securitisation

Chapter 1:Introduction

Technological advancements have changed the face of the world of finance. Today, it is

more a world of transactions than a world of relations.

Transactions mean the coming together of two entities with a common purpose, whereas

relations mean keeping together of these two entities. For example, when a bank

provides a loan of a sum of money to a user, the transaction leads to a relationship: that

of a lender and a borrower. However, the relationship is terminated when the very loan is

converted into a debenture. The relationship of being a debenture holder in the company

is now capable of acquisition and termination by transactions.

1.1 Basic meaning of Securitisation

"Securitisation" in its widest sense implies every such process, which converts a

financial relation into a transaction.

History of evolution of finance, and corporate law, is replete with instances where

relations have been converted into transactions. In fact, the earliest, and by far

unequalled, contribution of corporate law to the world of finance is the ordinary share,

which implies piecemeal ownership of the company. Ownership of a company is a

relation, packaged as a transaction by the creation of the ordinary share. This earliest

instance of securitisation was instrumental in the growth of the corporate form of doing

business, and hence, industrialisation. The very concept of securitisation is as important

to the world of finance as motive power is to industry.

1.11 Asset Securitisation

The sense in which the term is used in present day capital markets, securitisation has

acquired a typical meaning of its own, and is at times, called asset securitisation. It is

taken to mean a device of structured financing where an entity seeks to pool its interest

in identifiable cash flows over time, transfer the same to investors either with or without

the support of further collaterals, and thereby achieve the purpose of financing.

For example: If I want to own a car to run it for hire, I could take a loan with which I

could buy the car. The loan is my obligation and the car is my asset, and both are

affected by my other assets and other obligations. This is the case of simple financing.

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On the other hand, if I were to analytically envisage the car, my asset, as having the

ability to generate a series of hire rentals over a period of time, I might sell a part of the

cash flow by way of hire rentals for a stipulated time and thus raise enough money to buy

the car. The investor is happier now, because he has a claim for a cash flow, which is not

affected by my other obligations; I am happier because I have the cake and eat it too, and

the obligation to repay the financier is taken care of by the cash flows from the car itself.

1.12 Blend of Financial Engineering and Capital Markets

The present-day meaning of securitisation is a blend of two forces that are critical in

today's world of finance: structured finance and capital markets. Securitisation leads to

structured finance, as the resulting security is not a generic risk in the entity that

securitises its assets but in specific assets or cash flows of such entity. Two, the idea of

securitisation is to create a capital market product, i.e., it results in the creation of a

"security" - a marketable product.

This meaning of securitisation can also be expressed as follows:

Securitisation is the process of commoditisation. The basic idea is to take the

outcome of this process into the capital market. Thus, the result of every

securitisation process is to create certain instruments, which can be placed in the

market.

Securitisation is the process of integration and differentiation. The entity that

securitises its assets first pools them (assuming it is not one asset but several assets,

as is normally the case)[integration]. Then, the pool is broken into instruments of

fixed denomination [differentiation].

Securitisation is the process of de-construction of an entity. If one envisages an

entity's assets as being composed of claims to various cash flows, the process of

securitisation would split these cash flows into different buckets, classify them, and

sell these classified parts to different investors according to their needs. Thus,

securitisation breaks the entity into various sub-sets.

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1.2 Meaning of Security

In the future, financial relations will be converted into and be transferable as "securities".

In connection with securitisation, the word "security" does not mean what it traditionally

might have meant under corporate laws or commerce: a secured instrument. Here it

means a financial claim, generally manifested in form of a document, and its essential

feature being marketability. To ensure marketability, the instrument must have general

acceptability as a store of value. Hence, it is either rated by credit rating agencies, or

secured by charge over substantial assets. Further, to ensure liquidity, the instrument is

generally made in homogenous lots.

1.3 Need for Securitisation

The generic need for securitisation is as old as that for organised financial markets.

Financial markets developed in response to the need of involving a large number of

investors in the market place. As the number of investors increases, the average size per

investors comes down. As the small investor is not a professional investor, he needs a

liquid instrument, which is easier to understand. This sets the stage for evolution of

financial instruments which would convert financial claims into liquid, easy to

understand and homogenous products, at times carrying certified quality labels (credit-

ratings or security), which would be available in small denominations to suit everyone's

wallets. Thus, securitisation generically is basic to the world of finance.

Following are the reasons as to why the world of finance prefers a securitised financial

instrument to the underlying financial claim in its original form:

1. Financial claims often involve sizeable sums of money, beyond the reach of the

small investor. The initial response to this was the development of financial

intermediation: an intermediary such as a bank would pool the resources of small

investors and use the same for the larger investment need of the user. However, then

came the following difficulty.

2. As small investors are typically not in the business of investments, liquidity of

investments is most critical for them.

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3. Generally, instruments are easier understood than financial transactions. An

instrument is homogenous, usually made in a standard form, and containing standard

issuer obligations. Besides, an important part of investor information is the quality

and price of the instrument, and both are easier known in case of instruments than in

case of financial transactions.

In short, the need for securitisation was almost inescapable, and present day's financial

markets would not have been what they are, unless some standard thing that market

players could buy and sell, that is, financial securities, were available.

1.4 Securitisation of Receivables

One of the applications of securitisation has been in the creation of marketable securities

out of or based on receivables. The intention of this application is to afford marketability

to financial claims in the form of receivables. Obviously, this application has been

applied to those entities where receivables form a large part of the total assets of the

entity. Besides, to be packaged as a security, the ideal receivable is one, which is

repayable over or after a certain period of time, and there is contractual certainty as to its

payment. Hence, the application was traditionally principally directed towards housing/

mortgage finance companies, car rental companies, leasing and hire purchase companies,

credit card companies, hotels, etc. Soon, electricity companies, telephone companies,

real estate hiring companies, aviation companies, insurance companies etc. joined as

users of securitisation.

Though the general meaning of securitisation is every such process whereby financial

claims are transformed into marketable securities, one can also say that securitisation is

a process by which cash flows or claims against third parties of an entity, either existing

or future, [that are illiquid], are identified, consolidated, separated from the originating

entity, and then fragmented into “securities” to be offered to a broad range of investors

through the capital markets.

Kenneth Cox says, “Securitisation is a process under which pools of individual loans or

receivables are packaged, underwritten and distributed to investors in the form of

securities.”

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Securitisation of receivables is a unique application of securitisation. For most other

securitisations, a claim on the issuer himself is being securitised. E.g.: in case of issuance

of debenture, the claim is on the issuing company. In case of receivables, a claim on the

third party, on whom the issuer has a claim, is securitised. Hence, what the investor in a

receivable-securitised product gets is a claim on the debtors of the originator. This may

at times further include, by way of recourse, a claim on the originator himself.

The involvement of the debtors in the receivables securitisation process adds unique

dimensions to the concept. One is the legal possibility of transforming a claim on a third

party as a marketable document. It is easy to understand that this dimension is unique to

securitisation of receivables, since there is no legal difficulty where an entity creates a

claim on itself, but the scene is totally changed where rights on other parties are being

turned into a tradable commodity. Two, it affords to the issuer the rare ability to originate

an instrument which hinges on the quality of the underlying asset. Hence, it allows the

issuer to make his own credit rating insignificant or less significant, and the intrinsic

quality of the asset more critical.

1.5 Features of Securitisation

A securitised instrument, as compared to a direct claim on the issuer, will generally have

the following features:

1. Marketability: The very purpose of securitisation is to ensure marketability to

financial claims. Hence, the instrument is structured to be marketable. Marketability

involves two postulates: (a) the legal and systemic possibility of marketing the

instrument (b) the existence of a market for the instrument.

In most jurisdictions of the world, well-coded laws exist to enable and regulate the

issuance of traditional forms of securitised claims, such as shares, bonds, debentures

(negotiable instruments). Most countries do not have legal systems pertaining to

securitised products, of recent or exotic origin, like securitisation of receivables. It is

imperative on part of the regulator to view any securitised instrument with the same

concern as in case of traditional instruments, for investor protection. However, where a

law does not exist to regulate such issuance, it is naïve to believe that it is not permitted.

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The second issue is of having a market for the instrument. Securitisation is a fallacy

unless the securitised product is marketable. The purpose will be defeated if the

instrument is loaded on to a few professional investors without any possibility of having

a liquid market therein. Liquidity is afforded either by introducing it into an organised

market (securities exchanges) or by one or more agencies acting as market makers, i.e.,

agreeing to buy and sell the instrument at pre-determined or market-determined prices.

2. Merchantable Quality: To be market-acceptable, a securitised product has to have

merchantable quality. Merchantable quality in case of financial products, means 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 general rule is: the more broad the base of the investors, the less is the

investors’ ability to absorb the risk, and hence, the more the need to securitise.

For widely distributed securitised instruments, quality evaluation, and its certification by

an independent expert, viz., rating, is common. The rating is for the benefit of the lay

investor, who is otherwise not expected to be able to appraise the degree of risk involved.

Securitisation is a case where a claim on the debtors of the originator is being bought by

the investors. Hence, the quality of the claim of the debtors assumes significance, which

at times enables investors to rely purely on the credit-rating of debtors and so, makes the

instrument totally independent of the originators’ own rating.

3. Wide Distribution: The basic purpose of securitisation is to distribute the product.

The extent of distribution, which the originator would like to achieve, is based on a

comparative analysis of the costs and the benefits achieved thereby. Wider distribution

leads to a cost-benefit, as the issuer is able to market the product with lower financial

cost. But a wide investor-base involves costs of distribution and servicing.

In practice, securitisation issues are still difficult for retail investors to understand.

Hence, most securitisations have been privately placed with professional investors.

However, in time to come, retail investors could be attracted to securitised products.

4. Homogeneity: To serve as a marketable instrument, the instrument should be

packaged into homogenous lots. Most securitised instruments are broken into lots,

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affordable to the marginal investor, and hence, the minimum denomination becomes

relative to the needs of the smallest investor. Shares in companies may be broken into

slices as small as Rs.10 each, debentures and bonds are sliced into Rs.100 to Rs.1000

each. Designed for larger investors, a commercial paper may be in denominations as high

as Rs. 5Lac. Other securitisation applications may also follow this logic.

The integration of several assets into one lump, and then their differentiation into

uniform marketable lots often invites the next feature: an intermediary for this process.

5. Special Purpose Vehicle (SPV): In case, the securitisation transaction involves any

asset or claim which needs to be integrated and differentiated, unless it is a direct and

unsecured claim on the issuer, the issuer will need an intermediary agency to act as a

repository of the asset or claim being securitised. Thus, the issuer will bring in an

intermediary agency to hold the security charge on behalf of the investors, and then issue

certificates to the investors of beneficial interest in the charge held by the intermediary.

So, the charge continues to be held by the intermediary, but the beneficial interest

becomes a marketable security.

1.6 Securitisation leads to Financial Disintermediation

If one imagines a financial world without securities, all financial transactions will be

carried only as one-to-one relations. If a company needs a loan, it will have to seek such

loan from the lenders, who will have to establish a one-to-one relation with the company.

Each lender has to understand the borrowing company, and look after his loan. This is

often difficult, and hence, a financial intermediary, such as a bank, pools funds from

many such investors, and uses these pooled funds to lend to the company. If the company

securitises the loan, and issues debentures to the investors, will this eliminate 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?

1.61 Utilities added by financial intermediaries

A financial intermediary initially came into the picture to avoid the difficulties in a direct

lender-borrower relation between the company and the investors. The difficulties could

have been one or more of the following:

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(a) Transactional difficulty: An average small investor would have a small sum to lend

whereas the company's needs would be large. The intermediary bank pools the investors’

funds to meet the company’s needs. The bank may issue securities of smaller value.

(b) Informational difficulty: An average small investor may not be aware of the

borrower company or may not know how to appraise or manage the loan. The

intermediary fills this gap.

(c) Perceived risk: The risk that 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, as the bank is a pool of several such

individual risks, the investors' preference of a bank to the company is reasonable.

Securitisation of the loan into bonds or debentures solves all the three difficulties in

direct exchange, and hence, avoids the need for a direct intermediary. 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 well disclosed. It avoids the perceived risk

difficulty, as the instrument is usually well secured and rated for investor satisfaction.

1.62 Securitisation: Changing the function of intermediaries

Disintermediation is an important aim of a present-day corporate treasurer, since by leap-

frogging the intermediary; the company reduces the cost of its finances. Hence,

securitisation has been employed to disintermediate.

However, it does not eliminate the need for the intermediary: it merely redefines the

intermediary's role. E.g.: if a company is issuing debentures to the public to replace a

bank loan, it may be avoiding the bank as an intermediary, but would still need the

services of an investment banker to successfully conclude the issue of debentures.

Traditionally, financial intermediaries made a transaction possible by performing a

pooling function, and 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 the background. E.g.: where the bank being the earlier intermediary was

eliminated and instead the services of an investment banker were sought to distribute a

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debenture issue, 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 intermediaries by fee-based distributors. In

the above example, the bank was a fund-based intermediary, a reservoir of funds, but the

investment banker was a fee-based intermediary, a catalyst, and a pipeline of funds.

In case of a direct loan, the lending bank was performing several intermediation

functions noted above: it was a distributor as it raised its own finances from a large

number of small investors; it was appraising and assessing the credit risks in extending

the corporate loan, and having extended it, it was managing the same. Securitisation

splits each of these intermediary functions, each to be performed by separate specialised

agencies. Distribution will be performed by the investment bank, appraisal by a credit-

rating agency, and management possibly by a mutual fund that manages the portfolio of

security investments of investors. Hence, securitisation replaces fund-based services by

several fee-based services.

Figure 1: Traditional Banking and Securitisation

1.7 Securitisation and Structured Finance

Securitisation is a "structured financial instrument". "Structured finance" has become a

buzzword in today's financial market. It means that a financial instrument is structured or

tailored to the risk-return and maturity needs of investors, rather than a simple claim

against an entity or asset.

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On the investors’ side, securitisation seeks to structure an investment option to suit the

needs of investors. It classifies the receivables or 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.

1.8 Securitisation as a Tool of Risk Management

Securitisation is more than just a financial tool. It is an important tool of risk

management for banks. It primarily works through risk removal but also permits banks to

acquire securitised assets with potential diversification benefits. When assets are

removed from a bank's balance sheet, without recourse, all the risks associated with the

asset are eliminated. Credit risk is a key uncertainty that concern domestic lenders. By

passing on this risk to investors, or to third parties when credit enhancements are

involved, financial firms are better able to manage their risk exposures.

