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  1. 1. SECURITIZATION INTRODUCTION OF SECURITIZATION A lot has been written and spoken about securitization in recent times. Indeed, one has been hearing about it in India since the early 1990s, but with increasing regularity in recent times. This concept note is intended to place the concept of securitization in the right perspective, and importantly, set aside some myths and misconceptions associated with it. The ‘deals’ that have been talked about are Citibank’s sale of its car loan portfolio, among others. With only this much information provided on this deal, it may be concluded that such transactions are only in the nature of refinancing arrangements, since no new marketable securitization, in our meaning, is explained in the following paragraph. Consider the case of a limited company and its financing advantages over a partnership firm. A partnership firm is based on relationships, which cumbersome to handle, and whose changes in composition could affect the firm’s liquidity. In the case of limited company, share is issued to each ‘partner’ and the company’s capital structure does not change with a change in the composition of its ‘partner’. Shareholder come and goes as they please. This is because the shareholder’s stake is concurrent with their holdings of share certificates, which are transferable pieces of paper, called securities. Securitization therefore is the process of converting relationship into transactions. The trend of debentures and bonds replacing illiquid loans by a bank is also a step in the direction of converting relationship into transactions. 1
  2. 2. SECURITIZATION Securitization is an innovation of the home loan financing segment of banking, called residential mortgage financiers. These organizations typically lend over a 20-year period, and need to raise finance of sufficiently long tenors. A major asset they hold are the receivables in respect of loans already granted. Thus, these receivables are sold in order to garner receivable for a whole new round of fresh loans. Therefore, the advantages of securitization are in the forms of. 1) making illiquid receivable liquid 2) getting loans of long tenors, thereby withstanding the shocks that could come from short term funding (asset-liability management or ALM) and 3) Lock on to a long-term, low-cost source of finance, enhancing their credit planning efforts. Apart from the stated advantages, securitization also in enhancing the Capital Reserve Adequacy Ratio (CRAR) and reduces the overall cost of capital due to transfer of risk off its balance sheet, as explained later. Thus, securitization involves financial engineering with several associated credit derivatives. 2
  3. 3. SECURITIZATION HISTORY OF SECURITIZATION Securitization may be said to have originated in Denmark. Loans were granted when bonds of an equal amount and tenor were sold. This is form of asset-liability matching, resource management, and even the interest margins are protected. Therefore seems to be sound policy. In Prussia, bonds backed by mortgage loan were issued by some banks, the instrument, and a bond symbolizing the underlying cash flows called pfandbrief. Interestingly, over its 200 years history, no pfandbriefs has ever been defaulted upon. However, standardization and liquidity seem to pose a problem, otherwise tradability of such instrument will be only in restricted markets. Securitization in its modern form really took off in Chicago. Chicago is also a home to many seminal developments in finance. Mortgage bankers would deploy their initial capital in creating mortgages. Fresh borrowers would have to turn away. Chicago mortgages banker struck upon the idea of selling the loan portfolios to larger mortgages banker. The largest mortgage bankers carved of the stream of underlying receivables into tradable denominations as in equity and bonds in order to attract investors and facilitate trading in these bonds. Other innovation followed. First, the interest and principle portions were separately traded. These are called STRIPS, the acronym for Separately Traded Interest Only (IO) and principal only (PO) Segments. Other innovation included the splitting up of the bonds to sort investors having an appetite for varied lengths of time. The details are explained elsewhere in this paper. To sum up, the underlying receivables were carved in a process known as slicing and dicing, analogous to the beef cuts that were sold as a marketable commodity, as opposed to trading in the 3
  4. 4. SECURITIZATION whole animal itself. Securitization instruments shorn of such innovations are known as plain vanilla securitization instruments. The concept of securitization is rapidly spreading in several countries in various stages of development. From the Danish origins and the pfandbriefs, securitization has spread and evolved in the US. Policy makers in several developing countries are keen that securitization takes off, since these are capital deficit countries. Securitization in these markets will strengthen lending agencies and improve their linkages with the capita markets. SECURITIZATION TRANSACTION PROCESS The successful execution of a securitization depends on the investor’s uncontested right to securitized cash flows. Hence, securitized loan need to be separated from the originator of the loan. In order to achieve this separation, a securitization is structured as a three-step frame work: 1. A pool of loan is sold to an intermediary by the originator of the loans. This intermediary (called a special purpose vehicle or SPV) is usually incorporated as trust. The SPV is an entity formed for the specific purpose of transferring the securitized loans out of the originator’s balance sheet, and does not carry out any other business. 2. The SPV issues securities, backed by the loan, and by the payment streams associated with these loans. These securities are purchase by investors. The proceeds from the sale of the securitized are paid to the originator as a purchase consideration for the loan receivables. 4
  5. 5. SECURITIZATION 3. The cash flows generated by the loans over a period of time are used to repay investors. There could also be some credit support built into the transaction to protest investors against possible losses in the pool. However, the investors will typically have no recourse to the originator. Diagrammatic representation of a securitization transaction Borrowers Credit Support (Given by the originator or third party) SPV (Trust managed by the trust) Investors Originator (Owner of the assets) Collection account (Operated by the trusty) Installment Payment Payment from borrower deposit from originator Transfer/sells loans Issues PTC Consideration Payment made to investors Loans (Assets) Consideration 5
  6. 6. SECURITIZATION PARTIES INVOLVED IN SECURITIZATION TRANSACTION • Originator: The originator is the original lender and the seller of the receivables. Typically, the originator is a Bank, a Non Banking Finance Company (NBFC), or a Housing Finance Company (HFC). Some of the larger originator in India includes ICICI Bank, HDFC Bank and Citigroup. • Seller: The seller pools the assets in order to securitize them. Usually, the originator and the seller are the same but in some cases originator sell their loans to the other companies that securities them. • Obligors/borrowers: The borrower is the counter party to whom the originator makes the loan. The payments made by borrowers are the sources of cash flows used for making investor payments. • Issuer: The issuer in a securitization deal is the special purpose vehicle (SPV) which is typical set up as a trust. The trust issues securities which investors subscribe to. • Investors: Investors are the purchase of the securities. Banks, Financial Institution, NBFC and Mutual Fund are the main investors in securitized paper. • Service: The service collects the periodic installments due from individual borrowers in the pool, make s payouts to investors, and follows up on delinquent accounts. The service also furnishes periodic information to the rating agency and the trustee on pool performance. There is a service fee payable to the service. In most cases, the originator acts as the service. 6
  7. 7. SECURITIZATION • Trustee: Trustees are normally reputed Banks, Financial Institutions or independent trust companies set up for the purpose of settling trusts. Trustees oversee the performance of the transaction till maturity and are vested with necessary powers to protest investor’s interests. • Arrangers: These are Investment banks responsible for structuring the securities to be issued, and liasoning with other parties such as investors, credit enhancers and rating agencies to successfully execute the securitization transaction. • Rating agencies: Independent rating agencies analyze the risks associated with a securitization transaction and assign a credit rating to the instrument issued. VARIOUS STAGES INVOLVED IN WORKING OF SECURITIZATION • Identification Process: The lending financial institution either a bank or any other institution for that matter which decides to go in for securitization of its assets is called the ‘originator’. The originator might have got assets comprising of a variety of receivables like commercial mortgages, lease receivables, hire purchase receivables etc. The originator has to pick up a pool of assets of homogeneous nature, considering the maturities, interest rates involved frequency of repayments and marketability. This process of selecting a pool of loans and receivable from the asset portfolios for securitization is called ‘identification processes. • Transfer Process: After the identification process is over the selected pool of assets are then ‘passed through’ to another institution which is ready to help the 7
