Securitization-the financial instrument of the new era”

8/3/2019 Securitization-the financial instrument of the new era”

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Executive Summary Executive Summary

Technological advancements have changed the face of the world of finance. It is today

more a world of transactions than a world of relations. Most relations have been

transactionalized.

1) Research Design Research Design:: -

The research design comprises of the purpose of the study, objectives, methodology,

scope & limitations of the project study.

2) Literature Review Literature Review : -This elucidates on the theoretical aspect of the “Securitization” process, factors

responsible for success & failure of this new tool.

3) NHB-HDFC RMBS Issue…. A case-study NHB-HDFC RMBS Issue…. A case-study: -

The issue structure, its features, hierarchy of payments, selection criteria and credit

enhancements are elaborated in brief.

4)4) Analysis & Interpretation: - Analysis & Interpretation: -

The comprehensive analysis through various examples has been enlightened in the

project.

5) Epilogue Epilogue: -

Epilogue is petite conclusive chapter of the project report. This encompasses the

Aftermath & Recommendations derived from analysis & project report

TABLE OF CONTENTS

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SR.

NO.CONTENTS

PAGE

NO.

1. INTRODUCTION 1

2. HISTORY 4

3. ASSET BACKED SECURITIES 7

4. MORTGAGE BACKED SECURITIES 11

5. SECURITIZATION OF RECEIVABLES 16

6. NEED FOR SECURITIZATION 18

7. FEATURES OF SECURITIZATION 23

8. BENEFITS OF SECURITIZATION 28

9. PURPOSE 29

10.ADVANTAGES AND THREATS OF

SECURITIZATION31

11. ECONOMIC IMPACT OF SECURITIZATION 3512. MAJOR PLAYERS 37

13. HOW IT WORKS 39

14. TYPES OF SECURITIZATION 47

15. RULES AND REGULATIONS 49

16.HOW IT CAN BE USED FOR RISK

MANAGEMENT54

17. CASE STUDY- NHB- HDFC RMBS ISSUE56

18. CONCLUSION 60

19. BIBLIOGRAPHY 65

20. WEBLIOGRAPHY 66

INTRODUCTION

One of the most prominent developments in international finance in recent decades and the

one that is likely to assume even greater importance in future, is securitization.

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Securitization is the process of pooling and repackaging of homogenous illiquid financial

assets into marketable securities that can be sold to investors. The process leads to the

creation of financial instruments that represent ownership interest in, or are secured by a

segregated income producing asset or pool of assets. The pool of assets collateralizes

securities. These assets are generally secured by personal or real property (e.g.

automobiles, real estate, or equipment loans), but in some cases are unsecured (e.g. credit

card debt, consumer loans).

The touchstones of securitization are:

• Legal true sale of assets to an SPV with narrowly defined purposes and activities

• Issuance of securities by the SPV to the investors collateralized by the underlying

assets• Reliance by the investors on the performance of the assets for repayment - rather

than the credit of their Originator (the seller) or the issuer (the SPV)

• Consequent to the above, “Bankruptcy Remoteness” from the Originator.

Apart from the above, the following additional characteristics are generally noticed:

· Administration of the assets, including continuation of relationships with obligors

· Support for timely interest and principal repayments in the form of suitable credit

enhancements

· Ancillary facilities to cover interest rate / forex risks, guarantee, etc.

· Formal rating from one or more rating agencies

Securitization. Securitization is the process of pooling various types of debt -- mortgages,

car loans, or credit card debt, for example -- and packaging that debt as bonds, pass-

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through securities, or collateralized mortgage obligations (CMOs), which are sold to

investors.

The principal and interest on the debt underlying the security is paid to the investors on a

regular basis, though the method varies based on the type of security. Debts backed bymortgages are known as mortgage-backed securities, while those backed by other types of

loans are known as asset-backed securities.

Securitization, in its most basic form, is a method of selling assets. Rather than selling

those assets "whole", the assets are combined into a pool, and then that pool is split into

shares. Those shares are sold to investors who share the risk and reward of the

performance of those assets. It can be viewed as being similar to a corporation selling, or "spinning off," a profitable business unit into a separate entity. They trade their ownership

of that unit, and all the profit and loss that might come in the future, for cash right now.

Illustration:-

A very basic example would be as follows. XYZ Bank loans 10 people $100,000 a piece,

which they will use to buy homes. XYZ has invested in the success and/or failure of those

10 home buyers- if the buyers make their payments and pay off the loans, XYZ makes a

profit. Looking at it another way, XYZ has taken the risk that some borrowers won't repay

the loan. In exchange for taking that risk, the borrowers pay XYZ interest on the money

they borrow.

From the perspective of XYZ, those loans are 10 different assets. They have value- one, if

the loan fails, XYZ takes ownership of the house. Two, if the loan succeeds, XYZ gets

their money back along with the interest they charge.

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XYZ can do two things with those loans. They can hold them for 30 years and, they would

hope, make a profit on their investment. Or they could sell them to some other investor,

and walk away. In doing this, they would make less profit than if they held onto them long

term, but they would benefit in that they make some profit while also getting their original

investment back. They give up some of the reward (profit) in exchange for not having the

risk.

So XYZ Bank decides they'd rather have the cash now. They could sell those 10 loans to

10 investors. Each investor would be taking a risk in buying those loans, because if any

loan defaults, that one investor loses. Naturally, investors would not be willing to pay very

much for those loans, knowing the risk involved. XYZ wants to sell those loans for the

best price they can get, so they decide to securitize those loans. They combine the 10 loans

into one entity, and then they split that one entity into 10 equal shares. Each investor still

pays the same $100,000, but instead of owning one loan, they will own 10% of all 10

loans. If one loan fails, every investor loses 10%.

The result is that XYZ bank is able to sell their assets for more money, and investors are

insulated from the volatility of directly owning mortgages.

HISTORY

"Asset securitization began with the structured financing of mortgage pools in the 1970s.

For decades before that, banks were essentially portfolio lenders; they held loans until they

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matured or were paid off. These loans were funded principally by deposits, and sometimes

by debt, which was a direct obligation of the bank (rather than a claim on specific assets).

But after World War II, depository institutions simply could not keep pace with the rising

demand for housing credit. Banks, as well as other financial intermediaries sensing a

market opportunity, sought ways of increasing the sources of mortgage funding. To attract

investors, investment bankers eventually developed an investment vehicle that isolated

defined mortgage pools, segmented the credit risk, and structured the cash flows from the

underlying loans. Although it took several years to develop efficient mortgage

securitization structures, loan originators quickly realized the process was readily

transferable to other types of loans as well."

In February 1970, the U.S. Department of Housing and Urban Development created the

transaction using a mortgage-backed security. The Government National Mortgage

Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage

loans.

To facilitate the securitization of non-mortgage assets, businesses substituted private creditenhancements. First, they over-collateralized pools of assets; shortly thereafter, they

improved third-party and structural enhancements. In 1985, securitization techniques that

had been developed in the mortgage market were applied for the first time to a class of

non-mortgage assets — automobile loans. A pool of assets second only to mortgages in

volume, auto loans were a good match for structured finance; their maturities, considerably

shorter than those of mortgages, made the timing of cash flows more predictable, and their

long statistical histories of performance gave investors confidence.

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This early auto loan deal was a $60 million securitization originated by Marine Midland

Bank and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS,

1985-1).

The first significant bank credit card sale came to market in 1986 with a private placementof $50 million of outstanding bank card loans. This transaction demonstrated to investors

that, if the yields were high enough, loan pools could support asset sales with higher

expected losses and administrative costs than was true within the mortgage market. Sales

of this type — with no contractual obligation by the seller to provide recourse — allowed

banks to receive sales treatment for accounting and regulatory purposes (easing balance

sheet and capital constraints), while at the same time allowing them to retain origination

and servicing fees. After the success of this initial transaction, investors grew to accept

credit card receivables as collateral, and banks developed structures to normalize the cash

flows.

Starting in the 1990s with some earlier private transactions, securitization technology was

applied to a number of sectors of the reinsurance and insurance markets including life and

catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the

disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX.

Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe

bonds, Life Insurance Securitization and Reinsurance Sidecars.

The first public securitization of Community Reinvestment Act (CRA) loans started in

1997. CRA loans are loans targeted to low and moderate income borrowers and

neighborhoods.

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As estimated by the Bond Market Association, in the United States, total amount

outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total

outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt

($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In

nominal terms, over the last ten years, (1995-2004,) ABS amount outstanding has grown

about 19 percent annually, with mortgage-related debt and corporate debt each growing at

about 9 percent. Gross public issuance of asset-backed securities remains strong, setting

new records in many years. In 2004, issuance was at an all-time record of about $0.9

trillion.

