SECURITIZATION

SECURITIZATION
Securitization is the financial practice of pooling various types of
contractual debt such as residential mortgages, commercial
mortgages, auto loans or credit card debt obligations and selling said
debt as bonds, pass-through securities, to various investors

Securitization defined
A process of pooling and repackaging of homogenous illiquid
financial assets into marketable securities that can be sold to
investors.
A credit arbitrage transaction that permits for more efficient
management of risks by isolating a specific pool of assets from
the originator's balance sheet

Major steps
1) Creation of a special purpose vehicle (SPV) to hold the financial
assets underlying the securities;
2) Sale of the financial assets by the originator or holder of the
assets to the special purpose vehicle, which will hold the assets
and realize the assets;
3) Issuance of securities by the SPV, to investors, against the
financial assets held by it.

HISTORY OF SECURITIZATION
Securitization may be said to have originated in Denmark. Loans were
granted when bonds of an equal amount and tenor were sold. This is
form of asset-liability matching, resource management, and even the
interest margins are protected. Therefore seems to be sound policy. In
Prussia, bonds backed by mortgage loan were issued by some banks,
the instrument, and a bond symbolizing the underlying cash flows

called pfandbrief. Interestingly, over its 200 years history, no

pfandbriefs has ever been defaulted upon. However, standardization
and liquidity seem to pose a problem, otherwise tradability of such
instrument will be only in restricted markets.
Securitization in its modern form really took off in Chicago. Chicago
is also a home to many seminal developments in finance. Mortgage
bankers would deploy their initial capital in creating mortgages. Fresh
borrowers would have to turn away. Chicago mortgages banker struck
upon the idea of selling the loan portfolios to larger mortgages
banker. The largest mortgage bankers carved of the stream of
underlying receivables into tradable denominations as in equity and
bonds in order to attract investors and facilitate trading in these bonds.
Other innovation followed. First, the interest and principle portions
were separately traded. These are called STRIPS, the acronym for
Separately Traded Interest Only (IO) and principal only (PO)
Segments. Other innovation included the splitting up of the bonds to
sort investors having an appetite for varied lengths of time. The
details are explained elsewhere in this paper. To sum up, the
underlying receivables were carved in a process known as slicing and
dicing, analogous to the beef cuts that were sold as a marketable
commodity, as opposed to trading in the whole animal itself.
Securitization instruments shorn of such innovations are known as
plain vanilla securitization instruments.
The concept of securitization is rapidly spreading in several countries
in various stages of development. From the Danish origins and the
pfandbriefs, securitization has spread and evolved in the US. Policy
makers in several developing countries are keen that securitization
takes off, since these are capital deficit countries. Securitization in
these markets will strengthen lending agencies and improve their
linkages with the capital markets.

STRUCTURE OF SECURITIZATION

Stages in the process of securitization

The originator determines which assets he wants to securitize
for raising funds.
The SPV is formed.
The SPV is funded by investors and issues securities to the
investors.
The SPV Acquires The Receivables Under An Agreement At
Their Discounted Value.

 The Servicer For The Transaction Is Appointed, Normally The

Originator.
The debtors are /are not notified depending on the legal
requirements.
The servicer collects the receivables, usually in an escrow
mechanism, and pays off the collection to the SPV.
The SPV either passes the collection to the investors, or
reinvests the same to pay off to investors at stated intervals.
In case of default, the servicer takes action against the debtors as
the SPVs agent.
When only a small amount of outstanding receivables are left to
be collected, the originator may clean up the transaction by
buying back the outstanding receivables.
At the end of the transaction, the originators profit, if retained
and subject to any losses to the extent agreed by the originator,
in the transaction is paid Off

PARTIES INVOLVED
Main parties
1. The originator: The entity on whose books the assets to be
securitized exist.
2. The Special Purpose Vehicle (Spv): The Entity, Which Buys
The Assets To Be Securitized From The Originator.
3. The Investors: The Entities Who Invest In The Securities

Other parties
The obligor : The originator's debtor that is the borrower of the
original loan.
The rating agency : The agency that rates the structure.
Administrator or servicer: The party that collects the payment
due from the obligor/s and passes it to the spv, follows up with
delinquent borrowers and pursues legal remedies available
against the defaulting borrowers.
Agent and trustee: The party that accepts the responsibility for
overseeing that all other the parties to the securitization deal
perform in accordance with the securitization trust agreement.
Structurer: The party that brings together the other parties
required to execute a securitization deal.
The regulators :Whose principal concerns relate to capital
adequacy, liquidity, and credit quality of the structure, and
balance sheet treatment of the transaction.
Credit enhancer: the party that provides a cover to spv or
investors in respect of any future losses associated with the pool
of assets.
Liquidity provider: the party that provides the facility to help
smoothen the timing differences faced by the SPV between the
receipt of cash flows from the underlying assets and the
payments to be made to investors.
Specialist functionaries such as legal and tax counsels,
accounting firms, pool auditors, etc.