1.9 Economic impact of securitisation

Securitisation is as necessary to the economy as any organised markets are. While this

single line sums up the economic significance of securitisation, the following can be seen

as the economic merits of securitisation:

1. Facilitates creation of markets in financial claims: By creating tradable securities

out of financial claims, securitisation helps to create markets in claims. It makes financial

markets more efficient by reducing transaction costs.

2. Disperses holding of financial assets: The basic intention of securitisation is to

spread financial assets amidst as many inestors as possible. Thus, the security is designed

in minimum size marketable lots. 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. Promotes savings: The availability of financial claims in a marketable form, with

proper credit ratings, and with double safety nets in form of trustees, etc., securitisation

makes it possible for lay investors to invest in direct financial claims at attractive rates.

This promotes savings.

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4. Reduces costs: As securitisation tends to eliminate fund-based intermediaries, and

leads to specialisation in intermediation functions, it saves the end-user company from

intermediation costs, since the specialised-intermediary costs are service-related, and

generally lower.

5. Diversifies risks: Financial intermediation is a case of diffusion of risk because of

accumulation by the intermediary of a portfolio of financial risks. Securitisation further

diffuses such diversified risk to a wide base of investors.

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. In this

sense, securitisation carries Gandhi's idea of a capitalist being a trustee of resources and

not the owner. Securitisation in its logical extension will enable enterprises to use

physical assets even without owning them, and to disperse the ownership to the real

owner thereof: the society.

1.10 Risks and Benefits of Securitisation

The Bank for International Settlements in a 1992 publication titled Asset Transfers and

Securitisation had the following to say on the risks and benefits of securitisation:

The possible effects of securitisation on financial systems may differ among countries

because of differences in the structure of financial systems or in the way the monetary

policy is executed. The effects will vary depending on the stage of development of

securitisation in a particular country. The net effect may be potentially beneficial or

harmful, but a number of concerns highlighted below may more than offset the benefits.

While asset transfers and securitisation can improve the efficiency of the financial

system and increase credit availability by offering borrowers direct access to end-

investors, the process may lead to some diminution in the importance of banks in the

financial intermediation process. This could weaken the relationship between lenders and

borrowers, particularly in countries where banks are predominant in the economy.

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Moreover, securitisation might lead to some pressure on the profitability of banks if non-

bank financial companies (NBFCs) exempt from capital requirements were to gain a

competitive advantage in investment in securitised assets.

Although securitisation can have the advantage of enabling lending to take place beyond

the constraints of the capital base of the banking system, it could lead to a decline in the

total capital employed in the banking system, thereby increasing the financial fragility of

the financial system, both nationally and internationally. With a substantial capital base,

credit losses can be absorbed by the banking system. But the smaller the capital base,

more losses must be shared by others. This concern applies especially in those countries

where banks have traditionally been the dominant financial intermediaries.

This article was written in 1992, and it over-stated the potential threats of securitisation.

Since 1992, the market has grown manifold but the threats apprehended here have yet

not materialised. Banks have not become smaller by selling assets, but on the contrary,

have grown. There are two myths in these apprehensions: 1) banks will securitise

substantial parts of their portfolio, which they do not. 2) banks will reduce their balance

sheet size by securitisation, which they do not.

One of the biggest inherent threats in securitisation deals is that the market participants

have necessarily believed securitised instruments to be safe, while in reality, many of

them represent poor credit risks or doubtful receivables. For example, many of the

health-care receivables or student loan receivables may not represent good credits.

One instance of a failure in securitisation deals in the United States of America (USA) is

the securitisation of health care receivables by a company called Towers Financial

Corporation. It was discovered that Towers had been overstating receivables generated

by it by some USD 126.5 million. The proceeds of the issue were used for paying lavish

salaries to the Tower’s officials. Its Chairman was later sentenced to 20 years in prison

for fraud.

Also, the first bank to securitise credit-card payments in 1987- Republic Bank Delaware,

-failed in 1988, and the Federal Deposit Insurance Corp. paid off investors early.

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Securitisation of receivables is one of the latest applications of the generic device of

securitisation. This device has, for the first time, brought to the fore the unlimited

potential of the applicability of securitisation to a diverse variety of assets.

Securitisation of receivables is the first application of the device to securitise and market

assets, hence, it is also referred to as ‘asset securitisation’. In present day capital market

usage, the term includes securities created out of a pool of assets, normally receivables,

which are put under the legal control of the investors through a special intermediary

created for this purpose. The securities are liquidated on the primary strength of the

assets in the pool, but may be supported by "credit enhancements" provided by the

originator or organised through external agencies.

2.1 Parties Involved

a) The Originator: The Originator is the entity that securitises its assets. He is the

original lender/supplier who sells the receivables due from its debtors (the Obligors).

Typically, the Originator is a Development Financial Institution, a Bank, Non-Banking

Financial Company, Housing Finance Company or a Manufacturing/ Service Company.

This is the entity on whose books the assets to be securitised exist. It is the prime mover

of the deal i.e. it sets up the necessary structures to execute the deal. It sells the assets on

its books and receives the funds generated from such sale, the Originator transfers both

legal and the beneficial interest in the assets to the Special Purpose Vehicle (SPV).

b) The Special Purpose Vehicle (SPV): Since securitisation involves a transfer of

receivables from the Originator, it would be inconvenient, to the extent of being

impossible, to transfer such receivables to the investors directly, since the receivables are

as diverse as the investors themselves. Besides, the base of investors could keep

changing, as the security is marketable. Thus, it is necessary to bring in an intermediary

that would hold the receivables on behalf of the end investors. This entity is created

solely for the purpose of the transaction: therefore, it is called a special purpose vehicle.

The function of the SPV could stretch from being a pure conduit or intermediary vehicle,

to a more active role in reinvesting or reshaping the cash flows arising from the assets

transferred to it, which would depend on the end objectives of the securitisation exercise.

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Thus, the originator transfers the assets to the SPV, which holds the assets on behalf of

the investors, issues to the investors its own securities and makes the upfront payment to

the Originator. Therefore, the SPV is also called the Issuer.

c) The Investors: They may be in the form of individuals or institutional investors like

financial institutions, mutual funds, provident funds, pension funds, insurance

companies, etc. They buy a participating interest in the total pool of receivables and

receive their payment in the form of interest and principal as per the agreed pattern.

d) The Obligator(s)/ Obligor(s): The Obligator is the Originator’s debtor (the borrower

of the original loan). The amount outstanding from him is the asset that is transferred to

the SPV. His credit standing is of paramount importance in a securitisation transaction.

e) Principal Structuring Advisor: He has no legal or necessary role, but is generally the

principal advisor on the structure.

f) Underwriter/Merchant Banker: This is the dealmaker who undertakes to get the

issuance subscribed.

g) The Rating Agency: Since the investors take on the risk of the asset pool rather than

the Originator, an external credit rating is important. The rating process would assess the

strength of the cash flow, the mechanism designed to ensure full and timely payment by

selection of loans of appropriate credit quality, the extent of credit and liquidity support

provided and the strength of the legal framework.

h) Legal Advisors: They are the legal counsels who draft the securitisation documents

and provide legal opinions.

i) Credit Enhancers: One or more agencies provide guarantee/ insurance or other credit

enhancement to the transaction.

j) Banker: A banker to operate the lock-box/escrow account where the collections will

be deposited; where the guaranteed reinvestment contract will be maintained

2.2 Certain Concepts

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The claims that the originator securitises could either be, existing receivables, or

receivables to arise in future. The latter is sometimes called future flows securitisation,

in which case the former is a case of asset-backed securitisation.

In US markets, another common distinction is between mortgage-backed securities

(MBS) and asset-backed securities (ABS). The former relates to the market for

securities based on mortgage receivables, which in the USA forms a substantial part of

total securitisation markets. Also See 2.6 – Page 27

Since it is important for the entire exercise to be a case of transfer of receivables by the

originator, not a borrowing on the security of the receivables, there is a legal transfer of

the receivables to a separate entity. In legal parlance, transfer is called assignment of

receivables. One must ensure that the transfer of receivables is respected by the legal

system as a genuine transfer. It has to be a true sale, and not merely financing against

the security of the receivables.

The securities issued by the SPV could either represent a direct claim of the investors on

all that the SPV collects from the receivables transferred to it: in this case, the securities

are called pass through certificates. Alternatively, the SPV might be re-configuring the

cash flows by reinvesting it, so as to pay to the investors on fixed dates, not matching

with the dates on which the transferred receivables are collected by the SPV. Here, the

securities are called pay through certificates. Also See 2.7- Page 28

Another word commonly used, is bankruptcy remote transfer. It means that the

transfer of the assets by the originator to the SPV is such that even if the originator goes

bankrupt, the investors’ rights on the assets held by the SPV are not affected.

2.3 The Process

If an entity having receivables as one of its major assets (leasing co.) has already created

these receivables, it means the company's working capital is tied in the receivables.

Securitisation will unlock this working capital, and make it free for further asset creation.

In this sense, securitisation is a mode of financing, or rather, a mode of disinvesting.

Figure 2: Typical Securitisation Structure

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While the originator selects the receivables to be securitised, a set of discriminants can

be used; but it is not advisable that the company cherry-picks assets, i.e., selects assets of

the best quality leaving behind poor quality assets with the company.

Such selected receivables will be transferred to a special purpose conduit, which could

be a trust or a special purpose corporation, the SPV. So, once the originating company

transfers the receivables to the SPV, the SPV becomes the owner of the receivables.

The SPV issues certificates to the investors indicating the money-value of their

beneficial interest in the pool of receivables. Alternatively the SPV may issue debt

instruments that pay off on stipulated dates, the payment for such debt securities to come

out of the sums received by the SPV. These may be called asset-backed notes or asset-

backed securities. Sometimes, these securities may also be traded on organised

exchanges or second-tier exchanges.

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The company may still continue to act as the servicer, that is, it will continue to collect

the receivables, and remit the proceeds to the investors.

The transfer of the receivables to the SPV, and the creation of beneficial rights therein,

involve complicated legal issues in most countries. Hence, there might be lengthy legal

documentation, and legal formalities (stamping) involved in completing the transfer.

The transfer of receivables to the investors through the vehicle of trust may be with or

without recourse, or with limited recourse to the issuer.

As the servicing is mostly done by the originating company, the debtors may often not

even know of the fact of securitisation, unless they are notified, The servicer continues to

collect the receivables, mostly in a separate escrow account, from where the collections

are drawn by the SPV. The SPV uses this collection, either to pay off to the investors

proportionately (pass-through securitisation), or reinvests the money to pay to the

investors on stated intervals (pay-through securitisation). In case of pass-throughs, since

the SPV would be making a proportionate payment to investors every period, the

transaction automatically comes to an end when substantially all receivables are paid off.

In case of pay-throughs, the originator may have provided some of his own cash, either

his retained profit or over-collateralisation support; therefore, the money left with the

SPV at the end is the originator's profit from the transaction.

If at all any enforcement is required against the debtors, the SPV will take action against

the debtors, but here again, the originator as an agent of the SPV may take the actual

physical and administrative action.

In addition, the following features may be included as part of a securitisation transaction:

-Credit enhancement to support timely payments of interest and principle and to handle

delinquencies

-Independent credit rating of the securitised paper from a well-known rating agency

-Providing liquidity support to investors, such as appointment of market makers.

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Table 1: Basic process of Securitisation of Receivables

2.4 Features of Securitisation of Receivables

1. Mode of Asset-based Financing

As financing markets have become more organised and investing more institutionalised

and hence, professionalised, there is a clear trend towards asset-based financing, rather

than user-based financing. Traditional financing is user- based. For example, where X

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Step 1 The originator either has or creates the underlying assets, that is, the

transaction receivables out of which he will securitise.

Step 2 The originator selects the receivables to be assigned.

Step 3 A special purpose entity is formed.

Step 4 The special purpose company acquires the receivables at their discounted

value (or nominal value if originator's profit is to be retained).

Step 5 The special purpose vehicle issues securities to investors- either debt type

securities or beneficial interest certificates. These are publicly offered or

privately placed as found conducive.

Step 6 The servicer for the transaction is appointed, normally the originator.

Step 7 The debtors are/ are not notified depending on the legal requirements.

Step 8 The servicer collects the receivables, usually in an escrow mechanism, and

pays off the collection to the SPV.

Step 9 The SPV either passes the collections to the investors, reinvests the same

to pay off to investors at stated intervals.

Step 10 In case of any default, the servicer takes action against the debtors as the

SPV's agent.

Step 11 When only a small amount of outstanding receivables are left to be

collected, the originator usually cleans up the transaction by buying back

the outstanding receivables.

Step 12 At the end of the transaction, the originator's profit, if retained and subject

to any losses to the extent agreed by the originator, in the transaction is

paid off.

The Basic Process of Securitisation of Receivables


gives a loan of a certain amount to Y, he looks at the credibility and the worth of

commitment made by Y as the basis of his credit. He confides in Y, the borrower or the

user of the money. He does so because (a) he has the mechanics to know and understand

the worth of Y's commitment; and/or (b) he does not have the mechanics to and

understand the worth of the application to which Y is going to put the borrowed money.

However, as investing becomes professionalised, the professional investor has the ability

to understand the application of the sum borrowed. Hence, he will place more weightage

to the use of the money rather than who the user of the money is.

The user of money is still a source of comfort of the lender. However, the institutional

investor for several reasons cannot afford strictly user-based risks:

(a) The professional investor invests based on a logical assessment of the credit- risks

and not merely based on hunches.

(b) User-based financing is necessarily subjective, since the user is an entity and not an

asset, and the credit-assessment of an entity is as subjective as face- reading. The

professional investor cannot go by subjective appraisal.

(c) Asset is a store of intrinsic value. Therefore, one who looked at the asset and not the

user stands a better chance of recovering his finances

It is difficult to say with certainty that asset-based financing is superior to user-based

financing, but there is a World-over drift towards such financing. The latest financial

innovations- leasing, factoring, leveraged buyouts, securitisation- confirm this move

The most important feature of asset-based financing is that the credit-worthiness of the

user becomes less significant, and the worth of the asset, more significant.

2. Mode of Structured Financing

Once financing is asset-based, the originator can structure the financing based on the

assets or based on the needs of the investor. As the investor is anyway looking at the

asset rather than the entity, the investor's claim is against specific assets, and so, it

becomes possible for the user entity to offer assets, which would suit the needs of the

investor.

