features of securitization

7/28/2019 Features of Securitization

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Oriental Institute of Management

Subject: LAW

Features of Securitization

Assignment by:

Name: Chandrakant R. Hake

Roll No. 1110

MFM 2nd

YEAR, 4TH

SEMESTER


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INDEX Page no.

DEFINITION.6

MEANING.....7

FEATURES OF SECURITIZATION.9

HISTORY.12

NEED14

WHAT CAN BE SECURITIZED? .....................................15

OPERATION.16

PROCESS..18

ADVANTAGES AND DISADVANTAGES....26

CASE STUDIES34

CONCLUSION..36

BIBLIOGRAPHY..37


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SUMMARY

Securitization creates value for organizations, investors, and consumers:

It separates the funding of receivables from their origination and servicing,

and allows origination and servicing revenues to grow without additional

balance sheet financing.

It provides cash flow and balance sheet management benefits.

It allows for targeted asset liquidation, improvements in asset liquidity,

and access to capital markets at rates different from enterprise credit

ratings.

The flexibility in transforming risks permits mutually beneficial matches

in targeted market opportunities, both for organizations and investors.

Deepercapital markets allow forprice discovery of illiquid assets, greater

access to funds for new firms and consumers, and greater financial

innovation.

Securitization creates risks of moral hazard and lack of transparency:

Separation of funding from origination can create moral hazard,

generating higher-than-expected risks and leading to conflicts between

investors, firm shareholders, and firm creditors.

Complexity of structural transformations creates lack of transparency,

which, in turn, can lead to greater illiquidity and possible market failure.These effects are worse in globally inter-connected markets.
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Objective of study

The objective of this study is to understand the concept of Securitization, its

history, and its importance in the field of financing in an ever booming globaleconomy.

Background

The first widely reported securitization deal in India occurred in 1990 when auto

loans were secured by Citibank and sold to the GIC mutual fund. However, the

sound legal framework for securitization was not drafted until 2002 when the

Securitization and Reconstruction of Financial Assets and Enforcement of

Security Ordinance (Ordinance) was promulgated by the president of India.

According to this law, securitization was defined as acquisition of financial

assets by any securitization company or reconstruction company from any

originator, whether by raising funds by such securitization or reconstructioncompany from qualified institutional buyers by issue of security receipts

representing undivided interest in such financial assets or otherwise. The notion

of financial assets for the above definition is stated as any debt or receivables.

Non-surprisingly, it follows that the definition of securitization in India is very

close to that of western countries, especially taking into account that the

experience of the UK is of special relevance to India


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Research Methodology

We have done exploratory research on TRIPS and for that we had used

secondary data.

We had collected secondary data from various published material like books and

from internet web site. From these various information and data we had done

qualitative and quantitative analysis to find out the impact of various forces and

effect of macro environmental factor.


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INTRODUCTION

DEFINITION:

Most attempts to define securitization make the same mistake; they

focus on the process of securitization instead of on the substance, or

meaning, of securitization. Hence, the most common definition of

securitization is that it consists of the pooling of assets and the issuance of

securities to finance the carrying of the pooled assets. Yet, surely, this

reveals no more about securitization than seeing one's image reflected in a

mirror reveals about one's inner character. In Lord Kelvin's terms, it is

knowledge of "a meager and unsatisfactory kind."

A better definition of securitization is that it consists of the use of

superior knowledge about the expected financial behaviour of particular

assets, as opposed to knowledge about the expected financial behaviour of

the originator of the chosen assets, with the help of structure to more

efficiently finance the assets. This definition is superior because it better

explains the need for the most essential aspects of any securitization

anywhere in the world under any legal system, and it better defines the

place of securitization within several of the broader financial trends that

have occurred at the end of our century.


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MEANING

Securitization, in the correct circumstances, is one of the very most

efficient forms of financing. This is because of two ad ditional trends. The

first is the increasing importance of the use of information to create

wealth. The second is the increasing sophistication of computers and their

uses. Securitization is made possible by the combination of these two

trends. Computers enable one to store and retrieve extensive data about

the historical behaviour of pools of assets. This historical data in turn

enables one to predict, under the right circumstances, the behaviour of

pools of such assets subsequently originated by the applicable originator.Because our knowledge about such behaviour may be so precise and

reliable, when structured correctly, a securitization may entail less risk

than a financing of the entity that originated the securitized assets.

Again in Lord Kelvin's terms, our knowledge about the likely

behaviour of pools of assets is "measurable" and we "express it in

numbers." It is a superior sort of knowledge from the perspective of theworld of finance. Accordingly, such a securitization may be fairly labelled

to be more efficient and indeed may require less over-all capital than

competing forms of financing.