  8. 8. SECURITIZATION originator to convert those pools of assets onto securities. This institution is called special purpose vehicle (SPV) or the trust. The pass through transaction between the originator and the SPV is either by way of outright sale basis. This process of passing through the selected pool of assets by the originator to a SPV is called transfer process and once this transfer process is over the assets are removed from the balance sheet of the originator. • Issue Process: After this process is over the SPV takes up the onerous task of converting these assets to various type of different maturities. On this basis SPV will issue securities to investors. The SPV actually splits the packages into individual securities of smaller values and they are sold to the investing public. The SPV gets itself reimbursed out of the sale proceeds. The securities issued by the SPV are called by different names like ‘Pay through Certificates’, ‘Pass through Certificates’. Interest only Certificate, Principal only Certificate. The securities are structured in such a way that the maturity of these securities may synchronies with the maturity of the securitized loans or receivables. • Redemption Process: The redemption and payments of interest on these securities are facilitated by the collections by the SPV from the securitized assets. The task of collection of dues is generally entrusted to the originator or a special service agent can be appointed for this purpose. This agency paid certain commission for the collection service rendered. The servicing agent is responsible for collecting the principal and interest payments on assets pooled when due and he must pay a special attention to delinquent accounts. Usually the originator is appointed as the service. Thus under securitization the role of the originator gets reduced to that of the collection agent on behalf of SPV in case he is appointed as a collection agent. A pass through certificate may be either ‘with recourse’ to the 8
  9. 9. SECURITIZATION originator or ‘without recourse’. The usual practice is to make it ‘without recourse’. Hence the holder of a pass through certificate has to look the SPV for payment of the principal and interest on the certificate held by him. Thus the main task of the SPV is to structure the deal raise proceeds by issuing pass through certificates and arrange for payment of interest and principal to the investors. • Credit Rating Process: The passed through certificate have to be publicly issued, they required credit rating by a good credit rating agency so that they become more attractive and easily acceptable. Hence these certificates are rated at least by one credit rating agency eve of the securitization. The issues could also be guaranteed by external guarantor institutions like merchant bankers which would enhance the credit worthiness of the certificates and would be readily acceptable to investors. Of course this rating guarantee provides to the investor with regard to the timely payment of principal and interest by the SPV. VARIOUS CATEGORIES OF SECURITIZATION INSTRUMENT: Asset Backed Securities (ABS) are instruments backed by receivable from financial assets like vehicle loans, credit cards, personal loans and other consumer loan but excluding receivables from housing loans. Mortgage Backed Securities (MBS) are the instruments backed by receivables from housing loans. Collateralised Debt obligation (CDO) is instruments backed by various types of debt including corporate loans or bonds. 9
  10. 10. SECURITIZATION Different types of securities: 1. Pass through and pay through certificates: In case of pass through certificates payments to investors depend upon the cash flow from the assets backing such certificates. In other words as and when cash (principal and interest) is received from the original borrower by the SPV it is passed on to the holders of certificates at regular intervals and the entire principal is returned with the retirement of the assets packed in the pool. Thus, pass through have a single maturity structure and the tenure of these certificates is matched with the life of the securitized assets. On the other hand pay through certificates has a multiple maturity structure depending upon the maturity pattern of underlying assets. Thus, two or three different types of securities with different maturity patterns like short term, medium term and long term can be issued. The greatest advantage is that they can be issued depending upon the investor’s demand for varying maturity pattern. This type of is more attractive from the investor’s point of view because the yield is often inbuilt in the price of the securities themselves i.e. they are offer at a discount to face value as in the casa of deep-discount bonds 2. .Preferred stock certificate: Preferred stocks are instruments issued by a subsidiary company against the trade debts and consumer receivables of its parent company. In other words subsidiary companies buy the trade debts and receivables of parent companies to enjoy liquidity. Thus trade debts can also 10
  11. 11. SECURITIZATION be securitized through the issue of preferred stocks. Generally these stocks are backed by guarantees given by highly rated merchant banks and hence they are also attractive from the investor’s point of view. These instruments are mostly short term in nature. 3. Asset-based commercial papers: This type of structure is mostly prevalent in mortgage backed securities. Under this the SPV purchases portfolio of mortgages from different sources (various lending institution) and they are combined into a single group on the basis of interest rate, maturity dates and underlying collaterals. They are then transferred to a Trust which in turn issued mortgage backed certificate to the investors. These certificates are issued against the combined principal value of the mortgages and they are also short term instrument. Each certificate is entitled to participate in the cash flow from underlying mortgages to his investments in the certificates. Other type Apart from the above there is also other type of certificate namely i. Interest only certificates ii. Principal only certificate. In the case of interest holding certificate payments are made to investors only from the interest incomes earned from the assets securitized. As the very name suggest payment are made to the investors only from the repayment of principal by the original borrower. In the case of principal only certificates 11
  12. 12. SECURITIZATION these certificate enables speculative dealings since the speculators know well that the interest rate movements would affect the bond value immediately. For instance the principal only certificate would increase the value when interest rate go down and because of these it becomes advantageous to repay the existing debts and resort to fresh borrowing at lower cost. This early redemption of securities would benefit the investors to a greater extent. Similarly when the interest rate goes up, interest holding certificate holders stand to gain since more interest is available from the underlying assets. One cannot exactly predict the future movements of interest and hence these certificates give much scope for speculators to play the game. Need of Special Purpose Vehicle (SPV) in securitization: The investor’s return in securitization transaction should depend purely on the securitized cash flows and should be insulated from the financial risks associated with the originator. Hence, it is necessary to have legal separation of these assets from the estate of the originator. This is achieved by means of sale of the assets to SPV. The SPV is set up solely for the purpose of the securitization transaction and does not engage in any other business activity. The SPV does not borrow or lend any money and hence cannot go bankrupt. Most SPV follow a set of pre-determined activities clearly identified by the securitization documents. Without the flexibility of taking any management decision. This mode of structuring the transaction ensures that securitized assets become bankruptcy remote from the originator. 12
