Download - Securitization in India

SECURITIZATION IN INDIA

CONVENTIONAL BOND STRUCTURE

Structure of a normal debt instrument

A debt instrument is the obligation of the issuer

Normally, the credit profile of the issuer depends on the aggregated earnings power of its businesses in the context of its financial risk profile and management capability

It is these businesses that would need to generate the cash flows for bond redemption

Earnings Power etc

Issuer Investor

Bonds

Cash

LIMITATIONS OF CONVENTIONAL DEBT

FUNDING Limited flexibility to enhance the credit quality of the

borrower

Largely standardized loan products homogenizing credit quality across cross-section of asset side inflows and liability side outflows

Firms unable to package out different levels of risk to meet varying needs of investors

Consequently, cost of funds linked to average credit profile of different cash flows

Are alternatives available?

WHAT ARE THE ALTERNATIVES

Third party credit support Full financial guarantee/ Bond Insurance Letter of Credit Partial Financial Guarantee

Escrowing of cash flows

Pledging/Assignment of future flows

Securitization Pledging/sale of a pool of retail receivables into a SPV Pledging/sale of liquid assets Pledging/sale of receivables from highly rated regular customers

into a SPV

THIRD PARTY CREDIT SUPPORT

Any support provided to conventional bond structure such that

The debt instrument can achieve a rating higher than that implied by the aggregate earnings power of the issuer who deploys the cash proceeds of the bonds in its businesses

Earnings Power etc

Issuer InvestorBonds

CashCredit Support


Full financial guarantee, letter of credit, bond insurance

Instruments rating is equated to the credit rating of the facility provider

Full credit support yet to commence as a commercial activity in India. Instances of full credit support usually a consequence of past relationships

International full credit support suppliers

Letters of credit- Commercial Banks

Bond insurance/ financial guarantees- monoline insurers

Partial Guarantee

Bond rating lies between the rating of the guarantor and the issuer

Initially provided by multilateral entities like IFC Washington, FMO


Non Guaranteed Guaranteed

1 2 3 4 5 6 7 8 9 10

10 equal annual installments with the last 6 installments

fully guaranteed by a AAA entity

Rating of obligor BBB +

Weighted average Tenor 5 years

% Guarantee 75%

BBB + Pricing 433 bps over G-sec

AA Pricing 114 bps over G-sec

Guarantee Cost 150 bps ( approx)

THIRD PARTY CREDIT SUPPORT…

Applications Weak entities that are a part of a stronger business groups-

guaranteed issuance, especially CP Entities with appetite for long tenor projects, where investor

comfort is restricted to short tenor lending Entities that enjoy long-term standing relationships with

banks- letter of credit backed issuance Entities that fit into the framework of multilateral agencies

like IFC can approach them for partial guarantee

ESCROWING OF CASH FLOWS

Escrow mechanism captures future sales to Highly rated customers, or A Pool of large numbers of customers

Applicable to corporate issuers when Escrowed revenues are exclusively made available for debt

servicing All operating expenses can be met out of remaining

revenue sources

Can achieve a rating enhancement of upto 2 notches due to prioritization achieved without impacting operations


Rating of company A+

Credit enhancement Escrowing of cash flows

Rating of structure AA

Pricing differential between A+ and AA 130 bps over comparable G-Sec


Applied several times for entities that are unlikely to go bankrupt like municipalities, governments and statutory bodies, for eg.

Escrow of energy sales by SEBs, property or other taxed by Municipalities

In addition, BPO, rent receivables have also been escrowed

Applications

Entities with a high asset turnover ratio where escrowing a small portion pf revenues could benefit a significant portion of the funding mix

Entities having a regular inflow of stable non-operating cash flows like rentals

ASSIGNMENT OF FUTURE FLOWS

• Future sales of goods with a ready market and relative price stability are assigned to an SPV. These are usually commodities or utilities

• Key risks: Price risk and generations risk

• Generation Risk of the said good/service is linked to the likelihood of continuance in operations of the facility operated can be mitigated by standby operator

Earnings Power etc

User InvestorBonds

CashSPE

Receivables

Cash

Generated and assigned over a period. Cash paid upfront

Generated and assigned over a period. Cash paid upfront

Responsibility for operating facility to generate receivables

Responsibility for operating facility to generate receivables

Standby OperatorStandby Operator

ASSIGNMENT OF FUTURE FLOWS

Applications

Entities with take or pay contract with a highly rated customer for any good or service

Entities producing a highly marketable commodity like oil, gas etc.