At the end of 2004, the larger sectors of this market are credit card-backed securities (21

percent), home-equity backed securities (25 percent), automobile-backed securities (13

percent), and collateralized debt obligations (15 percent). Among the other market

segments are student loan-backed securities (6 percent), equipment leases (4 percent),

manufactured housing (2 percent), small business loans (such as loans to convenience

stores and gas stations), and aircraft leases. More recently an attempt to securitize excess

energy generated by renewable energy resources is being attempted bt J. Brant Arseneau

and his team.

As the result of the credit crunch precipitated by the subprime mortgage crisis the market

for bonds backed by securitized loans was very weak in 2008 unless the bonds were

guaranteed by a federally backed agency. As a result interest rates are rising for loans that

were previously securitized such as home mortgages, student loans, auto loans and

commercial mortgage.

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ASSET BACKED SECURITIES.

All asset-backed securities are securities which are based on pools of underlying assets.

These assets are usually illiquid and private in nature. A securitization occurs to make

these assets available for investment to a much broader range of investors. The "pooling"

of assets occurs to make the securitization large enough to be economical and to diversify

the qualities of the underlying assets.

Asset backed securities may be used to remove assets from the issuer's balance sheet or to

manage risk by limiting lenders' recourse other than to the specific assets concerned. The

creation of an asset backed security requires the securitisation of a pool of assets or a series

of future cash flows. In some cases the assets may themselves be backed by other assets

belonging to the issuer's borrowers. For example, a bank might finance a large chunk of its

mortgage lending with an asset backed security.

Underlying collateral for ABS frequently includes:

• Auto Loans

• Credit Card Receivables

• Student Loans

Companies that issue these loans or receivables sell them to securities dealers which

package them into ABS. These companies typically benefit by having new cash on hand

that they can use to issue more loans.

Tranches will be created with differing yields and seniority rights to the cash flows, and

sold to investors or institutions depending on risk profile. In a

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sequential payout structure, all principal payments will go to the senior tranche until those

holders are fully paid off before principal payments flow down the ladder to the

mezzanine, and then subordinate, tranches. Likewise, senior tranches have claim on

interest payments, and interest cash flows can be diverted from the subordinate tranches to

more senior tranches to make up any shortfall. To compensate the mezzanine and

subordinate tranches for the increased risk of loss due to cash flow shortfalls, they receive

higher interest rates than the senior tranche.

ASSET BACKED SECURITIES – ILLSUTRATION

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The diagram illustrates the asset securitization technique. We start with a hypothetical

finance company, Finance Company Ltd (FCL). The company provides loans for private

automobiles, small delivery vans and trucks, and farm equipment. While the receivables

have a reliable payment history, the growth of FCL’s business means that it has strained

the limits of its leverage to dangerous levels. Equity capital is scarce, and the owners are

not willing to relinquish control by issuing public stock. Issuing a corporate bond would be

difficult and costly.

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http://globalsecuritization.com/



This company is ripe for asset securitization. Equity capital is scarce and costly, but the

assets themselves are sufficiently strong to support a high credit rating without the

backing of the originating lender.

After working with its bankers, the financial guarantee company, the regulatory and ratingagencies and the lawyers to structure the deal, FCL establishes the new company, called

FCL 1997-A, to buy its hire-purchase receivables and to issue asset-backed securities. This

new company or trust has no other purpose and will be dissolved after the securities

mature -- hence the term special-purpose vehicle (SPV).

The specially formed vehicle purchases the assets from FCL and sells notes or certificates

to investors. The investors stake is secured by the assets in the trust, which are held on behalf of investors and are no longer controlled by the originator or its creditors. The

investors, however, are getting more than secured claims. They are receiving predictable

cash flows from a selected pool of assets that has been screened by the originator, by the

rating agency, and in many cases by an independent guarantee company.

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MORTGAGE BACKED SECURITIES.

Large banking institutions and government sponsored entities (GSE's) purchase mortgages,

which abide by certain standards, and package them together into securities which

investors can buy. These securities are referred to as mortgage backed securities, or MBS. Mortgage backed securities bring liquidity into the mortgage markets and allow

lenders to issue more loans and enable them to offer better pricing with their loans.

Lenders no longer have to hold the mortgages on their books which frees up cash and

removes the portfolio risk at the same time. Additionally, MBS securities offer investors

the opportunity to buy securities with very high credit ratings. GSE's, such as Fannie Mae

and Freddie Mac are two of the largest originators of MBS and have the backing of the

U.S. government to ensure investors payment of principal and interest from the underlying

mortgages in the security. Securities issued from these two entities are also known as

"Agency" mortgage backed securities.

From an investor’s point of view, there are a few key benefits to an MBS. Firstly, they

offer substantially higher returns than treasury securities of similar term, in the area of 100

to 200 basis points. MBS securities also have very high credit quality ratings as well.

Agency securities are typically considered as safe as treasury securities while non agency

securities are AA to AAA rated. Finally, investors will receive regular monthly income

from these securities, especially pass-through.

MBS Variation

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There are three variations of a mortgage backed security: mortgage pass-through,

collateralized mortgage obligations (CMO), and stripped mortgage backed securities. The

most common type is a pass-through MBS.

Pass –Through MBS :-

When you purchase an pass-through security, you receive pro-rata cash flows generated

from the mortgage payments made by the underlying mortgage holders in the security.

This cash flow comes in three forms: interest payment, principal payment, and principal

prepayments. Pass through MBS are a efficient means to purchasing many mortgages as

there is much greater liquidity than that of an individual mortgage.

Collateralized Mortgage Obligation (CMO):-

A CMO is a special purpose entity which is created by the issuer of the security and this

entity owns the pool of loans that will be securitized. Collateralized mortgage

obligations are structured in that they have different classes of bonds, also known as

tranches. Each one of these classes follow a set of rules which governs items such as

principal repayment and prepayment absorption. Unlike the pass-through MBS, CMO's

provide certain classes of bond holders with less uncertainty regarding prepayment risks.

For example, a CMO deal may be established with 3 separate groups of bond holders. The

deal may stipulate that the first group will receive its principal back first; therefore, all

mortgage principal payments will be split pro-rata among that group of bond holders until

their principal is fully repaid. Effectively, this first group is going to be a shorter term

security due to the fact that it will absorb the prepayment risk first. Remember,

prepayments on mortgages are a risk to bond holders because it prevents them from

receiving interest payments on those amounts. The second group will then receive its

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principal back while the third group will follow. This is a very simple example of a CMO

but it was given to illustrate the idea that prepayment risk can be less uncertain based on

the tranche you are in.

MBS Strips

Stripped MBS securities are slightly different than CMO's; rather than have principal

distribution priorities, stripped MBS's split the principal and interest portions between

tranches. There is an IO and a PO class. These acronyms refer to interest-only and

principal-only. As there are no interest payments in the PO class, PO securities are

purchased at a substantial discount to par. Basically, the faster the prepayments occur, the

faster they receive their principal back and the higher the yield on the investment. As youcan see, PO tranches benefit from lower interest rate environments where prepayments are

much faster. IO investors on the other hand would prefer higher interest rates which result

in lower prepayments. The longer the principal remains unpaid, the more interest they will

make.

MORTGAGE BACKED SECURITIES – ILLSUTRATION

Assume a loan originator makes ten 30-year $100,000 8% fixed-rate qualifying mortgages,

which are sold to an agency. The agency extends its credit guarantee to the mortgages, for

which it receives a fee (generally around 0.5% per year of the outstanding principal

balance). The mortgages are then sold to a securities firm which, in turn, sells interests in

the pool of mortgages to

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investors. These interests are called participation certificates. Let’s say that this pool was

sold to five investors who purchased percentages of the pool in the following amounts:

Investor A made a $500,000 investment for a 50% ownership share of the pool; Investor B

invested $250,000 for a 25% ownership share; Investor C bought in with a $150,000

investment for a 15% ownership share; Investor D invested $75,000 and owns 7.5 percent

of the pool; and Investor E made a $25,000 investment and acquired a 2.5% ownership

share. As a result of these investments, the capital that’s loaned to the homebuyers has

ultimately come from these investors, having passed through two intermediaries: namely,

the originator and the agency.

After the loans close, the homeowners begin making their monthly payments to the lender.

