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Introduction to Securitization
• In a simple way, securitization involves taking a pool of financial assets that produces
reliable and largely predictable cash flows and repackaging it as tradable securities that can
be sold to investors.
• In other words, securitization refers to conversion of illiquid assets to liquid assets by
converting long duration assets into shorter ones and distributing them to a broad range of
investors through capital markets.
• Thus, securitization creates markets in financial claims. The assets may be anything
ranging from airline and cinema tickets, credit card receivables, auto loans, equipment
leases, hire purchase deals to housing loans and non-performing assets (NPAs).

In simpler words…..
• It is the financing or re-financing of income yielding assets by packaging them into a
tradeable form through an issue of bonds or other securities.

• Securitization is the pooling of cash flows and the issuance of securities backed by
underlying assets.

• Securitization is a financial transaction in which assets are pooled and securities

representing interests in the pool are issued.
Origin of Securitization

• Securitization is an innovative structured finance transaction which was born out of

the necessity faced by savings and loan associations of the United States of America
(USA), to save themselves from impending bankruptcy in 1970s, particularly, when
their spreads were turning negative as they had to pay high market interest rates to
attract short-term deposits, which were higher than the rates they were earning on
the long-term mortgage loans that had been sanctioned years before.

• While asset liability mismatch was a major problem, excess demand for loans over
the deposits collected was also another major problem. The solutions to these
problems were found in Securitization of debt. Today, Securitization is an
innovative banking product as a mode of financing and is in wide-spread use the
world over and has made a good beginning in India, too. In December, 2002, a legal
framework was provided in India through the "Securitization and Reconstruction of
Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act).
Asset classes that can be securitized

Fixed-rate mortgages Adjustable-rate Second mortgages

Home equity loans Automobile loans Commercial real estate loans

Credit card receivables Equipment leases Mobile home loans

Vacation time shares Recreational vehicles Small business administration


Lesser developed country debt Junk bonds Student loans

Francise loans Aircraft leases Auto dealer papers

Variable annuity fees Delinquent tax liens Utility stranded cost

Types of securitization


True sale, synthetic and “whole business” (the latter primarily used in the
United Kingdom and, to a lesser extent, continental Europe).

• In a true sale securitization, a company sells assets to a special purpose

vehicle/company (the SPV) which funds the purchase by issuing bonds to the capital

• In a synthetic securitization, the company does not sell any assets, but transfers the
risk of loss associated with certain of its assets to an SPV or a bank against payment
by such company of a premium or fee to the SPV.

• “Whole business” securitization is essentially a secured loan granted by an SPV to

the relevant company. To grant the loan, the SPV uses proceeds of bonds issued into
the capital markets whereby the company grants security over most of its assets in
favor of the bondholders.

1. Residential mortgage backed securities (MBS)

A type of security whose cash flows come from residential debt such as mortgages, home-
equity loans and subprime mortgages. This is a type of mortgage-backed securities that
focuses on residential instead of commercial debt. Holders of an RMBS receive interest
and principal payments that come from the holders of the residential debt. The RMBS
comprises a large amount of pooled residential mortgages.

2. Asset-Backed Security - ABS

A financial security backed by a loan, lease or receivables against assets other than real
estate and mortgage-backed securities. For investors, asset-backed securities are an
alternative to investing in corporate debt. An ABS is essentially the same thing as a
mortgage-backed security, except that the securities backing it are assets such as loans,
leases, credit card debt, a company's receivables, royalties and so on, and not mortgage-
based securities.
3. Collateralized debt obligations (CDO)

An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do
not specialize in one type of debt but are often non-mortgage loans or bonds. Similar in
structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation
(CBO), CDOs are unique in that they represent different types of debt and credit risk. In the
case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each
slice has a different maturity and risk associated with it. The higher the risk, the more the
CDO pays.

4. Commercial mortgage backed securities (CMBS)

A type of mortgage-backed security that is secured by the loan on a commercial property.

A CMBS can provide liquidity to real estate investors and to commercial lenders. As with
other types of MBS, the increased use of CMBS can be attributable to the rapid rise in real
estate prices over the years. Because they are not standardized, there are a lot of details
associated CMBS that make them difficult to value. However, when compared to a residential
mortgage-backed security (RMBS), a CMBS provides a lower degree of prepayment risk
because commercial mortgages are most often set for a fixed term.

