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CHAPTER 5

GUARANTEE

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Issuing Guarantee on behalf of the Housing Finance Companies

is also one of the business line of National Housing Bank. Researcher

has studied this business line of National Housing Bank and

examined the terms and conditions, exposure norms and securities

obtained from the Housing Finance Companies for issuing such

guarantee. Guarantee fee is charged by National Housing Bank from

Housing Finance Companies for issuing such guarantee; therefore, it

serves as a source of income for National Housing Bank. Researcher

has analyzed the role of National Housing Bank in this discipline and

thrown light on the dismal performance of National Housing Bank.

The Concept Of Guarantee And Its Benefits

assurance that something is of specified quality or

content

something offered as security that an obligation will be

fulfilled

something assuring a particular outcome

Issuing Guarantee stands for assuming responsibility, assuring,

becoming liable, becoming surety, committing oneself, giving

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assurance underwriting, and last but not the least for making oneself

answerable. Guarantee is a contract to perform the promise, or

discharge the liability of the third person in case of his default.

person in respect of whose default the guarantee is given is called the

guarantee is given is

must be committed by the third person on whose behalf a person

stands surety.

Tripartite Agreement

Every contract of guarantee has three agreements:

1) An agreement between the creditor and the principal

debtor.

2) An agreement between the surety and the creditor.

3) An agreement between the surety and the principal debtor.

Contract between the surety and the principal debtor is that of

indemnity. Principal debtor indemnifies the surety that if he pays the

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amount in case of default committed by him, he will indemnify him

in case of loss. This contract, if it is not express, is always implied.

Essentials Of Contract Of Guarantee

1) There must be a debt existing, which should be recoverable.

2) Existence of three parties in a contract of guarantee i.e.,

principal debtor, creditor and surety.

3) There must be a distinct promise, oral or written, by the

surety to pay the debt in case of default committed by the

principal debtor.

4) There should be some consideration.

5) The liability must be legally enforceable.

In case of a bank guarantee, it imposes absolute obligation on the

bank to fulfill the terms. Payment under the bank guarantee becomes

due on happening of contingency on occurrence of which guarantee

becomes enforceable.

A bank guarantee is an independent and distinct contract

between the bank and the beneficiary and is not qualified by the

underlying transaction and is the primary contract between the

person at whose instance the bank guarantee is given and the

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drawn between guarantee for due performance of works contract

towards security deposit. Obligation of bank remains same and has

to be discharged in manner provided in bank guarantee.

Guarantee And Underwriting

Guarantee is similar to underwriting. Underwriting in widely

prevalent in case of new issue of share and debentures. The

underwriters of issue of share or debenture undertakes to market a

certain percentage of the same and if a part of that is unable to find

the market, the underwriters will have to purchase the unsubscribed

portion.

Underwriting is an agreement entered into before the shares

are brought before the public that in the event of the public not

taking up the whole of them or the number mentioned in the

agreement, the underwriter will, for an agreed commission, take an

allotment of such part of the shares as the public has not applied for.

By entering into the agreement with underwriters the company has

not to worry at all about the sale of securities because of the

guarantee cover provided by the underwriters.

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So underwriting is equivalent to guarantee. Similar to

guarantee provider, the underwriter also charge a fee. The limits of

the commission or fee have been fixed by the Companies Act. It

cannot be more than 5 per cent in case of shares and 2.5 per cent in

case of debentures.

Both the underwriter or guarantee providers have to keep the

necessary finance with them. In the event of default by the debtor,

guarantee is invoked and the guarantor has to compensate the

creditor. Similar in case of underwriting, if adequate subscription is

not coming forward, the underwriter will have to purchase the

unsold security.

National Housing Bank is mandated to promote Housing

Finance Companies. National Housing Bank is not involved in

financing directly to customers. It is making fund based financing to

Primary Lending Institutions (PLIs) which is indirect financing.