The lender collects and records the payments, sends any late notices, maintains escrow

accounts, and executes foreclosure proceedings as necessary. These collective services,

which are known as servicing the mortgages, can also be provided by another entity if

servicing is handled by a third party. The lender (or third-party servicer) then passes on the

mortgage payments, minus its servicing fees (which are usually around 0.5% of the

outstanding balance) to the agency. The agency subtracts its fee for providing its credit

guarantee, and then distributes the payments to the investors on a prorated basis, according

to each investor’s percentage of ownership. Therefore, Investor A receives 50% of the

interest and principal that the agency can pay out, Investor B gets 25%, and on down the

line according to each investor’s ownership percentage.

The homeowners pay off a portion of their loans each month as part of their mortgage

payments. The investors, therefore, receive back a portion of their invested principal every

month. If any of the homeowners pay off their loans

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early, the principal that’s paid off is, again, distributed on a prorated basis to the investors.

This structure allows investors to invest in mortgages without having to devote any time or

incur any of the expenses of originating and servicing the loans. It also frees them from the

credit risk of mortgage investments. In the previous example, the investors received a 7%return on their investments, paying the other 1% of the mortgage rate to the loan servicer

and the agency. The cost of eliminating those problems associated with mortgage

investments is, according to many investors, money well spent.

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SECURITIZATION OF RECEIVABLES

One of the applications of the securitisation technique has been in creation of marketable

securities out of or based on receivables. The intention of this application is to afford

marketability to financial claims in the form of receivables. Obviously, this application has been applied to those entities where receivables form a large part of the total assets of the

entity. Besides, to be packaged as a security, the ideal receivable is one which is repayable

over or after a certain period of time, and there is contractual certainty as to its payment.

Hence, the application was traditionally principally directed towards housing/mortgage

finance companies, car rental companies, leasing and hire purchase companies, credit cards

companies, hotels, etc. Soon, electricity companies, telephone companies, real estate hiring

companies, aviation companies etc. joined as users of securitisation. Insurance companies

are the latest of the lot to make an innovative use of securitisation of risk and receivables,

though the pace at which securitisation markets are growing, the word "latest" is not

without the risk of being stale soon.

Though the generic meaning of securitisation is every such process whereby financial

claims are transformed into marketable securities, in the sense in which we are concerned

with this term here in this book, securitisation is a process by which cash flows or claims

against third parties of an entity, either existing or future, are identified, consolidated,

separated from the originating entity, and then fragmented into "securities" to be offered to

investors.

The involvement of the debtors in receivable securitisation process adds unique

dimensions to the concept, of which at least two deserve immediate mention.

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One, the legal possibility of transforming a claim on a third party as a marketable

document. It is easy to understand that this dimension is unique to securitisation of

receivables, since there is no legal difficulty where an entity creates a claim on itself, but

the scene is totally changed where rights on other parties are being turned into a tradable

commodity. Two, it affords to the issuer the rare ability to originate an instrument which

hinges on the quality of the underlying asset. To state it simply, as the issuer is essentially

marketing claims on others, the quality of his own commitment becomes irrelevant if the

claim on the debtors of the issuer is either market-acceptable or is duly secured. Hence, it

allows the issuer to make his own credit-rating insignificant or less significant, and the

intrinsic quality of the asset more critical.

Thus, Securitisation is a method:

Of funding receivables

Illiquid assets are converted into a security

Normally rated and

Which can be freely traded?

For example, a group of consumer loans can be transformed into a publicly issued debt

security.

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NEED FOR SECURITISATION

The generic need for securitisation is as old as that for organized financial markets. From

the distinction between a financial relation and a financial transaction earlier, weunderstand that a relation invariably needs the coming together and remaining together of

two entities. Not that the two entities would necessarily come together of their own, or

directly. They might involve a number of financial intermediaries in the process, but

nevertheless, a relation involves fixity over a certain time. Generally, financial relations are

created to back another financial relation, such as a loan being taken to acquire an asset,

and in that case, the needed fixed period of the relation hinges on the other which it seeks

to back-up.

Financial markets developed in response to the need to involve a large number of investors

in the market place. As the number of investors keeps on increasing, the average size per

investors keeps on coming down -this is a simple rule of the marketplace, because growing

size means involvement of a wider base of investors. The small investor is not a

professional investor: he is not as such in the business of investments. Hence, he needs an

instrument which is easier to understand, and is liquid. These two needs set the stage for

evolution of financial instruments which would convert financial claims into liquid, easy to

understand and homogenous products, at times carrying certified quality labels (credit-

ratings or security), which would be available in small denominations to suit every one's

purse. Thus, securitisation in a generic sense is basic to the world of finance, and it is a

truism to say that securitization

envelopes the entire range of financial instruments, and hence, the entire range of financial

markets.

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Following are the reasons as to why the world of finance prefers a securitised financial

instrument to the underlying financial claim in its original form:

(a) Financial claims often involve sizeable sums of money, clearly outside the reach of the

small investor. The initial response to this was the development of financialintermediation: an intermediary such as a bank would pool together the resources of

the small investors and use the same for the larger investment need of the user.

However, then came the second difficulty, noted below.

(b) Small investors are typically not in the business of investments, and hence, liquidity of

investments is most critical for them. Underlying financial transactions need fixity of

investments over a fixed time, ranging from a few months to may be a number of

years. This problem could not even be sorted out by financial intermediation, since if

the intermediary provided a fixed investment option to the seeker, and itself sought

funds with an option for liquidity, it would get caught into serious problems of a

mismatch. Hence, the answer was a marketable instrument.

(c) Generally, instruments are easier understood than financial transactions. An instrument

is homogenous, usually made in a standard form, and generally containing standard

issuer obligations. Hence, it can be understood generically. Besides, an important part

of investor information is the quality and price of the instrument, and both are far

easier known in case of instruments than in case of underlying financial transactions.

In short, the need for securitisation was almost inescapable, and present day's financial

markets would not have been what they are, unless some standard thing that market players

could buy and sell, that is, financial securities, were available.

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So powerful is the economic logic for securitisation that the trend towards securitisation

knows no limits. Capital markets are today a place where everything is traded: from claims

over entities to claims over assets, to risks, and rewards.

JARGON SIMPLIFIED

This section is essentially to quickly get familiarized with the essential securitisation

jargon.

The entity that securitises its assets is called the originator: the name signifies the fact that

the entity was responsible for originating the claims that are to be ultimately securitised.

There is no distinctive name for the investors who invest their money in the instrument:

therefore, they might simply be called investors.

The claims that the originator securitises could either be existing claims, or existing assets

(in form of claims), or expected claims over time. In other words, the securitised assets

could be either existing receivables, or receivables to arise in future. The latter, for the sake

of distinction, is sometimes called future flows securitisation, in which case the former is

a case of asset-backed securitisation.

In US markets, another distinction is mostly common: between mortgage-backed

securities and asset-backed securities. This only is to indicate the distinct application: the

former relates to the market for securities based on mortgage receivables, which in the

USA forms a substantial part of total securitisation markets, and securitisation of other

receivables.

Since it is important for the entire exercise to be a case of transfer of receivables by the

originator, not a borrowing on the security of the receivables, there is a legal transfer of

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the receivables to a separate entity. In legal parlance, transfer of receivables is called

assignment of receivables. It is also necessary to ensure that the transfer of receivables

isrespected by the legal system as a genuine transfer, and not as mere eyewash where the

reality is only a mode of borrowing. In other words, the transfer of receivables has to be a

true sale of the receivables, and not merely a financing against the security of the

receivables.

Since securitisation involves a transfer of receivables from the originator, it would be

inconvenient, to the extent of being impossible, to transfer such receivables to the investors

directly, since the receivables are as diverse as the investors themselves. Besides, the base

of investors could keep changing, as the resulting security is essentially a marketable

security. Therefore, it is necessary to bring in an intermediary that would hold the

receivables on behalf of the end investors. This entity is created solely for the purpose of

the transaction: therefore, it is called a special purpose vehicle (SPV) or a special

purpose entity (SPE) or, if such entity is a company, special purpose company (SPC).

The function of the SPV in a securitisation transaction could stretch from being a pure

conduit or intermediary vehicle, to a more active role in reinvesting or reshaping the cash

flows arising from the assets transferred to it, which is something that would depend on the

end objectives of the securitisation exercise.

Therefore, the originator transfers the assets to the SPV, which holds the assets on behalf

of the investors, and issues to the investors its own securities. Therefore, the SPV is also

called the issuer.

