securitisation of loans

7/29/2019 Securitisation of Loans

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Securitization ;

Securitisation, in its most basic form, is a method of financing assets. Rather than

selling those assets “whole,” the assets are combined into a pool, and then that pool

is split into shares. Those shares are sold to investors who share the risk and reward

of the performance of those assets. It can be viewed as being similar to a corporation

selling, or “spinning off,” a profitable business unit into a separate entity. They

trade their ownership of that unit, and all the profit and loss that might come in the

future, for cash right now. A very basic example would be as follows. XYZ Bank

loans 10 people $100,000 a piece, which they will use to buy homes. XYZ has

invested in the success and/or failure of those 10 home buyers- if the buyers make

their payments and pay off the loans, XYZ makes a profit. Looking at it another

way, XYZ has taken the risk that some borrowers won’t repay the loan. In exchange

for taking that risk, the borrowers pay XYZ a premium in addition to the interest

on the money they borrow. XYZ will then take these ten loans, and put them in apool. They will sell this pool to a larger investor, ABC. ABC will then split this pool

(which consists of high risk loans and low risk loans) into equal pieces. The pieces

will then be sold to other smaller investors, (as bonds).

Features of securitisation:

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

generally have the following features.

Marketability:



The very purpose of securitisation 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 securitised 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 andcredibility of operations.

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

securitisation is to broaden the investor base and bring the average investor

into the

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

introducing it

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

agencies

acting as market makers. That is, agreeing to buy and sell the instrument at

either predetermined or market-determined prices.



Quality of security:

To be accepted in the market, a securitised 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 theinvestors'

satisfaction. "To the investors' satisfaction" is a relative term, and

therefore, the

originator of the securitised instrument secures the instrument based on the

needs of the investors. The 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 securitise.

For widely distributed securitised 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 securitisation of receivables, the concept of quality undergoes

drastic

change; making rating is a universal requirement for securitisations.

Securitisation is a

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

investors.



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

Dispersion of Product :

The basic purpose of securitisation is to disperse the product as much as

possible.

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

based on a

comparative analysis of the costs and the benefits achieved. Wider

dispersion or

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 him. However,wide

investor base involves costs of distribution and servicing. In practice,

securitisation issues

are still difficult for retail investors to understand. Hence, most

securitisations have been

privately placed with professional investors.



Homogeneity:

The instrument should be packaged as into homogenous lots for

marketabilty of

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

marketing. Most

securitised instruments are broken into lots affordable to the small marginal

investor, and

hence, the minimum denomination becomes relative to the needs of thesmallest 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

securitisation

applications may also follow the same type of methodology.

Special purpose vehicle:

In case the securitisation involves any asset or claim which is direct and

unsecured claim on the issuer, the issuer will need an intermediary agency.It acts as a repository of the asset or claim, which is being securitised. In the

case of a secured debenture, it is a secured loan from several investors.

Here, security charge over the issuer's several assets needs to be integrated

and thereafter broken into marketable lots. For this purpose, the issuer will

bring in an intermediary agency whose function is to hold the security charge



on behalf of the investors. In turn, it issues certificates to the investors of

beneficial interest in the charge held by the intermediary. Thus, the charge

continues to be held by the intermediary, beneficial interest therein becomes

a marketable security. The same process is involved in securitisation of

receivables. The special purpose intermediary holds the receivables with it,

and issues beneficial interest certificates to the

investors.

Types of Securitizations

Securitization was initially used to finance simple, self liquidating assets such as

mortgages. But any type of asset with a stable cash flow can in principle be structured

into a reference portfolio that supports securitized debt. Securities can be backed not

only by mortgages but by corporate and sovereign loans, consumer credit, project

finance, lease/trade receivables, and individualized lending agreements. The generic

name for such instruments is asset-backed securities (ABS), although securitization

transactions backed by mortgage loans (residential or commercial) are called

mortgage- backed securities. A variant is the collateralized debt obligation, which uses

the same structuring technology as an ABS but includes a wider and more diverse

range of assets.

o mortgage loans ==> MBS

o consumer loans ==> ABS

o corporate loans ==> CLO

o corporate bonds ==> CBO



• Mortgage backed securities (MBS) were the first ones and are still the

most predominant type of securitization.

Cash Flow Types of Securitisation Structures ;

• There are three most common types of securitisations from the

perspective of cash flow:

Collateralized Debt, Pass-Through and Pay-Trough structures.

Collateralized debt

It is similar to asset-based borrowing.



The owner of assets borrows money and pledges assets to secure

repayment. The assets pledged may be measured according to their

market value upon sale or their ability to

generate a cash flow stream. The debt instrument need not match the

cash flow configuration

of any of the assets pledged.

