Innovations in Financial Intermediation

7/29/2019 Innovations in Financial Intermediation

1/112

Innovations in financial intermediation

Innovation has been important in the financial markets of the 1980s. It promises

to be at least as important during the next decade. Innovation in financial

markets brings change to financial products, the institutions that produce or

deliver these products, and the markets where they are traded. Old products

and ways of doing business are being replaced with new and more efficient

ones. During the 1980s we have seen the development of options and financial

futures, the deregulation of many depository financial institutions, the

introduction of a wide variety of new financial instruments, and the globalization

of many financial markets.

Two of the most important innovations during the 1980s have been thesecuritization of a wide variety of financial products and the evolution of

financial intermediaries as the providers of risk-management products. But

before we take up these specific examples of innovation in financial

intermediation, we need to focus on the process of innovation itself to

understand why so much of it has taken place in the last decade and whether it

will continue.

The Process of Innovation

Innovation is generally a response to a change in the environment. We can

make this idea more specific by formulating a list of the most important

environmental factors. The major changes in financial markets in the last

decade and those we can foresee in the next decade appear to be responses to

changes in one or more of these four environmental factors:

* The level and volatility of inflation and interest rates;

* Technological progress in computers and communications;

* Regulation; or

* Tax law.

1 Bhav


2/112

Probably the largest single cause of innovation in financial markets and

institutions in the last decade has been rising inflation and the resulting increase

in the level and volatility of interest rates in the 1970s and early 1980s. Many

types of financial products and many financial institutions were originally

designed with an environment of relatively low and stable interest rates in mind.

When interest rates increased, many institutions incurred substantial losses.

Investors shifted away from products, particularly regulated accounts at

commercial banks and savings and loans, that could not effectively compete in

the new environment. The innovations in the last decade can be divided into

three useful categories:

product,

process,

organizational innovations.

Two of the most important innovations in the last decade deal with the

securitization of some key financial markets and the growth of risk-management

services provided by intermediaries through the interest rate swaps market.

2 Bhav


3/112

SECURITIZATION OF FINANCIAL ASSETS

One of the most important innovations in the operation of financial

intermediaries is the securitization of many financial assets. Securitization

refers to the transformation of an asset that once had no secondary market into

a tradeable security with active secondary markets; it is the transformation of a

market where financial intermediaries hold loans on their books and fund them

by issuing distinct liabilities, an intermediated market, into an over-the-counter

and ultimately an auction market where the assets themselves are traded. A

number of assets once funded largely through financial intermediaries are now

becoming securitized. The market where securitization has gone the farthest is

the residential mortgage market. But auto loans and leases, consumer credit

cards, recreational vehicle and boat loans, and commercial loans from banks

are also becoming securitized to varying degrees.

Securitization began in the 1980s with mortgage payments, auto loans, and

credit card debt being pooled and used as collateral for securities offerings.

More recently, healthcare providers have securitized accounts receivables to

obtain low-cost, off-balance-sheet financing. As the need of both raise capital

and contain costs grows in health care, providers likely will make increased use

of this financing method.

Securitization involves pooling and structuring predictable cash flows, derived

from the transfer and sale of assets, to an entity that is "bankruptcy remote."

Among other benefits, securitization is an efficient source of off-balance-sheet

financing.

3 Bhav


4/112

History of securitization

Securitization was introduced to capital markets in the early 1980s, as

mortgage payments were pooled and used as collateral for securities issues.

The United States government played an active role by creating agencies that

guaranteed the securities' principal and interest. Securitization became a cost-

effective financing alternative to traditional bank sources for a large number of

thrifts and other mortgage originators. In 1985,securitization was extended to

include automobile loans and, shortly thereafter, other consumer assets, such

as credit-card receivables, second mortgages, and home-equity loans.

By the late 1980s, companies such as Citibank, General Motors Acceptance

Corporation, Marine Midland Bank, Chrysler Corporation, and Ford Motor

Company accessed the securitization market to raise billions of dollars of off-

balance-sheet financing. Over the next several years, new issuance of

consumer asset-backed securities averaged about $50 billion annually.

Following the initial focus on consumer assets, securitization of commercial

receivables was the next frontier to be developed, asset by asset. Investment

bankers positioned lease-rental payments as analogous to the cash flow from a

pool of automobile loans, while trade receivables were likened to credit-card

debt. By the end of the 1980s, securitization of trade receivables had become

an accepted financing option for companies in a variety of industries. Securities

backed by trade receivables used newly issued credit-card securities as a

pricing benchmark.

4 Bhav


5/112

Introduction to securitization

The key to securitization is transfer of a pool of assets - in this case, receivables

- to a bankruptcy-remote structure. The bankruptcy-remote structure insulates

the investor from any "corporate" risk of the entity selling the cash flow stream.

Once the cash-flow or asset is transferred, under no circumstances can it

become the property of the transferrer, not even if the transferrer files for

bankruptcy.

Certain conditions need to be satisfied to achieve a bankruptcy-remote sale of

assets, also called a "true" sale. A critical condition is the transference of the

assets to a special-purpose corporation created for the sole purpose of buying

assets and issuing debt. The receivables must be sold, not financed. The seller

records the transfer of assets as a Financial Accounting Standards (FAS) 77

sale for generally accepted accounting principals accounting purposes. The

seller is permitted limited recourse for purposes of providing a credit

enhancement for the receivables.

The security also must be structured in a manner that provides ample protection

for anticipated losses. The tenet "past is prologue" is implicit in rating and

structuring the security. Therefore, extensive historical analysis of the bad-debt

experience for the asset is performed. Based on this analysis, the rating

agencies size the protection at two to three times expected losses for a high

investment-grade rating of the securities. Because direct recourse to the seller

for losses only can be very limited (to ensure a bankruptcy-remote transfer), the

protection for losses usually takes the form of credit support from a highly ratedentity, such as a bank, an insurer, or a subordinated security held by the seller.

The subordinated security represents the residual cash flow of the transferred

assets after the debt service of the senior securities, taking into account any

5 Bhav


6/112

losses. The subordinated securities are accounted for by the seller as a capital

investment in the special-purpose corporation.

Securities backed by healthcare receivables usually take the form of medium-

term notes, with the term ranging from three to ten years. The life of the

receivable and the corresponding cash-flow and debt-service profile is similar to

the more familiar securities that are backed by credit-card debt. In consideration

of the short-term nature of the asset relative to the term of the debt, the notes

pay interest only for a stated term, then retire the principal at the end of the

"interest-only" (or "revolving") period. During the interest-only period, collections

from purchased receivables are used to purchase new receivables weekly.

Therefore, from the borrower's perspective, the securities are analogous to a

term working-capital line of credit.

6 Bhav


7/112

Why securitize?

Securitization provides a means for many to borrow at a better rate than they

can obtain on their own. In general, this observation is true for borrowers with

senior unsecured corporate-debt ratings of A or lower. While the cost of debt

may be a key motivating factor for securitization, other benefits, both tangible

and intangible, also apply. The limited-recourse nature of this financing method

is preferable to recourse debt, which can involve personal guaranty of a

borrower's principals. Securitization represents off-balance-sheet financing,

which improves leverage and certain other balance-sheet ratios. In addition, it

helps diversify financing sources. More available cash enables the borrower to

take advantage of prompt-pay-vendor discounts. The ability to plan ahead for

projects and investments also is enhanced.

Finally, receivables sellers are required to track payments, and abnormally high

delinquency rates trigger a wind-down of the financing. This requirement

encourages borrowers to effectively monitor their receivables, to monitor

reimbursement by individual payers, and to ensure that the collection process is

efficiently designed and executed. Receivables days outstanding, a measure of

efficiency, is invariably improved after securitization.

