Criteria Book 10

Structured Finance
Aircraft
Securitization Criteria
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Aircraft
Securitization Criteria
The Rating Process for Aircraft Financings .................3
The Spectrum of Financing Vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Corporate Rating Criteria and Their Relevance to Securitization . . . . . . . . . . . . . . 7
Criteria for Airline Equipment Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Legal Considerations for Airline Equipment Debt . . . . . . . . . . . . . . . . . . . . . . . . . 9
Criteria for Rating Enhanced Equipment Trust Certificates . . . . . . . . . . . . . . . . . 12
Aircraft Asset Risk Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
The Rating Process for

Aircraft Portfolio Securitizations . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Credit Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Cash Flow Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Legal Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Operations Review. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Rating Considerations for Lease Pools . . . . . . . . . . . . . . . . . . . . . 35

Sale versus Lease Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Lease Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Operating Lease versus Finance Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Aircraft Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Note Terms and Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Redemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Issuer Level Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Priority of Payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Purchase Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Stress Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Hedging. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Maintenance and Indemnities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 1

Special Considerations for Aircraft Loan Portfolios . . . . . . . . 45
Securitization Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Credit Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Rating Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Asset Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
The Servicer’s Role and Responsibilities. . . . . . . . . . . . . . . . . . . . 59

Servicer Responsibilities in the Securitization of Transportation Equipment . . . . . 59
Servicing an Operating Lease Transaction versus a Loan Portfolio Transaction . . . 62
Individual Functions of an Aircraft Servicer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Maintenance and Related Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Eurocontrol Liens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Airworthiness Directives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Stress Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Surveillance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
2
The Rating Process
for Aircraft Financings
S
tandard & Poor’s criteria for rating an aircraft financing depend on the nature
of the transaction. Transactions may be backed by a single airline and single
aircraft, or by different portfolio combinations of multiple aircraft operated by
multiple airlines. In order to rate such financings, analysts apply rating techniques
from both the Structured Finance and Corporate Ratings departments. The most
important factor in determining which rating approach should be applied is the
extent to which default risk on the rated security is driven by the airline’s credit
or by the value of the aircraft.
The main focus of this criteria review is to describe the analytical process used in
the rating of the various types of aircraft financing vehicles. Particular emphasis will
be placed on those transactions referred to as aircraft securitizations, which involve
packaging a diverse pool of aircraft assets. However, as variations are introduced
to the traditional financing methods, structures are increasingly taking on hybrid
features which require a high degree of integration between structured, corporate,
and legal analysis.
The Spectrum of Financing Vehicles

The spectrum of different financing vehicles ranges from those which rely mostly on
the airline credit to those which rely mostly on aircraft value (see chart 1). Beginning
with the credit end of the spectrum, traditional aircraft financings are those which
are simply secured debt or leases used to finance a single aircraft or group of aircraft
to a single airline. From a credit perspective, these financings are equivalent to
secured debt backed by aircraft. Standard & Poor’s would typically rate such debt
one or two “notches” (i.e., a plus or minus, one third of a full rating category)
above the airline’s corporate credit rating, that is, the company’s risk of insolvency.
These instruments are often referred to as equipment trust certificates when financing
a single plane in the United States, or as pass through certificates when financing
multiple aircraft.

Next along the spectrum are single model enhanced equipment trust certificates.
Enhanced ETC’s (EETCs) must meet additional criteria which allow higher ratings
due to the benefit derived from aircraft collateral value, a dedicated liquidity facility,
and other structural enhancements. Single model simply means that the transaction
is only financing one kind of plane (whether a single plane or several of the same
type). Diversified model EETCs, moving further along the spectrum from airline
credit to aircraft value, can achieve somewhat higher ratings because aircraft asset
risk has been diversified. Small portfolio securitizations, which bundle together aircraft
debt from several airlines and securitize it into tranched securities, is an emerging
asset class. These transactions are too small to be evaluated on the same basis as
diversified aircraft portfolio securitizations (see below), but involve more than one
airline and are analyzed as multi-airline EETCs.
Furthest along the spectrum credit to value are transactions generally referred to
as aircraft portfolio securitizations. These involve large numbers of airlines, many
of which may be unrated. These airlines are typically located in diverse geographic
regions, providing some benefit of diversity. Aircraft asset risk is even more diversified
than in the transactions discussed above, due to various combinations of aircraft
manufacturers and models. Within the category of aircraft securitizations, the portfolio
size and diversity can vary to a great extent. The type of financial asset being securitized
can also vary and structures may involve operating leases, tax-oriented finance leases,
and loans. The main difference between the ETC structures and the portfolio securi-
tizations is that the securitizations are not directly linked to the credit quality of a
particular airline.
The Rating Process

A Standard & Poor’s rating addresses the likelihood of an issuer making full and
timely payment of interest and ultimate repayment of principal in accordance with
the terms of the securities being rated. Most aircraft securitizations and enhanced
equipment trust certificates use “soft amortization” with a final legal maturity,
Chart 1
Aircraft Financing
Single Diversified
Traditional Model Model
Aircraft Enhanced Enhanced
Financings ETC ETC
Reliance on Reliance on
Airline Credit Aircraft Value
Small “ALPS”
Portfolio “Airplanes”
Securitizations “MSAF 1”
“AFT”
4
The Rating Process for Aircraft Financings
which is the principal payment addressed by the rating. The highest rating that
can theoretically be assigned is ‘AAA’, which reflects the opinion that an issuer’s
capacity to pay interest and repay principal is extremely strong.
Depending on the particular aircraft financing vehicle being rated, there may be
rating caps below ‘AAA’. For example, the maximum rating achievable in an ETC or
EETC will depend on the airline’s corporate credit rating. In an aircraft securitization,
certain asset types may not be suitable for ‘AAA’ structures. In particular, portfolio
securitizations of operating leases have to date been rated no higher than ‘AA’. The
maximum rating achievable on portfolio transactions will depend on the asset type,
the degree of overcollateralization and the strength of the credit, structure, and
legal analysis.
The rating process begins with a proposal discussion initiated by the deal arranger
or originator. Due to the complex nature of aircraft financings, initial discussions
should take place well in advance of the anticipated closing date. Though it is difficult
to generalize about the length of the rating process, which depends heavily on the
novelty of the structure, it is recommended that initial discussions take place at least
four to six months before a transaction is due to close. Initial contact is usually in
the form of a conference call or meeting during which the key features of the trans-
action are presented. A detailed paper outlining the structure and the proposed asset
pool should be provided at this stage. The purpose of this discussion is to identify
any significant credit, structural, or legal issues which may be unusual or complicated
and which may require additional time to consider or which could prevent the
assignment of the final ratings.
Asset Information Requirements

The following information should be presented in the form of a spreadsheet.
By individual asset classification: ■ Loan to value ratio; and

■ Asset type, (for example operating lease, ■ Term of assets being securitized.
finance lease, loan, etc.);
■ Aircraft models; On an aggregate basis, weighted by
■ Aircraft age; aircraft value and/or lease revenues:
■ Aircraft appraised value (typically,

■ Weighted average portfolio age;
three independent appraisals of base value); Proportions of various models of aircraft;
Proportions of narrowbodies and widebodies;
■ Airlines operating the aircraft;
■ Proportions of commercial jet, regional jet,
■ Airline ratings (internal or Standard & Poor’s); turboprops and freighter;
■ Country of carriers; Country concentrations; and
■ Loan amount; ■ Geographic region concentrations.

The formal rating process begins with the agreement on a timetable and the
assignment of an analyst who will be the daily contact at Standard & Poor’s. An
engagement letter will be issued which should be returned as soon as possible. If
the originator has not yet been in contact, the rating analyst typically introduces
him/herself to the relevant individuals.
The banker should shortly thereafter provide a detailed transaction book which
provides asset information on the portfolio (see box). Analysts will review this infor-
mation and may supplement it with visits to the relevant parties. The review is an
important part of the rating process. The project’s analyst or analysts may meet on
site with the management of the originator, and may also meet with the servicer (if
different from the originator), the back-up servicer, and any other third party
providers of crucial services, for example a cash administrator and hedging agent.
The purpose of these visits is to gain a thorough understanding of the asset and
industry, focusing in particular on the risks present and the operations of the compa-
nies involved in the securitization.
Information gained from the asset/credit analysis and due diligence will be used
in the structural analysis. Analysts will review cashflow statements prepared by the
banker which should replicate the asset and liability structure of the transaction.
Different cashflows will be reviewed for each of the rating stresses. In addition, all
legal documentation and opinions to be issued in connection with the transaction
will be reviewed.
The rating process is highly interactive during which the rating analyst will be in
continuous contact with the originator, deal banker, and their legal advisors. When
the transaction structure has been finalized, the analyst will present the transaction
to a rating committee. Any issues arising from the committee will be passed on to
the banker and other parties to be resolved. Once the documentation, including legal
opinions, is in final form and no further changes are required, a rating letter will
be issued.
Once a rating has been assigned, ongoing management reviews and surveillance will
be required to maintain the rating. On a periodic basis (typically, annually or more
frequently, if required), analysts may meet with the originator, servicer, back-up ser-
vicer, and necessary third parties. The purpose of these ongoing reviews is to discuss
any changes to the business and to review the application of agreed-upon procedures.
Ongoing performance of the transaction will be monitored by the surveillance group.
The purpose of the surveillance is to ensure that the rating continues to reflect the
performance of the transaction. Performance information will be required on a periodic
basis (monthly or quarterly). Before the transaction closes, Standard & Poor’s may
provide an itemized servicer report detailing all the necessary information required;
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it should likewise be informed of any changes concerning the original structure of

the transaction including management, credit policy, system changes or parties to
the transaction.
Corporate Rating Criteria and

Their Relevance to Securitization
An evaluation of airline credit and aircraft asset risk, which are undertaken by
corporate ratings analysts, provides analytical input into cash flow modeling of
aircraft securitizations. As noted above, aircraft securitizations are an extension of a
spectrum of financing forms that range from single aircraft leases or secured debt to
large multi-airline pools. Even in the largest securitizations, the number of aircraft
and airlines is not so large that a statistical approach to analysis, as may be appro-
priate for some asset-backed securities, can be used. Accordingly, a brief overview
of corporate criteria for rating aircraft-backed debt will be useful in understanding
Standard & Poor’s approach to evaluating securitizations.
Criteria for Airline Equipment Debt

The simplest form of aircraft financing is secured debt or debt in leveraged leases to
one airline. These financings would typically be rated one notch higher than the airline’s
corporate credit rating. This is based on enhanced prospects for full recovery following
a default. In the case of U.S. financings that qualify for protection under Section
1110 of the U.S. Bankruptcy Code, a one- or two-notch rating elevation is based
also on slightly reduced default risk. Section 1110 excludes certain types of leases
and secured debt from the automatic stay of creditor claims and substitution of
collateral sections of the Code. Creditors may repossess collateral if the debtor does
not resume debt service or lease rentals, and cure any past due amounts, within 60
days of filing for bankruptcy. This provides an incentive for continued payment
under these obligations in bankruptcy, though it does not require payment. Standard
& Poor’s rating enhancement for these U.S. financings is based on:
■ Section 1110’s legal provisions, which provide an incentive for continuing payment
of interest and principal (thus reducing default risk);

■ Accelerated access to collateral if payment is not made, under provisions of
Section 1110; and

■ The relatively good value retention, over long periods of time, of aircraft, ease of
tracking them, and the ability to realize their value by reselling aircraft to other
operators in a global market.

Qualifications for Section 1110 Rating Enhancement
To qualify for Section 1110 treatment, creditors must have a security interest in the
aircraft (for financings on planes delivered before Oct. 22, 1994, this must be a
purchase-money security interest), be a lessor, or be a conditional vendor. Collateral
must be aircraft or aircraft parts, and the debtor must be a qualified U.S. air carrier.
As discussed below, legal opinions are required to confirm the availability of Section
1110 benefits.
In addition, a two-notch rating elevation can be accorded only in those cases where
an airline’s size and market position make liquidation unlikely, allowing for a rea-
sonable possibility that the aircraft financing will continue to be paid at the contracted
rate through bankruptcy reorganization. Collateral that is technologically or eco-
nomically less desirable, or that is insufficient to cover outstanding secured debt by
a comfortable margin, would also not qualify for the rating enhancement, since a
bankrupt airline might well allow such equipment to be repossessed rather than
continue debt service.
Legal Opinions Needed

Standard & Poor’s requires that an issuer seeking a rating on aircraft financings
provides the following legal opinions to support the case for Section 1110 treatment:
■ An opinion that creditors have a first priority perfected security interest in the
equipment being financed and payments being made by the airline under the related
lease, if any, and that the relevant documents have been filed with the Federal
Aviation Administration of the US Department of Transportation.
■ When the lessor of the equipment to the airline is a trust, opinions bearing on
non-consolidation of the assets in the trust, of which the owner participant (equity
investor in a leveraged lease) is a beneficiary, with the estate of the owner participant
in bankruptcy. This opinion addresses the risk that cash payments from the lessee
to the debt holder may be delayed or diverted as a result of the owner
participant’s bankruptcy.
■ For pass-through certificates, an opinion on the valid formation of the pass-through
entity, and that the pass-through trust does not constitute an investment company
as defined in the Investment Company Act of 1940 and is not subject to federal
or state taxation.
Other opinions may be required, depending on the specifics of the transaction.
Degree of Enhancement
The degree of enhancement applied depends on the above factors and the airline’s
corporate credit rating. Investment-grade airlines receive a one-notch upgrade
(e.g., ‘A-’ to ‘A’), while speculative-grade airlines would typically receive a two-notch
8
enhancement (e.g., ‘B’ to ‘BB-’). When an airline is in Chapter 11 bankruptcy pro-

ceedings, the rating on Section 1110 obligations would be based on analysts’ estimate
of the likelihood of a successful reorganization and the particular features of the
equipment financing under consideration. Such a rating would typically be in the
‘CCC’ category, but might fall into the ‘B’ category if the financing in question is
very well secured, or has been affirmed by the bankruptcy court and the airline
seems likely to reorganize successfully.
Aircraft Financings Outside the U.S.