Pass through securitization

It is way to securitise assets with a regular cash

flow, by selling direct participations in the pool of assets. In other words, a

pass-through

certificate represents an ownership interest in the underlying assets and

thus in the resulting

cash flow. Principal and interest collected on the assets are “passed

through” to the

security holders; the seller acts primarily as a servicer.

A pay-through debt instrument

It is a borrowing instrument, not a participation.

Under the pay-through structure, the assets are typically held by a limited

purpose vehicle that issues debt collateralized by the assets. Like a pass-

through, the debt service is met by cash flow “paid through” to investors out

of the pledged collateral. Investors in a pay-through bond are not directowners of the underlying assets; they have simply invested in a bond backed

by some assets. Therefore, the issuing entity can manipulate

the cash flows, into separate payment streams. Thus pay-through

securities may be structured



so that asset cash flows can be reconfigured to support forms of debt

unlike those

•

• Parties and their Roles ;

The key parties involved in a securitisation and their roles3 are as

follows :

• _ Originator—

owner and “generator” of the assets to be securitised. Examples of

Originators are: banks and other financial institutions, corporates,

governments and

municipalities;

•

_ Seller—

seller of the assets to be securitised. In many cases, the Seller and the

Originator in a transaction are identical. This is however not

necessarily the case. For

instance, an entity may purchase assets from its affiliates and then act as

central Seller

in a securitisation;

_ Purchaser—

a special purpose vehicle (SPV) which purchases the assets to be

securitised.



The Purchaser funds the purchase price by issuing asset-backed

securities into

the capital markets (in this capacity, the Purchaser is also referred to as

the Issuer);

• _ Servicer—

services the assets to be securitised (frequently the Originator retains

this

role). Where receivables are securitised, the Servicer will collect,

administer and, if

necessary, enforce the receivables;

• _ Back-up Servicer—

will service the assets in the event the Servicer is unable to service

them, or in the event the Purchaser exercises its right to remove the

Servicer (for

instance, as a result of the insolvency of the Servicer);

• _ Liquidity Facility Provider—

provides a liquidity facility in relation to certain tranches

of the asset-backed securities. Typically, a liquidity facility is provided in

conduit

transactions where the Purchaser issues revolving short-term commercialpaper to

fund the purchase of the assets. The Purchaser may draw upon the

liquidity facility if



it is unable to refinance maturing commercial paper because of a market

disruption.

The liquidity facility thus secures commercial paper investors against a

default in such

a case. Liquidity facilities are also sometimes required in standalone

securitisations;

• _ Investors—

purchasers of the asset-backed securities. Examples of investors in the

securitisation market are: pension funds, banks, mutual funds, hedge

funds, insurance

companies, central banks, international financial institutions and

corporates

• Lead Manager—

arranger and structurer of the transaction (in the context of conduit

transactions, also referred to as Programme Administrator). The Lead

Manager is

often the primary distributor of the asset-backed securities in a particular

transaction.

Individual distributors are also referred to as Managers;

• _ Rating Agencies—



rate the asset-backed securities. Some of the rating agencies in

securitisation are Standard & Poor’s, Moody’s Crisil , CARE etc

• _ Hedge Providers—

hedge any currency or interest rate exposures the Issuer may have;

• _ Cash Administrator—

provides banking and cash administration services to the

Issuer;

• _ Security Trustee—

acts as a trustee for the secured creditors of the Issuer (notably,

holds the Issuer’s assets granted to it as security for the Issuer’s

obligations, on behalf

of the Investors);

• _ Note Trustee—

acts on behalf of the holders of the asset-backed securities;

_ Auditors—

if necessary they audit the asset pool as may be required under the

documentation of the relevant transactions.

The securitization process;

In its most basic form, the process involves two steps (see chart).



In step one, a company with loans or other income-producing assets the

originator identifies the assets it wants to remove from its balance sheet

and pools them into what is called the reference portfolio. It then sells this

asset pool to an issuer, such as a special purpose vehicle (SPV)—an entity

set up, usually by a financial institution, specifically to purchase the assets

and realize their off-balance-sheet treatment for legal and accounting

purposes.

In step two, the issuer finances the acquisition of the pooled assets by

issuing tradable, interest-bearing securities that are sold to capital market

investors. The investors receive fixed or floating rate payments from a

trustee account funded by the cash flows generated by the reference

portfolio. In most cases, the originator services the loans in the portfolio,

collects payments from the original borrowers, and passes them on—less a

servicing fee—directly to the SPV or the trustee.