  13. 13. SECURITIZATION Securitized instruments v/s Debentures v/s factoring An investor in a debenture issued by a bank or a loan originator will be on official liquidator’s list in the event of its winding up. However, a PTC holder has access to the obligor’s asset, and is hence saved from winding up. Liquidation or bankruptcy proceedings. PTC therefore, is understood to be bankruptcy-remote. Secondly, credit perception of PTC is based on the strength of the obligor and not the balance sheet of the originator. This is the feature that enhances the credit rating of the PTC, which is not the case in Debentures, which is based on the originator’s own balance sheet. For the above reasons, coupon rates on securitized instruments are lower than coupon rates on plain vanilla bonds. Thirdly, securitization can result in the return of a fraction of principal loan along with interest, as part of each installment. In the case of debentures and other bonds, the initial stream of payments is in respect of interest only, with entire repayment in bullet form on a specified maturity date. At period intervals, say monthly installments, every rupee of the installment amount is adjusted against a fraction of principal and balance against interest. There have also been interesting comparisons between securitization and factoring services. The similarities are in the refinancing aspect, as both the processes result in exchange of receivables for cash inflows. There are however, significant differences. 13
  14. 14. SECURITIZATION Factoring is predominantly a service, collection mechanism. With financing (in the case of advance factoring). Securitization is essentially a financing mechanism, with several other powerful financial engineering implications. Additionally, in factoring, no marketable financial instrument comes into existence. To sum up, it may be stated that an organization engaged in advance factoring may resort to securitization as a source of finance! Securitization different from traditional debt instruments: Securitized instrument have some distinct features which distinguish them from traditional debt: • Isolation of pool of assets: In the securitization the securitized assets are separated from the original lender through a sale to a separated legal entity called as a Special Purpose Vehicle (SPV) which acts as an intermediary. • Claims against a pool of assets: Traditional debt instrument represent claim against the company that issue the debt. Investors rely entirely on the borrower company’s credit quality for repayment of their debt. In securitization transaction, investor payout is made from collection of securitized assets and the instruments are thus claims on the assets securitized. Investor does not typically recourse to the originator. • Credit enhancement: Credit enhancement is an additional source of funds that can be used if collections on the assets are insufficient to pay investors 14
  15. 15. SECURITIZATION their dues in full. Credit enhancement thus support the credit quality of the securitized instrument and enable it to achieve a higher credit rating than the pool of assets on its own, in many cases the rating would also be higher than that of the originator. This is not possible in conventional debt. • Payment Mechanisms: securitized instrument typically incorporate structural features to ensure that scheduled payment reach investor in a timely manner. • Operational and administrative requirements: as the SPV is the only shell entity the administration of the pools of securitized loans involves multiple parties performing various functions. These functions include collection, accounting, and loan servicing, legal compliances etc which need to be performed through out the life of transaction. Economic benefit of securitization: Securitization creates tangible economic benefits. These benefits are more visible in US and other developed countries where securitization markets have matured over the past two decades. Market Efficiency: Through securitization process the companies holding financial assets like loans have ready access to low cost sources of fund and can reduce their dependence on financial intermediaries for their capital requirement. This translates into lower interest cost the benefits of which are also passed to the end consumers. 15
  16. 16. SECURITIZATION Specialisation: The classic bank/financial institution model of Origination- Funding-Credit administration of loans has led to an unbundling of roles and greater specialization as various player can now concentrate on their core function, be it origination, funding or credit administration. Streamlined system and process: Securitization demand high levels of data transparency and requires robust system. This enhances the overall monitoring and control of asset portfolios. Why securitize? An originator’s perspective. • Efficient Financing: In securitization it is possible to achieve much higher target rating for instrument than the originator’s credit raring by providing credit rating enhancements for the transaction. Thus the borrower can obtain fund at lower interest rates applicable to highly rated instrument and gain a pricing advantage. • Off balance sheet funding: For accounting purposes securitization is treated as a sale of assets and not as financing. Therefore the originator does not record the transaction as a liability on its balance sheet. Such off balance sheet raise funds without increasing the originator’s or debt equity ratio. 16
  17. 17. SECURITIZATION • Lower capital requirement: Securitization enables banks and financial institutions to meet regulatory capital adequacy norms by transferring assets and their associated risks off the balance sheet. The capital support the assets is released and the proceeds from securitization can be used for further growth and investment. • Liquidity management: Tenor mismatch due to long term assets funded by short term liabilities can be rectified by securitization as long term assets are converted into cash. Thus securitization is a tool of asset liability management. • Improvement in financial ratios: Since securitization help in undertaking larger transaction volumes with the same capital profitability and return on investment ratios increase post securitization. • Profit on sale: Securitization helps in up-fronting profits. This would otherwise accrue over the tenor of the loans. Profits arise from the spread is booked as profit leading to increased earnings in the year of securitization. Why invest? An investor’s perspective. Securitization instrument offer investors an attractive investment proposition since they combine above average yields with a strong credit performance. Potential investors in this instrument in India should consider the following factors: • Size of investment opportunity: The securitization market in India is growing leap and bound. In the financial year 2004-05, securitization 17
  18. 18. SECURITIZATION volumes are expected to reach Rs 250billion with 15% of retail loans (excluding MBS) currently funded through securitization. • Safety Features: Securitization offers investors a diversification of risks, since the exposure is to a pool of assets. Most issuances are highly rated by independent credit rating agency and have credit support built into the transactions. Investors get the benefit of the payment structure closely monitored by an independent trustee which may not always be in the case of traditional debt instruments. • Performance track record: Securitization instruments have demonstrated consistently good performance with no downgrades or defaults on any instrument in India. • Yields: Yields of ABS/MBS/CDO are higher than those of other debt instrument with comparable rating. Spreads of securitized instrument are typically in the range of 50-100 basis points over comparable AAA corporate bonds. • Flexibility: An important advantage of securitization is the flexibility to tailor the instrument to meet the investor’s risk and tenor appetite. o Durations can range from few months to many years. o Repayment are usually made on monthly basis but can be structured on a quarterly or semi annually basis. o Interest rate can be fixed or floating depending upon investor preferences. 18
  19. 19. SECURITIZATION UNDERSTANDING RISKS IN SECURITIZATION Risk investors face in securitization: Investors in securitized instruments can take advantage of the benefits that these instrument offer, however they also need to be aware of the inherent risks in these transaction. These risks classified into: • Asset pool risks which arise due to the unpredictable behavior of the underlying borrowers. The payment behavior of underlying borrowers can be estimated with a reasonable degree of accuracy based on historical data. • Legal risks due to lack of judicial precedence on securitization legislation and regulation. • Counter party risk arise as a securitization transaction involved multiple parties throughout the tenure of the instrument. The investor’s returns can be impacted by non-performance or bankruptcy of any of these counterparties. • Investment risks like all other investment securitized instruments are subject to market related risks. 19
