Securitisation in INDIA: FRAMEWORKSecuritisation, also termed as structured finance, is the creation and issuance of debt securities, orbonds, whose payments of principal and interest derive from cash flows generated by separate pool ofassets. Simply stated, it is a form of secured funding through issuance of bonds in a specific pool ofassets. Credit performance is directly linked to the cash flow generation of the pool of these assets. Thisfinancial tool, that was almost non-existent till the 1970s, is used by financial institutions and businessesto immediately realise the value of cash-producing assets like loans, or leases or trade receivables. Itallows originators to unlock the value of upfront assets.The idea of Securitisation was born in the 1970s when government mortgage agencies in the UnitedStates - Freddie Mac, Fannie Mae, and Ginnie Mae – issued mortgage based pass-through securities toinvestors; thus fostering a secondary market in home mortgages. This idea evolved as an outcome of thefinancial institutions’ inability to keep pace with the growing demand for housing finance. Traditionally,these were funded either by way of bank deposits and other financial institutions or by debt. Financialinnovations towards increasing the availability of mortgage finance led to investment bankers coming upwith an investment vehicle, which isolated the mortgage pools, segmented the credit risk, andstructured the cash flows from underlying loans. Subsequently, this vehicle caught the eye of theinvestors and the concept of asset securitisation came into existence. What developed as a techniquefor the mortgage market was applied for the first time in 1985 to auto loans which proved to be a bettermatch for structured finance as their maturities were shorter compared to mortgage loans that madethese pods of assets more ammendable to the structured products.Initiating securitisation requires the creation of a Special Purpose Vehicle (SPV), which is legally separatefrom the original holder of the assets. The SPV can either be a trust, corporation or a partnership firmset up specifically to purchase the originators assets which also acts as a conduit for the payment flows.In a typical transaction, the owner sells its assets to the SPV. The payment streams generated by theassets can then be repackaged to back an issue of bonds. In some cases, the SPV serves only to collectthe assets, which are then transferred to a trust. The trust inturn becomes the nominal issuer of thebonds/ securities. In both cases, the bonds are exchanged with an underwriter for cash. The underwriterthen sells the securities to investors.The final outcome of a securtitisation transaction is upfront funding of the originator via selling a streamof cash flows that was otherwise to accrue to a entity over a period of time. Alternatively, the financialasset is completely taken off from the balance sheet of the originator, thus not only providingimmediate liquidity but also mitigate the strain on capital adequacy. In the United States, the success ofsecuritisation allowed many individuals with sub-prime credit histories to access credit. It allowed moresub-prime loans to be made because it provided lenders an efficient way to manage credit risk.Securitisation in recent years has also emerged as a new means of financing bad debts.
Asset ClassesTypically, any asset that produces a predictable stream of cash flows can be securitised. The types ofassets that are securitised today include:•Mortgage-backed◦ Residential mortgage-backed securities (RMBS)◦ Commercial mortgage-backed securities (CMBS)•Retail Loan Pools◦ Credit card receivables◦ Auto loan receivables◦ Student loan receivables◦ Equipment lease / loan receivables◦ Trade receivables◦ Toll receipts•Risk Transfers◦ Insurance risk◦ Weather risk◦ Credit riskMortgage Backed Securities i.e. RMBS and CMBS, form the largest two segments of the securitisationmarket in the world.Structured Finance and SecuritisationOne of the crucial features of securitisation is the creation of different grades of securities with differentratings assigned to them. The term “structured finance” refers broadly to such rated products that arestructured to meet specific needs. The senior most class of securities is often rated triple A, the highestrating given based on largely two factors: isolation of the assets from the bankruptcy risks of theoriginator, as in being originator independent; and the creation of a credit risk mitigation device bysubordination of classes B and C, such that those lower classes provide credit support to class A. It ispossible that the size of classes B and C is so computed as to meet the rating objective for class A andsimilarly, the size of class C is so computed as to have class B accorded the desired rating. In other
