Term loans & securitisation

Term Loans, Debentures/Bonds
and Securitisation

By Prof Sameer Lakhani

TERM LOANS, DEBENTURES/BONDS
AND SECURITISATION

Term Loans

Debentures/Bonds/Notes

Securitisation

Solved Problem

Term Loans
Bonds/ debentures have emerged as substantial source of debt finance to corporate
in India in the context of (I) absence of term loan support by financial institutions, (ii)
freedom to corporate to design debt instruments, (iii) withdrawal of interest ceilings
on debt instruments, (iv) credit rating of debt instruments, and (v) setting up of the
wholesale debt market (WDM) segment by the NSE.

Term (long-term) loan is a loan made by a bank/financial institution to a business
having an initial maturity of more than 1 year. Term loans are also known as
term/project finance. The financial institutions provide project finance for new
projects as also for expansion/diversification and modernization

Features of Term Loans
Maturity
The maturity period of term loans is typically longer in case of
sanctions by financial institutions in the range of 6-10 years in
comparison to 3-5 years of bank advances. However, they are
rescheduled to enable corporates/borrowers tide over temporary
financial exigencies.
Negotiated
The term loans are negotiated loans between the borrowers and the
lenders. They are akin to private placement of debentures in
contrast to their public offering to investors
Security
All term loans are secured. While the assets financed by term loans
serve as primary security, all the other present and future assets of
the company provide collateral/secondary security for the term
loan.

Covenants
To protect their interest, the financial
institutions reinforce the asset security
stipulation with a number of restrictive terms
and conditions. These are known as covenants.
They are both positive/affirmative and negative
in the sense of what the borrower should and
should not do in the conduct of its operations
and fall broadly into four sets as respectively
related to assets, liabilities, cashflows and
control.

Negative Covenants
Asset-Related Covenants are intended to ensure the maintenance of a
minimum asset base by the borrowers. Included in this set of
covenants are:
 Maintenance of working capital position in terms of a minimum
current ratio,
 Restriction on creation of further charge on asset,
 Ban on sale of fixed assets without the lenders
concurrence/approval.

Liability-Related Covenants may, inter alia, include:
 Restrain on the incurrence of additional debt/repayment of
existing loan, say, without the concurrence/prior approval of the
lender/financial institution,
 Reduction in debt-equity ratio by issue of additional capital, and
 Prohibition on disposal of promoters shareholding.

Cashflow Related Covenants which are intended to restrain cash outflows
of the borrowers may include:
 Restriction on new projects/expansion without prior approval of the
financial institution,
 Limitation on dividend payment to a certain amount/rate and prior
approval of the financial institutions for declaration of higher
amount/rate,
 Arrangement to bring additional funds as unsecured loans/deposits to
meet overrun/shortfall, and
 Ceiling on managerial salary and perks.

Control Related Covenants aim at ensuring competent management for the
borrowers. This set of covenants may include
 Boroadbasing of board of directors and finalisation of management
set-up in consultation with the financial institution,
 Effective organisational changes and appointment of suitable
professional staff, and
 Appointment of nominee directors to represent the financial
institutions and safeguard their interests.

Positive Covenants
In addition to the foregoing negative covenants,
certain positive/affirmative covenants stating what the
borrowing firm should do during the term of a loan
are also included in a loan agreement. They provide,
inter alia, for
1) furnishing of periodical reports/financial
statements to the lenders,
2) maintenance of a minimum level of working
capital,
3) creation of sinking fund for redemption of debt
and
4) maintenance of certain net worth.

Repayment Schedule/Loan Amortisation
The term loans have to be amortised according to predetermined
schedule. The payment/repayment has two components:
1) Interest and
2) Repayment of principal.
The interest component of loan amortisation is a legally
enforceable contractual obligation. The borrowers have to pay a
commitment charge on the unutilised amount.
Typically, the principal is repayable over 6-10 years period after an
initial grace period of 1-2 years. Whereas the mode of repayment of
term loans is equal semi-annual instalments in case of institutional
borrowings, the term loans from banks are repayable in equal
quarterly instalments.

TABLE 1 Loan Amortisation Schedule (Equal Principal Repayment)
(Rs thousands)
Year Beginning Principal Interest Loan Ending
loan repayment (0.14) payment loan
(1) (2) (3) (4) (5) (6)
1 60.00 7.50 8.40 15.90 52.50
2 52.50 7.50 7.35 14.85 45.00
3 45.00 7.50 6.30 13.80 37.50
4 37.50 7.50 5.25 12.75 30.00
5 30.00 7.50 4.20 11.70 22.50
6 22.50 7.50 3.15 10.65 15.00
7 15.00 7.50 2.10 9.60 7.50
8 7.60 7.50 1.05 8.55 0.00

The debt servicing/loan amortisation pattern involving equal instalment
(interest + repayment of principal) is portrayed in Table 2.
TABLE 2 Loan Amortisation Schedule (Equal Instalment)
Year Beginning Payment Interest Principal Ending
loan instalment (0.14) repayment loan
@ [3 – 4] [2 – 5]
(1) (2) (3) (4) (5) (6)
1 Rs 60,000 Rs 12,934 Rs 8,400 Rs 4,535 Rs 55,466
2 55,466 12,934 7,776 5,168 50,298
3 50,298 12,934 7,042 5,896 44,406
4 44,406 12,934 6,216 6,718 37,688
5 37,688 12,934 5,276 7,658 30,030
6 30,030 12,934 4,204 8,730 21,300
7 21,300 12,934 2,982 9,952 11,348
8 11,348 12,934 1,588 11,346 0
@ Payment instalment = (Rs 60,000/PVIFA 8,14) = (Rs 60,000/4.6389) = Rs
12,934

Term Loan Procedure The procedure associated with a term loan
involves the following principal steps:
The borrower submits an application form which seeks
comprehensive information about the project. The application form
covers the following aspects:
1) Promoters’ background,
2) Particulars of the industrial concern,
3) Particulars of the project (capacity, process, technical
arrangements, management, location, land and buildings,
plant and machinery, raw materials, effluents, labour, housing,
and schedule of implementation),
4) Cost of project,
5) Means of financing,
6) Marketing and selling arrangements,
7) Profitability and cash flow,
8) Economic considerations, and
9) Government consents.

Term Loan Procedure When the application is considered complete, the
financial institution prepares a 'Flash Report' which is essentially a
summarization of the loan application. On the basis
of the 'Flash Report', it is decided whether the project justifies a detailed
appraisal or not.
The detailed appraisal of the project covers the marketing, technical,
financial, managerial, and economic aspects. The appraisal memorandum
is normally prepared within two months after site inspection. Based on
that, a decision is taken whether the project will be accepted or not.

If the project is accepted, a financial letter of sanction is issued to the
borrower communicating the assistance sanctioned and the terms and
conditions relating thereto.

On receiving the letter of sanction from the financial institution, the
borrowing unit convenes its board meeting at which the terms and
conditions associated with the letter of sanction are accepted and an
appropriate resolution is passed to that effect.

The agreement, properly executed and stamped, along with other
documents as required by the financial institution, must be returned to it.
Once the financial institution also signs the agreement, it becomes
effective.

Monitoring of the project is done at the implementation stage as well as the
operational stage. During the implementation stage, the project is
monitored through: (i) regular reports, furnished by the promoters, which
provide information about placement of orders, construction of buildings,
procurement of plant, installation of plant and machinery, trial production,
and so on, (ii) periodic site visits, (iii) discussion with promoters, bankers,
suppliers, creditors, and other connected with the project, (iv) progress
reports submitted by the nominee directors, and (v) audited accounts of
the company.