In the healthcare industry, Jersey City Medical Center - which is part of a

relatively cash-rich system - disproved the myth that receivables are sold only

by the cash-starved. The A-rated security had London Interbank offered rates

(LIBOR) +90 basis-points pricing, with a 79 percent advance rate against the

receivables. This rate was an incentive for the medical center to gain additional

liquidity at a lower rate than available sources could offer. The medical centerwas able to invest the proceeds of the issuance and earn a positive carry, to

benefit from prompt-pay-vendor discounts, and to increase its flexibility with

respect to project planning. As expected, the receivables-days-outstanding rate

improved after the securitization.

7 Bhav


8/112

From a corporate-finance perspective, securitization can be both a means and

an end to the consolidation process. For many providers, securitizing their

receivables, or securitizing those of an organization to be acquired, cangenerate part of the proceeds needed to finance an acquisition. In other

instances, when a merger is effected through a stock swap, issuing additional

stock often creates underleverage. When considering post-merger financing, if

a consolidated entity is rated less than A, securitization may be the most cost-

efficient means to raise capital (including equity financing) for the entity to move

forward.

8 Bhav


9/112

Demands of securitization

Schechner mentions that the composition of a mortgage pool and structure of

the transaction can be tailored to meet specific needs. Mortgages can be

selected and combined to reduce concentration in property types, geographies

or borrowers. The portfolio can also be selected to shorten or lengthen

maturities to better match assets and liabilities.

Securitization is widely seen as the best way to sell pools of commercial

mortgages because of the structuring flexibility, certainty of execution and the

capacity for very large transactions, according to Schechner.

The process has also been used increasingly as a source of mortgageorigination for high-quality single properties and property portfolios. Property

owners are foregoing the traditional mortgage lending market to access the

better pricing, increased certainty and greater depth of the securities market.

Shopping centers have been especially popular, according to Mark Ettenger,

head of the Retail Focus Group at Goldman Sachs.

Schechner also noted that securitization is "quite exciting" for insurance

companies, offering them opportunities to reduce their real estate exposureand shift a portion of the economic risk, leaving the insurance company with a

manageable first loss position. By acting as a conduit, insurance companies

can switch over their existing and now under-utilized underwriting capability to

write new mortgages. "It keeps the capability busy and makes it a profit center

without increasing their exposure," Schechner said.

"Given that a securitization can be equal in pricing with a traditional loan,

securitization has many benefits for larger deals, whether they are property-

specific or pools," Schechner said. "The framework of the transaction can be

more flexible as can the pricing. However, there are more upfront costs with

securitization in terms of rating agencies, trustees, additional documentation

9 Bhav


10/112

and sometimes the disclosure necessary for an SEC registration for public

offerings. "Sometimes it's worth it, sometimes it's not."

Orem of Morgan Stanley points out that the RTC is currently the major issuer,

that life insurance company portfolios and non-performing bank assets can also

benefit, and that Morgan Stanley is discussing equity issues with a number of

companies as well. "The focus is on finding ways to free up liquidity, both in

debt and equity," Orem said.

Equity securitization is also a very important emphasis at Kidder Peabody,

according to Baum. "We are actively pursuing the best Real Estate Investment

Trust (REIT) possibilities. We're evaluating what executions are available. The

focus is how to most effectively raise money in today's market," Baum said.

The direct access to capital markets, the custom-designed transactions and the

potentially lower cost of funds make it clear why securitization will continue to

attract the attention of a new broad pool of investors, help ease the credit

crunch and make real estate a more liquid investment

10 Bhav


11/112

Asset securitisation:

However, in the sense in which the term is used in present day capital market

activity, securitisation has acquired a typical meaning of its own, which is at

times, for the sake of distinction, called asset securitisation. It is taken to mean

a device of structured financing where an entity seeks to pool together its interest

in identifiable cash flows over time, transfer the same to investors either with or

without the support of further collaterals, and thereby achieve the purpose of

financing. Though the end-result of securitisation is financing, but it is not

"financing" as such, since the entity securitising its assets it not borrowing

money, but selling a stream of cash flows that was otherwise to accrue to it.

Blend of financial engineering and capital markets:

Thus, the present-day meaning of securitisation is a blend of two forces that are

critical in today's world of finance: structured finance and capital markets.

Securitisation leads to structured finance as the resulting security is not a generic

risk in entity that securities its assets but in specific assets or cashflows of such

entity. Two, the idea of securitisation is to create a capital market product - that

is, it results into creation of a "security" which is a marketable product.

This meaning of securitisation can be expressed in various dramatic words:

Securitisation is the process of commoditisation. The basic idea is to

take the outcome of this process into the market, the capital market. Thus,

the result of every securitisation process, whatever might be the area to

which it is applied, is to create certain instruments which can be placed in

the market.

Securitisation is the process of integration and differentiation . The

entity that securities its assets first pools them together into a common

hotchpot (assuming it is not one asset but several assets, as is normally

11 Bhav


12/112

the case). This is the process of integration. Then, the pool itself is broken

into instruments of fixed denomination. This is the process of

differentiation.

Securitisation is the process of de-construction of an entity. If one

envisages an entity's assets as being composed of claims to various cash

flows, the process of securitisation would split apart these cash flows into

different buckets, classify them, and sell these classified parts to different

investors as per their needs. Thus, securitisation breaks the entity into

various sub-sets.

12 Bhav


13/112

The Securitization Process and Rationale:

Securitisation is a multi-stage process starting from selection of financial assets

and ending with the final payment been made to investors. The originator having

a pool of such assets selects a homogeneous set from this pool and sells /

assigns them to SPV in return for cash.

The SPV in turn converts these homogeneous assets into divisible securities to

enable it to sell them to investors through private placement or stock market in

return for cash. Prior to selling the securities through private placement / stock

market, the SPV may take credit rating for the securitized assets. Investors

receive income and return of capital from the assets over the life-time of the

securities. Normally, the originator acts as the receiving and paying agent for

collection of the interest and the principal from obligors and passing on the same

to investors. The difference between the rate of interest payable by obligor and

the return promised to investors is servicing fee for the originator and SPV.

The originator by securitizing the financial assets transfers the risk associated

with economic downturn on cash flows or credit deterioration in a loan /receivable portfolio. The investors buy this risk in exchange for high fixed income

return. Investors buy this risk if they see the risk as a diversifying asset, the risk

premium demanded by them for underwriting such a risk is lower than the

internal funding costs of the originator who has a concentration of such a risk.

13 Bhav


14/112

The Financial Structure:

The financial structure of the securitized product is a function of the type of the

instrument to be issued i.e. Pass Through Certificates (PTC) or Pay Through

Certificates (Bonds /Debentures). In both the cases, assets are sold to SPV for

further sale to investors in the form of a new instrument. However, the similarity

ends here. In case of PTC, investors get a direct undivided interest in the assets

of SPV. The cash flows which include principal, interest and pre-payments

received from the financial asset are passed on to investors on a pro rata basis

after deducting the servicing fee etc. as and when occurred without any

reconfiguration. Therefore, the investor takes the reinvestment risk on the

payments received. The frequency of the payment is dependent on the frequency

of the payment from the financial assets. The PTC structure has a long life and

unpredictable cash flows that inhibit participation by some of the fixed income

investors. The pay through structure reduces the term to maturity and provides

some certainty regarding timing of cash flows. It is issued as a debt security

(bonds / debentures) and designed for variable maturities and yield so as to suit

the needs of different investors. The debt instrument is issued in the form of a

tranche and each tranche is redeemed one at a time. In this case, cash flows are

to be reconfigured since they have to match the maturity profile of the debt

security. The payment to investors is at different time intervals than the flows

from the underlying assets. Therefore, the reinvestment risk on the cash flows till

they are passed on the investors is carried by the SPV.