  20. 20. SECURITIZATION Investors are protected against these risks by means of structural features and credit enhancement which enable the instrument to achieve high credit ratings. Assets pool risk in a securitization and mitigation: Assets pool risks are classified into credit risks and prepayment risks. • Credit risks: Investors have a direct exposure to the repayment ability of the underlying borrowers whose loans have been securitized. If borrower default on payment of installments or make delay payment collection will be inadequate to scheduled investors payouts. Thus timely investor payments will depend on the credit quality of the pool borrower. • Mitigation: Credit enhancement provide for PTC is sizes to cover the expected levels of payment default and delays. In case there is short falls in the collection the credit enhancement is used to make timely payment to the investors. However, in the event of short falls over and above credit enhancement levels investors will incur losses on their investment. • Risk of prepayment: Investors face the risks that underlying borrowers may prepay all or part of the principal outstanding of their loans. When prepayment occurs they are passed on to the investor (unless the instrument structure provides for a separate class of PTC to absorb prepayments). This can affect investor in two ways: 20
  21. 21. SECURITIZATION o Reinvestment risk: If there are heavy prepayment in the pool the average tenure of the instrument reduces resulting in reinvestment risk for the investor. o Prepayment loss: If the investor has paid an additional consideration to receive excess interest spreads generated by the pool the investor principal outstanding is greater than the pool principal outstanding. Hence when the contract is prepaid this excess interest spread payable to the investor from that contract is lost. Hence prepayments can result in the shortfalls in payments. • Mitigation: Reinvestment risks can be mitigated by carving out a separate class of PTC from pool cash flows to absorb prepayments occurring in the pool. This class of PTC is called a ‘prepayment strip’ and commonly found in securitized instruments. Prepayment loss is mitigated as the credit enhancement is sized to cover such losses. However in case of excessive prepayment losses greater than the credit enhancement amount will be borne by the investor. • Property/asset price risk: Assets backing securitized instruments may be prepossessed and sold post securitization. The proceeds and loss on sale depends upon market values of the assets, which fluctuate. 21
  22. 22. SECURITIZATION LEGAL ISSUES WITH SECURITIZATION Documents that are used in securitization transaction: Following document is part of the securitization transaction and represents current practice in the securitization market. Some or all of these would be used in any securitization transaction. • Trust deed: This document settles a trust for the purpose of purchasing the receivables. The right and duties of the trustee are spelt in this document. • Deed of assignment of receivables: This document evidences the transfer of receivables to the trust for the consideration. It is made by the originator in the favors of SPV. • Declaration of trust: The unilateral document prepaid by the originator, where the originator acts as the SPV/trustee, declaring that it holds the receivables in trust for the investors. • Information memorandum: The offer document that provides details of the proposed securitization of receivables to the potential investors. 22
  23. 23. SECURITIZATION • Service agreement: Outlines the terms and conditions of the securitization transaction and the right and the duties involved. It also lays down the right and duties of servicing agents. • Cash collateral agreement: Spells out the termed and conditions under which the cash collateral and yield reserve can be utilized/released. This agreement is executed between the seller/service and a designated bank where the cash collateral will be maintained. • Power of attorney: This authorizes the trustee to execute acts and deeds with regards to the securitization contracts, including the enforcement of security. • Collection and payout account agreement: This document spells out the operational details of the collection account. Stamp duty impact securitization transaction: Stamp duty can be described as a tax levied on all documents of a commercial nature. Stamp duty is an important issue for securitization transaction executed in India due to: • Serious consequences of stamp duty evasion: Inadequately stamp documents attract an enormous penalty, sometimes as much as ten times the deficiency in stamp duty paid. Documents that are inadequately stamped are also not recognized in court as evidence and are therefore unenforceable. • Bearing the cost of stamp duty: The general is that the person claiming the benefit of a document should bear the stamp duty or any penalties/fines levied on that document. 23
  24. 24. SECURITIZATION • Differential role of stamp duty: All states in India are empowered to determine their own stamp duties and these vary from state to state. In most of the states sale of asset attracts high stamp duty, sometimes up to 12% of the value of the assets transferred. This result in prohibitive transaction costs. Only the states of Maharashtra, Gujarat, Tamil Nadu, West Bengal, Andhra Pradesh and Karnataka have enacted stamp duty law favorable to the transfer of assets. Legal expert believe that a consequence of the differential stamp duty is that if document executed in one state is taken into another state, the document is liable to be stamped in the second state if the stamp duty in the latter is higher. True sale of assets relevant in securitization: True sale ensures that the sale of assets in a securitization is absolute and binding and effectively removes the financial assets from the balance sheet of the originator. It is relevant since the investor’s return in asset securitization depends purely on cash flows from the securitized assets. A ‘true sale’ will ensure that the investor’s rights and entitlements in respect of these cash flows are not affected in case of bankruptcy or liquidity of the originator. There is no statutory definition or judicial interpretation of true sale as yet in India. However, the following issues are pertinent in evaluating a transaction for ‘true sale’: • Extent of recourse to and risk retained by the originator in the securitized assets: Generally company is of the opinion that in cases where the originator 24
  25. 25. SECURITIZATION retains a high level of risk in the assets, the courts are likely to recognize the transaction as a secured borrowing. • Options and obligations to repurchase assets: The presence of an option to repurchase does not by itself negate true sale. However, company treats an originator’s obligation to repurchase assets on account of deteriorating asset quality as inconsistent with true sale. • Extent of control retained by the originator over the assets: Company will acknowledge a transfer as a true sale only if the transferee gains unrestricted rights to the assets. Company like CRISIL, CARE also bases its analysis of a securitization transaction on professional opinion from an independent legal counsel, confirming that the transfer of assets is consistent with a true sale. NHB role in Mortgage Backed Securitization (MBS): The National Housing Bank (NHB) is a regulatory body to promote and support Indian housing finance companies (HFC and the housing portfolios of banks). NHB has played a lead role in starting up MBS and developing a secondary mortgage in India by: • Setting up Special Purpose Vehicle (SPV) for MBS and acting as a trustee to the issuance on behalf of investors. • Acting as a guarantor and facilitating MBS transactions. 25
  26. 26. SECURITIZATION • Acting as a refinancing arm for HFC by making loans and advances as well as rendering financial assistance to scheduled banks and HFC. • Making continual efforts to generate awareness about residential MBS among market participants. Risk applicable on MBS investments for Banks: To improve the flow of credit housing sector, RBI has liberalized the prudential requirement on risk weight for housing finance by Banks. Accordingly, Banks extending housing loan to individual against the mortgage of residential housing properties will be permitted to assign risk weight of 75% instead of the earlier requirement of 100% provided certain condition are met. However, Loans against the security of commercial real estate will continue to attract 100% risk weight. Moreover, bank investments in MBS of residential assets of HFC will also be eligible for risk of 75% for the purpose of capital adequacy, subject to certain terms and condition. • The loans should be securitized under the ‘true sale’ of assets to the SPV. • The loans to be securitized should be loans advanced to individuals for acquiring/constructing residential houses, which should have been mortgaged to HFC by way of exclusive first charge. 26