There is no uniform name for the securities issued by the SPV as such securities take

different forms. These securities could either represent a direct claim of the investors on all

that the SPV collects from the receivables transferred to it: in this case, the securities are

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called pass through certificates or beneficial interest certificates as they imply

certificates of proportional beneficial interest in the assets held by the SPV. Alternatively,

the SPV might be re-configuring the cash flows by reinvesting it, so as to pay to the

investors on fixed dates, not matching with the dates on which the transferred receivables

are collected by the SPV. In this case, the securities held by the investors are called pay

through certificates. The securities issued by the SPV could also be named based on their

risk or other features, such as senior notes or junior notes, floating rate notes, etc.

Another word commonly used in securitisation exercises is bankruptcy remote transfer.

What it means is that the transfer of the assets by the originator to the SPV is such that

even if the originator were to go bankrupt, or get into other financial difficulties, the rights

of the investors on the assets held by the SPV is not affected. In other words, the investors

would continue to have a paramount interest in the assets irrespective of the difficulties,

distress or bankruptcy of the originator.

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Special purpose

vehicle

FEATURES OF SECURITISATION

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

the following features:

Features of securitisation

1. Marketability Marketability : -

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Marketability

Merchantable

quality

Wide

distribution

Homogenity



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 features

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.

As far as the legal possibility of marketing the instrument is concerned, traditional

mercantile law took a contemporaneous view of marketable documents. In most

jurisdictions of the world, laws dealing with marketable instruments (also referred to as

negotiable instruments) were mostly limited in application to what were then in circulation

as such. Besides, the corporate laws mostly defined and sought to regulate issuance of very

usual corporate financial claims, such as shares, bonds and debentures. For any codified

law, this is not unexpected, since laws do not lead commerce: most often, they follow, as

the concern of the lawmaker is mostly regulatory and not promotional.

Hence, in most jurisdictions of the world, well-coded laws exist to enable and regulate the

issuance of traditional forms of securitised claims, such as shares, bonds, debentures and

trade paper (negotiable instruments). Most countries lack in legal systems pertaining to

other securitised products, of recent or exotic origin, such as securitisation of receivables.

On a policy plane, it is incumbent on the part of the regulator to view any securitised

instrument with the same concern as in case of traditional instruments, for reasons of

investor protection.

However, it needs to be noted that where a law does not exist to regulate issuance of a

securitised instrument, it is naive to believe that the law does not permit such issuance. As

regulation is a design by humanity itself, it would be ridiculous to presume that everything

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that is not regulated is not even allowed. Regulation is an exception and freedom is the

rule.

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 securitisationwill 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.

2. Merchantable quality 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 that 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 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.

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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 originators' own rating.

3. 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.

4. 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.

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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. This

often invites the next feature : an intermediary to achieve this process.

5. 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.

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.

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BENEFITS OF SECURITISATION

Securitisation offers a wide range of benefits to both the originators and investors.

Originator's perspective--Securitisation offers an effective and relatively quick

alternative funding source.

Securitisation is an off-balance sheet-funding alternative. It generates cash for the

originator without any addition to borrowings (without increasing the debt to equity

ratio). Companies that have capital adequacy pressures can undertake securitisation to

raise funds.

Securitisation helps in “upfronting” profits. In case of high-yielding portfolios like car

loans and truck loans, there is a profit on sale, as the inherent yield in the portfolio is

typically higher than the coupon rate on ABS. Hence, there is a boost to bottom-line and

earnings per share (EPS) in the year of securitisation.

As securitised papers are highly rated, cost of borrowing is relatively lower. Even for

originators rated in the AA category, there is likely to be a price advantage in

securitisation as AAA has a premium price. This is all the more attractive for investors

whose own credit ratings are lower.

Since securitisation helps to undertake larger business with the same capital, profitability

and return on investment ratios improve post-securitisation.

After securitisation, medium-term assets are replaced by cash leading to mitigation of tenor

mismatch, improving asset-liability management. Banks, financial institutions (FIs) and

non-banking finance companies (NBFCs) who are fully exposed to certain industries,

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corporates or groups can do further business without violating exposure norms by

securitising a part of the existing exposure.

After securitisation, credit and prepayment risks are eliminated as these are passed on to

investors. With the advantage of a high rating, there is access to a wider base of investors.

PURPOSE

Securitisation is one way in which a company might go about financing its assets. There

are generally seven reasons why companies consider securitisation:

1.1. To improve their return on capital, since securitisation normally requires less capital To improve their return on capital, since securitisation normally requires less capital

to support it than traditional on-balance sheet funding;to support it than traditional on-balance sheet funding;

2.2. To raise finance when other forms of finance are unavailable (in a recession banksTo raise finance when other forms of finance are unavailable (in a recession banks

are often unwilling to lend - and during a boom, banks often cannot keep up with theare often unwilling to lend - and during a boom, banks often cannot keep up with the

demand for funds);demand for funds);

3.3. To improve return on assets - securitisation can be a cheap source of funds, but theTo improve return on assets - securitisation can be a cheap source of funds, but the

attractiveness of securitisation for this reason depends primarily on the costsattractiveness of securitisation for this reason depends primarily on the costs

associated with alternative funding sources;associated with alternative funding sources;

4.4. To diversify the sources of funding which can be accessed, so that dependence uponTo diversify the sources of funding which can be accessed, so that dependence upon

banking or retail sources of funds is reduced;banking or retail sources of funds is reduced;

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5.5. To reduce credit exposure to particular assets (for instance, if a particular class of To reduce credit exposure to particular assets (for instance, if a particular class of

lending becomes large in relation to the balance sheet as a whole, then securitisationlending becomes large in relation to the balance sheet as a whole, then securitisation

can remove some of the assets from the balance sheet);can remove some of the assets from the balance sheet);

6.6. To match-fund certain classes of asset - mortgage assets are technically 25 year To match-fund certain classes of asset - mortgage assets are technically 25 year

assets, a proportion of which should be funded with long term finance;assets, a proportion of which should be funded with long term finance;

7.7. To achieve a regulatory advantage, since securitisation normally removes certainTo achieve a regulatory advantage, since securitisation normally removes certain

risks, which can cause regulators some concern, there can be a beneficial result inrisks, which can cause regulators some concern, there can be a beneficial result in

terms of the availability of certain forms of finance.terms of the availability of certain forms of finance.

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ADVANTAGES AND THREATS OF SECURITISATION

Advantages

1. To the Issuer

a) Lower cost – If structured properly securitisation can actually reduce the

costs of raising funds.

b) Alternate investor base – for many entities, typical Securitisation investors

such as insurance companies, asset manager, pension funds and the like may

not just be available for access, other than for investment in a Securitisation

program.c) Perfect matching of assets and liabilities – It refers to maturity mismatches

between assets and liabilities. Mismatches spell either higher risk, or higher

costs, and therefore, intermediaries try to achieve perfect match between

maturities of assets and liabilities.

d) Makes the issuer-rating irrelevant – Being an asset based financing,

Securitisation may make it possible even for a low-rated borrower to seek

cheap finance, purely on the basis of the asset quality. Hence the issuer makes

himself irrelevant in a properly structured Securitisation exercise.

e) Helps in capital adequacy requirements – One of the very strong

motivations for Securitisation is that it allows the financial entity to sell off

some of its on-balance-sheet assets, and thus, remove them from the balance

sheet, and hence reduce the amount of capital required for regulatory

purposes.

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f) Improves capital structure – By being able to market an asset outright

Securitisation avoids the need to raise a liability, and hence, it improves the

capital structure. Alternatively if Securitisation proceeds are used to pay off

existing liabilities, the firm achieves a lower debt equity ratio.

g) Not regulated as a loan – Securitisation does not suffer from borrowing

related hassles, as it is not taken by regulation to be a debt.

h) Reduces credit concentration – Concentration, either sectoral, or

geographical, implies risk. Securitisation by transferring on a non-recourse

basis exposure by an entity has the effect of transferring risk to the investor.

i) Avoids interest rate risk – One of the primary motives in Securitisation of

mortgage receivables was to transfer interest rate risk to the investors. The

lenders were subject to risk since the mortgage carried a fixed rate of return

while the loans taken by the lenders had a variable rate. When the mortgages

were securitised, the lender made an instant spread on the basis of a fixed rate

and therefore, completely avoided the price risk.

j) Arbitraging on liquidity and term structure – In Securitisation structures,

particularly related to long-term receivables, is that the originator or the

conduit manager makes profits by arbitraging on the yield differences in the

term structure of interest rates.

k) Improve accounting profits – There is an upfront recognition of profits.

