Innovations in financial intermediation Innovation has been important in the financial markets of the 1980s.

It promises to be at least as important during the next decade. Innovation in financial markets brings change to financial products, the institutions that produce or deliver these products, and the markets where they are traded. Old products and ways of doing business are being replaced with new and more efficient ones. During the 1980s we have seen the development of options and financial futures, the deregulation of many depository financial institutions, the introduction of a wide variety of new financial instruments, and the globalization of many financial markets. Two of the most important innovations during the 1980s have been the securitization of a wide variety of financial products and the evolution of financial intermediaries as the providers of risk-management products. But before we take up these specific examples of innovation in financial intermediation, we need to focus on the process of innovation itself to understand why so much of it has taken place in the last decade and whether it will continue. The Process of Innovation Innovation is generally a response to a change in the environment. We can make this idea more specific by formulating a list of the most important environmental factors. The major changes in financial markets in the last decade and those we can foresee in the next decade appear to be responses to changes in one or more of these four environmental factors: * The level and volatility of inflation and interest rates; * Technological progress in computers and communications; * Regulation; or * Tax law.

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Probably the largest single cause of innovation in financial markets and institutions in the last decade has been rising inflation and the resulting increase in the level and volatility of interest rates in the 1970s and early 1980s. Many types of financial products and many financial institutions were originally designed with an environment of relatively low and stable interest rates in mind. When interest rates increased, many institutions incurred substantial losses. Investors shifted away from products, particularly regulated accounts at commercial banks and savings and loans, that could not effectively compete in the new environment. The innovations in the last decade can be divided into three useful categories: product, process, organizational innovations. Two of the most important innovations in the last decade deal with the securitization of some key financial markets and the growth of risk-management services provided by intermediaries through the interest rate swaps market.

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SECURITIZATION OF FINANCIAL ASSETS One of the most important innovations in the operation of financial intermediaries is the securitization of many financial assets. Securitization refers to the transformation of an asset that once had no secondary market into a tradeable security with active secondary markets; it is the transformation of a market where financial intermediaries hold loans on their books and fund them by issuing distinct liabilities, an intermediated market, into an over-the-counter and ultimately an auction market where the assets themselves are traded. A number of assets once funded largely through financial intermediaries are now becoming securitized. The market where securitization has gone the farthest is the residential mortgage market. But auto loans and leases, consumer credit cards, recreational vehicle and boat loans, and commercial loans from banks are also becoming securitized to varying degrees. Securitization began in the 1980s with mortgage payments, auto loans, and credit card debt being pooled and used as collateral for securities offerings. More recently, healthcare providers have securitized accounts receivables to obtain low-cost, off-balance-sheet financing. As the need of both raise capital and contain costs grows in health care, providers likely will make increased use of this financing method. Securitization involves pooling and structuring predictable cash flows, derived from the transfer and sale of assets, to an entity that is "bankruptcy remote." Among other benefits, securitization is an efficient source of off-balance-sheet financing.

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History of securitization Securitization was introduced to capital markets in the early 1980s, as mortgage payments were pooled and used as collateral for securities issues. The United States government played an active role by creating agencies that guaranteed the securities' principal and interest. Securitization became a costeffective financing alternative to traditional bank sources for a large number of thrifts and other mortgage originators. In 1985,securitization was extended to include automobile loans and, shortly thereafter, other consumer assets, such as credit-card receivables, second mortgages, and home-equity loans. By the late 1980s, companies such as Citibank, General Motors Acceptance Corporation, Marine Midland Bank, Chrysler Corporation, and Ford Motor Company accessed the securitization market to raise billions of dollars of offbalance-sheet financing. Over the next several years, new issuance of consumer asset-backed securities averaged about $50 billion annually. Following the initial focus on consumer assets, securitization of commercial receivables was the next frontier to be developed, asset by asset. Investment bankers positioned lease-rental payments as analogous to the cash flow from a pool of automobile loans, while trade receivables were likened to credit-card debt. By the end of the 1980s, securitization of trade receivables had become an accepted financing option for companies in a variety of industries. Securities backed by trade receivables used newly issued credit-card securities as a pricing benchmark.

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Introduction to securitization The key to securitization is transfer of a pool of assets - in this case, receivables - to a bankruptcy-remote structure. The bankruptcy-remote structure insulates the investor from any "corporate" risk of the entity selling the cash flow stream. Once the cash-flow or asset is transferred, under no circumstances can it become the property of the transferrer, not even if the transferrer files for bankruptcy. Certain conditions need to be satisfied to achieve a bankruptcy-remote sale of assets, also called a "true" sale. A critical condition is the transference of the assets to a special-purpose corporation created for the sole purpose of buying assets and issuing debt. The receivables must be sold, not financed. The seller records the transfer of assets as a Financial Accounting Standards (FAS) 77 sale for generally accepted accounting principals accounting purposes. The seller is permitted limited recourse for purposes of providing a credit enhancement for the receivables. The security also must be structured in a manner that provides ample protection for anticipated losses. The tenet "past is prologue" is implicit in rating and structuring the security. Therefore, extensive historical analysis of the bad-debt experience for the asset is performed. Based on this analysis, the rating agencies size the protection at two to three times expected losses for a high investment-grade rating of the securities. Because direct recourse to the seller for losses only can be very limited (to ensure a bankruptcy-remote transfer), the protection for losses usually takes the form of credit support from a highly rated entity, such as a bank, an insurer, or a subordinated security held by the seller. The subordinated security represents the residual cash flow of the transferred assets after the debt service of the senior securities, taking into account any

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losses. The subordinated securities are accounted for by the seller as a capital investment in the special-purpose corporation. Securities backed by healthcare receivables usually take the form of mediumterm notes, with the term ranging from three to ten years. The life of the receivable and the corresponding cash-flow and debt-service profile is similar to the more familiar securities that are backed by credit-card debt. In consideration of the short-term nature of the asset relative to the term of the debt, the notes pay interest only for a stated term, then retire the principal at the end of the "interest-only" (or "revolving") period. During the interest-only period, collections from purchased receivables are used to purchase new receivables weekly. Therefore, from the borrower's perspective, the securities are analogous to a term working-capital line of credit.

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Why securitize? Securitization provides a means for many to borrow at a better rate than they can obtain on their own. In general, this observation is true for borrowers with senior unsecured corporate-debt ratings of A or lower. While the cost of debt may be a key motivating factor for securitization, other benefits, both tangible and intangible, also apply. The limited-recourse nature of this financing method is preferable to recourse debt, which can involve personal guaranty of a borrower's principals. Securitization represents off-balance-sheet financing, which improves leverage and certain other balance-sheet ratios. In addition, it helps diversify financing sources. More available cash enables the borrower to take advantage of prompt-pay-vendor discounts. The ability to plan ahead for projects and investments also is enhanced. Finally, receivables sellers are required to track payments, and abnormally high delinquency rates trigger a wind-down of the financing. This requirement encourages borrowers to effectively monitor their receivables, to monitor reimbursement by individual payers, and to ensure that the collection process is efficiently designed and executed. Receivables days outstanding, a measure of efficiency, is invariably improved after securitization. In the healthcare industry, Jersey City Medical Center - which is part of a relatively cash-rich system - disproved the myth that receivables are sold only by the cash-starved. The A-rated security had London Interbank offered rates (LIBOR) +90 basis-points pricing, with a 79 percent advance rate against the receivables. This rate was an incentive for the medical center to gain additional liquidity at a lower rate than available sources could offer. The medical center was able to invest the proceeds of the issuance and earn a positive carry, to benefit from prompt-pay-vendor discounts, and to increase its flexibility with respect to project planning. As expected, the receivables-days-outstanding rate improved after the securitization.

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From a corporate-finance perspective, securitization can be both a means and an end to the consolidation process. For many providers, securitizing their receivables, or securitizing those of an organization to be acquired, can generate part of the proceeds needed to finance an acquisition. In other instances, when a merger is effected through a stock swap, issuing additional stock often creates underleverage. When considering post-merger financing, if a consolidated entity is rated less than A, securitization may be the most costefficient means to raise capital (including equity financing) for the entity to move forward.

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Demands of securitization Schechner mentions that the composition of a mortgage pool and structure of the transaction can be tailored to meet specific needs. Mortgages can be selected and combined to reduce concentration in property types, geographies or borrowers. The portfolio can also be selected to shorten or lengthen maturities to better match assets and liabilities. Securitization is widely seen as the best way to sell pools of commercial mortgages because of the structuring flexibility, certainty of execution and the capacity for very large transactions, according to Schechner. The process has also been used increasingly as a source of mortgage origination for high-quality single properties and property portfolios. Property owners are foregoing the traditional mortgage lending market to access the better pricing, increased certainty and greater depth of the securities market. Shopping centers have been especially popular, according to Mark Ettenger, head of the Retail Focus Group at Goldman Sachs. Schechner also noted that securitization is "quite exciting" for insurance companies, offering them opportunities to reduce their real estate exposure and shift a portion of the economic risk, leaving the insurance company with a manageable first loss position. By acting as a conduit, insurance companies can switch over their existing and now under-utilized underwriting capability to write new mortgages. "It keeps the capability busy and makes it a profit center without increasing their exposure," Schechner said. "Given that a securitization can be equal in pricing with a traditional loan, securitization has many benefits for larger deals, whether they are propertyspecific or pools," Schechner said. "The framework of the transaction can be more flexible as can the pricing. However, there are more upfront costs with securitization in terms of rating agencies, trustees, additional documentation

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and sometimes the disclosure necessary for an SEC registration for public offerings. "Sometimes it's worth it, sometimes it's not." Orem of Morgan Stanley points out that the RTC is currently the major issuer, that life insurance company portfolios and non-performing bank assets can also benefit, and that Morgan Stanley is discussing equity issues with a number of companies as well. "The focus is on finding ways to free up liquidity, both in debt and equity," Orem said. Equity securitization is also a very important emphasis at Kidder Peabody, according to Baum. "We are actively pursuing the best Real Estate Investment Trust (REIT) possibilities. We're evaluating what executions are available. The focus is how to most effectively raise money in today's market," Baum said. The direct access to capital markets, the custom-designed transactions and the potentially lower cost of funds make it clear why securitization will continue to attract the attention of a new broad pool of investors, help ease the credit crunch and make real estate a more liquid investment

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Asset securitisation: However, in the sense in which the term is used in present day capital market activity, securitisation has acquired a typical meaning of its own, which is at times, for the sake of distinction, called asset securitisation. It is taken to mean a device of structured financing where an entity seeks to pool together its interest in identifiable cash flows over time, transfer the same to investors either with or without the support of further collaterals, and thereby achieve the purpose of financing. Though the end-result of securitisation is financing, but it is not "financing" as such, since the entity securitising its assets it not borrowing money, but selling a stream of cash flows that was otherwise to accrue to it. Blend of financial engineering and capital markets: Thus, the present-day meaning of securitisation is a blend of two forces that are critical in today's world of finance: structured finance and capital markets. Securitisation leads to structured finance as the resulting security is not a generic risk in entity that securities its assets but in specific assets or cashflows of such entity. Two, the idea of securitisation is to create a capital market product - that is, it results into creation of a "security" which is a marketable product. This meaning of securitisation can be expressed in various dramatic words:

Securitisation is the process of commoditisation. The basic idea is to take the outcome of this process into the market, the capital market. Thus, the result of every securitisation process, whatever might be the area to which it is applied, is to create certain instruments which can be placed in the market.

Securitisation is the process of integration and differentiation . The entity that securities its assets first pools them together into a common hotchpot (assuming it is not one asset but several assets, as is normally

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the case). This is the process of integration. Then, the pool itself is broken into instruments of fixed denomination. This is the process of differentiation.

Securitisation is the process of de-construction of an entity. If one envisages an entity's assets as being composed of claims to various cash flows, the process of securitisation would split apart these cash flows into different buckets, classify them, and sell these classified parts to different investors as per their needs. Thus, securitisation breaks the entity into various sub-sets.

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The Securitization Process and Rationale: Securitisation is a multi-stage process starting from selection of financial assets and ending with the final payment been made to investors. The originator having a pool of such assets selects a homogeneous set from this pool and sells / assigns them to SPV in return for cash. The SPV in turn converts these homogeneous assets into divisible securities to enable it to sell them to investors through private placement or stock market in return for cash. Prior to selling the securities through private placement / stock market, the SPV may take credit rating for the securitized assets. Investors receive income and return of capital from the assets over the life-time of the securities. Normally, the originator acts as the receiving and paying agent for collection of the interest and the principal from obligors and passing on the same to investors. The difference between the rate of interest payable by obligor and the return promised to investors is servicing fee for the originator and SPV. The originator by securitizing the financial assets transfers the risk associated with economic downturn on cash flows or credit deterioration in a loan / receivable portfolio. The investors buy this risk in exchange for high fixed income return. Investors buy this risk if they see the risk as a diversifying asset, the risk premium demanded by them for underwriting such a risk is lower than the internal funding costs of the originator who has a concentration of such a risk.

