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Securitization ;

Securitisation, in its most basic form, is a method of financing assets. Rather than selling those assets whole, the assets are combined into a pool, and then that pool is split into shares. Those shares are sold to investors who share the risk and reward of the performance of those assets. It can be viewed as being similar to a corporation selling, or spinning off, a profitable business unit into a separate entity. They trade their ownership of that unit, and all the profit and loss that might come in the future, for cash right now. A very basic example would be as follows. XYZ Bank loans 10 people $100,000 a piece, which they will use to buy homes. XYZ has invested in the success and/or failure of those 10 home buyers- if the buyers make their payments and pay off the loans, XYZ makes a profit. Looking at it another way, XYZ has taken the risk that some borrowers wont repay the loan. In exchange for taking that risk, the borrowers pay XYZ a premium in addition to the interest on the money they borrow. XYZ will then take these ten loans, and put them in a pool. They will sell this pool to a larger investor, ABC. ABC will then split this pool (which consists of high risk loans and low risk loans) into equal pieces. The pieces will then be sold to other smaller investors, (as bonds).

Features of securitisation:

A securitised instrument, as compared to a direct claim on the issuer, generally have the following features.

Marketability:

The very purpose of securitisation is to ensure marketability to financial claims. Hence, the instrument is structured to be marketable. This is one of the most important features of a 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. Legal aspect with respect to marketing instrument is concerned; traditional law relating to business practices has not evolved much. Negotiable instruments were mostly limited in application to what were then in circulation as such. Besides, the corporate laws mostly defined and sought to regulate issuance of usual corporate financial claims, such as shares, bonds and debentures. This gives raise to the need for a codified system of law for security and credibility of operations. The second issue is marketability of the instrument. . The purpose of securitisation is to broaden the investor base and bring the average investor into the capital markets. Either liquidity to a securitised instrument is obtained by introducing it into an organized market (such as securities exchanges) or by one or more agencies acting as market makers. That is, agreeing to buy and sell the instrument at either predetermined or market-determined prices.

Quality of security:

To be accepted in the market, a securitised product has to have a merchantable quality. The concept of quality in case of physical goods is something, which is acceptable in normal trade. When applied to financial products, it would mean the financial commitments embodied in the instruments are secured to the investors' satisfaction. "To the investors' satisfaction" is a relative term, and therefore, the originator of the securitised instrument secures the instrument based on the needs of the investors. The rule of thumb is the more broad the base of the investors, the less is the investors' ability to absorb the risk, and hence, the more the need to securitise. For widely distributed securitised instruments, evaluation of the quality, and its certification by an independent expert, for example, rating is common. The rating serves for the benefit of the lay investor, who is not expected to appraise the risk involved. In case of securitisation of receivables, the concept of quality undergoes drastic change; making rating is a universal requirement for securitisations. 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. This at times enables investors to rely on the credit rating of debtors (or a portfolio of debtors) in the process make the instrument independent of the oringators' own rating.

Dispersion of Product :

The basic purpose of securitisation is to disperse the product as much as possible. The extent of distribution, which the originator would like to achieve, is based on a comparative analysis of the costs and the benefits achieved. Wider dispersion or 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 him. However, 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.

Homogeneity:

The

instrument

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homogenous

lots

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marketabilty of the product. Homogeneity, like the above features, is a function of retail marketing. Most securitised instruments are broken into lots affordable to the small marginal investor, and hence, the minimum denomination becomes relative to the needs of the smallest investor. Shares in companies may be broken into slices as small as Rs. 10 each, but debentures and bonds are sliced into Rs. 100 each to Rs. 1000 each. Designed for larger investors, commercial paper may be in denominations as high as Rs. 5 Lac. Other securitisation applications may also follow the same type of methodology.

Special purpose vehicle:


In case the securitisation involves any asset or claim which is direct and

unsecured claim on the issuer, the issuer will need an intermediary agency. It acts as a repository of the asset or claim, which is being securitised. In the case of a secured debenture, it is 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 function is to hold the security charge

on behalf of the investors. In turn, it issues certificates to the investors of beneficial interest in the charge held by the intermediary. Thus, the charge continues to be held by the intermediary, beneficial interest therein becomes a marketable security. The same process is involved in securitisation of receivables. The special purpose intermediary holds the receivables with it, and issues beneficial interest certificates to the investors.