SECURITIZATION - BASICS

Securitization is the pooling of “homogeneous”, “financial"," cash flow producing”, “illiquid” assets and issuing claims on those assets in the form of marketable / tradable securities

Typically, a lender / originator advances a loan to borrower and over a period of time, he expects to receive repayment of principal and interest.

In securitization, the lender / originator sells the right to receive the future receivables to a third party and receives the present value of the receivables at the initiation of the transaction

The higher yield associated with these securities attracts investors who are willing to bear the associated credit, prepayment and liquidity risk


The basic principles of direct assignment remain the same - the only difference being that the investor records the transaction as ‘loans’ in its books and doesn’t invest in a tradable security

The originator also provides an upfront credit enhancement in the transaction to cover for the shortfalls in the pool because of borrower defaults;

The primary advantage of securitization is the flexibility provided in terms of unbundling of risks and allocation of the same to various parties who are able to manage those risks


Securitization involves sale, transfer, pledge of specified assets to a Bankruptcy-remote Special Purpose Vehicle (SPV)

The SPV in turn issues Notes (Pass Through Certificates) to investors in order to fund the purchase of the assets

Investors (banks, insurance companies, and specialised funds) rely on the cash flows (principal, interest and sale proceeds when sold after foreclosure) generated by the underlying assets to pay interest and principal on the notes

The risk associated with the assets is stratified by looking at historical default and loss information

Generally, the Originator remains the Servicer of the pool of the assets it had sold to the SPV

Key Features of Securitization

All the risks and rewards associated with underlying pool are transferred to the buyer

The transaction structure should be such that the bankruptcy of the seller does not affect the underlying pool

There is no recourse to seller once the underlying pool is sold

Key Features of Securitization

Pass Through – Refers to securitization structure where the SPV makes payments, or rather, passes payments to the investors, on the same periods, and subject to the same fluctuations, as are there in the actual receivables viz. amount collected every month is passed through to investors, after deducting fees and expenses.

Pay Through – Where the payment to the investors are routed through SPV who does not strictly pay the investors only when the receivables are collected by it, but keeps paying on the stipulated dates irrespective of the collection dates. In order to allow for smoothed payment to investors by removing the fluctuations in its collections, the SPV uses a guaranteed investment contract or credit enhancements or both.

Credit enhancements – Refers to one or more initiatives taken by the originator in a securitization structure to enhance the security, credit or the rating of the securitised instrument.

Loan to value ratio – In case of asset based lending, means the amount of loan as a percent of the value of the asset on which the loan is secured.

SECURITIZATION VS. TRADITIONAL DEBT

Securitization

Isolation of pool – true sale

Claim only against the pool – no impact of issuer bankruptcy

Typically both principal and interest repaid monthly

Credit enhancement helps in getting a higher rating than the issuer

Traditional Debt

The issuer holds the assets – provides security

Claim against the issuer company

Monthly interest; bullet principal payments

Rating cannot be higher than the issuer debt rating

Securitization vs Bilateral Assignment

Receivables based financing

Securitization through issue of tradable instruments would attract a wider investor base and thereby result in lower cost of funds to the Originator

Full RecourseOn Balance SheetNo capital ReliefNo gain on SaleBilateral or CMI

Limited RecourseOff Balance SheetRelease of capitalPossible gain on SaleNo capital market investors

Limited RecourseOff Balance SheetRelease of capitalPossible gain on SaleBanks and capital market investors