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The Financial Structure: The financial structure of the securitized product is a function of the type of the instrument to be issued i.e. Pass Through Certificates (PTC) or Pay Through Certificates (Bonds /Debentures). In both the cases, assets are sold to SPV for further sale to investors in the form of a new instrument. However, the similarity ends here. In case of PTC, investors get a direct undivided interest in the assets of SPV. The cash flows which include principal, interest and pre-payments received from the financial asset are passed on to investors on a pro rata basis after deducting the servicing fee etc. as and when occurred without any reconfiguration. Therefore, the investor takes the reinvestment risk on the payments received. The frequency of the payment is dependent on the frequency of the payment from the financial assets. The PTC structure has a long life and unpredictable cash flows that inhibit participation by some of the fixed income investors. The pay through structure reduces the term to maturity and provides some certainty regarding timing of cash flows. It is issued as a debt security (bonds / debentures) and designed for variable maturities and yield so as to suit the needs of different investors. The debt instrument is issued in the form of a tranche and each tranche is redeemed one at a time. In this case, cash flows are to be reconfigured since they have to match the maturity profile of the debt security. The payment to investors is at different time intervals than the flows from the underlying assets. Therefore, the reinvestment risk on the cash flows till they are passed on the investors is carried by the SPV. The Act has named the securitized instrument as Security Receipt which has been added as a security in The Securities Contract (Regulation) Act, 1956 and thereby makes it available for trading through stock exchange mechanism. As per the definition of security receipt in the Act (section 2(zg)) transfer of only an undivided interest in the financial asset is allowed and thus the Act recognizes only pass-through certificates (PTC) as the possible instrument for securitization. This has eliminated the possibility of issuing pay through certificates in Indian

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markets which are more investor friendly and are the norm in the international markets outside USA. Players and Their Role: The number of players in the securitisation process is large. They can be grouped in two categories the main players and the facilitators . The main players and their role are as follows: The Originator is an entity owning the financial asset that are the subject matter of securitisation. Originator is normally making loans to borrowers or is having receivables from customers. It is the originator who initiates the process for securitisation and is the major beneficiary of it. As already stated, the Act envisages only banks and financial institutions acting as originators. The Obligor (borrower) takes the loan or uses some service of the originator that he has to return. His debt and collateral constitutes the underlying financial asset of securitisation. The Investor is the entity buying the securitized instrument. Section 7 (1) of the Act allows only Qualified Institutional Buyers (QIBs) to invest in Security Receipt (securitized product). The Act has thereby restricted the players in the market. The rational is that being a new product only informed, big players capable of taking risk shall be allowed to invest in it. Special Purpose Vehicle (SPV) is a legal entity in the form of a trust or company created for the purpose of securitisation. It buys assets (loans / receivables etc.) from originator and packages them into security for further sale to investors. In securitisation, one of the primary concern of participants is to ensure non-bankruptcy of the SPV. The Act has recognized SPV as a vehicle to promote securitisation. Section 2 (v) and 2 (za) restricts the legal structure of SPV to a company under the Companies Act, 1956. In order to have effective supervision of such companies 15 Bhav

and to make them bankruptcy proof, Section 3 of the Act has prescribed Registration, Net worth and Corporate Governance requirements for them. These requirements are expected to help in orderly development of the market for securitized product. However, nothing debars such a SPV from floating separate trust(s) for each securitisation program. Facilitators play a very crucial role in the securitisation chain. Their services are instrumental in enhancing the credit worthiness of the product which is one of the prime reasons apart from collateral for the run away success of securitized products Credit Rating Agency provides rating to the securitized instrument and thus provide value addition to security. Insurance Company / Underwriters provide cover against redemption risk to investor and /or under-subscription. The Trustee acts on behalf of the investors and has priority interest in the financial asset supporting the securitized product. Trustee oversee the performance of other parties involved in securitization transaction, review periodic information on the status of the pool, superintend the distribution of the cash flow to the investors and if necessary declare the issue in default and take legal action necessary to protect investors interest. Receiving and Paying Agent is the entity responsible for collecting periodic payment from obligors and paying it to investors. Normally, the originator performs this activity.

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Benefits and Threats: Securitization offers major benefits to originator and provides a low risk high yield instrument to investors. The main benefits to the originator are two fold. One, originator s funds get blocked after it extends loan or expects receivables. Securitization converts these illiquid assets into marketable securities and thus provides alternate source of funding for the originator. Second, the illiquid assets are sold to SPV and are removed from the balance sheet of the originator. This improves capital adequacy and lowers capital requirement for a given volume of asset creation by the originator. By regularly securitizing its illiquid assets the originator can continue to expand its business without increasing its capital / equity. There are other attractions as well like separation of the credit risk of the illiquid assets from the credit risk of the originator since the originator markets claims on other assets. Securitized product is thus a distinct bundle whose credit risk is based on the intrinsic quality of the financial assets having credit enhancement measures and is independent of the credit risk of the originator. This lowers the cost of funds for the originator as the new security is not clubbed with the rating of the Originator and is used to raise funds at much lower cost. Securitization can be used to reduce credit concentration either sectoral or geographical by regularly transferring such concentration to investors of securitized product. Thus it is possible to expand operations in a particular portfolio of assets without increasing total exposure. Additionally, it transfers the interest rate risk, default risk of loans and receivable from originator to investors. However, securitization is a complicated process involving large number of intermediaries and huge upfront legal and rating costs. Therefore it is viable only in case of large sourcing. It also tends to disclose originator s customer information to third parties and this may.prove to be harmful in a competitive 17 Bhav

environment. Sometimes securitization forces originator to strip off its good quality assets leaving only junk assets on its books.

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Features of securitisation: A securitised instrument, as compared to a direct claim on the issuer, will generally have the following features: Marketability: The very purpose of securitisation is to ensure marketability to financial claims. Hence, the instrument is structured so as to be marketable. This is one of the most important feature of a securitised 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. The second issue is one of having or creating a market for the instrument. Securitisation is a fallacy unless the securitised product is marketable. The very purpose of securitisation will be defeated if the instrument is loaded on to a few professional investors without any possibility of having a liquid market therein. Liquidity to a securitised instrument is afforded either by introducing it into an organised market (such as securities exchanges) or by one or more agencies acting as market makers in it, that is, agreeing to buy and sell the instrument at either pre-determined or market-determined prices. Merchantable quality: To be market-acceptable, a securitised product has to have a merchantable quality. The concept of merchantable quality in case of physical goods is something which is acceptable to merchants 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 securitised instrument secures the

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instrument based on the needs of the investors. The general rule 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 securitise. For widely distributed securitised instruments, evaluation of the quality, and its certification by an independent expert, viz., rating, is common. The rating serves for the benefit of the lay investor, who is otherwise not expected to be in a position to appraise the degree of risk involved. In case of securitisation of receivables, the concept of quality undergoes drastic change making rating is a universal requirement for securitisations. As already discussed, securitisation 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, which at times enables to investors to rely purely on the credit-rating of debtors (or a portfolio of debtors) and so, make the instrument totally independent of the oringators' own rating.

Wide Distribution: The basic purpose of securitisation 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, securitisation issues are still difficult for retail investors to understand. Hence, most securitisations have been privately placed with professional investors. However, it is likely that in to come, retail investors could be attracted into securitised products.

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Homogeneity: To serve as a marketable instrument, the instrument should be packaged as into homogenous lots. Homogeneity, like the above features, is a function of retail marketing. Most securitised instruments are broken into lots affordable to the 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 securitisation applications may also follow this logic. The need to break the whole lot to be securitised into several homogenous lots makes securitisation an exercise of integration and differentiation: integration of those several assets into one lump, and then the latter's differentiation into uniform marketable lots.

Special purpose vehicle: In case the securitisation involves any asset or claim which needs to be integrated and differentiated, that is, unless it is a direct and unsecured claim on the issuer, the issuer will need an intermediary agency to act as a repository of the asset or claim which is being securitised. Let us take the easiest example of a secured debenture, in essence, a secured loan from several investors. Here, security charge over the issuer's several assets needs to be integrated, and thereafter broken into marketable lots. For this purpose, the issuer will bring in an intermediary agency whose basic function is to hold the security charge on behalf of the investors, and then issue certificates to the investors of beneficial interest in the charge held by the intermediary. So, whereas the charge continues to be held by the intermediary, beneficial interest therein becomes a marketable security.

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The same process is involved in securitisation of receivables, where the special purpose intermediary holds the receivables with itself, and issues beneficial interest certificates to the investors.

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Risk Profile: The difference between yield on the assets and yield to investors is the spread which is the gain to the originator. A portion of the amount earned out of this spread is kept aside in a spread account to service investors. This amount is taken back by the originator only after the payment of principal and interest to investors. Other third party credit enhancement measures such as insurance, guarantee and letter of credit are also used by originator to get a better credit rating for the instruments. With such multiple options for risk reduction and natural diversification inherent in the product, can a securitized instrument be presumed to be risk free? No. Primary risks associated with securitized product are prepayment risk and credit risk. The pre-payment means refinancing at lower rate of interest or early repayment of the loan amount in part or in full. This risk is associated with mortgaged backed products using the pass through structure (PTC). Generally, loan agreements allow the borrower to make an early payment of the principal amount. The risk originates from the possibility of obligor making such early payment of principal amount and thereby disturbing the yield and the investment horizon of the investors. For premium securities, accelerated prepayment reduces the average life and yield since the principal is received at par which is less than the initial price. Opposite is the case of securities purchased at a discount. Consequently, investors have to predict the average life of such securities and may have to look for alternate investment opportunities in a changed interest rate scenario. The Act provides for PTC as the securitized instrument and so the pre-payment risk will exist in Indian market. Factors affecting pre-payment and corresponding pre-payment models to evaluate this risk will have to be developed in order to make investment decisions. Credit risk reflects the risk that the obligor may not be able to make timely payments on the loans or may even default on the loans. In case of defaults, internal and external riskenhancement measures will come into play.

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The inherent nature of the securitized instrument makes it less risky. The cash flow from the securitized instrument is backed by tangible identified financial assets earmarked exclusively for an instrument and is independent of the originator. Dependability of these cash flows is further strengthened as signified by the ageing of the portfolio. This means, an asset having a cash flow for three years would be monitored for the first 8 to 10 months to determine its historic loss profile. Earmarking a specific pool of aged assets is the core feature contributing to lowering the risk associated with securitized product. Further, the pool of borrowers creates a natural diversification in terms of capacity to pay, geography, type of the loan etc and thereby lowers the variability of cash flows in comparison to cash flows from a single loan. So, lower the variability, lower is the risk associated with the resulting securitised instrument. Understanding of risk enhancement measures, which at times are used in combination, is also necessary to analyze the risk profile of securitized product. Normally, these risk enhancement measures are provided to cover the historic risk profile (first level risk) of the financial assets and some percentage of losses which may be higher than the historic risk profile (second level risk). Internal risk enhancement measures like over-collateralization, liquidity reserve, corporate undertaking, senior / sub-ordinate structure, spread account etc. cover the first level risk. External risk enhancement measures like insurance, guarantee, letter of credit are used to cover the second level risk. Finally, the mortgaged backed securitized product in the foreign markets are backed by a guarantor who guarantee to the investors the timely payment of interest and principal. As of now, such guarantees do not exist in Indian market. However, National Housing Board (NHB) is working in this direction to guarantee securitization of housing loan mortgages.

The funny piece below seeks to capture the inherent risks of securitisation: 24 Bhav

10 reasons as to why the Titanic was actually a securitisation instrument: 1) The downside was not immediately apparent. 2) It went underwater rapidly despite assurances it was unsinkable. 3) Only a few wealthy people got out in time. 4) The structure appeared iron-clad. 5) Nobody really understood the risk. 6) The disaster happened overnight London time. 7) Nobody spent any time monitoring the risk. 8) People spent a lot trying to lift it out of the water. 9) People who actually made money were not in original deal. 10) Despite the disaster, people still went on other ships. The above highlights the risks inherent in securitisation. One of the biggest inherent threat in securitisation deals is that the market participants have necessarily believed securitised instruments to be safe, while in reality, many of them represent poor credit risks or doubtful receivables.

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The Legal Structure and Constraints: The intermediaries involved in creating a securitized product have to comply with multiple legal provisions to give shape to the product. The financial asset is transferred from the originator to the SPV and thereby attracts the relevant provisions of Stamp Act, The Transfer of Property Act, 1882, The Negotiable Instruments Act and Registration Act. These provisions throw up the issues related with i. ii. iii. iv. v. vi. Stamp duty Registration charges in case of mortgage back securities Negotiability / transferability of new security Assignment of mortgage backed receivables, Assignment of future receivables and Issue of part assignment.

These issues, on the one hand, make securitized product economically unviable due to high stamp duty and registration charges. On the other hand, lack of clear supporting legal provisions for the features which are integral part of the process of securitization hinders wider acceptability of the product. The Act has addressed above mentioned issues by providing appropriate definition of financial assets and securitization and recognizing security receipt as a security under the Securities Contract (Regulation) Act, 1956. However, the problem arising due to stamp duty and registration have not been addressed to the satisfaction of the participants and would therefore make it economically unviable. The securitization chain attracts the incidence of stamp duty at three stages. One, at the time of acquisition of financial assets by SPV from the originator. The Act provides two modes.for acquisition of assets: (i) by issuing a debenture which will attract stamp duty on the instrument of transfer and on the issue of debentures, and

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(ii)

by entering into an agreement which being a conveyance and would attract stamp duty. The second incidence of stamp duty arises when the Security Receipt is created. Finally, transfer of security receipt from one investor to another in the secondary market would attract stamp duty unless issued in demat form.

The incidence of stamp duty is one of the major concerns which make securitization transactions financially unviable. Stamp duty is a state subject and in most of the states the duty ranges from 4% to 12%. Four states viz. Maharashatra, Tamil Nadu, Gujarat and West Bengal have recognized the commercial benefits of securitization and have reduced stamp duty on such transactions. The Act has not addressed the issue of stamp duty and the same is left to respective state governments to decide. Other area of concern is the registration requirements on transfer of mortgage backed receivables from immovable property which again adds to the cost of securitization transaction and needs to be addressed. Another impediment is the taxation of income of various entities of securitization transaction since the existing provisions are likely to result into double taxation.