  27. 27. SECURITIZATION • The loans to be securitized should be accorded an investment grade credit rating by a credit rating agency at the time of the assignment of SPV. • The securitized loans should be originated from housing finance company/banks. Can banks investment in PTC: Banks can invest in PTC. The Reserve Bank of India (RBI) issued guidelines in November 2003 prescribing prudential limits for banks on all non-SLR investment, specifically for investments in unlisted securities. In December 2003, RBI clarified that investment in either security receipts issued by securitization companies/reconstruction Company registered with RBI, or Assets Backed Securities (ABS) and Mortgage Backed Security (MBS) which are rated at or above the minimum investment grade will not be reckoned as unlisted non-SLR securities for computing compliance with the prudential limits prescribed in the above guidelines. Therefore there is no impact on the ability of the banks to invest in PTC as issued currently in transaction. It is expected that the PTC would soon be specifically notified as securities under SCRA and hence get listed. 27
  28. 28. SECURITIZATION RATING PROCESS IN SECURITIZATION Rating scale employed by credit rating agency in securitization transaction: Credit rating agency has developed a framework for rating the debt obligation of Indian corporate supported credit enhancements. For example CRISIL ratings of structured obligation (SO) factor the credit enhancement extended by an entity, which could be in the form of guarantees, over collateral, cash etc. (SO) rating are based on the same scale as CRISIL other rating (AAA through D for long term debt, and P1 through P5 for short term debt). The rating indicates the degree of certainty regarding timely payment of financial obligation on the instrument. Provisional rating: When any credit rating agency rates a securitized pool of assets, it initially assigns a ‘provisional rating’. The provisional rating assigned is valid for a period of 90 days, before which the originator must comply with the following: • Submit copies of all executed transaction documents to credit rating agency. 28
  29. 29. SECURITIZATION • Submit a letter from the trustee confirming that the transaction documents have been executed to the trustee’s satisfaction. • Furnish representation and warranties as stipulated by credit rating agency. • Submit an auditor’s certificate where required. • Submit the required legal opinion from an independent counsel. Upon receipt of the above documents, credit rating agency examines if the documents are in line with the transaction structure as envisaged at the time of assigning provisional rating. If the documentation and the other compliances are to credit rating agency satisfactions than agency issues a letter of compliance for the transaction formalizing rating. 29
  30. 30. SECURITIZATION Rating process for securitization: 30
  31. 31. SECURITIZATION Mandate letter received from the client Transaction details and structure communicated to rating company. Company send its information requirement to the client specifying details of the information needed for the analysis. Based on information made available, the rating team has detail managed meetings to understand the originator business, process, assets quality parameters, pool characteristics etc. Team put together a rating report based on its interactions and presents its report and recommendations to the rating committee. A provisional rating is assigned to the transaction. If the client accepts this, Company issues a rating letter with the rationale for the rating assigned A compliance letter for the rating is issued once the final transaction documents, legal opinion and other compliance documents have been received by Company legal analyst and compliance team. Company does not end with the issue of the initial rating. Company has a dedicated surveillance team, which monitors the performance of the securitized pool every month to ensure that it is line with the outstanding rating Initial Rating Process Post issue Monit oring 31
  32. 32. SECURITIZATION Typical due diligence done at the time of rating: Credit rating agency carries out a through due diligence for all rating, before and after the provisional rating. • Originator due diligence: The due diligence of originator MIS and the risks control mechanism give a fairly good idea of the originator assets portfolio vis-à-vis industry benchmarks, and forms critical inputs in the stipulation of the credit enhancement levels for transaction. • Pool due diligence: Agency check if all pool contracts adhere to stipulated selection criteria. Auditor’s statement are obtained to ensures that all information furnished to rating agency relating to the pool has been verified and found to be correct and true. • Transaction structure: Rating agency analyses the structure for each transaction to adequately assess any risks which investors might face. This is extremely important as the structure is becoming more complex. • Legal due diligence: The legal team also checks the draft transaction documents, to identify any legal issues pr legally untenable clauses. The basic documentation examined is the trust deed, assignment agreement/deed of assignment, service agreement and cash collateral agreement. The corporate undertaking or guarantee is also examined where relevant. 32
  33. 33. SECURITIZATION 33 Due diligence structure Origination system Credit appraisal and underwriting Disbursement and post disbursal documentation Collection and recovery mechanism Management Information System (MIS) Risk Control Mechanis m
  34. 34. SECURITIZATION Surveillance process adopted by rating agency: Rating agency believes it is of vital importance to monitor pool performance so that it is in line with the outstanding rating. Surveillance is necessary because the receivables from the pool of assets are used to service investors payouts. The investor’s recourse is thus limited to these receivable, and to credit enhancements, if any provided by the originator. Additionally, complex structures have been introduced recent times in the securitization market, with issuances incorporating staggered payouts mechanisms, floating rate instruments and trigger based structures. These complexities require close monitoring by the trustee and the rating agency to ensures that the instruments adhere to the originally stipulated and appropriate action is initiated at the right time in case of any deviation. Rating agency has set up a dedicated surveillance team to monitor the performance of rated pools. Transaction is monitored on a monthly basis and the key parameter is tracked. This is done on the basis of monthly servicer reports provided by servicer/trustees. The reports are checked for accuracy and performance analysed. Thereafter, the team interacts with the concerned parties to understand the reasons behind the trends, and the likely steps have been or need to be undertaken to arrest adverse fluctuations in the pools performance. A comprehensive review is under taken at least once a year, unless warranted more frequently by deviations in the monitorables from rating agency estimates. 34
  35. 35. SECURITIZATION Key monitorables of rating agency surveillance process: • Collective performance: The collection performance is analysed in terms of monthly collection ratio (MCR) and cumulative collection ratio (CCR).The MCR gives the flow element of the pool collection performance and acts as an early warning indicator. The CCR reflects the stock element of the pool collection performance. • Delinquency level: Credit rating agency analysis the overdue levels in terms of various delinquency buckets. This analysis provides an estimate of the credit losses in the pool to date and gives an indicator of future losses. • Counter party credit quality: Rating agency also monitors the credit quality of the counter parties involved in the transaction. These include the servicer, the trust, the retention account bank, the cash collateral bank or guarantor and the swap counter party. • Credit support: The credit enhancement available indicates the level of cushion in the transaction. This cushion is required to withstand relevant stress levels for the corresponding rating category. This parameter rounds off the overall analysis and ensures that the outstanding rating is current. In addition the credit rating agency monitors other parameters such as prepayment, collection efficiencies and collateral utilization. 35
  36. 36. SECURITIZATION Indian experience with securitization: Securitization commenced in India with a car loan transaction originated by Citibank in 1992. Since then, the market has grown rapidly, with India become the third largest securitization market in Asia, after Japan and Korea. Proceeds from Asset Backed Securitization (ABS) transaction account for close to 15% of incremental disbursements in the Indian consumer finance market, underlining the importance of securitization as a financing tool. Market sophistication has also increased rapidly in 2004-05 with the advent of new asset classes and structures. Breaking new ground: • 1992: First auto loan securitization was done by Citibank. • 2000: First MBS was done by National Housing Bank. • 2001: First offshore transaction backed by aircraft purchase receivable. • 2004: First successful multi asset was done by ICICI Bank. Size of the market: Rating agency estimates that over 330 transactions, involving a cumulative volume of Rs 530 billion, have been placed in the market. Issuance has grown exponentially with ABS volumes growing at a CAGR of 51% and MBS volumes growing at a CAGR of 65% since 2000. 36
