assets generating the receivables.

Origination Risk The receivables should have stable or increasing generation projections, a low possibility of obsolescence and a large, stable international market.

Fitch considers the following in its assessment of the likelihood of the airline continuing to generate ticket receivables for the routes sold into the securitization:

• Strength of the Airline’s Market Position in the Routes: In addition to a historical analysis, Fitch considers expected market share, taking special note of existing or potential code-sharing agreements with other international carriers. • Importance of the Routes to the Airline: The routes should be a vital part of the airline’s business and/or difficult to discontinue. • Diversity of Eligible Routes: The more diverse the eligible routes are the less reliance there will be on demand levels within any single international corridor for the generation of receivables. • Local Regulatory Environment: The local government can create and/or remove barriers to entry, controlling access to the market and affecting the stability of an airline’s international operations. • Seasonality of the Receivables: During periods of traditionally low volumes, the receivables should still generate sufficient cash flow to cover the debt service. • Consumer Preferences, Technological Forces and Other Demand Factors.

Obligor Risks Obligors should be domiciled in countries with sovereign ratings equal to or higher than the securitization rating. Likewise, the obligors themselves should have credit ratings that are commensurate with the securitization rating. In ticket receivable securitizations, the direct obligors (i.e., the entities that sign the notice and acknowledgment agreements to pay into the trust accounts) are the credit card networks, highly rated correspondent banks, ARC or other similar clearing networks. While some of these entities may not be capable of receiving a traditional credit rating, they may be considered to pose minimal credit risk, as is the case with ARC due to its exclusive clearing activities.

Size of Issuance and Debt Profile The amount of debt securities that can be issued by an airline is directly related to the amount of future secured cash flow they are expected to generate. The magnitude of the debt-service coverage required depends on the projected stability of the cash flows under stress and the desired rating for the securitization.

Similarly, as in other future flows, the debt profile of the company is important. Airlines are unique in that they typically have very large lease obligations in order to finance aircraft. While this may offer financial flexibility (e.g., via returning planes and getting out of leases) during times of stress, it also must be recognized that these essential-use-equipment payments are a priority of a company and rank similar to future flow in seniority. In determining the ability to rate over the corporate rating, Fitch will review the size and nature of the airline’s debt obligations and judge the degree of financial flexibility during stress scenarios.

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Structured Finance

„ Appendix 7: Future Flow Securitizations of Telephone Net Settlement Fees Telephone companies based in emerging-market countries can issue debt that is secured by their future foreign currency cash flows. When someone in a foreign country places a call to a number in the local country, the foreign telephone carrier must use the network of a local company to complete the call. The foreign company owes a per-minute fee, fixed in a tariff, to the local company for providing the service. Similarly, when a customer of the local company makes a call to the foreign country, the local company owes a per-minute fee to the foreign company. The amounts payable between companies are offset on a regular basis. Since call volume is typically greater into the emerging-market country, the local telephone carrier will usually have a foreign currency receivable upon settlement. This net settlement flow represents the collateral in a future flow securitization of telephone net settlement fees.

If the securitization is structured properly, it will be shielded from some of the risk of the sovereign and can obtain a rating higher than the foreign currency rating of the sovereign. Furthermore, in certain situations, based on the results of a going concern assessment, a structure backed by a true sale may be able to obtain a rating higher than the local currency rating of the emerging-market telephone company.

Key points of Fitch’s analysis include the following:

• The likelihood that the local telephone carrier will remain in business and stay competitive for the life of the securitization. • The regulatory environment in the emerging-market country and its potential effect on competition in the market. • A projection of international call volume. • The likelihood the local telephone carrier will continue to have net cash inflow from the settlement with the foreign carrier. • Possibility that the telephone tariff may change over the life of the deal, thereby affecting the net telephone settlement amount. • Reliability of the foreign telephone carrier to meet its payment obligations to the local carrier in a timely manner.

Regulatory and Market Risk Many emerging-market countries have undergone the privatization or opening of their telecommunications sectors. Deregulation can have a large influence on a company’s ability to compete both domestically and abroad. Understanding an issuer’s competitive position within a changing environment is fundamental to the analysis.