During the operational stage, the project is monitored with the help of (i)
quarterly progress report on the project, (ii) site inspection, (iii) reports of
nominee directors, and (iv) comparison of performance with promise. The
most important aspect of monitoring, of course, is the recovery of dues
represented by interest and principal repayment.

Project Appraisal
Financial institutions appraise a project from the marketing, technical,
financial, economic, and managerial angles. The principal issues
considered and the criteria employed in such appraisal are discussed
below.
Market Appraisal
The importance of the potential market and the need to develop a suitable
marketing strategy cannot be over-emphasised. Hence, efforts are made to
(i) examine the reasonableness of the demand projections, (ii) assess the
adequacy of the marketing infrastructure in terms of promotional effort,
distribution network, transport facilities, stock levels and so on, and (iii)
judge the knowledge, experience, and competence of the key marketing
personnel.

Technical Appraisal
The technical review done by the financial institutions focuses mainly on
the following aspects: (i) product mix, (ii) capacity, (iii) process of
manufacture, (iv) engineering know-how and technical collaboration, (v)
raw materials and consumables, (vi) location and site, (vii) building, (viii)
plant and equipment, (ix) manpower requirements, and (x) break-even
point.

Financial Appraisal The financial appraisal seeks to assess the
following:
Reasonableness of the Estimate of Capital Cost While assessing the
capital cost estimates, efforts are made to ensure that (i) padding or under-
estimation of costs is avoided, (ii) specification of machinery is proper, (iii)
proper quotation are obtained from potential suppliers, (iv) contingencies
are provided, and (v) inflation factors are considered.

Reasonableness of the Estimate of Working Results The estimate of
working results is sought to be based on (i) a realistic market demand
forecast, (ii) price computations for inputs and outputs that are based on
current quotations and inflationary factors, (iii) an approximate time
schedule for capacity utilization, and (iv) cost projections that distinguish
between fixed and variable costs.

Adequacy of Rate of Return The general norms for financial
desirability are as follows: (i) internal rate of return, 15 per
cent, (ii) return on investment, 20-25 per cent after tax, (iii)
debt-service coverage ratio, 1.5 to 2. In applying these norms,
however, a certain degree of flexibility is shown on the basis
of the nature of the project, the risks inherent in the project,
and the status of the promoter.
Appropriateness of the Financing Pattern The institutions
consider the following in assessing the financial pattern: (i) a
general debt-equity ratio norm of 1.5:1, (ii) a requirement that
promoters should contribute a certain percentage of the
project cost, (iii) stock exchange listing requirements, and
(iv) the means of the promoter and his capacity to contribute
a reasonable share of the project finance.

Managerial Appraisal In order to judge the managerial capability of
the promoters, the following aspects are considered:
Resourcefulness This is judged in terms of the prior experience of
the promoters, the progress achieved in organising various
aspects of the project, and the skill with which the project is
presented.
Understanding This is assessed in terms of the credibility of the
project plan (including, inter alia, the organisation structure, the
staffing plan, the estimated costs, the financing pattern, the
assessment of various inputs, and the marketing programme) and
the details furnished to the financial institutions.

Commitment This is gauged by the resources (financial,
managerial, material, and other) applied to the project and the zeal
with which the objectives of the project, short-term as well as long-
term, are pursued. Managerial review also involves an assessment
of the calibre of the key technical and managerial personnel
working on the projects, the schedule for training them, and the
remuneration structure for rewarding and motivating them.

Debentures/Bonds/Notes

Debenture/bond is a debt instrument indicating
that a company has borrowed certain sum of
money and promises to repay it in future under
clearly defined terms.

Attributes
As a long-term source of borrowing, debentures have some contrasting
features compared to equities .
Trust Indenture When a debenture is sold to investing public, a trustee is
appointed through an indenture/trust deed.
Trust (bond) indenture is a complex and lengthy legal document stating the
conditions under which a bond has been issued.
Trustee is a bank/financial institution/insurance company/ firm of attorneys
that acts as the third party to a bond/debenture indenture to ensure that
the issue does not default on its contractual responsibility to the bond/
debenture holders.
Interest The debentures carry a fixed (coupon) rate of interest, the payment
of which is legally binding/enforceable. The debenture interest is tax-
deductible and is payable annually/semi-annually/quarterly.

Maturity
It indicates the length of time for redemption of par value. A
company can choose the maturity period, though the redemption
period for non-convertible debentures is typically 7-10 years. The
redemption of debentures can be accomplished in either of two
ways:
(1) Debentures redemption reserve (sinking fund)
A DRR has to be created for the redemption of all debentures with a
maturity period exceeding 18 months equivalent to at least 50 per
cent of the amount of issue/redemption before commencement of
redemption.
(2) Call and put (buy-back) provision.
The call/buy-back provision provides an option to the issuing
company to redeem the debentures at a specified price before
maturity. The call price may be more than the par/face value by
usually 5 per cent, the difference being call premium. The put
option is a right to the debenture-holder to seek redemption at
specified time at predetermined prices.

Security
Debentures are generally secured by a charge on the present and
future immovable assets of the company by way of an equitable
mortgage
Convertibility
Apart from pure non-convertible debentures (NCDs), debentures
can also be converted into equity shares at the option of the
debenture-holders. The conversion ratio and the period during
which conversion can be affected are specified at the time of the
issue of the debenture itself. The convertible debentures may be
fully convertible (FCDs) or partly convertible (PCDs). The FCDs
carry interest rates lower than the normal rate on NCDs; they may
even have a zero rate of interest. The PCDs have two parts:

1) Convertible part,
2) Non-convertible part.

Credit Rating
To ensure timely payment of interest and redemption of
principal by a borrower, all debentures must be
compulsorily rated by one or more of the four credit
rating agencies, namely, Crisil, Icra, Care and FITCH
India.
Claim on Income and Assets
The payment of interest and repayment of principal is a
contractual obligation enforceable by law.
Failure/default would lead to bankruptcy of the
company. The claim of debenture-holders on income
and assets ranks with other secured debt and higher
than that of shareholders–preference as well as equity.

Evaluation
Advantages
The advantages for company are (i) lower cost due to lower
risk and tax-deductibility of interest payments, (ii) no dilution
of control as debentures do not carry voting rights. For the
investors, debentures offer stable return, have a fixed
maturity, are protected by the debenture trust deed and enjoy
preferential claim on the assets in relation to shareholders.

Disadvantages
The disadvantages for the company are the restrictive
covenants in the trust deed, legally enforceable contractual
obligations in respect of interest payments and repayments,
increased financial risk and the associated high cost of
equity. The debenture-holders have no voting rights and
debenture prices are vulnerable to change in interest rates.

Innovative Debt Instruments
In order to improve the attractiveness of bonds/debentures,
some new features are added. As a result, a wide range of
innovative debt instruments have emerged in India in recent
years. Some of the important ones among these are discussed
below.
Zero Interest Bonds/Debentures (ZIB/D)
Also known as zero coupon bonds/debentures, ZIBs do not
carry any explicit/coupon rate of interest. They are sold at a
discount from their maturity value. The difference between the
face value of the bond and the acquisition cost is the
gain/return to the investors. The implicit rate of return/interest
on such bonds can be computed by Equation 1.
Acquisition price = Maturity (face) value/(1 + i)n (1)
Where I     = rate of interest
n    = maturity period (years)

Deep Discount Bond (DDB)
A deep discount bond is a form of ZIB. It is issued at a deep/steep discount over its
face value. It implies that the interest (coupon) rate is far less than the yield to maturity.
The DDB appreciates to its face value over the maturity period.
The DDBs are being issued by the public financial institutions in India, namely, IDBI,
SIDBI and so on.
The merit of DDBs/ZIDs is that they enable the issuing companies to conserve cash
during their maturity. They protect the investors against the reinvestment risk to the
extent the implicit interest on such bonds is automatically reinvested at a rate equal to
its yield to maturity. However, they are exposed to high repayment risk as they entail a
balloon payment on maturity.