2. To the Investor

a) Better security – The investors have a direct claim over a portfolio of assets,often diversified and reasonably credit enhanced. Investors are not affected

by any of the risks that beset the originator.

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b) Good ratings – With increasing institutionalization of investment function,

investments are being managed by professional managers who prefer a

formally rated instrument to an unrated one. With Securitisation investors get

a avenue where the securities are top rated. Rating resilience is also present as

the chances of the rating getting downgraded are very minimal.

c) Better matching with investment objectives – Investors looking for a safe

high- grade investment can pick up senior most A-type product, while those

looking for a mediocre risk but with higher rate of return can opt for a B-type

option. Similarly, investors can look at investing over a short-term, medium

term or long term. It is even possible for investors to for a fixed rate

investment, floating rate investment or inverse floating rate investment.

d) Few instances of defaults – there is no instance of default so far in almost a

decade of Securitisation issuance.

Threats

a) Costly source – In actual experience, Securitisation has shown to be a costly source,

primarily in emerging markets. Being a new product the investors place a penalty

for their own lack of understanding. Besides, the costs of rating and legal fees also

tend to be huge.

b) Uneconomical for lower requirements – Since there are huge upfront costs in the

form of rating fees and legal costs, including stamp duties where applicable, would

add up to a heavy initial payment, Securitisation in order to be cost effective has to

be limited to large sourcing.

c) Leaves entity with junk assets – One of the common concerns about Securitisationis: if the investors have preference for cherry-picked assets, Securitisation will leave

the originator with junk assets.

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d) Makes profit accounting volatile – The originator accelerates future profits on the

securitised portfolio and puts the same on books upfront. Unless a continued growth

in volume of Securitisation is maintained, this would impact future profitability

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ECONOMIC IMPACT OF SECURITISATION

Securitisation is as necessary to the economy as any organised markets are. While this

single line sums up the economic significance of securitisation, the following can be seen

as the economic merits in securitisation:

♣ Facilitates creation of markets in financial claims:

By creating tradeable securities out of financial claims, securitisation helps to

create markets in claims which would, in its absence, have remained bilateral

deals. In the process, securitisation makes financial markets more efficient,

by reducing transaction costs.

♣ Disperses holding of financial assets:

The basic intent of securitisation is to spread financial assets amidst as many

savers as possible. With this end in view, the security is designed in minimum

size marketable lots as necessary. Hence, it results into dispersion of financial

assets. One should not underrate the significance of this factor just because

most of the recently developed securitisations have been lapped up by

institutional investors. Lay investors need a certain cooling-off period before

they understand a financial innovation. Recent securitisation applications,

viz., mortgages, receivables, etc. are, therefore, yet to become acceptable to

lay investors. But given their attractive features, there is no reason why they

will not.

♣ Promotes savings:

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The availability of financial claims in a marketable form, with proper

assurance as to quality in form of credit ratings, and with double safety-nets

in form of trustees, etc., securitisation makes it possible for the lay investors

to invest in direct financial claims at attractive rates. This has salubrious

effect on savings.

♣ Reduces costs:

As discussed above, securitisation tends to eliminate fund-based

intermediaries, and it leads to specialisation in intermediation functions. This

saves the end-user company from intermediation costs, since the specialised-

intermediary costs are service-related, and generally lower.

♣ Diversifies risks:

Financial intermediation is a case of diffusion of risk because of

accumulation by the intermediary of a portfolio of financial risks.

Securitisation further diffuses such diversified risk to a wide base of

investors, with the result that the risk inherent in financial transactions gets

very widely diffused.

♣ Focuses on use of resources, and not their ownership:

Once an entity securitises its financial claims, it ceases to be the owner of

such resources and becomes merely a trustee or custodian for the several

investors who thereafter acquire such

claim. Imagine the idea of securitisation being carried further, and not only

financial claims but claims in physical assets being securitised, in which case

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the entity needing the use of physical assets acquires such use without

owning

the property. The property is diffused over an investor crowd. In this sense,

securitisation carries Gandhi's idea of a capitalist being a trustee of resources

and not the owner. Securitisation in its logical extension will enable

enterprises to use physical assets even without owning them, and to disperse

the ownership to the real owner thereof: the society.

MAJOR PLAYERS

The major "players" in the Securitisation game, all of whom require legal representation to

some degree, are as follows (this terminology is typical, but different terms are used; for

example the "originator" is often referred to as the "issuer" or "seller"):

♣ Originator Originator - the entity that either generates ‘Receivables’ in the ordinary

course of its business or purchases and assembles portfolios of Receivables

(in that sense, not a true "originator"). Its counsel works closely with counsel

to the Underwriter/Placement Agent and the Rating Agencies in structuring

the transaction and preparing documents and usually gives the most

significant opinions.

♣ Issuer Issuer - the special purpose entity, usually an owner trust (but can be another

form of trust or a corporation, partnership or fund), created pursuant to a

Trust Agreement between the Originator and the Trustee, which issues the

Securities and avoids taxation at the entity level.

♣ TrusteesTrustees - usually a bank or other entity authorized to act in such capacity.

The Trustee, appointed pursuant to a Trust Agreement, holds the Receivables,

receives payments on the Receivables and makes payments to the Security

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holders. Counsel to the Trustee provides the usual opinions on the Trust as an

entity, the capacity of the Trustee, etc.

♣ Investors Investors - the ultimate purchasers of the Securities. Usually banks, insurance

companies, retirement funds and other "qualified investors." In some cases,

the Securities are purchased directly from the Issuer, but more commonly the

Securities are issued to the Originator or Intermediate SPE as payment for the

Receivables and then sold to the Investors, or in the case of an underwriting,

to the Underwriters.

♣ Custodian -Custodian - an entity, usually a bank that actually holds the Receivables asagent and bailee for the Trustee or Trustees. The trustees themselves can act

as custodians.

♣ Rating Agencies Rating Agencies – CRISIL, ICRA, CARE. In Securitisations, the Rating

Agencies frequently are active players that enter the game early and assist in

structuring the transaction. In many instances they require structural changes,

dictate some of the required opinions and mandate changes in servicing

procedures.

♣ Servicer Servicer - the entity that actually deals with the Receivables on a day-to-day

basis, collecting the Receivables and transferring funds to accounts controlled

by the Trustees. In most transactions the Originator acts as Servicer.

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SECURITISATION-HOW IT WORKS

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Securitisation in its basic form consists of the pooling of a group of homogeneous loans,

the sale of these assets to special purpose company or trust, and the issue by that entity of

marketable securities against the pooled assets. The payment of interest and principal on

the securities is directly dependent on the cash flows arising from the underlying pooled

assets. ABS is a process that creates a series of securities which is collateralised by assets

mortgaged against loans, assets leased out, trade receivables, or assets sold on hire

purchase basis or installment contracts on personal property. This process comprises of –

♣♣ Formation of a pool out of homogeneous future cash flow; Formation of a pool out of homogeneous future cash flow;

♣♣ Identification of underlying assets from which the stream of future cash flow are Identification of underlying assets from which the stream of future cash flow are

expected to be derived;expected to be derived;

♣♣ Determination of Loan to Value (LTV), which is a suitable fraction of the remaining Determination of Loan to Value (LTV), which is a suitable fraction of the remaining

principal balance relating to the underlying assets yet to be recovered from the principal balance relating to the underlying assets yet to be recovered from the

customers;customers;

♣♣ Securitisation of LTV and passing thereof to the retail investor in the form a an debt Securitisation of LTV and passing thereof to the retail investor in the form a an debt

instrument;instrument;

♣♣ Collateralisation of such debt instruments by the underlying assets.Collateralisation of such debt instruments by the underlying assets.

Pooling of homogenous assets – To initiate securitisation process a pool of homogenous

assets such as mortgages, lease or hire purchase portfolio are pooled. Homogeneity is

necessary to enable a cost efficient analysis of the credit risk of the pooled asset and to

achieve a common payment pattern For

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example, an NBFC / bank gives assets on lease or sold on hire purchase basis to the retail

or corporate customers. Such lease or hire purchase transactions create a stream of future

cash flows, which are called lease rentals or hire purchase installments. A stream of such

cash flow forms a pool. The NBFC / bank which sells the asset pool is called originator.

The originator sell such pool to an institution called Special Purpose Vehicle (SPV) who in

turn converts the pool into securitised instruments, called Participation Certificates (PCs).