The analysis begins with a review of the current state of the industry. Often regulators have specific goals behind a privatization or market-opening strategy. Beyond the immediate advantage of income derived from the selling off of state assets and/or concession rights, emerging-market governments likely hope to increase telecommunications service to urban areas, expand service into rural areas, reduce long-distance rates and modernize technology, among other goals. The strongest companies will have strategies that complement government expectations. Alignment avoids the potential for a conflict of interest against the regulatory body that has the authority to oversee and manipulate the industry.

Competition is increasing in most emerging-market countries. Industry maturation can have four principal effects on a telephone net settlements securitization: market share changes; call volume growth; change in ratio of incoming to outgoing calls; and changes in tariff rates.

Market Share All other things held equal, market share loss means less traffic through a carrier’s network. Less traffic means less revenue, which would translate to lower coverage on a net settlements securitization. The degree of

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Structured Finance

„ Appendix 7: Future Flow Securitizations of Telephone Net Settlement Fees

(cont’d.) regulation in competitive markets has a strong effect on market share stability. Regulation can create significant barriers to entry and help stabilize the industry. Conversely, a broader opening of the market can create very damaging market share wars that quickly erode the value of companies across the industry.

As stabilizing mechanisms, government regulations address several issues that effectively create barriers to entry. For example, to be eligible for a concession, a market entrant must usually comply with minimum network expansion requirements. This cost can be prohibitive for many applicants, thus effectively barring them entry to the market.

Call Volume Call volume growth results from two competitive factors. First, as mentioned, increased availability of telecommunications services is an eventual outcome of competitive markets. With more lines in service, volume grows. Second, competition decreases the price to make a long-distance call. Price reductions increase demand, bringing about greater volume.

Ratio of Incoming to Outgoing Calls A telephone net settlement securitization depends on the volume of incoming calls being greater than outgoing calls. The size of the differential directly affects the amount of dollars paid to the issuer by international carriers. If call volume growth of outgoing calls outpaces growth on incoming calls, a securitization could be negatively affected by a decreased differential or, in the worst case, a negative differential that leaves the issuer owing fees to the international carriers and zero collateral for the securitization. For emerging-market telephone companies, typical historical ratios of inbound to outbound minutes with the major telecommunications carriers are between 4-to-1 and 6-to-1.

Tariffs Often the most significant factor affecting the stability of flows to a net settlement securitization is an unexpected decline in the settlement tariff. While rates vary for different countries, most are at least influenced by agreements with the U.S. Federal Communications Commission (FCC). In August 1997, the FCC adopted a policy to influence the reduction of international settlement tariffs on the basis that existing rates greatly exceeded the actual costs of completing calls and ultimately inflate prices to U.S. consumers. It was also judged that this represented a subsidy from the United States to foreign countries and carriers. The FCC recommended a tariff scale based on a country’s per-capita income level. While there is no legal authority to enforce their recommendation, major international carriers support the recommendations and continue negotiations to reduce settlement tariffs. In many cases, developing countries are, at least in part, accepting an adjustment. In some cases, tariffs have been cut by as much as 80% over the past decade. For coverage levels in a net settlement transaction, the direct effect can be quite damaging. The strongest issuers of net settlement securitization will minimize the uncertainty around this issue by acknowledging the spirit of the FCC recommendation and setting up a reasonable time frame to achieve compliance.

Obligor Risk In a net settlement receivables securitization, the obligors are usually a limited number of highly rated foreign carriers, which are often the most important players in the foreign markets. Fitch explores the historical relationships between the international carriers and the emerging-market carriers as part of the analysis. The obligor profile is also an important factor regarding sovereign redirection risk. While there are alternative carriers that are not involved in existing transactions, they represent small amounts of the overall business. Disallowing interconnection with the largest carriers would have a very detrimental effect on the issuer and often the overall market for international calls.

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Structured Finance

„ Appendix 7: Future Flow Securitizations of Telephone Net Settlement Fees

(cont’d.)

Technology Risk Fitch also focuses on new technologies, such as calls made through mobile providers and the Internet, that may take market share away from the traditional fixed-line call providers. To project future telephone settlement minutes, Fitch will begin with a historical analysis and examine potential sources of volatility.

Copyright © 2006 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004. Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided “as is” without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax- exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from USD1,000 to USD750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from USD10,000 to USD1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.

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