Ratings above the airline’s corporate credit rating, typically a one-notch enhance-
ment, are possible for obligations that are well secured with desirable equipment,
where the prevailing legal system recognizes rights of secured creditors and lessors,
and where access to the collateral is likely to be reasonably timely. While other
legal systems rarely have provisions comparable to Section 1110, their insolvency
regimes are, in other respects, sometimes more favorable to creditors than is the
U.S. Bankruptcy Code. In these cases, the modest rating enhancement is based
on prospects for post-default recovery.
Legal Considerations for Airline Equipment Debt

Equipment Notes
As noted above, the simplest forms of aircraft financings in the U.S. that qualify for
one- or two-notch upgrades are secured debt and secured debt issued in leveraged
leases to one airline. In a secured debt transaction, the airline, as owner of the air-
craft, issues equipment notes pursuant to an indenture entered into with a security
trustee. The airline’s interest in the aircraft and any related rights are granted to the
security trustee, for the benefit of the noteholders, as security for repayment of the
notes. In these transactions, it is required that the noteholders have the benefit of a
first priority perfected security interest over the aircraft and any related collateral,
and would have the benefits of Section 1110 in the airline’s bankruptcy.
Legal opinions are also required confirming the availability of the benefits of
Section 1110 and the status and effectiveness of the ownership and security interests
in the aircraft. Since the U.S. has an exclusive filing system administered by the U.S.
Federal Aviation Administration (FAA) for perfecting and prioritizing interests in
aircraft, specialized aviation counsel addresses the sufficiency and effectiveness of
the required FAA filings. Counsel qualified in the relevant jurisdictions address the
validity and enforceability under local law of the interests in the aircraft, as well as
the enforceability of the notes issued. Standard & Poor’s reviews whether any claims
may be asserted by creditors of the seller of the aircraft to the airline in the event of

the seller’s insolvency. Most direct sales by an aircraft manufacturer to an airline,
where the seller has no other continuing role in the transaction, will not raise “true
sale” issues requiring specific legal opinions.
Equipment Notes in Leveraged Leases

The traditional U.S. leveraged lease (USLL) involves the issuance of equipment notes
to fund the debt portion of the purchase price of an aircraft. Typically, the nominal
issuer of the notes is the trustee of a trust formed solely for the purpose of acquiring
and leasing the aircraft. Simultaneously with the acquisition of the aircraft from the
airline, the trustee leases the aircraft to the airline. The trustee, pursuant to an indenture
entered into with a security trustee, issues the notes as limited recourse obligations.
The issuer’s ownership interest in the aircraft, as well as its interest in the lease and
most other property and rights of the equipment trust, are granted as security for
repayment of the notes. The trustee also issues certificates to the beneficiary of the
trust (the owner participant) as consideration for the contribution by the owner
participant to the trust of the equity portion of the purchase price.
In the traditional USLL, it is essential that the ownership and leasing of the air-
craft by the nominal issuer does not introduce any risks that may impede access to
the airline’s credit supporting the lease or access to the aircraft in the event of the
airline’s insolvency. The benefits of Section 1110 would not be available against the
nominal issuer, as the owner of the aircraft, or the owner participant, as beneficiary
of the trust, in the event of their bankruptcy. All of the debtor protections afforded
to a bankrupt entity and its property would be available to prevent access to the air-
craft or the airline’s credit through the lease in their bankruptcy. In order to rate
the equipment notes above the issuer credit rating of the airline, Standard & Poor’s
anticipates performance of the lease in the airline’s reorganization or realization of
the value of the aircraft in a timely exercise of remedies.
Therefore analysts will review the nominal issuer to determine whether it qualifies
for the status of a bankruptcy-remote entity. The bankruptcy-remoteness criteria
depend on the form of the entity being examined, but for any form there are com-
mon requirements including, among other things, that:
■ The entity must have limited purposes and activities, consistent with the minimum
required to perform its role in the transaction;

■ It must be restricted in its ability to incur additional debt to prevent, among other
things, a default on an obligation that may have a risk of default greater than that
of the rated securities;
■ It must be sufficiently separated from the operations and activities of any other
entity to sustain an independent legal existence, thereby lessening the risk of

attack from the other party’s creditors; and
10
■ Its assets should be subject to first priority perfected security interests to reduce
the incentive that any unsecured or subsequent creditor may have to attempt to
reach these assets.
The ownership structure of the issuer will also be reviewed to assess the potential
effect on the issuer of the bankruptcy of its owner. In the traditional USLL, the ben-
eficiary of the trust, the owner participant, constitutes the ownership interest. In
a bankruptcy of the owner participant, the analysis principally focuses on the
following risks:
■ That the liquidator, receiver, or bankruptcy trustee for the owner participant
would direct the trustee to terminate the trust and distribute the trust assets to
the owner participant;
■ That the interest of the owner participant in the trust may be construed as an
ownership interest in the aircraft and the lease; and

■ That the assets and liabilities of the trust may be combined with the owner partici-
pant’s estate in bankruptcy under the doctrine of substantive consolidation, a

theory of agency, or another similar principle.
Each of these events would result in the aircraft and the lease being brought into
the owner participant’s bankruptcy estate, which would be inconsistent with a
rating based on the airline’s credit and the recovery value of the aircraft. Based on
its assessment of these risks in the financing, legal opinions bearing on one or more
of these risks will be requested.
The legal opinions for a secured debt financing discussed above (including the
Section 1110 opinion) also are required. Additional legal opinions are required
addressing the creation, perfection and priority of the ownership and leasehold
interests of the trust and the airline in the aircraft, the valid formation of the trust
and the enforceability of its obligations, and the absence of federal and state taxation
at the equipment trust level.
Pass-Through Certificates
Pass-through certificate offerings are an extension of the secured debt financings dis-
cussed above. These certificates bundle together equipment notes issued for various
aircraft with identical payment terms into new securities that reflect the ratings of
the underlying notes.
Pass-through trusts are established pursuant to pass-through trust agreements
between the airline and the pass-through trustees. For each aircraft in an offering,
the related equipment trust, or the airline, issues equipment notes in various series
with payment terms that correspond to the terms desired for the respective pass-
through certificates. Each pass-through trustee purchases the corresponding notes
with the proceeds from the sale of the related pass-through certificates. The purchasers
of the each series of pass-through certificates are deemed to be the grantors of the

related pass-through trust and in the aggregate hold the entire beneficial interest in
the pass-through trust.
In addition to the opinions required for each underlying equipment note transaction
(including the Section 1110 opinions), opinions are required for these securitizations
that confirm the validity and enforceability of the pass-through certificates, the valid
formation of the pass-through trust, the absence of federal and state taxation at the
pass-through trust level, and the absence of regulation as an investment company
under the U.S. Investment Company Act of 1940. Typically, the pass-through certifi-
cates are sold in arm’s-length transactions to disinterested third-party investors. For
each pass-through trust, these certificateholders constitute the owners of the trust.
This ownership structure ordinarily does not raise the types of risks, such as those
arising because of the owner participant’s role in a leveraged lease, that would result
in additional opinion requests.
Criteria for Rating Enhanced Equipment Trust Certificates

Enhanced equipment trust certificates fall between simple aircraft debt, which is
akin to a secured corporate bond, and diversified portfolio securitizations by building
on a corporate credit to achieve higher ratings through overcollateralization and
structural enhancements. In these financings, the airline credit is typically undiversified
(i.e., a single airline), but the aircraft portfolio may consist of one model of plane or
several, allowing some credit for diversifying asset risk.
Standard & Poor’s was the first to suggest this structure in general terms, in a criteria
article written in late 1993, and even called them “enhanced equipment trust certifi-
cates.” Now they are often packaged together as pass-throughs, and thus called
“enhanced pass-through certificates.”
The key features of these financings that allow a higher rating are:
■ Debt tranching, providing for various levels of overcollateralization;
■ Dedicated liquidity facilities, which usually pay interest only while an aircraft is
being repossessed and sold;

■ “Soft” amortization scheduling, so that interest is paid on a fixed schedule but
principal is legally not due until the final maturity date (which is after the expected
maturity date); and
■ Reliance on a secure legal mechanism to assure access to the collateral on a timely
and predictable basis.

In effect, these structures get extra ratings credit by converting the collateral value
of the aircraft into reduced default risk for the rated securities, rather than better
recovery prospects after a default.
Higher ratings can be assigned to aircraft financings that are structured to allow
creditors to use proceeds from the sale of collateral to repay principal and interest
12
on a timely basis. EETCs add a dedicated source of liquidity support to pay interest
and tranche the debt to increase the likelihood of repaying principal on the securities
that have been rated higher than the airline’s (unenhanced) equipment trust certifi-
cate rating. For U.S. financings, which is the principal market for these deals, the
liquidity facility must cover 18 months of debt service (typically interest only) and
the tranched debt can achieve ratings up to three full rating categories (e.g. ‘BB’ to
‘AA’) above the airline’s Section 1110 unenhanced equipment trust certificate rating.
To qualify for this rating treatment, a security based on obligations of a U.S.
airline must:
■ Qualify for protection under Section 1110 of the U.S. Bankruptcy Code
(see above); and

■ Have a dedicated source of liquidity, such as a letter of credit, committed credit
facility, or cash collateral account sufficient to cover 18 months of debt service on

the rated securities, if the aircraft financing is rejected in bankruptcy proceedings
(or, conceivably, by mutual agreement outside of bankruptcy).
Inasmuch as an airline would owe any interest that has accrued following the last
scheduled payment, whether that comes due before or after a bankruptcy filing, the
liquidity facility in practice would cover between about 12 months (if the filing
occurred one day before a scheduled payment, which are typically semiannual) and
a full 18 months (if the filing occurred one day after a payment date) from the date
of filing for bankruptcy.
Rating Financings of Non-U.S. Airlines

The EETC approach may be feasible for constructing aircraft financings by airlines
outside of the U.S., as well. Standard & Poor’s has examined a number of proposals
of this type, though only one (financing several widebody aircraft leased to Qantas
Airways Ltd.) has been assigned a rating as of this writing. The most important
analytical issues in these cases are legal ones:
■ Does the prevailing legal jurisdiction recognize clearly the rights of lessors or
secured creditors to repossess collateral? How many comparable precedents can

be cited in that jurisdiction?
■ How quickly can lessors or secured creditors act to enforce their rights? While the
U.S. Bankruptcy Code is generally less favorable to creditors than those of some
other nations, Section 1110 is an exception, with its clear 60 day limit on suspension
of equipment debt service.
■ If creditors must await resolution of insolvency proceedings, how long is that likely
to take? This could represent an additional period which the dedicated liquidity
facility must cover, which in turn has implications for the effective loan-to-value
available to EETC holders.

■ To the extent that a flag carrier is given credit for potential support from the gov-
ernment of that country, would this same national interest work against the interests
of equipment creditors? Recovery of aircraft could be delayed in such cases by
legal maneuvers or pressure from government authorities.
To the extent that rights of repossession and their application in practice are less
clear than in the U.S., Standard & Poor’s is likely to limit the potential upgrade
above an airline’s relevant equipment debt rating to less than the three full categories
possible for U.S. airlines. The asset value analysis, and thus target loan-to-values for
various upgrades, would not differ from that for an U.S. financing, however.
There are ways to help meet these concerns with the structure, particularly as
regards the liquidity facility:
■ A longer liquidity facility (though that must be balanced against its effect on
collateral recovery for certificateholders);

■ Subordination of liquidity facility repayment to some or all of the certificateholders—
a considerable advantage if it can be arranged;

■ Alternatively, stretching out the repayment period for the liquidity facility, so that
it can withstand a rescheduled lease obligation; and

■ Backstop guarantees of repossession by a highly rated party, which would pay off
certificate-holders if the plane is not recovered within a defined period, and then
take over the creditors’ security interest.
Aircraft prices and lease rates have historically been quoted in dollars, no matter
where the operating airline was domiciled. All EETCs rated to date have been dollar
denominated, preventing any currency mismatch. However, airlines outside the U.S.
generate most of their revenues in currencies other than the dollar, and often would
prefer to raise debt in those currencies. Since the potential divergence in exchange
rate between the dollar and any other currency (excluding, perhaps, those currently
pegged to the dollar) over a period up to 20 years or more is huge, that exposure
would in most cases have to be covered with a currency swap or similar arrangement.
With the launch of the euro, Airbus has begun quoting aircraft prices when
requested in euros, as well as dollars, and Boeing will likely follow suit at some
point. While this eases the potential currency mismatch in a Euro-denominated
EETC, it does not eliminate the problem. Even if every European airline were to
immediately conduct its aircraft transactions entirely in euros, the universe of potential
buyers paying in euros for a repossessed aircraft would be only about one third of
the current world market (the European Union generates about one third of world
traffic). Thus, resale and release liquidity for aircraft collateral would be consider-
ably less than is currently the case for dollar-denominated EETCs. Accordingly, the
extent to which the Euro becomes an alternative currency for aircraft transactions,
which may well vary from model to model, will be considered in rating any potential
euro-denominated EETC.
14
The Role of Aircraft Collateral in EETCs

Rating upgrades above the airline’s unenhanced equipment trust certificate rating
will be assigned to qualifying securities based on an evaluation of asset value risk,
given the aircraft being financed and the amount of debt raised. Asset risk in EETCs
and in aircraft portfolio securitizations are judged on the same factors (see following
section). The analytical result of that judgment is expressed as target loan-to-values
for specified rating upgrades in the case of EETCs and as reductions in aircraft value
or lease rates to be used in cash flow modeling in the case of portfolio securitizations.
Because the industry conditions in which an investment grade airline would fail
are likely to be more unfavorable than those for speculative grade airlines, the market
value declines (and thus loan-to-value ratios) that are assumed are slightly more
conservative (up to 5% lower required loan-to-value at the maximum potential
rating enhancement) for airlines whose Section 1110 rating is in the ‘BBB’ category.
Standard & Poor’s has not yet rated an enhanced ETC for an airline whose Section
1110 rating is in the ‘A’ category, but market value decline assumptions in that case
would be more conservative still.
In the simplest case, for one or more new technology planes of a single model
financed in a typical enhanced ETC structure, upgrades would be assigned based
on the levels of loan-to-value ratio (the amount of rated debt as a percentage of
collateral value) as follows:
■ A range of 62-66% for a one category upgrade,
■ A range of 44-51% for two categories, and
■ A range of 26-36% for three categories, depending on the particular aircraft
model and the Section 1110 rating of the airline.

Rating enhancements falling between the full upgrade levels specified above are
possible, with the loan-to-values required interpolated between the levels shown
(approximately 5% for each notch). When any of the factors affecting asset risk
depart from a simple case such as this, the guideline loan-to-values also change.
Examples of several actual EETCs, with loan-to-values on senior tranches of debt,
are shown in “Aircraft Asset Risk Evaluation”, below.
The required loan-to-values resulting from estimated asset risk can be seen in
table 2. The table shows the loan-to-values of the senior (‘A’ class) certificates for
the transactions listed in table 1 (need to attach), and how they compare with the
“standard” case.
The criteria assume the provider of the dedicated liquidity facility would have first
claim on proceeds from sale of collateral, and the guideline loan-to-values are sized
to account for that arrangement, as long as 18 months of scheduled interest payments
do not exceed 10% of collateral value throughout the life of the transaction.
Repayment of advances to cover scheduled principal payments do not cause a like

issue for overcollateralization levels, since they represent only a change in the recipi-
ent (that is, repayment is to the liquidity provider instead of the bondholders), not
the amount owed. Liquidity facilities for EETCs typically do not cover scheduled
principal payments.
The investor should be aware that, while the chance of default on an enhanced
ETC is typically less than that on a simple, unenhanced aircraft financing, the recovery
on the enhanced ETC declines more rapidly with a deterioration in asset values. For
example, a junior tranche of an enhanced ETC might represent $10 million of an
$80 million financing and have a loan-to value of 70% on the $100 million aircraft
value. The value of the aircraft could decline to $70 million without causing any
shortfall to these certificateholders (ignoring, for simplicity, the claim of the liquidity
provider). However, that junior certificate bears all of the impact of the next $10
million decline in asset value, so that the certificateholder receives no recovery of
principal by the time the asset value has declined to $60 million.
This relationship is shown in more detail in chart 2, which shows the range of
potential recovery for each class of certificates and for the liquidity provider in a
multi-tranche enhanced equipment trust certificate. The most junior tranche (at a
65% loan-to-value ratio) begins to fall short of full recovery first, and declines
rapidly with further deterioration in collateral value. The other tranches suffer
the same fate, in order, as greater declines in collateral value are assumed, with
the liquidity provider being affected only when the asset recovery is less than 10%
of the expected value.
Chart 2
Recovery on Certificates
EETC Liquidity EETC 40% LTV EETC 54% LTV EETC 65% LTV
120%
100%
80%
60%
40%
20%
0%
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Aircraft Recovery
16
Role of the Liquidity Facility

The 18-month liquidity facility is crucial to the U.S. EETC structure because it provides
time for bondholders to repossess and sell aircraft collateral in an orderly fashion
and realize proceeds to cover outstanding principal. The 18-month period was chosen
based on a study of aircraft sales following liquidation of entire airline fleets (for
example, the case of Braniff Airways Inc. in 1983). Although resale of used aircraft
has sometimes taken longer than 18 months, that period still allows a reasonable
amount of time to seek buyers, even in depressed markets. The liquidity facility
would also cover pre-bankruptcy accrued interest and any payments on the rated
securities that happen to fall into the 60-day grace period following a bankruptcy
filing, before accrued rentals and or debt payments under Section 1110 must be cured.
The provider of the liquidity facility must have a short-term debt rating at least
consistent with the highest rating sought on the relevant EETC. For example, a
short-term rating of ‘A-1+’ would be needed for EETCs rated ‘AA-’ or above. The
short-term rating of the liquidity provider must, in any case, be at least ‘A-1’. If
the liquidity provider were to be downgraded below the level required on EETCs it
supports, it must either find a suitably rated replacement provider or fund a cash
collateral account with the full amount committed. If the liquidity provider were
unable to do that (which is contractually required in the liquidity agreements) the
affected EETCs would likely be downgraded.
The first instance in which a liquidity facility downgrade affected EETCs occurred
in June 1999, when KBC Bank N.V. was downgraded to ‘AA-’/‘A-1+’ to ‘A+’/‘A-1’.
KBC provided liquidity facilities supporting four EETCs. In two cases—one for cer-
tificates issued by Federal Express Corp., where the senior tranche of debt was rated
‘AAA’, and another for certificates issued by Continental Airlines Inc., where the
senior tranche was rated ‘AA+’—KBC Bank was replaced as liquidity provider. In
two other cases—where the senior tranche was rated ‘AA-’ (issued by America West
Airline Inc. and American Trans Air Inc.)—Standard & Poor’s determined that the
differential between KBC’s revised long-term debt rating of ‘A+’ and the EETCs
rated ‘AA-’ was small enough that ratings were affirmed and no replacement of the
liquidity provider was necessary.
Legal Considerations for EETCs

The securities in EETC transactions already rated have been various classes of either
pass-through certificates issued by various pass-through trusts that hold corresponding
series of equipment notes or debt securities issued by a single trust that holds all of
the equipment notes. In the case of pass-through certificates, the legal considerations
discussed above for equipment notes and pass-through trusts are relevant.