The preferred definition of securitization with which this essay

began thus reveals why securitization often is preferable to other forms of

financing. It also explains most of the structural requirements of

securitization. For, to take advantage of superior information of the

expected behaviour of a pool of assets, the ability of the investor to rely

on those assets for payment must not be materially impaired by the

financial behaviour of the related originator or any of its affiliates. In

most legal systems, this is not practicable without the isolation of those

assets legally from the financial fortunes of the originator. Isolation, in

turn, is almost always accomplished by the legal transfer of the assets to


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another entity, often a special purpose entity ("SPE") that has no

businesses other than holding, servicing, financing and liquidating the

assets in order to insure that the only relevant event to the financ ial

success of the investors' investment in the assets is the behaviour of such

assets. Finally, almost all of the structural complexities that securitization

entails are required either to create such isolation or to deal with the

indirect effects of the creation of such isolation.

For example, the (i) attempt to cause such transfers to be "true

sales" in order to eliminate the ability of the originator to call on suchassets in its own bankruptcy, (ii) "perfection" of the purchaser's interest in

the transferred assets, (iii) protections built into the form of the SPE, its

administration and its capital structure all in order to render it "bankruptcy

remote", and (iv) limitation on the liabilities that an SPE may otherwise

incur are each attributes of the structure of a securitization designed to

insure that the isolation of the transferred assets is not only theoretical butalso real.

Similarly, attempts to (i) limit taxes on the income of the SPE or the

movement across borders of the interest accrued by transferred

receivables, (ii) comply with the various securities or investment laws that

apply to the securities issued by the various SPEs in order to finance their

purchases of the assets, or (iii) comply with the bank regulatory

restrictions that arise in connection with such transfers, the creation of

SPEs and the other various roles played by banks in connection with

sponsoring such transactions each constitute a reaction to indirect

problems caused by the structuring of the above described transfer and the

SPE to receive the transferred assets.


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FEATURES OF SECURITIZATION

A securitized instrument, as compared to a direct claim on the issuer, will

generally have the following features.

1. Marketability:

The very purpose of securitization is to ensure marketability to financial

claims. Hence, the instrument is structured to be marketable. This is one of the

most important features of a securitized instrument, and the others that follow are

mostly imported only to ensure this one. The concept of marketability involves

two postulates:

(a) The legal and systemic possibility of marketing the instrument

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

Legal aspect with respect to marketing instrument is concerned;

traditional law relating to business practices has not evolved much. Negotiable

instruments were mostly limited in application to what were then in circulation

as such. Besides, the corporate laws mostly defined and sought to regulate

issuance of usual corporate financial claims, such as shares, bonds and

debentures. This gives raise to the need for a codified system of law for security

and credibility of operations. We need to note that when law is not in existence,we should not conclude that it is not permitted.

The second issue is marketability of the instrument. . The purpose of

securitization is to broaden the investor base and bring the average investor into

the

capital markets. Either liquidity to a securitized instrument is obtained by

introducing it into an organized market (such as securities exchanges) or by one


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or more agencies acting as market makers. That is, agreeing to buy and sell the

instrument at either pre-determined or market-determined prices.

2. Quality of security:

To be accepted in the market, a securitized product has to have a

merchantable quality. The concept of quality in case of physical goods is

something, which is acceptable in normal trade. When applied to financial

products, it would mean 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 securitized instrument secures

the instrument based on the needs of the investors. The rule of thumb 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 securities.

For widely distributed securitized instruments, evaluation of the quality,

and its certification by an independent expert, for example, rating is common.

The rating serves for the benefit of the lay investor, who is not expected to

appraise the risk involved.

In case of securitization of receivables, the concept of quality undergoes

drastic change; making rating is a universal requirement for securitizations.

Securitization 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 assumessignificance. This at times enables investors to rely on the credit rating of debtors

(or a portfolio of debtors) in the process make the instrument independent of the

oringators' own rating.


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3. Wide Distribution:

The basic purpose of securitization 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 in the sense that the issuer is able to market the product with

lower return, and hence, lower financial cost to himself.

But wide investor base involves costs of distribution and servicing. In

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

Hence, most securitizations have been privately placed with professional

investors. However, it is likely that in to come, retail investors could be attracted

into securitized products.

4. Homogeneity:

The instrument should be packaged as into homogenous lots for marketability

of the product. Homogeneity, like the above features, is a function of retail

marketing. Most securitized instruments are broken into lots affordable to the

small 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, but debentures and bonds are sliced into Rs. 100

each to Rs. 1000 each. Designed for larger investors, commercial paper may be

in denominations as high as Rs. 5 Lac. Other securitization applications may alsofollow the same type of methodology.