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Investor needs can be expressed in various ways. If investor needs are classified based on

their attitudes towards risks, there may be aggressive investors willing to take risks for

better returns, or there may be risk-averse conservative investors. Securitisation structure

can, accordingly carve out securities that are rated at the best possible level, and those

that are junior, or speculative, though they carry a very high rate of return.

Investor needs could also be classified as short-term or long-term. Here again,

securitisation tranches can be categorised into those that pay off fast, those that regularly

pay income but reinvest principal, and those, which are zero coupon bonds.

Securitisation expands the structuring flexibility, since it splits the same asset into many

assets. Thus, it can create different classes of securities linked to the same asset: E.g.:

different maturity periods, different preferential rights, etc. Securitisation has been used

even for creating purely risk-based structures, such as catastrophe bonds carrying

substantially high rates of return but inherent risk for a total loss of principal.

3. Securitisation of Claims against Third Parties

From the legal and investor point of view, the single most important difference between

securitisation of receivables and any other security issuance is that the former seeks to

market claims against third parties and not claims against the originator.

This poses unique problems for the law. Though the right of receiving a certain sum

under a contract is a property, since it is a claim against third parties, there might be a

specific procedure prescribed for its transfer. Securitisation transactions, in most

countries tend to get complicated on account of these legal procedures.

Besides, property laws of most countries require a written document to transfer a

receivable, since transfer of receivables is incapable of a physical manifestation such as

delivery of the receivable. This may also involve exorbitant stamp duties.

Except for negotiable instruments, laws have not visualised parties dealing in

receivables. Hence, most laws have not addressed the difficulties arising in case of a

private asset, such as a receivable being converted into a public asset, such as a security.

What will be the position in case the transferor transfers a part of his interest in a

receivable? These distinctive legal features lead to issues, which have unclear answers in

most jurisdictions.

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That securitised instrument is a claim against third parties is also relevant from the point

of view of investors. Each investor acquires a claim over a receivable or a pool of

receivables. There may not be any claim on the issuer entity. Hence, the quality of the

security is entirely dependent upon a credit assessment of the receivable or the pool.

4. Recourse Features

Being a case of asset-based financing, most originators would ideally like the investor to

look at the asset only, and hence, not have any recourse to the originator. That is, the

investor gets a legally tenable right over the receivable, and hence, he has to recover his

money only from the debtor. In case of failure on the part of the debtor to pay, the

investor has to exercise his rights through the special purpose intermediary, viz., the trust

holding rights over the receivables.

Non-recourse securitisation as far as the originator is concerned should not be taken as a

means of financing, but as a means of financial restructuring. The originator incurs no

obligation to the investors, except to a pre-defined extent. Hence, the securitisation does

not appear as a balance-sheet liability.

However, in most securitisations, the originator is required to add an element of his own

liability to the structure, as a tool of credit enhancement. This is by way of limited

recourse provisions, or by way of participation as an investor himself, with his rights

subordinated to those of the other investor. Unlimited recourse is foreign to the concept

of securitisation, because if the originator continues to carry the same risk in the

transferred portfolio as he did prior to securitisation, the entire transaction may be re-

characterised as a financial transaction rather than a securitisation transaction.

5. Asset Features

Any asset that produces a cash flow over time is a securitisable asset. Given this basic

attribute, securitisation applications have been taken to extremely exotic and

unimaginable extents. However, securitisable assets have some basic attributes:

I. Asset should represent cash flows:

The asset in question should give rise to cash flows over a period of time. Normally, the

cash flows should be steady and easy to identify.

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II. Quality of Receivables:

Securitisation is primarily meant to create a derivative asset (the security) out of a basic

asset (the receivables). The originator expects the derivative asset to stand on its own

worth, and hence, make the credit rating of the originator insignificant. Thus the

receivables being securitised should be of high quality. Past payment statistics are taken

as a yardstick of quality. However, if the securitised receivables have any collateral

protection, the backing adds up to the quality of the receivable.

If the cash flow pool by itself does not have an underlying collateral, it may be necessary

to back up the cash flows with extraneous securities or provide for over-collateralisation.

Quality is to be decided based on the needs and perception the investors. At times, the

investor might lay more stress on a recourse provision rather than on asset-quality.

III. Diversification of the portfolio:

If the quality of the components of the portfolio is extremely good, diversification

becomes unnecessary. Generally, securitisation is resorted to market rights in several

small-ticket items, each of which individually may not be an acceptable risk, but all

taken together become acceptable, because of the diversification of risk.

The degree of distribution of the portfolio is an important issue in its rating. A rating

agency would like to ensure that the portfolio is so diversified that the contagious effect

of decay in a single asset, is not likely to affect the health of the portfolio. No individual

asset should have a significant value relative to the size of the portfolio.

IV. Size of individual receivable:

Diversification and size or quality of the individual receivable act as mutually offsetting

factors: small size and relatively poor quality of the receivable is offset by greater

diversification, and vice versa.

V. Periodicity of payments:

The payment on account of the underlying assets should be periodic, and not one time.

Periodically paying assets are more conducive to securitisation as they have a smooth

regular cash flow, and give enough money for regular servicing of investors. 24


VI. Homogeneity of the assets:

The underlying assets should by and large be homogenous. E.g.: car loans of the same or

similar type- say, for the same maturity, similar risk features etc. The advantage in

homogenous assets is that the pooling and the analysis of the pool will be easier, since

historical data can be applied to project the risks in the portfolio. E.g.: car loans and

equipment leases will not be fit to be pooled, as their features are totally different.

VII. No executory clauses:

The contracts to be securitised must work, even if the originator goes bankrupt. The

contract should not contain an obligation on the part of the originator or issuer.

VIII. Capacity to assign:

Securitisation involves transfer of a right to receive - it is a transfer of a right against a

third party to the assignee. Thus, it is required that the law or the contract between the

parties should not prohibit the right to assign. Normally, the right to assign a receivable

is an inherent property right, but legal formalities may be required.

IX. Independence from the originator:

The on-going performance of the assets and the making of claims against the debtors

must be independent of the existence of the Originator. As far as possible, the underlying

contracts should not require something to be done by the originator or should not depend

upon the originator being a running concern.

X. Assets should preferably be free of withholding taxes/ pre-paid taxes:

If withholding taxes were applicable on payments to be made by the debtors, who would

take the credit for the withholding tax? The originator collects the payment, but on behalf

of the SPV, which in turn collects it on behalf of the investors. It would be logistically

impossible to allow the benefit to set off to the investors directly: thus, the SPV/

originator will be forced to take the credit for the pre-paid tax, which may be technically

objectionable. Also, as withheld taxes qualify for a refund only after the tax assessment

is complete, a residuary receivable, which may be collected much after the expiry of the

scheme, may be created.

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6. Issuer Features

I. Receivables as major assets:

Securitisation of receivables presupposes that the issuer has a bulk of its assets or future

assets in form of receivables. Besides, the receivables must satisfy the features discussed,

significantly, that the receivable should not be for a very short term to frustrate the

securitisation exercise. Generally the following companies find securitisation a viable

option:

(a) Real estate finance companies: Securitisation of receivables originated with

mortgage finance companies. These companies are best suited, since they satisfy the

features more than any one else. They are predominantly a receivable-oriented company.

The receivables are quite long- term. They are generally secured by way of mortgage

over the property finance. In the USA, where it originated, these mortgages were also

secured by guarantees from the Govt. The receivables also satisfy the diversification

features.

Based on excellent security, viz., real estate, it is possible for these companies to part

with receivables on non-recourse basis. Even as of now, the market for real-estate

securitisation is much larger than all other varieties.

(b) Non-mortgage finance companies: Securitisation was caught up by other finance

companies, particularly automobiles financing companies. Auto-loan companies broadly

fulfilled the necessary features. The security in this case was also considered good,

because of title over a utility asset with ready remarketing possibilities.

Later, leasing companies, consumer assets financiers entered the fray, coupled with

credit enhancement techniques such as collaterals, recourse provisions, etc.

(c) Car rental companies: These companies rent out cars on contractual hiring terms,

and they are essentially securitising an estimated rental value based on past experience.

Hence, a future asset and not a pre-contracted receivable is being securitised here.

(d) Credit card companies: The average credit period in a credit card deal is generally

very short, may be a month. But as the credit is revolving, based on past experience, a

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receivable is created. There is a special revolving structure, since it is impossible to

match the payment made by the cardholder with the payment to the investor.

(e) Hoteliers and real-estate renters: Based on occupancy experience in case of hotels

and estimated rentals in case of real estate, future receivables have been securitised,

generally with either a recourse provision or a collateral.

(f) Electricity and telephone companies: They have an excellent opportunity of

securitising electricity meter rentals and telephone rentals. The receivables in these cases

are very widely spread, and delinquency record very favourable.

(g) Banks: To overcome capital adequacy problems, banks have resorted to

securitisation of their loan portfolios by issue of participation certificates or transferable

loan certificates. They are not exactly a mechanism to transfer receivables, but they

allow the holder to participate in the benefits arising of the portfolio of loans securitised.

Wherever a reasonably certain sum of money will be received over a certain time period,

not very short, securitisation possibility exists. Some of the latest applications include

securitisation of intellectual property rights, sports earnings, music royalties, etc.

II. Financial and organisational strength:

As such, in securitisation, the financial strength of the issuer is not important. However,

no securitisation (except those guaranteed by external agencies) is completely

independent of the originator. Originator rating casts a shadow on the securitisation

transaction. Hence, the originator should be a reasonably strong entity. While the

financial strength of the originator may not be very significant, his organisational

strength certainly is, since the originator would continue to service the product.

7. SPV features

The following are necessary from the legal viewpoint and to safeguard investor interests:

I. Sub-contracting services required for maintaining the SPV and its assets –e.g.:

administering its receivables, company secretarial work, so that SPVs do not have an

administrative infrastructure of their own and do not have obligations that could take

them to bankruptcy.

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II. SPVs are not permitted to have any employees (normally) or to have general

fiduciary responsibilities to third parties (e.g.: acting as a trustee)

III. Any person who contracts with the SPV must agree not to sue it in event of failure

of the SPV to perform under the contract (unless he is ‘senior’ and effectively rated)

IV. All of the SPVs liabilities (present and future) should be quantifiable, and shown

to be capable of being met out of the resources available to it; funds, which are due to the

SPV, have to be separated as soon as they are received.

8. Investor features

I. Professional and fixed, regular income investor: Most investors in securitised

products, except for mortgage-backed securities, are institutional investors.

II. Investor for a fixed period: In view of limited common-investor interest, secondary

markets in securitisation may not be vibrant. Hence, securitised products may not be very

liquid. Because of accounting rules, the issuer is discouraged from giving any buy-back

facility for securitised products, unless the off-balance-sheet treatment is not a serious

concern. Hence, investors must have the ability to keep investments locked over a term.

2.5 Securitisation and Factoring

Factoring is an age-old British concept, where the factor acquires the debts of a client,

pays for the same instantly, and generally manages the same.

Though the device used for securitisation and factoring is the same, viz., transfer of

receivables, the nature and the inherent purpose in the two are entirely different. A factor

intends to offer services relating to the management of a client's receivables portfolio,

whereas the intention of securitisation is to render marketable the receivables, while the

creditor company (issuer) would continue to manage the receivables. In case of

factoring, financing is incidental and the prime purpose is to transfer the servicing of the

receivables to the factor. In case of securitisation, financing is a predominant objective

and transfer of servicing is either not there at all, or even if it is there, it is to a

specialised servicer.

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Factoring normally does not remove the credit risks inherent in the receivables, unless

the factor buys receivables without recourse. In case of securitisation, one of the basic

purposes is to limit, if not completely remove, risks in the portfolio.

Factoring is mostly one-to-one transaction: the creditor transfers the portfolio to the

factor who collects it. In case of securitisation, the creditor transfers the portfolio to the

SPV, which issues marketable securities to fund the acquisition: therefore, a marketable

security is the end-result.

2.51 Securitisation and Portfolio Sales

A portfolio sale occurs when one originator sells a portfolio, e.g.an auto loan portfolio, to

another. Normally, the acquirer is also an auto finance company, and usually larger.

Sometimes, banks also transfer their loans, either to a specific borrower or to a group of

borrowers, to other banks.

Securitisation differs from such portfolio sales in its basic purpose. The purpose is not to

transfer a portfolio from one market player to another, but to transfer the portfolio

reconfigured as marketable securities to investors in the capital market. In case of

portfolio sales, the sale is normally accompanied by transfer of servicing: not so in case

of securitisation. Securitisation classifies risks, splits them and allocates them to various

entities either as credit enhancers or as different classes of investors: portfolio sales

transfer generic risk in the portfolio.

2.6 Mortgage-Backed Securities and Asset-Backed Securities

Distinction is often made in the US-market parlance between mortgaged-backed

securities and asset-backed securities. The former refers to the securitisation of mortgage

loans-commercial as well as residential. The latter is mostly taken to mean securitisation

of non-mortgage assets.

In USA, the mortgage market is considered very safe since the mortgages are guaranteed

by the agencies such as the Government National Mortgage Association (GNMA),

Federal National Mortgage Association (FNMA) or Federal Home Loan Mortgage

Corporation (FHLMC). Therefore, mortgage backed securities are normally not

29


collateralised, and are mostly risk-free except for prepayment risk. However, in case of

non-mortgage securities, over- collateralisation is normally insisted.

The existence of collateral requirements would lead to a difference in structure. In the

agency structures, the agencies themselves act as the managers of the SPV. They set up

trusts to issue notes to investors, and with the money so raised; they buy the mortgages

created by the mortgage financiers/ credit unions. Once securitised, the mortgage creator

is completely off any responsibility as regards the administration of the SPV.

2.7 Various Forms Of Securitisation Structures

Securitisation structures refer to the way the investors have a right to share the cash

flows arising out of the pool of receivables beneficially owned by them. None of these

structures are universal and the suitability for different classes differs.

2.71 Pass-throughs or non-tranched Securitisation

Securitisation originated in the USA in mortgage financing markets, and the earliest

securitisation technique used was a pass-through.

The issuer (SPV) passes to the investors the entire interest in the securitised portfolio. All

that the SPV does is collects the receivables and pays them over. The investors have a

direct beneficial, proportional interest in the pool of receivables, as also in the collections

based on the pool. For example, if there are 1000 pass-through certificates in a pass

through issue, and for any particular month, the SPV collects $ 15,406,000; each pass-

through certificate holder will be paid $ 15,406. In other words, what the investors get,

and how the investors get, is what the SPV receives, and how the SPV receives.

