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1.1EXECUTIVE SUMMARY Securitization creates value for organizations, investors, and consumers:

It separates the funding of receivables from their origination and servicing, and allows origination and servicing revenues to grow without additional balance sheet financing.

It provides cash flow and balance sheet management benefits. It allows for targeted asset liquidation, improvements in asset liquidity, and access to capital markets at rates different from enterprise credit ratings.

The flexibility in transforming risks permits mutually beneficial matches in targeted market opportunities, both for organizations and investors.

Deeper capital markets allow for price discovery of illiquid assets, greater access to funds for new firms and consumers, and greater financial innovation.

Securitization creates risks of moral hazard and lack of transparency:

Separation of funding from origination can create moral hazard, generating higher-than-expected risks and leading to conflicts between investors, firm shareholders, and firm creditors.

Complexity of structural transformations creates lack of transparency, which, in turn, can lead to greater illiquidity and possible market failure. These effects are worse in globally inter-connected markets.


1.2Objective of study
The objective of this study is to understand the concept of Securitization, its history, and its importance in the field of financing in an ever booming global economy.

1.3 Background
The first widely reported securitization deal in India occurred in 1990 when auto loans were secured by Citibank and sold to the GIC mutual fund. However, the sound legal framework for securitization was not drafted until 2002 when the Securitization and Reconstruction of Financial Assets and Enforcement of Security Ordinance (Ordinance) was promulgated by the president of India. According to this law, securitization was defined as acquisition of financial assets by any securitization company or reconstruction company from any originator, whether by raising funds by such securitization or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise. The notion of financial assets for the above definition is stated as any debt or receivables. Non-surprisingly, it follows that the definition of securitization in India is very close to that of western countries, especially taking into account that the experience of the UK is of special relevance to India


1.4 Research Methodology

We have done exploratory research on TRIPS and for that we had used secondary data. We had collected secondary data from various published material like books and from internet web site. From these various information and data we had done qualitative and quantitative analysis to find out the impact of various forces and effect of macro environmental factor.




Most attempts to define securitization make the same mistake; they focus on the process of securitization instead of on the substance, or meaning, of securitization. Hence, the most common definition of securitization is that it consists of the pooling of assets and the issuance of securities to finance the carrying of the pooled assets. Yet, surely, this reveals no more about securitization than seeing one's image reflected in a mirror reveals about one's inner character. In Lord Kelvin's terms, it is knowledge of "a meager and unsatisfactory kind." A better definition of securitization is that it consists of the use of superior knowledge about the expected financial behaviour of particular assets, as opposed to knowledge about the expected financial behaviour of the originator of the chosen assets, with the help of structure to more efficiently finance the assets. This definition is superior because it better explains the need for the most essential aspects of any securitization anywhere in the world under any legal system, and it better defines the place of securitization within several of the broader financial trends that have occurred at the end of our century.


2.2 MEANING Securitization, in the correct circumstances, is one of the very most efficient forms of financing. This is because of two additional trends. The first is the increasing importance of the use of information to create wealth. The second is the increasing sophistication of computers and their uses. Securitization is made possible by the combination of these two trends. Computers enable one to store and retrieve extensive data about the historical behaviour of pools of assets. This historical data in turn enables one to predict, under the right circumstances, the behaviour of pools of such assets subsequently originated by the applicable originator. Because our knowledge about such behaviour may be so precise and reliable, when structured correctly, a securitization may entail less risk than a financing of the entity that originated the securitized assets. Again in Lord Kelvin's terms, our knowledge about the likely behaviour of pools of assets is "measurable" and we "express it in numbers." It is a superior sort of knowledge from the perspective of the world of finance. Accordingly, such a securitization may be fairly labelled to be more efficient and indeed may require less over-all capital than competing forms of financing. The preferred definition of securitization with which this essay began thus reveals why securitization often is preferable to other forms of financing. It also explains most of the structural requirements of securitization. For, to take advantage of superior information of the expected behaviour of a pool of assets, the ability of the investor to rely on those assets for payment must not be materially impaired by the financial behaviour of the related originator or any of its affiliates. In most legal systems, this is not practicable without the isolation of those assets legally from the financial fortunes of the originator. Isolation, in turn, is almost always accomplished by the legal transfer of the assets to