Types of Securitizations Securitization was initially used to finance simple, self liquidating assets such as mortgages. But any type of asset with a stable cash flow can in principle be structured into a reference portfolio that supports securitized debt. Securities can be backed not only by mortgages but by corporate and sovereign loans, consumer credit, project finance, lease/trade receivables, and individualized lending agreements. The generic name for such instruments is asset-backed securities (ABS), although securitization transactions backed by mortgage loans (residential or commercial) are called mortgage- backed securities. A variant is the collateralized debt obligation, which uses the same structuring technology as an ABS but includes a wider and more diverse range of assets.

o o o

mortgage loans ==> MBS consumer loans ==> ABS corporate loans ==> CLO
o

corporate bonds ==> CBO

Mortgage backed securities (MBS) were the first ones and are still the most predominant type of securitization.

Cash Flow Types of Securitisation Structures ; There are three most common types of securitisations from the perspective of cash flow: Collateralized Debt, Pass-Through and Pay-Trough structures.

Collateralized debt It is similar to asset-based borrowing.

The owner of assets borrows money and pledges assets to secure repayment. The assets pledged may be measured according to their market value upon sale or their ability to generate a cash flow stream. The debt instrument need not match the cash flow configuration of any of the assets pledged. Pass through securitization It is way to securitise assets with a regular cash flow, by selling direct participations in the pool of assets. In other words, a pass-through certificate represents an ownership interest in the underlying assets and thus in the resulting cash flow. Principal and interest collected on the assets are passed through to the security holders; the seller acts primarily as a servicer. A pay-through debt instrument It is a borrowing instrument, not a participation. Under the pay-through structure, the assets are typically held by a limited purpose vehicle that issues debt collateralized by the assets. Like a passthrough, the debt service is met by cash flow paid through to investors out of the pledged collateral. Investors in a pay-through bond are not direct owners of the underlying assets; they have simply invested in a bond backed by some assets. Therefore, the issuing entity can manipulate the cash flows, into separate payment streams. Thus pay-through securities may be structured

so that asset cash flows can be reconfigured to support forms of debt unlike those

Parties and their Roles ;

The key parties involved in a securitisation and their roles3 are as follows :

_ Originator

owner and generator of the assets to be securitised. Examples of Originators are: banks and other financial institutions, corporates, governments and municipalities;

_ Seller

seller of the assets to be securitised. In many cases, the Seller and the Originator in a transaction are identical. This is however not necessarily the case. For instance, an entity may purchase assets from its affiliates and then act as central Seller in a securitisation; _ Purchaser a special purpose vehicle (SPV) which purchases the assets to be securitised.

The Purchaser funds the purchase price by issuing asset-backed securities into the capital markets (in this capacity, the Purchaser is also referred to as the Issuer);

_ Servicer services the assets to be securitised (frequently the Originator retains this

role). Where receivables are securitised, the Servicer will collect, administer and, if necessary, enforce the receivables;

_ Back-up Servicer will service the assets in the event the Servicer is unable to service

them, or in the event the Purchaser exercises its right to remove the Servicer (for instance, as a result of the insolvency of the Servicer);

_ Liquidity Facility Provider

provides a liquidity facility in relation to certain tranches of the asset-backed securities. Typically, a liquidity facility is provided in conduit transactions where the Purchaser issues revolving short-term commercial paper to fund the purchase of the assets. The Purchaser may draw upon the liquidity facility if

it is unable to refinance maturing commercial paper because of a market disruption. The liquidity facility thus secures commercial paper investors against a default in such a case. Liquidity facilities are also sometimes required in standalone securitisations;

_ Investors purchasers of the asset-backed securities. Examples of investors in the

securitisation market are: pension funds, banks, mutual funds, hedge funds, insurance companies, central banks, international financial institutions and corporates

Lead Manager

arranger and structurer of the transaction (in the context of conduit transactions, also referred to as Programme Administrator). The Lead Manager is often the primary distributor of the asset-backed securities in a particular transaction. Individual distributors are also referred to as Managers;

_ Rating Agencies

rate the asset-backed securities. Some of the rating agencies in securitisation are Standard & Poors, Moodys Crisil , CARE etc

_ Hedge Providers

hedge any currency or interest rate exposures the Issuer may have;

_ Cash Administrator

provides banking and cash administration services to the Issuer;

_ Security Trustee

acts as a trustee for the secured creditors of the Issuer (notably, holds the Issuers assets granted to it as security for the Issuers obligations, on behalf of the Investors);

_ Note Trustee

acts on behalf of the holders of the asset-backed securities; _ Auditors if necessary they audit the asset pool as may be required under the documentation of the relevant transactions.

The securitization process;

In its most basic form, the process involves two steps (see chart).