2.711 Difficulties in Pass-through Structures

The US mortgage market was suitable for a pass-through structure as the mortgages were

backed by guarantees from government agencies. There were meagre chances of default.

The greatest difficulty with the pass-through structure is the erratic, unpredictable cash

flow structure, and the periodicity of the cash flows. So, if the underlying receivables are

payable every month, investors get repaid every month, imposing heavy servicing costs.

30


Pass-throughs have therefore been largely confined to the agency-facilitated mortgage

market. However, this market itself is sufficiently large, and in fact, mortgage pass-

throughs represent the largest segment of the securitisation market.

2.72 Pay-through Structure

The difficulty with pass-throughs was the direct association of recoveries with payments

to the investors. Monthly repayments may not suit retail investors, who prefer quarterly

or half-yearly receipts. That requires dissociation between recoveries and repayments.

This led to the super-imposition of a loan structure on a securitisation device: the SPV

instead of transferring undivided interest on the receivables would issue debt securities,

normally bonds, repayable on fixed dates, but such debt securities in turn would be

backed by the mortgages transferred by the originator to the SPV. As in case of the pass

through structure, the originator would transfer the mortgages to the SPV, the SPV

would make temporary reinvestment of such cash flows (to the extent required for

bridging the gap between the date of payments on the mortgages and the date of

servicing of the bonds), and use the cash flows from the mortgages along with the

income out of reinvestment to retire the bonds. Such bonds were called mortgage-

backed bonds. The word "pay through,” indicates that as against pass throughs, where

the payment on account of the mortgages is simply passed through the SPV to the

investors, in the present case, it is paid through the SPV to the investors. Here the SPV is

not merely a passive conduit, but it receives, reinvests and pays money.

2.73 Collateralised Mortgage Obligation Bonds

As the pay-through structure had already mixed and matched an element of traditional

debt with securitisation, the next logical development was to add an element of financial

engineering: resulting into creation of collateralised mortgage obligation (CMO) bonds.

Though the pay-through mechanism solved one of the difficulties of the pass-through:

that is, mismatching the recoveries and repayments, it still did not allow the investors the

facility of differing tenure choice and differing repayment choices. Passing on equal

payment to all is ignoring their differing needs. The CMO bonds solved this difficulty.

31


The CMO structure breaks the investors into different tranches, based on the duration for

which they want to invest. E.g.: the A series of investors would be repaid first- so the

entire principal collected, is first used to fully pay off the A class investors. Once A class

is fully retired, repayments are made to B class. The last is the Z class, which would

receive a bullet payment right at the end of the transaction. In the meantime, the interest

collected may be passed on to all the investors as per their outstanding investment.

Thus, this structured investment option allows the investors to invest according to their

investment objectives. Short-term investors would carry lesser of risk, get paid back first,

and hence would expect a lesser rate of return. Medium-term investors have more risk to

shoulder, as their investment will be subject to all risks that remain after paying off the A

class investors. It is Z class investors (normally the originator himself) who takes all the

risks, and can target the highest rate of return.

CMO bonds are a hybrid between pay-through and pass-through structures. The

payments received by the SPV from the underlying mortgages are passed through to the

investors. However, the cash flows are repaid in tranches to different investors and the

risks are being divided- thus, there is the re-configuration element also.

2.74 Revolving Assets Securitisation

This is used for short-lived assets such as credit card receivables, short-term lease

rentals, etc. Here, the originator passes interest to the investors in a revolving pool of

assets, where assets pay off, but are re-instated by fresh stock of receivables.

Credit card receivables typically pay off within a month or so. The entire principal along

with the interest is paid off within this time. On the other hand, the investors would like

to lock in their money for a reasonably long period, say 3 years or so. The money is

pooled with the SPV, which buys the requisite amount of credit card receivables from the

originator, and once these receivables are paid off, it retains the interest for servicing the

investors. When it is time to amortise the receivables, the principal collected is used to

pay off the principal to the investors either in several instalments or in a bullet payment.

Most revolving assets securitisation have a right to acceleration of principal repayment:

in case of certain events, the SPV may use the principal repayments in any month not for

acquiring fresh receivables but for paying off the investors before the scheduled

32


repayment date. This is a basic protection needed, because the assets are of a revolving

nature, and every month or so, the investors' asset cover in form of receivables is being

depleted, until it is replenished. This results into an originator's performance risk: if the

originator exits business, or does not produce new receivables to replenish those paid off,

the investors may have no asset backing for their investments. In order to take care of

such contingency, there might be a trigger event, a decline in receivables generation over

a certain period, which would lead to acceleration of repayment to the investors.

2.75 Future flows Securitisation

Securitisation of future flows is an exciting application of securitisation, particularly for

emerging market countries. Mexico was the first country to securitise future flows in

1987- securitisation by Teléfonos de México S.A. de C.V. of telephone receivables.

Here, the asset being transferred by the originator is not an existing claim against

existing obligors, but a future claim against future obligors. The claims are yet to be

created, against obligors who are yet to be identified. Examples can be: export

receivables (normally crude exports), future royalties, hotel revenues, sports receivables.

Most of the future flow securitisations are by originators from emerging markets, whose

offshore borrowing abilities are stymied by the sovereign rating of the country where the

originator is stationed. E.g.: If a Brazilian originator having export revenues were to raise

offshore money, the international rating of the originator is capped at the rating of the

country, even though his domestic rating may be AAA. Such an originator will either not

be able to source cross-border funding at all (from investors who as a matter of policy do

not invest in below-investment grade securities) or would have to pay a very high cost.

Future flow securitisation essentially aims at piercing the rating of the sovereign and

having a security of the originator rated above the rating of the sovereign. If, in the

example above, the originator is an exporter, exporting oil to US buyers, and if he

securitises the oil exports such that the receivables are trapped and deposited in an

account in New York, which is assigned to the SPV, the investors would:

not be subject to exchange risk, as the receivables are in foreign exchange

not be subject to sovereign risk as the receivables have been assigned by way of a

true sale outside the country of the originator.

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2.751 Motivations in future flow securitisation

An originator in a future flow securitisation would look essentially at two motivations:

does it allow the originator to borrow more than under traditional funding methods?

does it allow the originator to borrow at lesser cost than traditional funding methods?

A future flow securitisation may allow the originator to borrow more, since, while a

typical traditional lender looks at the assets on the balance sheet (receivables which have

fallen due), a future flow investor looks at receivables that are not on the balance sheet.

A future flow transaction may even allow the originator to borrow at lesser costs, for

reasons discussed above, particularly in case of cross border financing.

2.76 Asset-backed commercial paper conduits

They are essentially asset-backed funding devices, usually for trade receivables. These

are specialised conduits/ intermediate agencies that acquire trade receivables of several

originators, and issue commercial paper (CP) backed by such receivables. Most ABCP

conduits are organised by banks, as liquidity is important for a CP program.

The template for the present-day ABCP conduits was created by Citibank in 1983. Banks

view ABCP programs as a substitute for direct working capital funding to their clients.

Instead of keeping traditional working capital finance on their balance sheet, a bank

would motivate its customers to sell their trade receivables to the conduit, which would

be funded by capital markets by issuance of commercial paper. The bank would merely

provide a stand by support in terms of liquidity and credit enhancements.

The motivation of the bank is simple: it keeps the bank's balance sheet light. The bank

has to keep lower capital for the assets, to the extent of the off-balance sheet

commitment for liquidity. For the corporate borrowers, this would be a more efficient

and perhaps cheaper way of working capital funding as it disintermediates the bank.

Because of the existence of a specialised conduit, the costs of setting up conduits or

coming out with a commercial paper issue of one's own are avoided. Hence, the ABCP

conduit is an efficient alternative to commercial paper issuance. Larger borrowers with

good ratings have set up their own single-seller conduits.

34


3.1 Advantages of Securitisation for the Issuer

1. Lower cost

Cost reduction is one of the most important motivations in securitisation. Securitisation

seeks to break an originating company's portfolio into echelons of risks, trying to align

them to different investors' risk appetite. This alchemy supposedly works - the weighted

overall cost of a company that has securitised its assets seems to be lower than a

company that depends on generic funding. One of the most tangible effects of

securitisation is to reduce the extent of risk capital or equity required for a given volume

of asset creation. Assuming that equity is the costliest of all sources of capital, lower

equity requirements do result into lower costs.

Securitisation enables the originator to achieve a rating arbitrage - obtain a rating that a

generic funding could not have. Such a rating is possible due to the structural

enhancements in securitisation – senior/junior structures, or a Z-bond structure.

In future flows securitisation; the objective of the originator is to achieve ratings higher

than the rating of the entity or the rating of the originator’s country. As securitisation

makes such higher ratings possible, it enables the originator to borrow at lower costs.

2. Retail distribution of assets

Securitisation enables a financial intermediary to retail-market its assets to a large

section of investors. The intermediary’s role is changed from a fund-based intermediary

to a distributor of an asset, while maintaining its spreads. Retail distribution of liabilities

remains the aim of any financial firm. Securitisation offsets a retail liability against a

retail asset, and hence, achieves this purpose.

3. Makes the issuer-rating irrelevant

Being an asset-based financing, securitisation may make it possible even for a low-rated

borrower to seek cheap finance, purely on the strength of the asset-quality. One of the

common statements, rating companies make is: in a normal debt issuance, we rate a

35


product. In structured finance, the issuer dictates the rating, and the structure is worked

out accordingly. It is possible to obtain a AAA rating for securitised products,

irrespective of the originator’s rating -there should be adequate legal protection against

the originator’s bankruptcy and adequate credit enhancement.

4. Off-balance sheet financing

Financial intermediaries look at securitisation essentially as an off-balance-sheet funding

method. The off-balance sheet feature could be looked at either from the accounting

viewpoint, or from the regulatory viewpoint. The latter is relevant for computation of

regulatory capital or capital adequacy requirements. From the accounting viewpoint: the

tendency, of financial institutions and others, to prefer off-balance sheet funding over on-

balance sheet funding is because the former allows higher returns on assets, and higher

returns on equity, without affecting the debt-equity ratio. As tools of managerial

performance, these have a definite relevance.

Securitisation allows a firm to create assets, make income thereon, and yet put the assets

off the balance sheet the moment they are transferred through securitisation. Thus, the

income from the asset is accelerated and the asset disappears from the balance sheet,

leading to an improvement in both income-related ratios as also asset-related ratios.

5. Helps in capital adequacy requirement

Capital adequacy requirements are requirements relating to minimum regulatory capital

for financial intermediaries. A very strong motivation for securitisation is that it allows

the financial entity to sell some of its on-balance sheet assets, and remove them from the

balance sheet, and hence reduce the amount of capital required for regulatory purposes.

Alternatively, if the amount raised by selling on-balance-sheet assets is used for creating

new assets, the entity is able to increase its asset-creation without a haircut for its capital.

Motivated by this, large commercial banks have made extensive use of securitisation.

This has led to formation of some regulations on capital requirements for securitisation

in different countries. These regulatory requirements define the conditions subject to

which securitisation will be given off-the-balance-sheet treatment, and, if off the balance

sheet, the required capital deduction for the risks retained by the originator.

36


In spite of these guidelines, it is a common experience that securitisation has enabled

banks either to reduce the level of their on-balance sheet assets, or to achieve a higher

amount of asset-generation with a given amount of capital.

6. Improves capital structure

By being able to market an asset outright (while not losing the stream of profits therein),

securitisation avoids the need to raise a liability, and hence, it improves the capital

structure. Alternatively, if securitisation proceeds are used to pay off existing liabilities,

the firm achieves a lower debt-equity ratio.

The improvement of capital structure as a result of lower debt-equity ratio may not be a

mere accounting gimmick - if securitisation results into either transfer of risks inherent in

assets, or capping of such risks, there is a real re-distribution of risks taking place,

leaving the firm with a healthier balance sheet and reduced risk.

7. Better opportunity of trading on equity with no increased risk

This point is a re-statement of the accounting and capital-adequacy-related benefits,

discussed earlier. The ability to create assets, as a result of off-balance-sheet treatment

and regulatory freedom, results into more profits and hence a stronger firm.

8. Extends credit pool

Securitisation keeps the other traditional lines of credit undisturbed; hence, it increases

the total financial resources available to the firm. Many firms, in addition to regular

borrowings have tried securitisation, not in place of it.

9. Not regulated as a loan

Most countries have laws regulating borrowing abilities of financial companies, since

they are taken as para-banking companies. Securitisation does not suffer borrowing-

related fetters, as it is not taken by regulation to be debt. E.g., a regulation relating to

borrowings from public will not be attracted, since it is not a case of borrowing.

From the point of view of law, often, the distinction between securitisation and

borrowing is based on a strict interpretation of the word "borrowing": thus, securitisation

with recourse may not qualify for off-balance sheet purposes or for capital adequacy 37


requirements, but when it comes to a borrowing-related legislation, the same is not to be

taken as a debt. In India, for example, securitisation will escape regulation pertaining to

raising of deposits by financial companies, as such regulation is a part of the law not a

prudential regulation.

10. Reduces credit concentration

Securitisation has also been used by many entities for reducing credit concentration.

Concentration, either sectoral or geographical, implies risk. Securitisation by transferring

on a non-recourse basis by an entity has the effect of transferring risk to the investor.

11. Escapes taxes based on interest

For technical purposes, securitisation would not be treated as "interest" on loans. Hence,

if there are taxes based on interest earnings, they would not be applicable to investors'

earnings in securitised products. In India, interest-tax on interest income of banks/

financial institutions will not be applicable in case of investments in securitised products.

Besides, withholding taxes that apply solely to interest payments will not apply in case of

a tax-acceptable securitisation.

3.2 Advantages of Securitisation for the Investors

Needless to emphasise, advantages to the originator would not carry much relevance

unless securitisation was an attractive option for investors too. All over the world,

investors, particularly institutional investors, have shown active interest in investing in

securitised products. Rating agencies have helped in promoting these interest levels since

most securitised products have obtained good ratings, and in several cases, even with the

downgrading of the entity, the structured finance offerings have not been downgraded.

