SECURITISATION OF

FINANCIAL ASSETS
 Securitisation is a process by which

(iii)intangible and illiquid assets are monetized into cash,

(iv) (ii) risks related to the specific assets are separated from the transferor's (i.e., the originator) own credit
and operating risk, and
(v) (iii) securities are issued to investors which are designed for the specific risk tolerance profile of such
investors.
The above statements define the theme of securitisation

Simply stated, a securitization is the term used to describe the process of issuing securities backed by the
cash flows from a pool of underlying assets. Securitization has also been defined as "the sale of equity or
debt instruments, representing ownership interests in, or secured by, segregated, income-producing asset
or pool of assets, in a transaction structured to reduce or reallocate certain risks inherent in owning or
lending against the underlying assets and to ensure that such interests are more readily marketable and,
thus, more liquid than ownership interests in and loans against the underlying assets." The cash from the
certificate holders goes to the originator, and the originator can then use that cash to originate more
loans. The certificate holders receive monthly payments, constituting a paydown of their principal
investment and interest on that investment."

 RBI: Securitisation is a process by which assets are sold to a bankruptcy remote special purpose
vehicle (SPV) in return for an immediate cash payment. The cash flow from the underlying pool of assets
is used to service the securities issued by the SPV. Securitisation thus follows a two-stage process. In the
first stage there is sale of single asset or pooling and sale of pool of assets to a 'bankruptcy remote'
special purpose vehicle (SPV) in return for an immediate cash payment and in the second stage
repackaging and selling the security interests representing claims on incoming cash flows from the asset
or pool of assets to third party investors by issuance of tradable debt securities
 Elements of Securitisation

 Conversion of existing illiquid assets like

loans, advances and receivables into tradable
security
 Reconverting them into fresh assets through
capital market operations
 Securitisation in India

 As of June 30, 2001, the outstanding securitized assets in the US were over
USD 5 trillion (ABS - USD 1.2 trillion, MBS - USD 3.8)[3], a staggering 25%
of all debt outstanding. For India, this figure is a paltry 1.6% with less than
INR 100 billion of outstanding securitized debt.

 While there has been a lot of discussion about the potential of securitization
in India, actual deal activity has not kept pace. While some early adopters
like ICICI, TELCO and Citibank have been actively pursuing securitization,
almost all the transactions in the market so far have been privately placed
with a majority of them being bilateral fully bought out deals.

 Lack of appropriate legislation and legal clarity, unclear accounting

treatment, high incidence of stamp duties making transactions unviable, lack
of understanding of the instrument amongst investors, originators and, till
recently, even rating agencies are some of the glaring reasons for the lack
of activity in the area of securitization in India.
 Need for Securitisation in India
 In the Indian context, securitization is the only ray of hope for funding
resource starved infrastructure sectors like Power *. For power utilities
burdened with delinquent receivables from state electricity boards (SEBs),
securitization seems to be the only hope of meeting resource requirements.
 As on December 31, 1998, overall SEB dues only to the central agencies
were over Rs. 184 billionSecuritization can help Indian borrowers with
international assets in piercing the sovereign rating and placing an
investment grade structure.
 An example, albeit failed, is that of Air India’s aborted attempt to securitize
its North American ticket receivables. Such structured transactions can help
premier corporates to obtain a superior pricing than a borrowing based on
their non-investment grade corporate rating.
 A market for Mortgage backed Securities (MBS) in India can help large
Indian housing finance companies (HFCs) in churning their portfolios and
focus on what they know best - fresh asset origination. Indian HFCs have
traditionally relied on bond finance and loans from the National Housing
Bank (NHB). MBS can provide a vital source of funds for the HFCs.
 Why Securitisation

2. A convenient mechanism to suit changing

needs of borrowers and lenders
3. Matches supply of funds with demand
demands for funds through floating
negotiable securities
4. Shifts the source of repayment from earning
to a pool of assets
 Genesis and Growth