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Listing and Trading: Originators will be keen to get Security Receipt listed on stock exchanges to enhance its liquidity and thereby its attractiveness for investors. This would require framing of disclosure parameters for the securitized instrument. The aim of such disclosures is to assist the market in assessing the creditworthiness and the pricing of the instrument. Two features of the securitized instrument are the determinants of the disclosure requirement for stock exchanges. One, the periodic reduction in the face value of the instrument after each set of receivables from obligors is passed on to investors. Secondly, this reduction in the face value of the instrument might be higher or lower than the scheduled reduction in face value since the cash flows is a function of the performance of the pool of assets i.e. pre-payment and credit risk. Disclosures can be divided into two: initial disclosure and continuing disclosure. The initial disclosure shall concentrate on information having significant effect on pre-payment and credit risk such as lender s credit policy, characteristics of the loans, of the properties that collateralize the loans and of obligors, etc.: 1. Lender s credit policy shall disclosure loans selection policy, documentation, filling, collection etc. 2. Loan related disclosure will be coupon, difference of weighted average coupon for the pool and the current market benchmark rate, original weighted average yield, original tenure, remaining tenure, weighted average remaining tenure to maturity, age of the loans, size of the loans, start and end date etc. 3. Property / collateral information will require geographical distribution, type of the property and other features of the pool of financial assets.

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4. Other collateral information like performance expectation based on the aging analysis of the portfolio, current / cumulative principal defaults, pre-payment assumptions, periodic rating will also required to be disclosed. 5. Instrument specific information like scheduled principal and interest payment dates and the corresponding amount, allotment date, record date, total original face value, scheduled principal and interest distribution amount are to be informed upfront. 6. Obligor information will comprise loan purpose, their social and economic profile etc. 7. Details of credit enhancement measures and how they are going to be activated and work in case there is a short fall in the receivables from obligors. The continuing disclosure requirements will keep investors updated on the performance of the pool and as to the funds collected. Information like number of delinquencies till date and the corresponding amount, new delinquencies for the period and the corresponding amount, the scheduled outstanding face value and actual outstanding face value of the instrument, current weighted average yield, face value prior to and after each payment date, the current and cumulative interest and principal shortfall / excess for the pool and for the instrument, amount drawn from credit enhancement measures and the balance available etc. are to be disclosed to enable the market to judge the creditworthiness and to price the instrument. Stock exchanges would be required to set-up ex-dates for each scheduled payment date.

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Pricing: For taking the investment and pricing decisions for securitized securities, investors need to find answers to the following question: the dynamics of the risk transferred in securitization transaction, the expected value of loss being transferred and the compensation for this expected loss, whether this will be a diversifying asset in the investor s portfolio and the fair risk premium to be paid for underwriting this exposure. Once, an understanding of the above issues is gained, it is possible to develop pricing models incorporating the effect of relevant risks. Given an understanding of above issues, the initial pricing is based on the creditworthiness, the presumed pre-payment rate and the financials of the instrument. The creditworthiness is used to arrive at the required discount factor and the presumed pre-payment rate is factored to determine the reduced average life vis--vis the stated tenure of the instrument. The financials cover the suitability of the instrument in the portfolio of the investor. The discount factor is a function of the interest rate scenario, investor s risk profile and the creditworthiness of the instrument and would comprise a benchmark rate and a risk premium on it. The bench mark rate could be a GOI security having similar average maturity / duration while the rate of risk premium would vary by investors. The historical analysis of past data of pre-payment is done to get the presumed pre-payment rate and the reduced tenure. Using these parameters, the price of the securitized instrument is calculated like a plain bond by applying the discounted net present value method. However, a securitized instrument has an embedded option of pre-payment and the value of this option is reduced from the plain bond price to arrive at the expected price of it. The pricing for the secondary market after the cash flows have commenced throw up another challenge, since, the actual performance of the pool is to be 30 Bhav

factored in the prices. Therefore, the effect of past delinquencies and accelerated pre-payments are to be.considered for assessing the future cash flows. Projecting delinquencies and accelerated pre-payments based on past performance of a instrument for arriving at an appropriate risk premium is a complex problem that depends on both economic variables (interest rate, inflation, economic trend and credit deterioration) and demographic variables (frequency of moves, nature of borrowers etc). This implies, at times the actual outstanding face value may be higher or lower than the scheduled face value. Determining the present price for such an instrument will be a teaser. If the outstanding amount is more, it means the pool is turning to be delinquent and may need to be priced even lower than the scheduled face value. If the outstanding amount is less, it means the pool is prepaying thereby taking away the initial yield expected by investors for a given tenure and need to be priced accordingly. Therefore, the market would have to develop pre-payment and default analysis models in order to price securitized instruments. Also, the instrument requires the investors to be vigilant while pricing it since the scheduled face value of it will keep changing after each payment date. Overall, the Act has provided the much need legal sanctity to securitization by recognizing the securitization instrument as a security under the SCR Act. However, sponsors are restricted to banks and financial institutions and the nature of the instrument to pass through certificates. This limits the scope of financial assets that can be securitized and the coupon & tenure flexibility associated with pay through instruments. These restrictions, may limit the utility of securitization for Indian markets. Additionally, the issue of stamp duty and registration has not been tackled and will make securitization transactions financially unviable in some states. Taxation is another matter which shall be clarified at the earliest. Finally, it is still not clear whether securitization can be done outside the parameters of the Act or not. On 31 Bhav

the other hand, market participants namely sponsors, investors and stock exchanges need to equip themselves to meet the challenges of this new product. For making investment decisions, investors shall develop pre-payment and pricing models. This would require them to understand the nature of the new instrument and its risk profile. At the same time, stock exchanges need to frame appropriate disclosure and monitoring requirements to meet the peculiar nature of this product. However, these limitations shall not delay the introduction of this product through Exchange mechanism and thereby restrict its wide spread acceptability.

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TYPES OF SECURTIZATION: Asset-Backed Securities (ABS) Asset Backed Securities (ABS) are securities that are issued with a structure that repayment is intended to be obtained from an identified pool of assets. Two types: Fully-supported: repayment is supported by a financial guarantee (surety bond, letter of credit, third party guarantee or irrevocable liquidity facility). This provides both liquidity and credit protection for investors: the provider of the support has agreed to provide funds to the SPV (Special Purpose Vehicle) to repay investors without regard to the value of assets owned by the SPV. Partially-supported: repayment primarily depends on the cash flow

expected to be realized on the pool of assets, as well as liquidity and credit enhancement from third parties. The credit enhancement / insurance providing companies are often referred to as Monoline insurers as this is their only business (they also insure other types of debt such as municipal bonds) and this sector is dominated by four companies: AMBAC (American Municipal Bond Assurance Corporation) MBIA (Municipal Bond Insurance Association) FGIC (Financial Guaranty Insurance Company) FSA (Financial Security Assurance) The ABS market is so well developed in the United States that assets (primarily loan receivables) are originated right into an ABS program. The assets are of all types and are primarily loans (either secured or unsecured): Credit Card receivables

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 Automobile loans Bank loans Boat loans Highly-leveraged bank loans Manufactured home loans Railroad rolling stock Aircraft Single-family residential mortgages Single-family home equity loans (HEL) Commercial real estate mortgages Student loans Vacation time shares The financing of the receivables held in the SPV is usually accomplished by issuing short-term commercial paper to investors (through commercial paper dealers). The amount of commercial paper issued usually matches the level of assets held by the SPV. The short-term commercial paper needs to constantly be rolled over and the pricing to and acceptance by investors reflects the performance of the underlying receivables, the credit enhancement indicated above and the availability, performance an yield of alternative investments. The credit enhancement of a securitization can also be achieved by dividing it into tranches and allowing some tranches be exposed first to any loss from defaulting / under-performing indivdual asset or group of assets first. In this manner, these front-line tranches almost function like an equity piece such that the investors in the other tranches (Mezzanine tranches) are stisfied first before the lower tranches. These lower-rated (first loss) tranches usually receive a higher yield (due to their higher risk position) when the security is first structured in order to attract investors when first brought to market. Asset-backed securitizations also usually have a backup liquidity facility in place provided by a stand-by commitment from a syndicate (group) of banks. This 34 Bhav

facility protects the investors who purchase the commercial paper. If for some reason the SPV cannot attract the same or new investors to roll over the commercial paper or there is insufficient cash flow generated by the pool to pay off maturing commercial paper then the SPV draws on the backup liquidity facility to payoff the investors and the bank group then become the owners of the assets held by the SPV (to either wait for the cash flow to improve or to liquidate the portfolio). Asset-backed securitizations usually have a hierarchy / priority of who receives a payment first from the cash flow generated by the underlying assets and a hierarchy / priority of who receives repayment first in the event of the liquidation of the assets. This hierarchy of descending payments from senior to successive subordinated investors is known as the "waterfall" such that those nearest to the top in the hierarchy are compensated first when assets are "liquefied": Pay fees first to the Trustee, Servicer / Asset manager Pay interest due to the most senior notes. If over-collateralization and interest coverage tests are not met, redeem notes until test is in compliance Pay interest due to the next subordinated tranche. If overcollateralization and interest coverage tests are not met, redeem the most senior notes first and then this subordinated tranche until test is in compliance Service all subordinate tranches in the hierarchy of investors in the securitization Satisfy as many tranches according to their priority as is necessary and there are sufficient assets to continue to do so Satisfy most subordinate equity investors if there are sufficient assets to do so

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Mortgage-Backed Securities (MBS) The most well-known asset backed security market is that of the Mortgage Backed Securities (MBS) market. There are RMBS (Residential Mortgage Backed Securities) and CMBS (Commercial Mortgage Backed Securities). In the RMBS market, companies such as the Federal National Mortgage Association (FNMA / Fannie Mae) purchase mortgages (individually or in groups) in the primary market from banks (savings and commercial), credit unions, insurance companies, etc., and packages the loans into MBS (which it guarantees for full and timely payment of principal and interest). FNMA issues various types of debt instruments in the global markets to fund its purchase of mortgages prior to securitization. MBS are sometimes also referred to as Mortgage Pass-Through Certificates as the pro-rata share of the monthly interest, amortized principal payments (net of fees paid to to the issuer, servicer and/or guarantor of the respective security issue) and unscheduled principal pre-payments (many of the individual underlying mortgages have no penalty prepayment features that allow the mortgagee / borrower to make partial or full principal payments) generated by the underlying pool of individual residential mortgages in the securitization are "passed through" to the investors holding an undivided interest in the specific security. Due to the principa pre-payment feature repayment of principal to the holder of a pass-through security may accelerate during times of a declining interest rate environment, thus shortening the life of the security. Each securitized pool has a Weighted Average Coupon / WAC (all of the mortgages within a specific security must be within 200 bps. of the WAC). The pass-through rate is lower than the WAC / interest rates on the underlying mortgages in the pool. FNMA provides a guarantee for its MBS for the timely payment of principal and interest to the investor, whether or not there is sufficient cash flow from the underlying group of mortgages. As some lenders continue to

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service the loan on the behalf of FNMA and the investor, part of the interest rate differential is used to compensate the lender for the servicing function. In addition, a portion of the interest rate ditterential is used to compensate FNMA for providing a guarantee of the security. Each security also has a Weighted Average Maturity (WAM), which indicates the average maturity in months of the underlying mortgages in the pool. Only GNMA is authorized to issue a guarantee with the full faith and credit of the United States government for the timely payment of prinicipal and interest on mortgage-backed securities issued by institutions approved by GNMA and backed by pools of Federal Housing Administration-insured or Veterans Administration-guaranteed mortgages. FNMA issues both fixed-rate mortgage and adjustable rate mortgage (ARM) securities.

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Commercial Mortgage-Backed Securities (CMBS) Similar to residential mortgage backed securities in form and function, however the mortgages in the pool are on multi-family or commercial real estate (industrial and warehouse properties, office buildings, retail space, shopping malls, cooperative apartments, hotels, motels, nursing homes, hospitals and senior living centers). CMBS are issued in both public and private transactions and are issued in a variety of structures, including multi-class structures featuring senior and subordinated classes. The underlying mortgage loans of the securitization tend to lack standardized terms with regard to rate (fixed and floating), term, amortization and some properties also have comply with certain environmental laws and regulations.

Collateralized Mortgage Obligation (CMO) A Collateralized Mortgage Obligation (CMO) is a security that is collateralized by a pool of individual mortgages. This pass-through security is divided into various tranches of payment streams with varying maturities and payment priority (seniority). Some of the lower-rated tranches must absorb any loss prior to the higher rated tranches. Some tranches may payoff more rapidly than other tranches. The division of the security in the various tranches increases the differnt types of investor profiles than a single security could be marketed to. The division can also eliminate prepayment risk from some investor classes. The common CMO structures are: Interest Only, Principal Only, Floater, Inverse Floater, Planned Amortization Class, Support, Scheduled, Sequential, Targeted Amortization Class, and Z or Accrual Bond. Unfortunately, due to the uniqueness of many of the multi-class (tranches) CMOs they are less liquid.

Stripped Mortgage-Backed Securities (SMBS) In an SMBS the interest and principal payments from a standard FNMA MBS are "stripped" out of the original security to create two new classes of security. One

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class of security receives the interest only (IO strip) and one class receives the principal only (PO strip). While they are exclusive of each other they can still be recombined if necessary at a later date. The pricing on either stripped security is usually at a discount from the par value of the underlying MBS. In a declining interest rate environment when the prepayment of residential mortgages accelerates as home owners refinance to lower rates, the PO strips also experience accelerated principal prepayment which increases the yield of the PO strip discounted security. However, in a declining interest rate environment, the IO strip receives less cash due to less outstanding principal balances on which to calculate interest, thus the yield actually declines on the IO strip. In a rising interest rate environment, with lower volumes of prepayment of principal, the IO strip yield performs as expected or has an improved yield as there is sufficient prinicipal and maturity of the underlying mortgages to sustain the interest payments (however, the yield may not be as attractive as newly issued MBS with WAC that reflect the recent increase in mortgage interest rates).