another entity, often a special purpose entity ("SPE") that has no businesses other than holding, servicing, financing and liquidating the assets in order to insure that the only relevant event to the financial success of the investors' investment in the assets is the behaviour of such assets. Finally, almost all of the structural complexities that securitization entails are required either to create such isolation or to deal with the indirect effects of the creation of such isolation.

For example, the (i) attempt to cause such transfers to be "true sales" in order to eliminate the ability of the originator to call on such assets in its own bankruptcy, (ii) "perfection" of the purchaser's interest in the transferred assets, (iii) protections built into the form of the SPE, its administration and its capital structure all in order to render it "bankruptcy remote", and (iv) limitation on the liabilities that an SPE may otherwise incur are each attributes of the structure of a securitization designed to insure that the isolation of the transferred assets is not only theoretical but also real.

Similarly, attempts to (i) limit taxes on the income of the SPE or the movement across borders of the interest accrued by transferred receivables, (ii) comply with the various securities or investment laws that apply to the securities issued by the various SPEs in order to finance their purchases of the assets, or (iii) comply with the bank regulatory restrictions that arise in connection with such transfers, the creation of SPEs and the other various roles played by banks in connection with sponsoring such transactions each constitute a reaction to indirect problems caused by the structuring of the above described transfer and the SPE to receive the transferred assets.


2.3 FEATURES OF SECURITIZATION A securitized instrument, as compared to a direct claim on the issuer, will generally have the following features.

1. Marketability: The very purpose of securitization is to ensure marketability to financial claims. Hence, the instrument is structured to be marketable. This is one of the most important features of a securitized instrument, and the others that follow are mostly imported only to ensure this one. The concept of marketability involves two postulates: (a) The legal and systemic possibility of marketing the instrument

(b) The existence of a market for the instrument. Legal aspect with respect to marketing instrument is concerned; traditional law relating to business practices has not evolved much. Negotiable instruments were mostly limited in application to what were then in circulation as such. Besides, the corporate laws mostly defined and sought to regulate issuance of usual corporate financial claims, such as shares, bonds and debentures. This gives raise to the need for a codified system of law for security and credibility of operations. We need to note that when law is not in existence, we should not conclude that it is not permitted. The second issue is marketability of the instrument. . The purpose of securitization is to broaden the investor base and bring the average investor into the capital markets. Either liquidity to a securitized instrument is obtained by


introducing it into an organized market (such as securities exchanges) or by one or more agencies acting as market makers. That is, agreeing to buy and sell the instrument at either pre-determined or market-determined prices. 2. Quality of security: To be accepted in the market, a securitized product has to have a merchantable quality. The concept of quality in case of physical goods is something, which is acceptable in normal trade. When applied to financial products, it would mean the financial commitments embodied in the instruments are secured to the investors' satisfaction. "To the investors' satisfaction" is a relative term, and therefore, the originator of the securitized instrument secures the instrument based on the needs of the investors. The rule of thumb is the more broad the base of the investors, the less is the investors' ability to absorb the risk, and hence, the more the need to securities. For widely distributed securitized instruments, evaluation of the quality, and its certification by an independent expert, for example, rating is common. The rating serves for the benefit of the lay investor, who is not expected to appraise the risk involved. In case of securitization of receivables, the concept of quality undergoes drastic change; making rating is a universal requirement for securitizations. Securitization is a case where a claim on the debtors of the originator is being bought by the investors. Hence, the quality of the claim of the debtors assumes significance. This at times enables investors to rely on the credit rating of debtors (or a portfolio of debtors) in the process make the instrument independent of the oringators' own rating.