2. Severe financial crisis faced by certain states

in US during 1969-70
3. Federal government restriction on inter-state
lending and borrowing
4. Raised funds from surplus states by issuing
instruments backed by mortgaged properties
 PLAYERS AND THEIR ROLES

The Players and their Role:

2. Originator: An entity making loans to borrowers or
having receivables from customers
3. Special Purpose Vehicle: The entity which buys assets
from Originator and packages them into security for
further sale
a. Bankruptcy remote
b. Separates the risk of assets from the credit risk of the seller
4. Credit Enhancer: To reduce the overall credit risk of a
security issue by providing senior subordinate structure,
over-collateralization or a cash collateral
 PLAYERS AND THEIR ROLES(CONT)

2. Credit Rating Agency: To provide value

addition to security
3. Insurance Company / Underwriters: To provide
cover against redemption risk to investor and /
or under-subscription
4. Obligors: Whose debts and collateral constitute
the underlying assets of securitisation
5. Investor: The party to whom securities are sold
 SECURITISATION PROCESS

1. Selection of assets by the Originator

2. Packaging of designated pool of loans and
advances (assets)
3. Underwriting by underwriters
4. Assigning or selling to of assets to SPV in
return for cash
5. Conversion of the assets into divisible
securities
 SECURITISATION PROCESS

1. SPV sells them to investors through private

placement or stock market in return for cash
2. Investors receive income and return of capital
from the assets over the life time of the securities
3. The risk on the securities owned by investors is
minimized as the securities are collateralisied by
assets
4. The difference between the rate of the borrowers
and the return promised to investors is the
servicing fee for originator and SPV
Securitisation -Process
 Features of securitisation
A securitised instrument, as compared to a direct claim on the issuer,
will generally have the following features

Marketability
Merchantable quality
Wide Distribution
Homogeneity
 Role of SPV

Plays the below roles

 Intermediary
 Helps in the Pooling process
 Holding of pooled securities as a repository
 Investor of securities
 Bankruptcy remote transfer
 What are the interlinked processes?

 Pooling and transfer

 Issuance
 Credit enhancement and tranching
 Servicing
 Repayment structures
 SECURITISATION OF FINANCIAL
ASSETS
Requirements for Eligible Collaterals:
2. Assets to be securitised to be homogeneous in
terms of:
3. Underlying assets
4. Maturity period
5. Cash flow profile
 SECURITISATION OF FINANCIAL
ASSETS
Eligible Collaterals ( few examples)
2. Housing finance
3. Term loan finance
4. Car loan
5. Credit card receivables
6. Export credit
 SECURITISATION OF FINANCIAL
ASSETS
Structure of Securitisation:
2. Pass Through Certificates:
 Sale of asset to SPV
 Investors purchase interest in the assets of
SPV

Cash flow (interest and principal) passed
through as and when occurred without any
reconfiguration
 Payments made are most often on monthly
basis