TYPES OF SECURITIZATION

TYPES OF
SECURITIZATION

ASSET BACKED
SECURITIZATION

FUTURE FLOW
SECURITIZATION

Asset Backed Securitization: Asset Backed Securitization

Involves The Conversion Of Existing Assets Into Marketable
Securities.
Future flow securitization: Future flow securitization
involves the conversion of future cash flows into marketable
securities.

TYPES OF SECURITIZATION STRUCTURE

TYPES OF
SECURITIZATION
STRUCTURE

CASH FLOW
STRUCTURE

SYNTHETIC
STRUCTURE

 In a cash flow-based securitization, the ownership of the assets

whose cash flows are to be securitized, are actually transferred
to the SPV.
In a synthetic securitization, the cash flows and/or economic
exposure are transferred to the SPV through the use of a credit
derivative. Synthetic SPVs do not assume actual ownership of
any assets.

SECURITIES ISSUED BY SPV

ON THE BASIS OF
UNDERLYING

ON THE BASIS OF
STRUCTURE

ASSET
BACKED
SECURITIES

PASS-THROUGH
CERTIFICATES

MORTGAGE
BACKED
SECURITIES

PAY-THROGH
CERTIFICATES

On the basis of underlying

Asset Backed Securities (ABS): Securities Issued By SPV
In A Securitization Transaction Are Referred To As Asset
Backed Securities (ABS) Because Investors Rely On The
Performance Of The Assets That Collateralize The Securities.
The Asset In Question Could Vary From Auto Loan/Lease/Hire

Purchase, Credit Card, Consumer loan, student loan, healthcare

receivables and ticket receivables to even future asset
receivables.
Mortgage backed securities (MBS): Mortgage backed
securities (MBS) are the securities backed by mortgage loans
that is loans secured by specified real estate property, wherein
the lender has the right to sell the property, if the borrower
defaults.

On the basis of structure

Pass-through Certificates: Pass-through Certificates Are In
The Nature Of Participation Certificates That Enable The
Investors To Take A Direct Exposure On The Performance Of
The Securitized Assets.

Pay-through Certificates: PayThrough Certificates Give

Investors Only A Charge Against The Securitized Assets, While
The Assets themselves are owned by the SPV.

VARIOUS STAGES INVOLVED IN WORKING OF

SECURITIZATION
Identification Process: The lending financial institution either a
bank or any other institution for that matter which decides to go
in for securitization of its assets is called the originator. The
originator might have got assets comprising of a variety of
receivables like commercial mortgages, lease receivables, hire

purchase receivables etc. The originator has to pick up a pool of

assets of homogeneous nature, considering the maturities,
interest rates involved frequency of repayments and
marketability. This process of selecting a pool of loans and
receivable from the asset portfolios for securitization is called
identification processes.
Transfer Process: After the identification process is over the
selected pool of assets are then passed through to another
institution which is ready to help the originator to convert those
pools of assets onto securities. This institution is called special
purpose vehicle (SPV) or the trust. The pass through transaction
between the originator and the SPV is either by way of outright
sale basis. This process of passing through the selected pool of
assets by the originator to a SPV is called transfer process and
once this transfer process is over the assets are removed from
the balance sheet of the originator.
Issue Process: After this process is over the SPV takes up the
onerous task of converting these assets to various type of
different maturities. On this basis SPV will issue securities to
investors. The SPV actually splits the packages into individual
securities of smaller values and they are sold to the investing
public. The SPV gets itself reimbursed out of the sale proceeds.
The securities issued by the SPV are called by different names
like Pay through Certificates, Pass through Certificates.
Interest only Certificate, Principal only Certificate. The
securities are structured in such a way that the maturity of these
securities may synchronies with the maturity of the securitized
loans or receivables.
Redemption Process: The redemption and payments of interest
on these securities are facilitated by the collections by the SPV
from the securitized assets. The task of collection of dues is
generally entrusted to the originator or a special service agent