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HISTORY

Before the 1970s banks lent to customers and keep loans portfolios

till the due date, by financing thanks to the deposits of theircustomers. The surge of the credit after World War II forces banks

to find new resources, particularly with securitization debut, first

applied to home loans then it more and more spread to other

products.

The securitization of assets started in the United States in the

1970s. In February 1970, the American department of housing and

urban development completes the first true securitization, on home

loans. For decades before that, banks were essentially portfolio lenders; they

held loans until they matured or were paid off. These loans were funded

principally by deposits, and sometimes by debt, which was a direct obligation of

the bank (rather than a claim on specific assets). After World War II, depository

institutions simply could not keep pace with the rising demand for housing

credit. Banks, as well as other financial intermediaries sensing a market

opportunity, sought ways of increasing the sources of mortgage funding. To

attract investors, bankers eventually developed an investment vehicle that

isolated defined mortgage pools, segmented the credit risk, and structured the

cash flows from the underlying loans. Although it took several years to develop

efficient mortgage securitization structures, loan originators quickly realized the

process was readily transferable to other types of loans as well."

In February 1970, the U.S. Department of Housing and Urban

Development created the transaction using a mortgage-backed security. The

Government National Mortgage Association (GNMA or Ginnie Mae) soldsecurities backed by a portfolio of mortgage loans. To facilitate the securitization


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of non-mortgage assets, businesses substituted private credit enhancements.

First, they over-collateralized pools of assets; shortly thereafter, they improved

third-party and structural enhancements

In 1985, securitization techniques that American Bankruptcy Institute had been

developed in the mortgage market were applied for the first time to a class of

non-mortgage assetsautomobile loans. A pool of assets second only to

mortgages in volume, auto loans were a good match for structured finance; their

maturities, considerably shorter than those of mortgages, made the timing of cash

flows more predictable, and their long statistical histories of performance gave

investors confidence. The market developed thanks to the add ict ion of

successive improvements like the use of Special Purpose Vehicle or

of a third party. It has enabled securitization of an asset for the first

time, other than a portfolio of home loans, in this case credits for the

purchase of cars. These kinds of assets are still one of the most

securitized products. This operation was a securitization amounting

to 60 million dollars made by the Marine Midland Bank.

In 1986, the first securitization of the credit portfolio of credit cards

took place, amounting to 50 million dollars. In 1988, the French

regulation is fitted to allow the securitization by using the

mechanism of claims equity. From the 1990s, securitization spreads

to products coming from insurance, with issues that reach 15 billiondollars in 2006.

In 2004, and according to the Bond Market Association, the sum

total of securitized amounts in the United States was up to 1,8

trillions of dollars, that is about 8% of the sum total of duties market

(2,6 trillion) or 39% of the sum total of firms debts. It is the result

of a medium raise of 19% in nominal value during the period of


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1995-2004. This year marks an historical record with issues up to

900 billion dollars.

In 2006, the United Kingdom represented 52% of the issues out of

CDO. It was followed by Spain, Germany and the Nederland. With 7,

7 billion dollars of issues on a European market of 370, 9 billion

dollars, France was the 5th. The actual market is mainly American

and European.

NEED

Financial markets developed in response to the need to involve a

large number of investors. As the number of investors keeps on

increasing, the average size per investors keeps on coming down,

because growing number means involvement of a wider base of

investors.

The small investor is not a professional investor. He needs an

instrument, which is easier to understand, and provides liquidity and

legal sanction. These needs set the stage for evolution of financial

instruments which would convert financial claims into liquid, easy to

understand and homogenous products. They would be available in

small denominations to suit even a small investor. Therefore,

securitization in a generic sense is basic to the world of finance, and

it is right for us to say that securitization envelopes the entire range

of financial instrument s, and the range of financial markets. Recent

years have witnessed the wide spread of Western financial innovations into

developing markets. Globalisation and integration of capital markets, started in

the 1990s, have made it possible for such big global players as India to adopt

new financial strategies which allow increasing liquidity and acceleratingdevelopment of the capital markets. One of these financial innovations is


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securitization, the process of transformation of illiquid assets into a security

which can be traded in the capital markets. Although the state of securitisation in

India is far from that of the USA and the UK, the market for securitised assets

grows at a fascinating pace. This work attempts to analyse the origination,

development and current condition of securitisation in India.

WHAT CAN BE SECURITIZED?