  37. 37. SECURITIZATION Originator and investor in securitization market: Securitization has gained popularity over the years as reflected in the increasing number of originator entering in the market. Some key originator in the market includes ICICI Bank, HDFC Bank, Citigroup, and Tata group. The predominant investors in securitized instrument are mutual funds, public sector bank, foreign bank, private sector banks and insurance company. Asset classes securitized in India: Forms of Special Purpose Vehicle used in India market: Assets Backed Securities Collateralized Loan Obligation Cars Corporate bonds Commercial vehicles Municipal bonds Two wheelers W.C. & term loan facilities Construction equipment Sales tax loan receivable Aircraft purchase receivable Corporate loans Personal loans Oil receivable Utility vehicles Lease receivable Used cars Three vehicles Mortgage Backed Securities Office equipment receivable Residential loans 37
  38. 38. SECURITIZATION In India, an SPV is typically in the nature of trust. The trust is usually settled by the third party who is appointed as the trustee, to manage the trust properties (the securitized assets) and distribute the income from the same. The trustee is the legal owner of the assets, whereas investor is entitled to all the benefit arising from the trust properties. An SPV can also be formed by declaring trust over the assets. In such cases, the originator holds the assets are transferred to the investors, while the legal ownership of the assets continues to vest with the originator in its capacity as the trustee. Common structure used in the Indian market to securitise assets: Structures have evolved in India based on investor risk, tenor preferences, and issuer requirement. • Fully amortising structure: In India, we see fully amortising instrument (i.e. principal is repaid to the investors along with the interest over the tenor of the PTC). This is different from bullet structure, where the entire principal is repaid at maturity. Fully amortising structure is designed to closely reflect the full repayment of the underlying loans through the interest and principal payment. • Par and premium structure: In par structure, the investor pays a consideration equal to the principal outstanding (par value) of future cash flows. In return the investor is entitled to receive scheduled principal repayment from the pool of receivable along with a pre decide rate of interest. Par structure also has an element of Excess Interest 38
  39. 39. SECURITIZATION Spread (EIS) generated if the yield on the pool is higher than the yield on the PTC. The originator has the right to receive the EIS amount. A premium structure is one where the investor pays a consideration greater than the principal outstanding of future cash flows, for the additional right to receive EIS arising from the securitized assets. Predominantly, par structure is used in MBS and premium structure is used in ABS. • Senior subordinate structure: Cash flows from the securitized assets can be carved into multiple classes of securities having different tenors and risk profiles. The senior class is accorded the first claim on the cash flows from the pool, whereas the subordinate class has a lower claim. Thus, the subordinate class is ‘first loss price’ and the support payment to the senior classes. Typically in India, senior classes are highly rated instruments while subordinate classes are unrated and retained by the originator. • Fixed and floating rate structures: PTC is issued at both fixed and floating rates of interest. The motivation for fixed or floating rates depends on interest rate trends in the economy. Investor preferences and other such parameters. Recently there have been many issuances at floating rates, where the rates are benchmarked to a designated index like the NSE, MIBOR. If underlying assets are fixed rate loans, floating coupon rates introduce the element of interest rate risk in the transaction. This risk can be mitigated by using an interest rate swap with a swap provider who exchange rate payouts made by the trust for floating rate payout to the investors. 39
  40. 40. SECURITIZATION Credit enhancement found in India: The most common forms of credit enhancement found in the Indian market are listed below. They are not mutually exclusive a combination of two or more forms of credit support is often used. • Cash collateral: This is an external form of credit support. The originator or the third party provides a predetermined amount of cash, which is put into the reserve account. Withdrawals can be made from this account to off set losses on the securitized assets. The cash collateral is held by the trustee in the favor of investors. • Excess interest spread: This is an internal form of credit enhancement available in transactions where the interest rate received on underlying loans is higher than the interest rate paid on the PTC backed by those loans. This give rise to excess margin or spread that can be applied to offset in the pool collection. • Subordinate tranches: One of the common methods of credit enhancement is senior subordinate tranches structure, where the subordinate tranches acts as a credit enhance for the senior tranches. • Over collateralization: This is the form of credit enhancement where the principal outstanding of securitized assets is greater then the principal outstanding of the PTC. For example, if Rs 150 million of assets backs Rs 100 million of PTC, then Rs 50 million is the over collateral in the 40
  41. 41. SECURITIZATION transaction. After the PTC redeemed, the over collateral assets belong to the residual beneficiary in the transaction. • Guarantees: A legally valid and enforceable guarantee from the higher rated entity for funding shortfalls in collections is external form of credit enhancement. Such guarantee if present are usually limited to predetermined amount. Waterfall mechanism structured: The term ‘waterfall’ is used to describe the order of priority in which proceeds realized from securitized assets will be utilized. Payments to stake holders in the securitization will be made as per the term and conditions laid out in the ‘waterfall’. • Statutory or regulatory dues pertaining to the securitized receivable. • Expenses incurred by service provider like the trustee agent, rating agency, auditor and legal advisors. • Senior PTC holder’s payment. • Top up cash collateral. The residential amount. If any is paid to subordinate PTC holders, if there are no subordinate PTC, the residual amount flows back to the residual beneficiary in the transaction, usually the originator. Innovation in Securitization 41
  42. 42. SECURITIZATION Strips STRIPS are the acronym for Separately Traded Interest and Principal Segments. The interest and principal steam of cash flow are deterministic and are known in advance. These are sold at their present values as deep discount bonds. The principal only (PO) and interest only (IO) segments represent two synthetic instruments that are excellent hedging instruments. By investing in various combinations, investors can create their own risk-return profile, something not enabled by holding plain-vanilla puts. The strip reacts differently to changes in interest rate behavior. To understand this better, think of strips to be the present values of a stream of cash flows, denoted by Where C represents the cash flow from the underlying receivables T Represents the timing of the cash flow, R Represents the current rate discounting, the market yield The price movements of strips are impacted the repayment effect, discounting effect and their combined effect. 42
  43. 43. SECURITIZATION In the case of PO, a fall in market interest rates would induce mortgage borrowers to prepay existing loans and borrow a fresh at lower rates. This will accelerate the cash flows appearing in the numerator, and reduce the discounting factor in the denominator; both effect together leading to a value appreciation and hence price of a PO. Reserve is the case for a rise in the interest rates where borrowers would stay put and tend to prepay, and the denominator rising, leading to a fall in the price of a PO. In the case of the IO, a fall in the markets interest rates would reduce the denominator to lift the price. However, due to repayment, large section of outstanding would be bereft of future interest inflows. This represent losses in the interest income to service the IO. The magnitude of interest rates shift and prepayments would determine the combined effect and final value of the IO. A rise in the interest rates would protect the numerator, but there will also be a rise in the denominator. Here again, the combined effect and the impact on the final valuation depends on the magnitudes of the rate shift. Hedging instruments, bank investing in the long end of the market would like interest rates to be high. They therefore would buy Pos to protect their losses. Bank wanting interest rates to fall to increase their lending volumes would be interested in getting hedge protection by investing in Ions. Thus, it is to be understood that PO and IO strip moves in opposite directions in relation to interest rates shift in order to devise hedging strategies. Tranched transactions 43