In step one, a company with loans or other income-producing assets the originator identifies the assets it wants to remove from its balance sheet and pools them into what is called the reference portfolio. It then sells this asset pool to an issuer, such as a special purpose vehicle (SPV)an entity set up, usually by a financial institution, specifically to purchase the assets and realize their off-balance-sheet treatment for legal and accounting purposes. In step two, the issuer finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them onless a servicing feedirectly to the SPV or the trustee. Disadvantage BACK TO from bankruptcy of seller

Originator retains no legal interest in assets Typically structured into variousclasses/tranches, rated by one or more rating agencies Reference special portfolio(collateral) vehicle [SPV]) Senior Asset tranche(s)Junior originator Capital tranche market Underlying assets Issues asset-backed securities Issuing agent (e.g., purpose investors Transfer of assets from the originator to the issuing vehicle SPV issues debt securities (assetbacked) to investors Mezzanine tranche(s).

Working of securitization; (diagramz) Securitization represents an alternative and diversified source of finance based on the transfer of credit risk (and possibly also interest rate and currency risk) from issuers to investors.

portfolio is divided into several slices, called tranches, each of which has a different level of risk associated with it and is sold separately. Both investment return (principal and interest repayment) and losses are allocated among the various tranches according to their seniority. The least risky tranche, for example, has first call on the income generated by the underlying assets, while the riskiest has last claim on that income. The conventional securitization structure assumes a three-tier security design junior mezzanine, senior tranches This structure concentrates expected portfolio losses in the junior, or first loss position, which is usually the smallest of the tranches but the one that bears most of the credit exposure and receives the highest return. There is little expectation of portfolio losses in senior tranches, which, because investors often finance their purchase by borrowing, are very sensitive to changes in underlying asset quality. It was this sensitivity that was the initial source of the problems in the subprime mortgage market 2007. When repayment issues surfaced in the riskiest tranches, lack of confidence spread to holders of more senior tranches causing panic among investors and a flight into safer assets, resulting in a fire sale of securitized debt. .Securitization started as a way for financial institutions and corporations to find new sources of fundingeither by moving assets off their balance sheets or by borrowing against them to refinance their origination at a fair market rate. It reduced their borrowing costs and, in the case of banks, lowered regulatory minimum capital requirements. For example, suppose a leasing company needed to raise cash. Under standard procedures, the company would take out a loan or sell bonds. Its ability to do so, and the cost, would depend on its overall financial health and credit rating.If it could

find buyers, it could sell some of the leases directly, effectively converting a future income stream to cash. The problem is that there is virtually no secondary market for individual leases. But by pooling those leases, the company can raise cash by selling the package to an issuer, which in turn converts the pool of leases into a tradable security. Moreover, the assets are detached from the originators balance sheet (and its credit rating), allowing issuers to raise funds to finance the purchase of assets more cheaply than would be possible on the strength of the originators balance sheet alone. For instance, a company with an overall B rating with AA-rated assets on its books might be able to raise funds at an AA rather than B rating by securitizing those assets. Unlike conventional debt, securitization does not inflate a companys liabilities. Instead it produces funds for future investment without balance sheet growth. Investors benefit from more than just a greater range of investible assets made available through securitization. The flexibility of securitization transactions also helps issuers tailor the risk-return properties of tranches to the risk tolerance of investors. For instance, pension funds and other collective investment schemes require a diverse range of highly rated longterm fixed-income investments beyond what the public debt issuance by governments can provide. If securitized debt is traded, investors can quickly adjust their individual exposure to credit-sensitive assets in response to changes in personal risk sensitivity, market sentiment, and consumption preferences at low transaction cost. Sometimes the originators do not sell the securities outright to the issuer (called true sale securitization) but instead sell only the credit risk associated with the assets without the transfer of legal title (synthetic securitization). Synthetic securitization helps issuers exploit price difference between the acquired (and often illiquid) assets and the price investors are willing to pay for them (if diversified in a greater pool of assets).

True sale securitization: Put de diagram

The diagram shows a typical structure for a true sale securitisation. The Originator (for instance a bank selling mortgages) sells certain assets (the Assets) to the Issuer. The Assets will be serviced by the Servicer (often the Originator), for instance with respect to mortgages sold to the Issuer, the Originator will continue, on behalf of the Issuer, to collect principal and interest from borrowers on such mortgages and will, where appropriate, take enforcement action in respect of such default mortgages. As the Issuer has no employees it will appoint a Cash Administrator to make all relevant payments on its behalf and is also likely to app The Issuer funds the purchase of those assets by selling asset-backed securities (whose performance is dependent on the performance of the Assets) (the Bonds) to the Managers who will in turn sell those securities to the Investors. Investors will be free to sell the Bonds or retain them.