Loan/Advance Debenture Backed by charge & Escrow

Bilateral Assignment of receivables between Originator & Purchaser

Securitization vide issue of tradable instruments by an SPV

Bilateral Assignment: Structure Diagram

Originator Obligors

Purchaser/ Investor

Servicer

Credit Rating Agency

Credit Enhancement

Lease/Loan/Other Agreements

Payment towards Obligation

Purchase ConsiderationAssignment

Of

Receivables

Credit enhancement and rating may be optional in a bilateral transaction depending on the comfort of the purchaser / investor

PARTIES TO A SECURITISATION

OriginatorInitial owner of the assetsSells its asset to the SPV

Obligor Contractual debtor to Originator Pays cashflows that are securitised

SPVSet up specifically for transaction

Purchases assets from Originator Company/Trust/ Mutual Fund

InvestorsSubscribe to securities

issued by SPV


Servicer Collects monies from Obligors, monitors and maintains assets

Receiving & Paying Agent

Banker for the deal. Manages inflows& outflows, invests interim funds, accesses cash collateral

Credit enhancement

provider

Provides credit enhancement by way of swaps, hedges, guarantees, insurance etc.

Merchant banker

As structurer for designing& executing the transaction and as arranger for the securities


(CONTD.)Credit Rating

AgencyProvides a rating for the deal based on structure, rating of

parties, legal and tax opinion etc

Legal & Tax Counsel

Provide key opinions on the structure & underlying contracts

AuditorAppointed for conducting due diligence both initial and

during tenor of deal

CustodianR&T Agents

Appointed for safe custody of the underlying documents and registration/ transfer of securities

EXCHANGE OF FUNDS - INITIAL

Finance Company Ltd. (Originator) Trust (SPV) Investors

Trustee

Rating AgencyBorrowers

Trust Agreement

Asset-BackedSecurities

ProceedsProceeds

Rating with specified credit enhancement

Sale of assets

Loan agreement Servicing Agreement

EXCHANGE OF FUNDS - ONGOING

Finance Company Ltd. (acting as servicer) Trust (SPV) Investors

Trustee

Rating AgencyBorrowers

Trustee Responsibilities

Monthly investorpayments

Monthly loan repayments

RatingLoan repayments

Monthly reports

Collection reports

Form of SPV and role of Trustee are critical in a securitization

Tranching of Liabilities

Cash flows from securitized assets

6 month PTCs

1 year PTCs

5 year PTCs

Originator SPV Investors

Cash flows from securitized assets

Senior PTCs

AAA(SO)Originator SPV Investors

Retained Unrated Tranche

PAR AND PREMIUM STRUCTURES

Par StructuresPar Structures

Investor pays a consideration equal to the principal outstanding (par value) of the poolInvestor pays a consideration equal to the principal outstanding (par value) of the pool

Typically, interest generated on the pool is higher than the yield to the investor, the difference is called excess interest spread (EIS)

Typically, interest generated on the pool is higher than the yield to the investor, the difference is called excess interest spread (EIS)

EIS provides credit support to the investors. the originator retains a subordinated right to receive the EIS.EIS provides credit support to the investors. the originator retains a subordinated right to receive the EIS.

In return, investor is entitled to receive scheduled principal repayments along with a contracted yieldIn return, investor is entitled to receive scheduled principal repayments along with a contracted yield

Premium StructuresPremium Structures

Investor pays a consideration equal to the present value of future cash flows. The investor pays a premium to receive the excess interest spread

Investor pays a consideration equal to the present value of future cash flows. The investor pays a premium to receive the excess interest spread

No excess interest in the structureNo excess interest in the structure

The rating takes care of the fact that the investor payouts are higher and credit enhancement is calculated accordinglyThe rating takes care of the fact that the investor payouts are higher and credit enhancement is calculated accordingly

In return, investor receives the entire cash flows generated from the poolIn return, investor receives the entire cash flows generated from the pool

Prepayments in the underlying pool are passed on to the investorPrepayments in the underlying pool are passed on to the investor

As investor principal outstanding is higher than the pool principal, the credit enhancement is utilized to cover the prepayment shortfallAs investor principal outstanding is higher than the pool principal, the credit enhancement is utilized to cover the prepayment shortfall

BENEFITS OF SECURITIZATION

Efficient use of capital

Off balance sheet treatment and hence release of a portion of capital tied up by these assets

Allows the company to continuously churn assets and expand business volumes even when capital availability is scarce

Balance sheet management

Off-balance sheet treatment and upfront profit generated has a positive impact on financial results like Return of Assets, Earnings per share, Net spread etc.