National Housing Bank has limited resources. Guarantee is non fund

based product by which a sort of assurance is held out to lender

about assured performance by the beneficiary Housing Finance

Company. Guarantee serves quite a different purpose which

sometimes even direct finance cannot serve. Issuing guarantee stands

for assuming responsibility and becoming surety and committing

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itself for an assured performance for the beneficiary housing finance

company.

Scheme For Issuing Guarantee

Housing Finance companies depend to a great extent on

refinance assistance from National Housing Bank. However, the

extension of refinance assistance by National Housing Bank is

Owned Funds, its borrowing power etc. In addition, in the present

liberalized environment, the Housing Finance Companies prefer to

raise resources directly from market in order to eliminate the cost of

intermediation. Besides National Housing Bank refinance facility,

Housing Finance Companies mainly depend upon term loans from

banks and public deposits. Of late, the maturity profile of public

deposits has been shortening, leading to asset liability mismatch for

Housing Finance Companies. One way to overcome this problem is

floatation of bonds or debentures having a longer maturity period of

say five to seven years. To attract the investors at competitively low

rates, such bonds/debentures should have sufficiently high rating.

Many of the HFCs have not been able to float bonds/debentures

because of the lower credit rating from the rating agencies for various

reasons including the inherent mismatch between assets and

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considered critical and accordingly a scheme was introduced to

extend guarantee to the bonds/ debentures to be floated by HFCs if

these companies meet certain laid down criteria. Under the scheme,

National Housing Bank provides top ended guarantee relating to the

repayment of principal and interest which will provide necessary

credit enhancement and will enable HFCs to acquire higher credit

rating leading to competitive pricing of these instruments. The salient

features of the scheme are as under:

Scope Of The Scheme

The Scheme envisages provision of guarantee by National

Housing Bank to the investors regarding repayment of principal and

interest during the top end (say last two years) irrespective of the

repayment schedule fixed by the HFC and the guarantee cannot

exceed 67 per cent of the total amount to be raised and the interest

thereon.

Terms And Conditions Of Guarantee

The followings are the terms and conditions laid down by NHB

for the Housing Finance Companies desirous of availing the

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guarantee from National Housing Bank. The bond issue must carry

- The

approved rating agencies are Credit Rating Information Services of

India Ltd. (CRISIL), ICRA Ltd, Credit Analysis and Research Ltd

(CARA) and FITCH Rating India Pvt. Ltd. However, the Bank can

consider providing the guarantee in the case of an instrument being

The Net Owned Funds of the HFC shall be at least Rs.30

crores or more.

Net NPAs shall be less than 2 per cent.

The HFC shall have earned profit during the last three years

or since its inception if it is in existence for less than 3 years.

The overdue for more than 3 months should not exceed 10

per cent of the aggregate demand for the year.

The promoters and the management of the HFC are found

to be satisfactory.

The HFC has complied with all the provisions of the

Housing Finance Companies (NATIONAL HOUSING

BANK) Directions, 1989 as amended from time to time and

all the provisions of the Housing Finance Companies (NHB)

Directions, 2010 on prudential norms.

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The maturity of the bonds/debentures shall be for a period

of five years to begin with.

Further the coupon rate to be fixed for the bond issue shall

be as per market conditions i.e. it should be in line with the

prevalent rate of interest on the similar securities.

Exposure Norms

For the purpose of extending guarantee to the HFCs, exposure

limits have been fixed by National Housing Bank along with the

annual refinance limit. The aggregate amount of the guarantee in a

year can be maximum up to the actual amount of the bond to be

floated at a time or the annual refinance limit provided in a particular

year, whichever is less. The overall borrowing, including the amount

to be mobilized through the bond/debenture issue, shall not be more

than seven times of the Net Owned Funds of the company.

Minimum Size Of The Issue

The minimum size for each issue should be Rs.10 crores and it

will be subject to the overall borrowing powers fixed under the

Housing Finance Companies (National Housing Bank) Directions,

2010.