If the rated securities are debt securities issued by a single trust, the same legal
considerations are relevant, except that the review of the ownership of the issuing
trust usually results in the identification of additional risks to be addressed in the
legal opinions. In this respect, the analysis of the issuer is more like the analysis of
the trust that is the nominal issuer of equipment notes. In addition, if the EETCs are
debt securities, legal opinions will be required confirming the validity and enforce-
ability of the securities and that the noteholders have the benefit of a first priority
perfected security interest over the equipment notes and any other trust property.
If the underlying equipment financings in a proposed EETC transaction include
Japanese or other cross-border leveraged leases or other “double dip” features
designed to obtain tax benefits for investors in more than one country, the analysis
must conclude that cash flows would not be interrupted and the EETC-holders’
rights would not be compromised on account of these features, or in the event of
the bankruptcy of any equity investor or other party to these arrangements. Trans-
action counsel should conduct, or coordinate, the due diligence investigation, including
legal advice in the relevant jurisdictions, necessary to support these conclusions.
Standard & Poor’s will review the results of this due diligence. Certain risks that
have been identified in traditional Japanese leveraged leases and some other hybrid
forms of equipment financing are discussed below under “Special Considerations
for Bank Loan Portfolios—Legal Considerations.”
As discussed above, debt tranching to achieve various overcollateralization levels
and a dedicated liquidity facility to maintain payments on the rated securities during
the projected repossession period are required to achieve enhanced ratings. Typically,
debt tranching is achieved through consensual subordination in an inter-creditor
agreement among the issuers, or issuer, of the rated securities, the liquidity provider,
and a subordination or collateral agent. Subordination agreements are expressly
recognized under the U.S. Bankruptcy Code. If, even in an issuer’s bankruptcy, none
of the parties to the subordination agreement could negate the effect of the subordi-
nation provisions, then there would be a greatly diminished incentive to commence
bankruptcy proceedings against an issuer. The effectiveness of the subordination
provisions thereby also supports the conclusion that an issuer is a bankruptcy-
remote entity.
Legal opinions are also required confirming that the inter-creditor agreement is
enforceable under its governing law and against the parties to the agreement. If the
governing law is not a U.S. jurisdiction, generally an opinion is required confirming
that the subordination provisions will be enforceable even in an issuer’s bankruptcy.
A legal opinion also should confirm that the equipment notes held by the subordination
or collateral agent on behalf of the parties to the inter-creditor agreement would not
be considered property of the agent if it were to become insolvent.
18
For rated EETCs, dedicated liquidity facilities have been in the form of committed
credit facilities, cash collateral accounts, and letters of credit. Legal opinions are
required confirming that the liquidity facility is enforceable under its governing law
and against the liquidity provider. If the liquidity provider is not a U.S. bank, an
opinion is required confirming that the liquidity provider’s obligations are at least
the same priority as its unsecured and unsubordinated debt. For non-U.S. liquidity
providers, the legal opinions should address the recognition of the choice of law in
the agreements, the submission to jurisdiction clauses, and the enforceability of
U.S. judgements.
The legal review for EETC transactions frequently is a time-consuming part of the
total analysis and should start as early as possible. In the case of non-U.S. EETCs, a
more general review of the relevant legal jurisdictions (including any conflicts of
laws analysis, if necessary) as applied to the underlying equipment note financings
and the securitization structure would require additional time. The jurisdictional
legal review usually can proceed in parallel with the economic analysis on the basis
of a detailed term sheet or transaction summary and the relevant jurisdictional surveys.
Aircraft Asset Risk Evaluation

Standard & Poor’s evaluates aircraft collateral in aircraft securitizations and EETCs
using a scoring system that covers the following factors:
Technological Risk. What is the risk that the aircraft will become economically
unattractive during the term of the financing due to advances in technology or regu-
latory change? Examples of technological risk include aircraft which do not comply
with noise regulations being phased in the U.S. and Europe, and the accelerating
replacement of some types of turboprop regional aircraft by regional jets. Typically,
the more recently the aircraft model was introduced and the shorter the term of the
transaction, the less technological risk is perceived.
Market Liquidity. How liquid is the resale market for this type of plane likely to
be in the future? Analysts will look at the number of planes in service and on order,
the number of operators, and the breadth of the manufacturer’s product line, among
other factors. Narrowbody aircraft are typically considered to be slightly more liquid,
other things being equal, than widebody aircraft.
Diversification by aircraft type. If the pool of assets being financed consists of
multiple types of planes, the risk of very weak resale values is somewhat reduced,
since movements of aircraft values are not fully correlated. Again, analysts will
look not only at how many models of planes are in the pool, but also how different
each is from the others. Thus a pool consisting of one narrowbody and one wide-
body would usually be judged more favorably on this factor than a pool of two
narrowbodies.

Manufacturer evaluation. How strong is the market presence of the manufacturer
of the aircraft being financed? How broad is its product line and what are the
prospects for those products? Is there any diversification of manufacturers in the
pool being financed? The highest scores here are given to the two leading manufacturers
of large jet transports, Boeing Co. and Airbus Industrie.
Servicer Evaluation. Is there an active manager of aircraft leases or a dedicated
remarketing agent (as is typical in multi-airline securitizations)? How capable and
experienced is that manager? The large providers of aircraft operating leases, Inter-
national Lease Finance Corp. and the General Electric Capital Aviation Services
(GECAS) unit of General Electric Capital Corp., have been assigned the highest
scores on this factor. For EETCs, there typically is no dedicated manager or
resale agent.
Other Factors. Will the plane be operated in relatively favorable or difficult condi-
tions? Is the maintenance likely to be performed to high standards? Is the user going
to configure the plane in a way which would require expensive alterations before
another airline can use it? Are there any other factors which could affect materially
the plane’s resale value?
Table 1
Asset Risk in Aircraft Financings
Aircraft Technological Market Aircraft Manufacturer Servicer Other

Collateral Risk Liquidity Diversity Evaluation Evaluation Factors
America 4 A320 Modern Popular, None Major None Major airline
West technology liquid (single model) manufacturer in developed
Airlines Inc. aircraft aircraft country
1997-1 financed for
up to 20 yrs.
Airplanes 229 aircraft Mostly Mostly Very Generally GE Capital Mix of
Pass of 30 models modern liquid diverse reflects Aviation airlines in
Through technology models, portfolio world, Services— both developed
Trust aircraft; risk but some portfolio, top tier and less
higher in less so but Airbus operating developed
later stress under- lessor countries
scenario represented
Federal 4 MD11F, 5 Modern Below Modest Airbus and None Major
Express Corp. A300-600F technology, average diversity McDonnell airline in
1997-1 but slightly liquidity (1 small, Douglas developed
higher risk 1 midsize (now Boeing) country
than new widebody)
models
Continental 8 B757-200, Modern Popular, Modest Major None Major
Airlines Inc. 22 B737-500 technology liquid diversity manufacturer airline in
1997-1 aircraft aircraft (1small, developed
financed 1 midsize country
for up to narrowbody)
20 yrs.
20
The foregoing factors are evaluated and weighted in the approximate order listed
to judge the likely severity of market value declines in a repossession scenario. Table
1 shows four aircraft financings rated in 1996 and 1997 and comments on the above
asset risk factors for those transactions. Table 2 shows how the asset risk evaluation,
combined with the airlines’ underlying credit quality combine to produce target loan
to values needed to achieve high ratings.
Aircraft Appraisals
Underwriters of an EETC, as well as for other aircraft transactions, are typically
required to arrange for “desktop” (i.e., without physical inspection) appraisals from
three recognized appraisers. The resulting appraisals provide an estimate of base
value, which is supposed to represent the long-term value based on various restrictive
(and optimistic) assumptions. Typically, the value used for purposes of calculating
an initial loan-to-value ratio would be the lesser of the average or median of the
three appraised base values. Standard & Poor’s realizes that these appraisals are
often somewhat inflated relative to actual market transactions and has factored this
into the loan-to-value guidelines. Further, analysts can and have used lower values
than the appraised base values in their analyses, sometimes setting aside appraisals
believed to be less plausible.
Depreciation Assumptions
The specified levels of overcollateralization must be maintained throughout the life
of the rated security, with debt paying down in proportion to the declining aircraft
value. For transactions involving recently delivered, modern technology aircraft
Standard & Poor’s has used the following depreciation schedule:
■ For years 1-15, 3% per year;
■ For years 16-20, 4% per year;
■ For years 21-25, 5% per year; and
■ For the residual at end of year 25, 10%.
Table 2
Aircraft Financing Loan to Value Ratios
‘A’ certificate initial Upgrade above

loan to value ratio (%) Rating ETC rating
America West Airlines Inc. 1997-1 40 AA- +2 2/3
Airplanes Pass Through Trust 64 AA n.a.
Federal Express Corp. 1997-1 40 AAA +2 1/3
Continental Airlines Inc. 1997-1 40 AA +3
n.a. not applicable

This depreciation schedule is not a prediction of future prices, but an approximate
trend line from which assumed market value declines are applied. It incorporates the
interaction of economic depreciation of the asset and the partly offsetting effect of
increasing prices for new planes, which indirectly influence the market price of older
aircraft. The depreciation curve reflects also the fact that the range of possible air-
craft values will widen over time given increasing uncertainty. Therefore, while the
difference in value between a new plane and a one-year-old used plane is probably
greater than a single year’s 3% depreciation, it also less likely that aircraft values
would fall sharply in the near term.
For planes embodying older technology or which have other adverse asset risk
factors, assumed depreciation would be more rapid. Further, if the aircraft being
financed were delivered years earlier, the depreciation rates must be re-sized to
account for the difference between original delivery value and current value. For
example, if a plane is 10 years old, the analysis would assume that its expected
value would be about 70% of original delivery value. In order to calculate deprecia-
tion going forward from that point, one must account for the fact that the new base
value is only 70% as large as the original one, and the depreciation schedule above
calls for a decline in year 11 of 3% of the original value. The adjusted depreciation
rate would therefore equal about 4.3% of the current value (3%/0.7 = 4.3%) for
year 11. One can calculate similar adjustments for all combinations of aircraft age
and depreciation rate going forward.
For freighter aircraft, which fly fewer cycles (takeoffs and landings) and fewer
hours than passenger aircraft, the depreciation assumptions are more generous. New
freighters would generally be assumed to depreciate 3% per annum over 30 years to
a 10% residual. Freighters converted from passenger planes will be judged on a case
by case basis. Regional aircraft would generally be considered to have a shorter eco-
nomic life and the depreciation schedule is therefore somewhat more conservative.
22
The Rating Process
for Aircraft Portfolio
Securitizations
T
he following section will discuss the four aspects involved in assigning a rating
to an aircraft securitization, and will highlight how the corporate rating
analysis serves as an input into the review. While in any structured finance
transaction Standard & Poor’s will conduct a credit analysis, cash flow and structure
analysis, legal analysis, this section focuses on the rating concerns specific to aircraft
financings. It is not an exhaustive treatment of general securitization issues.
Credit Analysis
The primary credit risk in an aircraft securitization is a reduction in cashflows due
to a combination of airline delinquency or default (credit risk) and a reduction in
the value of the aircraft (asset risk). This reduction in value could be manifested by
a reduction in the collateral sale value or an inability to re-lease the plane at adequate
lease rates. Such reduction, if on a temporary basis, may lead to a liquidity stress,
but if permanent and for a significant amount, could lead to losses as cashflows
become insufficient to repay debt in full. Applying techniques from structured
finance and corporate ratings, analysts will evaluate the risk of airline defaults as
well as declining aircraft and lease values. Credit support in aircraft securitizations
usually takes the form of subordination, reserve funds or overcollateralization to
address these risks. Support from appropriately rated parties is another option.
In analyzing credit risk, the risk of high levels of airline defaults in a given portfolio
is seen to be a function of:
■ The estimated credit quality of the individual airlines,
■ The degree of uncertainty surrounding that credit estimate, and
■ The degree of diversification.
Analysts will use actual ratings (including public information or “pi” ratings in
some countries such as Japan) of airlines where possible in judging credit quality.

However, most airlines in diversified securitizations are not rated. In those cases,
analysts will make an assessment of credit quality, based on its knowledge of the airline
and the industry. Such assessments can have several levels of certainty, and are dis-
counted based on uncertainty, how high the rating is, and how diversified the overall
portfolio of airlines is. Thus, a rating estimate based on limited information which
arrives at a high rating, and which forms part of a relatively undiversified pool, will
be discounted (lowered) heavily. Conversely, a low rating, or one based on extensive
information and in a well diversified portfolio, will not be discounted at all.
In assessing credit quality, analysts will consider not onlythe combination of airlines
in the portfolio at closing, but also the potential for future adverse changes in the
airline portfolioas well as the future composition of the airlines. This is due to the
fact that as a lease comes to its normal expiration or an airline defaults, the aircraft
may be re-leased or sold. If the aircraft is to be re-leased, the analysis must consider
the potential universe of new lessees. The general view is that as a portfolio ages, the
attractiveness of the ageing aircraft decreases. Airlines interested in aging aircraft
tend to be of lower credit quality and located in weaker jurisdictions, thereby resulting
in increased credit risk for longer term financings.
A second factor in assessing credit risk is the diversification of airlines. How many
airlines in how many countries and regions are in the portfolio? Does the portfolio
include flag carriers (the principal airline providing international service)? Are there
charter and cargo airlines? Do these airlines operate in developed or less-developed
countries? Concentration in highly rated credits is obviously a benefit. The mere
fact that one portfolio may have more aircraft by number may not lead to more
diversification if large portions of the portfolio are leased to the same or only a
few carriers.
Another component in analyzing credit risk is an examination of the historical
performance of the originator’s portfolio. Analysts will look at the originator’s
delinquency and default experience, as well as its repossessions and recoveries. Has
its portfolio shown any significant changes in terms of growth or concentration?
How does the securitized pool compare to the retained pool? What does the originator
believe to be the re-leasing prospects in the future?
In analyzing the future credit quality and diversification of the portfolio, Standard
& Poor’s will assume that concentration limits with respect to credit quality, country
and regional exposures, and individual obligors will be met. By evaluating the airline
credit risk, the default rates for each of the rating scenarios will be derived. The size
of the portfolio, by number of aircraft and airlines, will determine the method of
application for these default rates. If the portfolio is sufficiently diversified, analysts
will request that stress scenarios model the default rate as a certain percentage of the
portfolio by aircraft value. However, if the portfolio consists of a limited number of
aircraft and airlines, it may be more appropriate to adopt a default pattern on an
airline-by-airline basis.
24
The Rating Process for Aircraft Portfolio Securitizations
The other component of credit risk is the asset quality, which is described above
(see Aircraft Asset Risk Evaluation in the “Aircraft Financings” section). The outcome
of the asset analysis is a value decline assumption. For a transaction that contemplates
the sale of aircraft upon an airline default, this assumption is used to calculate the
recovery proceeds upon an aircraft sale. For a lease deal, this analysis will be translated
into a stressed lease rate upon a re-leasing event. For a transaction involving aircraft
loans, the result will be a recovery assumption expressed as a percentage of aircraft
collateral, which indirectly determines the recovery on the principal amount of
defaulted assets.
Cash Flow Analysis