• It provides liquidity to the originators (Non-Banking Finance Companies/Banks)

• Securitized debt is cheaper and with this deal the originators can beat the ratings given by
the rating agencies and diversify the credit risk.

• Originators can plan their capital adequacy requirements by using securitization to reduce
the risk weighted assets.

• Securitization allows the Originator to diversify its funding sources away from banks
and tap the capital markets (almost) directly, with-out having to issue securities
on its own.

5. The Receivables are moved "off balance sheet" and replaced by a cash equivalent (less
expenses of the Securitization), thus improving the Originator's balance sheet and
resulting in gain or loss, which itself is usually an intended, beneficial consequence.

6. In non-revolving structures, and those with fixed interest rate Receivables, assets and
related liabilities can be matched, eliminating the need for hedges.
7. Because the Originator usually acts as Servicer and there is normally no need to give
notice to the obligors under the Receivables, the transaction is transparent to the Originator's
customers and other persons with whom it does business.

8. The Securities issued in the Securitization are more highly rated by participating rating
agencies (because of the isolation of the Receivables in a "bankruptcy-remote" entity), thus
reducing the cost of funds to the Originator when compare to traditional forms of financing.

Investors in asset-backed securities can benefit in a number of ways, including the


•Through assed-backed securities, they can invest in asset classes and risk tranches of their
choice and generate the associated returns.

•This offers investors the opportunity to optimise the structure their portfolios and access
markets which otherwise they could not invest in;

•asset-backed securities have historically often been less volatile as compared to corporate

• asset-backed securities have been known to offer a yield premium over comparably rated
government, bank and corporate bonds; asset-backed securities are usually not susceptible to
event risk or the risk of a rating downgrade of a single borrower.
Originator - the entity that either generates Receivables in the ordinary course of its business,
or purchases and assembles portfolios of Receivables (in that sense, not a true "originator").

Trustees - usually a bank or other entity authorized to act in such capacity. The Trustee,
appointed pursuant to a Trust Agreement, holds the Receivables, receives payments on the
Receivables and makes payments to the Securityholders.

Issuer - the special purpose entity, usually an owner trust (but can be another form of trust or
a corporation, partnership or fund), created pursuant to a Trust Agreement between the
Originator (or in a two step structure, the Intermediate SPE) and the Trustee, that issues the
Securities and avoids taxation at the entity level.

Investors - the ultimate purchasers of the Securities. Usually banks, insurance companies,
retirement funds and other "qualified investors."

Underwriters/Placement Agents - the brokers, investment banks or banks that sell or place
the Securities in a public offering or private placement.

Custodian - an entity, usually a bank, that actually holds the Receivables as agent and bailee
for the Trustee or Trustees.
Rating Agencies - Moody's, S&P, Fitch IBCA and Duff & Phelps. In Securitizations, the
Rating Agencies frequently are active players that enter the game early and assist in
structuring the transaction. In many instances they require structural changes, dictate some of
the required opinions and mandate changes in servicing procedures.

Servicer - the entity that actually deals with the Receivables on a day to day basis, collecting
the Receivables and transferring funds to accounts controlled by the Trustees. In most
transactions the Originator acts as Servicer.

Backup Servicer - the entity (usually in the business of acting in such capacity, as well as a
primary Servicer when the Originator does not fill that function) that takes over the event that
something happens to the Servicer.
Loan payments

Obligors Originator
Provides loan
Proceeds of rated securities
True sale of assets
Special purpose Credit
entity enhancement
Credit enhancement
Issuance of rated securities Payment for rated securities


Issuance of rated securities Payment for rated securities



In the banking system, high level of NPAs can be serious drag on overall
performance of economy on account of diversion of its management and financial
resources towards recovery of NPAs. Greater the resources needed by banks to
reserve for losses, lesser is the amount of capital they can leverage. Consequently it
makes the banks risk averse in providing new loans leading to credit crunch in the
financial market, amounting to economic and financial degradation. ARCs are
established to acquire, manage, and recover illiquid or NPAs from lenders,
unlocking value trapped in them via an institutional platform.
Asset Reconstruction Company (ARC) [Securitization Company (SC)/Reconstruction
Company (RC)] is a company set up to provide a focused approach to the problem of Non
Performing Assets of Banks, popularly known as NPAs:

•Isolating NPAs from the Financial System (FS),

•Freeing the FS to focus on their core activities and
•Facilitating development of market for distressed assets.