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Security

The HFCs desirous of availing the guarantee will have to create

a floating charge on the assets equivalent to 125 per cent of the

principal amount in favour of National Housing Bank. In case the

HFC offers any other security in addition to a floating charge for its

existing borrowing or is in a position to provide further security, the

same shall also be asked for. In case of the HFCs, where personal or

corporate guarantee has been obtained, the same shall be extended to

cover the guarantee for the bonds or debentures.

Guarantee Fee

For extending the guarantee, the HFCs are be charged 75 basis

points per year of the amount to be floated as guarantee commission

and this is payable to NHB upfront.

Creation Of Reserve

Further, it is obligatory on the part of the HFC, seeking cover of

guarantee from the NHB, that it shall create appropriate

bond/debenture redemption reserves as may be laid down under the

Companies Act so that at the time of maturity of the debt , it has

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enough fund to repay the debt along with the interest thereon. The

size of the redemption reserve and the annual contribution from the

HFC shall be determined in consultation with NHB.

Returns To Be Submitted

The HFC, seeking guarantee for the issue of bonds or

debentures, is required to furnish quarterly or half yearly returns or

information as may be required by NHB.

Guarantee Fee As Source Of Income

Guarantee fee is a source of income. Non fund based fee

income is vital for any financial institutional. It is earned by just en-

cashing its own reputation and commitment.

Credit Enhancement To Residential Mortgage Backed Securities

(RMBS) Of Primary Lending Institutions By Way Of NHB

Guarantee.

The NHB during 2003-04 proposed the introduction of

Mortgage Guarantee Scheme. The idea was to mitigate risk involved

in any housing finance exposure of HFCs by compensating in full if

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there are any defaults by the borrowers. If the HFCs get such type of

guarantee, then these companies will set competitive prices for their

home loan products and result will be that people from low income

and middle income group will be motivated to avail loan from the

banks and the HFCs. Further the guarantee by NHB will make such

residential mortgage backed securities (RMBS) marketable and

provide liquidity to the primary lending institutions. The then

Chairman of NHB was of the opinion that in absence of mortgage

credit guarantee, the HFCs are prevented from venturing into

various risk categories. Guidelines were framed by NHB in

consultation with RBI, to frame the Residential Mortgage Backed

Securities (RMBS) Scheme. This is expected to reduce credit

enhancement costs, improving viability of RMBS transactions and

encouraging the Housing Finance Companies (HFCs) and Banks to

take up securitization of their home loan portfolios.

Under the arrangement, NHB would offer to provide/furnish

an irrevocable Guarantee in its corporate capacity, to the RMBS

issues of eligible Primary Lending Institutions (PLIs) viz. HFCs and

banks, with the main intent to obtain Rating of investment grade

indicating highest safety AAA(So) from an approved Rating Agency.

At the same time, in order to ensure that the cash flows to the

investors are sufficiently protected, it has been stipulated that there

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should be adequate subordination and collateral levels to the

Guaranteed Class of RMBS which are commensurate with high levels

of safety grade of Rating (AA(So)) for the RMBS by an approved

credit rating agency. Thus, the intent of the scheme is to enable the

HFCs to obtain AAA (So) benefits with collaterals equivalent to AA

(So) requirements.

originator(s) to derive the pricing and other benefits of a AAA (So)

RMBS at AA(So) terms, it has been stipulated that layer(s) of credit

enhancements such as cash flows of Subordinated Class RMBS

(subscribed by originator) and Cash Collateral/reserve, etc. (as

prescribed by the Rating Agency) shall act as the first level credit

only in the event of exhaustion of the initial layer(s) of such credit

enhancements. Therefore, in the event of any shortfalls in the

collectio

Guarantee shall be invoked as last resort only after the residual

income/principal of subordinate RMBS and all other forms of

collaterals stipulated for the AA(So) rating have been

exhausted/completed in a payout.