Secured Premium Notes (SPNs)
The SPN is a secured debenture redeemable at a premium over the face value/purchase
price. The SPN is a tradeable instrument. A typical example is the SPN issued by TISCO
in 1992. Its salient features were
 Each SPN had a face value of Rs 300. No interest would accrue during the first year
after allotment.
 During years 4-7, principal will be repaid in annual instalment of Rs 75. In addition,
Rs 75 will be paid each year as interest and redemption premium.
 A warrant was attached to the SPN entitling the holder to acquire one equity share
for cash by payment of Rs 100.
 The holder was given an option to sell back the SPN at the par value of Rs 300.

The before tax rate of return on the SPN = 13.65 per cent, that is
0 0 0 150 150 150 150
300 = + + + + + +
(1+ r ) (1+ r ) 2 (1+ r ) 3 (1+ r ) 4 (1+ r ) 5 (1+ r ) 6 (1+ r ) 6
Floating Rate Bonds (FRBs)
The interest on such bonds is not fixed. It is floating and is linked to a
benchmark rate such as interest on treasury bills, bank rate, maximum rate
on term deposits.
Callable/Puttable Bonds/Debentures/Bond Refunding
Beginning from 1992 when the Industrial Development Bank of India issued
bonds with call features, several callable/puttable bonds have emerged in
the country in recent years. The call provisions provide flexibility to the
company to redeem them prematurely. Generally, firms issue bonds
presumably at lower rate of interest when market conditions are favourable
to redeem such bonds.

Evaluation
The bond refunding decision can be analysed as a capital budgeting
decision. If the present value of the stream of net cash savings exceeds the
initial cash outlay, the debt should be refunded.

Example 1 : The 22 per cent outstanding bonds of the Bharat Industries Ltd
(BIL) amount to Rs 50 crores, with a remaining maturity of 5 years. It can now
issue fresh bonds of 5 year maturity at a coupon rate of 20 per cent. The
existing bonds can be refunded at a premium (call premium) of 5 per cent.
The flotation costs (issue expenses + discount) on new bonds are expected to
be 5 per cent. The unamortised portion of the issue expenses on existing
bonds is 1.5 crore. They would be written off as soon as the existing bonds
are called/refunded.

If the BIL is in 35 per cent tax bracket, would you advise it to call the bond?

Solution
(Amount in Rs crore)
Annual net cash savings (Working note 2) 0.71
PVIFA (10,13) (Working note 3) 3.517
Present value of annual net cash savings 2.497
Less: Initial outlay ((Working note 1) 3.600
NPV (bond refunding) (1.103)
It is not advisable to call the bond as the NPV is negative.

Working Notes
(1)(a)Cost of calling/refunding existing bonds
         Face value 50.0
                 Plus: Call premium (5 per cent) 2.5 52.5
    (b)Net proceeds of new bonds
         Gross proceeds 50.0
                Less: Flotation costs 2.5 47.5
    (c)Tax savings on expenses
         Call premium 2.5
                Plus: Unamortised issue costs 1.5
    4.0 × (0.35 tax) 1.40
Initial outlay [(1a) – (1b) – (1c)] 3.60
(2)(a)Annual net cash outflow on existing bonds
        Interest expenses 11.00
               Less: Tax savings on interest expenses and
              amortisation of issue costs : 0.35 [11.0 + (1.5/5)] 3.96 7.04
    (b)Annual net cash outflow on new bonds
         Interest expenses 10.00
               Less: Tax savings on interest expenses and
              amortisation of issue costs : 0.35 [10.0 + (2.5/5)] 3.67 6.33
           Annual net cash savings [(2a) – (2b)] 0.71

(3)Present value interest factor of 5 year annuity, using a 13 per cent after tax [0.20 (1 –
0.35)] cost of new bonds = 3.517

Issue of Debt Instruments
A company offering convertible/non-convertible debt instruments
through an offer document should, in addition to the other relevant
provisions of these guidelines, comply with the following provisions.

Requirement of Credit Rating
A public or rights issue of all debt instruments (i.e. convertible as
well as non-convertible) can be made only if credit rating of a
minimum investment grade is obtained from at least two registered
credit rating agencies and disclosed in the offer document .

Requirement in Respect of Debenture Trustees
A company must appoint one/more debenture trustee(s) in
accordance with the provisions of the Companies Act before issuing
a prospectus/letter of offer to the pubic for subscription of its
debentures.

Creation of Debenture Redemption Reserves (DRR)  A company has
to create DRR as per the requirements of the Companies Act for
redemption of debentures in accordance with the provisions given
below:
If debentures are issued for project finance, the DRR can be created
up to the date of com-mercial production, either in equal instalments
or higher amounts if profits so permit. In the case of partly convertible
debentures, the DRR should be created with respect to the non-
convertible portion on the same lines as applicable for fully non-
convertible debenture issue. In the case of convertible issues by new
companies, the creation of DRR should commence from the year the
company earns profits for the remaining life of debentures.

Distribution of Dividends
In case of companies which have defaulted in payment of interest on
debentures or their redemption or in creation of security as per the
terms of the issue, distribution of dividend would require approval of
the debenture trustees and the lead institution, if any.
Redemption  The issuer company should redeem the debentures as
per the offer document.

Disclosure and Creation of Charge
The offer document should specifically state the assets on
which the security would be created as also the ranking of the
charge(s). In the case of second/residual charge or
subordinated obligation, the associated risks should also be
clearly stated.
Requirement of Letter of Option
Where the company desires to rollover the debentures issued
by it, it should file with the SEBI a copy of the notice of the
resolution to be sent to the debenture-holders through a
merchant bank prior to despatching the same to the
debenture-holders. If a company desires to convert the
debentures into equity shares (according to the procedure
discussed subsequently), it should file with the SEBI a copy of
the letter of option to be sent to the debenture-holders through
a merchant bank prior to despatching the same to the
debenture-holders.

Rollover of Non-Convertible Portions of Partly Convertible Debentures
(PCDs)/Non-Convertible Debentures (NCDs) By Company Not Being in Default
The non-convertible portions of PCDs/NCDs issued by a listed company, the value
of which exceeds Rs 50 lakh, can be rolled over without change in the interest rate
subject to (i) Section 121 of the Companies Act and (ii) the following conditions, if
the company is not in default: (i) passing of a resolution by postal ballot, having
assent of at least 75 per cent of the debentures; (ii) redemption of debentures of
all the dissenting holders, (iii) obtaining at least two credit ratings of a minimum
investment grade within six months prior to the date of redemption and
communicating to the debenture-holders before rollover, (iv) execution of fresh
trust deed, and (v) creation of fresh security in respect of roll over debentures.