REMIC (Real Estate Mortgage Investment Conduit) A REMIC is a multi-class, investment grade mortgage-backed security created by Fannie Mae, Ginnie Mae, Freddie Mac and other entities. The monthly cashflow from the underlying mortgages are allocated to various tranches, resulting in each tranche having a separate and different maturity, coupon and payment priority compared to the other tranches in the security. The REMIC is not subject to income tax (except on net income from prohibited transactions, net income from foreclosure property, and contributions made after the startup day). In addition, REMICs also produce a residual of paper gains and losses in value ("phantom income" and "phantom loss"). Holders of the REMIC investment are required to pay tax on the phantom income however they actually never receive any actual cash. Phantom losses can by utilized to offset gains from other investments. Thus, investors in REMICs must pay other qualified entities to purchase the residual and the tax liability it generates (pension plans and non-

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U.S. individuals are barred from owning a residual). For other information about REMICs, see sections 860A through 860G of the Internal Revenue Code (IRC).

Real Estate Synthetic Investment Securities (RESI) A RESI is a security collateralized by a pool of mortgages like many mortgagebacked securities. However, unlike other MBS, a RESI passes along any loss incurred from an underlying mortgage to an investor. Thus, if a property ever goes into foreclosure and there is insufficient value received from the sale of the property to satisfy the outstanding mortgage principal and accrued interest, then that loss is passed on to the investor. The security is divided into several tranches with the lowest rated tranche incurring the first losses and then each successively rated tranche incurring the next losses if the first tranche is liquidated by accumulated losses. In exchange, the lowest rated tranche receives a very high market interest rate in the form of a margin over LIBOR.

Collateralized Bond Obligation (CBO) CBO (Collateralized Bond Obligations) are securitized pools of high-yielding bonds and leveraged loans, whose purchase is financed by debt. The issuer, normally a bankruptcy-remote special purpose vehicle (SPV), buys a pool of assets (public bonds) which it then uses to collateralize a series of securities. By subordinating or ranking each series or tranche in terms of seniority, the issuer effectively protects the most senior tranches against potential losses by forcing the junior classes to accept the risk of first loss. The bottom tranche rarely carries a coupon or attracts a rating thus it function similar to equity. To obtain a Triple-A rating, the senior securities must typically be over collateralized one-and-a-half times. Thus, $500 million in assets assembled, no more than $330 million in senior securities ($500 million divided by 1.5), and would have to place $170 million in junior subordinated securities to close the transaction. 40 Bhav

Collateralized Loan Obligation (CLO) CLO (Collateralized Loan Obligations) allows a bank/issuer to bundle lowmargin corporate loans into a new type of bond sold in the ABS market. To the purchaser they offer higher yields than typical credit card and auto loan ABS. However, purchasers take on new types of downgrade and default risks, combined with the novelty of the CLO may make it difficult to trade. Sometimes it is not evident what corporate credits the CLO wrapper is hiding: the pooled loans meet only certain criteria of the rating agencies. In some issues the loans are not fully isolated from the bank such that if the bank's debt rating were to be downgraded, so would the rating on the CLO itself. For the banks, selling a CLO frees up capital tied up in low margin loans (the bank must set aside capital even for blue-chip issuers, however, it cannot charge a higher interest rate due to the low default profile for the blue-chip corporations. Banks that have securitized their loan portfolios can lower their overall regulatory capital requirement. The collateral in a CLO consists of investment grade and noninvestment grade corporate loans, with several tranches of rated securities issued based on the prioritization of cash flows, with the most subordinate tranche (or an equity tranche retained by the bank) absorbing the first launches from default. The most senior tranche holds the lowest credit risk and receives the higher rating compared to the other tranches. Credit enhancement is provided by the prioritization of cash flows, cash reserve accounts, letters of credit or guarantees. Ratings are also based on historical default and recovery information for underlying assets, industry and obligor diversity, minimum interest coverage ratios, minimum collateral ratings tests and hedging transactions (to hedge against currency and/or interest rate related risk).

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The

structure

is

that

the

bank

assigns

the

loans

to

Seller/Servicer/Asset Manager; who in turn sells the loans to the Issuer Trust (a bankruptcy remote special purpose vehicle that is limited to the acquisition and managment of the collateral and the issuance of ABS); the Trust issues ABS to invesotrs and uses the proceeds to purchase the loans; a Trustee protects investor's security in the collateral; the bank may act (or a third party) as a swap counter-party for currency/interest rate hedging. If the transfer of the loan is done by participation without the knowledge of the Obligor, then the default of the originating bank could result in the Trust being the unsecured creditor of the bank/seller without recourse to the Obligor. Assignments represent a more complete transfer. CLN (Credit Linked Note) are debt instruments backed by the full credit of the selling institution but whose performance is based on the reference loan(s).

Synthetic CLO In a synthetic CLO The assets remain on the balance sheet of the sponsor. Instead, the credit risk of the collateral pool of loans is transferred to the SPV by means of a credit derivative (portfolio default swap).

Collateralized Debt Obligation (CDO) Refers to multi-class CMOs, CBOs and CLOs held by an SPV. The SPV can divide a portfolio of securities into various tranches with various maturities, interest rates, seniority, credit enhancement and external credit rating in order to market the securitixation to several investor profiles.

FASIT (Financial Asset Securitization Investment Trust)

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A FASIT is a tax structure established by U.S. Legislation for the purpose of attracting investment business to the United States and away from offshore tax havens. As long as a FASIT has a particular capital structure and adheres to certain investment regulations, then the FASIT can accumulate and distribute its gross earnings without incurring U.S. taxation. CDOs may be issued in the form of "regular interests" in a FASIT. For information on FASITs, see sections 860H through 860L of the Internal Revenue Code (IRC).

Special Purpose Vehicle (SPV) Structure SPV: Special Purpose vehicle; a bankruptcy remote corporation that issues rated securities/commercial paper and uses the proceeds to purchase assets (usually trade and term receivables) from a seller (in a single seller program) or multiple sellers (in a multi-seller program). The bankruptcy remote aspect is important as this way the SPV is not caught up in any problems or failings of the parent organization and the receivables in the securitization pool cannot be claimed by creditors of the parent. Multi-seller programs are typically established by a bank known as a sponsor. The entities who sell assets to the SPV are often customers of the sponsoring bank. Because the SPV really does not have any active or functional employees, the bank is usually engaged as "administrator" of the SPV to perform all of its operational functions. For a single seller program, the SPV purchases assets from one seller. The seller often takes on the role of administrator/servicer for the SPV (similar to the bank in the multi-seller). Although the SPV is established for the benefit of the single seller, it is maintained as a separate entity. The SPV issuer of notes backed by the receivables is usually known as the Owner Trust. The notes are issued subject to an indenture between the Owner Trust and in many instances, the asset may be held by a third party, bankruptcy

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remote special purpose corporation solely for the purpose of managing, leasing or servicing the assets. The Owner Trust still maintains an interest in the underlying collateral by exchanging the proceeds from the CP issuance to the third party and receiving funding notes or certificates (with a specified beneficial interest in certain specified collateral designated for the securitization) from the third party entity. The Owner Trust issues CP or medium term notes to investors backed by its own assets which include the securitization entity's certificates or notes of beneficial interest in the asset. Issuance of the Commercial Paper will be backed up by a Liquidity Facility made up of banks that are committed to paying off maturing commercial paper, and perhaps, a credit derivative structure that protects investors, and/or a Credit Facility such as a Letter of Credit Facility that would provide additional over-collateralization of the assets. Over-collateralization is based on the historical performance/default rate, and/or the estimated residual value of the asset. The scheduled payment stream from the asset is passed through to a collateral account which is then used to pay-off maturing commercial paper/medium term notes. When a company pledges away its income to asset-backed investors, it effectively places corporate bondholders in a second position claim on the assets of the company / financial institution. If the company goes bankrupt, then the corporate bond holders would not be allowed to go after the assets previously promised to the asset-backed trust, at least not until the asset-backed investors were paid off.

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Gain on sale accounting: Earnings are only as good as the company's assumptions on performance of each securitization. If the pool of loans does not perform as well then the company has overstated its earnings. The triple-A rating that the ratings agencies confer upon these deals is based on various types of credit enhancement built in that make loss of principal highly unlikely. But the triple-A ratings do not address the risk that high losses within the securitized trust will force the deal to pay off early leaving bondholder's with reinvestment risk. Nor does the initial rating suggest how the bond may perform in the secondary market. Deposit Trust: conveys a participation interest to the owner trust, which then issues notes and certificates to investors. SIV (Structured Investment Vehicle) are credit arbitrage vehicles. They issue debt in the U.S. and Euro medium-term note and commercial paper markets, and with the proceeds, purchase assets of varying maturities. These assets consist of traditional classes of debt and ABS. Derivatives transactions are used to eliminate both i nterest-rate and foreign-exchange risk. Since the SIVs are funding at the AAA levels but can purchase securities/assets at varying investment-grade rating levels, they can pick up credit spread over the life of that asset. SNAP (Structured Note Asset Packaging) are repackaged notes, which includes a trust structure that allows it to ring-fence a pool of underlying assets into separate new issues. Student Loans Student loans for higher education purposes at the 2-year college, 4-year college, gradute degree programs and trade schools are securitized in the United

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States. The Student Loan Marketing Association (SLMA or Sallie Mae), is the Government Sponsored Enterprise (GSE) that purchases these loans from financial institutions and specialized lending programs, and then securitizes a pool of student loans that are in turn sold to investors. SLMA also guarantees individual issued securitizations (although many of the loans securitized already have a FFELP / Federal Guaranteed Student Loan Program federal government guarantee). However, the SLMA is in the process of terminating its GSE designation and becoming a privatized concern by September 30, 2006. The successor entity is SLM Corp., which will continue to use the Sallie Mae name. All existing securitizations funded by debt incurred by SLMA (a AAA rated entity) will have to be refinanced as part of the privatization completion, as the successor entity, SLM Corp. is only a single-A+ rated issuer. Some of the largest originators of student loans include: National Education Loan Network, Collegiate Funding Services, Education Lending Group, Inc., and College Loan Corp.

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SECURTISATION LEADING CHANGE IN MARKETS

Securitisation and structured finance: Securitisation is a "structured financial instrument". "Structured finance" has become a buzzword in today's financial market. What it means is a financial instrument structured or tailored to the risk-return and maturity needs of the investor, rather than a simple claim against an entity or asset. Does that mean any tailored financial product is a structured financial product? In a broad sense, yes. But the popular use of the term structured finance in today's financial world is to refer to such financing instruments where the financier does not look at the entity as a risk: but tries to align the financing to specific cash accruals of the borrower. On the investors side, securitisation seeks to structure an investment option to suit the needs of investors. It classifies the receivables/cash flows not only into different maturities but also into senior, mezzanine and junior notes. Therefore, it also aligns the returns to the risk requirements of the investor. Securitisation as a tool of risk management: Securitization is more than just a financial tool. It is an important tool of risk management for banks that primarily works through risk removal but also permits banks to acquire securitized assets with potential diversification benefits. When assets are removed from a bank's balance sheet, without recourse, all the risks associated with the asset are eliminated, save the risks retained by the bank. Credit risk and interestrate risk are the key uncertainties that concern domestic lenders. By passing on these risks to investors, or to third parties when credit enhancements are involved, financial firms are better able to manage their risk exposures.

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Securitisation: changes the function of intermediation: Hence, it is true to say that securitisation leads to a degree of disintermediation. Disintermediation is one of the important aims of a present-day corporate treasurer, since by leap-frogging the intermediary, the company intends to reduce the cost of its finances. Hence, securitisation has been employed to disintermediate. It is, however, important to understand that securitisation does not eliminate the need for the intermediary: it merely redefines the intermediary's loan. Let us revert to the above example. If the company in the above case is issuing debentures to the public to replace a bank loan, is it eliminating the intermediary altogether? It would possibly be avoiding the bank as an intermediary in the financial flow, but would still need the services of an investment banker to successfully conclude the issue of debentures. Hence, securitisation changes the basic role of financial intermediaries. Traditionally, financial intermediaries have emerged to make a transaction possible by performing a pooling function, and have contributed to reduce the investors' perceived risk by substituting their own security for that of the end user. Securitisation puts these services of the intermediary in a background by making it possible for the end-user to offer these features in form of the security, in which case, the focus shifts to the more essential function of a financial intermediary: that of distributing a financial product. For example, in the above case, where the bank being the earlier intermediary was eliminated and instead the services of an investment banker were sought to distribute a debenture issue, the focus shifted from the pooling utility provided by the banker to the distribution utility provided by the investment banker. This has happened to physical products as well. With standardisation, packaging and branding of physical products, the role of intermediary traders, particularly 48 Bhav

retailers, shifted from those who packaged smaller qualities or provided to the customer assurance as to quality, to the ones who basically performed the distribution function. Securitisation seeks to eliminate funds-based financial intermediaries by feebased distributors. In the above example, the bank was a fund-based intermediary, a reservoir of funds, whereas the investment banker was a feebased intermediary, a catalyst, a pipeline of funds. Hence, with increasing trend towards securitisation, the role of fee-based financial services has been brought into the focus. In case of a direct loan, the lending bank was performing several intermediation functions noted above: it was distributor in the sense that it raised its own finances from a large number of small investors; it was appraising and assessing the credit risks in extending the corporate loan, and having extended it, it was managing the same. Securitisation splits each of these intermediary functions apart, each to be performed by separate specialised agencies. The distribution function will be performed by the investment bank, appraisal function by a creditrating agency, and management function possibly by a mutual fund who manages the portfolio of security investments by the investors. Hence, securitisation replaces fund-based services by several fee-based services.