These PCs are collateralised by the leased out / hired out assets, and marketed to the retail

customers. SPV holds the mortgaged instrument or ownership documents relating to the

assets. The servicer to the SPV, who in turn service the retail investors, channelises the

relevant portion of the future cash flow. By selling the future cash flows the originator

NBFC / bank would be able to realise the locked in cash in leased / hire purchase stocks

and pays the matured liability which caused liquidity problem or grow further with the

funds so garnered.

Two Different Routes - It is also possible that originator sells the pool to a financial

intermediary who has the two options –

(i) It may take the asset to its own book, create a new series of security and market it to the

retail investors: the underlying leased or hire purchase stock provides the collateral for

the new series of security,

(ii) It may form a Special Purpose Vehicle (SPV) which in turn can buy the future cash

flows, take the underlying assets to its book, creates a new series of security and market it

to retail customers.

In the first case, the structure should be as follows:

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A company that has lease / hire purchase portfolio (say an NBFC) sells

the pool to an FI. Such assets are then out from the Balance Sheet of the

NBFC.

The FI takes such assets into its book, securities them and place to the

retail investors. Cash flow arising out of the lease/ hire purchase

portfolio is received by the FI and the retail investors are also serviced

by it.

It enjoys the margin that arises out of the finance income that is in

excess over the finance expense payable to the retail investor. For

example, in a securitisation of 500 crore pool, one per cent interest

differential makes 5 crore fee based income for the FI.

In the second case, the FI will form an SPV, which will take over the assets and securities

them. The SPV is created when –

The FI does not want to expose itself to the NBFC because of its

cumulative exposure to the same party is already high;

The FI does not want to take the assets to its Balance Sheet for the

possible adverse impact on its Risk Weighted Asset structure and

capital adequacy.

Recourse Securitisation - Investors are not normally prepared to take on all credit

risks associated with ABS. The simplest form of enhancement would be recourse

arrangement with the originator. The institution engaged in securitisation or the SPV

may enjoy recourse to the seller in case of failure of the customers to cash flow. It

becomes simply a servicer. In case of recourse securitisation the SPV enjoys lesser

margin.

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Generally, the seller becomes the servicer. It may open an escrow account for servicing the

PCs. The servicer collects the cash flow from lessee, hire purchaser or loaner and routes it

to the SPV. The SPV merely passes the funds to the retail investors. In this arrangement,

securitised asset creates Off Balance Sheet Liability to the seller.

Other forms of credit enhancements are: irrevocable letters of credit, third party insurance,

spread account, cash collateral accounts, over – collateralisation, senior – subordinated

structure. An irrevocable letter of credit may be issued by a third party bank to cover a

portion of the assets normally equal to the estimated loss profile. Non – bank insurance

companies in the United Kingdom provide third party insurance against the default risk.

Spread account is a reserve built using interest differential between interest earning from

the pool and pass through interest. This spread is used built reserve instead of passing to

the originator. A cash collateral account is a deposit equal to the necessary credit

enhancement, which is held for the benefit of the retail investors. The account is drawn

down in case loss in the pool. Over collateralisation means the value of underlying assets

in the pool is maintained at a higher level as compared to PCs issued. In a senior –

subordinated structure at least two classes of securities are issued. The senior tranche

enjoys prior claim over cash flow from underlying assets so that default risk is passed to

the junior tranche. Credit enhancement techniques as stated above can also be used in

combination of one another.

Non -Recourse securitisation -The securitisation may be without recourse but the

collateral may be designed to have a bankruptcy remote structure to enjoy all the rights

which the seller would have enjoyed on the leased / hire purchase stock in case of failure

of the customers to pay lease rentals / hire purchase installments. The Banks and FIs who buy securitised Participation Certificates in fact invests in a special type of debt

instruments

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that enjoys liquidity (if proper secondary market exists for securitised instruments) and

also accepts reinvestment risk .

Fund Enhancement - In the developed countries sellers and services are the banks,

financial institutions, Nifco and housing finance companies that has lease portfolio, hire purchase portfolio or loan portfolio from which there will be cash inflow in future. These

financial intermediaries enter into securitisation deal for enhancement of the funds

available for expanding the level of operation or for sorting out the liquidity problem.

Special purpose vehicle is an entity that acquires the future cash flow and place to the retail

investors, the retail investors are mutual funds, insurance companies, pension funds and

corporates, and the intermediaries trust, banks and other financial intermediaries which

have surplus cash for investment in fixed income securities.

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Pass-Through Certificates

Under the mechanism of Pass-Through Certificates, all the cash flows are received by the

originator and passed on directly to the investor through an intermediary known as the

SPV. The assignment may or may not be with recourse. If the assignment contains a ‘with

recourse’ clause, then the originator can be hauled up by the SPV in case of defaults in the

payment of inflows from the underlying assets. In such an eventuality, the originator

regains his rights in the receivables.

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Pay-Through Certificates

Under the mechanism of Pay-Through Certificates, all cash flows received by the

originator, are reinvested by the SPV in gilts or other securities (which bear a fixed rate of

interest). Proceeds from such investments are utilised by the SPV to make payments to the

investors.

Stripped Derivative Structures

Lastly, under the Stripped Derivative Structure, cash flows accruing to an SPV are broken

into two cash streams i.e.: Principal Only (PO) and Interest Only (IO). Stripped derivativesecurities are then issued against such segregated cash flows. The PO holders are paid out

of the sums derived from the principal component, whereas holders of IO securities are

paid out of the interest earnings. These securities are volatile as the value of POs goes up

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in a climate of declining interest rates. On the other hand, where the trend is towards

increasing rates of interest, the value of IOs increases as more interest accrues on the

underlying securities. Holders of the instruments issued by the SPV can be either PO

holder or IO holders. Speculators take a position depending upon their view of interest rate

movements.

TYPES OF SECURITISATION

The securitisation market can be broadly divided into 5 sectors

1. Asset Backed Securities (ABS)

In the case of car loans

2.Mortgage Backed Securities (MBS)

In the case of housing loans

3.Collateralised Bond Obligations (CBO)

In the case of bond receivables

4.Collateralised Loan Obligations (CLO)

In the case of industrial loan receivables

5.Collateralised Debt Obligations (CDO)

Are a combination of CLOs and CBOs

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Of the previous mentioned types of securitisation the ones predominantly used are Asset-

Backed Securitisation and the Mortgage Backed Securitisation.

♣♣ Mortgage Pass-Through SecuritiesMortgage Pass-Through Securities

Mortgage pass-through securities are securities wherein mortgages are pooled together and

undivided interests or participations in the pool are sold. The mortgage backing a pass-

through security is generally of the same loan type in terms of amortization level payment,

adjustable-rate etc. Additionally, they are similar with respect to maturity and loan interest

rate to the extent where the cash flows can be projected as if the pool were a single

mortgage. The originator services the mortgages collecting the payments and “passing

through” the principal and interest to the security holders after deducting the servicing,

guarantee and other fees.

When you invest in a mortgage backed security you are lending money to a home buyer or

business. MBS are a way for smaller regional banks to lend mortgages to their customers

without having to worry if they have the assets to cover the loan. Instead, they act as a

middleman between the home buyer and the investment markets.

♣♣ Commercial Mortgage Backed Securities - CMBS Commercial Mortgage Backed Securities - CMBS

Similar to a Mortgage Backed Security, but secured by loans with commercial property

instead of residential property.

Because they are not standardized there are a lot of details associated CMBS' which makethem difficult to value.

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♣♣ Asset Backed Securities Asset Backed Securities

Asset-backed securities are securities backed by financial assets. These assets generally

are receivables other than mortgage loans and may consist of credit card receivables, auto

loans, manufactured-housing contracts, junk bonds, equipment leases, small business loans

guaranteed by some agency home-equity loans etc. They differ from the other kind of

securities offered in that their credit worthiness (generally AAA) derives from sources

other than the paying ability of the originator of the underlying assets. They essentially are

secured by collateral and credit enhanced by internal structural features or external

protections

RULES AND REGULATIONS

Securitisation Act

Until recently there was no specific law that governed securitisation transactions. In 1999

the Reserve Bank of India formed a working group to study the issues relating to the

securitisation of assets. The working group highlighted some of the critical problems and

had made a number of recommendations for changes to existing laws to accommodate

securitisation transactions, including amendments to the Transfer of Property Act and the

various pieces of stamp legislation. The Narasimham Committee I and II hadrecommended in the past the creation of asset reconstruction companies and the

Andhyarujina Committee Report had recommended the enactment of a specific law

regulating securitisation.