Rollover of NCDs/PCDs By a Listed Company Being in Default
The non-convertible portion of PCDs/NCDs by listed companies exceeding Rs 50
lakh can be rolled over without change in the interest rate subject to Section 121
of the Companies Act and the following conditions, namely, (a) a resolution by
postal ballot, having assent of at least 75 per cent of the debenture-holders,(b)
along with the notice for passing the resolution, send to the debenture-holders
auditor’s certificate on the cash flow of the company with comments on its
liquidity position, (c) redemption of debentures of all the dissenting debenture-
holders, and (d) decision of the debenture trustee about the creation of fresh
security and execution of fresh trust deed in respect debentures to be rolled over.

Additional Disclosures in Respect of Debentures The offer
document should contain:
a) premium amount on conversion, time of conversion;
b) in case of PCDs/NCDs, redemption amount, period of maturity,
yield on redemption of the PCDs/NCDs;
c) full information relating to the terms of offer or purchase,
including the name(s) of the party offering to purchase, the
(non-convertible portion of PCDs);
d) the discount at which such an offer is made and the effective
price for the investor as a result of such discount;
e) the existing and future equity and long-term debt ratio;
f) servicing behaviour on existing debentures, payment of due
interest on due dates on term loans and debentures and
g) a no objection certificate from a financial institution or banker
for a second or charge being created in favour of the trustees
to the proposed debenture issues has been obtained.

Secondary Market for Corporate Debt Securities Any listed company making issue of
debt securities on a private placement basis and listed on a stock exchange should
comply with the following:
1) It should make full disclosures (initial and continuing) in the manner prescribed in
Schedule II of the Companies Act, 1956, SEBI (Disclosure and Investor Protection)
Guidelines, 2000 and the Listing Agreement with the exchanges.
2) The debt securities should carry a credit rating of not less than investment grade
from a credit rating agency registered with the SEBI.
3) The company should appoint a debenture trustee registered with the SEBI in respect
of the issure of debt securities.
4) The debt securities should be issued and traded in demat form.
5) The company should sign a separate listing agreement with the stock exchange in
respect of debt securities and comply with the conditions of listing.
6) All trades with the exception of spot transactions, in a listed debt security, should be
ex-ecuted only on the trading platform of a stock exchange.
7) The trading in privately placed debts should only take place between qualified QIBs
and high networth individuals (HNIs), in standard denomination of Rs 10 lakhs.
8) The requirement of Rule 19(2)(b) of the Securities Contract (Regulation) Rules, 1957
would not be applicable to listing of privately placed debt securities on exchanges,
provided all the above requirements are complied with.
9) If the intermediaries with the SEBI associate themselves with the issuance of private
placement of unlisted debt securities, they will be held accountable for such issues.

Rating of Debt Instruments
Credit rating of debentures by a rating agency is mandatory. It provides a simple
system of gradation by which relative capacities of borrowers to make timely
payment of payment and repayment of principal on a particular type of debt
instrument can be noted. A rating is specific to a debt instrument and is intended
to grade different and specific instruments in terms of the credit risk associated with
the particular instruments. Although it is an opinion expressed by an independent
professional organization, on the basis of a detailed study of all the relevant factors,
the rating does not amount to any recommendation to buy, hold or sell an instrument
as it does not take into consideration factors such as market prices, personal risk
preferences of an investor and such other considerations, which may
influence an investment decision The main elements of the rating methodology are

(1) Business risk analysis
(2) Financial risk analysis
(3) Management risk.

The rating agencies in India are CRISIL, ICRA, CARE and Fitch India.

Rating Methodology
A rating is assigned after assessing all the factors that could affect the credit
worthiness of the entity. Typically, the industry risk assessment sets the stage for
analyzing more specific company risk factors and establishing the priority of these
factors in the overall evaluation.

For instance, if the industry is highly competitive, careful assessment of the issuer's
market position is stressed. If the company has large capital requirements, the
examination of cash flow adequacy assumes importance. The ratings are based on
the current information provided by the issuer or facts obtained from reliable
sources. Both qualitative and quantitative criteria are employed in evaluating and
monitoring the ratings.

Business Risk Analysis
The rating analysis begins with an assessment of the company’s environment
focusing on the strength of the industry prospects, pattern of business cycles as
well as the competitive factors affecting the industry. The vulnerability of the
industry to Government controls/regulations is assessed.

The nature of competition is different for different industries based on price, product
quality, distribution capabilities, image, product differentiation, service and so on.
The industries characterized by a steady growth in demand, ability to maintain
margins without impairing future prospects, flexibility in the timing of capital outlays,
and moderate capital intensity are in a stronger position
The main industry and business factors assessed include:

Industry Risk  Nature and basis of competition, key success factors, demand and
supply position, structure of industry, cyclical/seasonal factors, government policies
and so on.
Market Position of the Issuing Entity Within the Industry  Market share, competitive
advantages, selling and distribution arrangements, product and customer diversity
and so on.
Operating Efficiency of the Borrowing Entity  Locational advantages, labour
relationships, cost structure, technological advantages and manufacturing efficiency
as compared to competitors and so on.
Legal Position  Terms of the issue document/prospectus, trustees and their
responsibilities, systems for timely payment and for protection against fraud/forgery
and so on.

Financial Risk Analysis
After evaluating the issuer’s competitive position and operating
environment, the analysts proceed to analyse the financial strength of the
issuer. Financial risk is analysed largely through quantitative means,
particularly by using financial ratios. While the past financial performance
of the issuer is important, emphasis is placed on the ability of the issuer to
maintain/improve its future financial performance. The areas considered in
financial analysis include:

Accounting Quality  Overstatement/understatement of profits, auditors
qualifications, method of income recognition, inventory valuation and
depreciation policies, off Balance sheet liabilities and so on.
Earnings Protection  Sources of future earnings growth, profitability ratios,
earnings in relation to fixed income charges and so on.
Adequacy of Cash Flows  In relation to debt and working capital needs,
stability of cash flows, capital spending flexibility, working capital
management and so on.
Financial Flexibility  Alternative financing plans in times of stress, ability to
raise funds, asset deployment potential and so on.
Interest and Tax Sensitivity  Exposure to interest rate changes, tax law
changes and hedging against interest rates and so on.

Management Risk
A proper assessment of debt protection levels requires an
evaluation of the management philosophies and its strategies. The
analyst compares the company’s business strategies and financial
plans (over a period of time) to provide insights into a
management’s abilities with respect to forecasting and
implementing of plans. Specific areas reviewed include:
1) Track record of the management: planning and control
systems, depth of managerial talent, succession plans;
2) Evaluation of capacity to overcome adverse situations; and
3) Goals, philosophy and strategies.

Rating Symbols
Rating symbol is a symbolic expression of opinion of the rating
agency regarding the investment/credit quality/grade of the debt
instrument/obligation.

EXHIBIT 1  CRISIL Rating Symbols
The rating of debentures is mandatory. CRISIL assigns alpha-based rating scale to
rupee-denominated debentures. It categorises them into three grades namely, high
investment, investment and speculations.
High Investment Grade  includes:
AAA - (Triple A) Highest Security  The debentures rated AAA are judged to offer the
highest safety against timely payment of interest and principal. Though the
circumstances providing this degree of safety are likely to change, such changes
as can be envisaged are most unlikely to affect adversely the fundamentally strong
position of such issues.
AA - (Double A) High Safety  The debentures rated AA are judged to offer high
safety against timely payment of interest and principal. They differ in safety from
AAA issues only marginally.
Investment Grades  are divided into:
A - Adequate Safety  The debentures rated A are judged to offer adequate safety
against timely payment of interest and principal; however, changes in
circumstances can adversely affect such issues more than those in the higher
rated categories.
BBB - (Triple B) Moderate Safety  The debentures rated BBB are judged to offer
sufficient safety to against timely payment of interest and principal for the present:
however, changing circumstances are more likely to lead to a weakened capacity
to pay interest and repay principal than for debentures in higher rated categories.