Synthetic securitization ;

It is very similar to a true sale and most of the structural features are the same. The key difference is that the Originator does not sell any assets to the Issuer (and therefore, does not obtain any funding or liquidity under the transaction). Instead the Originator will enter into a credit default swap with the Issuer in respect of an asset or pool of assets. Under this contract the Issuer will pay the Originator an amount equal to any credit losses suffered in respect of such asset or pool of assets (less a minimum threshold amountsimilar to an excess in insurance). The Originators exposure to those assets is therefore transferred to the Issuer. The Originator in return will pay a fixed amount to the Issuer, usually on a quarterly basis. The Issuer will issue Bonds to Investors via the Managers. The Issuers ability to repay principal and pay interest under the Bonds will depend on whether the Issuer has to make payments under the credit default swap. The Issuers income streams in a synthetic transaction are the fixed amounts paid by the Originator under the credit default swap and interest amounts received on the collateral. In order to collateralise its obligations under the credit default swap and the Bonds the Issuer usually purchases securities as collateral. These are normally highly rated government debt securities. They also need to be relatively liquid in order that they can be sold and the proceeds used to pay amounts under the credit default swap or Bonds. Whole Business Securitisation ; This type of securitisation originated in the United Kingdom. It involves the provision of a secured loan from an SPV to the relevant Originator. The SPV issues bonds into the capital markets and lends the proceeds to the Originator. The Originator services its obligations under the loan through the profits generated by its business. The Originator grants security over most of its assets in favour, ultimately, of the Investors. Whole business

securitisation

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management buy out of the originator.

Advantages;

Securitisation is one way in which a company might go about financing its assets. Reasons for companies to go for securitisation : 1. to improve their return on capital, since securitisation normally requires less capital to support it than traditional on-balance sheet funding; 2. to raise finance when other forms of finance are unavailable (in a recession banks are often unwilling to lend - and during a boom, banks often cannot keep up with the demand for funds); 3. to improve return on assets - securitisation can be a cheap source of funds, but the attractiveness of securitisation for this reason depends primarily on the costs associated with alternative funding sources;

4. to diversify the sources of funding which can be accessed, so that dependence upon banking or retail sources of funds is reduced; 5. to reduce credit exposure to particular assets (for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitisation can remove some of the assets from the balance sheet); 6. to match-fund certain classes of asset - mortgage assets are technically 25 year assets, a proportion of which should be funded with long term finance; securitisation normally offers the ability to raise finance with a longer maturity than is available in other funding markets; 7. to achieve a regulatory advantage, since securitisation normally removes certain risks which can cause regulators some concern, there can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitisation as a means of managing the restriction on their wholesale funding abilities).

. Economic impact of securitisation:

Securitisation is necessary to the economy similar to organized markets .

1. Creates of markets in financial claims:


By creating tradeable securities out of financial claims, securitisation helps to create markets in claims, which would, in its absence, have remained bilateral deals. In the process, securitisation makes financial markets more efficient, by reducing transaction costs.

2. Spread of holding of financial assets:


The basic intent of securitisation is to spread financial assets amidst as many savers as possible. the security is designed in minimum size marketable lots as necessary. Hence, it results into dispersion of financial assets. One should not underrate the significance of this factor just because institutional investors have lapped up most of the recently developed securitisations. Lay investors need a certain cooling-off period before they understand a financial innovation.

3. Promotion of savings:
The availability of financial claims in a marketable form, with proper assurance as to quality in form of credit ratings etc., securitisation makes it possible for the simple investors to invest in direct financial claims at attractive rates. If the bank rate are lower

than the rates offered by securities, investors will go for these instruments.

4 Reduces costs:
Securitisation tends to eliminate fund-based intermediaries, and it leads to specialization in intermediation functions. This saves the End-user Company from intermediation costs, since the specialized-intermediary costs are servicerelated, and comparatively lower .

5 Risk diversification :
Financial intermediation is a case of diffusion of risk because of accumulation by the intermediary of a portfolio of financial risks. Securitisation spreads diversified risk to a wide base of investors, with the result that the risk inherent in financial transactions is diffused.

6 Focuses on use of resources, and not their ownership:


Once an entity securitises its financial claims, it ceases to be the owner of such resources and becomes merely a trustee or custodian for the several investors who thereafter acquire such claim. Imagine the idea of securitisation being carried further, and not only financial claims but claims in physical assets

being securitised, in which case the entity needing the use of physical assets acquires such use without owning the property. The property is diffused over investors. In this sense, securitisation process assumes the role of a trustee of resources and not the owner.

