PROJECT: STRUCTURED FINANCE

TABLE OF CONTENT
1: SECURITIZATION....................................................................................3 2: SECURITISATION TRANSACTION.......................................................4 3: PARTIES INVOLVED IN A SECURITISATION TRANSACTION.......6 4: ASSET CLASSES UNDER SECURITIZATION......................................7 5: ECONOMIC BENEFITS OF SECURITIZATION....................................8 6: DIFFERENCE BETWEEN SECURITISATION AND TRADITIONAL DEBT INSTRUMENTS...............................................................................11 7: RISKS INVESTORS FACE IN SECURITISATION DEALS................12 8: GLOBAL STRUCTURED FINANCE.....................................................14 9: INDIAN STRUCTURED FINANCE.......................................................15 10: FUTURE PROSPECTS OF INDIA........................................................20

1: SECURITIZATION
Securitisation is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors. Inshort, securitisation is the process of conversion of illiquid loans into tradable securities. 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 collateralises securities. These assets are generally secured by personal or real property (e.g. automobiles, real estate, or equipment loans), but in some cases are unsecured (e.g. credit card debt, consumer loans). Traditionally, a lender advances a loan to a borrower and gets repayment of principal, along with interest, over a period of time. In securitisation, the lender sells his right to receive the future payments from the borrowers to a third party and receives consideration for the same much earlier than the maturity of the original loans. These future cash flows from borrowers are sold to investors in the form of marketable securities.

2: SECURITISATION TRANSACTION
The successful execution of a securitisation depends on the investor's uncontested right to securitised cash flows. Hence, securitised loans need to be legally separated from the originator of the loans. In order to achieve this separation, a securitisation is structured as a three-step framework:

1. A pool of loans is sold to an intermediary by the originator of the loans. This intermediary (called a Special Purpose Vehicle, or SPV) is usually incorporated as a trust. The SPV is an entity formed for the specific purpose of transferring the securitised loans out of the originator's balance sheet, and does not carry out any other business. 2. The SPV issues securities, backed by the loans, and by the payment streams associated with these loans. Investors purchase these securities. The proceeds from the sale of the securities are paid to the originator as purchase consideration for the loan receivables. 3. The cash flows generated by the loans over a period of time are used to repay investors. There could also be some credit support built into the transaction to protect investors against possible losses in the pool. However, the investors will typically have no recourse to the originator.

The key elements of securitization are: Legal true sale of assets to an SPV Issuance of securities by the SPV to the investors collateralized by the underlying assets Reliance by the investors on the performance of the assets for repayment rather than the credit of their Originator (the seller) or the issuer (the SPV) Consequent to the above, Bankruptcy Remoteness (no right over the sold out loan in case of Bankruptcy) from the Originator. Apart from the above, the following additional characteristics are generally noticed: Administration of the assets, including continuation of relationships with obligors support for timely interest and principal repayments in the form of suitable credit enhancements ancillary facilities to cover interest rate / forex risks, guarantee, etc. Formal rating from one or more rating agencies

3: PARTIES INVOLVED IN A SECURITISATION TRANSACTION

The entities involved in a securitisation deal, and their role, are briefly explained below. It is possible for a single party in any transaction to perform multiple roles. Originator: The originator is the original lender and the seller of the receivables. It 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. Seller: The seller pools the assets in order to securitise them. Usually, the originator and the seller are the same, but, in some cases, originators sell their loans to other companies that securities them. Obligors/borrowers: The borrower is the counter party to whom the originator makes the loan. The amount outstanding from the Obligor is the asset that is transferred to the SPV. The payments made by borrowers are the source of cash flows used for making investor payments. 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. Issuer: The issuer in a securitisation deal is the special purpose vehicle (SPV), which is typically set up as a trust. The trust issues securities, which investors subscribe to. Servicer: The servicer collects the periodic installments due from individual borrowers in the pool, makes payouts to investors, and follows up on delinquent accounts. The servicer also furnishes periodic information to the rating agency and the trustee on pool performance. There is a service fee payable to the servicer. Trustee: Trustees are normally reputed Banks, Financial Institutions or independent trust companies set up for the purpose of settling trusts. Trustees oversee the performance of the transaction till maturity, and are vested with the necessary powers to protect investors' interests. Arrangers: These are Investment banks responsible for structuring the securities to be issued, and liasoning with other parties such as investors, credit enhancers and rating agencies to successfully execute the securitization transaction.

