11 securitization

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INTRODUCTION OF SECURITIZATIONA lot has been written and spoken about securitization in recent times. Indeed, one has been hearing about it in India since the early 1990s, but with increasing regularity in recent times. This concept note is intended to place the concept of securitization in the right perspective, and importantly, set aside some myths and misconceptions associated with it. The deals that have been talked about are Citibanks sale of its car loan portfolio, among others. With only this much information provided on this deal, it may be concluded that such transactions are only in the nature of refinancing arrangements, since no new marketable securitization, in our meaning, is explained in the following paragraph. Consider the case of a limited company and its financing advantages over a partnership firm. A partnership firm is based on relationships, which cumbersome to handle, and whose changes in composition could affect the firms liquidity. In the case of limited company, share is issued to each partner and the companys capital structure does not change with a change in the composition of its partner. Shareholder come and goes as they please. This is because the shareholders stake is concurrent with their holdings of share certificates, which are transferable pieces of paper, called securities. Securitization therefore is the process of converting relationship into transactions. The trend of debentures and bonds replacing illiquid loans by a bank is also a step in the direction of converting relationship into transactions.



Securitization is an innovation of the home loan financing segment of banking, called residential mortgage financiers. These organizations typically lend over a 20-year period, and need to raise finance of sufficiently long tenors. A major asset they hold are the receivables in respect of loans already granted. Thus, these receivables are sold in order to garner receivable for a whole new round of fresh loans. Therefore, the advantages of securitization are in the forms of. 1) making illiquid receivable liquid 2) getting loans of long tenors, thereby withstanding the shocks that could come from short term funding (asset-liability management or ALM) and3) Lock on to a long-term, low-cost source of finance, enhancing their credit

planning efforts. Apart from the stated advantages, securitization also in enhancing the Capital Reserve Adequacy Ratio (CRAR) and reduces the overall cost of capital due to transfer of risk off its balance sheet, as explained later. Thus, securitization involves financial engineering with several associated credit derivatives.



HISTORY OF SECURITIZATION Securitization may be said to have originated in Denmark. Loans were granted when bonds of an equal amount and tenor were sold. This is form of asset-liability matching, resource management, and even the interest margins are protected. Therefore seems to be sound policy. In Prussia, bonds backed by mortgage loan were issued by some banks, the instrument, and a bond symbolizing the underlying cash flows called pfandbrief. Interestingly, over its 200 years history, no pfandbriefs has ever been defaulted upon. However, standardization and liquidity seem to pose a problem, otherwise tradability of such instrument will be only in restricted markets. Securitization in its modern form really took off in Chicago. Chicago is also a home to many seminal developments in finance. Mortgage bankers would deploy their initial capital in creating mortgages. Fresh borrowers would have to turn away. Chicago mortgages banker struck upon the idea of selling the loan portfolios to larger mortgages banker. The largest mortgage bankers carved of the stream of underlying receivables into tradable denominations as in equity and bonds in order to attract investors and facilitate trading in these bonds. Other innovation followed. First, the interest and principle portions were separately traded. These are called STRIPS, the acronym for Separately Traded Interest Only (IO) and principal only (PO) Segments. Other innovation included the splitting up of the bonds to sort investors having an appetite for varied lengths of time. The details are explained elsewhere in this paper. To sum up, the underlying receivables were carved in a process known as slicing and dicing, analogous to the beef cuts that were sold as a marketable commodity, as opposed to trading in the



whole animal itself. Securitization instruments shorn of such innovations are known as plain vanilla securitization instruments. The concept of securitization is rapidly spreading in several countries in various stages of development. From the Danish origins and the pfandbriefs, securitization has spread and evolved in the US. Policy makers in several developing countries are keen that securitization takes off, since these are capital deficit countries. Securitization in these markets will strengthen lending agencies and improve their linkages with the capita markets. SECURITIZATION TRANSACTION PROCESS The successful execution of a securitization depends on the investors uncontested right to securitized cash flows. Hence, securitized loan need to be separated from the originator of the loan. In order to achieve this separation, a securitization is structured as a three-step frame work:1. A pool of loan is sold to an intermediary by the originator of the loans. This

intermediary (called a special purpose vehicle or SPV) is usually incorporated as trust. The SPV is an entity formed for the specific purpose of transferring the securitized loans out of the originators balance sheet, and does not carry out any other business.2. The SPV issues securities, backed by the loan, and by the payment streams

associated with these loans. These securities are purchase by investors. The proceeds from the sale of the securitized are paid to the originator as a purchase consideration for the loan receivables.




The cash flows generated by the loans over a period of time are used to repay investors. There could also be some credit support built into the transaction to protest investors against possible losses in the pool. However, the investors will typically have no recourse to the originator.

Diagrammatic representation of a securitization transaction

Originator (Owner of the assets)

Transfer/sells loans Consideration

Issues PTC SPV (Trust managed by the trust) Investors Consideration Payment made to investors

Payment from borrower deposit from originator Loans (Assets) Installment Payment Borrowers

Collection account (Operated by the trusty)

Credit Support (Given by the originator or third party)




Originator: The originator is the original lender and the seller of the receivables. Typically, the originator is a Bank, a Non Banking Finance Company (NBFC), or a Housing Finance Company (HFC). Some of the larger originator in India includes ICICI Bank, HDFC Bank and Citigroup.

Seller: The seller pools the assets in order to securitize them. Usually, the originator and the seller are the same but in some cases originator sell their loans to the other companies that securities them.

Obligors/borrowers: The borrower is the counter party to whom the originator makes the loan. The payments made by borrowers are the sources of cash flows used for making investor payments.

Issuer: The issuer in a securitization deal is the special purpose vehicle (SPV) which is typical set up as a trust. The trust issues securities which investors subscribe to.

Investors: Investors are the purchase of the securities. Banks, Financial Institution, NBFC and Mutual Fund are the main investors in securitized paper.

Service: The service collects the periodic installments due from individual borrowers in the pool, make s payouts to investors, and follows up on delinquent accounts. The service also furnishes periodic information to the rating agency and the trustee on pool performance. There is a service fee payable to the service. In most cases, the originator acts as the service.



Trustee: Trustees are normally reputed Banks, Financial Institutions or independent trust companies set up for the purpose of settling trusts. Trustees oversee the performance of the transaction till maturity and are vested with necessary powers to protest investors interests.

Arrangers: These are Investment banks responsible for structuring the securities to be issued, and liasoning with other parties such as investors, credit enhancers and rating agencies to successfully execute the securitization transaction.

Rating agencies: Independent rating agencies analyze the risks associated with a securitization transaction and assign a credit rating to the instrument issued.


Identification Process: The lending financial institution either a bank or any other institution for that matter which decides to go in for securitization of its assets is called the originator. The originator might have got assets comprising of a variety of receivables like commercial mortgages, lease receivables, hire purchase receivables etc. The originator has to pick up a pool of assets of homogeneous nature, considering the maturities, interest rates involved frequency of repayments and marketability. This process of selecting a pool of loans and receivable from the asset portfolios for securitization is called identification processes.

Transfer Process: After the identification process is over the selected pool of assets are then passe