Conclusions from the evaluation of credit and asset risk form the basis of assumptions
used in the cash flow modeling of stress scenarios. It is important that the cash flow
and payment structure of a transaction allow for the full and timely payment of
principal and interest, under worst case assumptions. The severity of these assumptions
varies according to the rating sought on the bonds.
Since aircraft pool securitizations vary from transaction to transaction, a standard
cash flow model is not used. Rather, analysts will review transaction-specific propri-
etary models prepared by the issuer, or its investment banker, that will model the
stressed asset cash flows and the required payments to bondholders and other third
parties. Any shortfall in revenue must be covered by a form of credit enhancement
to provide the additional source of funds. The cash flow runs should demonstrate
how the stressed revenue along with the credit enhancement is sufficient to meet
payments under the terms of the rated securities. Depending on the terms of the
rated securities, it is quite possible that final advance levels (amount of debt raised
versus aircraft portfolio value) could differ significantly, even given the sameset of
stressed asset cash flows airline credit quality and aircraft asset value risk characteristics.
The cash flow model should demonstrate that the transaction has sufficient liquidity
to pay interest and principal when due.
Analysts will develop worst-case assumptions, which will then be tested through
various sensitivity analyses in order to judge the robustness of the cash flows
(see table 1 for sample runs). The variables are as follows:
■ Default timing;
■ Airline default rates;
■ Recovery and loss severity;
■ Repossession and remarketing periods;
■ Repossession and remarketing costs;
■ Planes off lease (aircraft on ground); and

■ Planes that cannot be repossessed during the term of the financing due to legal
or other problems (lost aircraft).
Default Timing
The term of the transaction is the key determinant of how many recessions should
be modeled in the cash flows. In general, one recession is assumed to occur in every
eight- to ten-year period of a deal. This frequency is chosen to reflect the average
term of an economic cycle in the airline industry, and to reflect the likelihood that a
transaction requiring a long period to repay all debt will likely face more than one
industry downturn. No attempt is made to predict the timing of an actual industry
recession. Rather, these downturns are modeled so as to place greater relative stress
in scenarios testing repayment of debt with higher target ratings.
The timing of defaults in the cash flow model should be tailored to the characteristics
of the asset pool and the payment allocations within the transaction. It is a general
rule that recessions placed at the beginning years of a cash flow model would be
more severe than later recessions if the transaction incorporates a sequential pay
structure whereby senior classes receive principal before subordinated tranches.
However, depending on the transaction structure, payment terms, and collateral
Table 1
Typical Cash Flow Stresses for Operating Lease Deals
With approximate ranges

Test AA A BBB BB
Depression 1, start (mos) 18-24 18-24 30-36 30-36
Depression 2, start (mos) 126-132 126-132 138-144 138-144
Length of depression (yrs) 3 3 3 3
Lessee defaults, depression 1 (%) 75-88 60-74 45-60 24-46
Lessee defaults, depression 2 (%) 88-93 75-79 60-65 30-51
Lessee defaults, outside depression (%) 5 5 5 5
Lease rate decline, depression1 (%) 46-60 36-45 26-36 16-25
Lease rate decline, depression 2 (%) 68-85 54-70 42-55 30-40
Repossession/remarketing time, 12 11 10 8
inside depression (mos.)
Repossession/remarketing time, 6 6 4 2
outside depression (mos.)
Lease term, outside depression (yrs) 5 5 5 5
Lease term, depression 1 (yrs) 4 4 4 4
Lease term, depression 2 (yrs) 3 3 3 3
Repossession cost ($) 500,000- 500,000- 500,000- 500,000-
750,000 750,000 750,000 750,000
26
pool, other timing scenarios may need to be tested. For example, a transaction that
relies on the sale of aircraft, and in which a large number of aircraft are required to
be sold in a relatively short period prior to the legal final maturity, may be stressed
by placing a recession at the end of the transaction.
During each recession, it is assumed that a higher than normal level of losses will
occur. The term of the recession may differ, typically from two to four years, and is
of significance since losses will be applied over this term. By concentrating losses in
a shorter or longer time frame, the credit and liquidity impact of defaults can be tested.
Depending on whether the transaction contemplates the sale of an aircraft, the
release of a plane to another lessee or the foreclosure of a defaulted loan, the concept
of a recovery value will need to be modeled. This recovery would be modeled fol-
lowing a repossession and remarketing period, during which time no income will be
generated. Costs incurred during this work-out period also need to be modeled.
Airline Default Rates

As discussed above, the risk of widespread defaults depends on the credit quality of
the airlines and the diversification in the portfolio. Following the evaluation of airline
credit risk, analysts will assume stressed default rates for the various rating categories.
Two types of defaults will be modeled: those that occur on an ongoing basis and
those which would occur in a depression.
Ongoing defaults are assumed to occur throughout the deal when a recession is
not being modeled. The rate of these defaults reflects the number of airlines which
are expected to fall behind in their payments in a normal operating environment.
This rate will be based on an examination of the originator’s delinquency and de-
fault experience, taking into account the economic environment reflected in these
numbers. The analysis will also factor in the probability that as the aircraft ages and
becomes less desirable, airlines of lower credit quality will enter the pool via releasing.
In addition to the ongoing defaults, there will be significantly higher default levels
associated with the depression scenarios. Defaults for ‘AA’ cash flows may range
from approximately 75% to 90% of the portfolio value being in repossession during
each of the depressions. For ‘BB’ stresses, the levels would be lower, for example in
the 25%-50% range. As mentioned earlier, default rates used in the second depression
would tend to be at the higher end of the range due to the additional risks associated
with an aging portfolio and uncertainty as to the identity of the airlines.
Various methods should be used to model these default rates in the cash flows :
default all requisite airlines up front; default airlines towards the end; default randomly;
and combinations of the above. The cash flows should be robust enough to withstand
varying patterns of default such that a temporary spike or sustained level of losses,
consistent with the rating level, would not result in an interruption in payments
to noteholders.

Recovery and Loss Severity Assumptions
As mentioned earlier, the result of the aircraft asset analysis is a series of recovery
assumptions for each rating level. For a sale or operating lease deal, provided that
the legal analysis demonstrates adequate access to the aircraft collateral, it is assumed
that the aircraft can be sold or re-leased following an airline default or the expiration
of a lease. An aircraft that is returned to the portfolio in the midst of a recession
would obviously have a lower value than one which is sold or re-leased in a more
normal operating environment. Similarly, if the issuer has to foreclose on a defaulted
loan, the recovery proceeds will depend on the security structure. Standard & Poor’s
assumes that all defaults which occur within a recession would be subject to stressed
recovery rates. Depending on the time required to foreclose, such recovery proceeds
may only appear in the cash flows following the expiration of the recession period
itself.
Where two recessions are modeled in the cash flows, loss severity assumptions are
more severe for the later recessions. These higher decline assumptions reflect the
reduced attractiveness of an aging fleet and the increasing risk of new technologies
being introduced.
Repossession and Remarketing Period

The repossession period is the time it takes to repossess an aircraft if the defaulting
lessee has not agreed to a voluntary repossession. Obviously, an aircraft is only valuable
to the owner if it has the right to repossession. Analysts will request a jurisdictional
survey for each jurisdiction where an aircraft in the portfolio is expected to be regis-
tered, domiciled, or principally used. Where the portfolio is of a sufficient size, at
closing it may be possible to provide surveys for currently relevant jurisdictions and
a selection of other jurisdictions which are likely to be relevant in the future. The
purpose of this questionnaire is to determine whether the issuer has sufficient legal
rights to repossess, sell, re-register and export for its own benefit the aircraft leased
to a defaulting carrier.
In conducting this analysis, issuer’s counsel would need to take into account the
domicile of the airline, jurisdiction of registration of the aircraft, and operating juris-
dictions. Once the legal right to repossess the aircraft has been demonstrated, the
time for repossession must be determined. Analysts will review any special legal or
regulatory provisions which may increase or decrease repossession time and the lessor’s
own track record and will analyze any industry and market information available.
The remarketing period is the time necessary to find a new lessee once the aircraft
has been returned to the lessor. If a lease has reached its scheduled expiration date,
this period will be shorter than if the aircraft had been returned from a defaulting
lessee. A lessor will have advance warning of scheduled lease maturities and normally
28
would arrange to lease or obtain commitments for aircraft coming off-lease many
months in advance of the lease maturity date.
The best option to minimize remarketing time would be to re-lease to the same
carrier. Within a depression, it is assumed that the remarketing period will be longer
because the balance between the supply and demand for leased aircraft or aircraft
sales may be affected. In a depression, more planes become available for re-leasing
due to the large number of lessee defaults and the increased likelihood that credit-
impaired lessees will have a lack of capital or liquidity to lease aircraft.
During the combined repossession and remarketing period, it is assumed that the
aircraft affected would generate no income. In “AA” rating scenarios, the combined
down time during a recession may be about 12 months; for “BB” stresses, 8 months
would be a typical period.
Repossession and Remarketing Costs

If a lessor decides to repossess an aircraft, it will incur costs for a variety of reasons:
legal work, insurance, pilot expenses, fuel, storage, documents for de-registration,
and export of aircraft. In the cash flow simulations, repossession and remarketing
costs per plane may range from $500,000 to $750,000 per event. The lessor’s historical
experience is a factor in determining the final amounts. In addition, the number of
planes in the portfolio is considered—for large portfolios, it may be possible to
assume an average cost. Costs may differ depending on whether the portfolio consists
of commercial jets or the regional variety.
Aircraft on Ground
The cash flow impact of a certain percentage of aircraft on ground (AOG) also
needs to be modeled. It is assumed that no lessor would be in a position where
100% of its fleet would be generating revenue. Aircraft may be leased to delinquent
lessees who have defaulted on a temporary basis or are in the process of working
out a payment plan with the lessor; they may be in a repossession and remarketing
scenario; they may be in the midst of being reconfigured for a new lessee; or there
may be delays in the start of the lease, etc. Data on the originator’s historical AOG
levels will be examined and a level chosen for each rating scenario.
Lost Aircraft
Occasionally, there may circumstances in which no residual value should be attributed
to an aircraft which has been securitized. It is not always possible to predict with
certainty the location of an aircraft at the time of the intended repossession. Unless
the aircraft happens to be in a jurisdiction for which a jurisdictional questionnaire
has been answered, analysts will not always know what procedures the issuer must
follow in order to retrieve the aircraft from its lessee and the time such a procedure

would take. It is possible that the aircraft repossession proceedings may still be con-
tinuing at a time when payments are due to noteholders. If this is the case and it is
likely that access to the collateral or sale proceeds will be withheld or delayed, then
a zero recovery value would be applied to that aircraft.
This stress is more applicable to smaller portfolios where the loss of one aircraft
would have a more significant impact on the cashflows. In a large portfolio, diversity
in the number of jurisdictions could mitigate this risk.
Legal Considerations
The simplest form of aircraft portfolio securitization involves the issuance of debt
securities to fund the acquisition of aircraft from the current owner, which ordinarily
is an aircraft leasing company or aircraft manufacturer. The seller of the aircraft,
either directly or indirectly through subsidiaries, will have leased the aircraft to a
variety of airlines in various jurisdictions, and the aircraft are conveyed subject to
the existing leases. The issuer, either directly or indirectly through one or more
wholly-owned subsidiaries, becomes the lessor.
The issuer contracts with a leasing company to service its portfolio of aircraft. As
discussed in the section “The Servicer’s Role and Responsibilities”, these services
usually include collecting lease rents, remarketing, re-leasing and repossessing aircraft,
and other functions related to portfolio management. The issuer also contracts with
other parties to provide necessary financial, administrative, and corporate services
and may enter into financial agreements, such as swaps and liquidity facilities.
As security for the repayment of the notes, the issuer grants mortgages, charges, or
assignments over its ownership interests in the aircraft, its interests in the leases and
any subleases, its rights under the servicing, administration and other agreements,
and its other property (including, for example, accounts, deposits, and reserves). As
discussed above, the rated securities typically are tranched by subordination resulting
in different ratings for each series. These series reflect the different likelihood of
repayment from the stressed cash flows.
In this simple form of securitization, the principal legal issues include:
■ The bankruptcy-remoteness of the issuer and other parties whose bankruptcy will
not be assumed in the review,

■ The true sale of the aircraft assets and any other rights or assets to the issuer, and
■ The effectiveness of the security arrangements and creditors’ rights.
Other legal issues arise in the analysis of the underlying leasing transactions, the
issuer’s financial and other agreements, the tax status of various parties and payments,
and issues specific to the legal status of the parties to the transactions and laws of
the jurisdictions relevant to the parties and the assets.
30
Most securitization structures are not as simple as the example presented above.
In practice, complex legal and analytical issues that are specific to a proposal are the
rule rather than the exception. The following discussion of principal legal issues,
together with other relevant Standard & Poor’s publications, is intended to provide
a foundation for identifying issues that often require more subtle legal and analytical
judgments, and revised requirements, than is reflected below.
Bankruptcy-Remote Entities
Standard & Poor’s bankruptcy-remoteness criteria depend on the form of the entity,
but common requirements for any form are set out above under “Legal
Considerations for Airline Equipment Debt.” For certain ownership structures, analysts
may conclude that the ultimate owners of a corporate issuer would have little incentive
to commence a bankruptcy proceeding against the issuer or its affiliates in the aircraft
ownership or leasing chain. An example of this ownership structure would be a
company organized in the Cayman Islands whose entire equity interests are held
pursuant to a declaration of trust for the benefit of charitable interests and which
otherwise is in compliance with all other criteria. As discussed in the section referred
to earlier in this paragraph, many trust structures raise concerns about risks that
need to be particularly addressed in legal opinions. In addition, corporate structures
frequently include interests that raise such risks.
In addition to the issuer’s owners, the originator typically has a continuing role in
the securitization structure that raises concerns about the effect of its insolvency on
the issuer’s status that must be addressed in one or more opinions bearing on these
risks. The legal analysis will focus principally on the following risks:
■ That the assets and liabilities of the issuer and its affiliates may be combined with
the originator’s estate in bankruptcy under the doctrine of substantive consolidation,

a theory of agency, or another similar principle;
■ That the continuing role of the originator may be inconsistent with accepting a
true sale conclusion with respect to the conveyance of the assets by the originator;
and
■ That the conveyed assets may be so vital to the reorganization of the originator in
its bankruptcy that it would have a very great incentive to commence bankruptcy
proceedings against the issuer, or to cause such a proceeding to be commenced.
These concerns are not easily addressed by legal opinions alone and require
Standard & Poor’s to assess the relevant features of the securitization structure
from both an analytical and a legal perspective.

True Sale
The true sale review of the conveyances of assets into the issuer has two prongs.
First, the conveyance must validly and effectively convey the asset, and ownership
must be perfected in the issuer under all applicable laws, including any regulatory
requirements. Second, the conveyance must be irrevocable and not subject to avoidance
even in the seller’s insolvency.
For entities subject to the U.S. Bankruptcy Code, this conclusion will be expressed
in a legal opinion to the effect that, in the transferor’s insolvency, the assets would
not be viewed as property of the estate of the transferor under Section 541 or be
subject to the automatic stay under Section 362(a) of the U.S. Bankruptcy Code.
For certain assets, Standard & Poor’s also may require a legal opinion to the
effect that the transferred assets and the related debt service payments to the note-
holders would not be recoverable as a preference under Section 547(b) of the U.S.
Bankruptcy Code or be deemed a fraudulent conveyance under state or federal law.
Equivalent opinions will be required in relevant non-U.S. jurisdictions.
If the aircraft manufacturer is the originator, it frequently will have provided some
form of seller financing or support in the underlying lease transactions being conveyed
into the securitization structure or will have, directly or indirectly, a continuing role
or obligations in the securitization. Standard & Poor’s requires true sale opinions
in these securitizations even for assets conveyed, directly or indirectly, by the
aircraft manufacturer.
Security Interests and Creditors’ Rights

A first priority perfected security interest in the aircraft assets and the other property
and rights of the issuer principally serves two purposes. First, it provides a direct
route for the security trustee to dispossess any other interests and proceed to realize
on the collateral on a timely basis in the event of a default. Second, it provides a sig-
nificant disincentive for any unsecured creditor, any creditor with a lower priority
interest, or the holder of any equity or beneficial interest to commence bankruptcy
proceedings against the issuer, or to cause such proceeding to be commenced.
In this simple form of securitization, legal opinions are required confirming that
the noteholders have the benefit of a first priority security interest (or its non-U.S.
equivalent) over the aircraft assets and other property and rights of the issuer.
Where non-U.S. law governs the creation, perfection, and priority of the security
and where the issuer (or another grantor) is not a U.S. entity, transaction counsel
should provide its analysis of the applicable laws and proposed opinions for
Standard & Poor’s to review early in the rating process.
As discussed above under “Legal Considerations for EETCs”, Standard & Poor’s
considers that the effectiveness of subordination provisions under applicable law,
32
even in the issuer’s bankruptcy, greatly diminishes the incentive for any parties
bound by such terms to commence bankruptcy proceedings against an issuer. Legal
opinions confirming such effectiveness are required for non-U.S. entities generally as
a part of Standard & Poor’s review of the tranched debt and the bankruptcy-remoteness
of the issuer.
Operations Review
The review performed on the portfolio should be at least equal to the market standard
if the portfolio of aircraft assets were sold to a third party. An operations or corporate
review consists of reviewing both qualitative and quantitative factors.
Qualitative factors will focus on ascertaining the position of the originator within
the industry and the overall risk assessment of that industry. Analysts will conduct
an extensive review of the originator and servicer’s operations. Any change in the
way the company undertakes its business could have an impact on the performance
of the portfolio. As will be mentioned in the servicer section, the role of this entity is
unique in a portfolio securitization and the analytical process will include an onsite
visit. Any other parties to the transaction who are deemed to play a crucial role to
the securitization, for example the hedging manager, will also be reviewed. In addition
to the onsite visit, analysts will examine operating manuals, internal information
systems, and any other documentation created for the purposes of the securitization.
Quantitative factors will focus on additional factors that could affect the final
credit enhancement levels, cash flows, and legal structure. These factors can include
such things as an audit of the portfolio data, a review of the individual leases, and
an examination of all relevant jurisdictional reviews.
It should be noted that analytical process relies on the originator, its accountants,
counsel, and other experts for the accuracy and completeness of the information
submitted in connection with the ratings. Standard & Poor’s retains the right to
require additional information that it feels necessary to conduct and maintain the
rating on a particular transaction.