In concept, all assets generating stable and predictable cash flows can be

taken up for securitization. In practice however, much of the securitised

paper issued have underlying periodic cashflows secured through contracts

defining cash flow volumes, yield and timing. In this respect,

securitization of auto loans, credit card receivables, computer leases,

unsecured consumer loans, residential and commercial mortgages,

franchise/royalty payments, and other receivables relating to telecom,

trade, toll road and future export have gained prominence. Typically, asset

portfolios that are relatively homogeneous with regard to credit, maturity

and interest rate risk could be pooled together to crea te a securitization

structure. However, to make reasonable estimates of the credit quality and

payment speed of the securitised paper, it would be essential to analyse the

historical data on portfolio performance over some reasonable length of

time.


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OPERATION

PARTIES TO A SECURITISATION TRANSACTION

There are primarily three parties to a securitisation deal, namely

A.The Originator: 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. In a true sale, the Originator

transfers both the

legal and the beneficial interest in the assets to the SPV.

B. The SPV: The issuer also known as the SPV is the entity, which would

typically buy the assets (to be securitised) from the Originator. The SPV istypically a low-capitalised entity with narrowly defined purposes and

activities, and usually has independent trustees/directors. As one of the

main objectives of securitisation is to remove the assets from the balance

sheet of the Originator, the SPV plays a very important role inas much as

it holds the assets in its books and makes the upfront payment for them to

the Originator.

C. The Investors: The investors may be in the form of individuals or

institutional investors like FIs, mutual funds, provident funds, pension

funds, insurance companies, etc. They buy a participating interest in the


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total pool of receivables and receive their payment in the form of interest

and principal as per agreed pattern.

Besides these three primary parties, the other parties involved in a securitisation

deal are given below:

a) The Obligor(s): The Obligor is the Originator's debtor (borrower of the

original loan). The amount outstanding from the Obligor is the asset that is

transferred to the SPV. The credit standing of the Obligor(s) is of

paramount importance in a securitisation transaction.

b) The Rating Agency: Since the investors take on the risk of the asset

pool rather than the Originator, an external credit rating plays an important

role. The rating process would assess the strength of the cash flow and the

mechanism designed to ensure full and timely payment by the process of

selection of loans of appropriate credit quality, the extent of credit andliquidity support provided and the strength of the legal framework.

c) Administrator or Servicer: It collects the payment due from the

Obligor/s and passes it to the SPV, follows up with delinquent borrowers

and pursues legal remedies available against the defaulting borrowers.

Since it receives the instalments and pays it to the SPV, it is also called the

Receiving and Paying Agent.

d) Agent and Trustee: It accepts the responsibility for overseeing that all

the parties to the securitisation deal perform in accordance with the

securitisation trust agreement. Basically, it is appointed to look after the

interest of the investors.


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e) Structure: Normally, an investment banker is responsible as structurer

for bringing together the Originator, credit enhancer/s, the investors and

other partners to a securitisation deal. It also works with the Originator and

helps in structuring deals. The different parties to a securitisation deal

have very different roles to play. In fact, firms specialise in those areas in

which they enjoy competitive advantage. The entire process is broken up

into separate parts with different parties specialising in origination of

loans, raising funds from the capital markets, servicing of loans etc. It is

this kind of segmentation of market roles that introduces severalefficiencies securitisation is so often credited with.

PROCESS

By entering into securitisation a lower-rated entity can access debt capital

markets that would otherwise be the preserve of higher-rated institutions. Thesecuritisation process involves a number of participants. In the first instance is

the originator, the firm whose assets are being securitised. The most common

process involves an issuer acquiring the assets from the originator.

The issuer is usually a company that has been specially set up for the

purpose of the securitisation and is known as a special purpose vehicle or SPV

and is usually domiciled offshore. The creation of an SPV ensures that the

underlying asset pool is held separate from the other assets of the originator. This

is done so that in the event that the originator is declared bankrupt or insolvent,

the assets that have been transferred to the SPV will not be affected.. By holding

the assets within an SPV framework, defined in formal legal terms, the financial

status and credit rating of the originator becomes almost irrelevant to the

bondholders.


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The process of securitisation often involves credit enhancements, in which

a third-party guarantee of credit quality is obtained, so that notes issued under

the securitisation are often rated at investment grade and up to AAA-grade. The

process of structuring a securitisation deal ensures that the liability side of the

SPVthe issued notescarries lower cost than the asset side of the SPV. This

enables the originator to secure lower cost funding that it would otherwise be

able to obtain in the unsecured market. This is a tremendous benefit for

institutions with lower credit ratings.