The Act has named the securitized instrument as Security Receipt which has

been added as a security in The Securities Contract (Regulation) Act, 1956 and

thereby makes it available for trading through stock exchange mechanism. Asper the definition of security receipt in the Act (section 2(zg)) transfer of only an

undivided interest in the financial asset is allowed and thus the Act recognizes

only pass-through certificates (PTC) as the possible instrument for securitization.

This has eliminated the possibility of issuing pay through certificates in Indian

14 Bhav


15/112

markets which are more investor friendly and are the norm in the international

markets outside USA.

Players and Their Role:

The number of players in the securitisation process is large. They can be

grouped in two categories the main players and the facilitators . The main

players and their role are as follows:

The Originator is an entity owning the financial asset that are the subject

matter of securitisation. Originator is normally making loans to borrowers or is

having receivables from customers. It is the originator who initiates the process

for securitisation and is the major beneficiary of it. As already stated, the Act

envisages only banks and financial institutions acting as originators.

The Obligor (borrower) takes the loan or uses some service of the originator

that he has to return. His debt and collateral constitutes the underlying financial

asset of securitisation.

The Investor is the entity buying the securitized instrument. Section 7 (1) of

the Act allows only Qualified Institutional Buyers (QIBs) to invest in Security

Receipt (securitized product). The Act has thereby restricted the players in the

market. The rational is that being a new product only informed, big players

capable of taking risk shall be allowed to invest in it.

Special Purpose Vehicle (SPV) is a legal entity in the form of a trust or

company created for the purpose of securitisation. It buys assets (loans /

receivables etc.) from originator and packages them into security for further sale

to investors. In securitisation, one of the primary concern of participants is toensure non-bankruptcy of the SPV.

The Act has recognized SPV as a vehicle to promote securitisation. Section 2 (v)

and 2 (za) restricts the legal structure of SPV to a company under the

Companies Act, 1956. In order to have effective supervision of such companies

15 Bhav


16/112

and to make them bankruptcy proof, Section 3 of the Act has prescribed

Registration, Net worth and Corporate Governance requirements for them. These

requirements are expected to help in orderly development of the market for

securitized product. However, nothing debars such a SPV from floating separate

trust(s) for each securitisation program.

Facilitators play a very crucial role in the securitisation chain. Their services are

instrumental in enhancing the credit worthiness of the product which is one of the

prime reasons apart from collateral for the run away success of securitized

products

Credit Rating Agency provides rating to the securitized instrument and thus

provide value addition to security. Insurance Company / Underwriters provide

cover against redemption risk to investor and /or under-subscription.

The Trustee acts on behalf of the investors and has priority interest in the

financial asset supporting the securitized product. Trustee oversee the

performance of other parties involved in securitization transaction, review

periodic information on the status of the pool, superintend the distribution of the

cash flow to the investors and if necessary declare the issue in default and take

legal action necessary to protect investors interest.

Receiving and Paying Agent is the entity responsible for collecting periodic

payment from obligors and paying it to investors. Normally, the originator

performs this activity.

16 Bhav


17/112

Benefits and Threats:

Securitization offers major benefits to originator and provides a low risk high yield

instrument to investors. The main benefits to the originator are two fold. One,

originator s funds get blocked after it extends loan or expects receivables.

Securitization converts these illiquid assets into marketable securities and thus

provides alternate source of funding for the originator. Second, the illiquid assets

are sold to SPV and are removed from the balance sheet of the originator. This

improves capital adequacy and lowers capital requirement for a given volume of

asset creation by the originator. By regularly securitizing its illiquid assets the

originator can continue to expand its business without increasing its capital /

equity.

There are other attractions as well like separation of the credit risk of the illiquid

assets from the credit risk of the originator since the originator markets claims on

other assets.

Securitized product is thus a distinct bundle whose credit risk is based on the

intrinsic quality of the financial assets having credit enhancement measures and

is independent of the credit risk of the originator. This lowers the cost of funds for

the originator as the new security is not clubbed with the rating of the Originator

and is used to raise funds at much lower cost.

Securitization can be used to reduce credit concentration either sectoral or

geographical by regularly transferring such concentration to investors of

securitized product. Thus it is possible to expand operations in a particular

portfolio of assets without increasing total exposure. Additionally, it transfers the

interest rate risk, default risk of loans and receivable from originator to investors.

However, securitization is a complicated process involving large number of

intermediaries and huge upfront legal and rating costs. Therefore it is viable only

in case of large sourcing. It also tends to disclose originator s customer

information to third parties and this may.prove to be harmful in a competitive

17 Bhav


18/112

environment. Sometimes securitization forces originator to strip off its good

quality assets leaving only junk assets on its books.

18 Bhav


19/112

Features of securitisation:

A securitised instrument, as compared to a direct claim on the issuer, will

generally have the following features:

Marketability:

The very purpose of securitisation is to ensure marketability to financial

claims. Hence, the instrument is structured so as to be marketable. This is

one of the most important feature of a securitised instrument, and the

others that follow are mostly imported only to ensure this one. The

concept of marketability involves two postulates: (a) the legal and

systemic possibility of marketing the instrument; (b) the existence of a

market for the instrument.

The second issue is one of having or creating a market for the instrument.

Securitisation is a fallacy unless the securitised product is marketable. The

very purpose of securitisation will be defeated if the instrument is loaded

on to a few professional investors without any possibility of having a liquid

market therein. Liquidity to a securitised instrument is afforded either by

introducing it into an organised market (such as securities exchanges) or

by one or more agencies acting as market makers in it, that is, agreeing to

buy and sell the instrument at either pre-determined or market-determined

prices.

Merchantable quality:

To be market-acceptable, a securitised product has to have a

merchantable quality. The concept of merchantable quality in case of

physical goods is something which is acceptable to merchants in normal

trade. When applied to financial products, it would mean the financial

commitments embodied in the instruments are secured to the investors'

satisfaction. "To the investors' satisfaction" is a relative term, and

therefore, the originator of the securitised instrument secures the

19 Bhav


20/112

instrument based on the needs of the investors. The general rule is: the

more broad the base of the investors, the less is the investors' ability to

absorb the risk, and hence, the more the need to securitise.

For widely distributed securitised instruments, evaluation of the quality,

and its certification by an independent expert, viz., rating, is common. The

rating serves for the benefit of the lay investor, who is otherwise not

expected to be in a position to appraise the degree of risk involved.

In case of securitisation of receivables, the concept of quality undergoes

drastic change making rating is a universal requirement for securitisations.

As already discussed, securitisation is a case where a claim on the

debtors of the originator is being bought by the investors. Hence, the

quality of the claim of the debtors assumes significance, which at times

enables to investors to rely purely on the credit-rating of debtors (or a

portfolio of debtors) and so, make the instrument totally independent of the

oringators' own rating.

Wide Distribution:

The basic purpose of securitisation is to distribute the product. The extent

of distribution which the originator would like to achieve is based on a

comparative analysis of the costs and the benefits achieved thereby.

Wider distribution leads to a cost-benefit in the sense that the issuer is

able to market the product with lower return, and hence, lower financial

cost to himself. But wide investor base involves costs of distribution and

servicing.

In practice, securitisation issues are still difficult for retail investors to

understand. Hence, most securitisations have been privately placed with

professional investors. However, it is likely that in to come, retail investors

could be attracted into securitised products.

20 Bhav


21/112

Homogeneity:

To serve as a marketable instrument, the instrument should be packaged

as into homogenous lots. Homogeneity, like the above features, is a

function of retail marketing. Most securitised instruments are broken into

lots affordable to the marginal investor, and hence, the minimum

denomination becomes relative to the needs of the smallest investor.

Shares in companies may be broken into slices as small as Rs. 10 each,

but debentures and bonds are sliced into Rs. 100 each to Rs. 1000 each.

Designed for larger investors, commercial paper may be in denominations

as high as Rs. 5 Lac. Other securitisation applications may also follow this

logic.