Alternate Source of Funding

Securitization is an alternative source of funding that does not use up limits set up by banks / institutions on the company and allows allocation of funds by investors over and above these limits

BENEFITS OF SECURITIZATION

Rating enhancement resulting in lower cost of funds

Capital markets and other investors demand yields linked to the rating of the issuers for direct debt investment

Securitization enables a company to achieve a rating several notches above its standalone rating and thereby lower its cost of funding

Converting illiquid assets to liquid assets

Preserving customer relationships

Securitization allows transfer of credit risk while preserving existing relationships with customers

Typically, the originator acts as servicer for the transaction and hence continues to be the point of interaction with the obligors.

ORIGINATOR’S OBJECTIVES

Each originator should define the objectives desired to be achieved through the proposed securitization transaction in order of priority

Access to an alternate source of funds / investor class

Optimization of regulatory capital requirement

Rating enhancement and reduction in cost of funds

Balance sheet management : liquidity, asset-liability matching, debt-equity ratio

Limited recourse financing

Risk management – Sector exposure / company exposure

Structure of securitization may vary significantly based on the priority of objectives of the originator

What can be Securitized

Receivables Example Assignability

Existing/Overdue Trade Receivables

Accruing Lease Receivables

Future- with off take Power Purchase

Future- without off take Credit Card/MTNL Billing

Future- without framework Air India Ticket Sales ?

Mere expectancy Offerings at a shrine X

Types of receivables

RECEIVABLES

CURENT RECEIVABLES (no performance risk of Originator for eg.

Lease, hire purchase, loans)

RETAIL RECEIVABLES (Diversified Obligor base) for eg. Car/ CV

Financing

CONTRACT BACKED RECEIVABLES for eg. Long term supply

contracts

SECURED RECEIVABLES

for eg. Secured Corporate Loans

FUTURE RECEIVABLES (performance risk of Originator for eg. Future

Sales Receivables)

CORPORATE RECEIVABLES (Concentrated Obligor base) for eg. Car/ CV

Financing

RECEIVABLES WITHOUT UNDERLYING CONTRACTS

for eg. Tea Sales at Auctions

UNSECURED RECEIVABLES

for eg. Utility Charges

Retail Assets Securitization

ABS market dipped in 2009

Absence of banks from this market

De-growth in retail originations

Tight liquidity

Concerns on asset quality

Largely becoming a liquidity providing instrument

Securitisation is a key resource raising avenue for NBFCs

CVs emerged as dominant asset class largely driven by Shriram, Tata Motors finance and Magma

Microfinance loans and gold loans are the emerging asset classes

0

200

400

600

800

1000

1200

1400

FY2003

FY2004

FY2005

FY2006

FY2007

FY2008

FY2009

0

20

40

60

80

100

120

Disbursement Issuance (Rs bil) No. of transactions

13%

4%2%4%

4%

5%

New / used Cars and UV Two wheeler

Personal loan SME loan

Mixed pool Others

Source: ICRA Research & Industry

TOP ABS ORIGINATORS

Banks have largely been non-existent in ABS market for last one year as the retail asset growth has been minimal / negative ABS continues to be a viable resource raising avenue for NBFCs focusing on asset finance Top originators for 2009-10 till date are Reliance Capital, Tata Motors Finance and Shriram Transport Finance Limited

Source: CRISIL report

WHAT AN ORIGINATOR LOOKS FOR

Advantages of securitization over traditional funding

Managing Asset liability mismatch

Capital relief

Off-balance sheet funding

Reducing concentration risk

Direct access to capital markets

Improved RoA / RoE

But, originators prefer to retain customer relationship and servicing

SECURITIZATION’S ANCILLARY BENEFITS

Securitization creates incentives for originator for

Developing transparent credit approval process

Efficient collection procedures, and for strong mechanisms to control this process