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Securitisation: changing the face of banking: Securitisation is slowly but definitely changing the face of modern banking and by the turn of the new millennium, securitisation would have transformed banking into a new-look function. Banks are increasingly facing the threat of disintermediation. When asked why he robbed banks, the infamous American criminal Willie Sutton replied "that's where the money is." No more so, a bank would say ! In a world of securitized assets, banks have diminished roles. The distinction between traditional bank lending and securitized lending clarifies this situation. Traditional bank lending has four functions: 1. originating, 2. funding, 3. servicing, and 4. monitoring. Originating means making the loan, funding implies that the loan is held on the balance sheet, servicing means collecting the payments of interest and principal, and monitoring refers to conducting periodic surveillance to ensure that the borrower has maintained the financial ability to service the loan. Securitized lending introduces the possibility of selling assets on a bigger scale and eliminating the need for funding and monitoring. The securitized lending function has only three steps: 1.originate, 2.sell, and 3.service. This change from a four-step process to a three-step function has been described as the fragmentation or separation of traditional lending.

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Capital markets fuelled securitisation: The fuel for the disintermediation market has been provided by the capital markets:

Professional and publicly available rating of borrowers has eliminated the informational advantage of financial intermediaries. Imagine a market without rating agencies: any one who has to take an exposure in any product or entity has to appraise the entity. Obviously enough, only those who are able to employ high-degree analytical skills will be able to survive. However, the availability of professionally and systematically conducted ratings has enabled lay investors to rely on the rating company's professional judgement and invest directly in the products or instruments of user entities than to go through financial intermediaries.

The development of capital markets has re-defined the role of bank regulators. A bank supervisory body is concerned about the risk concentrations taken by a bank. More the risk undertaken, more is the requirement of regulatory capital. On the other hand, if the same assets were to be distributed through the capital market to investors, the risk is divided, and the only task of the regulator is that the risk inherent in the product is properly disclosed. The market sets its own price for risk higher the risk, higher the return required.

Capital markets tend to align risks to risk takers. Free of constraints imposed by regulators and risk-averse depositors and bank shareholders, capital markets efficiently align risk preferences and tolerances with issuers (borrowers) by giving providers of funds (capital market investors) only the necessary and preferred information. Any remaining informational advantage of banks is frequently offset by other features of the capital markets: variety of offering methods, flexibility of timing and other structural options. For borrowers able to access capital markets 51 Bhav

directly, the cost of capital will be reduced according to the confidence that the investor has in the relevance and accuracy of the provided information. As capital markets become more complete, financial intermediaries become less important as cotact points between borrowers and savers. They become more important, however, as specialists that (1) complete markets by providing new products and services, (2) transfer and distribute various risks via structured deals, and (3) use their reputational capital as delegated monitors to distinguish between high- and low-quality borrowers by providing *third-party certifications of creditworthiness. These changes represent a shift away from the administrative structures of traditional lending to market-oriented structures for allocating money and capital. In this sense, securitisation is not really-speaking synonymous to disintermediation, but distribution of intermediary functions amongst specialist agencies.

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Securitisation and credit derivatives: Credit derivatives are only a logical extension of the concept of securitisation. A credit derivative is a non-fund based contract when one person agreed to undertake, for a fee, the risk inherent in a credit without acting taking over the credit. The risk could be undertaken either by guaranteeing against a default, or by guaranteeing the total expected return from the credit transaction. While the former could be just another form of traditional guarantees, the latter is the true concept of credit derivatives. Thus, if B bank has a concentration in say Iron and Steel segment while A bank has concentration in Textiles, the two can diversify their risks, without actually taking financial exposure, by engaging in credit derivatives. A can agree to guarantee the returns of B from a part of its Iron and Steel exposures, and B can guarantee the returns of A from Textiles (derivatives do not necessarily have to be reciprocal). Thus, A is now earning both from its own exposure in Iron and Steel, as also from the fee-based exposure it has taken in Textiles. Credit derivatives were logically the next step in development of securitisation. Securitisation development was premised on credit being converted into a commodity. In the process, the risk inherent in credits was being professionally measured and rated. In the second step, one would argue that if the risk can be measured and traded as a commodity with the underlying financing involved, why can't the financing and the credit be stripped as two different products? The development of credit derivatives has not reduced the role for securitisation: it has only increased the potential for securitisation. Credit derivatives is only a tool for risk management: securitisation is both a tool for risk management as also treasury management. Entities that want to go for securitisation can easily use credit derivatives as a credit enhancement device, that is, secure total returns from the portfolio by buying a derivative, and then securitise the portfolio.

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Potential for securitizing debt offerings: Jones also says she sees great potential for securitized debt offerings. "As there is significant pressure on domestic institutions to lessen their exposure to real estate, the securitized debt format can finance their balance sheet," she says. By developing conduit structures, traditional lenders may find their way back into the market, says Kane of Kenneth Leventhal. Mortgage conduits may also be the solution for bringing about the involvement of small borrowers in securitization. "Small borrowers should be a major force in the next few years, as conduits are designed to facilitate securitization by allowing them to join under the auspices of a conduit sponsor," Kane says.

Some institutions redirect strategy Away from securitization, the traditional markets are still somewhat dormant, according to Gunthel of Bankers Trust. "Most banking institutions have redirected their strategies, and income-producing property is not high on the agenda. This may change, but right now the market is still very much a huntand-peck exercise," he says. "Other traditional players such as insurance companies and thrift institutions have redirected a lot of their attention to singlefamily projects, and the pension community is more interested in rebalancing the real estate they have on their books." But as the devaluation process in real estate slows markedly, there is a little more optimism, Gunthel adds. Construction receives some financing While most traditional sources of construction and take-out financing are not available or offer low loan-to-value ratios, Bankers Trust claims to be virtually the only source of 100% construction financing today. Through the 54 Bhav

securitization of lease-backed notes, Bankers Trust can provide financing for expansion for investment-grade discount retailers, such as K mart. Essentially, the notes are corporate credit-backed notes supported by the lease obligation of the company as well as the property, Gunthel reports. A 1031 Exchange Can Be a Work of Art Creative alternatives in real estate abound, but devising options while deferring taxes may sound too good to be true. However, exchanges are as creative as the minds which conceive them and real estate exchanges offer unlimited possibilities to defer taxes. Consider this priceless work of art. An exchanger relinquishes property in one state encumbered by $1 million in debt and subsequently identifies foreclosure property in a different state as the replacement property. The accommodator acquires the foreclosure property free and clear of debt on the courthouse steps resulting in $1 million in debt relief (boot) for the exchanger. To avoid this issue the accommodator places $1 million of debt against the foreclosure property under a nonrecourse, fully assumable loan prior to deeding the property to the exchanger. The exchanger then defers the capital gains tax, equalizes the debt and acquires replacement property at a very attractive price. The exchanger relinquishes real property and selects an unimproved parcel of lesser value as the replacement property. The unimproved parcel is deeded to the accommodator to hold pending completion of the improvements. The exchanger then identifies a house (exclusive of any land) for purchase by the accommodator. The house is moved to the unimproved parcel recently acquired by the accommodator. (If the exchanger purchased the "house only," it would be considered a "non-like kind" exchange as no real property was conveyed with the house.) Additional improvements are then completed within the exchange period to increase the value of the replacement property to at least the value of the relinquished property at which time the property is deeded to the exchanger who enjoys full tax deferral in this artistic effort.

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Quality of Mortgage Originators More Critical Than Ever For local mortgage originators, the new environment in the mortgage banking industry gives increased importance to the quality of their correspondent relationships. With traditional sources of long-term mortgage financing becoming less available, mortgage originators who intend to remain players in the market need to find new reliable sources for their product. In most cases, this means developing a relationship with a mortgage banking firm that has ready access to national and international capital markets. In the multifamily industry, that puts a premium on finding mortgage bankers who work through existing conduits such as Fannie Mae's DUS program, Freddie Mac's Program Plus, private institutional investors and investment bankers. The rules of the game have changed, but this is not necessarily a bad thing for savvy mortgage originators who know their local markets and are prepared to evolve with the times. If anything, this is a golden opportunity for originators to improve their professional stature by becoming financial specialists who know the lay of the land and can get a transaction funded. The key ingredient that will make this happen is the quality of the originator's correspondent relationships. Mortgage originators should consider the following when looking for a correspondent relationship with a mortgage banker: Strength. The mortgage banker should possess demonstrable financial strength, primarily to ensure that loans can be funded without interruption. The importance of financial strength is that it infers reliability. It is a guarantee that approved loans will be closed. Evidence of a financially strong mortgage banker includes a net worth of at least $5 million, solid 56 Bhav

underwriting capabilities, and a significant multifamily servicing portfolio with adequate asset representation in the part of the country where the originator does business. Commitment. Since developing a long-term relationship takes time and effort, the correspondent chosen should be clearly committed to remaining in the mortgage financing market. Borrowers are thus assured that their loan requests will always get immediate attention. That is the value of commitment. It means one can do business with much more confidence. Access. Plain vanilla loans aren't adequate anymore; neither are mortgage bankers who only offer access to limited types of financing. Instead, a correspondent should have a diverse product line that offers the maximum range of options for the maximum range of customer loan requests. In today's environment, a lender needs flexibility. Access to a wide variety of loan products gives an originator more opportunities to get a borrower's business. Support. The mortgage banking firm selected should provide support from an experienced staff working with the latest technology. Expect quick turnaround time, responsive underwriting and efficient processing. Marketing Assistance. The final hallmark of a solid correspondent relationship is a cooperative approach that promotes mutually beneficial future business development. A mortgage banker can provide leads, referrals and contacts; more penetration in existing markets; and general marketing assistance through shared mailing and advertising campaigns. Ultimately, the originator's goal in developing a correspondent relationship with a mortgage banker should be to plug into a nationwide network. With the right correspondent, originators can deliver the power of Wall Street to the needs of Main Street 57 Bhav

INDIAN SECURITISATION MARKET : A SCENARIO ANALYSIS Securitisation as a financial instrument has been in the practiced in India since the early 1990s essentially as a device of bilateral acquisitions of portfolios of finance companies. As would be the case elsewhere too, securitisation finds its way of loan sales. There were quasi-securitisations for quite a while where creation of any form of security was rare and the portfolios simply ended from balance sheet of one originator over to that of another.

Form of security: In the later part of 1990s, creation of transferable securities in the form of passthrough certificates (PTCs) became common. The word PTC has almost become synonymous with securitisation in India and most market practitioners do not envisage issuance of notes or bonds as a securitised product. A typical Indian PTC does not abide by any specific structural features there are PTCs which have a specific coupon rate, there are structured PTCs and PTCs have different payback periods. In other words, many such PTCs are essentially debt instruments it is only that they are not called as such. The issuance of PTC has so intensely been associated with the market that even for completely bilateral deals which are really speaking loan sales, people have used trusts and PTCs.

Asset classes: Over time, the market has spread into several asset classes while auto loans and residential housing loans are still the mainstay, there are corporate loans,

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commercial mortgage receivables, future flow, project receivables, toll revenues, etc that have been securitised. CMBS transactions that are characteristic of the Western world where the commercial real estate itself is the real collateral, are not still not common. CLO/CDO transactions have also not surfaced as yet one solitary attempt by ICICI to float a CDO did not succeed, though single corporate loans have been securitised. Revolving structures are still not there. ABCP conduits also do not exist. Transactions are both rated and unrated. Transactions are both listed and unlisted.

Motive for securitisation: Synthetic transactions have also not emerged as yet. In fact, even for most cash transactions, capital relief does not sound like a very significant motive since the volumes are too small to have any tangible impact on the regulatory capital of the securitisers. The larger part of the countrys banking sector is still an investor rather than originator for securitisations. Thus the primary motive for most securitisers would be the skimming of excess spreads; for some, liquidity needs are obvious.

Nature and form of credit enhancements: Subordination is a commonly used form of credit enhancement. Since asset backed securities are still new, investors have a preference for AAA or AA rated instruments. Most transactions in the market, therefore, end up with a couple of senior classes. Multi-class issuances with several rated tranches are uncommon. Apart from subordination, over-collaterlisation, guarantees, recourse, cash reserves are used as other forms of enhancement. The extent of enhancements

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is relatively very high and not very painful, as there are no capital consequences of providing such enhancement see below.

Legal structure: In 2002, India enacted a law that reads Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (SARFAESI). Though masquerading as a securitisation-related law, this law does very little for securitisation transactions and has been viewed as a law relating to enforcement of security interests, as a very narrow avatar of personal property security laws of North America. In commercial practice, the SARFAESI has been very irrelevant for real life securitisations. Most securitisations in India adopt a trust structure with the underlying assets being transferred by way of a sale to a trustee, who holds it in trust for the investors. A trust is not a legal entity is law but a trustee is entitled to hold property which is distinct from the property of the trustee or other trust properties held by him. Thus, there is an isolation, both from the property of the seller, as also from the property of the trustee. The trust law has its foundations in UK trust law and is practically the same. Therefore, the trust is the special purpose vehicle. Most transactions to date use discrete SPVs master trusts are still not seen.

The trustee typically issues PTCs. A PTC is a certificate of proportional beneficial interest. Beneficial property and legal property is distinct in law the issuance of the PTCs does not imply transfer of property by the SPV but certification of beneficial interest.