Social benefits of Securitisation:


Securitisation does is to break a company, a set of various assets, into various subsets of classified assets, and offer them to investors. In situation without securitisation: each investor would be taking a risk in the unclassified, composite company. How can we call this as serving economic benefit if the company is made into different parts and sold to different investors? consider an imaginary holding company ABCLtd. It has on its balance sheet three wholly-owned subsidiaries, A, B, and C. The process of securitisation can be thought of as treating distinguishable pools of assets as if they were the wholly-owned subsidiaries, A, B and C. Lets make the following assumptions about the subsidiaries A, B and C.A is 100% debt financed (5-year debentures issued at 9%) with its only asset a single 5-year loan to an AAA-rated borrower paying 10%. B is a software company with no earnings or performance history, but with projections for attractive, volatile, future earnings. C is a well-known manufacturing company with predictable earnings. If ABC goes to the debt markets seeking additional unsecured funding, potential

investors would face the difficult task of evaluating its assets and assessing its debt repaying abilities. The assessed cost of marginal ABC borrowing might consist of an "average" of the calculated returns on the assets of the segments that comprise ABC. This average would necessarily reflect known and unknown synergies, and costs and associative risks arising from the collective ownership parts (i.e., the group's imputed contribution for credit support, insolvency risk and liability recourse) and would likely include an "uncertainty" discount. Now consider the probable outcomes if ABC are to legally sell the ownership of one or more of its "parts." In exchange for the exclusive rights to the cash flows from A, investors would return to ABC maximum equivalent value in the form of cash. Such an offering appeals to a wide range of investors. This includes investors with a preference for, and having superior information regarding the risk represented by A's obligors. Those new investors who have had an aversion for the risk presented by the associated costs and risks represented by B and C. This new arrangement returns to ABC is the full value the market attaches to the certainty of the information concerning A, without uncertainty of the information regarding Band C. The value of the resulting ABC shares

depends in part on the disposition of the cash received from the spin-off. If ABC retains the cash, there may be a discount or revaluation resulting from the market's assessment of ABC's ability to achieve a return equal or better than it would have earned from keeping the asset. There is always one clear collateral benefit to the resulting ABC that derives from any divestment. The perceived value of the remaining components are relieved of any previously imposed discount for the disposed component's credit support and insolvency risk. Holding aside separate considerations of corporate strategy and internal synergies, to the extent that the consideration received from the divestment improves (in the perception of the market) the capital structure of the resulting ABC and/or reduces the marginal funding cost for the resulting organization ABC. The decision to divest or securitise is simplified. If the information held by ABC concerning any of its segments is not or cannot be fully disclosed, or when disclosed will not be fully or accurately valued, the correct decision is to retain the asset. Without securitisation, ABC's bank faces significant and largely irreducible costs of evaluating the marginal impact on ABC's borrowing cost from ABC's pledging of assets (receivables) and of evaluating similar information for each other borrower that the lender or finances. If the imposed cost of borrowing is to be judged solely on the assets as we have seen, the most efficient way to assess the true cost of asset based borrowing). Evaluating each pool of assets and assessing the likelihood that the cash flows from them will be uninterrupted must be repeated for each borrowing. By developing a market for asset-specific expertise (not the least of which is

represented by the expertise of the rating agencies), and by relying on the capital markets to determine the best price for the rated asset-backed securities (such rating representing the expression of the information provided by the developed expertise), the cost of borrowings for issuers using properly organized securitisation structures has steadily decreased and is well below the cost of borrowing from a lending institution. DISADVANTAGES; Risks to investors Liquidity risk Credit/default: Default risk is generally accepted as a borrowers inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular securitys default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings. However, the credit crisis of 2007-2008 has exposed a potential flaw in the Securitisation process - loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and Securitisation, which doesn't encourage improvement of underwriting standards. The subprime mortgage crisis that began in 2007 has given the decades-old concept of securitization a bad name. Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities. Securitization got its start in the 1970s, when home mortgages were pooled by U.S. government-backed agencies. Starting in the 1980s, other income-producing assets began to be securitized, and in recent years the market has grown dramatically.In some markets, such as those for securities backed by risky subprime mortgages in the United