Disadvantage

BACK TO from bankruptcy of seller

• Originator retains no legal interest in assets Typically structured into

variousclasses/tranches, rated by one or more rating agencies

Reference portfolio(”collateral”) Senior tranche(s)Junior tranche

Underlying assets Issues asset-backed securities Issuing agent (e.g.,

special purpose vehicle [SPV]) Asset originator Capital market

investors Transfer of assets from the originator to the issuing vehicle

SPV issues debt securities (assetbacked) to investors Mezzanine

tranche(s).

Working of securitization; (diagramz)

Securitization represents an alternative and diversified source of finance

based on the transfer of credit risk (and possibly also interest rate and

currency risk) from issuers to investors.



portfolio is divided into several slices, called tranches, each of which has a

different level of risk associated with it and is sold separately. Both

investment return (principal and interest repayment) and losses are

allocated among the various tranches according to their seniority. The least

risky tranche, for example, has first call on the income generated by the

underlying assets, while the riskiest has last claim on that income.

The conventional securitization structure assumes a three-tier security

design

junior

mezzanine,

senior tranches

This structure concentrates expected portfolio losses in the junior, or first

loss position, which is usually the smallest of the tranches but the one that

bears most of the credit exposure and receives the highest return. There is

little expectation of portfolio losses in senior tranches, which, because

investors often finance their purchase by borrowing, are very sensitive to

changes in underlying asset quality. It was this sensitivity that was the initial

source of the problems in the subprime mortgage market 2007. When

repayment issues surfaced in the riskiest tranches, lack of confidence spread

to holders of more senior tranches— causing panic among investors and a

flight into safer assets, resulting in a fire sale of securitized debt.

.Securitization started as a way for financial institutions and corporations to

find new sources of funding—either by moving assets off their balance

sheets or by borrowing against them to refinance their origination at a fair

market rate. It reduced their borrowing costs and, in the case of banks,

lowered regulatory minimum capital requirements. For example, suppose a

leasing company needed to raise cash. Under standard procedures, the

company would take out a loan or sell bonds. Its ability to do so, and the

cost, would depend on its overall financial health and credit rating.If it could



find buyers, it could sell some of the leases directly, effectively converting a

future income stream to cash. The problem is that there is virtually no

secondary market for individual leases. But by pooling those leases, the

company can raise cash by selling the package to an issuer, which in turn

converts the pool of leases into a tradable security.

Moreover, the assets are detached from the originator’s balance sheet (and

its credit rating), allowing issuers to raise funds to finance the purchase of

assets more cheaply than would be possible on the strength of the

originator’s balance sheet alone. For instance, a company with an overall “B”

rating with “AA”-rated assets on its books might be able to raise funds at an

“AA” rather than “B” rating by securitizing those assets. Unlike conventional

debt, securitization does not inflate a company’s liabilities. Instead it

produces funds for future investment without balance sheet growth.

Investors benefit from more than just a greater range of investible assets

made available through securitization. The flexibility of securitization

transactions also helps issuers tailor the risk-return properties of tranches to

the risk tolerance of investors. For instance, pension funds and other

collective investment schemes require a diverse range of highly rated long-

term fixed-income investments beyond what the public debt issuance by

governments can provide. If securitized debt is traded, investors can quickly

adjust their individual exposure to credit-sensitive assets in response to

changes in personal risk sensitivity, market sentiment, and consumption

preferences at low transaction cost. Sometimes the originators do not sell

the securities outright to the issuer (called “true sale securitization”) but

instead sell only the credit risk associated with the assets without the

transfer of legal title (“synthetic securitization”). Synthetic securitizationhelps issuers exploit price difference between the acquired (and often

illiquid) assets and the price investors are willing to pay for them (if

diversified in a greater pool of assets).



True sale securitization:

Put de diagram

The diagram shows a typical structure for a true sale securitisation. The

Originator (for instance a bank selling mortgages) sells certain assets (the

Assets) to the

Issuer. The Assets will be serviced by the Servicer (often the Originator), for

instance with

respect to mortgages sold to the Issuer, the Originator will continue, on

behalf of the

Issuer, to collect principal and interest from borrowers on such mortgages

and will,

where appropriate, take enforcement action in respect of such default

mortgages.

As the Issuer has no employees it will appoint a Cash Administrator to make

all relevant

payments on its behalf and is also likely to app The Issuer funds the

purchase of those assets by selling asset-backed securities (whose

performance is dependent on the performance of the Assets) (the Bonds)

to the Managers who will in turn sell those securities to the Investors.

Investors will be free to sell the Bonds or retain them.

Synthetic securitization ;



It is very similar to a “true sale” and most of the structural features are the

same.