can be appointed for this purpose. This agency paid certain

commission for the collection service rendered. The servicing
agent is responsible for collecting the principal and interest
payments on assets pooled when due and he must pay a special
attention to delinquent accounts. Usually the originator is
appointed as the service. Thus under securitization the role of
the originator gets reduced to that of the collection agent on
behalf of SPV in case he is appointed as a collection agent. A
pass through certificate may be either with recourse to the
originator or without recourse. The usual practice is to make it
without recourse. Hence the holder of a pass through
certificate has to look the SPV for payment of the principal and
interest on the certificate held by him. Thus the main task of the
SPV is to structure the deal raise proceeds by issuing pass
through certificates and arrange for payment of interest and
principal to the investors.
Credit Rating Process: The passed through certificate have to
be publicly issued, they required credit rating by a good credit
rating agency so that they become more attractive and easily
acceptable. Hence these certificates are rated at least by one
credit rating agency eve of the securitization. The issues could
also be guaranteed by external guarantor institutions like
merchant bankers which would enhance the credit worthiness of
the certificates and would be readily acceptable to investors. Of
course this rating guarantee provides to the investor with regard
to the timely payment of principal and interest by the SPV.

ADVANTAGES OF SECURITIZATION
ADVANTAGES TO THE ORIGINATOR
Liquidity
Reduction in asset-liabilty mismatch.

 Reduced funding costs.

Lower capital requirements.
Transfer of risks.
Conversion of non-marketable assets into marketable securities.
Wider market access.
ADVANTAGES TO THE INVESTOR

Low event risk.

Structured issuances.
Higher yields fo similar/lower risk.
Diversification of investment opportunities
BENEFITS

1. Additional Source of Fund

The originator (i.e.the lending institution) is much benefitted
because securitisation provides an additional source of funds by
converting an otherwise illiquid asset into an ready liquidity. As
a result, there is an immediate improvement in the cash flow of
the originator.

2. Greater Profitability
Securitisation helps financial institutions to get liquid cash from
medium term and long term assets immediately rather than over
a longer period. It leads to higher recycling of funds which, in
turn, leads to higher business turnover and profitability. Again.
the cash flow could be recycled for investment in higher
yielding assets. This means greater profitability.It results in
additional business turnover.

3. Enhancement of Capital Adequacy Ratio

Securitisation enables financial institutions to enhance their
capital adequacy ratio by reducing their assets volume. The
process of securitisation necessitates the selection of a pool of
assets by the financial institutions to be sold or transferred,
they are removed from the balance sheet of the originator.
It results in the reduction of assets volume, thereby increasing
the capital adequacy ratio.

4. Spreading of Credit Risk

Securitisation facilities the spreading of credit risk to different
parties involved in the process of securitisation. In the absence
of securitisation, the entire credit risk associated with a
particular financial transaction has to be borne by the originator
himself. Now, the originator is able to diversify the risk factors
among the various parties involved in securitisation. Thus, it is
used as tool for risk management.

5. Lower Cost of funding

In view of enhancement of cash flows and diversifications of
risk factors, securitisation enables the originator to have an easy
access to the securities market at debt ratings higher than its
overall corporate rating. It means that companies with low credit
rating can issue asset backed securities at lower interest cost due
to high credit rating on such securities. This helps it to secure
funds at lower cost.

6. Provision of Multiple Instruments

From the investors point of view, securitisation provides
multiple new investment instruments so as to meet the varying
requirements of the investing public.

7. Higher rate of Return

When compared to traditional debt securities like bonds and
debentures, securitised securities offer better rate of return along
with better liquidity. These instruments are rated by good credit
rating agencies and hence more attractive.

8. Prevention of Idle Capital

In the absence of securitisation, capital would remain idle in the
form of ill-liquid assets like mortgages, term loans etc., in many
of the lending institutions. Now, securitisation helps recycling of
funds by converting these assets into liquidity, liquidity into
assets, and so on by means of issuing tradable and transferable
securities against these assets.

9. Better than Traditional Instruments

Certificates are issued to investors against the backing of assets
securitised. The underlying assets are used not only as a
collateral to the certificates but also to generate the income to
pay the principal and interest to the investors. It is better than
even mutual fund units because it is issued against the backing
for mutual fund certificates. Thus, these instruments, being
structured asset backed securities, afford a greater protection to
investors.
10.
Other Benefits
Securitisation, if carried out in true spirit, leads to greater
economy in the use of capital with efficiency and cost
effectiveness in both funding and lending.
In the long run, it is beneficial to the borrowers also. They will
be able to get funds at cheaper rates since the originators are
likely to pass on the benefit to the ultimate borrowers. There is

no doubt that securitisation is a low cost and innovative funding

source ensuring economy in the use of capital.

DISADVANTAGES OF SECURITIZATION
DISADVANTAGES TO THEORIGINATOR
Reduction In Portfolio Quality.
Increased Costs.
Size Limitations.
Lower capital requirements.
Risks of impairment.
DISADVANTAGES TO THE INVESTOR
Exposure to credit risk.
Risk of prepayment.
Reinvestment risk.
Commingling risk.
Sevicer risk.