States, the unexpected deterioration in the quality of some of the underlying assets undermined investor confidence. Both the scale and persistence of the attendant credit crisis seem to suggest that securitizationtogether with poor credit origination, inadequate valuation methods, and insufficient regulatory oversightcould severely hurt financial stability. Increasing numbers of financial institutions employ securitization to transfer the credit risk of the assets they originate from their balance sheets to those of other financial institutions,such as banks, insurance companies, and hedge funds.They do it for a variety reasons. It is often cheaper to raise money through securitization, and securitized assets were then less costly for banks to hold because financial regulators had different standards for them than for the assets that underpinned them. In principle, this originate and distribute approach brought broad economic benefits toospreading out credit exposures, thereby diffusing risk concentrations and reducing systemic vulnerabilities. Until the subprime crisis unfolded, the impact of securitization appeared largely to be positive and benign. But securitization also has been indicted by some for compromising the incentives for originators to ensure minimum standards of prudent lending, risk management, and investment, at a time when low returns on conventional debt products, default rates below the historical experience,and the wide availability of hedging tools were encouraginginvestors to take more risk to achieve a higher yield. Many of the loans were not kept on the balance sheets of those who securitized them, perhaps encouraging originators to cut back on screening and monitoring borrowers, resulting possibly in a systematic deterioration of lending and collateral standards.

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

Securitisation and financial disintermediation:

Securitisation used to result into financial disintermediation. If we imagine a financial world without intermediaries, all financial transactions will be carried only as one-to-one relations. For example, if a company needs a loan, if will have to seek such loan from the lenders, and the lenders will have to establish a one-to-one relation with the company. Each lender has to understand the borrowing company, and to look after his loan. This is difficult process in modern world of business. There is a financial intermediary, such as a bank, pools funds from many such investors. It uses these funds to lend to the company. If the company securitises the loan, and issue debentures to the investors eliminating the need for the intermediary bank. Since the investors may now lend to the company directly in small amounts each, in form of a security, which is easy to appraise, and which is liquid.

Utilities added by financial intermediaries:


A financial intermediary initially came into existence to avoid the difficulties in a direct lender-borrower relation between the company and the investors. the difficulties that will be addressed by the financial intermediary are as follows;

(a) Difficulty of transactions: An average small investor would have a small amount of sum to lend whereas the company's needs would be massive. The intermediary bank pools the funds from small investors to meet the needs of the company. The intermediary may issue its own security, of smaller value. (b) Non availability of information: An average small investor would either not be aware of the borrower company or would not know how to appraise or manage the loan. The intermediary fills this gap. (c) Risk perception of Risk: The risk as investors perceive in investing in a bank may be much lesser than that of investing directly in the company, though in reality, the financial risk of the company is transposed on the bank. However, the bank is a pool of several such individual risks, and hence, the investors' preference of a bank to the borrower understood easily. Securitisation of the loan into bonds or debentures addresses all the three difficulties in direct exchange between borrower and lender. It avoids the transactional difficulty by breaking the lumpy loan into marketable lots. It avoids informational difficulty because the securitised product is offered generally by way of a public offer, and its essential features are disclosed. It avoids the perceived risk difficulty, since the instrument is generally well secured and generally rated for the investors' satisfaction. company can be

Securitisation changes the function of intermediation:


It is true to say that securitisation leads to better disintermediation for its advantage. Disintermediation is one of the important aims of present-day organizations, since by skipping the intermediary, the company intends to reduce the cost of its finances. Securitisation has been employed to disintermediate. However, it is important to note that securitisation does not eliminate the need for the intermediary. It redefines the intermediary's role. In 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? No. Would 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. Therefore, securitisation changes the basic role of financial intermediaries. 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 this case, the focus shifts to the more essential function of a financial intermediary. That is distribution 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. Thus, the focus shifted from the pooling utility provided by the banker to the distribution utility provided by the investment banker. 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 fee-based intermediary, a catalyst, and a pipeline of funds. Hence, with increasing trend towards securitisation, the role of feebased financial services has been brought into the focus. In case of a direct loan, the lending bank was performing several intermediation functions. It is a distributor in the sense that it raised its own finances from a large number of small investors. It is appraising and assessing the credit risks in extending the corporate loan, and having extended it, it manages the same. Securitisation splits each of these intermediary

functions apart, each to be performed by separate specialized agencies. The investment bank, appraisal function, will perform the distribution function by a credit-rating agency and management function possibly by a mutual fund that manages the portfolio of security investments by the investors. Hence, securitisation replaces fundbased services by several fee-based services.