Rating agencies: Independent rating agencies analyse the risks associated with a securitisation transaction and assign a credit rating to the instrument issued. 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.

4: ASSET CLASSES UNDER SECURITIZATION

5: ECONOMIC BENEFITS OF SECURITIZATION

A. FOR ORIGINATOR: Efficient financing: Through securitisation, companies holding financial assets like loans have ready access to low-cost sources of funds, and can reduce their dependence on financial intermediaries for their capital requirements. This translates into lower interest costs, the benefits of which are also passed on to end consumers. In securitisation, it is possible to achieve a much higher target rating for instruments than the originator's credit rating, by providing credit enhancements for the transaction. Thus the borrower can obtain funding at lower interest rates applicable to highly rated instruments, and gain a pricing advantage. Off-balance sheet funding: For accounting purposes, securitisation is treated as a sale of assets, and not as financing. Therefore the originator does not record the transaction as a liability on its balance sheet. Such off-balance sheet transactions raise funds without increasing the originator's leverage or debt-to-equity ratio. Lower capital requirements: Securitisation enables banks and financial institutions to meet regulatory capital adequacy norms by transferring assets, and their associated risks, off the balance sheet. The capital supporting the assets is released and the proceeds from securitisation can be used for further growth and investment. Liquidity management: Tenor mismatch due to long term assets funded by short-term liabilities can be rectified by securitisation, as long-term assets are converted into cash. Thus, securitisation is a tool for Asset Liability management. Improvement in financial ratios: Since securitisation helps in undertaking larger transaction volumes with the same capital, profitability and return on investment ratios increase post securitisation. Profit on sale: Securitisation helps in up-fronting profits, which would otherwise accrue over the tenor of the loans. Profits arise from the spread between the interest rate received on underlying loans and the coupon rate paid on the securitised instruments backed by those loans. This interest spread is booked as profit, leading to increased earnings in the year of securitisation.

B. FOR INVESTORS: Return on investment/Yield: Securitized assets offer a combination of attractive Return on investments/yields (compared with other instruments of similar quality), increasing secondary market liquidity, and generally more protection by way of collateral overages and/or guarantees by entities with high and stable credit ratings. Yields of ABS/MBS/CDOs are higher than those of other debt instruments with comparable ratings. Spreads of securitised instruments are typically in the range of 50 - 100 basis points over comparable AAA corporate paper. Flexibility: An important advantage of securitisation is the flexibility to tailor the instrument to meet the investor's risk and tenor appetite. Durations can range from few months to many years. Repayments are usually made on a monthly basis but can also be structured on a quarterly or semiannual basis Interest rates can be fixed or floating depending on investor preferences

Safety Features: Securitisation offers investors a diversification of risk, since the exposure is to a pool of assets. Most issuances are also highly rated by independent credit rating agencies, and have credit support built into the transactions. Investors get the benefit of a payment structure closely monitored by an independent trustee, which may not always be the case in traditional debt instruments. Performance track record: Securitised instruments have demonstrated consistently good performance, with no downgrades or defaults on any securitised instrument in India till date. C. EFFECTS ON THE NATIONAL ECONOMY In those countries where a high proportion of residential montages and other claims have been securitized, the gains to the national economy can be measured in the billions of dollars. The effect of securitization on the economies of different countries is still difficult to assess because the technique is in its infancy in many parts of the world. Asset securitization, if introduced in a transparent and orderly fashion, offers Asian countries additional gains from:

1. Capital market development, as more high-quality securities are added to the fixed-income market. 2. A source of funds for rapidly growing, capital-constrained, banks, finance companies and industrial companies whose expansion depends on the extension of credit to their customers. 3. An expanded source of financing for residential home ownership. 4. The potential for financing of infrastructure projects, such as toll roads, that produce reliable revenue streams capable of being contractually assigned to a separate legal entity. In sum, there is a strong argument favoring the growth of asset securitization in those nations with developing capital markets as well as in the more mature ones.