3. Wide Distribution: The basic purpose of securitization is to distribute the product. The extent of distribution which the originator would like to achieve is based on a comparative analysis of the costs and the benefits achieved thereby. Wider distribution leads to a cost-benefit in the sense that the issuer is able to market the product with lower return, and hence, lower financial cost to himself. But wide investor base involves costs of distribution and servicing. In practice, securitization issues are still difficult for retail investors to understand. Hence, most securitizations have been privately placed with professional investors. However, it is likely that in to come, retail investors could be attracted into securitized products. 4. Homogeneity: The instrument should be packaged as into homogenous lots for marketability of the product. Homogeneity, like the above features, is a function of retail marketing. Most securitized instruments are broken into lots affordable to the small marginal investor, and hence, the minimum denomination becomes relative to the needs of the smallest investor. Shares in companies may be broken into slices as small as Rs. 10 each, but debentures and bonds are sliced into Rs. 100 each to Rs. 1000 each. Designed for larger investors, commercial paper may be in denominations as high as Rs. 5 Lac. Other securitization applications may also follow the same type of methodology.


Before the 1970s banks lent to customers and keep loans portfolios till the due date, by financing thanks to the deposits of their customers. The surge of the credit after World War II forces banks to find new resources, particularly with securit ization debut, first applied to home loans then it more and more spread to other products.

The securitization of assets started in the United States in the 1970s. In February 1970, the American department of housing and urban development completes the first true securitization, on home loans. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets). After World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well." In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans. To facilitate the securitization


of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements In 1985, securitization techniques that American Bankruptcy Institute had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence. The market developed thanks to the addiction of successive improvements like the use of Special Purpo se Vehicle or of a third party. It has enabled securitization of an asset for the first time, other than a portfolio of home loans, in this case credits for the purchase of cars. These kinds of assets are still one of the most securitized products. This op eration was a securitization amounting to 60 million dollars made by the Marine Midland Bank. In 1986, the first securitization of the credit portfolio of credit cards took place, amounting to 50 million dollars. In 1988, the French regulation is fitted to allow the securitization by using the mechanism of claims equity. From the 1990s, securitization spreads to products coming from insurance, with issues that reach 15 billion dollars in 2006. In 2004, and according to the Bond Market Association, the sum total of securitized amounts in the United States was up to 1,8 trillions of dollars, that is about 8% of the sum total of duties market (2,6 trillion) or 39% of the sum total of firms debts. It is the result of a medium raise of 19% in nominal value during the period of


1995-2004. This year marks an historical record with issues up to 900 billion dollars. In 2006, the United Kingdom represented 52% of the issues out of CDO. It was followed by Spain, Germany and the Nederla nd. With 7, 7 billion dollars of issues on a European market of 370, 9 billion dollars, France was the 5th. The actual market is mainly American and European.

2.5 NEED
Financial markets developed in response to the need to involve a large number of investors. As the number of investors keeps on increasing, the average size per investors keeps on coming down, because growing number means involvement of a wider base of investors. The small investor is not a professional investor. He needs an instrument, which is easier to understand, and provides liquidity and legal sanction. These needs set the stage for evolution of financial instruments which would convert financial claims into liquid, easy to understand and homogenous products. Th ey would be available in small denominations to suit even a small investor. Therefore, securitization in a generic sense is basic to the world of finance, and it is right for us to say that securitization envelopes the entire range of financial instruments, and the range of financial markets. Recent years have witnessed the wide spread of Western financial innovations into developing markets. Globalisation and integration of capital markets, started in the 1990s, have made it possible for such big global players as India to adopt new financial strategies which allow increasing liquidity and accelerating development of the capital markets. One of these financial innovations is


securitisation, the process of transformation of illiquid assets into a security which can be traded in the capital markets. Although the state of securitisation in India is far from that of the USA and the UK, the market for securitised assets grows at a fascinating pace. This work attempts to analyse the origination, development and current condition of securitisation in India.