The need to break the whole lot to be securitised into several

homogenous lots makes securitisation an exercise of integration and

differentiation: integration of those several assets into one lump, and then

the latter's differentiation into uniform marketable lots.

Special purpose vehicle:

In case the securitisation involves any asset or claim which needs to be

integrated and differentiated, that is, unless it is a direct and unsecured

claim on the issuer, the issuer will need an intermediary agency to act as a

repository of the asset or claim which is being securitised. Let us take the

easiest example of a secured debenture, in essence, a secured loan from

several investors. Here, security charge over the issuer's several assets

needs to be integrated, and thereafter broken into marketable lots. For this

purpose, the issuer will bring in an intermediary agency whose basic

function is to hold the security charge on behalf of the investors, and then

issue certificates to the investors of beneficial interest in the charge held

by the intermediary. So, whereas the charge continues to be held by the

intermediary, beneficial interest therein becomes a marketable security.

21 Bhav


22/112

The same process is involved in securitisation of receivables, where the

special purpose intermediary holds the receivables with itself, and issues

beneficial interest certificates to the investors.

22 Bhav


23/112

Risk Profile:

The difference between yield on the assets and yield to investors is the spread

which is the gain to the originator. A portion of the amount earned out of this

spread is kept aside in a spread account to service investors. This amount is

taken back by the originator only after the payment of principal and interest to

investors.

Other third party credit enhancement measures such as insurance, guarantee

and letter of credit are also used by originator to get a better credit rating for the

instruments. With such multiple options for risk reduction and natural

diversification inherent in the product, can a securitized instrument be presumed

to be risk free? No. Primary risks associated with securitized product are pre-

payment risk and credit risk. The pre-payment means refinancing at lower rate of

interest or early repayment of the loan amount in part or in full. This risk is

associated with mortgaged backed products using the pass through structure

(PTC). Generally, loan agreements allow the borrower to make an early payment

of the principal amount. The risk originates from the possibility of obligor making

such early payment of principal amount and thereby disturbing the yield and the

investment horizon of the investors. For premium securities, accelerated pre-

payment reduces the average life and yield since the principal is received at par

which is less than the initial price. Opposite is the case of securities purchased at

a discount. Consequently, investors have to predict the average life of such

securities and may have to look for alternate investment opportunities in a

changed interest rate scenario. The Act provides for PTC as the securitized

instrument and so the pre-payment risk will exist in Indian market. Factors

affecting pre-payment and corresponding pre-payment models to evaluate thisrisk will have to be developed in order to make investment decisions. Credit risk

reflects the risk that the obligor may not be able to make timely payments on the

loans or may even default on the loans. In case of defaults, internal and external

riskenhancement measures will come into play.

23 Bhav


24/112

The inherent nature of the securitized instrument makes it less risky. The cash

flow from the securitized instrument is backed by tangible identified financial

assets earmarked exclusively for an instrument and is independent of the

originator. Dependability of these cash flows is further strengthened as signified

by the ageing of the portfolio. This means, an asset having a cash flow for three

years would be monitored for the first 8 to 10 months to determine its historic loss

profile. Earmarking a specific pool of aged assets is the core feature contributing

to lowering the risk associated with securitized product.

Further, the pool of borrowers creates a natural diversification in terms of

capacity to pay, geography, type of the loan etc and thereby lowers the variability

of cash flows in comparison to cash flows from a single loan. So, lower the

variability, lower is the risk associated with the resulting securitised instrument.

Understanding of risk enhancement measures, which at times are used in

combination, is also necessary to analyze the risk profile of securitized product.

Normally, these risk enhancement measures are provided to cover the historic

risk profile (first level risk) of the financial assets and some percentage of losses

which may be higher than the historic risk profile (second level risk). Internal risk

enhancement measures like over-collateralization, liquidity reserve, corporate

undertaking, senior / sub-ordinate structure, spread account etc. cover the first

level risk. External risk enhancement measures like insurance, guarantee, letter

of credit are used to cover the second level risk.

Finally, the mortgaged backed securitized product in the foreign markets are

backed by a guarantor who guarantee to the investors the timely payment of

interest and principal. As of now, such guarantees do not exist in Indian market.

However, National Housing Board (NHB) is working in this direction to guaranteesecuritization of housing loan mortgages.

The funny piece below seeks to capture the inherent risks of securitisation:

24 Bhav


25/112

10 reasons as to why the Titanic was actually a securitisation instrument:

1) The downside was not immediately apparent.

2) It went underwater rapidly despite assurances it was unsinkable.

3) Only a few wealthy people got out in time.

4) The structure appeared iron-clad.

5) Nobody really understood the risk.

6) The disaster happened overnight London time.

7) Nobody spent any time monitoring the risk.

8) People spent a lot trying to lift it out of the water.

9) People who actually made money were not in original deal.

10) Despite the disaster, people still went on other ships.

The above highlights the risks inherent in securitisation. One of the biggest

inherent threat in securitisation deals is that the market participants have

necessarily believed securitised instruments to be safe, while in reality, many of

them represent poor credit risks or doubtful receivables.

25 Bhav


26/112

The Legal Structure and Constraints:

The intermediaries involved in creating a securitized product have to comply with

multiple legal provisions to give shape to the product. The financial asset is

transferred from the originator to the SPV and thereby attracts the relevant

provisions of Stamp Act, The Transfer of Property Act, 1882, The Negotiable

Instruments Act and Registration Act. These provisions throw up the issues

related with

i. Stamp duty

ii. Registration charges in case of mortgage back securities

iii. Negotiability / transferability of new security

iv. Assignment of mortgage backed receivables,

v. Assignment of future receivables and

vi. Issue of part assignment.

These issues, on the one hand, make securitized product economically unviable

due to high stamp duty and registration charges. On the other hand, lack of clear

supporting legal provisions for the features which are integral part of the process

of securitization hinders wider acceptability of the product. The Act has

addressed above mentioned issues by providing appropriate definition of

financial assets and securitization and recognizing security receipt as a

security under the Securities Contract (Regulation) Act, 1956. However, the

problem arising due to stamp duty and registration have not been addressed to

the satisfaction of the participants and would therefore make it economically

unviable.

The securitization chain attracts the incidence of stamp duty at three stages.One, at the time of acquisition of financial assets by SPV from the originator. The

Act provides two modes.for acquisition of assets:

(i) by issuing a debenture which will attract stamp duty on the instrument of

transfer and on the issue of debentures, and

26 Bhav


27/112

(ii) by entering into an agreement which being a conveyance and would

attract stamp duty. The second incidence of stamp duty arises when the

Security Receipt is created. Finally, transfer of security receipt from one

investor to another in the secondary market would attract stamp duty

unless issued in demat form.

The incidence of stamp duty is one of the major concerns which make

securitization transactions financially unviable. Stamp duty is a state subject

and in most of the states the duty ranges from 4% to 12%. Four states viz.

Maharashatra, Tamil Nadu, Gujarat and West Bengal have recognized the

commercial benefits of securitization and have reduced stamp duty on such

transactions. The Act has not addressed the issue of stamp duty and the same

is left to respective state governments to decide.

Other area of concern is the registration requirements on transfer of mortgage

backed receivables from immovable property which again adds to the cost of

securitization transaction and needs to be addressed. Another impediment is the

taxation of income of various entities of securitization transaction since the

existing provisions are likely to result into double taxation.

27 Bhav


28/112

Listing and Trading:

Originators will be keen to get Security Receipt listed on stock exchanges to

enhance its liquidity and thereby its attractiveness for investors. This would

require framing of disclosure parameters for the securitized instrument. The aim

of such disclosures is to assist the market in assessing the creditworthiness and

the pricing of the instrument. Two features of the securitized instrument are the

determinants of the disclosure requirement for stock exchanges. One, the

periodic reduction in the face value of the instrument after each set of receivables

from obligors is passed on to investors. Secondly, this reduction in the face value

of the instrument might be higher or lower than the scheduled reduction in face

value since the cash flows is a function of the performance of the pool of assets

i.e. pre-payment and credit risk.