Securitisation: changing role of banking systems

Banks are increasingly facing the threat of disintermediation. 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: originating; funding, servicing and 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: originate, sell, and service. This change from a four-step process to a three-step function has been described as the fragmentation or separation of traditional lending. Securitisation of Loans The concept of Securitisation of loans has been codified through the Securitization Act 2002 and this has proved to be the engineroom in the present day financial market. With this apparatus the banks and financial institutions can pass off their risks of unpaid debts but the risk only goes off from the individual institutions and not from the financial system. Therefore there is a possibility that the same might strike back again. The banking sector in India is growing very fast and its escalation has contributed substantially in the progress of the countrys financial market. Basic function of banks is to work as a financial intermediary by accepting deposits and giving out loans, Lending is part and parcel of the banking industry. loan is an amount of money advanced to the borrower for a stipulated time period and while repaying the amount the borrower is required to pay certain additional amount which is termed as interest. Such interest is nothing but the cost of money being used for that time period. kinds of loans, secured and unsecured. Unsecured loans are advanced without any security but in case of secured loans banks retain securities in the order of real estate, machinery and the like. The main object of keeping hold of security is to ensure that if the borrower makes a default then such security can be realized at the meeting of the deficiency. However this system was not satisfactory as the convulsion of those real estates and translation into liquid assets seemed impossible because of the legal complicatedness as well as the sloth of our judicial system. It took years for the banks to liquefy the security assets and appreciate the sum of

deficiency. Hence to trounce this difficulty the Parliament had enacted Recovery of Debts Due To Banks and Financial Institutions Act, 1993 (hereinafter referred to as Debt Recovery Act). This Act created a separate apparatus in the order of Debt Recovery Tribunals which were devolved with the responsibility of administering disputes pertaining non payment of debts. However one may say that this legislation was generic in nature and could not adjust with every corner of the changing trends of financial market. Hence it was imperative for the legislature to devise an even more unconventional device for the enforcement of rights of bankers and financial institutions as lenders. Consequently the Parliament acted out Securitisation and

Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (hereinafter referred to as Securitization Act). The Act is nothing but the fructification of Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance which was promulgated by the president in the year 2002 itself. This Act came into existence when in the financial market loans are started being treated like tradable securities. This Act has been passed in the year 2002. Section 2(f) of this Act defines borrower as a person who has taken financial assistance form any bank or financial institution in exchange of certain security in the order of mortgage, pledge or guarantee. Under section 2(j) default would mean non payment of any principal debt or interest thereon. Under section 2(zd) of this Act the banks and financial institutions as well as any consortium arrangement are regarded as secured creditors. Securities are generally classified into three categories 1.directly tradable in the market in a profitable manner 2. not directly tradable but the banks however can sell them in lesser profit and 3. not at all tradable.

The use of securitization process is meant for the third group of assets. In securitization process there are mainly two crafts: the original lender and a Special Purpose Vehicle (SPV). The SPV helps the original lender in liquefying the assets. The SPV converts these assets into marketable securities for investment and the cash flows to the original lender. This helps the original lender in meeting up the deficiency which arose out of the borrowers default. Apart from original lender and SPV, other parties involved in securitization process are merchant or investment banker, credit rating agency, servicing agency and the buyers of securities. INCLUDE IN DE CONCLUSION (As far as India is concerned the

advantages that securitization of loans may accrue is interesting. In an economy which is growing and in need of more capital, securitization helps in managing the limited capital efficiently. The commercial banks can reallocate their risks in a planned manner improving their credit and operating system. The investors are in an incessant enthusiasm for having more assets and this hunger can be bespoken by asset securitization. In long and medium stages securitization method is at the prospect of advancing the classiness standards of the banking as well as the financial institutions. In short the system of securitization can prove to be a vehicle for the augmentation the country. The process of securitization of loans has led India to witness a vogue in the banking sector. This fad may be termed something like belligerent banking. This is presently the guiding gospel of the banking sector. This is so because banks earn profit mainly form loans and lending involves a great deal of risk. Before providing loans the banker has to think twice, take a lot of factors into contemplation and apprise a lot of things. Furthermore there is always an atmosphere of worry about the repayment and finally a lot of accountability as these institutions are to deal with the public money. But of domestic savings as well as attracting overseas investments which might be imperative in the infrastructural enlargement of

with the surfacing of securitization of loans there is a feeling of security in the banking sector and it has tutored the banks not to behave like their traditional brothers and to expand instead. The driving force behind this changing concept is loans being treated like tradable securities to be packaged, sold and forgotten about. In this way securitization has emerged as the as the engine room of the financial market. Form the above forethought one may come to the outlook that securitization of loans is all right and there is no predicament. However if analysed in a different manner then there is one potential dilemma. This quandary comes when we think about securitization not from the perspective of individual financial instauration but from the standpoint of the financial system as a whole. We have already discussed previously that now a day isolationism has no place to function and hence things to be considered globally. Thus the debate in which we partake is not from the point of view of our own financial system but the universal one. This is because our country has already made a take off from isolationism and in the process of being more integrated with the global economic order. Therefore when one scrutinizes the concept of securitization of loans then he/she may face with the difficulty as to securitization of whatthe individual institutions or the financial system as a whole. The securitization of loans facilitates the original lender thinking that he is sticking to an opportune position which will abet him to transmit the jeopardy to the other investors and with this process the originator can getaway capital sufficiency requirements. But the hazard which securitization wants to avoid does not disappear from the financial system altogether. The securitization or reconstruction companies which buy and invest the securities engage themselves in a highly risk prone business and hence they have to highly depend again on the commercial banks for the supply of the required credits. Therefore incongruously the commercial banks are again driven to foster the business of these investors which