In concept, all assets generating stable and predictable cash flows can be taken up for securitization. In practice however, much of the securitised paper issued have underlying periodic cashflows secured through contracts defining cash flow volumes, yield and timing. In this respect, securitization of auto loans, credit card receivables, computer leases, unsecured consumer loans, residential and commercial mortgages, franchise/royalty payments, and other receivables relating to telecom, trade, toll road and future export have gained prominence. Typically, asset portfolios that are relatively homogeneous with regard to credit, maturity and interest rate risk could be pooled together to create a securitization structure. However, to make reasonable estimates of the credit quality and payment speed of the securitised paper, it would be essential to analyse the historical data on portfolio performance over some reasonable length of time.




3.1 PARTIES TO A SECURITISATION TRANSACTION There are primarily three parties to a securitisation deal, namely

A. The Originator: This is the entity on whose books the assets to be securitised exist. It is the prime mover of the deal i.e. 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.

B. The SPV: The issuer also known as the SPV is the entity, which would typically buy the assets (to be securitised) from the Originator. The 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 inas much as it holds the assets in its books and makes the upfront payment for them to the Originator.



C. The Investors: The investors may be in the form of individuals or institutional investors like FIs, mutual funds, provident funds, pension funds, insurance companies, etc. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per agreed pattern.

Besides these three primary parties, the other parties involved in a securitisation deal are given below:

a) The Obligor(s): The Obligor is the Originator's debtor (borrower of the original loan). The amount outstanding from the Obligor is the asset that is transferred to the SPV. The credit standing of the Obligor(s) is of paramount importance in a securitisation transaction.

b) The 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.

c) 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.



d) 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.

e) Structure: Normally, an investment banker is responsible as structurer for bringing together the Originator, credit enhancer/s, the investors and other partners to a securitisation deal. It also works with the Originator and helps in structuring deals. The different parties to a securitisation deal have very different roles to play. In fact, firms specialise in those areas in which they enjoy competitive advantage. The entire process is broken up into separate parts with different parties specialising in origination of loans, raising funds from the capital markets, servicing of loans etc. It is this kind of segmentation of market roles that introduces several efficiencies securitisation is so often credited with.

By entering into securitisation a lower-rated entity can access debt capital markets that would otherwise be the preserve of higher-rated institutions. The securitisation process involves a number of participants. In the first instance is the originator, the firm whose assets are being securitised. The most common process involves an issuer acquiring the assets from the originator.

The issuer is usually a company that has been specially set up for the purpose of the securitisation and is known as a special purpose vehicle or SPV and is usually domiciled offshore. The creation of an SPV ensures that the underlying asset pool is held separate from the other assets of the originator. This is done so that in the event that the originator is declared bankrupt or insolvent,


the assets that have been transferred to the SPV will not be affected.. By holding the assets within an SPV framework, defined in formal legal terms, the financial status and credit rating of the originator becomes almost irrelevant to the bondholders.

The process of securitisation often involves credit enhancements, in which a third-party guarantee of credit quality is obtained, so that notes issued under the securitisation are often rated at investment grade and up to AAA-grade. The process of structuring a securitisation deal ensures that the liability side of the SPV the issued notes carries lower cost than the asset side of the SPV. This enables the originator to secure lower cost funding that it would otherwise be able to obtain in the unsecured market. This is a tremendous benefit for institutions with lower credit ratings.



Mechanics of securitisation Securitisation involves a true sale of the underlying assets from the balance sheet of the originator. This is why a separate legal entity, the SPV, is created to act as the issuer of the notes. The assets being securitised are sold onto the balance sheet of the SPV.



The process involves: 1. Undertaking due diligence on the quality and future prospects of the assets; 2. Setting up the SPV and then effecting the transfer of assets to it; 3. Underwriting of loans for credit quality and servicing; 4. Determining the structure of the notes, including how many tranches are to be issued, in accordance to originator and investor requirements; 5. The notes being rated by one or more credit rating agencies; 6. Placing of notes in the capital markets.