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On June 21, 2002 the President of India promulgated the Securitisation and Reconstruction

of Financial Assets and Enforcement of Security Ordinance 2002 (“Ordinance”). The

Ordinance deals with three distinct concepts, namely (i) the securitisation of financial

assets, (ii) the reconstruction of financial assets of banks and financial institutions and (iii)

the perfection and enforcement of security interests by banks and financial institutions. In

the interest of time, rather than passing separate legislations governing securitisation

transactions1, the government bundled the provisions of the above-mentioned bills and

enacted a combined new legislation in form of the Ordinance.

Unlike the earlier securitisation bill [which vested power with the Securities and Exchange

Board of India to regulate entities acting as Special Purpose Vehicle (“SPV”) in

securitisation transactions, as well as related matters], the Reserve Bank of India has been

empowered to license and regulate securitisation companies and asset reconstruction

companies. However, the Ordinance does not preclude the applicability of other laws,

including the rules and regulations enacted by the capital markets regulator (i.e. Securities

and Exchange Board of India). The Ordinance defines a securitisation company and anasset reconstruction company, and requires registration with the Reserve Bank of India as a

precondition for the creation of a securitisation company or an asset reconstruction

company. The Ordinance prescribes the application of prudential norms to securitisation

companies in the form of minimum capital requirement. The Ordinance enables banks and

financial institutions with non-performing assets to unload the receivables due from

borrowers in favour of specialists in recovery (i.e. asset reconstruction companies). It also

enables secured creditors (including securitisation companies and asset reconstruction

companies) to sell the assets of defaulting borrowers without the sanction of courts and

enables banks and financial institutions to assume the management of defaulting borrowers

by displacing the management.

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Typically, the SPV is a thinly capitalized vehicle for holding assets in trust for investors.

As there is sufficient credit enhancements already built in by sponsors, there is no need to

capitalize the SPV. Thus, the owned-fund requirement is an additional burden on the

securitisation company. It is also envisaged that the Reserve Bank of India will prescribe

rules, amongst other things, for making provisions for bad and doubtful debts. Under the

Ordinance, the sponsors of a securitisation company or an asset reconstruction company

may not hold a controlling interest in the securitisation company and therefore, the

securitisation companies have an onerous obligation to broaden the shareholding of the

securitisation company. Because most of the funds in a SPV are raised in the form of pass-

through or debt securities issued to investors, such a broadening of the shareholding base

would be difficult to achieve.

The Ordinance has a non-obstante deeming clause, which mandates dispute resolution by

way of arbitration. At the same time, the Ordinance states that the provisions of the

Ordinance are not in derogation to other laws, including the Recovery of Debts due to

Banks and Financial Institutions Act. Under this legislation, in all cases where there is a

debt to banks and financial institutions, the case must be specifically referred to the debt

recovery tribunal. This seeming conflict creates confusion as to whether disputes should be

referred to arbitration or whether they should be filed with the debt recovery tribunal.

Although the Ordinance comes as a boon for banks and financial institutions saddled with

non-performing assets, it creates roadblocks for securitisation transaction by modifying the

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concepts of a traditional securitisation transaction. It is also not clear whether the

government intends this Ordinance to regulate only securitisation and reconstruction

transactions to be carried out by banks and financial institution, or whether there will be a

separate legislation governing securitisation transaction conducted by companies other

than banks and financial institutions.

However, the Ordinance left many questions and ambiguities under Indian law

unanswered. The definition of "true sale" under Indian law continues to be unclear. There

is a lack of legal case history to provide guidance as to how the courts would view

securitisation transaction in the event of the bankruptcy of the originator.

In addition to the Ordinance, the following statutes are applicable to a typical securitisation

transaction in India.

- The principles of winding up and liquidation of the originating entity are regulated by the

Companies Act 1956 (“Companies Act”). If the SPV is structured as a company, the

incorporation and the management of the corporate entity is governed by this law.

If the SPV is structured as a company under the Companies Act, it may fall under the

definition of a non-banking financial company requiring registration under Sec. 45-IA of

the Reserve Bank of India Act. However, under the existing regulatory framework, only

companies holding or accepting public deposits are subject to prudential norms and are

also required to comply with the statutory liquidity ratio requirements (which are

determined as a percentage of their public deposits).

- The relation between an investor and the SPV is governed by the Indian Trust Act 1882.

This law regulates the manner in which a trust is created and sets out the rights, duties and

liabilities of a trustee.

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- The transfer of interests in immovable property and the transfer of actionable claims

(chose in action) are governed by the Transfer of Property Act 1882. This law defines what

amounts to an actionable claim, covers claims to lease rentals, hire-purchase receivables

and credit card receivables and sets out the procedure for the transfer of actionable claims.

It requires that the transfer of an actionable claim be effected only by the execution of an

instrument in writing and signed by the transferor, and provides that such a transfer is

effective upon the execution of such instrument whether or not a notice to the debtor is

given. Under the law, unless a contrary interest is expressed, a transfer of a loan secured by

a mortgage on immovable property would transfer the mortgage interest as well. Finally,the property being transferred must exist in the present and therefore the transfer of future

receivables is not allowed.

- Stamp legislation (which includes the central stamp act and stamp legislation enacted by

various states) levies stamp duty on instruments of transfer, including deeds of assignment

and any other agreement or document underlying a securitisation transaction. Stamp laws

were devised during the colonial era and were originally designed for individualtransactions. The negative impact of high stamp duties on transactions such as asset

securitisations could not have been foreseen at the time the laws were enacted. The

margins in securitisation transaction are so thin that a high stamp duty can only frustrate

attempts at securitisation.

- Under the Indian Registration Act, any transfer of interest in immovable property

requires the registration of instruments with the appropriate government agency.

- The foreign exchange regulations enshrined in the Foreign Exchange Management Act

1999 and the rules and regulations enacted thereunder restrict full capital account

convertibility. The strict foreign exchange regulation acts as a hindrance to cross-border

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securitisation transactions, as prior governmental approval is required for a non-resident

person to invest in the securities issued by an SPV. The current exchange controls and

other regulatory provisions do not facilitate cross-border securitisation transactions in

which the originator may be located in India and the SPV and the investors are located in

another jurisdiction.

SECURITISATION- A RISK MANAGEMENT TOOL

Securitisation 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

securitised 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.

In today's banking, securitisation is increasingly being resorted to by banks, along with

other innovations such as credit derivatives to manage credit risks.

Securitisation and credit derivatives:

Credit derivatives are only a logical extension of the concept of securitisation. A credit

derivative is a non-fund based contract when one person agreed to undertake, for a fee, the

risk inherent in a credit without acting taking over the credit. The risk could be undertaken

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either by guaranteeing against a default, or by guaranteeing the total expected return from

the credit transaction. While the former could be just another form of traditional

guarantees, the latter is the true concept of credit derivatives. Thus, if B bank has a

concentration in say Iron and Steel segment while A bank has concentration in Textiles,

the two can diversify their risks, without actually taking financial exposure, by engaging in

credit derivatives. A can agree to guarantee the returns of B from a part of its Iron and

Steel exposures, and B can guarantee the returns of A from Textiles (derivatives do not

necessarily have to be reciprocal). Thus, A is now earning both from its own exposure in

Iron and Steel, as also from the fee-based exposure it has taken in Textiles.

Credit derivatives were logically the next step in development of securitisation.

Securitisation development was premised on credit being converted into a commodity. In

the process, the risk inherent in credits was being professionally measured and rated. In the

second step, one would argue that if the risk can be measured and traded as a commodity

with the underlying financing involved, why can't the financing and the credit be stripped

as two different products?

The development of credit derivatives has not reduced the role for securitisation: it has

only increased the potential for securitisation. Credit derivatives is only a tool for risk

management: securitisation is both a tool for risk management as also treasury

management. Entities that want to go for securitisation can easily use credit derivatives as

a credit enhancement device, that is, secure total returns from the portfolio by buying a

derivative, and then securitise the portfolio.

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CASE STUDY

NHB - HDFC RMBS Issue NHB - HDFC RMBS Issue

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Issue Structure Issue Structure

Class A PTC of the loan originated from HDFC in the state of Gujarat, Maharashtra,

Karnataka and Tamilnadu amounting to Rs. 59.7 Crores.

Tenure of the Class A PTCs is 83 months.

Interest Rate to be determined through Book Building route (11.35% to 11.85%).

Listing in the Wholesale Debt Market of NSE.

Rating "AAA (so)" by CRISIL.

Interest on Application Money - 10%.

Deemed date of Allotment - 1st September 2000.

Interest and Principal Payment Dates - 1st Business working day of the every

month.

Salient Features of the Issue Salient Features of the Issue

Isolation of the assets from the Originator by forming a SPV by NHB.