undertake a risky game. Thus an unseemly assessment of risk may result the peril might knock the door of the originator once again. For this reason the risk does not ebb from the system on the whole and in the natural course of financial market the same may trouble again. Therefore the decease that securitization wants to cure remains as it is and merely changes its position from one to another actor in the market. We need to bear this in mind that concept of banking is no longer a new one. We can find its traces in the medieval history also. However at that time banking was identified with money lending only. Now a day though banking is not only institutionalized money lending system but money lending and profit making forms the base for which the banks are meant for. It is not that banks have started giving loans only after the advent of securitization process. Lending was there even though the theme of securitization was absent. During that time the banks used to follow something what we call Principles of Good Lending or Fundamental Principles of Banking Business. These principles were regarded sound in the banking business and included proper disclosure of documents by the customers so that there is no bar in proceeding with the loan, actual assessment of customers repayment capability ensuring the due return in due time, rigid regulations to prevent hoodwinked and corrupt practices, a supervisory monitoring system and finally less formal techniques to promote best practices. Therefore to conclude with we must say that though we are standing on a time where the financial market is at its boom with the fast growth of the banking sector, we should not forget the basic values that is in continuation since long. These principles should not be discarded after the danger being shown. The Securitization Act indeed is a milestone but this is not to be extended so as to taking away the elementary dogma. In many of the cases the judges heard stating that the old precedents should not be held redundant just because they are old. They should be weighed in their own merits. Such benchmark can only be rejected when it is established that they

can not be borne any more and hence they are out-modeled. This inherent principle can also be applied to the emerging concept of credit securitization. It may not be possible to think that the fundamental principles of banking are of no use today. Hence securitization can be an appendage to these principles and not all in all a substitute)

Capital markets role in securitisation:


The capital markets have provided the needed impetus to disintermediation market. Professional and publicly available rating of borrowers has eliminated the informational advantage of financial intermediaries. Let us imagine a market without rating agencies: any investor has to take an exposure security has to appraise the entity. Therefore, only those who are able to employ analytical skills will be able to survive. However, the availability of professionally conducted ratings has enabled small investors to rely on the rating company's professional judgement and invest directly in the security instruments rather than to go through intermediaries. But this should not be construed as no role for banker.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 risks - 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. Other features of the capital markets frequently offset any remaining informational advantage of banks: variety of offering methods, flexibility of timing and other structural options. For borrowers able to access capital markets 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 touch points between borrowers and savers. They become more important 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.

Securitisation and structured finance:

securitization is a "structured financial instrument". It 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. the termstructured finance is to refer to such financing instruments where the financier does not look at the entity as a risk. He 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. Itclassifies 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:


Securitisation is more than just a financial tool. Banks generally work for risk removal. Securitisation but also permits bank to acquire securitized assets with potential diversification benefits. When assets are removed from a bank's balance sheet, all the risks associated with the asset are eliminated. In the process reduces the risks of the bank. Credit risk and interest-rate risk is the essential 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.

In today's banking, securitisation is increasingly being resorted to by banks, along with other innovations such as credit derivatives to manage credit risks.

Comparison of Securitisation and credit derivatives:


Credit derivatives are 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 either could be undertaken by guaranteeing against default or by guaranteeing the total expected returns from the credit transaction. While the former could be another form of traditional guarantees, the latter is the true concept of credit derivatives. Thus, if one bank has a concentration in say Iron and Steel segment while another bank has concentration in Textiles, the two can diversify their risks, without actually taking financial exposure, by engaging in credit derivatives. One can agree to guarantee the returns of other from a part of its Iron and Steel exposures, and reverse can also take place. Thus, the first bank is 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. . Bibliography 1. The Securitization and Reconstruction of Financial Assets and

Enforcement of Security Interest Act, 2002. 2. Tanan, M.L. Tanans Banking Law and Practice in India, Wadhwa and Wadhwa, 21st Edition, 2005. 3. Ghosh, D.N. Aggressive Published in Economic Publication, Vol. XLII, No.35. Banking Political and Passive Regulation, Trust

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