The sale of assets to the SPV needs to be undertaken so that it is recognised as a true legal transfer. The originator will need to hire legal counsel to advise it in such matters. The credit rating process will consider the character and quality of the assets, and also whether any enhancements have been made to the assets that will raise their credit quality. This can include

overcollateralization, which is when the principal value of notes issued is lower than the principal value of assets, and a liquidity facility provided by a bank.

A key consideration for the originator is the choice of the underwriting bank, which structures the deal and places the notes. The originator will award the mandate for its deal to the bank on the basis of fee levels, marketing ability and track record with its type of assets.



Illustrating the process of securitisation

To illustrate the process of securitisation, we consider an hypothetical airline ticket receivables transaction. The purpose of this section is to show the issues that will be considered by the investment bank that is structuring the deal.

Originator: ABC Airways plc Transaction: Ticket receivables airline future flow securitisation bonds 200m three-tranche floating rate notes, legal maturity 2012, average life 4.1 years Issuer: Airways No 1 Ltd Arranger: XYZ Securities plc Due diligence XYZ Securities will undertake due diligence on the assets to be securitised. For this case, it will examine the airline performance figures over the last five years, as well as model future projected figures, including:

1. Total passenger sales 2. Total ticket sales 3. Total credit card receivables 4. Geographical split of ticket sales

It is the future flow of receivables, in this case credit card purchases of airline tickets, that is being securitised. This is a higher-risk asset class than say, residential mortgages, because the airline industry has a tradition of greater volatility of earnings than say, mortgage banks.



Marketing approach

The present and all future credit card ticket receivables generated by the airline will be transferred to an SPV. The investment banks syndication desk will seek to place the notes with institutional investors across Europe. The notes are first given an indicative pricing ahead of the issue, to gauge investor sentiment. Given the nature of the asset class, during November 2002 the notes would be marketed at around three-month Libor plus 70-80 basis points (AA note), 120-130 basis points (A note) and 260-270 basis points (BBB note). The notes are benchmarked against recent issues with similar asset classes, as well as the spread level in the unsecured market of comparable issuer names.

The process leading to issue of notes is as follows:

1. ABS Airways plc sells its future flow ticket receivables to an offshore SPV set up For this deal, incorporated as Airways No 1 Ltd; 2. The SPV issues notes in order to fund its purchase of the receivables; 3. The SPV pledges its right to the receivables to a fiduciary agent, the Security Trustee, for the benefit of the bondholders; 4. The Trustee accumulates funds as they are received by the SPV; 5. The bondholders receive interest and principal payments, in the order of priority of the notes, on a quarterly basis.

In the event of default, the Trustee will act on behalf of the bondholders to safeguard their interests.



Financial guarantors The investment bank will consider if an insurance company, known as a monoline insurer, should be approached to wrap the deal by providing a guarantee of backing for the SPV in the event of default. This insurance is provided in return for a fee.

Financial modelling XYZ Securities will construct a cash flow model to estimate the size of the issued notes. The model will consider historical sales values, any seasonal factors in sales, credit card cash flows, and so on. Certain assumptions will be made when constructing the model, for example growth projections, inflation levels, tax levels, and so on. The model will consider a number of different scenarios, and also calculate the minimum asset coverage levels required to service the issued debt. A key indicator in the model will be the debt service coverage ratio (DSCR). The more conservative the DSCR, the more comfort there will be for investors in the notes. For a residential mortgage deal, this ratio might be approximately 2.5 3.0; however for an airline ticket receivables deal, the DSCR would be unlikely to be lower than 4.0. The model will therefore calculate the amount of notes that can be issued against the assets, whilst maintaining the minimum DSCR.