6: DIFFERENCE BETWEEN SECURITISATION AND TRADITIONAL DEBT INSTRUMENTS

Securitised instruments have some distinct features, which distinguish them from traditional debt: Isolation of pool of assets: In a securitisation, the securitised assets are separated from the original lender through a sale to a separate legal entity called a Special Purpose Vehicle (SPV), which acts as an intermediary. Claim against a pool of assets: Traditional debt instruments represent claims against the company that issues the debt. Investors rely entirely on the borrower company's credit quality for repayment of their debt. In securitisation transactions, investor payouts are made from collections on securitised assets, and the instruments are thus claims on the assets securitised. Investors do not typically have recourse to the originator. Credit enhancement: Credit enhancement is an additional source of funds that can be used if collections on the assets are insufficient to pay investors their dues in full. Credit enhancement thus supports the credit quality of the securitised instrument, and enables it to achieve a higher credit rating than the pool of assets on its own; in many cases the rating would also be higher than that of the originator. This is not possible in conventional debt. Payment Mechanisms: Securitised instruments typically incorporate structural features to ensure that scheduled payments reach investors in a timely manner. Operational & administrative requirements: As the SPV is only a shell entity; the administration of the pool of securitised loans involves multiple parties performing various functions. These functions include collection, accounting, loan servicing, legal compliance etc that need to be performed throughout the life of the transaction.

7: RISKS INVESTORS FACE IN SECURITISATION DEALS

Investors in securitised instruments can take advantage of the benefits that these instruments offer; however, they also need to be aware of the inherent risks in these transactions. These risks can be classified into: Asset pool risks: These arise due to the unpredictable behaviour of underlying borrowers. However, the payment behaviour of underlying borrowers can be estimated with a reasonable degree of accuracy based on historical data Counter party risks: These arise as a securitisation transaction involves multiple parties throughout the tenure of the instrument. The investor's returns can be impacted by nonperformance or bankruptcy of any of these counter parties. Investment risks: Like all other investments, securitised instruments are subject to market related risks. Investors are protected against these risks by means of structural features and credit enhancements, which enable the instruments to achieve high credit ratings. Credit risk: Investors have a direct exposure to the repayment ability of the underlying borrowers whose loans have been securitised. If borrowers default on payments of instalments, or make delayed payments, collections will be inadequate to service scheduled investor payouts. Thus, timely investor payments will depend on the credit quality of the pool borrowers. Risk of prepayments: Investors face the risk that underlying borrowers may prepay all or part of the principal outstanding on their loans. When prepayments occur, they are passed on to the investor (unless the instrument structure provides for a separate class of PTCs to absorb prepayments). This can affect the investor in two ways:

Reinvestment risk: If there are heavy prepayments in the pool, the average tenure of the instrument reduces, resulting in reinvestment risk for the investor.

Prepayment loss: If the investor has paid an additional consideration to receive 1 excess interest spreads generated by the pool, the investor's principal outstanding is greater than the pool principal outstanding. Hence, when a contract is prepaid, this excess interest spread payable to the investor from that contract is lost.

Property/asset price risk: Assets backing securitised instruments may be prepossessed and sold post securitisation. The proceeds and loss on sale depends upon market values of the assets, which fluctuate. Legal risk: In any securitisation transaction, it is essential that the transfer of receivables is a true sale, i.e. the originator should not retain any control over the receivables or any claim to the receivables that could override the claim of the PTC holders. Further, the transfer of receivables should not in any way vitiate the terms of the underlying loan documents. It should also be ensured that investors have unrestricted access to the cash collateral. CRISIL conducts its own due diligence to ascertain that the transaction structure conforms to a true sale. However, in the absence of any judicial precedent in India on the subject of true sale, CRISIL also bases its analysis on an independent legal opinion from an external legal counsel, certifying that: the assignment of receivables is valid in terms of the underlying loan documents; the transfer of receivables to the trust constitutes a true sale, that the structure ensures that receivables are bankruptcy remote from the originator in light of the originator continuing as the servicer; the cash collateral is bankruptcy remote from the originator; the transaction complies with all applicable laws; all transaction documents are valid and enforceable have been executed in accordance with the relevant stamp duty and registration laws. Servicer Risk: The investor faces the risk of bankruptcy and non-performance of the servicer, since the servicer is critical in ensuring robust collections from underlying borrowers. The transaction documents give the trustee the authority to appoint an alternate servicer in case of nonperformance or downgrade of the existing servicer. Commingling risk: This risk arises on account of time lag between pool collections and investor payouts (typically a month), during which the servicer continues to hold the pool collections. In this interim period, collections from the securitised loans may mingle with the normal funds of the servicer. In case of bankruptcy of the servicer, there could be problems in recovery of these funds and additional costs, which the investor will bear.