3.21 Who are securitisation investors?

Securitisation has drawn in a large cross-section of investors. The mortgage pass-

throughs in the USA are actively traded in organised markets and have drawn both

institutional and retail investors. But other asset classes resulting in creation of securities

are not easy for retail investors to understand. Besides, being high- grade, low return and

fixed income securities, securitisation has basically drawn institutional investors.

38


Some securitisation investors: high net worth individuals looking at diversification and

hedging, pension funds, insurance companies, bank trust departments, investment funds,

commercial banks, finance houses, mortgage banks, etc.

3.22 Investor Motivations

1. Good ratings

As already noted, many structured finance offerings have obtained good ratings. With

increasing institutionalisation of investment, investments are being managed by

professional managers who prefer a formally rated instrument to an unrated one.

2. Better matching with investment objectives

Securitised instruments are flexible to match with investors’ investment objectives.

Investors looking for a safe high-grade investment can pick a senior most A-type

product. Those looking for a mediocre risk with higher rate of return can opt for a B-type

option. Investors can also look at investing over a short term, medium term or long term.

3. Yield premiums

Securitised offerings have offered good yields with adequate security. Empirical data

reveal that an investor who maintained a good balance of emerging market and

developed market offerings has been able to come out with good rates of return.

4. Lesser regulation

If there are any regulations or taxes applicable on investment products, it is unlikely that

they will apply to securitisation products. E.g., investments by non-financial companies

may be limited by a statute, such as Sec372A of the Companies Act in India: but this

limitation will not apply to a securitisation transaction.

3.3 Limitations of Securitisation

1. Costly source

The aggregate cost of securitising assets is theoretically expected to be lower than the

cost of mainstream funding. However, securitisation has been shown to be a costly

39


source, primarily in emerging markets. Being a new product, investors pay a penalty for

their own lack of understanding. Also, the costs of rating and legal fees tend to be huge.

2. Uneconomical for lower requirements

The huge upfront costs in the form of rating fees and legal costs, including stamp duties

where applicable, would add up to a heavy initial payment. Securitisation in order to be

cost effective has to be limited to large sourcing.

3. Passes on data-base to investors

One of the most important limitations of securitisation is that the entire data about the

receivables is passed on to the SPV. The SPV may technically be under the control of the

originator himself, but beneficiaries have a legal right to inspect the books of the SPV.

Hence, in a competitive environment, a competitor may corner the company's portfolio

and push the originator out of the market.

4. Leaves the entity with junk assets

If the investors prefer cherry-picked assets, securitisation will leave the originator with

junk assets. If one imagines an entity as a composite of good, medium and poor assets, if

the good assets are chipped off, what remain are junk assets.

The Bank for International Settlements in a 1992 publication, said:

It is sometimes contended that banks in seeking a good market reception for their

securitised assets may tend to sell their best quality assets and thereby increase the

average risk in their remaining portfolio. Investor and rating agency demand for high

quality assets could encourage the sale of an institution's better quality assets.

Such arguments are not easy to support with empirical evidence. Banks that have

securitised large amounts of assets do not exhibit signs of lower asset quality. Banks,

which constantly securitise assets, are necessarily interested in maintaining the quality of

their loan portfolio. Any asset-quality deterioration would affect their reputation and

their rating and indeed the capital adequacy requirement imposed by their supervisors.

40


4.1 Introduction

The development of the securitisation market as a standard funding option across most

industries has been the result of a constantly expanding universe of securitisable non-

mortgage asset types. This chapter lays emphasis on three potential areas of

securitisation in India - MBS, ABS and Infrastructure Sector.

4.2 Mortgage Backed Securities (MBS)

Securitisation of assets began with, and in sheer volume remains dominated by

residential mortgages. The receivables are secured by mortgage over the property being

financed, thereby enhancing the comfort for investors (because mortgaged property does

not normally suffer erosion in value like other physical assets through depreciation). It is

more likely that real estate appreciates in value over time. Further,

The receivables are medium to long-term, catering to the needs of different investors;

The receivables consist of a large number of individual homogenous loans that have

been underwritten using standardised procedures, hence suitable for securitisation;

In USA, where it originated, mortgages were also secured by Government

guarantees;

The receivables also satisfy investor preference for diversification of risk, as the

geographical spread and diversity of receivable profile is very large.

In the Indian context, the funds requirement in the housing sector is immense, estimated

at Rs. 150,000 icrore during the current five-year plan. Of this, it is envisaged that about

Rs 52,000 crore would be financed by the formal sector. It is unlikely that this gap can be

filled out of budgetary allocation or regular bank credit. Securitisation allows this gap to

be bridged by directly accessing the capital markets without intermediation.

Securitisation tends to lower the cost at which the housing sector accesses funds. It also

facilitates a sufficiently deep long term debt market. It is estimated that about Rs 2,500

crore would be mobilised through securitisation during the current five-year plan.

i National Housing Bank41


4.3 Asset Backed Securities (ABS) – Existing assets

(a) Auto loans: In India, the auto sector has been thrown open to international

participation, greatly expanding the scope of the market. The security in this case is

considered good, because of title over a utility asset. The development of a second hand

market for cars in India has also meant that foreclosure is an effective tool in the hands

of auto loan financiers in delinquent cases. Originators are NBFCs and auto finance

divisions of commercial banks.

(b) Investments: Investments in long dated securities as also the periodical interest

instruments on these securities can be pooled and securitised. This is considered relevant

for India where financial institutions are carrying huge portfolios in Government

securities and other debt instruments, which are creating huge asset-liability mismatches.

(c) Others: Financiers of consumer durable, corporates whose deferred trade receivables

are not funded by working capital finance, etc are Originators of other asset classes

amenable to securitisation. Corporate loans, in a homogeneous pool of assets, are also

subject to securitisation.

Despite the fact that the markets for ABS are exceptionally large, there is virtually no

known instance so far, of an ABS transaction having failed. Industry experts attribute

this to three factors. ABS transactions are always planned, prepared and carried out with

great care. Second, the intrinsic value of the paper and particularly the high level of

transparency on the quality of the underlying assets. Third, ABS transactions are

sponsored generally by large and well-known institutions that cannot afford to jeopardise

their reputation with investors, the majority of which are institutional investors.

4.4 Securitisation of Infrastructure Receivables

The India Infrastructure Report 1995 estimated that a total outlay of Rs 400,000 –

450,000 crore would be required for infrastructure financing.

42


Along with the Government’s attempt at attracting private investment into infrastructure

funding, the role of innovative funding like securitisation is vital. The suitability of

securitisation for infrastructure funding stems from the fact that cash flows are stable and

concession driven, and the ultimate credit risk is partly guaranteed by the Government.

Securitisation is appropriate at the post-commissioning stage when the project begins to

generate cash, with overall project risk being largely replaced by credit risk.

4.5 Future receivables

Providers of utilities such as electricity and telephone services have an excellent

opportunity of securitising electricity meter rentals and telephone rentals. The

receivables in these cases are very widely spread, and delinquency record very

favourable. E.g.: VSNL, being a gateway for inward traffic of international calls, gets a

large and steady inflow of foreign exchange that is ideal for securitisation.

(a) Export receivables: Such securitisation can be considered by (i) financing FIs or (ii)

exporters themselves. The receivables must have a reasonable span of life so that they

can be segregated and covered by a market instrument. Among the Institutional lenders,

EXIM Bank may be able to undertake securitisation since they are involved in financing

exporters on deferred terms.

Here, the rights to receive future dollar cash flows can be transferred to an SPV outside

India. The offshore vehicle issues the securities. As a result, the cash flows are first

received outside India for payment to investors. Thus, it is possible to receive a rating on

the securities higher than the India sovereign ceiling. Consequently, these transactions

are not affected by the legal issues in India. Such transactions have been done in Mexico.

(b) Credit card receivables: As mentioned earlier, although the average tenure of credit

available to a credit card holder is generally very short (less than two months), it is

revolving in nature. Originators are credit card divisions/subsidiaries of commercial

banks, including a number of foreign banks.

(c) Airline ticket receivables: Future sales of airline tickets can be securitised

considering the predictability of their cash flows.

43


(d) Future oil sales: Oil sales from confirmed oilfields can form a large pool of assets,

suitable for securitisation, especially considering that the Obligors would normally be

high quality corporates

(e) Lease rentals: Equipment and real estate leases exhibit characteristics amenable to

securitisation, particularly in respect of a fixed payment schedule for the lease rentals. In

the Indian context, there is ample scope for securitisation of future flows in this asset

class in view of the impressive growth of hire purchase and leasing finance companies.

Originators are NBFCs and leasing divisions of commercial banks.

4.6 The Indian Experience

Securitisation is a relatively new concept in India but is gaining ground rapidly. CRISIL

rated the first securitisation deal in India in 1991 when Citibank securitised a pool of

Rs.16crore from its auto loan portfolio and placed the paper with GIC Mutual Fund.

Since then, securitisation of assets has begun to emerge as a clear option of fund raising

by corporates. Many manufacturing companies and service industries too are

increasingly looking towards securitising their deferred receivables and future flows also.

CRISIL has rated transactions worth over Rs 4,500 crore to date. Other rating agencies in

India, viz., ICRA, DCR and CARE have also been actively involved in the process. The

majority of these being in the nature of outright sales of auto loan portfolios without

subsequent issue of securities and do not amount to securitisation in the real sense. There

has till date been no instance of downgrading of the rating assigned to any of these

transactions. Securitisation has also been attempted for property rental receivables,

power receivables, telecom receivables, lease receivables etc.

Some of the pioneering transactions that have either been concluded or are being

structured in this regard are described in the following sections.

(a) Housing Loans: In India, of late there has been a positive orientation of Government

policies towards securitisation for the housing sector. The five-year Plan documents have

repeatedly emphasised the need for developing a secondary mortgage market (SMM) for

bridging the resource constraint confronting the housing sector.

The National Housing Bank (NHB) launched the first issue of MBS, based on the assets

of HDFC and LIC Housing Finance in August ’00 for Rs137 crore. NHB had been

44


working for years on its pilot project for creating liquidity from the huge pool of housing

mortgages in the country.

Under the scheme, HDFC got Rs 90 crore of its housing loan portfolio securitised, while

LIC Housing Finance Rs48 crore. The transaction involved the assignment of retail

housing loans form both housing finance companies to NHB. In April ’01, it launched

two more issues of MBS, comprising pools of housing loans originated by Canfin Homes

and LIC Housing Finance to raise Rs.91.6 crore.

As with the rest of the world, the potential for mortgage securitisation is enormous. In

the case of mortgage securitisation there are specific issues that stymie the process.

These are the long tenure of loans, low spreads, cumbersome foreclosure procedures,

prepayment risks etc., all of which have led to its tardy progress. A major hurdle in India

is simplified foreclosure norms. Once this happens, housing finance institutions (HFIs)

will be able to tackle delinquencies effectively and will be willing to lend with less

stringent credit evaluation. This is expected to enlarge volumes in the formal sector,

helping a wider section of society (who would otherwise have approached the

unorganised sector) to borrow at lower rates.

(b) Auto loans – Citibank Case: Citibank assigned a cherry-picked auto loan portfolio

to People’s Financial Services Ltd. (PFSL), an SPV floated for the purpose of

securitisation by paying the required amount of stamp duty (0.1%) to ensure true sale.

This is a limited company and can act only as SPV for asset securitisation. This SPV is

owned and managed by a group of distinguished legal counsels. PFSL then proceeded to

issue PTCs to investors. These certificates were rated by CRISIL and listed on the

wholesale debt market of the National Stock Exchange (NSE), with HG Asia and Birla

Marlin as the market makers. Global Trust Bank acted as the Investors’ Representative.

Citibank played the role of servicer. The certificates are freely transferable and each of

the transfer will have a stamp cost of 0.1%.

The coupon of the security was high in spite of good quality of the underlying asset

portfolio, because investors expected a premium to compensate for their unfamiliarity

with the certificates. The investor base was limited mostly to Mutual Funds. FIs were

hesitant because of the unsecured nature of the instrument and the absence of clarity on

whether the certificates could be treated on par with other debt securities in their

investment policy. Although the certificates were listed on the NSE, there was very little 45


secondary market activity because there was absence of adequate amount of alternative

security of similar risk profile.

Besides Citibank, NBFCs like Ashok Leyland Finance, 20 th Century Finance etc. have

securitised their auto loan portfolio, though, of course, these transactions involved

assignment of receivables only and not issuance of securities. The asset portfolios were

bought by one or two large institutions. TELCO has also reportedly sold over Rs 550

crore of its auto loan portfolio in multiple tranches through this route.

(c) SEB receivables – KEB case: Another important asset class for the purpose of

securitisation pertains to the power sector. The Government is keen to securitise the

outstanding dues of various State Electricity Boards (SEBs) and the total market of

such receivables is estimated at around Rs.10, 000 croreii. However, securitisation of

these receivables is feasible provided they are sufficiently credit enhanced, preferably

with Government guarantee.

The initiative in this regard has been taken by Karnataka Electricity Board (KEB)

who, in a recent transaction, are securitising around Rs 210 crore of their outstanding

dues from various State owned public enterprises. The outstanding dues of KEB are

being assigned to another State owned subsidiary, Karnataka Renewable Energy

Development Ltd. (KREDL) that is acting as the SPV and in turn issuing securities. The

securities are being credit enhanced by way of a guarantee from the Karnataka

Government with a structured payment mechanism. HUDCO has agreed to be the

investor and subscribe to the securities in full.

(d) Future Flows: As mentioned earlier, ‘future flow securitisation’ is gaining

momentum. Remittances from overseas workers, international telephone settlements,

export receivables, future sale of oil and gas and other commodities, project cash flows

and toll receivables are finding favour with investors. Some illustrations are:

(i) Future receivables - L&T case: Although Larsen & Toubro bagged the Build, Lease

and Operate contract for a 90-MW captive power plant for Indian Petrochemical

Corporation Ltd.(IPCL), it transferred it to an SPV – India Infrastructure Developers Ltd.

(IIDL) which issued debentures in the private placement market. The debentures would

be serviced out of the lease rentals due to IIDL from IPCL. L&T’s guarantee was also

ii SBI Capital Markets Ltd.46


available to a limited extent. The novelty of this transaction is that instead of a plain loan

with say, 3:1 debt equity ratio, the project was financed in the form of a securitisation-

like structure through the capital market with a much higher gearing ratio.