Credit rating It is common for securitisation deals to be rated by one or more of the formal credit ratings agencies such as Moodys, Fitch or Standard & Poors. A formal credit rating will make it easier for XYZ Securities to place the notes with investors. The methodology employed by the ratings agencies takes into account both qualitative and quantitative factors, and will differ according to the asset class being securitised. The main issues in a deal such as our hypothetical Airway No 1 deal would be expected to include: 1. Corporate credit quality 2. The competition and industry trends: ABC Airways market share, the competition on its network; 3. Regulatory issues, such as need to comply with forthcoming legislation that would impact its cash flow; 4. Legal structure of the SPV and transfer of assets; 5. Cash flow analysis.

Based on the findings of the ratings agency, the arranger may re-design some aspect of the deal structure so that the issued notes are rated at the required level. This is a selection of the key issues involved in the process of securitisation. Depending on investor sentiment, market conditions and legal issues, the process from inception to closure of the deal may take anything from three to 12 months or more. After the notes have been issued, the arranging bank will no longer have anything to do with the issue; however the bonds themselves require a number of agency services for their remaining life until they mature or are paid off. These agency services can include paying agent, cash manager and custodian.



3.3 PASS AND PAY THROUGH STRUCTURES The nature of the investors interest in the underlying assets determines whether a securitisation structure is a Pass Through or Pay Through structure. In a pass through structure, the SPV issues Pass Through Certificates which are in the nature of participation certificates that enable the investors to take a direct exposure on the performance of the securitised assets. Pay through, on the other hand, gives investors only a charge against the securitised assets, while the assets themselves are owned by the SPV. The SPV issues regular secured debt instruments. The term PTCs has been used in the report referring to pass through as well as pay through certificates.

Pay through structures permit de-synchronization of servicing of the securities from the underlying cash flows. In the pay through structure, the SPV is given discretion (albeit to a limited extent) to re-invest short term surpluses - a power that is not available to the SPV in the case of the pass through structure. In the pass through structure, investors are serviced as and when cash is actually generated by the underlying assets. Delay in cash flows is of course shielded to the extent of credit enhancement. Prepayments are, however, passed on to the investors who then have to tackle re-investment risk. A further advantage of the pay through structure is that different issues of securities can be ranked and hence priced differentially.




Securities issued by the SPV in a securitisation transaction are referred to as Asset Backed Securities (ABS) because 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. In practice, a further category is identified securities backed by mortgage loans (loans secured by specified real estate property, wherein the lender has the right to sell the property, if the borrower defaults). Such securities are called Mortgage Backed Securities (MBS). The most common example of MBS is securities backed by mortgage housing loans. All securitised instruments are either MBS or ABS.


The dominant player in Indian securitisation is ICICI Bank, the second largest bank in India with more than 560 branches. This bank issues more than 60% of all securitised papers in India and arranges all its own deals. ICICI offers a full range of loans to its customers including home loans, personal loans, car loans, and construction and medical equipment loans. All of them are securitised by the bank. The banks portfolio of outstanding car loans amounts to 1 billion.



In August 2004 ICICI completed the largest securitisation deal in India. The 220 million car loan securitisation was similar to US asset backed structures comprising three series of planned amortisation notes along with a companion bond to absorb excess prepayments, and incorporated fixed and floating rate options. The second leading player in the market is HDCF Bank. It also completed a notable deal making a transaction of 150 million backed by retail vehicle loans. The issue included four tranches with prepayment protection feature and periodically put options which could protect investors against interest rate rises. The mortgage-backed securities in India are relatively underdeveloped. The first issue was made in August 2000 by NHB (National Housing Board). Till October 2004, NHB made ten issues of mortgage-backed securities comprising 35,116 housing loans (Kothari and Gupta, 2005). However, despite the growing number of housing loans, the number of mortgage-backed securities issued remained stable on the basis of total issue. Finally, according to Fitch, estimates the investors base contains up to 15 mutual funds, 15 leading banks, insurers and other investors (Newsletter 2004).