Regulatory compliances: The Reserve Bank of India has a set of guidelines for banks relating to their transactions under the SARFAESI law but that contains only an opaque 60 Bhav

reference to capital relief. There are no clear guidelines on capital relief. However, it is generally felt that if a transaction attains off balance sheet treatment, it will result into capital relief. There are no specific capital implications on account of retention of subordinated tranches, though in practice, there are substantial junior stakes or overcollateralisations present in every transaction (see under Credit enhancements above). Among the regulatory costs, stamp duty is a major hurdle. The instrument of transfer of financial assets is, by law, a conveyance, which is a stampable instrument. Many states do not distinguish between conveyances of real estate and that of receivables, and levy the same rate of stamp duty on the two. The rates would therefore be weird going up to 10% of the value of the receivables. Some 5 states have announced concessional rates of stamp duty on actionable claims, limiting the burden to 0.1%, but there is an unclarity as to whether this concession can be availed for assets situated in multiple locations. The stamp duty unclarity and illogicality has in a way shaped the market players have limited transactions to such receivables as may be transferred without unbearable stamp duty costs. The SARFAESI law intended to resolve the stamp duty problem, but owing to its flawed language, did not succeed.

Taxation: The tax laws have no specific provision dealing with securitisation. Hence, the market practice is entirely based on generic tax principles, and since these were never crafted for securitisations, experts opinions differ.

The generic tax rule is that a trustee is liable to tax in a representative capacity on behalf of the beneficiaries therefore, there is a prima facie taxation of the SPV as a representative of all end investors. However, the representative tax is 61 Bhav

not applicable in case of non-discretionary trusts where the share of the beneficiaries is ascertainable. The share of the beneficiaries is ascertainable in all securitisations through the amount of PTCs held by the investors. Though the PTCs might be multi-class, and a large part might be residual income certificates in effect, the market believes, though with no reliable precedent, that there will be no tax at the SPV level and the investors will be taxed on their share of income. The scenario is, however, far from clear and the current thinking may be short lived.

Accounting rules: The Institute of Chartered Accountants of India has come out with a guidance note on accounting for securitisation. Guidance notes are issued by the Research Committee of the Institute and are recommendatory rather than mandatory. But where a method is recommended, it is expected to be followed, unless there are reasons not to. The guidance note is a mix of FAS 140 and FRS 5 approach. Generally, off balance sheet treatment is allowed, if risks and rewards are transferred. Gain on sales is computed based on the components approach underlying the US accounting standard. Originators are required to estimate the fair value of retained interests, and retained liabilities and apportion the carrying value of the asset in proportion of such retained and transferred interests.

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ABS Market Introduction The domestic asset-backed securities (ABS) market has grown considerably since FY2001. ABS issuance volumes have gone up more than 10 times in the last two years from. 3.2 billion in 2000-01 to As.35.5 billion in 2002-03. A regular and systematic analysis of pool performance is essential since in securitisation transactions, payments to investors largely depend on the cash flows from the securitised pools. The objective is to see how the pool's actual performance compares with its expected performance at the time of the initial rating and to ensure that this actual performance, along with the available credit enhancement, is consistent with the outstanding rating.

Since a securitisation transaction's rating is a function of the pool's asset quality and the level of credit enhancement, a deficiency in anyone factor can be offset by the other. While pool performance is an important rating input, it is not the only factor that determines the overall level of credit protection available to an ABS investor. Credit enhancement mechanisms such as over-collateralisation, subordination, excess interest spread and cash collateral are an integral part of any ABS transaction. Moreover, in ABS transactions, the rated instruments amortize on a monthly basis. This means that with the passage of time, the repayment obligations on the instrument drop. As a result, the originally stipulated credit enhancement tends to increase in percentage terms. This flexibility with respect to reset of credit enhancement is a very useful tool as it takes care of any pool performance-related concerns during the course of the 63 Bhav

transaction to a large extent. Thus, the rating at any point in time is reflective of pool performance taken . together with credit enhancements available. Investors need only to monitor the rating of the instrument to evaluate the effective credit protection available.

Key parameters in monitoring the performance of ABS pools

Collection efficiency is a key indicator of a pool's performance. Hence, it is used as a benchmark to evaluate the performance of pools across originators and asset classes. Cumulative Collection Ratio The cumulative collection ratio (CCR) represents the ratio of total collections to total collectibles for the asset pool from the date of securitization to date. For example, if the monthly collectible is As 100 and the cumulative amount collected by the end of the third month is As 225, the CCR at the end of the third month will be 225/300, which is 75% of the total collectiblesThe CCR enables investors to evaluate the pool's stand-alone performance in the absence of any external support or enhancement mechanisms. While external credit enhancements provide protection from payment defaults, a high CCR indicates superior pool performance. Hence, it is a source of immense comfort to investors. The CCR is generally affected by: I. Delayed payments by borrowers, and 2. Non-payment by borrowers (resulting in ultimate credit losses)

CCR varies across asset classes

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A graphical representation of the CCR for two asset classes, commercial vehicles (CV) and cars reaffirms expectations that different asset classes display different CCR patterns over time (see CCR trend in CVs and cars). A truck operator depends on the earnings from the asset to make repayments on the loan as compared to car owners who repay loans through other stable sources of income. While the proportion of ultimate credit losses in car pools may not be substantially different from that in CV pools, the proportion of borrowers delaying payments in a CV pool is much higher than that in a car pool. Accordingly, collection delays are an important reason for the difference in the CCR curves of these two asset classes.

Seasoning of a pool impacts CCR Typically, the CCR increases with seasoning (months elapsed since securitization). Greater seasoning increases a borrower's equity in the financed asset, reducing his or her proclivity to default. CV pools begin with a low CCR, which increases sharply as the trucker's paymenj volatility gets absorbed. In comparison, car pools begin with a relatively high CCR, which increases marginally over time. Once the transaction has

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reached high seasoning, the CCR differential between the two asset classes falls substantially. Investors can analyse their pool's performance in terms of the actual CCR movement. Any substantial negative deviation of the observed CCR from the average CCR could serve as a good starting point to initiate a more detailed enquiry . Monthly Collection Ratio The monthly collection ratio (MCR), which is defined as collections for the month/billings for the month, represents the 'flow' element of the CCR ratio. In other words, the MCR reflects the monthly performance of a pool whereas CCR indicates the cumulative performance of the pool (represents 'stock' performance).

A comparison of cash collateral available presently as proportion of future payouts (CCFP) vis a vis stipulation, will enable investors to evaluate whether the transaction is supported by adequate credit enhancement levels.

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Any change in MCR leads to a change in CCR. By and large, MCR increases over time on account of enhanced collections from overdues. A significant drop in MCR during a particular month, or a continual downward trend in MCR on a continual basis should serve as a warning signal indicative of weakening collection performance. The MCR could be highly volatile for pools whose collection patterns are seasonal. The scope of improving the MCR through higher overdue collections is limited for pools that have a consistently superior collection performance and low overdues. In such cases, the MCR could drop below the CCR without having any significant negative impact on pool performance. Cash collateral available A comparison of cash collateral available presently as proportion of future payouts (CCFP) vis a vis will enable investors to evaluate whether the transaction is supported by adequate credit enhancement levels.

The two pools that have displayed a CCFP of 96% -98% of the original stipulation are recently rated pools. Although payouts to investors from these pools are yet to begin (on account of a staggered payout mechanism), the credit 67 Bhav

enhancement has been marginally utilised because of prepayments of some loans. Mathematically, therefore, the available cash has fallen without a proportionate reduction in payouts, leading to a reduction in the CCFP. The CCFP is, however, a mathematically derived output, which is not entirely dependent -on pool behavior. To this extent, investors ought to be careful when using this ratio for drawing conclusions about the pool's performance. A CCFP far in excess of the original , stipulation might not be a source of comfort but a fall in the CCFP below the original stipulation (other than for reasons described above) is a warning signal, indicating weak collections from the pool. Investors should, therefore, use this ratio to put a pool on 'negative watch' rather than to derive any substantive positive comforts from a high current CCFP . Performance review of ABS pools -July 2003 An asset class wise performance of pools is provided below. Commercial Vehicles and Construction Equipment Most CV and commercial equipment (CE) pools have exhibited stable performance and as on date, the CCR for most pools are in line with projections. Several pools originated by Ashok Leyland Finance Limited (ALFL) have, however, displayed volatility in collections over the last two months. The preliminary information received on collections for the month of September 2003 indicates that these shortfalls are being recovered and overall collections have stabilized. Cars Car pools have also performed according to expectations. Pools originated by ICICI Bank as well as those originated by Citibank are particularly noteworthy with CCRs consistently in excess of 98%. Two Wheelers 68 Bhav

Three two-wheeler pools, all originated by ALFL, have been securitized to date. These pools have shown somewhat volatile collections. Their CCRs are lower than those of CV/CE and car pools. Transactions involving two-wheeler pools, however, have credit enhancements that are adequate to alleviate any concerns on asset performance. FY2002-03 witnessed the emergence of personal loans as a new asset class in the securitization market with Citibank and ICICI Bank securitising parts of their respective personal loan portfolios has so far rated three personal loan transactions. Even though personal loans are unsecured in nature, the performance of the pools over the last 12 months has been satisfactory with CCRs in excess of 97% .The prepayment rates for personal loan pools are however, higher than those for other asset classes, which is a possible fallout of high interest rates on such loans. Personal Loans FY2002-03 witnessed the emergence of personal loans as a new asset class in the securitization market with Citibank and ICICI Bank securitising parts of their respective personal loan portfolios. CRISIL has so far rated three personal loan transactions. Even though personal loans are unsecured in nature, the performance of the pools over the last 12 months has been satisfactory with CCRs in excess of 97% .The prepayment rates for personal loan pools are however, higher than those for other asset classes, which is a possible fallout of high interest rates on such loans.

Utility Vehicles

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So far rated four pools of receivables backed by utility vehicles (UV), all of which have been originated by Mahindra and Mahindra FinanciaI Services Limited (MMFSL). As UV financing is largely concentrated in rural and semi urban areas, these pools exhibit seasonal collection patterns as a study of MMFSLs static pool performance over a three-year period (1999-2002) has revealed. CRISIL observes that sizeable collections are made as the contracts move towards their maturity dates. Of the four pools, however, the contracts in the first pool (VE rust 1) alone have seasoned for a sufficient period of time to enable us to derive any meaningful conclusions. With a seasoning of 18 months, collections from this 001 appear to have reached a certain level of stability (see performance sheet).

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MBS Market Mortgage Based Securtisation: The CMBS market provides liquidity and diversification to commercial real estate investors and ready access to capital for commercial lenders. As might be expected, commercial mortgages have significantly more complex and generally less standardized underwriting requirements and procedures than do residential mortgages. As the degree of standardization of commercial loans increases the need for specialized due diligence decreases. Residential mortgage origination, due diligence, and securitization have long been standardized through the actions of FHA, Fannie Mae, and other Government Sponsored Entities. The securitisation of housing loans, popularly known as Mortgage Backed Securitisation (MBS), commenced in India in 2000, with the maiden issuance of National Housing Bank (NHB) involving pools of Rs 1.35 billion. The market has witnessed rapid growth since then, with cumulative MBS issuances tilt March 31st 2004, amounting to Rs-41.1 billion. Timely surveillance and monitoring is a key element in rating MBS transactions, as investor payouts are directly inked to the cash flows generated from the pool. Analysis of MBS transactions reveals that they are sensitive to three key risks namely credit risk, interest rate fluctuations and prepayments by borrowers The Indian pools reported strong protection measures marked by robust credit performance, minima! Interest rate risk and complete coverage for prepayment risks.

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Credit risk reflects the possibility of non-payment 01 delayed payment by borrowers. Traditionally, credit tosses in the home loan segment have remained low, however, a recent study reported notably high non-performing loans (NPL") of 2 per cent as of March 31, 2003. This is primarily driven by the increase in loan sizes and loan-to-value (LTV) ratios over last two years. Currently, 'base case' credit loss of 4 per cent of pool cash flows over the tenure of the transaction. The base case number is adjusted to account for the originator's track record and pool specific characteristics like seasoning, loan sizes. LTVs, geographic concentration, etc, MBS transactions in India are exposed to 'basis risk' While the underlying pools comprise contracts at floating interest rates, the PTCs are issued at fixed rates. Hence, the transaction's relative safety depends on the movement of housing loan rates in the economy. While home loan rates have fallen steeply from fixed rate of 15 per cent per annum in 2000-01 to floating rate of 8 per cent per annum today, PTCs issued in 2000 still carry a fixed rate of 12 per cent per annum.

The requirement for maximum credit enhancement is ascertained by considering the worst-case scenario. Borrowers prepay their mortgages for various reasons - to obtain refinancing at lower rates, on account of increased income levels or sale of properties due to rising property values, etc. While such prepayments reduce outstanding pool principal, they also lead to faster amortization of PTCs than originality envisaged leading to a higher level of reinvestment risk.

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Evaluation of the pool is based on the following three performance indicators that address key risks comprehensively, are easy to understand, and act as effective early warning signals for deterioration in performance. Threshold Collection rate (TCR); TCP represents the minimum monthly collection ratio (Monthly collections/Monthly billings) required on pool cash flows, to ensure timely servicing of PTC payouts. A low TCR indicates low credit risk in the pool. Threshold Interest rate (TIR): TIR is the minimum pool yield that can ensure adequate and timely servicing of PTC payouts. The lower the TIR, the greater the protection available in terms of interest rate shocks, Threshold Prepayment rate (TPR): TPR represents the maximum level of prepayments that can be sustained by the pool so as to avoid shortfalls in meeting investor payouts. A high TPR indicates greater prepayment protection levels available to PTCs.