UNDERSTANDING RISKS IN SECURITIZATION

Risk investors face in securitization:
Investors in securitized instruments can take advantage of the
benefits that these instrument offer, however they also need to
be aware of the inherent risks in these transaction. These risks
classified into:

 Asset pool risks which arise due to the unpredictable

behavior of the underlying borrowers. The payment
behavior of underlying borrowers can be estimated with a
reasonable degree of accuracy based on historical data.
Legal risks due to lack of judicial precedence on
securitization legislation and regulation.
Counter party risk arise as a securitization transaction
involved multiple parties throughout the tenure of the
instrument. The investors returns can be impacted by
non-performance or bankruptcy of any of these
counterparties.
Investment risks like all other investment securitized
instruments are subject to market related risks.
Investors are protected against these risks by means of structural
features and credit enhancement which enable the instrument to
achieve high credit ratings.
Assets pool risk in a securitization and mitigation:
Assets pool risks are classified into credit risks and prepayment risks.
Credit risks: Investors have a direct exposure to the repayment
ability of the underlying borrowers whose loans have been
securitized. If borrower default on payment of installments or
make delay payment collection will be inadequate to scheduled
investors payouts. Thus timely investor payments will depend
on the credit quality of the pool borrower.
Mitigation: Credit enhancement provide for PTC is sizes to
cover the expected levels of payment default and delays. In case
there is short falls in the collection the credit enhancement is
used to make timely payment to the investors. However, in the
event of short falls over and above credit enhancement levels
investors will incur losses on their investment.

 Risk of prepayment: Investors face the risks that underlying

borrowers may prepay all or part of the principal outstanding of
their loans. When prepayment occurs they are passed on to the
investor (unless the instrument structure provides for a separate
class of PTC to absorb prepayments). This can affect investor in
two ways:
o Reinvestment risk: If there are heavy prepayment in the
pool the average tenure of the instrument reduces
resulting in reinvestment risk for the investor.
o Prepayment loss: If the investor has paid an additional
consideration to receive excess interest spreads generated
by the pool the investor principal outstanding is greater
than the pool principal outstanding. Hence when the
contract is prepaid this excess interest spread payable to
the investor from that contract is lost. Hence prepayments
can result in the shortfalls in payments.
Mitigation: Reinvestment risks can be mitigated by carving out
a separate class of PTC from pool cash flows to absorb
prepayments occurring in the pool. This class of PTC is called a
prepayment strip and commonly found in securitized
instruments. Prepayment loss is mitigated as the credit
enhancement is sized to cover such losses. However in case of
excessive prepayment losses greater than the credit
enhancement amount will be borne by the investor.
Property/asset price risk: Assets backing securitized
instruments may be prepossessed and sold post securitization.
The proceeds and loss on sale depends upon market values of
the assets, which fluctuate.

SECURITIZATION IN INDIA
The first securitization transaction in india was completed in
1991.
Securitization has become a solid source of funding via the
capital markets in india. although the market remains
predominantly domestic, with ratings assigned within the
national scale, efforts to access the International Capital Markets
are being explored by larger originators.
The growth in the indian securitization market has been largely
fuelled by the repackaging of retail assets and residential
mortgages of banks and financial institutions .
Asset Backed Securitization (ABS) Is the largest Product Class.
The mortgage backed securities (MBS) market has been rather
slow in taking off despite a growing housing finance market due
to the long maturity periods and the risk arising from
prepayment / repricing of the underlying loan
Securitization In India Largely Adopts A Trust Structure With
The Underlying Assets Being Transferred By Way Of Sale To A
Trustee Company. The Spv, Formed As A Trustee Company,
Issues Securities That Are Either pass through certificates or pay
through certificates . The Trustee is the Legal Owner of the
Underlying Assets in Both The Scenarios.
Issuance Volume By Number Of Transactions Is Significant In
India, With Dozens Of Deals Coming To Market Each Year
Across All Asset Classes. Yet Significant Growth Potential
Within This Market Remains, With Public Sector Banks Still
Not Having Entered The Securitization Arena.

BOOKS:
Introduction To Securitization by frank j. Fabozzi and Vinod kothari
Securitization Within Economic Sector by ANDREJ NOSKO
Marketing of financial services BY Avdhani.V.K.

WEBSITES:
www.rbi.org.in
www.pnbindia.com
www.managementparadIse.com
www.scribd.com
www.projectspadarise.com
www.goggle.com
www.wikipedia.com
www.crisil.com