3.6 ADVANTAGES AND DISADVANTAGES Benefits of Securitization

There are several key benefits that securitization provides to market participants and the broader economy:

Frees capital for lending - Securitization provides financial institutions with a mechanism for removing assets from their balance sheets, thereby increasing the pool of available capital that can be loaned out.

Lowers the cost of capital - A corollary to the increased abundance of capital is that the rate required on loans is lower; lower interest rates promote increased economic growth. (Read about how the Federal Reserve controls interest rates and stimulates the economy in How Much Influence Does The Fed Have? and The Federal Reserve's Fight Against Recession.)

Makes non-tradable assets tradable This action increases liquidity in a variety of previously illiquid financial products.

Spreads the ownership of risk - Pooling and distributing financial assets provides greater ability to diversify risk and provides investors with more choice as to how much risk to hold in their portfolios. (For further reading, check out How Do Banks Determine Risk?)

Provides profits for financial intermediaries - Intermediaries benefit by keeping the profits from the spread, or difference, between the interest rate on the underlying assets and the rate paid on the securities that are issued.

Creates an attractive asset class for investors - Purchasers of securitized products benefit from the fact that securitized products are often highly


customizable and can offer a wide range of yields. (Learn more in Understanding Structured Products.) Risks in Securitization (a) Bankruptcy / Performance Risk: Since future flow transactions rely on the future generation of cash flow to repay investors, the continued existence and performance of the borrower throughout the tenure of the transaction are critical considerations to investors. Indeed, this risk generally acts as the limiting constraint on the rating of the transaction and consequently determines the tenure as well as the pricing. The ultimate rating may be enhanced by at most one notch above the local currency rating of the borrower in case the securitisation constitutes a true sale transaction under the bankruptcy laws of the borrower. In other words, should the borrower become insolvent, no creditors of the borrower would be able to make a claim against the receivables sold to investors. So long as the borrower continues to operate (even in bankruptcy), investors will receive payments on the receivables on time and unhindered. In terms of mitigating this risk, there is very little that can be done structurally without obtaining the support or guarantee of a rated third party.

(b) Generation Risk: There still is another risk related to the sustained generation of the receivables at certain levels from a host of factors outside of the control of the borrower, e.g. anticipated reserves may not materialise or seasonal variations in the anticipated levels of receivables may occur. This risk is mitigated through adequate over-collateralisation. Further, in order to protect investors against more sustained long-term declines in the levels of receivables generated, early amortisation triggers are usually built into the transaction that will trigger the repayment of the securities on an accelerated basis if a predefined trigger level is breached.


(c) Price Risk and Off-take Risk: These refer to likely price variations or the concern that the Obligors in the future cease buying or reduce their purchasing level of the goods or service from the seller.

Advantages to issuer i) Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.[11]

ii) Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis.[14] Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.



iii) Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning power" of the assets. iv) Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on. v) Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business. vi) Off balance sheet: Derivatives of many types have in the past been referred to as "offbalance-sheet." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying


assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets. vii) Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company. viii) Admissibility: Future cash flows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset. ix) Liquidity: Future cash flows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash


would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates. Disadvantages to issuer May reduce portfolio quality: If the AAA risks, for example, are being

securitized out, this would leave a materially worse quality of residual risk. Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization. Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions. Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips. Advantages to investors Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis) Opportunity to invest in a specific pool of high quality assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.



Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities. Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable). Risks to investors Liquidity risk Credit/default: Default risk is generally accepted as a borrowers inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular securitys default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings. However, the credit crisis of 20072008 has exposed a potential flaw in the securitization process loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage improvement of underwriting standards.



Event risk Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer. Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates. Moral hazard: Investors usually rely on the deal manager to price the securitizations underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread. Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.