Rating Considerations
for Lease Pools
T
he first aircraft operating lease pool structure (ALPS) transaction, originated
by GPA Group PLC (ALPS 1992-1), relied on the sale of aircraft to generate
sufficient proceeds to repay the rated debt. Subsequent operating lease port-
folios, by contrast, rely upon both lease and residual cashflows associated with a
portfolio of aircraft to ensure ultimate repayment of outstanding debt. The intention
is that the aircraft will be re-leased upon the expiration of the existing leases. From
a cashflow perspective and assuming the same portfolio, it could be argued that an
investor in rated debt should be indifferent to a sales liquidation structure or a releasing
transaction. The reason behind this is that in a theoretically efficient market, the
liquidation proceeds of an aircraft should be equal to the net present value of the
expected future earnings stream of that aircraft, i.e. the aircraft’s lease revenue.
Sale versus Lease Structures

Markets, however, are not fully efficient. In a depressed environment, there is often
a penalty associated with selling aircraft. This loss will be a function of the severity
of the depression and the imbalance of supply and demand. In other words, the
principal benefit of a re-leasing structure is the elimination of the forced sale into
a severe recession.
The foregoing does not imply that lease rates would not decline in a depressed
environment. In fact, while the sale of an aircraft in a recession would not result in
realizing the plane’s highest price, lease rates would also fall in a recession. This
would occur since lessors would be willing to lease their aircraft at concessionary
rates over a short period of time, rather than to have an aircraft on ground generating
no income. However, unlike the forced sale, which would “crystallize” the loss
on that aircraft once it is sold, an aircraft that is leased at a depressed lease rate
could at least be re-leased at higher rates once that lease expires and the depression
has ended.

While the above may indicate that a re-leasing structure is better than a forced sale
structure, there are also uncertainties associated with re-leasing. Lessee composition,
demand for aircraft, aircraft values, and lease rates are subject to change. This is
particularly true for a transaction which extends far into the future.
Lease Rates
An important foundation for the analysis of operating lease transactions is the pro-
jection of future lease rates; that is, the expected payment to be made by the lessee
during the term of the lease. Once the current leases in the portfolio expire or a lessee
defaults, the aircraft must be re-leased, and it is this future lease payment which
must be forecasted. The methodology used to calculate future lease rates may vary,
and one such method which applies the concept of gross asset yield is outlined
below. The exact formula used may change on a deal by deal basis, but the various
methodologies must be capable of being compared to each other in order to maintain
consistency in the approach.
Standard & Poor’s used the following formula to calculate monthly lease rates for
the Airplanes Pass-Through Trust (“APTT”) transaction rated in 1996:
(Aircraft Base Value * Depreciation Adjustment Factor)*
(Spread + INDEX)/12 * Lease Value Decline = Monthly Lease Rate
This formula indicates that lease rates are a function of the depreciated value of
an aircraft. The lease rate formula also factors in a spread over the costs of funds.
This spread represents the lessor’s desired return on its investment. Finally, depending
on whether the re-leasing event is to take place outside or within a depression, the
lease rate may be subjected to a decline in value which reflects the aircraft’s asset
value risk and the severity of the stress scenario being modeled. Following are
descriptions of the formula terms.
Aircraft Base Value. The aircraft appraisals used in securitizations are similar to
the requirements mentioned in the “Corporate Rating Criteria” section.
Depreciation Adjustment Factor. The initial aircraft values determined by
appraisals are then depreciated in accordance with Standard & Poor’s assumptions
for a depreciation curve. The curve should depreciate the base value of an aircraft
over its economic life. The use of appraisals and depreciation assumptions are de-
scribed above in the “Aircraft Asset Risk Evaluation” section. While different aircraft
types may be subject to different depreciation curves, the portfolio is generally assessed
as a whole and a summary curve is derived which reflects the attributes of the whole
portfolio. Different depreciation assumptions are used for large passenger aircraft,
regional aircraft, and freighters.
36
Rating Considerations for Lease Pools
(Spread + Index)/12. The depreciated appraisal values as calculated above would

next be multiplied by a gross asset yield which has two components: a spread which
changes with the age of the aircraft and an index which represents the costs of
funds. To calculate the spread, historical data reflecting lease rates and aircraft values
over the useful life for all the aircraft in the portfolio should be obtained and analyzed.
From this analysis, a spread curve is derived which will show that the spread com-
ponent of the lease rate increases with the age of the aircraft. This is to be expected
since lease rates as a percentage of aircraft value increase with the age of an aircraft.
Stated another way, aircraft values decline more rapidly than lease rates until a plane
is fairly old, because that value incorporates a declining expected remaining life
in service. The resultant annual lease rate was then divided by 12 to calculate a
monthly figure.
Lease Value Decline. The above lease rates reflect the payment which could be
expected from an aircraft on lease assuming a given base value. However, base value
may have no resemblance to actual value, particularly in a recession. It is therefore
necessary to assume a lease value decline, adjusting the lease rate downwards to
take into account the nature of the aircraft and the economic environment being
modeled. Lease value declines will be derived for each of the rating stress scenarios
(see “Aircraft Asset Risk Evaluation”), and the declines used in the stress testing
will be more severe for lease rates which have to be projected in the later stages
of the transaction.
The results of the lease rate analysis can be presented in a lease rate curve that
reflects the gross revenue line, before stress testing. The gross yield method is only
one of the approaches which can be used to calculate lease rates in operating lease
deals. Certain transactions have been analyzed using a lease rate depreciation curve,
Chart 1
Sample Of Gross Asset Yield By Age of Aircraft
Historical Lease Yield
30
25
20
(%)
15
10
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Age of aircraft (years)

analogous to an aircraft value depreciation curve. Analysts may also consider appraisers’
projected future lease rates. Regardless of the calculations used, the purpose of the
lease rate analysis is to create a curve which reflects the intermediate to long term
trend line, taking into consideration the length of the transaction, the aging of the
fleet, and the asset models (see charts 1 and 2).
Operating Lease versus Finance Lease

While the majority of portfolio securitizations have involved pools of single investor
operating leases, debt in leveraged leases (usually longer term finance leases) has also
been securitized. Under an operating lease, the lessor retains the risk and reward
associated with the aircraft’s residual value. If the lessor is successful at obtaining a
lease rate or a sale value above the market value of the aircraft, this positive benefit
accrues to the lessor.
However, when debt in a leveraged lease is securitized, the holders of the securi-
tized debt are entitled only to repayment of the underlying leveraged lease notes.
Any upside benefit will be retained by the equity investor. In terms of the rating
analysis, this effectively diminishes the credit value of a diversified aircraft portfolio,
since lower sale proceeds or lease rates on one aircraft cannot be offset by above
market performance of another. This affects principally the junior-most tranche in a
securitization (or EETC), since more senior securities benefit from subordination of
lower tranches. Thus, the senior tranche in a securitization of leveraged lease debt
can capture the value at the expense of more junior tranches, but the junior tranches
Chart 2
Sample Of Aircraft Spreads By Age Of Aircraft
(basis
points) Spread
2200
2000
1800
1600
1400
1200
1000
800
600
400
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Age of aircraft (years)
38
cannot capture value at the expense of the equity investors. Stated another way, the
various tranches of a securitization are cross collateralized in the cash flows from
the leases and aircraft; the equity is not. While there is a difference in the manner of
evaluating an operating lease and a leveraged lease pool, the following comments
apply equally for both lease types.
Aircraft Sales
As stated at the outset of this section, the primary repayment methods for operating
lease transactions are lease rentals and residual cashflows. However in certain trans-
actions and in limited circumstances, the issuer will be able to sell the aircraft. This
sale feature gives the issuer more flexibility to generate income should re-leasing not
be the more attractive option.
Note Terms and Conditions

Note terms and conditions vary considerably between transactions depending upon
the structure and the preferences of the underlying issuers and lead managers. Most
operating lease transactions have consisted of multiple tranche issuances, with ratings
ranging from ‘AA’ to ‘BB’. Bonds have paid interest on both a floating- and fixed-rate
basis. Simultaneous with the issuance of the rated notes, there is usually an unrated
tranche of securities which may be retained by either the originator or a third party.
Redemption
Typically, the issuer will have the ability to redeem any class or sub-class of notes at
their redemption price plus accrued but unpaid interest. The redemption price will
be set for at least the outstanding principal amount of the notes plus certain premiums,
payment of which is dependant on the redemption dates. The notes may only be
redeemed in order of priority and provided that there are sufficient funds to do so.
Issuer Level Taxation

Unless taxes are included in the cash flows, all payments of principal, interest, and
premium, if any, on the notes are expected to be made without any deductions for
withholding tax. Legal opinions should be delivered to the effect that, as of the closing
date, the issuer will not be subject to income or other taxes and that payments by
the issuer on the rated securities may be made free of withholding on account of any
taxes. Upon the imposition of such a tax, the issuer may choose to redeem in whole
the relevant notes of any class without premium. Otherwise, payments will be made
net of such withholding.

Amortization
The amortization profiles of most of the operating lease portfolios provide for the
pro-rata paydown of the rated notes subject to certain pre-determined schedules. The
purpose of these schedules is to fully pay down the notes within their final legal
maturities, while maintaining a level of overcollateralization equal to, or higher
than, that at closing. Supplemental principal payment schedules are available for
some of the higher rated classes.
Protection may be built in at the senior tranches by a principal adjustment mecha-
nism. Certain structures may result in a faster paydown, funds permitting, if the
declines in the value of the aircraft portfolio are greater than the declines assumed
due to depreciation. Therefore, should a reappraisal of the portfolio reveal that aircraft
values have fallen more than their depreciated value, or should a sale of aircraft
result in a reduction of the portfolio value, the impact of the principal adjustment
amount would be to accelerate a paydown of the senior notes. Payment of these
amounts would be made possible by diverting payments from the lower-rated tranches.
Priority of Payments
The priority of payments will vary between transactions depending upon the structure
put forward by the lead manager. The primary purpose of the priority of payments
is to allocate payments to various classes of notes and to third parties. A sample
waterfall may look as follows for a structure involving rated class A, B, C and
D notes:
■ Servicer cost and other expenses*,
■ Class A interest,
■ Class A minimum principal,
■ Class B interest,
■ Class B minimum principal,
■ Class C interest,
■ Class D interest,
■ Class A principal adjustment amount,
■ Class C scheduled principal,
■ Class D scheduled principal,
■ Class E minimum interest,
■ Class B supplemental principal,
■ Class A supplemental principal,
■ Class D outstanding principal,
■ Class C outstanding principal,
■ Class E supplemental interest,
40
■ Class B outstanding principal,

■ Class A outstanding principal,
■ Class E accrued unpaid interest, and
■ Class E outstanding principal.
* Certain fees will be capped with the balances subordinated below rated securities.
Since the rated notes are not repaid in sequential order, the repayment of the notes
by their final legal maturities are ensured by certain minimum principal amounts.
Should there be sufficient cash to do so, the payments are accelerated by the supple-
mental principal amounts. Assuming these distributions can be made, any extra
monies available will then be used to paydown the outstanding principal. The unrat-
ed notes will be paid down last.
The priority of payments may also provide for the replenishment of a liquidity
reserve. Items covered by this reserve amount could include potential interest short-
falls, maintenance obligations, the repayment of security deposits, and certain other
contingencies, for example deferred tax liabilities. An important function of this
reserve could be to ensure that timely interest payments are made regardless of a
temporary cash shortfall arising from the underlying leases. The priority of payments
could be structured such that there are separate liquidity reserves for each class of
notes, and separate top up facilities at different stages in the priority of payments
depending on the class of notes.
Purchase Options
Purchase options are another item which must be taken into account when analyzing
operating lease portfolios. These options usually allow lessees to purchase aircraft
at prices below either their estimated fair market value or their estimated net book
value at the option exercise date. Going forward, new lessees may also negotiate
leases with similar purchase options.
The impact of the exercise of these options is two-fold. First, if the exercise price
of these options are significantly below the appraisal values of the aircraft and a
large number of lessees exercised their options, this may adversely impact the repayment
of the notes. The second impact is that the exercise of these options may trigger
deferred tax liability claims on the issuer. The value declines used in cash flow simu-
lations will be considered (see “Credit Analysis” section) to ensure they are sufficiently
conservative to address the risk that these exercise prices would be below those
assumed in its stress tests. The severity of the value declines would render this risk
highly unlikely.

Stress Tests
The cash flow modeling that is applicable to an operating lease deal would follow
the format outlined in the “Aircraft Portfolio Securitization” section. These transac-
tions will tend to finance the aircraft to the end of its economic life which is
assumed to be 25 years for commercial jet aircraft.
The term of the lease will have an effect on how many leasing events would occur
per aircraft. The terms of the leases vary, depending on whether the lease is written
outside a depression (typically five years), within the first depression (four to five
years) or within the second depression (three to four years). Shorter lease terms are
used within depressions to reflect the tendency of lessors in a recessionary environment
to write leases of a shorter duration in order to reduce their exposure to depressed
lease rates.
Insurance
Another factor which is reviewed in operating lease portfolios is insurance. The air-
craft must be insured to a level consistent with commercial practices of aircraft
lessors operating in a similar industry. Insurance must cover all frame or hull war
risks, frame/hull war contingency, frame/hull deductible contingency, and third party
liability. Reports issued by a third party insurance broker indicating that insurance is
in full force and effect and is in adequate amounts will be reviewed. The financial
strength of those insurance companies underwriting these policies will also be factored
into the analysis, in addition to how those exposures are managed.
Political Risk Insurance

■ Depending on the domicile of the assets, political risk insurance (PRI) may be
required for any carriers domiciled in, or operating out of, legally questionable
jurisdictions. The insurance is designed to cover failure by a government to allow
an aircraft to be deregistered, exported, and removed from a jurisdiction. The pur-
pose of the insurance is to mitigate potential losses which may arise from the
Issuer’s inability to repossess the aircraft and the subsequent timely sale or releasing
of the aircraft.
Accordingly, PRI must be taken out for aircraft which are operated by airlines that
are domiciled in countries which have a Standard & Poor’s foreign currency sovereign
rating of ‘BB-’ or lower, or which are assigned a DRI five-year Political Risk Score
greater than 30. Standard & Poor’s DRI Global Risk Service considers a number of
domestic political risks that could impact investment in any one country. These
include: military coup risk, major insurgency/rebellion, government instability, insti-
tutional failure, and government ineffectiveness, among others. The DRI score is a
probability scale of 1 to 100, rising with increasing risk. Obtaining PRI for those
42
jurisdictions which meet these two criteria should provide investors with additional
comfort that political risks arising in certain jurisdictions would not impact the
transaction negatively. For those countries which are unrated, Standard & Poor’s
will evaluate those jurisdictions on a case-by-case basis during the ratings process.
Hedging
Interest rate exposure should be offset by swaps which should be entered between
the issuer and a suitably rated counterparty. The swap counterparties used in the
hedging strategy will be supporting parties to the transaction, and thus the necessary
language will have to incorporated into the swap agreement regarding the replacement
of the swap counterparty in the event of a downgrade.
The hedging strategy for operating lease deals incorporates a degree of operational
risk not seen in traditional structured financings and represents a departure from the
scenario in which the term of the swap is consistent with the term of the deal. The
hedging strategy is dynamic and is aimed at eliminating any exposure which could
arise from a mismatch in the amount of fixed- and floating-rate leases compared to
fixed- and floating-rate notes. The profile of the asset base is continually changing
as leases either mature or default. Since the timing of these events will not be known
at closing, the issuer will rely on the services of a third party who will be responsible
for sourcing swaps on an ongoing basis.
Currency exposure, to the extent that it exists, must be fully hedged. To date, all
debt issuances have been in US dollars. Lease rentals and aircraft values are also
denominated in US dollars, although Airbus has begun quoting aircraft prices also
in euros.
Maintenance and Indemnities

Operating leases generally contain “hell and high water” clauses which expressly
require the lessee to pay for costs, expenses, and liabilities incurred in relation to the
operation of the aircraft, such that the lessor has no residual liability for the payment
of any of these obligations s while the aircraft is with the lessee. Analysts will review
the leases, or representative standardized leases, as applicable, to assess the allocation
of these responsibilities during the lease term. See “Maintenance and Related Issues”
in the “The Servicer’s Role and Responsibilities” section for a discussion of maintenance
responsibilities that arise in the re-leasing context and that the servicer performs, or
has performed, on behalf of the lessor while the aircraft is in possession of the servicer.