words, the entire transaction could be engineered or structured, to meet specific investor needs. Thus,use of structured finance principles allows the originator company to create securities that meetinvestor needs. Rating is not the only basis for structuring of securities though. There are several otherfeatures with respect to which securities may differ like interest sensitivity (i.e., duration and convexity),maturity or average life, cash flow pattern and prepayment.The transfer of assets in turn is also a transfer of risk. There is an element of credit risk, interest rate riskor similar risks for most financial assets, and securitisation transactions transfer these risks in astructured fashion. The one who takes the first loss risk is a junior holder, and the one who takessubsequent risk is the senior. There could also be mezzanine security holders if there are more thanthree classes of A, B and C securities.Parties involved in a Securitisation TransactionPrimarily there are three parties to a securitisation transaction:•The Originator: This is the entity on whose books the assets to be securitised exist and is the primemover of the deal. The entity designs the necessary structures to execute the deal. In a true sale of theassets, the Originator transfers both the legal and the beneficial interest in the assets to the SPV.•The SPV: This entity is the issuer of the bond/security paper and is typically a low-capitalised entitywith narrowly defined purposes and activities. It usually has independent trustees / directors. The SPVbuys the assets to be securitised from the Originator, holds the assets in its books and makes upfrontpayment to the Originator.•The Investors: The investors could be either individuals or institutions like financial institutions (FIs),mutual funds, pension funds, insurance companies, etc. The investors buy a participating interest in thetotal pool of assets and receive their payments in the form of interest and principal as per an agreedpattern.Apart from these three primary players, others involved in a securitisation transaction include:•The Obligor(s): The obligor is the Originator’s debtor or the borrower of the original loan. The creditstanding of the Obligor is very important in a securitisation transaction, as the amount outstanding fromthe Obligor is the asset that is transferred to the SPV.•The Rating Agency: The rating process assesses the strength of the cash flows and the mechanismdesigned to ensure full and timely payment. In this regard the rating agency plays an important role as itassesses the process of selection of loans of appropriate credit quality, the extent of credit and liquiditysupport provided and the strength of the legal framework.
•Administrator or Servicer: Also called as the receiving and paying agent, it collects the payment duefrom the Obligor(s) and passes it to the SPV. It also follows up with delinquent borrowers and pursueslegal remedies available against defaulting borrowers.•Agent and Trustee: It oversees that all the parties involved in the securitisation transaction perform inaccordance with the securitisation trust agreement. Its principal role is to look after the interests of theinvestors.•External Credit Enhancements: Underwriters sometime resort to external credit enhancements toimprove the credit profile of the instruments. There are various types of external credit enhancementssuch as surety bonds, third-party guarantees, letters of credit (LC) etc.•Structurer: Normally, an investment banker is responsible for bringing together the Originator, creditenhancer, the investors and other partners to a securitisation deal. He also helps in structuring the dealsalong with the Originator.The segmentation of roles of different parties to the securitisation deal helps in building specialisationand introducing efficiencies. The entire process is broken into distinct parts with different partiesconcentrating on origination of loans, raising funds from the capital markets, servicing of loans, etc.The figure given below shows a simple securitisation process.Types of Securitisation Instruments•Pass Through Securities: Also know as participation certificates, it represents direct ownership interestin the underlying asset pool. All the periodic payments of principal and interest are collected by theservicer and passed on to the investors. In this structure there is no modification of the cash flow as it isreceived from the obligor(s).•Tranched Securities: In this type of security, the cash flows from the obligors are prioritised intotranches. The first tranche receives the first priority of payment followed by subsequent tranches.•Planned Amortisation (PAC) Tranches: A principal sinking fund is created that takes care ofprepayments beyond a certain band. This ensures stability of cash flows and hence offers lower yieldscompared to similar tranches without a sinking fund.•Z-Tranches or Accretion Bonds: No interest is paid during a certain period (lock out period) duringwhich the face value of the bond increases due to accrued interest. After the lock out period, thetranche holders start receiving interest and principal payments.•Principal Only (PO) Securities: The PO investors receive only the principal component of the underlyingloans. These bonds are usually issued at a deep discount to their face value and redeemed at face value.