CONTD.
Speculative Grades  comprise:
BB - (Double B) Inadequate Safety  The debentures rated BB are judged to carry
inadequate safety of the timely payment of interest and principal; while they are
less susceptible to default than other speculative grade debentures in the
immediate future, the uncertainties that the issuer faces could lead to inadequate
capacity to make interest and principal payments on time.
B - High Risk  The debentures rated B are judged to have greater susceptibility to
default; while currently interest and principal payments are met; adverse business
or economic conditions would lead to a lack of ability or willingness to pay interest
or principal.
C - Substantial Risk  The debentures rated C are judged to have factors present
that make them vulnerable to default; timely payment of interest and principal is
possible only if favourable circumstances continue.
D - Default  The debentures rated D are in default and in arrears of interest or
principal payments or are expected to default on maturity. Such debentures are
extremely speculative and returns from these debentures may be realised only on
reorganisation or liquidation.
Note: (1) CRISIl may apply ‘+’ (plus) or ‘–’ (minus) signs for ratings from AA to C to
reflect comparative standing within the category. The contents within parenthesis
are a guide to the pronunciation of the rating symbols.

EXHIBIT 2 ICRA Rating Symbols
ICRA symbols classify them into eight investment grades.
LAAA Highest Safety This indicates a fundamentally strong position. Risk
factors are negligible. There may be circumstances adversely affecting the
degree of safety but such circumstances, as may be visualised, are not likely
to affect the timely payment of principal and interest as per terms.
LAA+, LAA, LAA– High Safety Risk factors are modest and may vary slightly.
The protective factors are strong and the prospects of timely payment of
principal and interest as per the terms under adverse circumstances, as may
be visualised, differs from LAAA only marginally.

LA+, LA, LA– Adequate Safety Risk factors vary more and are greater during
economic stress. The protective factors are average and any adverse change
in circumstances, as may be visualised, may alter the fundamental strength
and affect the timely payment of principal and interest as per the terms.
LBBB+, LBBB, LBBB– Moderate Safety This indicates considerable variability
in risk factors. The protective factors are below average. Adverse changes in
the business/economic circumstances are likely to affect the timely payment
of principal and interest as per the terms.

CONTD.
LBB+, LBB, LBB- Adequate Safety The timely payment of interest and
principal are more likely to be affected by the present or prospective changes
in business/economic circumstances. The protective factors fluctuate in case
of economy/business conditions change.

LB+, LB, LB– Risk Prone Risk factors indicate that obligations may not be met
when due. The protective factors are narrow. Adverse changes in the
business/economic conditions could result in the inability/unwillingness to
service debts on time as per the terms.

LC+, LC, LC- Substantial Risk There are inherent elements of risk and timely
servicing of debts/obligations could be possible only in the case of continued
existence of favourable circumstances.

LD Default Extremely Speculative Indicates either already in default in
payment of interest and/or principal as per the terms or expected to default.
Recovery is likely only on liquidation or reorganisation.

Issue Procedure
Debt securities mean non-convertible securities, including
bonds/debentures and other securities of a body
corporate/any statutory body, which create/acknowledge
indebtedness, but excluding bonds issued by
Government/other bodies specified by the SEBI, security
receipts and securitised debt instruments. Private placement
is an offer to less than 50 persons, while public issue is an
offer/invitation to public to subscribe to debt securities. The
main element of the SEBI regulations relating to issue and
listing of debt securities are: issue requirements, listing,
conditions for continuous listing and trading, obligations of
intermediaries/issuers, procedure for action for violation, and
pow-ers of the SEBI to issue general order.

Any issuer who has been restrained/prohibited/debarred by
the SEBI from accessing the securities market/dealing in
securities cannot make public issue of debt securities. To
make such an issue the conditions to be satisfied on the date
of filing of draft/final offer document are in-principle approval
for their listing, credit rating from at least one SEBI-
registered rating agency and agreement with a SEBI-
registered depository for their dematieralisation. The issuer
should appoint merchant bankers/trustees and not issue
such securities to provide loan to, acquisition of shares of,
any person who is a part of the same group/under the same
management. The issuer should advertise in a national daily
with wide circulation on/before the issue opening date.
Application forms should be accompanied by a copy of the
abridged prospectus. The issue could be fixed-price or book-

built. The minimum subscription and underwriting
arrangement should be disclosed in the offer document and
it should not contain any false/misleading statement. A trust
deed must be executed and debenture redemption reserve
should be created. The creation of security should be
disclosed in the offer document.
The listing of debt securities is mandatory. The issuer should
comply with the conditions of listing specified in the listing
agreement.
The debt securities issued to public or on private placement
basis should be traded/cleared/settled in a recognised stock
exchange subject to conditions specified by the SEBI
including conditions for reporting of all such trades.
The debenture trustees, issuers and merchants bankers
should comply with their obligations specified by the SEBI.

In case of violation of any regulation(s), the SEBI may carry
out inspection of books of accounts/ records/documents of
the issuers/intermediaries. It can issue such directions as it
may deem fit. An aggrieved party may prefer an appeal with
the SAT.
In addition to the other requirements, an issuer of CDIs
(Convertible debt instruments) should comply with the
following conditions: (i) obtain credit rating, (ii) appoint
debenture trustees, (iii) create debenture redemption fund,
(iv) assets on which charge is proposed are sufficient to
discharge the liability and free from encumbrances. They
should be redeemed in terms of the offer document.

The non-convertible portion of the partly CDIs can be rolled
over without change in the interest rate if 75 per cent of the
holders approve it; an auditors certificate on its liquidity
position has been sent to them; the holding of all holders
who have not agreed would be redeemed; credit rating has
been obtained and communicated to them before rollover.
Positive consent of the holders would be necessary for
conversion of optionally CDIs into shares. The holders
should be given the option not to convert them if the
conversion price was not determined/disclosed to the
investors at the time of the issue.
The terms of issue of securities adversely affecting the
investors can be altered with the consent/sanction in writing
of at least 75 per cent/special resolution of the holders.

Securitisation
Securitization is the process of pooling and repackaging of homogeneous
illiquid financial assets, such as residential mortgage, into marketable
securities that can be sold to investors.

The process leads to the creation of financial instruments that represent
ownership interest in, or are secured by a segregated income producing
asset or pool, of assets. The pool of assets collateralizes securities. These
assets are generally secured by personal or real property such as
automobiles, real estate, or equipment loans but in some cases are
unsecured, for example, credit card debt and consumer loans.

Securitisation Process
1) Asset are originated through receivables, leases, housing loans or any
other form of debt by a company and funded on its balance sheet. The
company is normally referred to as the “originator”.
2) Once a suitably large portfolio of assets has been originated, the assets
are analyzed as a portfolio and then sold or assigned to a third party,
which is normally a special purpose vehicle company (‘SPV’) formed for
the specific purpose of funding the assets. It issues debt and purchases
receivables from the originator.
3) The administration of the asset is then subcontracted back to the
originator by the SPV. It is responsible for collecting interest and principal
payments on the loans in the underlying pool of assets and transfer to the
SPV.
4) The SPV issues tradable securities to fund the purchase of assets.
5) The investors purchase the securities because they are satisfied that the
securities would be paid in full and on time from the cash flows available
in the asset pool.
6) The SPV agrees to pay any surpluses which, may arise during its funding
of the assets, back to the originator.
7) As cash flow arise on the assets, these are used by the SPV to repay
funds to the investors in the securities.