Disclosures can be divided into two:

initial disclosure and

continuing disclosure.

The initial disclosure shall concentrate on information having significant effect on

pre-payment and credit risk such as lender s credit policy, characteristics of the

loans, of the properties that collateralize the loans and of obligors, etc.:

1. Lender s credit policy shall disclosure loans selection policy, documentation,

filling, collection etc.

2. Loan related disclosure will be coupon, difference of weighted average coupon

for the pool and the current market benchmark rate, original weighted average

yield, original tenure, remaining tenure, weighted average remaining tenure to

maturity, age of the loans, size of the loans, start and end date etc.

3. Property / collateral information will require geographical distribution, type of

the property and other features of the pool of financial assets.

28 Bhav


29/112

4. Other collateral information like performance expectation based on the aging

analysis of the portfolio, current / cumulative principal defaults, pre-payment

assumptions, periodic rating will also required to be disclosed.

5. Instrument specific information like scheduled principal and interest payment

dates and the corresponding amount, allotment date, record date, total original

face value, scheduled principal and interest distribution amount are to be

informed upfront.

6. Obligor information will comprise loan purpose, their social and economic

profile etc.

7. Details of credit enhancement measures and how they are going to be

activated and work in case there is a short fall in the receivables from obligors.

The continuing disclosure requirements will keep investors updated on the

performance of the pool and as to the funds collected. Information like number of

delinquencies till date and the corresponding amount, new delinquencies for the

period and the corresponding amount, the scheduled outstanding face value and

actual outstanding face value of the instrument, current weighted average yield,

face value prior to and after each payment date, the current and cumulative

interest and principal shortfall / excess for the pool and for the instrument,

amount drawn from credit enhancement measures and the balance available etc.

are to be disclosed to enable the market to judge the creditworthiness and to

price the instrument. Stock exchanges would be required to set-up ex-dates for

each scheduled payment date.

29 Bhav


30/112

Pricing:

For taking the investment and pricing decisions for securitized securities,

investors need to find answers to the following question: the dynamics of the risk

transferred in securitization transaction, the expected value of loss being

transferred and the compensation for this expected loss, whether this will be a

diversifying asset in the investor s portfolio and the fair risk premium to be paid

for underwriting this exposure. Once, an understanding of the above issues is

gained, it is possible to develop pricing models incorporating the effect of

relevant risks.

Given an understanding of above issues, the initial pricing is based on the

creditworthiness, the presumed pre-payment rate and the financials of the

instrument. The creditworthiness is used to arrive at the required discount factor

and the presumed pre-payment rate is factored to determine the reduced

average life vis--vis the stated tenure of the instrument. The financials cover the

suitability of the instrument in the portfolio of the investor. The discount factor is a

function of the interest rate scenario, investor s risk profile and the

creditworthiness of the instrument and would comprise a benchmark rate and a

risk premium on it. The bench mark rate could be a GOI security having similar

average maturity / duration while the rate of risk premium would vary by

investors. The historical analysis of past data of pre-payment is done to get the

presumed pre-payment rate and the reduced tenure.

Using these parameters, the price of the securitized instrument is calculated like

a plain bond by applying the discounted net present value method. However, a

securitized instrument has an embedded option of pre-payment and the value ofthis option is reduced from the plain bond price to arrive at the expected price of

it.

The pricing for the secondary market after the cash flows have commenced

throw up another challenge, since, the actual performance of the pool is to be

30 Bhav


31/112

factored in the prices. Therefore, the effect of past delinquencies and accelerated

pre-payments are to be.considered for assessing the future cash flows.

Projecting delinquencies and accelerated pre-payments based on past

performance of a instrument for arriving at an appropriate risk premium is a

complex problem that depends on both economic variables (interest rate,

inflation, economic trend and credit deterioration) and demographic variables

(frequency of moves, nature of borrowers etc).

This implies, at times the actual outstanding face value may be higher or lower

than the scheduled face value. Determining the present price for such an

instrument will be a teaser. If the outstanding amount is more, it means the pool

is turning to be delinquent and may need to be priced even lower than the

scheduled face value. If the outstanding amount is less, it means the pool is pre-

paying thereby taking away the initial yield expected by investors for a given

tenure and need to be priced accordingly. Therefore, the market would have to

develop pre-payment and default analysis models in order to price securitized

instruments. Also, the instrument requires the investors to be vigilant while

pricing it since the scheduled face value of it will keep changing after each

payment date.

Overall, the Act has provided the much need legal sanctity to securitization by

recognizing the securitization instrument as a security under the SCR Act.

However, sponsors are restricted to banks and financial institutions and the

nature of the instrument to pass through certificates. This limits the scope of

financial assets that can be securitized and the coupon & tenure flexibility

associated with pay through instruments.

These restrictions, may limit the utility of securitization for Indian markets.

Additionally, the issue of stamp duty and registration has not been tackled and

will make securitization transactions financially unviable in some states. Taxation

is another matter which shall be clarified at the earliest. Finally, it is still not clear

whether securitization can be done outside the parameters of the Act or not. On

31 Bhav


32/112

the other hand, market participants namely sponsors, investors and stock

exchanges need to equip themselves to meet the challenges of this new product.

For making investment decisions, investors shall develop pre-payment and

pricing models. This would require them to understand the nature of the

new instrument and its risk profile. At the same time, stock exchanges need to

frame appropriate disclosure and monitoring requirements to meet the peculiar

nature of this product. However, these limitations shall not delay the introduction

of this product through Exchange mechanism and thereby restrict its wide spread

acceptability.

32 Bhav


33/112

TYPES OF SECURTIZATION:

Asset-Backed Securities (ABS)

Asset Backed Securities (ABS) are securities that are issued with a structure

that repayment is intended to be obtained from an identified pool of assets. Two

types:

Fully-supported: repayment is supported by a financial guarantee

(surety bond, letter of credit, third party guarantee or irrevocable liquidity

facility). This provides both liquidity and credit protection for investors: the

provider of the support has agreed to provide funds to the SPV (Special

Purpose Vehicle) to repay investors without regard to the value of assets

owned by the SPV.

Partially-supported: repayment primarily depends on the cash flow

expected to be realized on the pool of assets, as well as liquidity and

credit enhancement from third parties.

The credit enhancement / insurance providing companies are often referred to asMonoline insurers as this is their only business (they also insure other types of

debt such as municipal bonds) and this sector is dominated by four companies:

AMBAC (American Municipal Bond Assurance Corporation)

MBIA (Municipal Bond Insurance Association)

FGIC (Financial Guaranty Insurance Company)

FSA (Financial Security Assurance)

The ABS market is so well developed in the United States that assets (primarily

loan receivables) are originated right into an ABS program.

The assets are of all types and are primarily loans (either secured or unsecured):

Credit Card receivables

33 Bhav
http://www.credfinrisk.com/#spvhttp://www.credfinrisk.com/#spv


34/112

Automobile loans

Bank loans

Boat loans

Highly-leveraged bank loans

Manufactured home loans

Railroad rolling stock

Aircraft

Single-family residential mortgages

Single-family home equity loans (HEL)

Commercial real estate mortgages

Student loans

Vacation time shares

The financing of the receivables held in the SPV is usually accomplished by

issuing short-term commercial paper to investors (through commercial paper

dealers). The amount of commercial paper issued usually matches the level of

assets held by the SPV. The short-term commercial paper needs to constantly be

rolled over and the pricing to and acceptance by investors reflects the

performance of the underlying receivables, the credit enhancement indicated

above and the availability, performance an yield of alternative investments.