Special Considerations for
Aircraft Loan Portfolios
S
everal different types of aircraft financing structures have been rated by
Standard & Poor’s. These transactions have been either corporate secured
debt structures (ETCs and EETCs, primarily for U.S. airlines) or operating
lease portfolio securitizations of internationally diversified pools of aircraft assets.
Recently, proposals have been reviewed for aircraft financing structures where the
underlying assets in the securitization would consist of a bank’s interests in aircraft
loans made in various forms of financing transactions. There are certain structural,
credit and asset evaluation issues in these proposals that distinguish them from
operating lease portfolio securitizations. The rating implications of these issues
are discussed in the following section.
Securitization Structure
In operating lease securitizations, the originators typically are aircraft leasing companies
or manufacturers. The assets transferred into the securitization structure consist,
directly or indirectly, of their ownership interests in a portfolio of aircraft. These
transfers are designed to effect a true sale in order to isolate the assets from the
insolvency risk of the originator. Although there may be intermediate entities
between the issuer and the aircraft assets in the resulting securitization structure,
these entities are constituted to support the conclusion that they are bankruptcy-
remote entities and that there are not insolvency risks between the issuer and the
assets. Therefore, the analysis proceeds on the basis that the issuer will have effective
rights to the aircraft and the corresponding lease payments upon an airline’s default.
The originators of the aircraft loans generally are financial institutions, primarily
Japanese and European banks, that have a history of providing significant loan
financing to the aircraft sector. The assets that are transferred into the securitization
structure consist of their interests in these loans. Loan portfolios have included
direct loans where the bank is the sole lender and syndicated loans where the bank

has a funding obligation. The loans generally are fully funded, although some loans
include refunding obligations under certain circumstances.
If a direct or syndicated loan is freely assignable, the transfer ordinarily may be
accomplished in accordance with true sale criteria for loan assets. In some instances,
the loans may prohibit the outright sale of the loan to a third party but may permit
the creation of a participation. Generally, a loan participation does not remove the
insolvency risk of the transferor. In other cases, the bank may be able to create a
trust for the assets that does not violate the prohibition on assignment. A request
will be made for legal opinion and regulatory confirmation, as necessary, that transfers
would not contravene the terms of the loans, that they would be unavoidable and
recognized in the bank’s insolvency, administration, or regulatory proceedings, and
that the security over the interests could be realized without delay. For a more detailed
discussion of these true sale issues for transfers of bank loans, see Standard & Poor’s
Global CBO/CLO Criteria: Market Innovations, May 1998.
The underlying aircraft financings in the loan portfolios also differ from operating
lease securitizations. Although an aircraft loan portfolio may include secured loans
to airlines and traditional USLLs, loan portfolios have been reviewed where the pre-
dominant forms of loans include more complex, tax-advantaged, and cross-border
financing transactions that involve multiple parties, such as Japanese leveraged leases
(JLLs), ownership foreign sales corporations (O-FSCs), and commission foreign sales
corporations (C-FSCs).
Despite the complexities of these underlying financing transactions, they frequently
are presented as loans in which the primary credit risk is the airline. A review of
these transactions, however, indicates that some of the underlying financing transactions
have characteristics that introduce risks which may impede access to the aircraft,
and therefore would have an adverse impact on the recovery assumptions.
Credit Analysis
Aircraft asset value risk exists in both operating lease and loan portfolio deals. However,
compared to operating lease portfolios, loan portfolios may have certain positive
features affecting airline credit risk. There may be a significant difference, however,
in the credit exposure. Operating lease deals do not have a defined list of airline
credits for the term of the securitization. Since the securitization is typically designed
to finance the aircraft through to the end of its economic life, for some aircraft as
long as 25 years, but the term of an operating lease typically would be five years,
the rating process involves taking a view as to the likely future airline obligors
upon re-leasing.
In some loan portfolios, the terms of the loans are no longer than the terms of the
corresponding leases to the airlines. For those loans, the likelihood that the original
46
Special Considerations for Aircraft Loan Portfolios
airline would be the obligor throughout the term of the financing would mitigate the
uncertainty as to the airline credit inherent in operating leases. This increased certainty
as to the airline credits is a positive feature for those loan portfolios.
Generally, the aircraft loan portfolios reviewed have included better quality airlines,
including several flag carriers. Operating lease deals generally have had non-investment
grade lessees. Another positive feature for loan portfolios that have been reviewed is
the greater diversification regarding obligors and geographic concentrations. Finally,
there is a significantly reduced reliance on the servicer. The bank originator acts
merely as a collection agent and does not have an active role in remarketing, re-leasing,
or repossessing the aircraft.
Nevertheless, particular loan portfolios may have negative features. Although the
lease term and loan maturity terms may match for some loans, if there is minimal
amortization during the term, as is often the case, then a large balloon payment at
the end of the loan must be matched by a corresponding payment under the lease.
This lease payment often is in the form of a purchase option. Since the purchase
option price is unlikely to reflect current fair market value, there will be greater
repayment risk. The airline also may be unable to make a large balloon payment. As
noted above, loan portfolios ordinarily do not have a leasing company servicer on
which the securitization issuer may rely for remarketing, re-leasing, and repossessing
aircraft. Minimal amortization and the absence of an active servicer are negative
features of these loans.
Further, where the lease term ends earlier than the loan matures, as is the case for
many loans that for tax reasons must be disassociated from the airline’s credit, typically
the lessee must choose among a purchase option based on a large balloon payment
under the loan, returning the aircraft and making a similarly large payment, or
locating a substitute lessee and repricing the loan. These complex lease term options
frequently rely on deemed incentives rather than legal obligations to compel a pre-
payment of the loan. The absence of a leasing company servicer, the mismatch in
terms between the loan and the lease, and the lack of clear repayment obligations
upon lease termination are negative features of these types of loans.
As mentioned above, credit risk may not be limited to the airline. Significant credit
exposure may exist in that many of the underlying financing transactions are dependent
on, and exposed to the credit risk of, interim borrowers and lessors and their respective
owners. The default risk of these third parties must be factored into the rating
analysis to determine if and how these risks may be addressed with additional liq-
uidity, credit reserves, or other credit enhancements. In order to model the complexities
inherent in certain underlying financing transactions, onerous assumptions related to
losses and recoveries may need to be made. Some loans will have a zero recovery
value; other loans will have a reduced recovery amount.

Some portfolios include syndicated loans where the originator would not be trans-
ferring a controlling interest in certain loans. For these portfolios, an analysis will be
made of the loans where there is not a controlling interest. Determinations must be
made as to whether the issuer would have access to the aircraft through the exercise
of remedies and, if so, the amount of time it would take to arrive at a decision on a
troubled loan. These determinations will affect the length of the recovery periods.
Failure by a syndicate of lenders to come to an agreement on the enforcement procedure
for defaulted airlines may result in sub-optimum decisions, leading to not only a
delay in the recovery procedure but a possible reduction in recovery proceeds.
Rating Levels
Perhaps the most significant distinction between operating lease and loan portfolio
financings is the maximum rating achievable. To date, the most senior tranches of
operating lease securitizations have been rated no higher than ‘AA’. Features which
limit the maximum ratings are the uncertainty of the identity of subsequent airline
lessees, small portfolios with little diversification, as well as the uncertainty of events
relating to the long legal final maturities associated with the bonds. The absence of
these key concerns in loan portfolios may make it possible for these transactions to
be rated ‘AAA’ provided that the structural elements of the securitization support
that rating level and that rating issues such as those discussed above are satisfactorily
addressed at that rating level.
Many of the most problematic issues for ‘AAA’ rating levels arise from the type of
aircraft financing transactions underlying the loans in a portfolio. One the one hand,
secured loans and USLLs are included in some loans portfolios. As discussed above,
when these financing forms are in compliance with the rating criteria they may support
corporate enhanced ratings, in limited instances, even ‘AAA’ ratings. C-FSCs, if
properly structured, are a variation on the USLL financing form and also may be a
suitable support for ‘AAA’ loan portfolios.
On the other hand, the rating approach required to evaluate the multitude of risk
and recovery assumptions that arise in traditional O-FSCs likely would result in
their exclusion from portfolios supporting ‘AAA’ ratings. Single- and multiple-lessor
JLLs are included in many loan portfolios. The traditional single-lessor JLL is similar
is some respects to the traditional USLL. However, JLLs must be re-evaluated upon
any new reorganization bankruptcy reform legislation that might be put in place in
Japan. The initial assessment of single-lessor JLLs assumed that U.S.-style bankruptcy
reorganization proceedings would not be available to the entities reviewed and that
security over their assets could be enforced notwithstanding their bankruptcy. For
JLLs where the lessor consists of multiple lessors, whether jointly or through another
legal form, unresolved issues have been identified regarding the nature of the
48
common ownership, property rights, and obligations in these forms, in addition to

the bankruptcy reform legislation issue.
The lack of a controlling interest in a loan is a serious issue for all the underlying
financing forms and likely would have an adverse impact on recovery values. The
lack of a controlling interest undermines Standard & Poor’s existing market value
assumptions that the holders of the rated securities can control the exercise of remedies,
including sale of the collateral.
The final outcome of the rating process will depend on the composition of the
particular loan portfolio as well as the structure of the proposed securitization.
Although it is possible that a particular loan portfolio may support a ‘AAA’ rating
for a portion of the offering, it also is probable that a lesser total amount of debt
would be rated as compared to an operating lease transaction.
Asset Evaluation
The starting point for a rating analysis of an aircraft loan portfolio is a legal review
to determine the strengths and weakness of the forms of financing underlying the
loans. Only then can the cash flows be properly stressed in determining a transaction’s
capital structure. In the succeeding paragraphs, basic descriptions of the most common
structures that are expected to comprise a loan portfolio are presented. Accompanying
each section is the approach Standard & Poor’s expects to take in stressing the
cash flows.
Chart 1
Traditional USLL Loan
Owner
Participant
Equity Trust Equity

Contribution Agreement Residual
Payments
Purchase Price Debt Service
Sale Trustee/ Loan

Airline Trust Lenders
Lease Security
Rentals Loan Proceeds

Aircraft

Secured Loans and U.S. Leveraged Leases
Secured loans and debt issued in USLL transactions are discussed in the “Criteria for
Airline Equipment Debt” section. For secured loans and USLL debt that are in com-
pliance with rating criteria, no additional liquidity or credit stresses need be modeled
in the cash flows. The only default risk factored into the analysis is the credit of the
airline itself (see chart 1).
A loan portfolio may include USLLs that do not comply with Standard & Poor’s
criteria. For example, in certain USLLs, the owner participant may terminate the
equipment trust voluntarily, or an acceptable owner trust legal opinion may not be
provided. Should this be the case, analysts will consider the risk addressed by the
criteria in question. An analysis would be made of the impact of the insolvency of
the owner participant, and the likelihood of this occurring, and may seek relevant
legal opinions. In this example, a legal opinion likely might be requested to the effect
that the assets of the trust would not be consolidated with the owner participant in its
insolvency and that the first priority security interest in the aircraft and the lease
would be unaffected by the termination or consolidation of the trust. There is a
strong likelihood that, for such non-complying USLLs, additional liquidity requirements
would be incorporated in the cash flows.
Commission Foreign Sales Corporations

C-FSCs generally are USLLs designed to capture certain tax benefits available for
U.S. products that are used predominantly outside of the U.S. A foreign sales corpo-
ration, which is a wholly-owned subsidiary of the equity participant, acts as an
agent for the equity in arranging the USLL. The agent receives a commission for its
services. If this is the only role of the agent, and the USLL otherwise is in compliance
with the applicable criteria, the credit analysis of a C-FSC would be the same as
a USLL.
Japanese Leveraged Leases

The form of JLL financing included in loan portfolios normally involves a loan made
by a Japanese bank to a Japanese limited purpose company for the purpose of funding
up to 80% of the purchase price of an aircraft. Typically, the Japanese borrower is a
wholly-owned subsidiary of a Japanese leasing company or another Japanese bank
(parent). In addition to the loan from the bank, the borrower enters into agreements,
called Tokumei-Kumiai (TKs), with various investors (TK investors) to fund the balance
of the purchase price of the aircraft.
After purchasing the aircraft, the borrower, as TK lessor, leases the aircraft, either
directly or through a sub-lessor, to an airline. For tax reasons, the lease rentals are
constant throughout the lease term, resulting in fixed-rate payments under the loan.
50
The airline enters into an interest rate swap with the lenders to provide them with a
floating-rate return. The parent provides an agreement, usually in the form of a
comfort letter, to maintain the TK lessor’s solvency and its limited purpose status
(see chart 2) . Tax benefits are passed on to the TK Investors and the airline in the
form of deferred tax on profits and lower lease rentals.
A portion of the lease rentals will be allocated to make loan payments (dollar
payments) and a portion will be available for payments to the TK investors (yen
payments). Large balloon dollar payments and yen payments are due upon the
termination of the lease. The security for the loan may vary with the jurisdiction
of the airline. Typically, the security includes the following: a mortgage over the air-
craft in the jurisdiction of registry; an assignment of the TK lessor’s rights under the
lease, excluding the yen payments; and a pledge over the TK lessor’s bank account
in Japan that receives the dollar payments from the airline.
In order to conclude that the relevant rating for evaluating a JLL loan would be
the rating of the airline only, as in the case of complying USLLs, all entities in the
financing that do not satisfy the bankruptcy-remoteness criteria are assumed to
Chart 2
Example of a JLL Loan
TK
Investors
Parent
Invested
Amount TK
Wholly- Yen
Agreements
Payments
owned
Subsidiary
Dollar
Debt Service
TK Loan
Airline Lease Lenders
Lessor Security
Rentals Loan Proceeds

Aircraft
Fixed
Rate
Floating
Rate Swap

become insolvent. The potential effect of these insolvencies on the cash flows and
timely access to the collateral is reviewed to determine whether liquidity or credit
reserves may be necessary for the ratings sought on the securities.
As discussed above, it is expected that the analysis of the TK lessor itself will be
affected by proposed reorganization bankruptcy reform legislation in Japan. Since
the TK lessor is the borrower under the loan, the owner of the aircraft, the grantor
of the security ,and the counterparty to the lease, it is very unlikely that these tradi-
tional JLLs could be included in loan portfolios until this uncertainty is resolved.
Even prior to the legislative proposal, many issues were identified in the JLLs that
presented rating concerns. These issues broadly fall into four areas: bankruptcy-
remoteness issues, including the TK lessor’s relationship with its parent and the
TK investors; property rights and security interests; lease termination; and swap
agreement issues.
In the area of bankruptcy-remoteness issues and the TK Lessor’s relationship with
its parent and the TK investors, some of the issues include the following:
■ Under Japanese law, certain bankruptcy-remoteness criteria requirements would
not be enforceable and, consequently, analysts would not conclude that a wholly-
owned subsidiary of an operating company, such as the TK lessor, could be
bankruptcy-remote;
■ Usually the TK investor agreements do not comply with additional debt criteria
and the TK lessor lacks one or more other feature of bankruptcy-remoteness,

such as an independent director as well as legal and economic independence
from the parent;
■ If the parent’s rating is to be imputed to the TK lessor, the support agreement
must be the equivalent of a guaranty in compliance with Standard & Poor’s

guaranty criteria;
■ The parent support agreement may be avoided, rejected, or unenforceable in its
insolvency, affecting any recovery based on the parent’s creditworthiness;