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Mechanics of securitisation

Securitisation involves a true sale of the underlying assets from the

balance sheet of the originator. This is why a separate legal entity, the SPV, is

created to act as the issuer of the notes. The assets being securitised are sold onto

the balance sheet of the SPV.


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The process involves:

1.Undertaking due diligence on the quality and future prospects of the assets;

2. Setting up the SPV and then effecting the transfer of assets to it;

3. Underwriting of loans for credit quality and servicing;

4. Determining the structure of the notes, including how many tranches are to be

issued, in accordance to originator and investor requirements;

5. The notes being rated by one or more credit rating agencies;

6. Placing of notes in the capital markets.

The sale of assets to the SPV needs to be undertaken so that it is

recognised as a true legal transfer. The originator will need to hire legal counsel

to advise it in such matters. The credit rating process will consider the character

and quality of the assets, and also whether any enhancements have been made to

the assets that will raise their credit quality. This can include

overcollateralization, which is when the principal value of notes issued is lowerthan the principal value of assets, and a liquidity facility provided by a bank.

A key consideration for the originator is the choice of the underwriting

bank, which structures the deal and places the notes. The originator will award

the mandate for its deal to the bank on the basis of fee levels, marketing ability

and track record with its type of assets.


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Financial guarantors

The investment bank will consider if an insurance company, known as a

monoline insurer, should be approached to wrap the deal by providing a

guarantee of backing for the SPV in the event of default. This insurance is

provided in return for a fee.

Financial modelling

XYZ Securities will construct a cash flow model to estimate the size of the

issued notes. The model will consider historical sales values, any seasonalfactors in sales, credit card cash flows, and so on. Certain assumptions will be

made when constructing the model, for example growth projections, inflation

levels, tax levels, and so on. The model will consider a number of different

scenarios, and also calculate the minimum asset coverage levels required to

service the issued debt. A key indicator in the model will be the debt service

coverage ratio (DSCR). The more conservative the DSCR, the more comfortthere will be for investors in the notes. For a residential mortgage deal, this ratio

might be approximately 2.53.0; however for an airline ticket receivables deal,

the DSCR would be unlikely to be lower than 4.0. The model will therefore

calculate the amount of notes that can be issued against the assets, whilst

maintaining the minimum DSCR.


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Credit rating

It is common for securitisation deals to be rated by one or more of the formal

credit ratings agencies such as Moodys, Fitch or Standard & Poors. A formal

credit rating will make it easier for XYZ Securities to place the notes with

investors. The methodology employed by the ratings agencies takes into account

both qualitative and quantitative factors, and will differ according to the asset

class being securitised.

The main issues in a deal such as our hypothetical Airway No 1 deal would be

expected to include:

1. Corporate credit quality2.The competition and industry trends: ABC Airways market share, the

competition on its network;

3. Regulatory issues, such as need to comply with forthcoming legislation that

would

impact its cash flow;

4.Legal structure of the SPV and transfer of assets;

5. Cash flow analysis.

Based on the findings of the ratings agency, the arranger may re-design some

aspect of the deal structure so that the issued notes are rated at the required level.

This is a selection of the key issues involved in the process of

securitisation. Depending on investor sentiment, market conditions and legal

issues, the process from inception to closure of the deal may take anything from

three to 12 months or more. After the notes have been issued, the arranging bank

will no longer have anything to do with the issue; however the bonds themselves

require a number of agency services for their remaining life until they mature or

are paid off. These agency services can include paying agent, cash manager and

custodian.


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ASSET AND MORTGAGE BACKED SECURITIES

Securities issued by the SPV in a securitisation transaction are referred to

as Asset Backed Securities (ABS) because investors rely on the performance of

the assets that collateralise the securities. They do not take an exposure either on

the previous owner of the assets (the Originator), or the entity issuing the

securities (the SPV). Clearly, classifying securities as asset-backed seeks to

differentiate them from regular securities, which are the liabilities of the entity

issuing them.

In practice, a further category is identifiedsecurities backed by mortgage

loans (loans secured by specified real estate property, wherein the lender has the

right to sell the property, if the borrower defaults). Such securities are called

Mortgage Backed Securities (MBS). The most common example of MBS is

securities backed by mortgage housing loans. All securitised instruments are

either MBS or ABS.

PLAYERS AND THEIR ROLE

The dominant player in Indian securitisation is ICICI Bank, the second

largest bank in India with more than 560 branches. This bank issues more than

60% of all securitised papers in India and arranges all its own deals. ICICI offers

a full range of loans to its customers including home loans, personal loans, car

loans, and construction and medical equipment loans. All of them are securitised

by the bank. The banks portfolio of outstanding car loans amounts to 1 billion.