Clear and efficient processes invariably lead to lower credit enhancement

Public availability of information about pool performance adds to confidence in securitized paper

BENEFITS TO INVESTORS

Premium over equivalent rated plain securities

Focused risks associated with securities Portfolio diversification Tailored cash flow structures Flexible range of maturities Experienced risk assessment

BENEFITS TO THE FINANCIAL SECTOR

New forms of securities – market completion

Assists development of capital markets

Attracts conservative buyers

Draws international capital

Facilitates efficient allocation of risks

Originators – Incentive, Impacts

Secured Assets (100% risk weight and 9% capital), Unsecured Asset (125% risk weight and 9% capital)Capital

Relief 12%, 10% in case of Asset Finance CompaniesBa

nkN

BFC

Standard Provisioning – Secured Assets (0.4%), Unsecured Assets (2%). NPA are provided as per the RBI norms

Provisioning Relief No standard provisioning requirement. Relaxed provisioning

norms compared to Banks. Hence longer collection cycles, higher delinquencies compared to Banks

Bank

NBF

C


As per Basel – Rated piece (typically BBB) as per rating (typically 100% risk weight & 9% capital). Unrated to be fully deducted. No reset. Capital knock

off for Collateral To be fully deducted out of capital. No reset allowed. Basel

applicability??

Profit (IRR from pool – Sell down rate – expected collection cost – Expected credit losses) to be amortised by the seller

Profit Profit (IRR from pool – Sell down rate – expected collection

cost – Expected credit losses) to be amortised by the seller

Bank

Bank

NBF

CN

BFC


Proceeds from securitisation have no CRR/SLR requirement

Reduces priority sector requirementCost of funds Reduces cost of funds. More important in case of Non Asset

Finance NBFCs where provisioning requirement by Banks is leading to higher costs

Bank

NBF

C

BANKRUPTCY REMOTENESS

True sale of assets from the seller to the trustee

Legal separation of assets from the seller is achieved – investor is not exposed to credit worthiness of seller

Credit enhancement and liquidity facility – bankruptcy remoteness achieved through rating triggers

An independent legal opinion is taken post the transaction to cover all such legal issues

PERFORMANCE OF SECURITISATIONS IN INDIA

Unlike US, the rise in delinquencies has not led to widespread downgrades or defaults in securitised papers

Rating agencies largely pre-empted the deterioration in asset quality and have increased the credit enhancement requirement suitably

Safety cover for investors has remained robust

Till date, approximately 700 pools have been rated in India

38 pools have been downgraded so far

Only 3 of which have been downgraded to speculative grade

Some of these 38 pools have been upgraded back to AAA because of stable performance at later stages

Key Risks Credit Risk

It is the risk of non-payment of underlying obligors, which is dependent on underlying obligor’s ability and willingness to pay.

The underlying obligor’s ability to pay is primarily driven by adequacy and stability of income

Loan to value ratio and income generating capability of the underlying asset will indicate the obligor’s willingness to pay.

Market Risk Macro Economic Risk – affects underlying asset valuation, income generating

capacity, borrower’s income, market interest rates, change in regulations etc. Asset Risk - general risk perception of the asset; historic performance Prepayment Risk – prevailing and expected market interest rates and expected

income levels will influence the prepayment rates Interest Rate Risk – mismatch may arise in case where the collections from

underlying borrowers are based on fixed rate and the payouts to investors are based on floating rate and vice versa.

Key Risks

Counterparty Risk Servicer Risk – the ability of the servicer to service the

pool over the tenure of the transaction Commingling Risk – The time lag between the

collections from the underlying obligors and deposit into collection account give rise to commingling risk.

Other Counterparty Risk – The presence of other counterparties like collection account bank, credit collateral provider etc. give rise to performance risk.

Legal Risk

Download - Securitization in India

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