  44. 44. SECURITIZATION Tranched transactions are Collateralized Mortgage Obligation (Comes). The normal pass through mechanism is altered here to mean pay through. In other words, under the pay through structure, the SPV merely acts as a payment gateway. Under the pay through structure, the SPV plays an active role in determining which class of securitized instruments gets a priority in the principal repayment, meaning that the other classes of instrument get only the interest for the time being. The sequence goes on until, in a phased manner, all classes of instruments are fully redeemed with interest. This pattern facilitates the attraction of investors with varying appetites of loan tenors and interest rates. As an illustration, consider the following tranches: Type Amount raised (Rs. Lakhs) Coupon % p.a. Repayment Years A 50.00 8.00 1 to 5 B 50.00 8.25 6 to 10 CAT 50.00 8.50 11 to 15 The A, B and C classes of securities represent different classes of investors. The tranches are shown as fixed interest bearing securities. The interest rates are hypothetical and illustrative in nature. There could be a variation, where tranches C assume the name Z, where the entire interest is re-appropriated to the repayments of A, and the amounted temporarily 44
  45. 45. SECURITIZATION foregone is added back to the outstanding principal Z. these Z tranches are wildcards and are hedging instruments as well as catering to the appetite of risk friendly investors. Note that the presence of B, C and Z tranches serves as cushions to safeguard A. the presence of such cushions raises the credit rating of A class securities and hence lower there coupons obligation in the risk return matrix. It is possible to switch from an existing fixed-interest security like A, B or C into a floating rate mechanism, using financial techniques. The instruments so designed would be called Floaters and Inverse Floaters. A brief description is provided below. Floaters A coupon-bearing bond where the coupon rates is linked to a reference rate. The investors gains when the reference rates rises. The floating rates are equal to or above the reference rates, the difference between the two rates being the quality spread (i.e. the risk element embedded in the interest rate). Floaters are issued on a stand-alone basis or complementary to Inverse Floaters. Inverse floaters 45
  46. 46. SECURITIZATION These are issued complementary to floaters. The coupons rates are pegged at a fixed ceiling rate minus floating rate. For example, if the floating rate is say 7%, and the ceiling rate is at roughly double, say, 155 the coupon on the inverse will yield (15-7)% = 8%. When floating rates rise to say 9%, the inverse will yield less, i.e. (15-9) % = 6% and vise versa. A set of floaters and inverse floaters can be used to replace fixed coupon bearing bonds. In such situations, class securities would be split in the ratio 1:1, via Rs. 25 lakhs floaters and other Rs. 25 lakhs inverse floaters. In many cases the investment bankers assist in designing such instruments. Variations of this theme are supper-floaters and super –inverse floaters. For example, Rs. 50 lakhs interest at 8.50 could be split in the ratio 2:1, into Rs. 34.5 lakhs floating at say 8% at a point in time, or say, reference rate of 7% + 1%, at a point in time. This comes with a co-existing inverse-floating rates of (ceiling of 24% - 2 times the floating rate of say 8%) = 44% at a given point in time. The inverse-floaters are issued for an amount of Rs. 17.5 lakhs, half the amount of the floating securities. Considering the magnitude of the amount and the ceiling interest rate, the inverse floaters assume the name ‘super-inverse’ floaters. A close perusal the two schemes outlined will reveals the interest rate hedging mechanism of the floating rate securitized instruments. CAT Bonds 46
  47. 47. SECURITIZATION Until now, the applicability of the securitization was assumed to be in the banking sector. However, Catastrophe Bonds as they are called is also an effective risk transfer and risk financing device in the insurance sector. The mechanism of CAT bonds is explained in the paragraph below. Let us assume that there is an insurance company, and it has done well in extending its business in say, Gujarat. The premium incomes are with the company. It could so happen that a catastrophe in Gujarat could lead to claim amounts that could wipe out this insurance company. The conventional method of dealing with such risk would be elements of re-insurance, where part of the premium would be ceded by the insurer to the reinsurers, taking a proportionate amount of risk also off its balance sheet. However, it must be appreciated that there could be some catastrophic events which make even so- called normally anticipated losses are exceeded. To avail of contingent financing for contingent events, the device of CAT Bonds has been innovated. Here, CAT Bonds are issued at a high coupon rate for the contingent amount, to cover the perceived under- financed claim-losses. Catastrophic losses beyond the threshold level trigger the appropriation of CAT Bonds principal proceeds to settle claims, the principal now not being repayable to the CAT Bonds investor. If no claim arises on CAT Bonds, the entire proceeds are refund on expiry of the term of the risk insured against, in which case the interest is a clean profit for the investors. The redemption amount is secured against stream of premium payments, as insurance companies gain credibility (hence business and premium inflows) when they successfully settle claims over a period of time. Thus, CAT Bonds represents the conversion of risk, packaging them into a tradable commodity and garnering capital markets solutions to safeguard against losses from natural calamities. 47
  48. 48. SECURITIZATION Notably, all that is an SPV acceptable to the potential investors, the SPV essentially is a trust that can be wound up once the objectives of the trust are achieved. Its role is only in appropriating payments in a diligent manner to safeguard the investor’s interest, it is the collective representation of the investors. Thus reinsurance-type protection as reinsurance can be offered through the mode of securitization, obviating the need for incorporation as a reinsurance company and the requisite minimum capital requirement of Rs.200 cores. CASE STUDIES ON SECURITIZATION 48
  49. 49. SECURITIZATION CASE STUDY 1: CITIGROUP – DIRECT ASSIGNMENT OF RECEIVABLES DEAL SUMMARY  Originator, Seller & Servicer: Citicorp Finance (India) Ltd.  Trustee: IDBI Trusteeship Services  Instrument: Direct assignment of Receivables from the Originator to Banks  Issue Size : Gross value of receivables – Rest 79.5 cores; Purchase Consideration (discount value) of Rest 72.4 Cores  Rating : AAA(so) from ICRA  Nature of Receivables : Arising from loan contracts for commercial vehicles entered into between Originator and borrowers who are Small Road Transport Operators (Strops)  Credit Enhancement:  Corporate Undertaking of 9.36% of assigned receivables 49
  50. 50. SECURITIZATION  CFIL shall assign right that it has under the Franchisee Agreement specific to the Loss sharing undertaking (varies between 0% to 30% of the amount financed) Provided by Franchisee and on the Earnest Money Deposit (EMD) Provided by each Franchisee against loan Agreements originated by the Franchisee acting as an Agents for CFIL.  Maturity : Door to Door of 47 Months; Average of 18 months SELECTION CRITERIA  The Pool has selected by CFIL from the loan contracts currently on its books using the following criteria as on December 31st 2004, which is referred to as the cut-off-Date: • No Over dues of greater than 60 days as on the cut- off date. • CFIL should not have initiated legal / repossession action against any borrowers • Minimum Seasoning on cut-off date of 2months • Contracts for financing intermediaries who then onward finance the vehicle to the final customer should not be included 50
  51. 51. SECURITIZATION • When both body and chassis is funded then both or none should be included in the pool. If only body is funded then such cases should not be included • The Receivables were generated in the ordinary course of its business by CFLD either directly or through its franchisees. 51
  52. 52. SECURITIZATION POOL CHARACTERISTICS Weight Average Seasoning of 4.5 months Delayed payments are common in the CV financing market hence some over dues SEASONING 8% 6% 0% 54% 31% 0% 1% Overdue Ageing CURRENT, 52%1 - 30 DAYS, 39% 31 - 60 DAYS, 9% ASSET WISE DISTRIBUTION MCV 46% HCV 15% LCV 39% 52
  53. 53. SECURITIZATION EFFECTIVE LOAN TO VALUE 65%-70% 25% 70%-75% 21% 60%-65% 28% <50% 1% 50%-55% 1% 55%-60% 6% 80%-85% 4% 75%-80% 14% 53