Swap Counterparty Risk: In transactions where a swap is required to convert interest rate from fixed to floating or vice-versa, the rating of the instrument is dependent on the timely discharge of obligations by the swap counterparty which agrees to swap the cash flows. Interest Rate Risk: If PTCs have a floating rate yield linked to a benchmark market rate, while the underlying pool of loans contains fixed rate contracts, there is a basis risk. The risk arises due to the possibility of a fluctuation in interest rates in the economy. This risk is generally borne by floating rate PTC investors. Interest rate risk could be mitigated by an interest rate swap or adequately covered by the credit enhancement.

8: GLOBAL STRUCTURED FINANCE

The United States is the largest, deepest and widest securitization market in the world Australia has a market size of A$10bn. and is dominated by residential mortgages and commercial property leases. In Japan, securitization is largely undeveloped with transactions confined to about US$4.8bn In Asia, assets worth only US$2bn. has been securitized, half of which were in Hong Kong. India, Indonesia, and Thailand are the future markets on horizon with a few deals of low volume having been concluded in each country. In Latin America, securitization transactions were up from about US$3.67bn. in 1995 to 10.3bn in 1996. In South Africa, very few transactions have taken place although the Government has enacted a special law in 1992.

9: INDIAN STRUCTURED FINANCE

Securitization is a relatively new concept in India but is gaining ground quite rapidly. One of the earliest structured financing deals in India was the India Infrastructure Developer issue on BOLT structure to institutional investors. Global Telesystems also used the SPV structure to raise capital on its telecom future receivables.ICICI and DOT did one of the first deals for securitizing receivables.

TELCO did a hire-purchase deal, where the future receivables from truck sales, along with the ownership of assets, were assigned to investors directly without an SPV. CRISIL rated the first securitization program in India in 1991 when Citibank securitized a pool from its auto loan portfolio and placed the paper with GIC Mutual Fund. While some of the securitization transactions which took place earlier involved sale of hire purchase or loan receivables of NBFCs arising out of auto-finance activity, many manufacturing and service companies are now increasingly looking towards securitizing their deferred receivables and future flows also. In FY2005, the market for SF transactions grew by 121%-y-o-y in value terms. The number of transactions increased only by 41%, pointing to a significant rise in average deal size. Within the SF domain, the ABS market showed maximum growth.

This was largely due to strong increase in retail lending by banks and NBFCs. The SF scenario is largely based on ABS, accounting for 72% of the SF market in 2005, covering a variety of asset classes like cars, commercial vehicles, construction equipment, two-wheelers and personal loans.

The three stages of securitization in India The early years The growth phase The new era

CHARACTERISTICS OF INDIAN MARKET Securitization began with the sale of consumer loan pools. Originators directly sold loans to buyers. Originators acted as servicers and collected installmenst due on the loans.