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In August 2004 ICICI completed the largest securitisation deal in India.

The 220 million car loan securitisation was similar to US asset backed

structures comprising three series of planned amortisation notes along with a

companion bond to absorb excess prepayments, and incorporated fixed and

floating rate options. The second leading player in the market is HDCF Bank. It

also completed a notable deal making a transaction of 150 million backed by

retail vehicle loans. The issue included four tranches with prepayment protection

feature and periodically put options which could protect investors against interest

rate rises. The mortgage-backed securities in India are relatively underdeveloped.

The first issue was made in August 2000 by NHB (National Housing

Board). Till October 2004, NHB made ten issues of mortgage-backed securities

comprising 35,116 housing loans (Kothari and Gupta, 2005). However, despite

the growing number of housing loans, the number of mortgage-backed securities

issued remained stable on the basis of total issue. Finally, according to Fitch,

estimates the investors base contains up to 15 mutual funds, 15 leading banks,

insurers and other investors (Newsletter 2004).


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ADVANTAGES AND DISADVANTAGES

Benefits of Securitization

There are several key benefits that securitization provides to market participants

and the broader economy:

Frees capital for lending - Securitization provides financial institutions

with a mechanism for removing assets from their balance sheets, thereby

increasing the pool of available capital that can be loaned out.

Lowers the cost of capital - A corollary to the increased abundance of

capital is that the rate required on loans is lower; lower interest rates

promote increased economic growth. (Read about how the Federal

Reserve controls interest rates and stimulates the economy in How Much

Influence Does The Fed Have? and The Federal Reserve's Fight Against

Recession.)

Makes non-tradable assets tradableThis action increases liquidity in a

variety of previously illiquid financial products.

Spreads the ownership of risk- Pooling and distributing financial assets

provides greater ability to diversify risk and provides investors with more

choice as to how much risk to hold in their portfolios. (For further reading,

check out How Do Banks Determine Risk?)

Provides profits for financial intermediaries - Intermediariesbenefit by

keeping the profits from the spread, or difference, between the interest rate

on the underlying assets and the rate paid on the securities that are issued.

Creates an attractive asset class for investors - Purchasers of securitized

products benefit from the fact that securitized products are often highly
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customizable and can offer a wide range of yields. (Learn more in

Understanding Structured Products.)

Risks in Securitization

(a) Bankruptcy / Performance Risk: Since future flow transactions rely on the

future generation of cash flow to repay investors, the continued existence and

performance of the borrower throughout the tenure of the transaction are critical

considerations to investors. Indeed, this risk generally acts as the limiting

constraint on the rating of the transaction and consequently determines the tenure

as well as the pricing. The ultimate rating may be enhanced by at most one notch

above the local currency rating of the borrower in case the securitisation

constitutes a true sale transaction under the bankruptcy laws of the borrower. In

other words, should the borrower become insolvent, no creditors of the borrower

would be able to make a claim against the receivables sold to investors. So long

as the borrower continues to operate (even in bankruptcy), investors will receive

payments on the receivables on time and unhindered. In terms of mitigating thisrisk, there is very little that can be done structurally without obtaining the

support or guarantee of a rated third party.

(b) Generation Risk: There still is another risk related to the sustained

generation of the receivables at certain levels from a host of factors outside ofthe control of the borrower, e.g. anticipated reserves may not materialise or

seasonal variations in the anticipated levels of receivables may occur. This risk is

mitigated through adequate over-collateralisation. Further, in order to protect

investors against more sustained long-term declines in the levels of receivables

generated, early amortisation triggers are usually built into the transaction that

will trigger the repayment of the securities on an accelerated basis if a predefined

trigger level is breached.
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(c) Price Risk and Off-take Risk: These refer to likely price variations or the

concern that the Obligors in the future cease buying or reduce their purchasing

level of the goods or service from the seller.

Advantages to issuer

i) Reduces funding costs:

Through securitization, a company rated BB but with AAA worthy cash

flow would be able to borrow at possibly AAA rates. This is the number one

reason to securitize a cash flow and can have tremendous impacts on borrowing

costs. The difference between BB debt and AAA debt can be multiple hundreds

of basis points. For example, Moody's downgraded Ford Motor Credit's rating in

January 2002, but senior automobile backed securities, issued by Ford Motor

Credit in January 2002 and April 2002, continue to be rated AAA because of the

strength of the underlying collateral and other credit enhancements.[11]

ii) Reduces asset-liability mismatch:

"Depending on the structure chosen, securitization can offer perfect

matched funding by eliminating funding exposure in terms of both duration and

pricing basis.[14]

Essentially, in most banks and finance companies, the liability

book or the funding is from borrowings. This often comes at a high cost.