"Legal True Sale" of assets to an SPV.

"Bankruptcy Remoteness" from the Originator.

Issuance of securities collateralized by the underlying assets by the SPV to

investors.

Reliance by the Investors of the performance of the assets for the repayment - rather

than the credit of the Originator (HDFC) or the issuer (the SPV).

NHB will act as sole Trustee and will hold and administer the receivables as Trust

property for the benefit of the PTC holders.

HDFC will act as Servicing and Paying Agent (S&P Agent).

Credit Rating by CRISIL as "AAA (so)".

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PTC to be listed on 'WDM" at NSE.

PTC issued in the state of Karnataka.

Hierarchy of Payments Hierarchy of Payments

Class A principal.

Fees to Service Providers - Trustee, Servicing and Paying Agent, Rating Agency,

legal and other out-of-pocket expenses, if any, in the said Order.

Class A interest.

Fees to HDFC towards 'Corporate Guarantee' provided as a Credit Enhancement.

Class B principal (only after retiring Class A PTCs).

Class B income.

Pool Selection Criteria Pool Selection Criteria

The loans were current at the time of selection.

The loans have a minimum seasoning of 12 months.

The pool consists of Mortgage loans in the state of Gujarat, Maharashtra,

Tamilnadu and Karnataka.

All the borrowers in the pool are individual.

Maximum LTV ratio is 80%.

EMI to Gross Income ratio is less than 40%.

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EMIs should not be outstanding for more than one month.

Loan size is in the range of Rs. 18,000 to Rs. 10 Lakhs.

Borrowers in the pool have one loan contract with the HFC.

The HFC has not taken any refinance with respect to these loans.

Loans are free from any encumbrances/charge on the date of selection.

Credit EnhancementsCredit Enhancements

Subordinated Class B PTC payouts

Corporate Guarantee Structure of HDFC

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CONCLUSION

The study of Securitization is of relevance because of the opportunities it offers as a source

of financing to a developing country like India. It is particularly useful for Banks and in the

financing of fund starved infrastructure projects.

For years, big has been beautiful in the Indian financial sector. Bankers loved to introduce

themselves as a bank with an asset base of millions of rupees.

Now all of a sudden leading banks are offloading loans worth thousands of crores in the

secondary market through the securitisation route.

The traditional drivers of securitisation have seen the desire of the issuer to get low-cost

funds, through new sources, in an off-balance sheet manner.

These are still the key drivers. What has helped improve investor perception in respect of

securitisation is ICICI’s mega securitisation in the year 2001. With a dearth of triple `A’

paper in the market ICICI was able to successfully offload loan assets worth Rs 7,000

crore.

This was followed by a Rs 2,300 crore securitisation of the merged ICICI Bank’s loan

portfolio in the first quarter of fiscal ’02-03.

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All this has inspired other institutions to go in for securitisation. Officials in SBI Capital

Markets confirm the trend stating that volumes of securitised issues arranged by them this

year have been almost double that last year.

Another pioneer in securitisation, Citibank, has concluded several deals, which includes asecuritisation of the bank’s personal loan portfolio. Besides, housing

finance major HDFC which secutitised a pool of around Rs 356 crore loan assets in the

first quarter of ’07-08, CANFIN Homes, the housing finance arm of Canara Bank, has

securitised one more pool of housing loans receivables and has already raised Rs 156

crore.

Kotak Mahindra Finance has securitised commercial vehicle loans worth Rs 76 crore.

Investor interest too is much better. While trying to sell the NHB’s mortgaged backed

securities issue, it took three weeks to convince the investors. But this time around, the

issue was sold in three days.

And going by the ratings trends of securitised paper by the four rating agencies in the

country could well be an indicator of shape of things to come in the market.

Crisil, for instance, has rated 54 transactions valued at Rs 1363 crore during April-June

’07-08 as compared to only two transactions worth Rs 52.7 crore in April-June ’01-02.

While Fitch Ratings has already rated one issue and working on other mandates. Care, on

the other hand, still has not come out with any ratings, though it is working on a few

mandates. Ratings major Icra too has rated volumes, much higher than last year’s levels.

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A big boost for securitisation has been the introduction of the `Securitisation and

Reconstruction of Financial Assets And Enforcement of Security Interest

Ordinance 2002’ that was promulgated, has given more acceptability to this product.

Besides, securitisation is also seen as a good balance sheet management strategy. For the

issuers, once an asset is securitised, it goes off the balance sheet and they can choose the

pool of assets for securitisation, which could best suit their asset liability management

needs and churn out resources.

Also, the recent boom in the retail loans too has added an impetus to securitisation as theseare generally considered good quality assets and offer good scope for selling to other

investors and generate more resources.

From the investor perspective, investing in securitised paper helps the investor’s asset base

than it would have happened in the normal course, as the decision is based on the credit

rating the paper enjoys and the issuer.

Securitisation allows the financial intermediary to sell its right to receive the future

payments from the borrowers to a third party and receive consideration for the same

upfront, the proceeds of which may further be redeployed in business.

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But an interesting trend that one notices in the recent securitisation deals concluded these

days is the variety in terms of the pool of assets selected and structures that issuers are

coming out with. Probably, for the first time, Citibank securitised Rs 284.1crore personal

loan portfolio — which is a clear break away from the auto-loan dominated pool of assets

in its most deals earlier.

It has also launched an on-tap securitisation programme called Citi SPOT which is targeted

at companies that undertake multiple securitisation issuances in a year.

Citi SPOT is a master set of terms and conditions under which companies can undertake a

series of securitisation issuances over a period of one year, up to a pre-determined limit.

ICICI has tried with a novel `securitised notes’ structure instead of the traditional PTC.

Though securitised notes are more or less similar to PTCs from the issuers’ perspective, it

gives flexibility to structure the underlying cash flows to meet the investor needs.

And in case of KMFL’s issue, the SPV issued three series of pass through certificates

(PTCs) to investors. Each of the PTCs had a different structure, in terms of tenor and

coupon rate. These give more flexibility to suit a variety of investor preferences, and in

some ways it ends up being tailor made for the investor.

But all is not hunky dory for securitisation. Though it is still very difficult to estimate the

size of the market in India, it comes nowhere close to the more developed markets in theUS. And here too problems remain.

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For any debt instrument to take off, the secondary market for debt is still not very

developed. Secondary market, which offers an easy exit route to investors, is almost non-

existent.

Though the securitisation ordinance has given some shape to these products, a number of grey areas still remain. A lot of clarification is still sought on a number of issues and the

RBI is working on them say the issuers.

For instance, it is still not clear as to which of the authorities the originator of the deal has

to notify himself. Besides, there is also no clarity as to whether the currently followed

processes of securitisation is sufficient or not.

Moreover, the investor base is still confined to Mutual Funds, a few private banks and

foreign banks. Bigger potential lies mainly in the public sector banks who are sitting on a

much more huge pool of funds.

They are still not looking at this product seriously. But there is a perceptible change in

their response to these products attitude. It is a question of mind-sets that need to be

changed.

Besides, Trusts and the PFs — other major source of huge funds — have limits on

investments in structured products. Efforts should be on to get them invest in these paper

as well. A number of regulatory changes in this sector could help release more funds for investment in securitised paper, it is felt.

After all these papers are much more stable and offer a higher yield than a plain vanilla

product and that definitely adds value to one’s investment portfolio.

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Since the late eighties, when securitisation made its beginning in India, the number as well

as the size of transactions has grown over the years. This trend is likely to continue and the

market would witness considerable growth in the coming years. The main motivating

factor in securitisation transactions in the past has been the management of capital

adequacy. While this would continue to be the demand driver, securitisation is likely to be

increasingly used for better asset liability management, exposure management, upfront

profit booking, etc.

Bibliography Bibliography

1) Bibliography Securitisation – The Financial Instrument of the New Millennium.

Vinod Kothari

References

Articles in

- The Economic Times

- The Financial Express

- The Business Standard

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Crisil Report on Securitisation

Structured Obligation

- Indian MBS Market: On a growth trajectory

- The Indian Auto Loan Securitisation Market: Geared for Growth

Webliography Webliography

www.nishithdesai.com

www.vinodkothari.com

www.indiainfoline.com

www.crisil.com

www.finweb.com

www.globalsecuritisation.com

www.teenanalyst.com/glossary/a/abs.html

www.asset-backed.com

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www.wapedia.mobi/en/Securitization

www.finpipe.com/assback.htm

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Securitization-the financial instrument of the new era”