Reinvestment risk carried by investor
 SECURITISATION OF FINANCIAL
ASSETS
1. Pay Through Certificates:
 Sale of assets to SPV
 SPV issues a debt security collateralized by
asset cash flows
 Cash flows (interest and principal) reconfigured
to suit the requirements of the investors i.e.
based on the maturity period of the security
 Reinvestment risk carried by SPV
 Each trench is redeemed one at a time
 Payments would be at different time intervals
than the flows from the underlying assets
SECURITISATION OF FINANCIAL
ASSETS
Instruments:
Depending on the structure of securitisation, the
instrument would be pass-through certificate
(PTC), a promissory note, a bond or debenture.
3. The PTC passes the cash flows from borrowers
in the same form to investors. However,
negotiability is restricted as the investor has to
return the PTC to SPV
4. Promissory note / bonds / debentures make
available different tenor maturities and yield to
different investors
 Benefits of Securitisation(issuer)
 Reduces funding costs:costs: Through securitization, a company rated BB but with AAA worthy cash flow would
be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can
have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple
hundreds of basis points.
points.
 Reduces asset-liability mismatch:
mismatch: "Depending on the structure chosen, securitization can offer perfect
matched funding by eliminating funding exposure in terms of both duration and pricing basis. Securitization
allows such banks and finance companies to create a self-funded asset book.
 Lower capital requirements:
requirements: Some firms, due to legal, regulatory,
regulatory, or other reasons, have a limit or range
that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for
accounting purposes, these firms will be able to lessen the equity on their balance sheets while maintaining
the "earning power" of the asset.
 Locking in profits:
profits: For a given block of business, the total profits have not yet emerged and thus remain
uncertain. Once the block has been securitized, the level of profits has now been locked in for that company,
thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
 Transfer risks (credit
(credit,, liquidity,
liquidity, prepayment,
prepayment, reinvestment, asset concentration): Securitization makes it
possible to transfer risks from an entity that does not want to bear it, to one that does..
 Earnings:
Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm.
When a securitization takes place, there often is a "true sale" that takes place between the Originator (the
parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true
sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings
for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings
of the parent company.
 Admissibility:
Admissibility: Future cashflows may not get full credit in a company's accounts (life insurance companies, for
example, may not always get full credit for future surpluses in their regulatory balance sheet), and a
securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.
 Liquidity:
Liquidity: Future cashflows may simply be balance sheet items which currently are not available for
spending, whereas once the book has been securitized, the cash would be available for immediate spending
or investment. This also creates a reinvestment book which may well be at better rates.
 Disadvantages to issuer

 May reduce portfolio quality: If the AAA risks, for example, are
being securitized out, this would leave a materially worse quality of
residual risk.
 Costs: Securitizations are expensive due to management and
system costs, legal fees, underwriting fees, rating fees and ongoing
administration. An allowance for unforeseen costs is usually
essential in securitizations, especially if it is an atypical
securitization.
 Size limitations: Securitizations often require large scale
structuring, and thus may not be cost-efficient for small and medium
transactions.
 Risks: Since securitization is a structured transaction, it may include
par structures as well as credit enhancements that are subject to
risks of impairment, such as prepayment, as well as credit loss,
especially for structures where there are some retained strips.
 Advantages to investors
 Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

 Opportunity to invest in a specific pool of high quality credit-enhanced assets:

Due to the stringent requirements for corporations (for example) to attain high ratings,
there is a dearth of highly rated entities that exist. Securitizations, however, allow for
the creation of large quantities of AAA, AA or A rated bonds, and risk averse
institutional investors, or investors that are required to invest in only highly rated
assets, have access to a larger pool of investment options.

 Portfolio diversification: Depending on the securitization, hedge funds as well as

other institutional investors tend to like investing in bonds created through
Securitizations because they may be uncorrelated to their other bonds and securities.

 Isolation of credit risk from the parent entity: Since the assets that are securitized
are isolated (at least in theory) from the assets of the originating entity, under
securitization it may be possible for the securitization to receive a higher credit rating
than the "parent," because the underlying risks are different. For example, a small
bank may be considered more risky than the mortgage loans it makes to its
customers; were the mortgage loans to remain with the bank, the borrowers may
effectively be paying higher interest (or, just as likely, the bank would be paying
higher interest to its creditors, and hence less profitable).
 Risks to investors
 Liquidity risk

 Credit/default: Default risk is generally accepted as a borrower’s 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 security’s default risk is its credit rating.

 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.

 Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS
move in response to changes in interest rates.. Furthermore, interest rate changes may affect the
prepayment rates on underlying loans that back some types of ABS, which can affect yields.