The following paragraphs provide a summary of analysis on the performance of 22 CRISIL rated MBS pools across 7 originators as on August 31 2004. Strong Credit Performance The MBS pools reported strong credit performance driven by minimal delinquencies, low TCRs and high credit loss coverage ratio, Most pools performed well with cumulative collection ratios (CCR - cumulative collections/ cumulative collectibles), above 90 per cent. The collection ratios noted an upward trend with the increasing seasoning of the transaction, enabling originators to iron out collection delays over time (see chart 2).

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The pools reported low TCRs indicating comfortable protection levels available to investors. The highest TCR at 90 per cent indicates the pool's capability to withstand credit losses to an extent of 10 per cent of the monthly billings. The level of credit safety is also reflected in the credit loss coverage i.e. ratio of maximum sustainable credit loss in a transaction (1 -TCR) to the present credit loss of the pool. Presently, more than 75 per cent of the rated pools have a credit coverage ratio above 10 with most pools having a coverage ratio above5. (See chart 3)

Minimal Interest rate risk The pools reported a healthy TIR providing comfortable protection against any interest rate risk. More than 80 per cent of the rated pools

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recorded a TIR below 4 per cent per annum, with the highest TIR being 5.5 per cent, (See chart 4). The figures imply that against current home loan rates of 7 8 per cent per annum, interest rates need to further drop by 300 - 400 basis points to impact the timely servicing of PTCs. Prepayment risk manifests primarily in premium structures, where prepayments result in an erosion of credit enhancement. Presently, all pools have a TPR of more than 100 per cent indicating full) coverage of premium in transactions. While their performance is likely to remain sensitive to the various parameters listed above the PTCs will sustain the highest ratings.

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THE ROAD AHEAD Asset backed securitisation commenced in India with a car loan transaction originated by Citibank in the year 1992. Since then, the market has grown rapidly, with India becoming one of the largest securitisation markets in Asia, after Japan and Korea. As per estimates, more than 300 transactions, involving a cumulative volume of Rs 500 Billion have been placed in the market till date. Enhanced volumes in the market have been accompanied by the emergence of new asset classes. Further, proceeds from ABS transactions account for close to 15 per cent of incremental disbursements in the Indian consumer finance market underscoring the importance of securitisation as a preferred mode of financing, The strong performance of securitisation transactions and the lack of alternative investment avenues have heightened investor appetite in such papers. As a result, average deal sizes have increased significantly over the last two years, with spreads on AAA rated pass through certificates (over comparable AAA corporate paper) falling to 30-40 basis points presently as compared to 100-125 points in 2000-01. Market Structures and practice PTCs have bond-like characteristics The securitisation market is dominated by finance companies and banks, which have used this mechanism to book profits and as a cost effective source of funding, rather than for purposes of capital relief. Given the nascent stage of the market, repayments on the PTCs have been structured to have bond-like characteristics, with a schedule of interest and principal, to be paid on a timely basis. Trenching of PTCs has become popular, but all of the senior trenches

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have been rated at AAA/ P1+ to address the investor's lack of familiarity with the product, besides poor investor interest at lower rated categories,

Bond like outflows coupled with volatile inflows lead to high credit enhancements The market has witnessed two trenches senior-subordinate structures, with levels of credit enhancement far in excess of norms seen internationally. This is mainly on account of the structural inflexibility of paying both interest and principal on a timely basis. This inflexibility of fixed outflows, coupled with volatile inflows result in credit enhancements that have to cover not just credit defaults, but timing mismatches too, leading to over-stated credit enhancements. PTC demand restricted to short tenor papers Market interest in securities papers, is considerable amongst mutual funds and private sector banks, primarily at the short end of the yield curve. However, the lack of interest in the product amongst large public sector banks and insurance companies, and lack of presence of pension funds, has led to a restricted market, especially for longer tenor MBS. This has resulted in a slowdown in the MBS market despite favorable capital treatment by the regulator. MBS transactions carry high basis risk, further adding to cm

enhancements Most housing loans are presently issued at floating rates of interest whereas PTGs issued are typically fixed rate in nature, leading to basis risk. Any change in home loan interest rates leads to changed pool inflow; whereas the pool payouts remain fixed, increasing the uncertainly (payments to investors. Credit enhancements are typically sized to cove for these losses, further adding to the inefficiency of transactions. Market sophistication has increased rapidly In 2004-05

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Increased investor demand, and the pressures of needing to obtain fine pricing have lead to innovations in the market, with the advent of several new structures in 2004-05. Some of the key innovations include... Planned Amortization Class (PAG) strips: During the last year, floating rate instruments, through the use of interest rate swaps have become quite popular. To ensure that the swap notional amounts are maintained as per the swap agreement, prepayment strips have been structure to absorb the volatility of prepayments. However, in retail finance, a base level of prepayments always occurs. Hence, some structures have built a base level of prepayments into the floating rate instruments' payout schedule, reducing the size of the high-cost prepayment strip. Interest only (10) strips: Asset classes like personal loans have very high levels of excess interest spread (EIS). Some structures have carved out a portion of the EIS into an 10 strip, which is an elegant mode of structuring. With an impending hike in interest rates in the retail finance assets, such strips will find a lot of interest. Repayments might slow down during rising interest rates and investors might get additional payouts in case of slower prepayments. Charge-off mechanism: Par structures have an element of excess interest spread (EIS), which are subordinated to the investor payouts- This spread is paid to the seller once the scheduled investor payouts are made. Some transactions have made more effective use of this spread by using it to charge-off delinquent contracts from the pool. The principal outstanding on the delinquent contracts (contracts overdue for more than six months) is prepaid to the investors from the EIS otherwise passed on to the seller The investor protection is enhanced as they are not exposed to the performance risk of the charged off contracts.

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Basel Norms and Securitisation: A make or break Situation Presently, there are no stringent capital requirements for originators who securities their assets, and retain the subordinate piece on their balance sheet as an investment. The subordinate pieces are treated as normal assets and allocated capital at the standard level', despite its characteristic as a first loss piece on the securitisation transaction. The lack of regulatory clarity on the matter has not helped either, The treatment of subordinate first loss piece as a standard asset has resulted in relative indifference of originators to the structuring inefficiencies or high levels of credit enhancements. The capital allocation norms proposed under the Basel-11 accord, which insist on a rupee to rupee allocation of capital for the subordination is set to change all that. Under these norms, a subordination of Rs. 100 on a Rs1000 pool would lead to a capital requirement of Rs. 100, whereas Rs. 9 is what would be allocated as per current practice (9 per cent of 100). Assuming no securitisation was done, a capital allocation of Rs. 90 (9 per cent of 1000) is required. As can be seen, the standard capital norm of 9 per cent would become the ceiling for credit enhancements. Any securitisation transaction with credit enhancement level above 9 per cent would become highly inefficient. On the flip side, the lower the level to credit enhancements, the greater is the capital arbitrage in securitisation vis--vis conventional lending. In the medium term, therefore, securitisation would have to be accompanied by Structures, which use credit enhancements more efficiently and thus, conserve capital. The exact time frame for more stringent capital allocation on securitisation transactions in the Indian context is not clear and to that extent, originators have some breathing space to evaluate various options. However with the implementation of the Basel norms in western markets, it is only a matter of time before they are implemented in India too, 79 Bhav

A road map for more efficient securitisation structures Move To timely payment of interest and ultimate payment of principal structures As has been explained before, payment of interest and principal on a timely basis imposes significant liquidity requirements on the transaction, which inflate credit enhancement. In comparison, structures which pay interest on a timely basis and principal on a receipt basis eliminate the liquidity requirements in the transaction, reducing the credit enhancements to cover losses on defaulted contracts alone. This structure, which is very popular internationally, represents an elegant option to increase effectiveness of structures. Consider non-AAA rated trenches The two tier AAA-subordinate trenches results in considerable risk retention on the originators books, as the subordinate piece has to credit enhance the senior rated piece to a AAA rating. In comparison, mezzanine strip/s rated at AA/A transfer higher levels of risks to external investors, besides credit enhancing the senior most AAA piece. The residual risk retained by the originator would reduce significantly, with the corresponding higher levels of capital relief. From the investor's perspective, the steep fall in interest rates during the last 3 years and the upward movement in recent times, have eroded the ability of the investors to make money purely based on interest rate movements. Investors will now need to go down the credit spectrum and look at non-AAA ratings to get a yield-pickup, thus increasing the potential of non-AAA ratings in the market. Basis risk mitigation if MBS transactions through floaters and inverse floaters The basis risk prevalent in MBS transactions can be eliminated through a combination of a swap backed floater and inverse floater instruments. Under this structure, the two instruments would provide different returns to the Investors, 80 Bhav

with rising interest rate favoring one investor and falling interest rates favoring the other. This eliminates the basis risk as the risks are parceled out to two separate investors.

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NEW ASSET CLASSES AND CONCEPTS Most of the concepts discussed above, are of relevance in the traditional realms to ABS and MBS structuring. However, the market is presently on the threshold of new products and asset classes like Asset- Backed Commercial Paper (ABCP), Commercial Mortgage Backed Securitisation (CMBS) and credit card backed ABS. ABCP: ABCP conduits own assets of varying tenor. The assets can be revolving, amortizing or of any other nature. However, the common feature across various ABCP deals is the short-term nature of the instruments issued by the conduits. The ABCP issues commercial paper (CP) typically for a period less than 270 days to finance the assets in the pool. The CP is typically rolled over and is backed by adequate liquidity support to ensure highest ratings. In India, while the appetite for the short-term instruments has been good, the longer tenor instruments do not find many takers. ABCP might be a good solution to bridge the sellers' need for long-term funding and the investors' requirement for short-term instruments, GMBS: The commercial property market In India has been on an upswing for the last 3-4 years. High credit quality obligors as well as diversified pools of retail investors occupy reasonably large amounts of property. The secured nature of the transaction, the stability of property rentals from obligors, as well as the diversity of the obligor pools are key positives which should find ready takers in the investing community. Credit cards: As credit card is a revolving facility, securitisation of the card receivables can be made efficient only if the pool is revolving in nature. The first revolving asset securitisation in India was concluded in March 2004, when rated the first trenches of working capital facility backed pool of receivables. Traditionally, credit card receivables have

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enjoyed very high levels of excess interest spread, which can be booked as profits in such securitisation transactions. In the US market, more than half the credit card receivables generated are securities and it is a matter of time before this trend is replicated in India.

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The Following is the Proprietor Information From Mahindra and Mahindra Financial Services Limited.

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SECURITIZATION

Obtain the Board permission for Securitizing the receivables by putting up an appropriate resolution in the board meeting. Obtain NOC from the lead bank, Trustees of secured NCD's. Appointment of Rating Agency, Merchant Banker, Legal Counselor, Due Diligence Auditor, Trustee for the SPY and Registrar & Transfer Agent. Enter into Rating Surveillance Agreement with the Rating Agency. Provide Portfolio information to Rating Agency of the last 3 years, which is to be arranged from the MIS department, to determine the pool selection criteria and send the same to Rating Agency. Based on the selection criteria Extract the pool of loan agreements to be securitized and determining the future cash flow. Pool Selection Criteria(Annexure 1). Send the pool to Rating Agency for analysis and rating purpose. Pay the Rating Fees to the Rating Agency and obtain the rating rationale for the pool. Get the pool information audited from the Due Diligence Auditor . Get the quote from all the Merchant Bankers and select the Merchant Banker as per the best quote. Prepare the Information Memorandum after incorporating the Rating Rationale or provide the same information to Merchant Banker to prepare Information Memorandum. Send the Information Memorandum & the audited pool information to the Rating Agency, Merchant Banker and the Trustee. Send the Rating Rationale, Information Memorandum to the legal Counsel for drafting the documents. Stamp the Deed of Assignment.

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Open a Corpus account with the Trustee by depositing an initial amouru of Rs 1000 -in case company is settling the trust.

Assist to enter the Tri-party Agreement between Registrar & Transfer Agent, Trustee and National Securities Depository Limited (NSDL). Arrange Cash collateral either in form of F.D or Bank Guarantee as acceptable to Rating Agency.

Discount the Future Cash flow at the agreed rate to assure the amount to be revised from the trustees.

Prepare the Cheque of our investment in subordinate PTC's and deposit the same in the SPV account opened specifically for this purpose. Give the copy of Cheque along with Information Memorandum & legal documents to the Accounts department for passing the entry in the company's book of our investment in the securitisation transaction.

Collect the Cheque from the trustees towards the purchase consideration. Give copy of advice and/ or Cheque to Account's department for passing the entry in the company's book. Prepare monthly collection report to be given to the Trustees and Rating Agency. (Annexure 2) Calculate the discounted value of preclosed contracts and revised cash flow if there are any contracts preclosedin that month. Prepare the Cheque towards monthly payout and deposit the same in SPV and if there is any withdrawal from the credit enhancement in the previous month ensure that the same is restored before any payment is made to the subordinate 86 Bhav

PTC. The amount should be deposited in the collection & payout A! C in 2 days prior to the respective payout dates.

Collect the Cheque from the trustee towards subordinate investment, if

0 On 6 monthly basis obtain certificate of the Due Diligence auditor of the monthly report

and forward the same to the Rating Agency.

Pool Selection Criteria -Annexure 1

. The

pool contracts have a minimum seasoning of three months.

. The overdues on the contracts do not exceed a period of one month. . The originator has not initiated nor does it propose to initiate repossession proceedings or legal proceedings against any of the underlying obligors. . Only contracts directly originated by the seller and whose collection is directly undertaken by the seller have been included.