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Terms Of NHB's Guarantee To Residential Mortgage Backed

Securities (RMBS)

(i) Eligible Primary Lending Institutions:

a. Housing Finance Companies (HFCs) registered with

National Housing Bank

b. Scheduled Banks

Eligibility Criteria For HFCs For Being Eligible For

Guarantee:

a. The HFC should be registered with NHB to carry out

housing finance activity in the country. The HFC

should provide long-term finance for purchase, repair,

up gradation of dwelling units by home-seekers.

b. The HFC should have been in active business of

providing long term finance continuously for the

preceding 5 years.

c. The Gross Non Performing Assets (NNPA) of the HFC

should not be more than 5 per cent of the Gross

Advances.

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d. The originating PLI should secure a minimum rating of

4-Star under the Internal Credit rating Mechanism of

NHB.

Eligibility Criteria For Scheduled Banks:

The Gross Non-Performing Assets of the Bank as

percentage of the Gross Advances should not exceed

10% for the entire portfolio of the bank.

The Scheduled Commercial Bank should have been in

active business of banking and finance in India,

continuously for the preceding 5 years.

(ii) Eligible Pool Of Residential Mortgage Loans

The Pool of Residential Mortgage Loans underlying the RMBS

should satisfy NHB's Selection Criteria. Due diligence Certificate

should be obtained from Statutory Auditors of the Company or a

firm of Chartered Accountants acceptable to NHB, duly indicating

that every individual loan in the pool of home loans being

securitized, satisfy the stipulated pool selection criteria.

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(iii) Eligible Structure Of RMBS

RMBS and not for subordinated RMBS.

(iv) Limit Of The Guarantee

eligible PLIs shall be limited to least of the following:

100 per cent of the Size of the Senior Class of RMBS;

A sum of Rs.100.00 crores per RMBS issue;

(v) Requirements Of RMBS Structure

The Originators will be required to provide credit

enhancements (by way of subordinate portion, cash collaterals etc.) to

the extent necessary to ensure at least AA rating or equivalent thereof

in the hierarchy of the structural credit enhancements (such as senior-

subordinate structure and cash collaterals) provided in the structure

of RMBS.

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(vi) Validity Of The Guarantee

The Guarantee shall remain valid until full discharge of the

RMBS and is meant to ensure repayment of principal and interest of

the senior portion if payments received from the underlying pool of

housing loans are not sufficient to satisfy the amount payable to

holders of the senior RMBS.

(vii) Replenishment Of Guarantee Amount

In the event of invoking of Guarantee at any time during the

currency of the RMBS thereby resulting in depletion of the level of

Guarantee limit for the residual period of the RMBS, NHB

(Guarantor) shall be entitled to be replenished from the pool

collections in subsequent months in excess of the amounts payable to

the holders of the senior portion. It will be ensured that

replenishment of Guarantee from the pool cash flows to the extent of

payments earlier met by NHB together with interest thereon, shall

figure in the hierarchy of payments immediately after the payment of

dues of the senior RMBS holders (for whom the guarantee was

provided). On replenishment of such amount, the amount

guaranteed by NHB shall stand reinstated subject to the condition

however that the total liability of NHB under the guarantee at any

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given point of time shall not exceed the amount of senior Class RMBS

outstanding.

In respect of the amount utilised for making the timely interest

and / or principal payments to the RMBS holders by invoking of

Guarantee, NHB (Guarantor) shall be entitled to be replenished with

interest equal to the Pass-through Rate applicable to the RMBS

holders for whom the Guarantee was provided.

(viii) Guarantee Fee To NHB

The main intent of providing Guarantee to senior Class of

RMBS would be to reduce the levels of credit enhancements. The

Guarantee fee to NHB will be higher of the following

50 per cent of the Net Saving to Originator as a result of

Senior

Class RMBS (Guaranteed by NHB) 0.20 per cent p.a. of

the outstanding Senior Class of RMBS Guaranteed

The 'Net Saving' to the originator as a result of NHB's

Guarantee is determined in a transparent manner

during the rating process and equally shared between

NHB and the holders of the subordinate

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RMBS/originator. The Guarantee fee to NHB shall be

finalised by NHB in consultations with the originator,

at the time of each issue.