 Contractual agreements

 Moral hazard: Investors usually rely on the deal manager to price the securitizations’ 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.
 Hurdles to securitisation in India
 Stamp Duty:
Duty: In India, stamp duty is payable on any instrument which seeks to transfer rights or receivables.
Therefore, the process of transfer of the receivables from the originator to the SPV involves an outlay on account
of stamp duty, which can make securitisation commercially unviable in states that still have a high stamp duty.
Pass Through Certificate (PTC) that merely evidences title to the receivables, then such an instrument should not
attract stamp duty,but state governments take a different view. SEBI has suggested to the government on the
need for rationalisation of stamp duty with a view to developing the corporate debt and securitisation markets in
the country, which may going forward be made uniform across states as also recommended by the Patil
Committee

 Foreclosure Laws:
Laws: Lack of effective foreclosure laws also prohibits the growth of securitisation in India. The
existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer
property in cases of default

 Taxation related issues:

issues: The tax laws have no specific provision dealing with securitisation. Hence, the market
practice is entirely based on generic tax principles, and since these were never crafted for securitisations, experts’
opinions differ. The generic tax rule is that a trustee is liable to tax in a representative capacity on behalf of the
beneficiaries – therefore, there is a prima facie taxation of the SPV as a representative of all end investors.
However, the representative tax is not applicable in case of non-discretionary trusts where the share of the
beneficiaries is ascertainable. The share of the beneficiaries is ascertainable in all securitisations – through the
amount of PTCs held by the investors. Though the PTCs might be multi-class, and a large part might be residual
income certificates in effect, the market believes, though with no reliable precedent, that there will be no tax at the
SPV level and the investors will be taxed on their share of income.

 Legal Issues:
Issues: Investments in PTCs are typically held-to-maturity. As there is no trading activity in these
instruments, the yield on PTCs and the demand for longer tenures especially from mutual funds is dampened. Till
recently, Pass through Certificates (PTC) were not explicitly covered under the Securities Contracts (Regulation)
Act, definition of securities. This was however ammended with the Securities Contracts (Regulation) Amendment
Act, 2007 passed with a view to providing a legal framework for enabling listing and trading of securitised debt
instruments. This will bring about listing of PTCs which in turn will support market growth.

 Eligiblity: Very few investors are made eligible to invest in PTC. A broader aspect in this will pave way for further
liquidity and trading oppurtunities
 Some examples
 First securitisation deal in India between Citibank and GIC Mutual Fund in 1991 for
Rs 160 mn
 L&T raised Rs 4,090 mn through the securitisation of future lease rentals to raise
capital for its power plant in 1999.
 India’s first securitisation of personal loan by Citibank in 1999 for Rs 2,841 mn.
 India’s first mortgage backed securities issue (MBS) of Rs 597 mn by NHB and HDFC
in 2001.
 Securitisation of aircraft receivables by Jet Airways for Rs 16,000 mn in 2001 through
offshore SPV.
 India’s first sales tax deferrals securitisation by Govt of Maharashtra in 2001 for Rs
1,500 mn.
 India’s first deal in the power sector by Karnataka Electricity Board for receivables
worth Rs 1,940 mn and placed them with HUDCO.
 India’s first Collateralised Debt Obligation (CDO) deal by ICICI bank in 2002
 India’s first floating rate securitisation issuance by Citigroup of Rs 2,810 mn in 2003.
The fixed rate auto loan receivables of Citibank and Citicorp Finance India included in
the securitisation
 India’s first securitisation of sovereign lease receivables by Indian Railway Finance
Corporation (IRFC) of Rs 1,960 mn in 2005. The receivables consist of lease
amounts payable by the ministry of railways to IRFC
 India’s largest securitisation deal by ICICI bank of Rs 19,299 mn in 2007. The
underlying asset pool was auto loan receivables
 http://www.financialexpress.com/news/Indian-securitisation/191022/0
 How to Invest in Securitized Product

 Investor should familiar with the following issues

 Asset
 Historical performance
 Structure
 Credit enhancement
 Creditability of parties involved

Risk & Risk mitigation
 Credit Rating
 Other benefits or disadvantages
 Return
 Secondary market