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ABS POOLS The report throws light on our monitoring and surveillance of ABS pools. Covering 48 CRISIL-rated asset-backed securities (ABS) pools across five asset classes and eight originators. the report analyses the performance of these pools vis-a-vis the assumptions made at the time of initial rating, the collections efficiencies and credit enhancement utilization levels. Being the first in the series, an easy guide on some key pool performance indicators is enclosed Of the 48 pools covered in this study, 17 pools have exhibited a lower MCR than the CCR in July 2003. While four of these pools are collecting at a CCR of over 98%, 10 pools originated by Ashok Leyland Finance have displayed a marginal dip in their collection performance in the last couple of months. CRISIL expects this situation to correct itself in the coming months. In the interpretation of MCR, the following factors need to be kept in mind: .Pools in the early months of a transaction (the first six months) have a low base of current billings as well as overdues and therefore, tend to display volatility in collections, which could be reflected in a low MCR and CCR. Generally, these ratios stabilize over time as the cumulative collectibles and collections increase.

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ANNEXURE Rating Criteria adopted by CRISIL for Asset Backed Securitisation (ABS) transactions Possibility of targeting a credit rating The rating methodology for ABS broadly consists of evaluation the following: Credit Risk Structural/Payment Risk Credit Enhancement Legal Risk Unlike in plain vanilla instruments, in securitisation transactions it is possible work towards a target credit rating, which could be much higher than the originators own credit rating. This is possible through a mechanism called Credit enhancement, which is explained in the later paragraphs. The purpose of credit enhancement is to ensure timely payment to the investors, if the actual collection from the pool of receivables for a given period are short of the contractual payouts on ABS. ABS are normally non-recourse instruments and therefore, the repayment on ABS would have to come from the underlying assets and the credit enhancement. Therefore, the rating criteria centrally focus on the quality of the underlying assets. Credit risk The principal credit risk in asset backed financing is the potential impairment of cash flows resulting from delinquency or loss on securitised assets. CRISIL uses a qualitative and quantitative approach supported by on-site management meetings for evaluating credit risk. The following factors need to be looked into: Originator analysis If the originator is not a rated company, CRISIL takes an implicit view of the rating. This is because, of, inter alia, the continued dependence on the originator for servicing. Portfolio analysis

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In portfolio analysis, the emphasis is on that segment of business of the originator from which assets are drawn for securitisation. Factors considered include length of experience, size, market position and reach, competitive advantages of the originator, origination systems, underwriting standards, decision making process, documentation process, monitoring and collection mechanism, and Management Information Systems. Other factors include analysis of the of the types of the physical asset that has been financed i.e., whether the asset financed is a car or a truck or machinery,.etc., ease of repossession, availability of resale market and resale value, whether the assets financed are new or old. The portfolio is also analysed over several parameters like geographical location, borrower profile, type of vehicle, size of loan, etc. in order to gain an understanding into the relative performance of the different segments. Historical repossessions, credit loss and prepayments are studied in detail. Historical collection efficiency for at least 5 years is analysed with the help of a sophisticated model in order to get a clear idea of the collection pattern. Pool analysis In pool analysis, the focus is on the pool being securitised. CRISIL normally specifies the criteria for pool selection like minimum seasoning, zero delinquency at the time of selection, maximum loan to value ratios, etc. CRISIL studies the size of the pool in relation to the overall portfolio of the originator (WHY) The pool is also analysed over geographical location, borrower-profile, type or model of the vehicle, tenure, etc. to gain insights into the risk profile of the pool vis--vis the portfolio. Structural / Payment Risk In the analysis of the structural/payment risk the flow of cash from the underlying obligors to the investors is studied. The factors considered are the structure of the transaction, the mode of collection from the underlying borrowers, payment schedules to investors, etc. Evaluation of servicer / trustee The ability and willingness of the servicer and the trustee to manage and maintain control on the assets and the payment stream from the assets are analysed. The servicer or trustee should not be allowed to resign until a suitable successor is appointed. They should be 105 Bhav

paid a fee for their services and it should be attractive enough for others to get interested in acting as the servicer/trustee if a need arises to replace the existing servicer/trustee. Commingling Risk The risk that the cashflows from the securitised pool would get mixed with those of the originator is referred to as co-mingling risk. In transactions where separate collection accounts are not opened for the pool assets, the pool cashflows get mixed with that originator, if the originator performs the function of servicing. Analysis of this risk includes an estimation of the quantum of funds commingled considering the time period for which the funds are retained by the originator before passing on to the investors. Depending on the originator's short term rating, the level of credit enhancement is adjusted to address the risk of commingling. Credit Enhancement CRISIL has developed a sophisticated model to determine the extent and form of credit enhancement necessary for the desired level of rating. The rating is a function of the asset quality and the quantum of credit enhancement. Higher the rating sought, higher would be the credit enhancement required for a given pool of assets. Similarly, for a given rating, better the asset quality of the pool, lower would be the quantum of credit enhancement. Quantum of credit enhancement The quantum of credit enhancement required is arrived at by subjecting the pool cashflows to various stress tests. This involves analysis of the projected investor payouts on the securitised instrument, expected cashflows from the pool, the historical performance of the portfolio from which the pool has been drawn, quality of the pool vis-vis the portfolio, outlook for the asset class during the tenure of the instrument, etc. Thereafter, an appropriate stress multiple is used to arrive at the level of credit enhancement required for the desired rating. Form of credit enhancement Credit enhancements come in various forms viz. cash collateral, letter of credit, guarantees, over collateralisation, subordinate securities, etc. In case of third party credit enhancements like guarantee or line of credit, the rating of the instrument would be equated to the rating of the third party extending the credit enhancement. Therefore,

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when the rating of the concerned third party changes, there will be a corresponding change in the rating of the ABS. Cash collateral is used to meet the shortfall in the pool collections for the purpose of making the investor payout for a given period. Later, when the pool collections are in excess of investor payouts, the excess is used to top up the cash collateral to the stipulated level. Guarantees and Line of Credit would also function in the same way. Overcollateralisation and subordination are credit enhancement mechanisms, which are built into the pool itself. Here the credit enhancement is achieved is by according higher payment priority to the rated senior paper. Repayment on lower rated or unrated subordinate paper is made only after meeting full obligations on the senior paper. Legal Risk Legal analysis is at the very core of the process of rating ABS. While the overall objective is to ensure that there is a true sale of assets to the investors and that the cashflows to the investors are not impaired in the event of the bankruptcy of the originator and the issuer, it involves a fairly detailed study of the legal.documents to ensure that the investors interest is not compromised. Besides, the securitisation transaction should comply with the local laws. In securitisation transactions, the rating is based on the strength of assets and the credit enhancement mechanism backing the instrument. Due to this, often the rating on ABS is higher than the stand alone rating of the originator. Therefore it is important to ensure that legally the assets and the credit enhancement mechanism are bankruptcy remote i.e., the bankruptcy of the originator will not impact the investors claim on the pools cashflows. Bankruptcy remoteness is achieved when there is a true sale of the pool assets to the SPV. While evaluating the legal integrity, CRISIL, in addition to studying the documents, relies on legal opinion obtained from legal counsels. Future Trend Since the late eighties, when securitisation made it beginning in India, the number as well as the size of transactions has grown over the years. This trend is likely to continue and the market would witness considerable growth in the coming years. 107 Bhav

The main motivating factor in securitisation transactions in the past has been the management of capital adequacy. While this would continue to be the demand driver, securitisation is likely to be increasingly used for better asset liability management, exposure management, upfront profit booking, etc. Traditionally in the fund based business segment of the financial services sector in India, a single entity was engaged in the entire gamut of activities viz. Raising funds, locating borrowers, carrying out credit appraisal of the borrowers, servicing of the loans and recovery. Owing to the rapidly changing environment, realignment is likely to happen in this sector. One could see specialisations emerging in the market. In developed markets like USA, particularly in the mortgage market, there is a considerable amount of specialisation. Typically, in these markets, a single entity does not perform more than one or two of the activities mentioned earlier. The trend is already visible in the autoloans sector. A number of medium and small NBFCs are finding it difficult to raise funds at competitive rates. These NBFCs, however, have a relatively low cost distribution network in place to originate and service loans. On the other hand, large companies and Foreign Banks find that it is not economical to create a large distribution network in terms of extensive branch network across the country due their high cost structure. However, these companies, given their size, parent support, managerial talent and a high credit rating have a much stronger funding capability. Securitisation could be effectively used to combine these two complementary pools of resources. NBFCs could originate loans and securitise them and sell to large companies. And they could use the proceeds of the sale to originate more.loans and the process could go on. The small NBFCs could continue to service the loans which would ensure a steady flow of fee income.

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Rating criteria adopted by CRISIL for Mortgage Backed Securitisation (MBS) transactions Introduction The rating methodology for MBS broadly consists of evaluation the following: Credit Risk Structural/Payment Risk Credit Enhancement Legal Risk Quantifying the amount of loss a mortgage will experience in all economic scenarios is the key to CRISIL's approach to modelling credit risk. CRISIL uses varying stress assumptions to gauge mortgage pool performance. CRISIL's credit analysis of mortgage pool performance focusses on the risk of loss as a result of economic and credit factors. Credit risk The principal credit risk in any mortgage backed financing is the potential impairment of cash flows resulting from delinquency or loss on securitised mortgages. CRISIL uses a qualitative and quantitative approach supported by meetings with the management for evaluating credit risk. The following factors need to be looked into: Originator analysis If the originator is not a rated company, CRISIL takes an implicit view of the rating. This is because, of, inter alia, the continued dependence on the originator for servicing. Portfolio analysis In portfolio analysis, the emphasis is on the entire mortgage loan portfolio of the originator. Factors considered include length of experience, size, market position and reach, competitive advantages of the originator, origination systems, underwriting standards, decision making process, documentation process, monitoring and collection mechanism, and Management Information Systems. The portfolio is also analysed over several parameters like geographical location, borrower profile, loan to value ratio, size of loan, etc. in order to gain an understanding 109 Bhav

into the relative performance of the different segments. Historical repossessions, credit loss and prepayments are studied in detail. Historical collection efficiency for at least 5 years is analysed with the help of a sophisticated model in order to get a clear idea of the collection pattern. Pool analysis In pool analysis, the focus is on the pool being securitised. CRISIL normally specifies the criteria for pool selection like minimum seasoning, zero delinquency at the time of selection, maximum loan to value ratios, etc. CRISIL studies the size of the pool in relation to the overall portfolio of the originator. The pool is also analysed over geographical location, borrower-profile, loan to value ratio, tenure, etc. to gain insights into the risk profile of the pool vis--vis the portfolio. Structural / Payment Risk In the analysis of the structural/payment risk the flow of cash from the underlying obligors to the investors is studied. The factors considered are the structure of the transaction, the mode of collection from the underlying borrowers, payment schedules to investors, etc. Evaluation of servicer / trustee The servicer and the trustee play a very important role in a securitisation transaction. The ability and willingness of the servicer and the trustee to manage and maintain control on the assets and the payment stream from the assets are analysed and considered to be one of the key determinants of the rating decision by CRISIL. Co-mingling Risk The risk that the cashflows from the securitised pool would get mixed with those of the originator is referred to as co-mingling risk. In transactions where separate collection accounts are not opened for the pool assets, the pool cashflows get mixed with that originator, if the originator performs the function of servicing. Analysis of this risk includes an estimation of the quantum of funds co-mingled considering the time period for which the funds are retained by the originator before passing on to the investors. 110 Bhav

Depending on the originator's short term rating, the level of credit enhancement is adjusted to address the risk of co-mingling. Credit Enhancement CRISIL has developed a sophisticated model to determine the extent and form of credit enhancement necessary for the desired level of rating. The rating is a function of the asset quality and the quantum of credit enhancement. Higher the rating sought, higher would be the credit enhancement required for a given pool of assets. Similarly, for a given rating, better the asset quality of the pool, lower would be the quantum of credit enhancement. Quantum of credit enhancement The quantum of credit enhancement required is arrived at by subjecting the pool cashflows to various stress tests. This involves analysis of the projected investor payouts.on the securitised instrument, expected cashflows from the pool, the historical performance of the portfolio from which the pool has been drawn, quality of the pool vis-vis the portfolio, outlook during the tenure of the instrument, etc. Thereafter, an appropriate stress multiple is used to arrive at the level of credit enhancement required for the desired rating. Form of credit enhancement Credit enhancements come in various forms viz. cash collateral, letter of credit, guarantees, over collateralisation, subordinate securities, etc. In case of third party credit enhancements like guarantee or line of credit, the rating of the instrument would be equated to the rating of the third party extending the credit enhancement. Therefore, when the rating of the concerned third party changes, there will be a corresponding change in the rating of the MBS. Cash collateral is used to meet the shortfall in the pool collections for the purpose of making the investor payout for a given period. Later, when the pool collections are in excess of investor payouts, the excess is used to top up the cash collateral to the stipulated level. Guarantees and Line of Credit would also function in the same way. 111 Bhav

Overcollateralisation and subordination are credit enhancement mechanisms, which are built into the pool itself. Here the credit enhancement is achieved is by according higher payment priority to the rated senior paper. Repayment on lower rated or unrated subordinate paper is made only after meeting full obligations on the senior paper. Legal Risk Legal analysis is at the very core of the process of rating MBS. While the overall objective is to ensure that there is a true sale of assets to the investors and that the cashflows to the investors are not impaired in the event of the bankruptcy of the originator and the issuer, it involves a fairly detailed study of the legal documents to ensure that the investors interest is not compromised. Besides, the securitisation transaction should comply with the local laws. In securitisation transactions, the rating is based on the strength of assets and the credit enhancement mechanism backing the instrument. Due to this, the rating on MBS is often higher than the stand alone rating of the originator. Therefore it is important to ensure that legally the assets and the credit enhancement mechanism are bankruptcy remote i.e., the bankruptcy of the originator will not impact the investors claim on the pools cashflows. Bankruptcy remoteness is achieved when there is a true sale of the pool assets to the SPV. While evaluating the legal integrity,

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