Credit Enhancement
Investors in securitized instruments take a direct exposure on the
performance of the underlying collateral and have limited or no
recourse to the originator. Hence, they seek additional comfort in the
form of credit enhancement. It refers to the various means that
attempt to buffer investors against losses on the asset collateralizing
their Investment.

These losses may vary in frequency, severity and timing, and depend
on the asset characteristics, how they are originated and how they are
administered. The credit enhancements are often essential to secure
a high level of credit rating and for low cost funding. By shifting the
credit risk from a less-known borrower to a well-known, strong, and
larger credit enhancer, credit enhancements correct the imbalance of
information between the lender(s) and the borrowers.

External Credit Enhancements
They include insurance, third party guarantee and letter of credit.
Insurance Full insurance is provided against losses on the assets.
This tantamounts to a 100 per cent guarantee of a transaction’s
principal and interest payments. The issuer of the insurance looks to
an initial premium or other support to cover credit losses.

Third-Party Guarantee This method involves a limited/full guarantee
by a third party to cover losses that may arise on the non-
performance of the collateral.

Letter of Credit For structures with credit ratings below the level
sought for the issue, a third party provides a letter of credit for a
nominal amount. This may provide either full or partial cover of the
issuer’s obligation.

Internal Credit Enhancements Such form of credit enhancement
comprise the following:
Credit Trenching (Senior/Subordinate Structure) The SPV issues two
(or more) tranches of securities and establishes a predetermined
priority in their servicing, whereby first losses are borne by the holders
of the subordinate tranches (at times the originator itself). Apart from
providing comfort to holders of senior debt, credit tranching also
permits targeting investors with specific risk-return preferences.

Over-collateralisation The originator sets aside assets in excess of the
collateral required to be assigned to the SPV. The cash flows from
these assets must first meet any overdue payments in the main pool,
before they can be routed back to the originator.

Cash Collateral This works in much the same way as the over-
collateralisation. But since the quality of cash is self-evidently higher
and more stable than the quality of assets yet to be turned into cash,
the quantum of cash required to meet the desired rating would be
lower than asset over-collateral to that extent.

Spread Account The difference between the yield on the assets and
the yield to the investors from the securities is called excess spread. In
its simplest form, a spread account traps the excess spread (net of all
running costs of securitization) within the SPV up to a specified
amount sufficient to satisfy a given rating or credit equity requirement.
Only realizations in excess of this specified amount are routed back to
the originator. This amount is returned to the originator after the
payment of principal and interest to the investors.

Triggered Amortization This works only in structures that permit
substitution (for example, rapidly revolving assets such as credit
cards). When certain preset levels of collateral performance are
breached, all further collections are applied to repay the funding. Once
amortization is triggered, substitution is stopped and the early
repayment becomes an irreversible process. The triggered
amortization is typically applied in future flow securitization

Parties to a Securitisation Transaction
The parties to securitisation deal are (i) primary and (ii) others. There are three
primary parties to a securitisation deal, namely, originators, special purpose
vehicle (SPV) and investors. The other parties involved are obligors, rating
agency, administrator/servicer, agent and trustee, and structurer.
Originator is the entity on whose books the assets to be securitized exist. It
is the prime mover of the deal, that is, it sets up the necessary structures to
execute the deal. It sells the assets on its books and receives the funds
generated from such sale. In a true sale, the originator transfers both the legal
and the beneficial interest in the assets to the SPV.

SPV (special purpose vehicle) is the entity which would typically buy the assets
to be securitised from the originator. An SPV is typically a low-capitalised
entity with narrowly defined purposes and activities, and usually has
independent trustees/Directors. As one of the main objectives of securitisation
is to remove the assets from the balance sheet of the originator, the SPV plays a
very important role in as much as it holds the assets in its books and makes the
upfront payment for them to the originator.

Investors The investors may be in the form of individuals or institutional
investors like FIs, mutual funds, provident funds, pension funds, insurance
companies and so on.

Obligors are the borrowers of the original loan. The credit standing of an obligor(s)
is of paramount importance in a securitisation transaction
Rating Agency Since the investors take on the risk of the asset pool rather than
the originator, an external credit rating plays an important role. The rating process
would assess the strength of the cash flow and the mechanism designed to ensure
full and timely payment by the process of selection of loans of appropriate credit
quality, the extent of credit and liquidity support provided and the strength of the
legal framework.
Administrator or Servicer It collects the payment due from the obligor(s) and
passes it to the SPV, follows up with delinquent borrowers and pursues legal
remedies available against the defaulting borrowers. Since it receives the
instalments and pays it to the SPV, it is also called the Receiving and Paying Agent
(RPA).
Receiving and paying agent is one who collects the payment due from the obligors
and passes it on to the SPV.
Agent and Trustee It accepts the responsibility for overseeing that all the parties to
the securitisation deal perform in accordance with the securitisation trust
agreement. Basically, it is appointed to look after the interest of the investors.
Structurer Normally, an investment banker is responsible as structurer for
bringing together the originator, the credit enhancer(s), the investors and other
partners to a securitisation deal. It also works with the originator and helps in
structuring deals.

Asset Characteristics: The assets to be securities should have the
following characteristics
Cash Flow A principal part of the assets should be the right to
receive from the debtor(s) on certain dates, that is, the asset can be
analysed as a series of cash flows.
Security If the security available to collateralise the cash flows is
valuable, then this security can be realised by a SPV.
Distributed Risk Assets either have to have a distributed risk
characteristic or be backed by suitably-rated credit support.
Homogeneity Assets have to relatively homogenous, that is, there
should not be wide variations in documentation, product type or
origination methodology.
No Executory Clauses The contracts to be securitised must work
even if the originator goes bankrupt.
Independence From the Originator The ongoing performance of
the assets must be independent of the existence of the originator.

The securitisation process is depicted in Figure 1.

Ancillary
Obligor service provider
Interest and principal

Sales of assets Issue of securities

Special purpose
Originator Investors
vehicle

Consideration for Subscription of securities
assets purchased

Credit rating of
securities

Rating agency

Structure

Figure 1: Securitisation Process

Instruments of Securitisation
Securitisation can be implemented by three kinds of instruments differing
mainly in their maturity characteristics. They are:
(1) Pass through certificates
The cash flows from the underlying collateral are passed through to the
holders of the securities in the form of monthly payment of interest, principal
and pre-payments. In other words, the cash flows are distributed
on a pro-rata basis to the holders of the securities.

Some of the main features of PTCs are:
They reflect ownership rights in the assets backing the securities.

Pre-payment precisely reflects the payment on the underlying mortgage. If it is

a home loan with monthly payments, the payments on securities would also be
monthly but at a slightly less coupon rate than the loan.
As underlying mortgage is self-amortising. Thus, by whatever amount it is

amortized, it is passed on to the security-holders with re-payment.
Pre-payment occurs when a debtor makes a payment, which exceeds the

minimum scheduled amount. It shortens the life of the instrument and skews
the cash flows towards the earlier years.

(2) Pay Through Security
A key difference between PTC and PTS is the mechanics of principal repayment
process. In PTC, each investor receives a pro-rata distribution of any principal
and interest payment made by the borrower. Because these assets are self-
amortising assets, a pass through, however, does not occur until the final asset
in the pool is retired. This results in large difference between average life and
final maturity as well as a great deal of uncertainty with regard to the timing of
the return of the principal.