Securitization allows such banks and finance companies to create a self-funded

asset book.
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iii) Lower capital requirements:

Some firms, due to legal, regulatory, or other reasons, have a limit or

range that their leverage is allowed to be. By securitizing some of their assets,

which qualifies as a sale for accounting purposes, these firms will be able to

remove assets from their balance sheets while maintaining the "earning power"

of the assets.

iv) Locking in profits:

For a given block of business, the total profits have not yet emerged and

thus remain uncertain. Once the block has been securitized, the level of profits

has now been locked in for that company, thus the risk of profit not emerging, or

the benefit of super-profits, has now been passed on.

v) Transfer risks (credit, liquidity, prepayment, reinvestment, asset

concentration):

Securitization makes it possible to transfer risks from an entity that does

not want to bear it, to one that does. Two good examples of this are catastrophe

bonds and Entertainment Securitizations. Similarly, by securitizing a block of

business (thereby locking in a degree of profits), the company has effectively

freed up its balance to go out and write more profitable business.

vi) Off balance sheet:

Derivatives of many types have in the past been referred to as "off-

balance-sheet." This term implies that the use of derivatives has no balance sheet

impact. While there are differences among the various accounting standards

internationally, there is a general trend towards the requirement to record

derivatives at fair value on the balance sheet. There is also a generally accepted

principle that, where derivatives are being used as a hedge against underlying


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assets or liabilities, accounting adjustments are required to ensure that the

gain/loss on the hedged instrument is recognized in the income statement on a

similar basis as the underlying assets and liabilities. Certain credit derivatives

products, particularly Credit Default Swaps, now have more or less universally

accepted market standard documentation. In the case of Credit Default Swaps,

this documentation has been formulated by the International Swaps and

Derivatives Association (ISDA) who have for a long time provided

documentation on how to treat such derivatives on balance sheets.

vii) Earnings:

Securitization makes it possible to record an earnings bounce without any

real addition to the firm. When a securitization takes place, there often is a "true

sale" that takes place between the Originator (the parent company) and the SPE.

This sale has to be for the market value of the underlying assets for the "true

sale" to stick and thus this sale is reflected on the parent company's balance

sheet, which will boost earnings for that quarter by the amount of the sale. Whilenot illegal in any respect, this does distort the true earnings of the parent

company.

viii) Admissibility:

Future cash flows may not get full credit in a company's accounts (life

insurance companies, for example, may not always get full credit for futuresurpluses in their regulatory balance sheet), and a securitization effectively turns

an admissible future surplus flow into an admissible immediate cash asset.

ix) Liquidity:

Future cash flows may simply be balance sheet items which currently are

not available for spending, whereas once the book has been securitized, the cash


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would be available for immediate spending or investment. This also creates a

reinvestment book which may well be at better rates.

Disadvantages to issuer

May reduce portfolio quality: If the AAA risks, for example, are being

securitized out, this would leave a materially worse quality of residual risk.

Costs: Securitizations are expensive due to management and system costs, legal

fees, underwriting fees, rating fees and ongoing administration. An allowance for

unforeseen costs is usually essential in securitizations, especially if it is an

atypical securitization.

Size limitations: Securitizations often require large scale structuring, and thus

may not be cost-efficient for small and medium transactions.

Risks: Since securitization is a structured transaction, it may include par

structures as well as credit enhancements that are subject to risks of impairment,

such as prepayment, as well as credit loss, especially for structures where there

are some retained strips.

Advantages to investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality assets: Due to the

stringent requirements for corporations (for example) to attain high ratings, there

is a dearth of highly rated entities that exist. Securitizations, however, allow for

the creation of large quantities of AAA, AA or A rated bonds, and risk averse

institutional investors, or investors that are required to invest in only highly rated

assets, have access to a larger pool of investment options.


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

as other institutional investors tend to like investing in bonds created through

securitizations because they may be uncorrelated to their other bonds and

securities.

Isolation of credit risk from the parent entity: Since the assets that are securitized

are isolated (at least in theory) from the assets of the originating entity, under

securitization it may be possible for the securitization to receive a higher credit

rating than the "parent," because the underlying risks are different. For example,

a small bank may be considered more risky than the mortgage loans it makes to

its customers; were the mortgage loans to remain with the bank, the borrowers

may effectively be paying higher interest (or, just as likely, the bank would be

paying higher interest to its creditors, and hence less profitable).

Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrowers inability to

meet interest payment obligations on time. For ABS, default may occur when

maintenance obligations on the underlying collateral are not sufficiently met as

detailed in its prospectus. A key indicator of a particular securitys default risk is

its credit rating. Different tranches within the ABS are rated differently, with

senior classes of most issues receiving the highest rating, and subordinatedclasses receiving correspondingly lower credit ratings.

However, the credit crisis of 20072008 has exposed a potential flaw in the

securitization processloan originators retain no residual risk for the loans they

make, but collect substantial fees on loan issuance and securitization, which

doesn't encourage improvement of underwriting standards.


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Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are

subject to some degree of early amortization risk. The risk stems from specific

early amortization events or payout events that cause the security to be paid off

prematurely. Typically, payout events include insufficient payments from the

underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed

Securities spread, a rise in the default rate on the underlying loans above a

specified level, a decrease in credit enhancements below a specific level, and

bankruptcy on the part of the sponsor or servicer.

Currency interest rate fluctuations: Like all fixed income securities, the prices

of fixed rate ABS move in response to changes in interest rates. Fluctuations in

interest rates affect floating rate ABS prices less than fixed rate securities, as the

index against which the ABS rate adjusts will reflect interest rate changes in the

economy. Furthermore, interest rate changes may affect the prepayment rates on

underlying loans that back some types of ABS, which can affect yields. Homeequity loans tend to be the most sensitive to changes in interest rates, while auto

loans, student loans, and credit cards are generally less sensitive to interest rates.

Moral hazard: Investors usually rely on the deal manager to price the

securitizations underlying assets. If the manager earns fees based on

performance, there may be a temptation to mark up the prices of the portfolio

assets. Conflicts of interest can also arise with senior note holders when the

manager has a claim on the deal's excess spread.

Servicer risk: The transfer or collection of payments may be delayed or reduced

if the servicer becomes insolvent. This risk is mitigated by having a backup

servicer involved in the transaction.


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CASE STUDY

CASE STUDIES

Auto loans

Citibank Case

Citibank assigned a cherry-picked auto loan portfolio to Peoples 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 Pass Through Certificates 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 0.10%. 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 MFs. 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 investmentpolicy.

Although the certificates were listed on the NSE, there was very little

secondary market activity because there was absence of adequate amount of

alternative security of similar risk profile. Besides Citibank, NBFCs like Ashok

Leyland Finance, 20th Century Finance etc. Have securitised their auto loan

portfolio, though, of course, these transactions involved assignment of


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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.

Future receivables - L&T case

The recent case of a power plant construction being financed through the

capital markets is an example of future flow securitisation. Although Larsen &

Toubro bagged the Build, Lease and Operate contract for a 90-MW captive

power plant for Indian Petrochemical Corporation Ltd. (IPCL), it preferred totransfer it to an SPVIndia 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&Ts guarantee was also

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 highergearing ratio.


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CONCLUSION

Originating in the mortgage markets of the US in the 1970s securitisation

hasdeveloped and come a long way from there to spread throughout the globe to

benefitorganisations

Securitisation is the buzzword in today's World of Finance. It's not a new subject

tothe developed economies. It is certainly a new concept for the emerging

marketslike India. The Technique of Securitisation definitely holds great promise

for aDeveloping Country like India.

Securitisation has worked well over the other tools of financing as it does

notincrease the liability of the Originator but at the same time provides him

financing.It infact converts the NPA of the company into cash flows.

The above features help infrastructure companies to get finance easily and

alsohelps the banks by reducing the burden on them and helping them to

concentrate ontheir core business activities.

But the tool has not been utilized to its fullest in our country as cuase of the legal

complications. However a welcome step was seen in the form that securitized

paper scan now be traded as assets in the market and also the reduction in the

stamp duty of the securitization transaction.

The development till offlate was slow but the future for securitization is said

to be very bright in Asias 2nd largest economy where financing is of prime

importance and the growth potential are very high.


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BIBLIOGRAPHY

WEB SITES

WWW.VINODKOTHARI.COM

WWW.BSEINDIA.COM

WWW.NHB.ORG.IN

WWW.ECONOMICTIMES.COM

WWW.WICKIPEDIA.COM

WWW.SOOPLE.COM
http://www.vinodkothari.com/http://www.vinodkothari.com/http://www.bseindia.com/http://www.bseindia.com/http://www.nhb.org.in/http://www.nhb.org.in/http://www.economictimes.com/http://www.economictimes.com/http://www.wickipedia.com/http://www.wickipedia.com/http://www.wickipedia.com/http://www.economictimes.com/http://www.nhb.org.in/http://www.bseindia.com/http://www.vinodkothari.com/

features of securitization

Documents