The credit enhancement of a securitization can also be achieved by dividing it

into tranches and allowing some tranches be exposed first to any loss from

defaulting / under-performing indivdual asset or group of assets first. In this

manner, these front-line tranches almost function like an equity piece such that

the investors in the other tranches (Mezzanine tranches) are stisfied first before

the lower tranches. These lower-rated (first loss) tranches usually receive ahigher yield (due to their higher risk position) when the security is first structured

in order to attract investors when first brought to market.

Asset-backed securitizations also usually have a backup liquidity facility in place

provided by a stand-by commitment from a syndicate (group) of banks. This

34 Bhav


35/112

facility protects the investors who purchase the commercial paper. If for some

reason the SPV cannot attract the same or new investors to roll over the

commercial paper or there is insufficient cash flow generated by the pool to pay

off maturing commercial paper then the SPV draws on the backup liquidity facility

to payoff the investors and the bank group then become the owners of the assets

held by the SPV (to either wait for the cash flow to improve or to liquidate the

portfolio).

Asset-backed securitizations usually have a hierarchy / priority of who receives a

payment first from the cash flow generated by the underlying assets and a

hierarchy / priority of who receives repayment first in the event of the liquidation

of the assets. This hierarchy of descending payments from senior to successive

subordinated investors is known as the "waterfall" such that those nearest to the

top in the hierarchy are compensated first when assets are "liquefied":

Pay fees first to the Trustee, Servicer / Asset manager

Pay interest due to the most senior notes. If over-collateralization and

interest coverage tests are not met, redeem notes until test is in

compliance

Pay interest due to the next subordinated tranche. If over-

collateralization and interest coverage tests are not met, redeem the most

senior notes first and then this subordinated tranche until test is in

compliance

Service all subordinate tranches in the hierarchy of investors in the

securitization

Satisfy as many tranches according to their priority as is necessary

and there are sufficient assets to continue to do so

Satisfy most subordinate equity investors if there are sufficient assetsto do so

35 Bhav


36/112

Mortgage-Backed Securities (MBS)

The most well-known asset backed security market is that of the Mortgage

Backed Securities (MBS) market. There are RMBS (Residential Mortgage

Backed Securities) and CMBS (Commercial Mortgage Backed Securities). In the

RMBS market, companies such as the Federal National Mortgage Association

(FNMA / Fannie Mae) purchase mortgages (individually or in groups) in the

primary market from banks (savings and commercial), credit unions, insurance

companies, etc., and packages the loans into MBS (which it guarantees for full

and timely payment of principal and interest). FNMA issues various types of debt

instruments in the global markets to fund its purchase of mortgages prior to

securitization.

MBS are sometimes also referred to as Mortgage Pass-Through Certificates as

the pro-rata share of the monthly interest, amortized principal payments (net of

fees paid to to the issuer, servicer and/or guarantor of the respective security

issue) and unscheduled principal pre-payments (many of the individual

underlying mortgages have no penalty prepayment features that allow the

mortgagee / borrower to make partial or full principal payments) generated by theunderlying pool of individual residential mortgages in the securitization are

"passed through" to the investors holding an undivided interest in the specific

security. Due to the principa pre-payment feature repayment of principal to the

holder of a pass-through security may accelerate during times of a declining

interest rate environment, thus shortening the life of the security.

Each securitized pool has a Weighted Average Coupon / WAC (all of the

mortgages within a specific security must be within 200 bps. of the WAC). The

pass-through rate is lower than the WAC / interest rates on the underlying

mortgages in the pool. FNMA provides a guarantee for its MBS for the timely

payment of principal and interest to the investor, whether or not there is sufficient

cash flow from the underlying group of mortgages. As some lenders continue to

36 Bhav


37/112

service the loan on the behalf of FNMA and the investor, part of the interest rate

differential is used to compensate the lender for the servicing function. In

addition, a portion of the interest rate ditterential is used to compensate FNMA

for providing a guarantee of the security. Each security also has a Weighted

Average Maturity (WAM), which indicates the average maturity in months of the

underlying mortgages in the pool.

Only GNMA is authorized to issue a guarantee with the full faith and credit of the

United States government for the timely payment of prinicipal and interest on

mortgage-backed securities issued by institutions approved by GNMA and

backed by pools of Federal Housing Administration-insured or Veterans

Administration-guaranteed mortgages.

FNMA issues both fixed-rate mortgage and adjustable rate mortgage (ARM)

securities.

37 Bhav


38/112

Commercial Mortgage-Backed Securities (CMBS)

Similar to residential mortgage backed securities in form and function, however

the mortgages in the pool are on multi-family or commercial real estate (industrial

and warehouse properties, office buildings, retail space, shopping malls,

cooperative apartments, hotels, motels, nursing homes, hospitals and senior

living centers). CMBS are issued in both public and private transactions and are

issued in a variety of structures, including multi-class structures featuring senior

and subordinated classes. The underlying mortgage loans of the securitization

tend to lack standardized terms with regard to rate (fixed and floating), term,

amortization and some properties also have comply with certain environmental

laws and regulations.

Collateralized Mortgage Obligation (CMO)

A Collateralized Mortgage Obligation (CMO) is a security that is collateralized

by a pool of individual mortgages. This pass-through security is divided into

various tranches of payment streams with varying maturities and payment priority

(seniority). Some of the lower-rated tranches must absorb any loss prior to the

higher rated tranches. Some tranches may payoff more rapidly than other

tranches. The division of the security in the various tranches increases the

differnt types of investor profiles than a single security could be marketed to. The

division can also eliminate prepayment risk from some investor classes. The

common CMO structures are: Interest Only, Principal Only, Floater, Inverse

Floater, Planned Amortization Class, Support, Scheduled, Sequential, Targeted

Amortization Class, and Z or Accrual Bond. Unfortunately, due to the uniqueness

of many of the multi-class (tranches) CMOs they are less liquid.

Stripped Mortgage-Backed Securities (SMBS)

In an SMBS the interest and principal payments from a standard FNMA MBS are

"stripped" out of the original security to create two new classes of security. One

38 Bhav


39/112

class of security receives the interest only (IO strip) and one class receives the

principal only (PO strip). While they are exclusive of each other they can still be

recombined if necessary at a later date. The pricing on either stripped security is

usually at a discount from the par value of the underlying MBS. In a declining

interest rate environment when the prepayment of residential mortgages

accelerates as home owners refinance to lower rates, the PO strips also

experience accelerated principal prepayment which increases the yield of the PO

strip discounted security. However, in a declining interest rate environment, the

IO strip receives less cash due to less outstanding principal balances on which to

calculate interest, thus the yield actually declines on the IO strip.

In a rising interest rate environment, with lower volumes of prepayment of

principal, the IO strip yield performs as expected or has an improved yield as

there is sufficient prinicipal and maturity of the underlying mortgages to sustain

the interest payments (however, the yield may not be as attractive as newly

issued MBS with WAC that reflect the recent increase in mortgage interest rates).

REMIC (Real Estate Mortgage Investment Conduit)

A REMIC is a multi-class, investment grade mortgage-backed security created byFannie Mae, Ginnie Mae, Freddie Mac and other entities. The monthly cashflow

from the underlying mortgages are allocated to various tranches, resulting in

each tranche having a separate and different maturity, coupon and payment

priority compared to the other tranches in the security. The REMIC is not subject

to income tax (except on net income from prohibited transactions, net income

from foreclosure property, and contributions made after the startup day). In

addition, REMICs also produce a residual of paper gains and losses in value

("phantom income" and "phantom loss"). Holders of the REMIC investment are

required to pay tax on the phantom income however they actually never receive

any actual cash. Phantom losses can by utilized to offset gains from other

investments. Thus, investors in REMICs must pay other qualified entities to

purchase the residual and the tax liability it generates (pension plans and non-

39 Bhav


40/112

U.S. individuals are barred from owning a residual). For other information about

REMICs, see sections 860A through 860G of the Internal Revenue Code (IRC).