It is registered under The Companies Act, 1956 and regulated by Reserve Bank of India as
an Non Banking Financial Company [u/s 45I ( f ) (iii) of RBI Act, 1934]. RBI has exempted
ARCs from the compliances under section 45-IA, 45-IB and 45-IC of the Reserve Bank Act,

It has legal standing under section 3 of the "Securitisation and Reconstruction of Financial
Assets and Enforcement of Security Interest (SRFAESI) Act, 2002".
The pilot ARC, in India, is Asset Reconstruction Company (India) Limited.

ARC will function like a Mutual Fund. The assets acquired by ARC will be transferred to
one or more trusts [set up u/s 7(1) and 7(2) of SRFAESI Act, 2002] at the price at which the
financial assets were acquired from the originator (Banks/FIs). The trusts shall issue
Security Receipts to Qualified Institutional Buyers [as defined u/s 2(u) of SRFAESI Act,
2002]. The trusteeship of such trusts shall vest with the ARC.
ARC will get only management fee from the trusts. Any upside in between acquired price and
realized price will be shared with the beneficiary of the trusts (Banks/FIs) and ARC. Any
downside in between acquired price and realized price will be borne by the beneficiary of the
trusts (Banks/FIs). In fact, ARC is a bankruptcy remote company.

The word asset reconstruction company is a typical Indian word - the

global equivalent of which is asset management companies. The word "asset
reconstruction" in India owes its origin to Narsimham I which envisaged the
setting up of a central Asset Reconstruction Fund with money contributed by
the Central Government, which was to be used by banks to shore up their
balance sheets to clean up their non-performing loans. This idea never worked:
so Narsimham II thought of asset reconstruction companies, the likes of which
had already been successful in Malaysia, Korea and several other countries in
the World. To keep the tune the same as the original idea of asset
reconstruction fund, as also to give an impression that ARCs are not merely
concerned with realisation of bad loans but they are going to do
"reconstruction", that is, try and resurrect bad loans into good ones, the word
ARC has been used in India.

•Relieving banks of the burden of NPAs would allow them to focus better on managing the
core business including new business opportunities.

•The transfer should help restore depositor and investor confidence by ensuring the lender’s
financial health. ARCs are meant to maximise recovery value while minimizing costs.

•ARCs can also help build industry expertise in loan resolution, besides serving as a catalyst
for important legal reforms in bankruptcy procedures and loan collection.

•ARCs can play an important role in developing capital markets through secondary asset

•Centralization of bad loans in one or a few hands and therefore obviously more clout.

•It is possible to give special legislative powers to a few AMCs rather than to each bank.

•Banks are left with cleaner balance sheets and do not have to deal with problem clients.
Regular banking relations with the group are not affected.
• Because it deals with a larger portfolio, it can mix up good assets with bad ones and make a
sale which is palatable to buyers. It is easier to do a capital-market based funding for an AMC
than for the banks themselves.

Asset reconstruction is likely to play an increasingly important role as (a) the number of
impaired assets in the financial system increase and (b) learnings from the ongoing crisis lead
to evolution of speedy systems and procedures for asset reconstruction.

In India, ARCs came into being in response to the growing NPL levels in the financial system
and the need to have mechanisms to resolve them in a timely manner. At the same time, there
was no imminent financial crisis to justify direct Government intervention. As a result, and
rightly so, GoI has encouraged the asset reconstruction space to develop in a competitive

Simultaneously, the legal system has been revamped to enable the institutions and ARCs
implement quick resolutions of impaired assets. The legal framework, has over a period of
time, has become more conducive for resolution of impaired assets with the introduction of
Lok Adalats, Debt Recovery Tribunals and SARFAESI