•Interest Only (IO) Securities: The IO investors receive only the interest component of the underlyingloans. These securities have no face or par value and its cash flow diminishes as the principal is repaid orprepaid.•Floater and Inverse Floater Securities: The floater and inverse floaters are instruments that pay avariable interest rate linked to an index such as LIBOR. The Floater pays an interest rate in the samedirection of interest rate movements while a reverse floater pays an interest rate in the oppositedirection of the interest rate movements.•Amortizing and Non-amortizing Securities: The principal repayment for instruments issued could bedone either by a) repaying total amount at maturity, or b) through out the life of the security. The latterrefers to a schedule of payments called amortisation schedule and securities issued under this are calledamortizing securities. Loans having this feature include, car & home loans.Types of Securitisation StructuresThe SPV pre-designs the type of bonds to be issued depending on the deal structure. The broad type ofsecuritisation structures include:•Cash vs. Synthetic Structures: Most transactions world over follow the cash structure in which theoriginator sells assets and receives cash instead. In a synthetic transaction, the seller keeps his title andinvestment on the assets unaffected. In other words, he does not sell assets for cash but merelytransfers risks/rewards relating to the asset by entering into a derivative transaction. When securitiesare issued by the SPV, they carry such embedded derivative. Synthetic securitisation is gainingpopularity in Europe and Asia.•True Sale vs. Secured Loan Structures: The true sale structure involves sale of a specific pool of assetswhere the originator tansfers both the legal and the beneficial interest in the assets. In a secured loanstructure, the originator takes a loan similar to any secured lending. Investor rights in this case areprotected by creating a fixed and a floating charge over the undertaking of the originator in favour of asecurity trustee. The assets are generic assets of the originator and the trustee is empowered to takepossession of the assets at times of certain trigger events to prevent the assets from being burdenedany further. The use of secured loan structure depends on the legal provisions of the country concerned.The secured loan structure is more popular in the UK.•Pass Through vs. Collateral Structure: In a pass through structure, the SPV issues participationcertificates that enable investors to take a direct exposure on the performance of the securitised assets.Investors are serviced as and when cash is actually generated by the underlying assets. Risks likedelay/disruptions in cash flows is mitigated via credit enhancement. (As investors do not have recourseto the Originator, they seek comfort through credit enhancement methods by which risks intrinsic to thetransaction are re-allocated.) Pass through structure is the most basic and simplest way of securitisationin mortgage markets. In a collateral structure (also known as pay through structure), the SPV retains the
assets to be securitised with it and gives investors only a charge against the securitised assets. The SPVissues debt that is collateralised by the assets that are transferred by the originator. This is also referredto as the Pay through structure and popularly known as collateralised mortgage obligations (CMO).•Discreet Trust vs. Master Trust: Discreet trust implies one SPV for a single identified pool of assetswhere investors participate in the cash flow of the pool. In the creation of a master trust, the Originatorsets up a large fund in which large pools of receivables are transferred, much larger than the size of thefunding raised by investors. Several security issuances can be created from this fund either concurrentlyor consecutively. The master trust serves as a tool to create disparities between the repaymentstructures and the tenure of the securities and assets in the pool. Master trusts are increasinglybecoming the preferred mode of securitisation as a result of their flexibility.•Conduit vs. Standalone Transactions: In conduit transactions, the purchaser or conduit sources theassets from multiple originators and securitises the assets by issuing asset-backed commercial paper.Since commercial papers of short term duration, it becomes necessary for the conduit to avail of shortterm or bridge financing from banks. In standalone transactions, the conduit purchases the assets froma single originator. In this case the conduit issues securities of a maturity matching the maturity of theunderlying asset pool.Benefits of SecuritisationGlobalisation, deregulation of financial markets and growing cross border business transactions hasreset the ambience among financial institutions, increasing manifold opportunities for financialengineering. Securitisation increases the lending capacity of an FI without having to find additionalcapital or deposits. Securitisation facilitates specialisation and is gaining wide acceptance as the mostinnovative form of asset financing. A significant impact of securitisation is the profiling and placement ofdifferent risks and rights of an asset with the most efficient owners. It provides capital relief, improvesmarket allocation efficiency, expands opportunities for risk sharing and risk pooling, increases liquidity,improves the financial ratios of FIs and banks, creates multiple streams of cash flows for the investors, istailored to the risk profile of a number of customers and facilitates asset-liability management. Therequirements for capital adequacy in recent years have also motivated financial institutions and banksto securitise. On the demand side, investors are motivated to buy these securities as they view these ashaving risk characteristics, compatible with the profile.