■ In a parent insolvency, the TK lessor may be voluntarily or involuntarily joined in
the insolvency proceeding or consolidated with the parent;

■ A parent or TK lessor insolvency, as a default under the loan, may result in a
termination of the lease and the swap, even if the airline were performing; timely
or ultimate access to the aircraft may be affected by the insolvency proceedings or
by the airline contesting repossession;
■ In its insolvency, a TK investor may assert a proprietary interest in the aircraft
that could affect the timeliness of payments or, if successful, loss of collateral
value;
■ Upon a TK investor insolvency, TK lessor could be required to repay its investment
interest under the TK agreement, which could render TK lessor insolvent; if its
52
claim is not satisfied, the TK investor may assert a lien against the aircraft that
may result in the sale of the aircraft; and
■ Other parties to a subleasing arrangement may not be bankruptcy-remote entities,
thereby introducing additional default risks dependent on credits other than those
reflected in the rating.
In the area of property rights and security interests, many issues arise in these
multi-jurisdictional transactions, to the extent that the following may occur:
■ The security over the aircraft may not be perfected against the TK lessor in Japan;
security created in the jurisdiction of registry may not be enforceable against the
TK lessor in Japan; or the aircraft may be subject to claims prior to this unperfected
security through the parent or the TK lessor.
■ Security over the Japanese accounts may not be perfected; the lenders’ interests
then may be subject to prior claims through the parent or the TK lessor.
■ Dollar payments may be subject to Japanese legal proceedings in the TK lessor’s
insolvency that could affect the timeliness of payments or result in the loss of
cash flows.
■ If the lease were characterized as a rental lease in the TK lessor’s insolvency, the
assignee of the dollar payments would be entitled to only a limited number of

payments rather than the expected cash flows.
■ If the lease were characterized as a finance lease, repossession of the aircraft may
be delayed, hindered or prevented entirely in the airline’s insolvency.

Lease termination, particularly in the context of a loan with a large bullet payment,
raises issues such as the following:
■ The airline may be unwilling or unable to exercise its purchase option for the aircraft
or to make a termination payment when returning the aircraft at the end of the
lease term; the repayment of the loan then would depend on the sale of the aircraft.
■ A parent or TK lessor insolvency, as a default under the loan, may result in termi-
nation of the lease requiring the airline to make termination payments when it
may be unwilling or unable to do so.
■ Where the airline does not exercise its purchase option upon lease termination, its
termination payment may be considered an unenforceable penalty; the repayment

of the loan then would depend on the sale of the aircraft.
■ The securitization issuer, as successor to the originator, may have refunding oblig-
ations in the event of certain termination events under the lease; any refunding
obligations would be unfunded at the issuer level.
Among other swap agreement issues are the following:
■ The rating addresses swapped cash flows. If the airline defaults in its swap pay-
ments while it is still performing under the lease, the airline may not be able to
be dispossessed of the aircraft.

■ The securitization issuer, as successor to the originator, may have payment
obligations under the swap agreement that would be unfunded at the issuer level.
The parent’s and the TK investors’ relationships with the TK lessor raise concerns
as to whose credit risk, in addition to the airline’s, must be reflected in assessing the
loan. The TK lessor’s failure to qualify as a bankruptcy-remote entity, its legal status
in insolvency and the multi-jurisdictional property rights and security arrangements,
raise concerns as to the effects of the insolvency of the airline, and each of these
other parties, on the lenders’ ability to look to the aircraft assets on a timely basis,
if at all.
For JLL loans, transaction counsel should present surveys of the relevant legal
jurisdictions and a review of the credit terms and legal issues. Only by understanding
the risks to repayment of these loans, including realization on the aircraft assets, will
Standard & Poor’s be able to determine whether the risks are quantifiable and capable
of being addressed through liquidity or credit enhancements for that rating level.
For other JLLs, the lessor may consist of multiple lessors, either jointly or through
another legal form. As noted in the “Rating Levels” section, a number of unresolved
issues exist regarding the nature of the common ownership, property rights, and
obligations in these forms, in addition to the bankruptcy reform legislation issue.
Further legal analysis would be required for any of these loans to be included in
a rated portfolio.
Ownership Foreign Sales Corporations

O-FSCs are forms of aircraft financing that provide tax benefits to certain owners of
U.S. manufactured aircraft that are used predominantly outside of the U.S. The O-FSCs
often have a greater variety of terms and features than other types of loans. These
variations have a similar core of transaction participants and tend to have similar
general categories of risks and rating issues, although these vary on a loan by
loan basis.
The common transaction participants typically include an equity investor (parent),
its special purpose or leasing company subsidiary (equity intermediary, or EI), a special
purpose company or trust established by the equity intermediary (borrower), and a
company wholly owned by the borrower in a qualified jurisdiction (foreign sales
corporation, or FSC lessor).
The lenders make a loan to the borrower, which contributes the loan proceeds,
together with an amount received from the equity intermediary (or indirectly from
the parent), to the FSC lessor for the purpose of funding the purchase of an aircraft.
The FSC lessor purchases the aircraft and leases the aircraft to an airline outside
of the U.S.
There may be various intermediaries between the FSC lessor and the airline,
including sub-lessors, conditional purchasers, and nominee owners, and the airline
54
itself may be a conditional purchaser. Some O-FSC loans may have embedded
Japanese leveraged leases or other hybrid characteristics. In addition, the airline
enters into an interest rate swap with the lenders. Chart 3 provides a diagram of an
example of the transaction participants in a basic O-FSC loan.
In order to realize the desired tax benefits in an O-FSC financing, the loan must
not be characterized as indebtedness of the FSC lessor. In response to this require-
ment, originators designed O-FSC financings where the debt is disassociated from
the owner of the aircraft, and the credit and performance of participants other than
the airline may affect timely repayment of the loan. In the O-FSC loans reviewed by
Chart 2
Example of O-FSC Loan
Parent
Possible pledge,
support or other
assurance
Contribution Dividends
Possible pledge,
Equity guaranty or
Intermediary other security
(Wholly-owned
subsidiary)
Contribution Dividends
Debt Service
See discussion
Borrower Loan
of possible (Wholly-owned Lenders
Security
security subsidiary)
Loan proceeds
Contribution
Dividends
Fixed
Rate
Airline FSC Lessor
Lease (Wholly-owned
subsidiary)
Rentals
Aircraft
Floating
Rate Swap

Standard & Poor’s, common features include a mismatch of the lease and loan
obligations, lack of security over the aircraft assets, and reliance on the parent and
equity intermediary. Although these features, among others, may achieve the desired
result from a tax perspective, the evaluation of the relevant credits and likely recoveries
must reflect these more complex arrangements and the resulting risks.
Typically, the lease terminates much earlier than the loan matures and a substantial
amount of debt remains outstanding upon termination. The swap also terminates
upon lease termination. The airline typically has several alternatives at the end of
the lease term, but it may not re-lease the aircraft. Among other alternatives, the air-
line may propose a replacement lessee, in which case the lenders may elect to re-price
the loan, including a new swap, with the new lessee, or elect not to quote a rate for
re-pricing, in which case the borrower must locate new lenders to refinance the loan.
If the airline is willing and able to do so, it may also purchase the aircraft for an
amount at least sufficient to prepay the loan. These typical alternatives raise issues
as to the timing of repayment and the identity of the credit, if any, obligated to make
the payments due at the end of the lease term. These issues are further complicated in a
loan where the originator does not have a controlling interest and would not be able
to direct the elections of the lenders.
The loan is an obligation of the borrower. The FSC lessor does not have a repay-
ment obligation to the borrower or a debt owing to the lenders. So as not to risk
characterization of the loan as the FSC lessor’s debt, it does not grant security interests
in the aircraft assets to the lender or the borrower. The importance of a first priority
perfected security interest over assets that may be the source of the loan repayment,
and the role of security interests in a bankruptcy-remoteness analysis, are discussed
earlier under the legal considerations for other forms of aircraft financing. The
absence of security interests over the aircraft assets significantly increases the difficulty
of concluding that the financing structure is bankruptcy-remote from the interests of
the parent and EI.
The borrower may grant, or agree to grant under certain circumstances, to the
lenders a pledge of its shares in the FSC lessor. Certain originators, however, may
not include this feature because, in their view, this too closely connects the FSC
lessor to the debt for tax purposes. The EI may pledge its shares in the borrower to
the lenders, or the parent may pledge its shares in the EI (particularly if it is a spe-
cial purpose company), in each case to secure their respective obligations under any
guaranties or assurances entered into for the benefit of the lenders. Many O-FSC
loans, however, do not include either parent or EI pledges.
In addition to the absence of security interests over the aircraft assets and direct
remedies against the airline, the lenders do not have the benefit of the airline’s sup-
port for the financing structure that is characteristic of USLLs. For this, and for
other aspects of the financing, the lenders must look to the EI or its parent. This
56
support may be evidenced in a guaranty, indemnity, or other support agreement,

through covenants in the loan documents, or through other assurances. Analysts will
assess this support, the remedies for default under these obligations, and the alternatives
to the performance of the obligations in connection with evaluating the credit
dependencies of the O-FSC loan.
In the O-FSC loans reviewed by Standard & Poor’s, the insolvency of members of
the equity group could materially affect the timely payment in full of the borrower’s
loan obligations. Therefore, in analyzing the credit quality of O-FSC financings,
consideration is given to the default probability not only of the airline, but also of
the parent, the equity intermediary, the borrower and the FSC lessor as members of
the equity group. Since the EI, or its parent, is not a bankruptcy-remote entity, ana-
lysts will review the possible effects on the entire equity group of the automatic stay,
substantive consolidation, avoidable preference and fraudulent transfer, and other
bankruptcy risks, as well as liabilities that may be attributable to the group of related
entities. Concerns raised in this review are considered in modeling recoveries in a
parent or EI default.
In analyzing an O-FSC portfolio with only airline and equity group risks, the
aggregate frequency of default would be allocated between these risks. The overall
credit quality the airlines and the equity groups would be considered in determining
the percentage of defaults relating to airline risk and to equity group risk, respectively.
For defaults relating to airline risk, aircraft sale values would be the main component
in sizing recovery value. For defaults relating to equity group insolvency, the previously
discussed review of the effects of insolvency on the equity group, including any
claims or interests that may impede or burden recovery of the aircraft, would be
considered. The severity of these assumptions may lead to reduced or zero recovery
levels. Standard & Poor’s will stress the portfolio’s cash flows whereby equity group
defaults, partial and total loss of lease revenues and aircraft are modeled into the
capital structure.
Even if the equity investor group does not default, the credit risk of the loan may
change as the Parent or EI may, for example, assume the debt as a direct obligation
while releasing any pledges or other guaranties, transfer its interest to another
investor, or provide substitute collateral in place of the borrower’s obligations. This
“assumption rating” may be lower than the rating of the original parent or EI or the
airline itself. As part of the rating review, these risks may be factored into default
risk and recovery assumptions.
O-FSC loans are complicated financings that often include many risks that need to
be assessed in addition to those briefly discussed in this section. Although an assumed
approach to modeling the risks of these structures is set out generally above, originators
should expect that the total amount of debt rated for O-FSC loan portfolios would
be significantly less than for portfolios of direct secured loans or USLLs.

The Servicer’s Role
and Responsibilities
Servicer Responsibilities in the
Securitization of Transportation Equipment
The role of the servicer is even more important in securitization of leases or other
financings of transportation equipment such as aircraft than in traditional structured
financings that securitize financial assets such as credit card receivables or mortgages.
In these transactions, repayment of debt requires that the servicer do much more
than collect payments. Often, the servicer must re-lease the equipment many times,
even assuming the users of the equipment perform on their leases. The re-leasing
function is not a fall-back in case credits go bad; it is an expected activity needed to
make the deal work on an ongoing basis.
The responsibilities of the servicer in a securitization are, for the lack of a better
term, to service or tend to the assets, and thereby maximize cash flows for the benefit
of the noteholders. Furthermore, the servicer is charged with the responsibility to
insure and maintain that investors’ retain a first perfected security interest in the
assets and associated collateral throughout the life of the transaction.
Criteria have been developed to analyze securitization of transportation equipment
using a combination of structured and corporate finance methodologies. The extent
to which the corporate approach is used (and to which the competitive and financial
strength of the servicer therefore becomes a rating constraint) depends on how actively
the servicer is involved in managing the assets to generate cash flow. Following are
questions used to determine the degree of servicer involvement in generating cash flows:
■ How frequently are the assets re-leased? As a result, how much of the debt in the
securitization can be repaid off the initial leases? This is probably the most important
single determinant of credit linkage to the servicer. Typically, a servicer is committed
to lease out assets on a nondiscriminatory basis with other managed assets, usually
including the servicer’s own equipment fleet. If the servicer has excess inventory
in its own fleet, or if its competitive position in the industry is deteriorating, it
is inevitably going to affect performance of the issuing entity’s assets as well.

■ How easy is repossession and re-leasing? Ease of repossession is judged on the
basis of legal issues, logistical considerations, skill and experience needed, and so
forth. This varies from asset to asset and also between types of lease.
■ Are non-financial services included in the lease rentals? Again, this varies by asset
and lease type. Some transportation leases include payments for maintenance and
repair services, making equipment available in certain locations, and so forth. In
those cases, the servicer is obviously more deeply embedded in the deal.
■ Is there a committed backup servicer? Are non-committed alternative servicers
readily available?
■ What legal issues may be involved? Is the issuing special purpose vehicle truly
bankruptcy remote from the servicer? Do the bondholders have a direct or indirect
perfected security interest in the assets? How likely are legal challenges to rights of
repossession?
The answers to these questions make it possible to place a particular transaction
on a spectrum that runs from traditional structured securitizations, where the ser-
vicer plays a limited and mainly administrative role, to cases where the so-called
securitization is close to secured corporate debt.
For securitizations of aircraft operating leases and loans, the following particular
responses should apply:
■ How frequently are assets re-leased? Aircraft operating leases are typically 3-5
year medium term contracts. Given the often weak credits involved, re-leasing can,
in practice, occur more often.
■ How easy is repossession and re-leasing? That varies from country to country,
based on legal jurisdiction and other factors. Fortunately, aircraft are large, visible
assets that often fly internationally and can be seized abroad.
■ Are non-financial services included in lease rentals? No; these are “triple net”
financial leases, with the operator responsible for all maintenance, insurance,
regulatory compliance, and so forth.
The answers to questions regarding the servicer arrangements and legal issues vary
from transaction to transaction. Typically, securitizations of aircraft operating leases
have either had a committed backup servicer or had a primary servicer that was very
strong financially (General Electric Capital Aviation Services or International Lease
Finance Corp.).
Standard & Poor’s considers that aircraft securitizations, while requiring more
substantial servicer involvement than in securitizations of self-liquidating financial
assets, involve relatively less servicer involvement than transactions involving some
other transportation assets (e.g., leased marine cargo containers, truck leases, railcar
leases). Accordingly, ratings of aircraft securitizations can be considerably higher
than the actual or estimated rating of the servicer. In addition, as discussed in the
60
The Servicer’s Role and Responsibilities
“Asset Risk Evaluation” section, an evaluation of the servicer’s abilities is an input