The PTS structure, on the other hand, substitutes a sequential retirement of
bonds for the pro-rata principal return process found in pass through. Cash
flows generated by the underlying collateral is used to retire bonds. Only one
class of bonds at a time receives principal. All principal payments go first to the
fastest pay trance in the sequence then becomes the exclusive recipients
of principal. This sequence continues till the last tranches of bonds is retired.

(3) Stripped Securities
Under this instrument, securities are classifies as Interest only (I0) or
Principally only (PO) securities. The I0 holders are paid back out of the interest
income only while the PO holders are paid out of principal repayments only.

Normally, PO securities increase in value when interest rates go down because
it becomes lucrative to prepay existing mortgagor and undertake fresh loans at
lower interest rates. As a result of prepayment of mortgages, the maturity
period of these securities goes down and investors are returned the money
earlier than they anticipated.

In contrast, I0 increase in value when interest rates go up because more
interest is collected on underlying mortgages. However, in anticipation of a
decline in the interest rates, prepayments of mortgages declines and maturities
lengthen. These are normally traded by speculators who make money by
speculating about interest rate changes.

Types of Securities
The securities fall into two groups:
Asset Backed Securities (ABS)
The investors rely on the performance of the assets that
collateralise the securities. They do not take an exposure either on
the previous owner of the assets (the originator), or the entity
issuing the securities (the SPV). Clearly, classifying securities as
‘asset-backed’ seeks to differentiate them from regular securities,
which are the liabilities of the entity issuing them. An example of
ABS is credit card receivables. Securitisation of credit card
receivables is an innovation that has found wide acceptance.

Mortgage Backed Securities (MBS)
The securities are backed by the mortgage loans, that is, loans
secured by specified real estate property, wherein the lender has
the right to sell the property, if the borrower defaults.

Issue Procedure
The main elements of the SEBI regulations relating to public offers of
securitised debt instruments (SDIs) and listing on a recognised stock
exchange are: registration of trustees, constitution/management of
special purpose distinct entities (SPDEs), schemes of SPDEs, public
offer of SDIs, rights of investors, listing of SDIs, inspection and
disciplinary proceedings, and action in case of default.
Public offer and listing of SDIs can be made only by SPDEs if their
trustees are registered with the SEBI and it complies with all the
applicable provisions of these regulations and the Securities Contracts
(Regulation) Act. However, SEBI-registered debenture trustees, RBI-
registered securitisation/asset reconstruction companies, NHB and
NABARD would not require registration to act as trustees. A SDI means
any certificate/instrument issued to an investor by SPDE which
possesses any debt/receivables including mortgage debt assigned to it
and acknowledging beneficial interest of such investors.

While considering registration, the SEBI would have regard to all
relevant factors, including: (i) track record, professional competence
and general reputation of the applicant, (ii) objectives of a body
corporate applicant, (iii) adequacy of its infrastructure, (iv) compliance
with the provisions of these regulations, (v) rejection by the SEBI of
any previous application and (vi) the applicant/promoters/directors are
fit and proper person.
The registration of the trustees would be subject to the following
conditions: (i) prior approval of the SEBI to change its
management/control, (ii) adequate steps for redressal of investors
grievances, (iii) abide by the provisions of these regulations/Securities
Contracts (Regulation) Act, (iv) forthwith inform the SEBI (a) if
information/particulars previously submitted is false/misleading (b) of
any material change in the information submitted and (v) abide by the
specified code of conduct.
The SPDE should be constituted as a trust entitled to issue SDIs. The
trust deed should contain the specified clauses.

A SPDE may raise funds by offering SDIs through a scheme. The
scheme should consist of the following elements: (i) obligation to
redeem the SDIs, (ii) credit enhancement and liquidity facilities, (iii)
servicers, (iv) accounts, (v) audit, (vi) maintenance of records, (vii)
holding of originator and
(viii) winding up.
The stipulations relating to the public offer of the SDIs are: (i) offer to
the public, (ii) submission of draft offer document and filing of final
offer document, (iii) arrangement for dematerialisaion, (iv) mandatory
listing, (v) credit rating, (vi) contents of the offer document, (vii)
prohibition on misstatements in the offer document, (viii) underwriting
of the issue, (ix) offer period, (x) minimum subscription, (xi) allotment
and other obligations and (xii) post-issue obligations.
The rights of investors are two-folds: free transferability of the SDIs
and their rights in the securities issued by the SPDE.

The provisions relating to the listing of the SDIs include: (a) application
for listing, (b) minimum public offering for listing, (c) continuous listing
conditions and (d) trading.
As regards inspection and disciplinary proceedings, the provisions
relate to (1) power of the SEBI to call for information, (2) right of
inspection by the SEBI, (3) obligations of the SPDE on inspection, (4)
appointment of auditor/valuer and (5) submission of report to the SEBI.
Action in case of default would result in suspension/cancellation of
registration of the SPDE. The SEBI may also issue the specified
directions to the SPDE/trustees. An aggrieved party may prefer an
appeal to the SAT.

Principal Terms of the PTCs
The NHB in its corporate capacity as also in its capacity as a sole trustee of the SPV
Trust would issue securities in the form of Class A and Class B PTCs. The Class B
PTCs are subordinated to Class A PTCs and act as a credit enhancement for Class
A PTC holders. Only Class A PTCs are available for subscription through the issue.
The Class B PTCs would be subscribed to by the HDFC itself (i.e. the originator).
Their features are listed in Format 1.

FORMAT 1
Particulars Class A PTCs Class B PTCs
(a) Senior/subordinate Senior Subordinate
status
(b) Face value Rs 9,94,998 Rs 10,04,062.14
(c) Pass through rate 11.35% to 11.85% per No fixed interest rate but
annum payable monthly would receive all residual
cash flows from the pool
(d) Tenure 83 months 141 months
(e) Schedule payment In 83 monthly payouts Redemption of principal
pattern comprising principal amount would begin only
and after class A PTCs are
interest extinguished, except in
case of prepayments
(f) Subscribed to by Investors HDFC (the originator)

The return on the Class A PTCs would be in the form of monthly pay-outs
comprising principal repayments and interest payments. As per the scheduled
repayment pattern, Class A PTCs would be redeemed fully, over the first 83
months starting from the deemed date of allotment.

The actual principal repayment on Class A PTCs each months, would correlate to
the principal portion of the corresponding EMI realizations from the receivables
pool and the tenure of the PTCs is, hence, subject to defaults (over and above the
credit enhancements) and prepayments if any. Interest would be paid each month
at the pass-through rate, on the outstanding principal of the Class A PTCs as at
the beginning of that month.

Entering Into Memorandum of Agreement
The HDFC and the NHB entered into a Memorandum of Agreement on July 7, 2000,
to entitle the NHB to take necessary steps to securities the said housing loans,
including circulation of the Information Memorandum and collection of subscription
amount from investors.
Acquisition of the Housing Loans by the NHB
The NHB would acquire the amount of balance principal of the housing loans
outstanding as on the cut-off date, that is, May 31, 2000, along with the underlying
mortgages/other securities, under the deed of assignment. There would be absolute
transfer of all risks and benefits in the housing loans to the NHB (through the deed
of assignment), and subsequently to the SPV Trust (through the declaration of
trust).