Benefits to the Originators, especially FIsFor FIs, securitisation is an opportunity offered in the form of capital relief, capital allocation efficiency,and improvements in financial ratios.•Lower cost of borrowing: Securitisation reduces the total cost of financing as assets are transferred to aseparate bankruptcy-resistant entity. To that extent FIs need not maintain capital to maintain theircapital adequacy norms. Also, entities with a riskier credit profile can benefit from lowered borrowingcosts.•A source of liquidity: FIs could face a liquidity crunch either due to their risky credit profile or delayedreceivables. The liquidity provided by securitisation acts as a very powerful tool, that FIs could use toadjust the asset mix quickly and efficiently. Further, the risks in an asset portfolio can be identified andapportioned to arrive at an effective asset mix.•Improved financial indicators: Securitisation leads to capital relief that improves the company’sleverage and in turn the Return on Equity. The repercussions of securitisation on the balance sheet of acompany can vary depending on the strategy for its capital structure and its appetite for increasing ordecreasing leverage.•Asset-Liability Management: Securitisation offers the flexibility in structuring and timing cash flows toeach security tranche. It provides a means whereby customised securities can be created which helps inmatching the tenure of the liabilities and assets.•Diversified fund sources: By securitising its receivables, the instrument of which could be sold to globalinvestors, the originator has an opportunity to diversify its funding source.•Positive signals to the Capital Markets: Lenders are at times trapped in a situation where they cannotrollover their debt due to downgrading of their ratings, possibly due to economic changes. Under thesecircumstances, securitisation enables lenders like FIs to increase the rating of debt much higher thanthat of the issuer through the intrinsic credit value of the asset. This enables the FIs to obtain funding.•An avenue for divestiture: Securitisation offers an optimal exit route for entities that wish to exit abusiness comprising of financial assets without going through the mergers and acquisition route.Benefits to the InvestorsInvestors purchase risk-adjusted securities based on its level of maturity and seniority. For instance, anauto loan or credit card receivables backed paper carries regular monthly cash flows, which can matchthe requirements of investors like mutual funds.•New Asset Class: Securitised products provide new investment avenues for investors to enhance theirreturn or to diversify their portfolio. For instance, an investor in the United States whose investment ispredominantly in US assets can diversify by investing in securities offered by an SPV in Asia.
•Risk Diversification: As the underlying pool of receivables is spread across diverse customers theinvestors need not have a thorough understanding of the underlying assets. The investor is insulatedfrom customer specific event risk.•Customisation: Securitisation of financial assets allows tailoring of cash flows to the risk profile of theinvestors. A certain stream of cash flow coming from an underlying asset pool can be broken intotranches and offered as per the investor risk appetite.•Decoupling with Originator: The investor is insulated from the credit profile of the Originator. Thisseparation of the Originator and the investor helps at the time of bankruptcy or default or creditdowngrades.