CASE STUDIES Auto loans Citibank Case Citibank assigned a cherry-picked auto loan portfolio to Peoples Financial Services Ltd. (PFSL), an SPV floated for the purpose of securitisation by paying the required amount of stamp duty (0.1%) to ensure true sale. This is a limited company and can act only as SPV for asset securitisation. This SPV is owned and managed by a group of distinguished legal counsels. PFSL then proceeded to issue Pass Through Certificates to investors. These certificates were rated by CRISIL and listed on the wholesale debt market of the National Stock Exchange (NSE), with HG Asia and Birla Marlin as the market makers. Global Trust Bank acted as the Investors Representative. Citibank played the role of servicer. The certificates are freely transferable and each of the transfer will have a stamp cost of 0.10%. The coupon of the security was high in spite of good quality of the underlying asset portfolio, because investors expected a premium to compensate for their unfamiliarity with the certificates. The investor base was limited mostly to MFs. FIs were hesitant because of the unsecured nature of the instrument and the absence of clarity on whether the certificates could be treated on par with other debt securities in their investment policy.

Although the certificates were listed on the NSE, there was very little secondary market activity because there was absence of adequate amount of alternative security of similar risk profile. Besides Citibank, NBFCs like Ashok Leyland Finance, 20th Century Finance etc. Have securitised their auto loan


portfolio, though, of course, these transactions involved assignment of receivables only and not issuance of securities. The asset portfolios were bought by one or two large institutions. TELCO has also reportedly sold over Rs 550 crore of its auto loan portfolio in multiple tranches through this route.

Future receivables - L&T case

The recent case of a power plant construction being financed through the capital markets is an example of future flow securitisation. Although Larsen & Toubro bagged the Build, Lease and Operate contract for a 90-MW captive power plant for Indian Petrochemical Corporation Ltd. (IPCL), it preferred to transfer it to an SPV India Infrastructure Developers Ltd. (IIDL) which issued debentures in the private placement market. The debentures would be serviced out of the lease rentals due to IIDL from IPCL. L&Ts guarantee was also available to a limited extent. The novelty of this transaction is that instead of a plain loan with say, 3:1 debt equity ratio, the project was financed in the form of a securitisation like structure through the capital market with a much higher gearing ratio.



CHAPTER 5 CONCLUSION Originating in the mortgage markets of the US in the 1970s securitisation hasdeveloped and come a long way from there to spread throughout the globe to benefitorganisations Securitisation is the buzzword in today's World of Finance. It's not a new subject tothe developed economies. It is certainly a new concept for the emerging marketslike India. The Technique of Securitisation definitely holds great promise for aDeveloping Country like India. Securitisation has worked well over the other tools of financing as it does notincrease the liability of the Originator but at the same time provides him financing.It infact converts the NPA of the company into cash flows. The above features help infrastructure companies to get finance easily and alsohelps the banks by reducing the burden on them and helping them to concentrate ontheir core business activities. But the tool has not been utilized to its fullest in our country as cuase of the legal complications. However a welcome step was seen in the form that securitized paper scan now be traded as assets in the market and also the reduction in the stamp duty of the securitization transaction. The development till off late was slow but the future for securitization is said to be very bright in Asias 2 nd largest economy where financing is of prime importance and the growth potential are very high.



CHAPTER 6 Recommendation

Securitization is defined as a sale of an asset by its original investor, where the asset can be any illiquid financial asset. For FIs and Banks, securitization of infrastructure loans offers manifold advantages. It provides additional source of funds, reduces funding costs, economy in the use of capital, greater re-cycling of funds and improves capital adequacy. In Indian context, securitization has not emerged as a viable technique due to following negative factors:

* Securitization attracts Stamp Duty under Transfer of Property Act, 1882 and the duty is as high as 13% to 17% in some States. * It also attracts heavy registration charges and incidence of double Income Tax. * The accounting treatment for securitized assets in the Lenders books is another grey area. If it has to be treated as an outright sale of the assets or as an off-balance sheet item, is not clear.

So removal of these legal and fiscal irritants would make securitization as a vehicle of financing infrastructure projects, in the coming future.