into determining value declines in cash flow modeling.
In evaluating the servicer’s abilities, analysts will determine the level of expertise
and requisite skills to maintain the transaction assets. In keeping with this evaluation,
access to the servicer’s employees, records, and systems are of critical importance in
determining whether a servicer possesses the necessary resources to service the trans-
action’s assets. It is of utmost importance that the servicer provide the necessary
transparency in its operations for making such an evaluation. This means that
the servicer most not only provide access to its staff, but also a full and complete
assessment of its historical performance.
The operations review that is usually performed is such that the servicer’s abilities
are considered sufficient to service the assets. However, one area of particular focus
is the specific nature or uniqueness of the role of servicer plays in a transaction.
Analysts will assess the transferablility of the servicer’s responsibilities to a successor
or back-up servicer. In the more commoditized areas of asset-backed finance, such as
credit cards, auto loans or mortgages, there is a wide and deep universe of potential
successor servicers. This ease of transferability is one of the primary reasons that
securitized debt can be rated above that of the asset transferor or parent corporation.
However, in the case of aircraft or other operating assets, the transferability of a
servicer’s functions is far more arduous. Whether aircraft, railcars, or containers,
there is usually a small and select world of potential servicers. Also, unlike a trans-
action based on financial assets, aircraft require a servicer with specific and unique
abilities to maintain a transaction’s assets at maximum efficiency. An aircraft servicer’s
ability to maintain and redeploy aircraft is specific to very few companies and is to
some extent correlated with its corporate credit rating.
Even if there are several potential successor servicers available, they may be an
unacceptable choice to the initial servicer for business and competitive purposes,
since most are probably the initial servicer’s competition. What company would
want to open itself up and divulge such things as customer lists and propriety secrets
to its rivals?
Accordingly, divorcing or negating the initial servicer risks from that of the rated
securities is more problematic. As a result, an effective back-up servicing plan will
be required for most transactions involving aircraft. The same would apply to secu-
ritization of aircraft engines. Without such a plan, the rating of the securities may
very well be limited significantly by the rating of the servicer. To date, no transactions
consisting of aircraft have been constrained by the servicer corporate credit rating,
either because the servicer was highly rated, or because an adequate back-up servicer
plan was incorporated into the transaction documents. However, even with a committed
backup, a financially weak servicer or one with a modest competitive position in the

aircraft financing industry may not be able to issue debt rated as highly as in the
transactions analyzed so far.
Servicing an Operating Lease Transaction

versus a Loan Portfolio Transaction
Over the past few years, Standard & Poor’s has rated aircraft portfolio based mainly
on operating leases. Ratings for another type of portfolio transaction can be expected:
those based on loans. The servicing requirements for a loan portfolio are not as
extensive as that for an operating lease portfolio. Unlike an operating lease portfolio,
a loan servicer will not have to re-lease or perform maintenance on aircraft. This is
because unlike an operating lease servicer, an aircraft that is collateral for a loan will
be sold as is and not re-loaned at the expiry of the loan. However, similar to an
operating lease servicer, a loan servicer will have to be proficient in repossessing and
selling aircraft. The next section provides a description of the principal servicing
responsibilities, noting which pertain to operating servicers and which to loan servicers.
Individual Functions of an Aircraft Servicer

The four major responsibilities on which an aircraft portfolio servicer will be evaluated
are its ability to redeploy off-lease aircraft, to sell aircraft, to repossess aircraft, and
to maintain off-lease aircraft.
Redeployment of Aircraft
In an operating lease transaction, an aircraft can be expected to be re-leased several
times. This is due to the fact that operating leases are generally of a maximum term
of 5 years while the term of transaction may be in excess of 20 years. Depending on
the aircraft’s age, it is reasonable to expect that an aircraft can be re-leased two to
three times over the life of the average securitization. It is therefore the responsibility
of the servicer to find new lessees for aircraft. Analysts will review a potential ser-
vicer’s re-leasing procedures and track record to judge its proficiency in redeploying
aircraft which come off lease or for those aircraft which are repossessed. The servicer
will need to provide its re-leasing policies; specifically, the necessary lead time necessary
before expiry of a lease to locate a new lessee. The servicer will also need to provide
its historical results; that is, its ability to re-lease aircraft and how long off-lease aircraft
are on the ground or not re-leased.
62
The Servicer’s Role and Responsibilities
Sale of Aircraft
A key component of principal payment is the sale of aircraft. Throughout the life of
an operating lease transaction, the servicer will have to determine whether it makes
economic sense to either sell or re-lease aircraft. For a loan portfolio transaction, the
servicer will have no other course of action but to sell the aircraft at the loan termi-
nation date. Therefore, the servicer must demonstrate its abilities to sell aircraft at
the optimal price. Aircraft sales are expected to occur during a recession in the aviation
industry. Consequently, the rating analysis will incorporate the servicer’s own history,
industry history, and the portfolio’s aircraft composition to determine appropriate
residual values.
Repossession of Aircraft
In any portfolio transaction, it is the servicer’s responsibility to collect monthly
loan/lease payments from the respective obligors. It is also the responsibility of the
servicer to monitor an airline that is in arrears on its loan/lease. If the servicer deter-
mines it is necessary to take possession of the aircraft due to payment delinquency,
then it needs to co-ordinate the return of the aircraft. In most cases, aircraft are
returned voluntarily. However, there are times when an amicable return of the aircraft
is not an option. If this should occur, the servicer will need to use legal measures to
seize the aircraft. In some cases, the servicer may have repossession personnel on
staff or out-source the repossession function to a third party. In either case, a review
the success rate regarding repossession of aircraft will be necessary.
Aircraft Maintenance
A servicer’s responsibilities regarding maintenance of aircraft are generally most
burdensome for an operating lease transaction, since for a loan portfolio, aircraft
generally are sold “as is” at the termination of the loan. When aircraft are in the
possession of the airline, the airline is responsible for performing all the necessary
maintenance. However, when an aircraft is in the control of the servicer, regularly
scheduled maintenance must be performed if the aircraft is going to be re-leased.
This maintenance can be anything from a routine “A” check to a full overhaul
known as a “D” check. In addition to maintenance, the servicer may be required to
reconfigure the interior of the aircraft for re-lease. A detailed understanding of the
servicer’s maintenance abilities and the portfolio maintenance needs will be required
for rating a transaction. A further discussion on determining maintenance requirements
is presented in the “Maintenance and Related Issues” section.

Maintenance and
Related Issues
Maintenance
Due to the nature of the airline business, especially passenger air travel, regular
maintenance of aircraft is essential to safety, and regulators play a prominent role
in overseeing maintenance practices. The condition and the maintenance of aircraft
are regulated by the aviation authorities of the jurisdiction in which the aircraft is
registered. Such requirements establish standards for repair, periodic overhauls, and
alteration by requiring that the owner or operator establish an airworthiness mainte-
nance and inspection program to be carried out by certified individuals qualified to
issue an airworthiness certificate. No aircraft may be operated without a current
certificate issued by the authority with which the aircraft is registered.
Most operating leases provide that the lessee is liable for all maintenance costs
which may arise. In the event that an aircraft is forcibly repossessed following for
example a rental payment default by the airline, the aircraft may require some
Chart 1
Maintenance Utility
(%)
100
Maintenance Utility Remaining
50
0
New First Second Third
Aircraft Overhaul Overhaul Overhaul
Time

outstanding maintenance work before it is in a condition to be re-leased or sold to
another airline.
A lessor’s primary risk in relation to maintenance is therefore the credit risk of the
lessees failure to pay in whole or in part for the maintenance utility they consume
(hours flown). An aircraft that has just been overhauled—airframe and engines—has
100% maintenance utility remaining (see chart 1).
There are considerable ongoing costs related to maintaining an aircraft to the
required standard. For example, airframe overhauls occur every six to ten years and
cost between $1 million and $5 million depending on the aircraft’s utilization pattern.
Engine overhauls occur more frequently, every two to four years, and the cost ranges
from $500,000 to $3 million, depending on utilization. In general, the rule is the
older the component for both engine and airframe, the higher the overhaul costs.
Due to such significant costs, the risk is that if the lessee is unable to make the
necessary payments, the value of the aircraft could depreciate much faster than if it
were properly maintained. The issuer of the rated notes may find itself having to pay
from its own cash flows the costs of an unperformed maintenance. Or the lessor
may be willing to lease or sell the aircraft at a discount. Such occurrences could
potentially expose a securitization to a shortfall in expected revenue.
There are two principal ways that lessees pay lessors for maintenance utility:
Cash Maintenance Reserve Payments. These are usually payments made on a reg-
ular, usually monthly, basis by the lessee to the lessor, and are generally based upon
the age and expected utilization of the aircraft in question. Therefore, at the time a
plane is taken out of service for maintenance, the lessor should already have funds
to cover the cost of the overhaul. Should a lessee default who has been making cash
maintenance reserve payments, the assumption is that the lessor would generally not
incur any reimbursed costs.
End of Lease Adjustments. This option would expose a lessor to a greater risk of
incurring maintenance costs and is thus usually only offered to better quality credits
or airlines that have demonstrated a good track record of payment. If the aircraft is
returned at the end of a lease in a worse than stipulated condition, the lessee must
make an end of lease payment to the lessor. Conversely, if the aircraft is returned in
a better than stipulated state, the lessor is obliged to pay the lessee. In the instance
where the lessee is expected to pay the lessor, and fails to do so, the lessor is exposed
to credit risk since it will have to apply its own funds to maintain the aircraft before
re-leasing it.
66
Maintenance and Related Issues
Eurocontrol Liens
Eurocontrol fees are payable to air traffic control authorities in all European countries
“infringed” by an aircraft’s flight path. The magnitude of the costs depends on the
aircraft weight, distance traveled, and country involved. Eurocontrol charges attach
to individual aircraft so that if a lessee returned an aircraft on which a charge is out-
standing, the lessor would have to discharge the fee before that aircraft could be
allowed to fly.
Airworthiness Directives
From time to time, the aviation authorities that regulate the operation of aircraft
may issue airworthiness directives (ADs) to aircraft operators. These directives usually
follow the detection of a major defect that could affect passenger safety.
Stress Tests
The analysis of the degree of exposure of a transaction to maintenance, Eurocontrol,
and ADs takes into account two concerns. First, assuming that a lessee has defaulted,
the issuer could be exposed to the costs of maintaining the aircraft before it is re-leased.
By making assumptions regarding the lessee default rates, cost of maintenance per
airframe and engine, and exposures to Eurocontrol and AD’s upon repossession,
analysts will calculate the aggregate costs that could be incurred by the issuer
throughout the transaction.
Standard & Poor’s does not believe that the above costs are adequately covered in
the repossession costs per plane. The figure of $500,000 to $750,000 reflects the
average costs incurred by a lessor, and while these amounts could have occurred
during an economic downturn, they may be understated if the portfolio is subjected
to the recessions of the severity suggested by the ratings. For these reasons, additional
reserves should be available to cover for maintenance and associated costs.
Second, assuming that no lessees default, the portfolio would still be exposed to
liquidity requirements. This liquidity stress is due to the differences in timing
between cash inflows from lessees and monies having to be paid out. Drawings on
the cash maintenance reserve contributions previously made by lessees and reim-
bursement to lessees who have overpaid on their end-of-lease adjustments both utilize
liquidity. On the other hand, lessees making regular maintenance payments and
those which owe end-of-lease payment to the lessor represent sources of liquidity.
Standard & Poor’s will review separate cash flows which should model the
sources and uses of maintenance expenditures. These scenarios should model two
scenarios: one in which lessees default and another in which all lessee payments are
made. An assumption will need to be made as to the percentage of the lessees which

are making reserve payments. Clearly, a larger percentage would reduce cash flow
requirements since it is assumed that related maintenance would be fully provided.
It will be necessary for a substantial portion of the leases to be subject to end-of-
lease payments. This assumption does not imply that the credit quality of the pool is
improving; rather, it is meant to reflect a scenario in a recession where a lessor has
reduced bargaining power and is forced to write leases with maintenance requirements
which are more in the lessee’s favor. Another assumption will be made regarding the
costs of various maintenance checks. While schedules are provided by the major
manufacturers which take into account the age and usage of the aircraft, analysts
will review these costs to determine if any adjustments are required.
The form of the maintenance reserves will be transaction specific. Whether this
reserve is merely in the form of a liquidity cushion or a true cash reserve will depend
on the requirements of the cash flows.
68
Surveillance
A
fter completion of the initial rating process, continuous rating surveillance
will be conducted. The purpose of surveillance is to monitor whether the
transaction is performing in accordance with that of the initial rating
expectations, as well as to identify emerging risks in the transaction. To the extent
that the transaction’s performance deviates substantially from that of the initial rating
stresses or assumptions, Standard & Poor’s reserves the right to take appropriate
rating action.
Accordingly, analysts will request information, known as servicer reports, to be
provided by the issuer or servicer on a monthly or quarterly basis. This information,
along with any other available data, will be used to monitor the ongoing performance
of the transaction. The information provided in the servicer’s report should contain
data relating to both the asset and liability performance of the transaction. The asset
information should include the following:
■ Current lease revenue,
■ Current appraised value of the portfolio,
■ Current level of arrears,
■ Maintenance inflows and outflows,
■ Income derived from sales or other sources,
■ All activity relating to the re-leasing of aircraft,
■ Current concentrations (airline, aircraft type, geographical), and
■ Any other notable servicing information relating to the portfolio.
The liability information should include the following (which should be broken
out at each tranche level):
■ Principle notes outstanding,
■ Principle redemption of notes,
■ Actual interest payments versus scheduled interest payments,
■ Drawings from transaction accounts,
■ Drawings from liquidity reserve,
■ Current credit enhancement levels, and
■ Current loan to value ratios.

Furthermore, Standard & Poor’s reserves the right to request periodic manage-
ment meetings with the servicer to insure that its abilities have not deteriorated in
such a manner that would have an adverse impact on asset performance. The sur-
veillance team also tracks the credit quality of those entities that are a supporting
rating to the transaction as well as regulator issues which have the potential to
impact a transaction negatively. At any time during the surveillance process, a rating
change may be necessary. In this circumstance, a press release will be disseminated
for all public issues.
Conclusion
Many changes have occurred since Standard & Poor’s initially rated aircraft transactions.
It is expected that the criteria presented here, which have been developed over the
past few years, will continue to reflect ongoing changes. Thus, Standard & Poor’s is
open to examining transaction proposals containing new structural mechanisms and
will consider each proposal on a case-by-case basis.
70

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Structured Finance

STANDARD & POOR’S RATINGS SERVICES

RATINGS INFORMATION SERVICES

The Rating Process for

Rating Considerations for Lease Pools . . . . . . . . . . . . . . . . . . . . . 35

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 1

The Servicer’s Role and Responsibilities. . . . . . . . . . . . . . . . . . . . 59

Maintenance and Related Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

The Spectrum of Financing Vehicles

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 3

The Rating Process

Asset Information Requirements

By individual asset classification: ■ Loan to value ratio; and

■ Aircraft appraised value (typically,

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 5

it should likewise be informed of any changes concerning the original structure of

Corporate Rating Criteria and

Criteria for Airline Equipment Debt

of interest and principal (thus reducing default risk);

Section 1110; and

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 7

Legal Opinions Needed

enhancement (e.g., ‘B’ to ‘BB-’). When an airline is in Chapter 11 bankruptcy pro-

Aircraft Financings Outside the U.S.

Legal Considerations for Airline Equipment Debt

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 9

Equipment Notes in Leveraged Leases

required to perform its role in the transaction;

entity to sustain an independent legal existence, thereby lessening the risk of

ownership interest in the aircraft and the lease; and

pant’s estate in bankruptcy under the doctrine of substantive consolidation, a

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 11

Criteria for Rating Enhanced Equipment Trust Certificates

being repossessed and sold;

and predictable basis.

(see above); and

facility, or cash collateral account sufficient to cover 18 months of debt service on

Rating Financings of Non-U.S. Airlines

secured creditors to repossess collateral? How many comparable precedents can

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 13

collateral recovery for certificateholders);

a considerable advantage if it can be arranged;

it can withstand a rescheduled lease obligation; and

The Role of Aircraft Collateral in EETCs

■ A range of 44-51% for two categories, and

■ A range of 26-36% for three categories, depending on the particular aircraft

model and the Section 1110 rating of the airline.

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 15

Role of the Liquidity Facility

Legal Considerations for EETCs

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 17

Aircraft Asset Risk Evaluation

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 19

Aircraft Technological Market Aircraft Manufacturer Servicer Other

■ For years 16-20, 4% per year;

■ For years 21-25, 5% per year; and

■ For the residual at end of year 25, 10%.

‘A’ certificate initial Upgrade above

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 21

■ The degree of uncertainty surrounding that credit estimate, and

■ The degree of diversification.

Standard & Poor’s Structured Finance ■ Aircraft Securitization Criteria 23

Cash Flow Analysis

■ Airline default rates;