(ii) RIICO case: This was the first attempt at issue of structured debt paper backed by

the cash flows arising out of future receivables of a utility. Rajasthan State Electricity

Board (RSEB) proposed to raise resources to the tune of Rs.250 crore, but because of its

weak balance sheet, was not able to access the market directly. Thus, a structure was,

devised whereby a pool of receivables comprising RSEB’s high value customers was

selected based on their payment history. The pool was rated and credit enhancements

were built. No SPV was set up specifically for the transaction, but an existing profit-

making Government Company, viz. Rajasthan State Industrial Development and

Investment Corporation Ltd. (RIICO), was selected as the borrowing entity and the

future cash flows and underlying receivables were charged to it. The bonds backed by

cash flows were issued by RIICO to investors by means of a privately placed issue. The

investors continued to have recourse to the issuer i.e. RIICO in the event of shortfall in

cash flows. The high stamp duties then prevalent, and certain legal and market-related

hurdles, delayed the introduction of full-fledged securitisation at that juncture.

Since the first issuance in 1991, ABSs have been very popular with the NBFCs in India.

Over Rs.2000 crore of debt has been raised through this routeiii. The repayment history of

all the issues has been extremely satisfactory. The level of cash collateral to support

'AAA' rating has come down. While the investors enjoyed a higher yield, the cost to

NBFCs was lower than the traditional sources such as bank loans and public deposits.

4.7 General

Emerging Markets (EMs) have high cost of raising funds and look for alternative

sources for raising funds at cheaper sources. Financial Institutions (FIs) in Asia have

iii Citibank, Mumbai

47


large illiquid debt to get rid off. These countries have the potential to benefit from

securitisation.

There is a huge potential for infrastructure finance in EMs. FIs can securitise their

loans for infrastructure projects and the same can be sold to potential local or foreign

investors. This presupposes a well-developed secondary debt market.

Government guaranteed loans may remain excluded from securitisation, as they are

less efficient.

Privatisation is revolutionising the economic practices in the EMs. Banks are going

to the markets for raising equity in the wake of reducing State funding. Their shares

are being quoted in the stock markets. They are being forced to improve ROE and the

efficiencies of the capital deployed. This gives them the opportunity to consider

securitisation in an aggressive way.

Market penetration of FIs in the area of origination of loans will be determined more

by the volume of loans originated during a period than by the amount of loans owned

at a particular point of time.

Certain potentials for securitisation especially in the mortgage sector in India are:

- Increasing share of tertiary sector, urbanisation and demand for houses

- Reduction of poverty and fast development of enlightened middle/upper middle classes

- Disappearance of joint family system and demand for new houses

- Housing initiatives

Presently, investors include FIs, pension funds, insurance companies, mainly from

USA or Europe. Local investors from Asia look forward for higher returns, as their

cost of raising funds is high. Saving rates in Southeast Asia have been 32% of GDP

versus 21% in Latin America. Although the local investors’ appetite is dependent

upon the deepening of the markets, the huge savings may provide potential as the

process for widening and deepening of these financial markets is taken up.

4.8 The Future

48


1. In brief, securitisation will grow in future for two significant reasons:

a) securitised paper is rated more creditworthy than the FI itself

b) strict capital requirements are imposed on the FIs

Future trends in securitisation of assets will not only be influenced by those FIs who are

knowledgeable about this process, and therefore, aware of its potential but will also be

affected by the level of knowledge in the financial community as a whole as well as the

perception of the regulators. While the benefits that securitisation brings in its wake are

well documented, it may be worthwhile to examine whether the domestic financial

markets are sufficiently developed to accept the product and utilise it efficiently.

2. The debt market has deepened and widened in recent years in India after the

introduction of financial sector reforms. The recommendation of the committee on

financial sector reforms (Narasimhan Committee Phase II) stipulates that the minimum

shareholding by Government /Reserve Bank of India in the equity of the nationalised

banks should be brought down to 33%. The same report also emphasises financial

restructuring with the objective of, interalia, hiving off non-performing-asset portfolio

from the books of the FIs through securitisation. According to an estimate, Indian banks

may be able to raise funds at 200 basis points (BP) above US Treasury rate for an issue

of US$150 mn, with a maturity of five years, giving them a gain of 200 to 400 BP over

domestic rates after taking care of related expenses. The securitised paper can be raised

in a period of 16 weeks after signing the mandate with advisors/lead manager. The costs

involved are advisors’ fee to the tune of 1.5% of issue size, rating agency fee

US$300,000, legal expenses US$500,000 and road shows US$100,000. The guidelines

of RBI restricting the quantum of the public deposits that can be raised by an NBFC have

given them further incentive to look for alternative sources of funds. The opening of the

insurance sector for privatisation can create demand for the securitised paper.

3. The Indian financial system is sound and well developed. A number of new financial

products have arrived and been tested in the market during the brief period since the

reforms began. The past few years have also witnessed a healthy trend towards

computerisation of transaction and information management systems. The availability of

computer technology would thus permit the capture and manipulation of large databases,

which are a basic requisite in structuring, securitised products.

49


4.The debt market is poised for substantial growth with the development of the sovereign

yield curve across different maturities and the active participation of primary dealers.

The Indian market has well-developed institutions, specialised regulators in banking,

capital markets, rating agencies and a well-developed regime of controls and supervision.

The existence of specialised financing institutions like Housing Finance Companies,

Urban/Infrastructure development Bodies like Housing and Urban Development

Corporation (HUDCO), Rural Electrification Corporation (REC) etc. who not only have

existing securitisable portfolios but also have the capacity to keep creating such assets

with a view to securitising them. Since most such institutions are facing resource

constraints, securitisation will enable them to focus on their core competency of

supporting infrastructure products through the gestation stage and securitising them later,

rather than funding them till maturity.

The domestic financial institutions are fast reaching their prudential limits in various

sectors. Further lending by them to these sectors is thus dependent upon their being able

to securitise their existing portfolios.

5. The investors with long-term funds have traditionally favoured equity and

Government securities portfolio and have stayed out of debt. Also the present illiquidity

of the loan portfolios does not allow FIs to actively manage or manipulate the related

sector, interest rate or maturity risks. This places a restriction on further asset expansion,

as assets once taken on the books necessarily need to be carried till maturity.

Securitisation will provide a solution for their requirements.

6. The market is thus at a stage where debt is increasingly going to be offered in a

tradable form, whether or not secondary market trades take place in individual cases.

Securitisation, by converting debt into tradable financial instruments, provides an

opportunity for more efficient reallocation of sector specific risks among a more

diversified set of players. By offering an exit option, it channelises surpluses that have so

far remained untapped, to capital–deficient sectors of the economy.

50


The environment for securitisation in EMs is different from that in developed markets for

various reasons like (i) Narrow investor base; (ii) Cultural factors; (iii) Poor capital

market infrastructure; (iv) Regulatory environment; (v) Legal hurdles; (vi) Lack of

proper accounting standards; (vii) Taxation burden; (viii) Poor asset-quality; (ix) System

deficiencies and (x) Lack of standardisation. The following paragraphs discuss these

issues:

5.1. Investor Base

They may be domestic or foreigners; individuals or institutions – financial or non-

financial, regulated or non-regulated; sovereign or non-sovereign. Investors look for (i)

Asset performance - Lack of historical or meaningful performance data may make it

difficult to predict performance; (ii) Third party performance- Reliance on asset

servicers, credit support providers etc.; (iii) Currency exposure and the availability of

swap opportunities at reasonable cost; and (iv) Secondary market liquidity. Investors also

look towards the services of the independent rating agencies to get confidence. An

underdeveloped secondary market for securitised assets that lacks liquidity is an obvious

problem to an FI in EM that is attempting to find investor acceptance. In India, the

following issues need further clarifications:

- The status of ‘Pass Through Certificates’ as ‘Securities’ under the SCRA is not clear;

- Investment in securitised paper (whether as PTCs or debt instruments) needs to be

specifically permitted for FIs

- Adequate disclosures about the assets need to be made to facilitate the investor to make

his/her view on the security.

5.2. Cultural Factors

In many EMs, decisions for loans are 'compromised' decisions rather than 'rational'

decisions. The process generates loans, which are less homogeneous and are not of high

quality. Further, nature of ‘participation certificates’ as distinct from traditional securities

such as shares and debentures needs to be recognised. In practice, the FIs as investors

look forward to security in the form of creation of charge over physical assets. The

mindset against unsecured investments has to undergo a significant change to accept

financial claims in the case of securitisation of future flows as collateral.51


5.3. Capital Market Infrastructure

Debt markets are at their infancy in many of the EMs due to the underdevelopment of

institutions and the instruments. Further,

- Foreclosure norms need to be simplified to facilitate speedy recovery;

- Securitised paper is not specifically included in proposed notification exempting stamp

duty on transfer of debt instruments in the depository mode. This would act as a negative

feature vis-à-vis standard debt instruments

- The market requires the emergence of back-up servicers to protect against any

negligence by the Originator (as Administrator)

5.4. Regulatory Environment

The regulations in a country for capital adequacy requirements are important motivators

for the Originators to undertake securitisation. Clear guidelines for the treatment of true

sale and off balance-sheet items can pave the way for securitisation. Further, many

financial experts believe that by diminishing the pivotal role of FIs in financial

intermediation, securitisation lessens the effectiveness of monetary policy. FIs and

regulators in many countries are concerned that the weakening of close ties between FIs

and their corporate customers may undermine not only traditional patterns of financial

intermediation, but patterns of corporate governance as well. In the Indian scenario, the

following issues need further attention:

- The guidelines for investments by insurance companies need to be clarified for

investments in securitised instruments

- Mutual funds are not permitted to invest in MBS

- The application of current NBFC norms to the Special Purpose Vehicle will render the

entire process inefficient.

5.5. Legal Provisions

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Since all legal provisions connected to securitisation are not consolidated under a single

statute, the task of developing a set of sound documents becomes much more tedious.

The legal issues in India (including recommendations) are discussed in detail in Chapter

6. They include:

- The Stamp duty on assignment of receivables is not uniform across states and also too

high in most states rendering securitisation unviable. While some State Governments

have reacted positively by reducing stamp duty on assignment of assets for securitisation,

resistance has been met within other States because of the loss of revenue

- Compulsory registration on transfer of assets involves registration fees, which adds to

the cost of securitisation

- Absence of clear legal provisions on partial assignment of assets and assignment of

future receivables

5.6. Accounting

If the Originator provides credit enhancements in the form of a limited guarantee or pool

substitution to a certain extent, there is said to be some recourse back to the Originator.

In the absence of clear accounting guidelines, accountants find it difficult to classify such

transactions as a sale treatment.

In case of financial intermediaries securitising their assets, the treatment of the over

collateralised assets in their books needs clarity.

Accounting for securitisation transactions is not clear on:

- De-recognition of assets from books of Originator

- Treatment for PTCs and the securitised assets in the books of the SPV where the pass

through structure is adopted

- Assignment of future receivables and their income recognition in the books of the

Originator

5.7. Taxation

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To encourage securitisation, the SPV needs to be tax neutral. Other impediments include:

- Transfer of income without transfer of underlying assets still makes Originator liable

for taxation

- It is not clear whether HFCs can continue to issue certificates to borrowers to claim

income tax benefits under Sec24 (1)(vi) and 88, after the receivables have been assigned

- Taxation of parties involved in securitisation is not clear, for example

* Capital gains implications on assignment of receivables by the Originator to the SPV

* Possibility of entity taxation of SPV

* TDS on passing on of cash flows by SPV to the investors

5.8. Quality of assets

The Originators need to have a minimum viable amount of quality assets to make the

securitisation transaction attractive in view of some minimum expenses to be incurred

for fees for structurer, rating agencies, lawyers, auditors, road shows, etc.

5.9. System Deficiencies

- Securitisation requires the Originator to have an efficient information capturing and

delivery system. Due to the heavy capital cost involved, both individual Originators and

the Indian financial system as a whole are not geared to meet these requirements

- Information on historical data is generally not available

- Very little information is available on the demographics of potential asset pools (auto

loans, individual housing loans, credit card dues, etc) that are amenable to securitisation

- Credit information on Originators and potential Originators is also not readily available

- Participation from credit bureaus in the process of securitisation is required.

5.10. Standardisation

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This refers to FIs and other lenders adopting common formats, practices and procedures

in loan origination, documentation, application and administration (servicing).

The Indian financial system is presently characterised by a lack of standardisation in all

aspects of loan origination with the exception of Government-sponsored loans or

housing loans granted by some of the large housing finance institutions. Each bank or

institution uses its own form of contract

Standardisation does not necessarily mean that all lenders must extend credit using the

same criteria or on the same terms but rather that certain fundamental aspects of the

lending process are standardised among lenders. For instance, lenders may adopt a

standard form of mortgage loan agreement that provides adequate legal protection to all

lenders. It ensures that investors in a pool of loans (or the rating agencies) do not have to

analyse the risk of several different legal documents.

Lenders may also agree to use loan applications that request the same information from

borrowers. This does not mean that each lender must grant credits on the same criteria

but that each lender is obtaining the same basic information from the borrowers making

it easier for investors to compare loans originated by different lenders. If applications ask

different questions, it is more difficult for investors to evaluate loans originated by one

lender against loans originated by another lender.

Standardisation of servicing typically involves the standardisation of the type of

information that is monitored (i.e. balance, payment history, address, etc.). In addition,

there can be standardisation of the documents and information that are maintained in

each loan file. There can be standardised data processing systems and software. It can

also facilitate a new servicer to take servicing, if required.

These impediments may have to be addressed by the Indian financial community in a

phased manner in order to make securitisation successful in the Indian financial system.

Legal and taxation issues in securitisation are only as significant as they are complicated-

Securitisation poses inordinate legal problems in most jurisdictions of the world. Some

of the issues are discussed below

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6.1. Stamp Duty

-- Applicable on the transfer/sale of receivables involved in securitisation, range is 3%-

13%

-- Maharashtra, Tamil Nadu, Gujarat, Kamataka and West Bengal have reduced stamp

duty on securitisation transactions to 0. 1 %

Recommendation

- Uniform stamp duty of 0. 1 % be levied in all states

- Monetary cap of Rs Two lakh be placed on such stamp duty

6.2. Registration Act, 1908

-- Registration charges payable impose additional costs to the transaction

Recommendation

- Every State Government prescribe a nominal sum, subject to a cap as registration for

securitisation deed

- Registration should not be required on issuance/transfer of securities/ certificates issued

pursuant to a registered Securitisation Deed

6.3. Transfer of Property Act, 1882

-- A common definition of securitisation is required

Recommendation

'Securitisation' shall mean:

(a) the transfer by sale/ assignment of the whole or part of the assets including actionable

claims by any entity which owns or has the rights, title interests in the assets to an SPV;

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(b) issuance of securitised debt receipts or securities, equity or certificates entitling

holder thereof to the receipts of monies on account of the assets (including by virtue of

any credit enhancement or liquidity facilities obtained by the SPV or specified person)

by assignee under clause a) above.