Real Estate Synthetic Investment Securities (RESI)

A RESI is a security collateralized by a pool of mortgages like many mortgage-

backed securities. However, unlike other MBS, a RESI passes along any loss

incurred from an underlying mortgage to an investor. Thus, if a property ever

goes into foreclosure and there is insufficient value received from the sale of the

property to satisfy the outstanding mortgage principal and accrued interest, then

that loss is passed on to the investor. The security is divided into several

tranches with the lowest rated tranche incurring the first losses and then each

successively rated tranche incurring the next losses if the first tranche is

liquidated by accumulated losses. In exchange, the lowest rated tranche receives

a very high market interest rate in the form of a margin over LIBOR.

Collateralized Bond Obligation (CBO)

CBO (Collateralized Bond Obligations) are securitized pools of high-yielding

bonds and leveraged loans, whose purchase is financed by debt.

The issuer, normally a bankruptcy-remote special purpose vehicle

(SPV), buys a pool of assets (public bonds) which it then uses to

collateralize a series of securities.

By subordinating or ranking each series or tranche in terms of

seniority, the issuer effectively protects the most senior tranches against

potential losses by forcing the junior classes to accept the risk of first loss.

The bottom tranche rarely carries a coupon or attracts a rating thus it

function similar to equity. To obtain a Triple-A rating, the senior securities must typically be over

collateralized one-and-a-half times.

Thus, $500 million in assets assembled, no more than $330 million in

senior securities ($500 million divided by 1.5), and would have to place

$170 million in junior subordinated securities to close the transaction.

40 Bhav
http://www.credfinrisk.com/#spvhttp://www.credfinrisk.com/#spvhttp://www.credfinrisk.com/#spvhttp://www.credfinrisk.com/#spv


41/112

Collateralized Loan Obligation (CLO)

CLO (Collateralized Loan Obligations) allows a bank/issuer to bundle low-

margin corporate loans into a new type of bond sold in the ABS market.

To the purchaser they offer higher yields than typical credit card and

auto loan ABS.

However, purchasers take on new types of downgrade and default

risks, combined with the novelty of the CLO may make it difficult to trade.

Sometimes it is not evident what corporate credits the CLO wrapper is

hiding: the pooled loans meet only certain criteria of the rating agencies. In

some issues the loans are not fully isolated from the bank such that if the

bank's debt rating were to be downgraded, so would the rating on the CLO

itself.

For the banks, selling a CLO frees up capital tied up in low margin

loans (the bank must set aside capital even for blue-chip issuers,

however, it cannot charge a higher interest rate due to the low default

profile for the blue-chip corporations. Banks that have securitized their

loan portfolios can lower their overall regulatory capital requirement.

The collateral in a CLO consists of investment grade and non-investment grade corporate loans, with several tranches of rated securities

issued based on the prioritization of cash flows, with the most subordinate

tranche (or an equity tranche retained by the bank) absorbing the first

launches from default. The most senior tranche holds the lowest credit risk

and receives the higher rating compared to the other tranches.

Credit enhancement is provided by the prioritization of cash flows,

cash reserve accounts, letters of credit or guarantees.

Ratings are also based on historical default and recovery information

for underlying assets, industry and obligor diversity, minimum interest

coverage ratios, minimum collateral ratings tests and hedging transactions

(to hedge against currency and/or interest rate related risk).

41 Bhav


42/112

The structure is that the bank assigns the loans to a

Seller/Servicer/Asset Manager; who in turn sells the loans to the Issuer

Trust (a bankruptcy remote special purpose vehicle that is limited to the

acquisition and managment of the collateral and the issuance of ABS); the

Trust issues ABS to invesotrs and uses the proceeds to purchase the

loans; a Trustee protects investor's security in the collateral; the bank may

act (or a third party) as a swap counter-party for currency/interest rate

hedging.

If the transfer of the loan is done by participation without the

knowledge of the Obligor, then the default of the originating bank could

result in the Trust being the unsecured creditor of the bank/seller without

recourse to the Obligor.

Assignments represent a more complete transfer.

CLN (Credit Linked Note) are debt instruments backed by the full credit

of the selling institution but whose performance is based on the reference

loan(s).

Synthetic CLO

In a synthetic CLO The assets remain on the balance sheet of the sponsor.Instead, the credit risk of the collateral pool of loans is transferred to the SPV by

means of a credit derivative (portfolio default swap).

Collateralized Debt Obligation (CDO)

Refers to multi-class CMOs, CBOs and CLOs held by an SPV. The SPV can

divide a portfolio of securities into various tranches with various maturities,

interest rates, seniority, credit enhancement and external credit rating in order tomarket the securitixation to several investor profiles.

FASIT (Financial Asset Securitization Investment Trust)

42 Bhav
http://www.credfinrisk.com/#spvhttp://www.credfinrisk.com/#spv


43/112

A FASIT is a tax structure established by U.S. Legislation for the purpose of

attracting investment business to the United States and away from offshore tax

havens. As long as a FASIT has a particular capital structure and adheres to

certain investment regulations, then the FASIT can accumulate and distribute its

gross earnings without incurring U.S. taxation. CDOs may be issued in the form

of "regular interests" in a FASIT. For information on FASITs, see sections 860H

through 860L of the Internal Revenue Code (IRC).

Special Purpose Vehicle (SPV) Structure

SPV: Special Purpose vehicle; a bankruptcy remote corporation that

issues rated securities/commercial paper and uses the proceeds to

purchase assets (usually trade and term receivables) from a seller (in a

single seller program) or multiple sellers (in a multi-seller program). The

bankruptcy remote aspect is important as this way the SPV is not caught

up in any problems or failings of the parent organization and the

receivables in the securitization pool cannot be claimed by creditors of the

parent.

Multi-seller programs are typically established by a bank known as a

sponsor. The entities who sell assets to the SPV are often customers ofthe sponsoring bank. Because the SPV really does not have any active or

functional employees, the bank is usually engaged as "administrator" of

the SPV to perform all of its operational functions.

For a single seller program, the SPV purchases assets from one seller.

The seller often takes on the role of administrator/servicer for the SPV

(similar to the bank in the multi-seller). Although the SPV is established for

the benefit of the single seller, it is maintained as a separate entity.

The SPV issuer of notes backed by the receivables is usually known

as the Owner Trust.

The notes are issued subject to an indenture between the Owner Trust

and in many instances, the asset may be held by a third party, bankruptcy

43 Bhav


44/112

remote special purpose corporation solely for the purpose of managing,

leasing or servicing the assets.

The Owner Trust still maintains an interest in the underlying collateral

by exchanging the proceeds from the CP issuance to the third party and

receiving funding notes or certificates (with a specified beneficial interest

in certain specified collateral designated for the securitization) from the

third party entity.

The Owner Trust issues CP or medium term notes to investors backed

by its own assets which include the securitization entity's certificates or

notes of beneficial interest in the asset.

Issuance of the Commercial Paper will be backed up by a Liquidity

Facility made up of banks that are committed to paying off maturing

commercial paper, and perhaps, a credit derivative structure that protects

investors, and/or a Credit Facility such as a Letter of Credit Facility that

would provide additional over-collateralization of the assets.

Over-collateralization is based on the historical performance/default

rate, and/or the estimated residual value of the asset.

The scheduled payment stream from the asset is passed through to a

collateral account which is then used to pay-off maturing commercial

paper/medium term notes.

When a company pledges away its income to asset-backed investors, it

effectively places corporate bondholders in a second position claim on the assets

of the company / financial institution. If the company goes bankrupt, then the

corporate bond holders would not be allowed to go after the assets previously

promised to the asset-backed trust, at least not until the asset-backed investors

were paid off.