  54. 54. SECURITIZATION Geographical distribution U.P. 5% Karnataka 11% Maharashtra 19% Orrisa 3% A.P 19% Kerala 4% H.P. 1% Goa 0% Delhi 0% Gujarat 6% Harayana 2% Jharkhand 3% M.P. 4% Punjab 1% Rajasthan 5% Tamil Nadu 4%Uttaranchal 0% W.B. 9% Chhattisgarh 3% Amount Financed 1 to 2 lacs, 0% 2 to 3 lacs, 6% 4 to 5 lacss, 14% 3 to 4 lacs, 17% 9 to 10 lacs, 0% 8 to 9 lacs, 5% 7 to 8 lacs, 15% 6 to 7 lacs, 23% 5 to 6 lacs, 20% ♦ CASESTUDY2 ♦ MMFSL – Securitization under floating rate Structure with swap Weight Average LTV of 68% (after imputing body cost of 25%) Geographically well diversified across 19 states. Weight Average Amount financed is Rs. 5.5% 54
  55. 55. SECURITIZATION Deal Summary • Originator, seller & servicer: Marinara & Marinara Financial Service Ltd. • SPV: VE Trust; Trustee: UTI Bank Ltd. • Instrument: Pass Through Certificates Maturity Coupon Issue Size Payment Frequency Strips A1 to A3 Door to door of 12 months; average of 6- 7 months NSE MIBOR + spread Rest 45 cores Quarterly Strip A4 to A6 Door to door of 28 months; average of 16-17 months NSE MIBOR + spread Rest 45 cores Quarterly Strip A7- prepayment strip Door to door of 35 months; average of 22 months Fixed Rate Rest 21 cores Monthly 55
  56. 56. SECURITIZATION • Rating: P1+/AAA(so) from CRISIL • Nature of Receivable: Arising from loan contracts for utility vehicles and cars entered into between originator and borrowers • Credit Enhancement:  Subordinate PTC of 9.8%  Cash Collateral of 5.75%  Opening over dues subordination Selection Criteria: The pool has been selected by MMFSL from the loan contracts currently on its books using the following criteria as on October 2003, which is referred to as the Cut-off-Date: • The pool comprises of only utility vehicles and cars. • The pool contracts have a minimum seasoning of three months. • The over dues on the contracts do not exceed a period of one month. • Only contracts directly originated by the seller and whose collection is directly undertaken by the seller have been included. • The maximum balance tenor as on February 1, 2004 is 35 months. • The original LTV of the contracts is restricted to a maximum of 90%. 56
  57. 57. SECURITIZATION Asset class Utility Vehicles and Passenger Cars Number of contracts 6,130 Total Receivables from Feb, 1 2004 (Rest.) 1,245,092,239.00 Average contract balance (Rest.) 203,115 Minimum contract balance (Rest.) 6,385 Maximum contract balance (Rest.) 529,000 Weighted average seasoning (monthly) (as on January 31, 2004) 11.35 Minimum seasoning (months) (as on January 31, 2004) 7.00 Weighted average balance maturity (months) 24.24 Maximum balance maturity 35.00 Weighted average LTV 73.31% % of pool with nil over dues (as on cut-off date) 74.74% 57
  58. 58. SECURITIZATION Pool Characteristics: 58
  59. 59. SECURITIZATION Asset wise classification of the pool Utility Vehicle, 66% Car, 34% C Overdue analysis Nil, 75% 30 Days, 25% Weight Average Seasoning 11.35 months 75% of the pool had nil over dues and balance had 1 EMI over dues 59
  60. 60. SECURITIZATION Seasoning as on Januray 31,2004 7 to 9, 29.77% 10 to 12, 52.80% 13 to 14, 17.43% 60
  61. 61. SECURITIZATION Loan to value ratio LTV 70% to 80%, 48% LTV<30%, 0% LTV 30% to 50%, 5% LTV>=95%, 3% LTV 80% to 90%, 21% LTV 90% to 95%, 1% LTV 50% to 60%, 8% LTV 60% to 70%, 14% Geographical distribution Gujarat, 10.54% Maharashtra, 9.74% West Bengal, 6.50% Haryana, 6.80% Karnatka, 4.83% Delhi, 2.54% Assam, 2.29% Others, 2.50% Orrisa, 2.12% Jharkhand, 2.15% Kerala, 6.43% Himachal Pradesh, 3.57% Andhra Pradesh, 4.10%Chhattisgarh, 3.65% Punjab, 6.65% Rajasthan, 2.28% M.P., 4.40% Tamil Nadu, 6.68% Uttar Pradesh, 12.23% Weighted Average LTV 73% Pool is geographically well diversified across 19 states 61
  62. 62. SECURITIZATION Structure Diagram Liquidity Reserve Originator/Seller (MMFSL) Investors Agent SPV Obligors Servicer Trustee Citibank Investors Collection Account Monthly Collection Payout on PTC Issue of floating rate & fixed rate PTC Interest rate Swaps Issue of subordinate PTC Sale of receivables & purchase consideration for receivable Interest rate swaps have been entered into between the Investors agent and Citibank to convert fixed pool to a floating rate coupon to investors. Collection Efficiency 54 56 58 60 62 64 66 68 70 72 74 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Months Collection% 62
  63. 63. SECURITIZATION Performance of previous issuances CFIL & CAN Issuance April 02 June 02 July 02 Oct 02 Issue size (Rest. Cores) 66.92 74.57 115.38 109.5 Total number of PTC 69 77 117 111 Issue rating AAA (so) P1 (so) +PSCE& AAA (so) P1 (so) +PSCE& AAA (so) LAAA (so)& MAAA (so) CE stipulated 8.00% 8.50% 8.50% 4.50%+PSCE O/s level of CE as % future investor cash flows 39.68% 13.51% 60.94% 41.73% Cum. Principal prepaid as a % of the original principal outstanding on the issuance 8.50% 3.97% 10.32% 3.43% Peak usage of CE (as a % of O/S CE) 16.52% 12.26% 6.42% 16.70% First 3 months 86.70% 76.80% 77.53% 93.42% First 6 months 92.27% 87.21% 86.68% 95.95% As on date 98.95% 119.29% 97.23% 97.93% ANALYSIS OF THE SURVEY 63
  64. 64. SECURITIZATION Analysis for the better understanding about Securitization. Questionnaire method was used to carry out the survey. A set of 5 question was used in the questionnaire, which varied from objective type of question. Questionnaire was framed and designed in such a manner that it could be filled up with in 5minutes by the person thus saving time of interviewee. The sample size of the survey was taken to be 50, of this 50 people 18 questioned were to business person, 20 people were servicemen and professional, 12 were student. Question Ranged from getting information about securities, securitization, credit rating etc. 1. Do you invest in securities? 21 29 0 5 10 15 20 25 30 Yes No 64
  65. 65. SECURITIZATION 2. Are you aware of securitization? 27 23 21 22 23 24 25 26 27 Yes No 3. Before you invest in company do you check credit rating? Yes No 29 19 0 5 10 15 20 25 30 4. Do you think securitization is important? 65
  66. 66. SECURITIZATION 25 25 0 5 10 15 20 25 Yes No 5. For securitization which one is better? 10 15 25 0 5 10 15 20 25 ABS MBS BOTH Summary 66
  67. 67. SECURITIZATION Securitization is the process of converting relationships into transactions. These transaction must lead to the creation of tradable instruments. Incomplete securitization is the non-existence of tradable securities, where the essential feature of relationship continues to prevail. Securitization enables financial institutions to raise from existing receivable streams. These resources are essentially stable and long-term, with protection to interest spreads. In the case of well-designed securitization structures, the cost of funds for financial instruments can be substantially reduced in comparison to plain conventional borrowing. The advantage for the investor are liquid investment for a range of tenors and risks profiles. The various forms of securitization include Asset Backed Securities, which includes receivables from loans for tangible assets, such as mortgages, automobiles and equipment. Securitization of credit card receivables, student loans and infrastructure and utilities receivables is also feasible, bit here the asset is stream of future cash flows and physical assets. The securitization process involves several players such as originator, the obligor, merchant banker, SPV, underwriters, investors, escrow bankers, rating agencies and credit insurance agencies. Innovation in securitized instruments are in the forms of STRIPS, where the interest and the principal components of receivable, in the pass through mode, are sold off separately. These can be used as hedging instruments. Another innovation is in term of carving up receivables and designing debt instruments for potential investors such as short-medium and long-term investors. Such structure are known as pat through structures or Collateralized Mortgage Obligation (CMO). Further add-on innovations in CMO are converting fixed rate coupon cash streams into variable rate cash streams using floaters and inverse floaters. Thus, securitization process involve financial engineering. 67
  68. 68. SECURITIZATION The success of securitization is very important in the development of the economy. Possible area for the application of securitization is residential and commercial mortgages, infrastructure receivables, custom bile and equipment loans, student loans and credit card loans. The advent of Catastrophe Bonds (CAT) is the interface between the capital markets and the insurance sector. 68
  69. 69. SECURITIZATION Conclusion: Securitization in is at the crossroads. A lot has been heard about it since 1990, very little done. We are familiar with the sad Indian story of minor irritants playing a major role in stalling major development. But just as the revolution in India was out come of import liberalization for computers, so also, it is only a matter of time before high quality securitization forms the backbone of housing, infrastructure and trade finance in India. Perhaps what we also need is Ginnie Mae and Fannie Mae type origination in India. 69
  70. 70. SECURITIZATION Bibliography:      Vipul prakashan 70