Progress Of Residential Mortgage Backed Securities (RMBS)

The National Housing Bank started extending guarantee to

RMBS in 2004-05. In this year NHB completed three issues of RMBS

involving 2892 housing loan amounting to Rs.99.33 crore originated

by one housing finance company and fully wrapped by NHB

guarantee. By the end of June, 2008 NHB has completed fourteen

RMBS transactions involving 38809 individual home loans of six

Housing Finance Companies and one Scheduled Commercial Bank,

housing loan amounting to Rs.862.20 crore.

Mortgage Risk Guarantee Fund

the FY 2011-12 has proposed to create a Mortgage Risk Guarantee

Fund under Rajiv Awas Yojana (RAY) to enable provision of housing

loans to Economically Weaker Section (EWS) and LIG households.

The Major objective of this Fund will be to provide default

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guarantee for housing loans upto 5 lakh sanctioned and disbursed by

the lending institutions without any collateral security and / or third

party guarantees to the new or existing borrowers in the EWS / LIG

categories.

The Government of India, Ministry of Housing & Urban

Poverty Alleviation (MoHUPA) will set up the trust under the

Mortgage Risk Guarantee Scheme. National Housing Bank is to

manage and administer the proposed Fund including providing the

infrastructure support & the required staff.

Guarantee On Loans Raised By National Housing Bank

Though NHB is a apex National Financial Institution yet it

seeks guarantee on the loan raised by it in the national and

international market. The guarantee provider is either Reserve Bank

of India or Government of India. The National Housing Bank has

paid guarantee fee to them for providing guarantee. The Central

Government guaranteed repayment of principal and interest in

respect of the bonds issued by NHB in the initial year.

Under the Housing Guarantee Programme of US AID, the NHB

has raised a loan of US $25 million in US capital market in the year

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1990-91 and Government of India had guaranteed the repayment of

loan and interest.

Similarly, NHB has borrowed US$120.4 million from Asian

Development Bank in the year of 2006-07 and the same was

guaranteed by Government of India.

The bank had made provision for guarantee fee amounting to

Rs.0.29 crore in 2005-06 and Rs.0.35 crore in 2006-07. The

accumulated provision of Rs. 3.41 crore has been made till June, 2007.

Analysis Of Performance Of The Guarantee Scheme

Income of National Housing Bank from this line of activity has

been on a very low side and does not figure prominently in the

income stream. The NHB Annual Reports for various years mention

the performance of the bank under its different products like

refinance facility, equity financing and project financing or direct

lending but no where the performance of the bank regarding product

of guarantee has been mentioned. Guarantee has not been extended

on the bonds or debentures floated by HFCs. National Housing Bank

has not been able to make this product popular and a happening line

of activity; therefore, it is listless activity. However in the case of

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other financial institutions and the banking system, we find that the

practice of extending guarantee and facility of underwriting on the

loans raised by the clients by way of issue of bonds and debentures is

very much prevalent and the underwriters and guarantor are earning

non fund based income.

However, the other product of guarantee i.e. Residential

Mortgage Backed Securities (RMBS) has been in currency for the last

few years and good progress has been made on that account. The

RMBS will help to develop and strengthen the secondary market in

India and provide liquidity to the primary lending institutions in the

housing finance market.

Conclusion

The need is there to explore the causes of non-performance of

National Housing Bank in this line. There is no harm to extend

guarantee to bonds and debentures issued by HFCs if these are rated

by rating agencies and enjoy good rating. There are a number of

credit rating agencies in the market who are ready to rate the issues.

National Housing Bank has not devoted attention to this non fund

based product. A limited volume of activity has been registered in

this area. Housing Finance Companies have also been lagging to

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avail of this facility. It needs quite some effort on the part of National

Housing Bank to make this product popular and further ease the

terms and conditions. Guarantee on Residential Mortgage Backed

Securities (RMBS) seems to a promising area where ample

opportunities exist. Volume of business under RMBS will pick up in

the years to come.