44 Bhav


45/112

Gain on sale accounting:

Earnings are only as good as the company's assumptions on performance of

each securitization. If the pool of loans does not perform as well then the

company has overstated its earnings.

The triple-A rating that the ratings agencies confer upon these deals is based on

various types of credit enhancement built in that make loss of principal highly

unlikely. But the triple-A ratings do not address the risk that high losses within the

securitized trust will force the deal to pay off early leaving bondholder's with

reinvestment risk. Nor does the initial rating suggest how the bond may perform

in the secondary market.

Deposit Trust: conveys a participation interest to the owner trust, which then

issues notes and certificates to investors.

SIV (Structured Investment Vehicle) are credit arbitrage vehicles. They issue

debt in the U.S. and Euro medium-term note and commercial paper markets, and

with the proceeds, purchase assets of varying maturities. These assets consist of

traditional classes of debt and ABS. Derivatives transactions are used to

eliminate both i nterest-rate and foreign-exchange risk. Since the SIVs are

funding at the AAA levels but can purchase securities/assets at varying

investment-grade rating levels, they can pick up credit spread over the life of that

asset.

SNAP (Structured Note Asset Packaging) are repackaged notes, which

includes a trust structure that allows it to ring-fence a pool of underlying assetsinto separate new issues.

Student Loans

Student loans for higher education purposes at the 2-year college, 4-year

college, gradute degree programs and trade schools are securitized in the United

45 Bhav


46/112

States. The Student Loan Marketing Association (SLMA or Sallie Mae), is the

Government Sponsored Enterprise (GSE) that purchases these loans from

financial institutions and specialized lending programs, and then securitizes a

pool of student loans that are in turn sold to investors. SLMA also guarantees

individual issued securitizations (although many of the loans securitized already

have a FFELP / Federal Guaranteed Student Loan Program federal government

guarantee). However, the SLMA is in the process of terminating its GSE

designation and becoming a privatized concern by September 30, 2006. The

successor entity is SLM Corp., which will continue to use the Sallie Mae name.

All existing securitizations funded by debt incurred by SLMA (a AAA rated entity)

will have to be refinanced as part of the privatization completion, as the

successor entity, SLM Corp. is only a single-A+ rated issuer. Some of the largest

originators of student loans include: National Education Loan Network, Collegiate

Funding Services, Education Lending Group, Inc., and College Loan Corp.

46 Bhav


47/112

SECURTISATION LEADING CHANGE IN MARKETS

Securitisation and structured finance:

Securitisation is a "structured financial instrument". "Structuredfinance" has become a buzzword in today's financial market. What it

means is a financial instrument structured or tailored to the risk-return and

maturity needs of the investor, rather than a simple claim against an entity

or asset.

Does that mean any tailored financial product is a structured financial

product? In a broad sense, yes. But the popular use of the term structured

finance in today's financial world is to refer to such financing instrumentswhere the financier does not look at the entity as a risk: but tries to align

the financing to specific cash accruals of the borrower.

On the investors side, securitisation seeks to structure an investment

option to suit the needs of investors. It classifies the receivables/cash

flows not only into different maturities but also into senior, mezzanine and

junior notes. Therefore, it also aligns the returns to the risk requirements

of the investor.

Securitisation as a tool of risk management:

Securitization is more than just a financial tool. It is an important tool of

risk management for banks that primarily works through risk removal but

also permits banks to acquire securitized assets with potential

diversification benefits. When assets are removed from a bank's balance

sheet, without recourse, all the risks associated with the asset are

eliminated, save the risks retained by the bank. Credit risk and interest-

rate risk are the key uncertainties that concern domestic lenders. By

passing on these risks to investors, or to third parties when credit

enhancements are involved, financial firms are better able to manage their

risk exposures.

47 Bhav


48/112

Securitisation: changes the function of intermediation:

Hence, it is true to say that securitisation leads to a degree of disintermediation.

Disintermediation is one of the important aims of a present-day corporate

treasurer, since by leap-frogging the intermediary, the company intends to

reduce the cost of its finances. Hence, securitisation has been employed to

disintermediate.

It is, however, important to understand that securitisation does not eliminate the

need for the intermediary: it merely redefines the intermediary's loan. Let us

revert to the above example. If the company in the above case is issuing

debentures to the public to replace a bank loan, is it eliminating the intermediary

altogether? It would possibly be avoiding the bank as an intermediary in the

financial flow, but would still need the services of an investment banker to

successfully conclude the issue of debentures.

Hence, securitisation changes the basic role of financial intermediaries.

Traditionally, financial intermediaries have emerged to make a transaction

possible by performing a pooling function, and have contributed to reduce the

investors' perceived risk by substituting their own security for that of the end user.

Securitisation puts these services of the intermediary in a background by making

it possible for the end-user to offer these features in form of the security, in which

case, the focus shifts to the more essential function of a financial intermediary:

that of distributing a financial product. For example, in the above case, where the

bank being the earlier intermediary was eliminated and instead the services of an

investment banker were sought to distribute a debenture issue, the focus shiftedfrom the pooling utility provided by the banker to the distribution utility provided

by the investment banker.

This has happened to physical products as well. With standardisation, packaging

and branding of physical products, the role of intermediary traders, particularly

48 Bhav


49/112

retailers, shifted from those who packaged smaller qualities or provided to the

customer assurance as to quality, to the ones who basically performed the

distribution function.

Securitisation seeks to eliminate funds-based financial intermediaries by fee-

based distributors. In the above example, the bank was a fund-based

intermediary, a reservoir of funds, whereas the investment banker was a fee-

based intermediary, a catalyst, a pipeline of funds. Hence, with increasing trend

towards securitisation, the role of fee-based financial services has been brought

into the focus.

In case of a direct loan, the lending bank was performing several intermediation

functions noted above: it was distributor in the sense that it raised its own

finances from a large number of small investors; it was appraising and assessing

the credit risks in extending the corporate loan, and having extended it, it was

managing the same. Securitisation splits each of these intermediary functions

apart, each to be performed by separate specialised agencies. The distribution

function will be performed by the investment bank, appraisal function by a credit-

rating agency, and management function possibly by a mutual fund who

manages the portfolio of security investments by the investors. Hence,

securitisation replaces fund-based services by several fee-based services.

49 Bhav


50/112

Securitisation: changing the face of banking:

Securitisation is slowly but definitely changing the face of modern banking and by

the turn of the new millennium, securitisation would have transformed banking

into a new-look function.

Banks are increasingly facing the threat of disintermediation. When asked why

he robbed banks, the infamous American criminal Willie Sutton replied "that's

where the money is." No more so, a bank would say ! In a world of securitized

assets, banks have diminished roles. The distinction between traditional bank

lending and securitized lending clarifies this situation.

Traditional bank lending has four functions:

1. originating,

2. funding,

3. servicing, and

4. monitoring.

Originating means making the loan, funding implies that the loan is held on the

balance sheet, servicing means collecting the payments of interest and principal,

and monitoring refers to conducting periodic surveillance to ensure that the

borrower has maintained the financial ability to service the loan. Securitized

lending introduces the possibility of selling assets on a bigger scale and

eliminating the need for funding and monitoring.

The securitized lending function has only three steps:

1.originate,2.sell, and

3.service.

This change from a four-step process to a three-step function has been

described as the fragmentation or separation of traditional lending.

50 Bhav


51/112

Capital markets fuelled securitisation:

The fuel for the disintermediation market has been provided by the capital

markets:

Professional and publicly available rating of borrowers has eliminated the

informational advantage of financial intermediaries. Imagine a market

without rating agencies: any one who has to take an exposure in any

product or entity has to appraise the entity. Obviously enough, only those

who are able to employ high-degree analytical skills will be able to survive.

However, the availability of professionally and systematically conducted

ratings has enabled lay investors to rely on the rating company'sprofessional judgement and invest directly in t

Documents

Innovations in Financial Intermediation