Creation of transferable securities backed by pool receivables (known as PTCs) became common in late 1990s. In 1990s, there were only six or seven issuances per year. Average issue size was about Rs.450 million. The volume of issuances grew exponentially beginning in 2000 due to rapid growth of consumer finance. Investors acceptance of securitized instruments also improved. There were approximately 75 issuances each year. Average issue size was about Rs.1900 million. From 2004 to 2005, 40% of vehicle finance was funded through ABS backed by auto loans. The growth of debt funds, the largest investors in securitized paper, also supported the expansion of the market. Citibank completed India's first revolving securitization issuance for its small and medium enterprises working capital loans in 2004. Strong performance and higher yields also attracted investors. High concentration of originators. Number of originators was less than 5 in 2000, and has become more than 20 in 2005. The top five originators account for 90% of the issuance volume. Banks have not yet adopted securitization because of regulatory concerns. Preference for highest rated tranches. Focus is on the short end of the maturity. Investors appetite is restricted to senior tranches that carry the highest ratings AAA / P1+. Originators retain the junior tranches as unrated paper. PTCs are structured to have a predetermined schedule of monthly interest and principal payments to be paid on timely basis. The structure in international market is different where interest is paid on a timely basis and principal is repaid according to instrument maturity. High level of credit enhancement compared to international norms. Timing mismatches due to delayed collection are also covered. Domination of ABS. Securitization has a 100% compounded annual growth rate, of which ABS accounts for over two-thirds of issuances. The growth of MBS was hindered by the low investor appetite for longer tenor assets

NOTABLE SHIFTS IN INDIAN MARKET

1. In ABS:

ABS is the dominant type of instrument in the Indian SF market. The growth of ABS issuances in recent years has been due to a continued increase in disbursements by key retail asset financiers, investors familiarity with the underlying asset class, relatively shorter average tenure of issuances and stability in the performance of a growing number of past pools.

FY2005 saw relatively newer asset classes such as loans for financing used cars, threewheelers and two-wheelers which were securitized in a significant way.

The average ABS deal size almost doubled y-o-y to Rs. 2.9billion in FY2005, mainly due to large pools securitized by leading vehicle financiers like ICICI Bank and HDFC Bank.

There is a growing preference for floating-rate yields, given the volatile interest rate conditions. Time-tranching is increasingly becoming the norm: during FY2005, 64% of ABS issuances involved multiple tranches with different tenures.

2. In MBS:

The largest ever MBS transaction in India, a RS. 12billion mortgage-backed pool of ICICI Bank happened in FY2005. MBS has the potential for maximum growth, given the significant expansion in the underlying housing finance business underway. However, the long tenure of MBS papers and the lack of secondary market liquidity still deter investors.

3. In CDO: Investment decisions influenced by the rating of the underlying corporate exposures in a CDO pool (and not purely the rating of the instrument) have impeded the growth of CDO in India. Corporate loan securitization has been far lower than that in retail securitization. MILESTONES IN THE GROWTH OF SECURITIZATION MARKET IN INDIA The first deal in India was in 1992 when Citibank securitized auto loans and placed a paper with GIC mutual fund worth about Rs. 16 Crores. In 1994-95, SBI Caps structured an innovative deal where a pool of future cash flows of high value customers of RSIDC were securitized. ICICI had securitized assets to the tune of Rs.2,750 crore in its books as at end March 1999. Another novel move was by Maharashtra government to securitize sales tax. The Maharashtra Vikrikar Rokhe Pradhikaran (MVRP) is the SPV to undertake this first of its kind transaction in the country. Securitization of rated transactions increased from less than Rs.1,000crore in 1998, to over Rs.30,000 crore in 2004 05. An oil monetization deal has been structured where the future flows of oil receivables accruing to a company were securitized. L&T has securitized lease receivables even before a power plant was completed. This has opened a new vista for financing power projects. This securitization deal financed even the assets to be created in future. The National Housing Bank (NHB) has made efforts to structure the pilot issue of mortgage backed securities (MBS).

10: FUTURE PROSPECTS OF INDIA

Securitization will grow in future for two significant reasons: (a) securitised paper is rated more creditworthy than the FI itself and (b) strict capital requirements are

imposed on the FIs. Moreover, the opening of the insurance sector for privatization can create demand for securitized paper. Future generation products Discounting of future receivables is slowly gaining momentum as a means of financing working capital. It operates on the basis of discounted value of a stream of future cash flows, and required complex structuring Securitization of present receivables: this is the most popular concept wherein a pool of receivables is bundled out to a buyer. This is mostly popular among financial institutions and banks. Vendor Line of Credit: Ideal for borrowers with strong customers; credit Risk is based on the assessment of the customer. Other short term products being developed include Demand Loans, Floating Rate Limits, MIBOR-linked debentures and FCNR (B) Loans.