Pool Selection Criteria
The loans in the pool comply with the following criteria:
 The loans were current at the time of selection,
 They have a minimum seasoning of 12 months,
 The pool consists of loans where the underlying property is situated in the states
of Gujarat, Karnataka, Maharashtra and Tamil Nadu,
 The borrowers in the pool are individuals,
 Maximum LTV (loan to value) ratio is 80 per cent,
 Instalment (EMI) to gross income ratio is less than 40 per cent,
 EMIs would not be outstanding for more than one month,
 Loan size is in the range of Rs 18,000 to Rs 10 lakh,
 Borrowers in the pool have only one loan contract with the HDFC,
 The HDFC has not obtained any refinance with respect to these loans.

Pool Valuation and Consideration for the Assignment
The consideration for the pool would be the aggregate balance principal of the
housing loans being acquired, recorded as outstanding in the books of the
HDFC as on that cut-off date.
Registration of Deed of Assignment and Payment of Stamp Duty
The trust has been declared, the assets would cease to be reflected in the
books of the NHB. The entire process of buying the receivables pool along with
the underlying mortgage security and declaring the trust would be legally
completed on the same day. The housing loans acquired by the NHB would be
registered with the sub-registrar of a district in which one of the properties is
located, in accordance with the provisions of the Transfer of Property Act, 1882
and the Indian Registration Act, 1908. The NHB proposed to register the deed
of assignment in the State of Karnataka, where the stamp duty is 0.10 per cent
ad valorem, subject to an absolute limit of Rs one lakh.

Declaration of Trust
After acquiring the housing loans, the NHB would make an express declaration
of trust in respect of the pool, by setting apart and transferring the housing
loans along with the underlying securities.

Issues of Pass Through Certificates
Once the housing loans have been declared as property held in trust, the NHB
in its corporate capacity as also trustee for the SPV Trust would issue Pass
Through Certificates (PTCs) to investors.

Credit Enhancements
The structure envisages the following credit enhancements for Class A PTCs:
(i) Subordinated Class B PTC pay-out,
(ii) Corporate guarantee from the HDFC, and
(iii) Excess spread.

Other Details The other details of the securitisation transaction are as follows.
Recovery on Defaults and Enforcement of Mortgages
The HDFC would administer the housing loans given to the borrowers, in its capacity as
the S&P Agent. Administering of such loans would include follow-up for the recovery of
the EMIs from the borrowers in the event of delays.
The trustee (NHB) would empower the HDFC, under the provisions of the servicing and
paying agency agreement, to enforce the mortgage securities where required, and
institute and file suits and all other legal proceedings as may necessary, to recover the
dues from defaulting borrowers.
Treatment of Prepayments on the Loans
Borrowers are permitted to prepay their loans in full or in part, and may be charged a
prepayment penalty for the same. Such prepayments in the securitised receivables pool
are passed on entirely to the two classes of PTC-holders
In the event of prepayment in a given month, the amount is passed on entirely to the
Class A and Class B PTC-holders in proportion to their respective principal balances
outstanding as of the beginning of that month.
Treatment of Conversion of Loans
In case of conversion by the borrowers of a loan from fixed rate to floating rate or vice-
versa, or to a lower fixed rate, the loan would continue to remain in the receivables pool.
The profit/loss on account of change in the interest rate would accrue to/be borne by the
receivables pool and indirectly the Class PTC-holders. The conversion charge received
from borrowers who have exercised the option would accrue to the Class B PTC-holders.
Repayment of Loan by the Borrower
On the borrower having completed repayment in all respects on the loan, the S&P Agent
would intimate the trustee and return the documents relating to the mortgage debt to the
borrowers.

Hindustan Copper Industries (HCI) manufactures copper pipe. It is contemplating
calling Rs 3 crore of 30-year, Rs 1,000 bonds (30,000 bonds) issued 5 years ago with
a coupon interest rate of 14 per cent. The bonds have a call price of Rs 1,140 and
had initially collected proceeds of Rs 2.91 crore due to a discount of Rs 30 per
bond. The initial flotation cost was Rs 3,60,000. The HCI intends to sell Rs 3 crore of
12 per cent coupon interest rate, 25-year bonds to raise funds for retiring the old
bonds. It intends to sell the new bonds at their par value of Rs 1,000. The estimated
flotation costs are Rs 4,40,000. The HCI is in 35 per cent tax bracket and its after
cost of debt is 8 per cent. As the new bonds must first be sold and their proceeds
then used to retire the old bonds, the HCI expects a 2-month period of overlapping
interest during which interest must be paid on both the old and the new bonds.
Analyse the feasibility of the bond refunding by the HCI.

Solution
Decision analysis for bond refunding decision
Present value of annual cashflow savings (Refer working note 2):
Rs 3,81,460 × 10.675 (PVIF8,25) Rs 40,72,086
Less: Initial investment (Refer working note 1) 32,57,500
NPV 8,14,586
Decision The proposed refunding is recommended as it has a positive NPV.

Working Notes
1. Initial investment:
(a) Call premium:
Before tax [(Rs 1,140 – Rs 1,000) × 30,000 bonds] Rs 42,00,000
Less: Tax (0.35 × Rs 42,00,000) 14,70,000
After tax cost of call premium Rs 27,30,000
(b) Flotation cost of new bond 4,40,000
(c) Overlapping interest:
Before tax (0.14 × 2/12/ × Rs 3 crore) 7,00,000
Less: Tax (0.35 × 7,00,000) 2,45,000 4,55,000
(d) Tax savings from unamortised discount on old bond
[25/30 × (Rs 3 crore – 2.91 crore) × 0.35] (2,62,500)
(e) Tax savings from unamortised flotation cost of old
bond (25/30 × Rs 3,60,000 × 0.35) (10,5,000)
32,57,500

2. Annual cash flow savings
(a) Old bond
(i) Interest cost:
Before tax (0.14 × 3 crore) Rs
42,00,000
Less: Tax (0.35 × Rs 42,00,000) 14,70,000 27,30,00
0
(ii) Tax savings from amortisation of
discount [(Rs 9,00,000@ ÷ 30) × (10,500)
0.35]
(iii) Tax savings from amortisation of
flotation cost [(Rs 3,60,000 ÷ 30) × (4,200)
0.40)
Annual after tax debt payment (a) 27,15,30
0
(b) New bond
(i) Interest cost:
Before tax (0.12 × 3 crore) 36,00,000
Less: Taxes (0.35 × Rs 36,00,000) 12,60,000
After tax interest cost 23,40,00
0
(ii) Tax savings from amortisation of
flotation cost [Rs 4,40,000 ÷ 25) × (6,160)
0.35

Dua Manufacturing (DM) has under consideration refunding of Rs 2 crore out-
outstanding bonds at Rs 1,000 par value as a result of recent decline in long-term
interest rates. The bond-refunding plan involves issue of Rs 2 crore of new bonds at
the lower interest and the proceeds to call and retire the Rs 2 crore outstanding
bonds. The DM is in 35 per cent tax bracket.

The details of the new bonds are: (i) sale at par value of Rs 1,000 each, (ii) 11 per
cent coupon rate,(iii) 20-year maturity, (iv) flotation costs, Rs 4,00,000, and (iv) a 3-
month period of overlapping interest.

DMs outstanding bonds were initially issued 10 years ago with a 30-year maturity
and 13 per cent coupon rate of interest. They were sold at Rs 12 par bond discount
from par value with flotation costs amounting to Rs 1,50,000 and their call at Rs
1,130. Assuming 7 per cent after-tax cost of debt, analyze the bond-refunding
proposal. Would you recommend it? Why?

Solution:

As the NPV is positive, the proposed bond-refunding is recommended

Term loans & securitisation

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