-- Easier assignment for mortgage backed receivables

-- To transfer a claim for a mortgage backed debt or claim for other types of secured

debt, the definition of actionable claim should be amended

Recommendation

Actionable Claim shall include a claim to a debt or any part including debt secured by

mortgage of, or charge on immovable property or by charge, hypothecation or pledge of

moveable property or beneficial interest in moveable property or receivables whether

such claim or interest is existent, accruing, conditional or contingent

-- Easier and automatic assignment of future receivables

-- Section 5 states that whilst transfer may take place at present or in future, the property

that is the subject matter of transfer must exist in present. A transfer of property that is

not existing operates as a contract to be performed in the future (an executory contract)

Recommendation

-- An actionable claim accruing in the future or conditional or contingent upon any event

shall be deemed to be a property capable of being transferred in present

6.4. Foreclosure Laws

Existing laws make it difficult to transfer property in case of default, as they are silent in:

1. the procedure for transfer of mortgages from the principal lender to any other entity

2. the procedure for speedy foreclosure and recovery against the mortgage without the

cumbersome and time-consuming process involving the intervention of the Courts.

Recommendation

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In the case of a mortgaged asset, the securitisation SPV shall have the right of sale of the

mortgaged property without the intervention of the court or obtaining a decree from the

Court in case the following are satisfied:

a. there is a delay of 60 days in the payment of principal or interest, and the mortgagor is

notified of the default by the SPV or its representative,

b. giving the mortgagor further 30 days period to make the payment of principal or

interest due in full, and

c. the mortgagor fails to make such payment within the said period of additional 30 days

provided that the mortgagor while mortgaging the property and securing of the debt had

specifically agreed to application of the summary procedures as defined above to his

mortgage debt.

6.5. Companies Act, 1956

-- Filing of Forms 8 & 13 under Sec135 is necessary for effecting modification of charge

Recommendation

To avoid multiplicity of filing forms, in case of transfer of charges pursuant to

securitisation, the Central Government must designate the Department of Company

Affairs as the sole repository of any alteration required to the Register of Charges

6.6. SEBI (Mutual Funds) Regulations, 1996

-- The Act states that MFs may invest in asset-backed securities excluding MBS

Recommendation

Removal of prohibition on investments in MBS (as a class of securitised debt) by MFs

6.7. Income Tax Act, 1961

The taxation issues arising in the process of asset securitisation are with reference to:

Obligor

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1. Under the Act, tax is deductible at source in case of payment of certain incomes.

According to current law, TDS would be deductible twice, once when obligor pays the

SPV and next, when the SPV pays the investors. This would involve locking of funds

with the IT Department and would affect the yield the investor would get.

Recommendation

Exempt the obligor from deducting TDS and the primary responsibility of deduction of

tax be on the SPV

Originator

1. Sec60 provides that in case of transfer of income without transfer of asset, the income

would be taxable in the hands of the transferor. Securitisation of future flows of income

of an asset which is not transferred may be taxable in the hands of the transferor e.g.

lease finance receivable where not the asset, but rent receivable is transferred.

Recommendation

Provide in Sec60 that such transaction would not be hit by the said provision

2. In case of securitisation of future flows, the originator would get NPV of future

incomes at one stroke. If income tax is payable on this NPV in year one, there would be

an acceleration of taxation of income. This would affect cash flows of the originator. It

has been suggested that any money received for future cash flows by the originator be

treated as borrowing until its treatment as a securitised asset could be decided upon.

Recommendation

Taxation of future incomes should be spread over the period to which it belongs

3. In case of securitisation of future incomes on a depreciable asset like lease, the

question arises whether depreciation should be granted on such an asset or not

Recommendation

Provision should be made for allowance of such depreciation

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4. Securitisation of loans advanced to finance, industrial, agricultural or infrastructure

development facility or construction or purchase of houses be recycled, if such loans can

be securitised. This would accelerate the creation of assets, which are socially desirable.

Recommendation

Such entities (financial corporation as Originator) should continue to derive the

deduction under Section 36(1)(viii) even after the loans have been taken off its balance

sheet for accounting purposes after securitisation

5. Section 10(23G) provides for exemption of any income by way of dividend interest or

long-term capital gain of an infrastructure capital fund or infrastructure capital company.

In case such an entity securitises future cash flows, a question would arise as to whether

the incomes received as a result of securitisation would be eligible for exemption.

Recommendation

They should continue to enjoy the exemption even after asset securitisation

SPV

1. the Act should provide for specific tax neutrality to the SPV. The net profit of the SPV

which is not to be passed over to investors, should be liable to tax at the normal rate.

2. The SPV should not be treated as a representative assessee

Servicer

1. The income received by the servicer (fees received for managing assets and

administration of the SPV) is taxable at the normal rate of tax.

Investor

1. To encourage investors to participate in securitisation, benefit of Sec88 should be

granted on investment in any paper of the SPV, which has securitised any asset related to

housing or infrastructure

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2. Investors would be taxed on the incomes arising out of securitisation. It is suggested

that incomes, which flow out of asset securitised in the next 3 years, should be made

exempt from Income Tax. After 3 years, there should be partial deduction and thus, this

income can be included in Sec8OL

6.8 Sales Tax

-- Under hire purchase transaction, delivery of goods on hire purchase agreement/

transfer of right to use is a deemed sale and attracts sales tax.

-- In case of sales of receivable along with underlying assets by the originator to the SPV

in a different state, the same would attract sales tax at the point of securitisation.

Recommendation

Exemption should be granted from sales tax to assets covered in securitisation

Accounting Treatment

Accounting is a crucial issue in securitisation, since one of the prime motivations is to

put assets off the balance sheet. Accounting for securitisation is not merely a matter of

presentation: it reflects on cost, and therefore, the very viability of the securitisation

option. If it results in putting the assets of the balance sheet, a securitisation option does

not constrain the firms’ existing financial resources, and therefore, is not an alternative to

equity; it has lesser costs. If it is a liability on the balance sheet, it competes with other

funding options.

Some issues in the accounting treatment for securitisation:

A 'sale' treatment for accounting purposes is preferred because it would enable the

originator to put the assets off the balance sheet

And a 'loan'/ 'financial' treatment for tax purposes would be preferable because the

gain made on assignment of receivables will not be taxable immediately

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At present, in India the basic issue with regard to accounting is: whether the

securitised assets should be considered as an off-balance sheet item or not

As per FRS 5 (UK), where the originator has transferred all significant benefits and

risks relating to the securitised assets and has no obligation to repay the

proceeds of the note issue, derecognition, i.e., removal of the securitised assets from

the balance sheet is appropriate

Securitisation accounting is not essentially based on risk/reward approach, but rather

the "transfer of control" approach. This means the assets have gone beyond the

reach of the transferor, where he cannot re-acquire the same, except at market price,

and the transferee is free to deal with the assets and make a profit on the assets

Any money received for future cash flows by the Originator should be treated as a

borrowing until its treatment as a securitised asset could be decided upon. This is

justified because an asset or a liability, which may arise in future, should not be

recognized. In accounting, only the past transactions or events can give rise to assets,

liabilities, income and expenses

The Research Committee (RC) of The Institute of Chartered Accountants of India

may consider the following issues:

o Accounting treatment in case of over-collateralisation to ensure that the

investors are not affected by the bankruptcy of the Originator.

o Inflows of proceeds in the books of Originator without corresponding

transfer of assets

If the Originator provides credit enhancements, there is said to be some recourse back to

him. In the absence of clear accounting guidelines, it is difficult to classify such

transactions as a sale treatment rather than a financing treatment. RC may examine the

issue.

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Certain areas need to be taken care of for the development of securitisation in India.

These measures with specific recommendations as discussed below are grouped into

Short Term, Medium Term and Long Term. The major recommendations on legal issues

(short-term) are included in Chapter 6. This chapter deals with other recommendations.

7.1 Short-term Measures [1 to 6 months]

7.11 General Awareness

Future trends in securitisation will not only be influenced by FIs who are aware of its

potential but will also be affected by the level of knowledge in the financial community,

as well as the perception of the regulators. There is an urgent need to increase the level

of awareness of the benefits and scope of securitisation among the financial community.

The most significant impact of securitisation arises from the placement of the different

risks and rights of an asset with the most efficient owners. Securitisation provides capital

relief, improves the financial ratios of the FIs, can create myriad cash flows for investors,

suits risk profiles of a variety of customers, enables FIs to specialise in a particular

activity, completes the markets with expanded opportunities for risk-sharing and risk-

pooling, increases liquidity, facilitates asset-liability management, and develops best

market practices. The process also paves the way for creation of sophisticated

institutions. Training Institutes of RBI/ FIs can play an important and positive role here.

7.12 Investment in Securitised Paper

1. The mindset of FIs has to undergo a change to accept asset-backed instruments as

secured instruments. FIs need to recognise that pass through and pay through certificates

have a character distinct from traditional securities such as shares and debentures. RBI

must clarify that FIs may include securitised paper as investible securities in their

investment policy.

Insurance Companies and Provident Funds (PFs) are amongst the large investors in the

debt markets. While LIC says that under sec. 27A of the Insurance Act, 1938, securitised

paper will fall under Unscheduled and Unsecured Investments, stipulated at 15% of their

Fund, other insurance companies and the Insurance Regulatory Authority (IRA) too

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need to consider securitised paper as eligible investments. The PF Commissioner can

also consider securitised paper as eligible investments by PFs.

2. Disclosure norms and rating will provide the touchstone. The existing rating agencies

have already acquired a fair degree of expertise in India by rating structured obligations

and other issues that are quite similar to securitisation. They will play an important role

in increasing investors’ confidence and ensuring maximum transparency in transactions.

The capability of the organisation to handle the complex securitisation transaction may

have to be evaluated in detail which may include the financial control, monthly

reporting, pool extraction, portfolio MIS, and treasury skills (structuring, pricing,

placement etc.). The rating agencies could gear up to evaluate such risks.

3. SEBI /Stock Exchanges need to list the requirements for various securities to be issued

under securitisation process. These may include minimum issue size, eligible stock

exchanges etc. In some cases, they may also dictate investor classes to which a particular

type of security may or may not be sold.

4. Steps are being taken by the Ministry of Finance to have dematerialised trading-

exempting stamp duty on transfer, (presently only in equity), also to debt securities.

5. Foreign Institutional Investors can serve as a major chunk of investors. They also have

the experience of investments in other EMs. Suitable guidelines/ rules may have to be

framed to encourage them to invest in securitised paper issued by Indian entities.

7.13 Origination and SPV related issues

1. The RBI may publish the identified characteristics of an SPV as guidelines for

securitisation transactions. The RBI Working Group (WG) recommends that the

Originator should have the flexibility in choosing an appropriate legal structure for the

SPV based on its individual requirements whether in the form of a company, trust, MF, a

statutory corporation, a society, firm, etc. Consequently, the provisions of the parent law

for incorporation of such entity, i.e., the Companies Act, Trust Act, Partnership Act, etc.

will apply to the formation of such SPVs. There is lack of clarity as to whether securities

issued by a trust are capable of being listed on a stock exchange. At present, MFs are the

only trusts, which have been specifically empowered to issue such securities. SEBI could 64


recognise such trustee companies and permit them to issue marketable securities as has

been done for MF units. While it may not be feasible to accommodate the spirit of

securitisation in its entirety within the MF Regulations, SEBI could consider framing a

suitable set of guidelines for regulating the securitisation activity on the lines of the MF

Regulations including structure of SPV, capitalisation and registration with SEBI. SPVs

in different forms may have to adhere to various recommendations, which include:

An SPV as a Company should be able to issue a new class of instrument viz. PTC

that is repaid only from the performance of the identified assets held by it for the benefit

of the investors in the PTC. This would prevent structural bankruptcy.

This new class of instruments should not be treated as a debt obligation of the SPV,

but one representing an undivided interest of the investor in the underlying asset.

The instruments are to be issued against a specified pool of assets

2. SPV as a company would normally require registration with RBI under Section 45-

IA of the RBI Act with the statutorily prescribed minimum capital for a new company.

However, in view of the fact that it would be a company, which would undertake only

the activity of asset securitisation, all the companies incorporated for the purpose could

be treated as a class of companies and would be regulated by a Regulatory Authority viz.

RBI or SEBI. RBI in exercise of its powers under section 45NC of the RBI Act could

exempt all such companies from the applicability of core provisions of RBI Act as has

been done in case of the Stock Broking Companies. NBFCs’ regulations of RBI will not

apply to most structures of SPVs. Detailed guidelines need to be issued in this regard.

3. Receivables are charged to working capital lenders as collateral. Experience has

indicated that obtaining a No-Objection Certificate (NOC) from the lenders with the

purpose of perfecting the sale is a difficult and time-consuming process. RBI may aid

such operational issues by advising banks to convey their approval/disapproval fast.

7.14 Disclosures

The WG recommends adequate disclosure norms for an “informed” decision by

investors and maximum transparency for the financial community including the

regulators. Thus, an ‘Offer document’ has been prepared, which can serve as a best

practice model. The document should include the following information:65


Description of the assets (summary of pool, geographical distribution etc.)

Transaction structure

Declaration on the historical performance

Information about Originator

Description of the issuer

End use of the funds

Statement of risk factors including legal risk, cash flow risk, Third party risks

(including credit enhancer risk, servicing risk etc.)

Disclaimers of the liabilities except those explicitly specified.

The Offer Document should give the rating rationale, which should seek to comment on

the quality of the receivables, payment structure, adequacy of the credit enhancements,

risks and concerns for investors and the mitigating factors etc.

Continuous disclosures, i.e. updating of information at regular intervals, are needed. The

issue of disclosures may be addressed in two ways:

The regulator may specify the type of asset classes that could be securitised and

specify the disclosure requirements separately for each asset class.

The regulator may lay down general norms of disclosure, which would be common

to all asset classes (e.g.: information pertaining to third party risk, cash flow risks, etc)

and retain the right to scrutinise and approve specific disclosures that may be required

for separate asset classes.

Instruments of securitisation may be offered to investors either by way of private

placement or by public issues. Although disclosures in regard to private placement of

debt is not regulated by any agency at the moment, it is recommended that there should

be certain minimum disclosures even for private placements for best practice. For public

issues, such disclosure requirements should be made mandatory by the regulator.

7.15 Prudential Norms

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RBI may issue operative guidelines on the criteria for true sale for FIs to claim off

balance sheet treatment for the securitised assets as well as credit enhancement, servicing

of securitisation schemes and also for providing liquidity support.

The criterion for ‘true sale’ is basic to the regulatory guidelines and determines the

capital relief. The proposed criteria would include the legal method and extent to which

the assets have been isolated from the Originator and recourse to the Originator. This

will include:

Transaction price for transfer of assets from Originator to SPV should be market

based

The transferred assets should be isolated from the transferor. Transferee/SPV and

holders of beneficial interests in the assets of SPV obtain the right to pledge or exchange

the transferred assets free of any restraining condition.

The transferor does not have control over the transferred assets through an agreement

that both, entitles and obligates the transferor to repurchase or redeem them before

maturity.

All risks and rewards of the seller in respect of assets should be transferred to SPV.

As regards investment in ABS/MBS by FIs, etc., specific instructions should be issued to

treat the investment in securitised papers outside the present % limit in shares and

debentures of corporate entities. Various departments of RBI (Department of Banking

Operations & Development, Urban Banking Department, Rural Planning & Credit

Department), Ministry of Finance, Insurance Regulatory Authority, Provident Fund

Commissioner, etc. may formulate specific guidelines for investments in securitised

paper. Once the regulatory framework is in place, the developments in the financial

sector should be monitored through reporting mechanism. A database of securitisation

activities should be maintained. The regulatory guidelines may be reviewed after one

year based on the experience gained in the intervening period. Special studies may be

undertaken to assess the impact of securitisation on the capital, debt and money market,

balance sheets of FIs with regard to risk profile, capital arbitrage, cherry picking, etc.

7.16 Other issues

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The concerned department/s of RBI may re-examine the issue of securitisation of export

receivables keeping in view the international practice and the huge potential therein. RBI

may issue a clarification that exporters would continue to be eligible for concessional

export finance in the event of a securitisation transaction being carried out as long as

upfront purchase consideration is paid in Foreign Currency.

7.2 Medium-term Measures [6 to 12 months]

1. In India, certain structured finance transactions have so far been entered into in the

name of securitisation transactions. The WG has identified certain impediments for true

asset securitisation due to lack of clarification in the provisions of certain statutes or lack

of adequate provisions relating to securitisation built in statutes. RBI should, take up

these issues with MOF, CBDT, etc. While these issues should be taken up in the short-

term, they should continue to be followed up in the medium-term, wherever needed.

2. Credit information is not readily available for investors to take an informed view on

the performance of the assets. Thus, adequate disclosures in the offer document by the

issuers are important. In this regard, Credit Bureaus may also play an important role. The

WG has already considered various aspects of setting up Credit Bureaus, including the

problems of secrecy laws, which may go a long way in providing data on the past

performance of the obligors including the delinquency rates in different pools of assets.

3. Originators serving as Administrators may gear up the internal control systems to

segregate pool of securitised assets from other assets.

4. Standardisation should be attempted. This refers to FIs and other lenders adopting

common formats, practices and procedures in loan origination, application,

documentation, and administration (servicing) to generate homogenous pool of assets.

5. The Originators need to have a minimum viable amount of quality assets to make the

securitisation transaction attractive in view of some minimum expenses to be incurred

for fees for structurer, rating agencies, lawyers, auditors, road shows, etc. FIs may review

their MIS and computer skills to meet the challenges of securitisation.

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6. The Indian financial community can draw lessons from the U.S. experience of

securitising non-performing assets (NPAs). Such assets can be securitised if they are

managed well and have the potential for appreciation (or capable of fetching higher price

for investors on sale than the discounted purchase price). Securitisation can be part of a

general programme to rehabilitate financial systems. As the experience suggests,

securitisation can be used both to sell good assets held by bad FIs and to dispose off

assets that are themselves impaired. The Japanese Government also sees securitisation as

the solution to Japan’s bad loan crisis.

7.3 Long-term Measures [12 to 24 months]

1. In the Indian context, entry of the private sector, needs to be encouraged to provide

pool insurance to asset-backed structures and play the role of multiline insurers. FIs

could also be encouraged to engage in the activity either on the strength of their existing

balance sheets or through independently managed subsidiaries floated specifically for

monoline insurance. The subsidiary route could be the preferred option because the

parent-bank/ FI may be an active investor in the market for securitised paper or may have

other exposures to the Originator and would in either case face a conflict of interest. It

will be worthwhile to draw lessons from the U.S. experience of Government guarantees

in MBS.

2. Two major benefits of securitisation have been emphasised in the infrastructure sector:

(i) cost of funding will be reduced; (ii) larger number of investors can be approached for

meeting the infrastructure needs. The support of a guarantee company could be

considered towards extending credit enhancements especially for the infrastructure

sector.

3. A host of financial intermediaries (servicers, market makers, etc.) with specialised

skills are also necessary to provide the building blocks for market growth.

4. Fiduciary Service Providers assist the Originator/ Administrator in the resolution of

any servicing related issues and preparation of the ‘Servicer Report’. Other functions

include periodic monitoring and liaisoning with the Originator/ Administrator and other

agencies for transaction data. New entities may emerge to serve as Fiduciary Service

Provider.

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5. Although, it has been suggested that RBI may take up with MOF/ CBDT etc.

regarding clarification on amendments to certain statutes, as short and medium term

measures; as a long term measure, GOI may consider bringing out an umbrella

legislation covering all aspects of securitisation.

Conclusion

With the capital market going through a lean phase and companies increasingly facing

funding problems, the focus is now on raising money through securitisation.

Securitisation is one of the many new tools, which finance managers will have to use to

ride uncertainty.

A versatile financing tool, securitisation enables customisation to meet client needs

across a wide range of industries in a variety of financing situations with existing or

future receivable cash flows. It offers many unprecedented benefits - the most significant

being that the transaction can enjoy a credit rating much higher than that of the

originator.

Originating in the mortgage markets in the USA in 1970s, an established financing tool

in developed economies, securitisation has quickly developed to become one of the most

important financial innovations of our time. Securitisation is fast becoming an

increasingly important source of financing in emerging markets. Across the world,

securitisation is being perceived as a means of providing access to diversified sources of

funds.

Securitisation is particularly relevant in the Indian context, especially since growth in

securitisation would add more high quality assets to the fixed income market and would

also provide the much-needed fillip to infrastructure financing.

There is a lot to learn from developed markets like the US, which is the largest

securitisation market in the world. Approximately 75%, or more of the global volumes in

securitisation are originated from the US. The US markets have historically been more

liquid, innovative and sophisticated. Enabling laws and regulations in France, Italy,

Spain and Belgium have been the leading factors in the growth and spread of European

securitisation since the early 1990s. Developing markets on the other hand, are

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fragmented and small. Nevertheless, the imperatives that acted as principal drivers in

these markets have to arrive soon.

India’s securitisation is in a nascent stage, exhibiting only elements of established

securitisation. But the few deals that have taken place in India represent only a fraction

of the potential. According to Mr Ramesh Sobti, country head, ABN Amro, “ As external

commercial borrowings are longer cheap source of funds, even rich corporates will start

securitising future receivables to raise funds.”

When it was launched 10 years ago, securitisation was hailed as a financial innovation,

which would release assets from the portfolio and provide instant liquidity of issuers and

at the same time give investors the choice of trading in another type of instrument.

Legislative and legal changes, however, leave much to be desired. The market is

seasoned for such products, but the ball is firmly in the court of the regulators and the

government for spelling out the rules of the game.

Once the enabling legal provisions and institutions fall in place, the economic logic for

securitisation is so powerful that the trend towards securitisation knows no limits. India

is still a long way from the saturation point that has been reached in other economies like

the UK where even aged rock artists have raised funds by securitising the future

receivables from royalty payments.

The Indian market is still waiting for the sun.

Executive Summary

The financial-services industry is in a state of flux in which the only constant is change.

The introduction of financial sector reforms in India has led to innovations in financial

markets and instruments. The phenomena of computerisation (technology), globalisation,

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institutionalisation and privatisation capture the dynamic innovations occurring in the

financial world, and suggest the "isation" of the industry. One of the most prominent

developments in international finance in recent times, that is likely to assume even

greater importance in the future, is ‘securitisation’. Securitisation is the process of

pooling and re-packaging homogenous illiquid loans and distributing them as marketable

securities. Increased pressure on operating efficiency, market niches, competitive

advantages and capital strength, all provide fuel for rapid changes. Securitisation is one

of the solutions to these challenges.

In this report, I have attempted to explore the intricacies of securitisation as a process of

financial engineering and its applicability to the Indian financial system.

Firstly, securitisation has been defined, and it’s features such as marketability,

merchantable quality, wide distribution, homogeneity, etc have been noted.

Securitisation has lead to disintermediation and has changed the face of banking. Along

with this, the economic impact of securitisation has also been talked about.

What is securitisation of receivables? Who are the parties involved in the process? These

questions have been answered. The features of receivables-securitisation (asset, issuer,

investor features), the various structures such as pass-through, pay-through, etc, have

been discussed in detail. The report also makes a reference to future flow securitisation.

Advantages and motivations in the form of lower cost, capital relief, improvement in

return on equity and return on assets, off balance sheet financing, asset liability

management, improved liquidity, etc. have been highlighted. Securitisation is a costly

source and is uneconomical for small requirements- these are some of its limitations.

The scope of securitisation in India has been looked at and emphasis is laid on three

potential areas of securitisation in India – Mortgage-backed Securities, Asset-backed

Securities and the Infrastructure Sector. Some Indian experiences such as the National

Housing Bank’s case, Citibank’s auto loans case, etc., have been discussed.

Various impediments viz., lack of investor-base, capital market infrastructure, regulatory

framework, legal provisions, accounting and taxation issues besides good quality assets,

past data and standardisation of documents have been identified.

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True sale characteristics of securitisation transactions are required to be reflected in the

books of accounts, statements to be furnished to the concerned regulators as also to the

tax authorities. Since there are no guidelines for accounting treatment of these

transactions, the accounting procedures with appropriate guidelines need to be framed by

the Institute of Chartered Accountants of India for the sake of uniformity.

The recommendations have been categorized into short-term, medium-term and long-

term. The Reserve Bank of India’s Working Group has suggested that securitisation

should be appropriately defined to lend uniformity of approach and restrict the benefits

provided by law/regulation for genuine securitisation transactions. The recommendations

also include rationalisation/reduction of stamp duties, inclusion of securitised

instruments in Securities Contract Regulation Act, removal of prohibition on investment

in mortgage backed securities by mutual fund schemes, tax neutrality of SPV, etc.

Medium-term measures would include increased flow of information through credit

bureau, standardisation of documents, improvement in the quality of assets, upgradation

of computer skills and exploring the possibilities of securitising non-performing assets.

The need to develop some insurance/guarantee institutions to give comfort to investors,

especially in infrastructure and mortgage sectors has been underscored as a long-term

measure. According to RBI’s Working Group, there is also a need for developing a host

of financial intermediaries with specialised skills and sophistication to provide the

building blocks for market growth. The Government of India should consider bringing

out an umbrella legislation covering all aspects of securitisation.

Two case studies- auto loans securitisation and mortgage-backed securitisation have been explored. I had the chance to interview Mr Majumdar, Factoring Services, HSBC. Thus, his views have been included.

In any field, awareness of the latest happenings is important, or you would be left

behind. Some recent news articles have been included too.

Interview with Mr. Basab Majumdar, Manager- HSBC, Factoring Services, India.

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Q. What would you say about Factoring and Securitisation?

A. There are 2 types of financing- “post-sale”, which is factoring and the other is

“future”, which is securitisation. For example: say, a supplier is supplying soapsuds to

Hindustan Lever Ltd (HLL). After the sale, he will get the invoice discounted and get

cash immediately, and later he will get the money from HLL. The supplier would submit

invoices from sales contracts, to the Factor. The Factor may provide financing to the

seller, by way of advance payments; may maintain accounts related to receivables;

collect accounts receivable and provide credit protection against default in payment by

buyer. The Factor would perform at least 2 of the above activities. Then, the buyer would

be informed in writing that all payment of receivables should be made to the Factor.

In securitisation, take Air India. If you take the Mumbai-London-New York sector and

see what the average ticket sales in the last 2 years were; take a percentage, say 60%;

then, give Air India 60% today. Here I have securitised their future receivables.

There will be a Special Purpose Vehicle (SPV) and an Escrow Account. Whenever

tickets sell, the proceeds would go to the Escrow and I would recover them from there.

Another example could be of credit card receivables. Credit card companies have card

merchants (places where the card can be used). You would see, how much card business

has gone through its counter. Say around Rs. 6 crores and you decided to give a 6-month

loan at 50% discount. Whenever there is a card transaction, part of it gets routed through

the Escrow.

HLL was leasing out a building for 3 years for Rs.8 lakh a month. They got the lease-

rental receivables securitised.

Factoring is done largely by banks as the risk is better but in securitisation, there is a

future sale.

Q. What according to you are the reasons for a slow growth in the market?

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A. It is mainly because of the legal system- assignment of assets, unclear laws regarding

many things; stamp duty is payable and then come accounting difficulties. Therefore, it

is not very encouraging.

Q. What is the scope of the market? What is the future?

A. It is definitely a growing market. HSBC is the largest factoring bank in India. It has

grown at an average rate of 80% p.a. Also, the benefits of factoring themselves will

encourage participation, once people are more aware.

Factoring is Turnover linked finance so you can finance a higher level of sales than

before and plan your company’s growth effectively.

Flexible cash flow to finance working capital requirements and improve

profitability

No collateral usually required as compared to other forms of finance

More time for core business activities since sales ledger management and

collections are handled by the Factor

Credit protection for exports reduces the incidence of bad debts

Regular MIS reports on specific buyers from the Factor reduce the time spent on

reconciliation of outstanding.

Q. Who are the players in the market today?

A. Citibank, HDFC, ICICI Bank.

Q. How would you compare the market here with a developed market, say the US?

A. The Indian market is not even 5-10 % of the levels of the West. People are not aware

–there is very low market awareness. Only big companies with large treasuries are

involved.

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