The key difference is that the Originator does not sell any assets to the

Issuer (and therefore, does not obtain any funding or liquidity under the

transaction). Instead the Originator will enter into a credit default swap

with the Issuer in respect of an asset or pool of assets. Under this contract

the Issuer will pay the Originator an amount equal to any credit losses

suffered in respect of such asset or pool of assets (less a minimum

threshold amount—similar to an “excess” in insurance). The Originator’s

exposure to those assets is therefore transferred to the Issuer. The

Originator in return will pay a fixed amount to the Issuer, usually on aquarterly basis. The Issuer will issue Bonds to Investors via the Managers.

The Issuer’s ability to repay principal and pay interest under the Bonds

will depend on whether the Issuer has to make payments under the credit

default swap. The Issuer’s income streams in a synthetic transaction are

the fixed amounts paid by the Originator under the credit default swap

and interest amounts received on the collateral. In order to collateralise

its obligations under the credit default swap and the Bonds the Issuer

usually purchases securities as collateral. These are normally highly rated

government debt securities. They also need to be relatively liquid in order

that they can be sold and the proceeds used to pay amounts under the

credit default swap or Bonds.

“Whole Business” Securitisation ;

This type of securitisation originated in the United Kingdom. It involves the

provision of a secured loan from an SPV to the relevant Originator. The

SPV issues bonds into the capital markets and lends the proceeds to the

Originator. The Originator services its obligations under the loan through

the profits generated by its business. The Originator grants security over

most of its assets in favour, ultimately, of the Investors. “Whole business”



securitisation is sometimes used to finance a taking private or

management buy out of the originator.

Advantages;

Securitisation is one way in which a company might go about financing its

assets.

Reasons for companies to go for securitisation :

1. to improve their return on capital, since securitisation normally requires

less capital to

support it than traditional on-balance sheet funding;

2. to raise finance when other forms of finance are unavailable (in a

recession banks are often unwilling to lend - and during a boom, banks often

cannot keep up with the

demand for funds);

3. to improve return on assets - securitisation can be a cheap source of

funds, but the

attractiveness of securitisation for this reason depends primarily on the costs

associated with alternative funding sources;



4. to diversify the sources of funding which can be accessed, so that

dependence upon

banking or retail sources of funds is reduced;

5. to reduce credit exposure to particular assets (for instance, if a particular

class of

lending becomes large in relation to the balance sheet as a whole, then

securitisation

can remove some of the assets from the balance sheet);

6. to match-fund certain classes of asset - mortgage assets are technically

25 year assets, a proportion of which should be funded with long term

finance; securitisation

normally offers the ability to raise finance with a longer maturity than is

available in

other funding markets;

7. to achieve a regulatory advantage, since securitisation normally removescertain risks which can cause regulators some concern, there can be a

beneficial result in terms of the availability of certain forms of finance (for

example, in the UK building societies consider securitisation as a means of

managing the restriction on their wholesale funding abilities).

. Economic impact of securitisation:

Securitisation is necessary to the economy similar to organized markets

.



1. Creates of markets in financial claims:

By creating tradeable securities out of financial claims, securitisation helps to

create markets in claims, which would, in its absence, have remainedbilateral deals. In

the process, securitisation makes financial markets more efficient, by

reducing

transaction costs.

2. Spread of holding of financial assets:

The basic intent of securitisation is to spread financial assets amidst as many

savers as possible. the security is designed in minimum size

marketable lots as necessary. Hence, it results into dispersion of financial

assets. One

should not underrate the significance of this factor just because institutional

investors

have lapped up most of the recently developed securitisations. Lay investors

need a

certain cooling-off period before they understand a financial innovation.

3. Promotion of savings:

The availability of financial claims in a marketable form, with proper

assurance as

to quality in form of credit ratings etc., securitisation makes it possible for

the simple

investors to invest in direct financial claims at attractive rates. If the bank

rate are lower



than the rates offered by securities, investors will go for these instruments.

4 Reduces costs:

Securitisation tends to eliminate fund-based intermediaries, and it leads to

specialization in intermediation functions. This saves the End-user Company

from

intermediation costs, since the specialized-intermediary costs are service-

related, and

comparatively lower

.

5 Risk diversification :

Financial intermediation is a case of diffusion of risk because of accumulation

by

the intermediary of a portfolio of financial risks. Securitisation spreads

diversified risk toa wide base of investors, with the result that the risk inherent in financial

transactions is

diffused.

6 Focuses on use of resources, and not their ownership:

Once an entity securitises its financial claims, it ceases to be the owner of such

resources and becomes merely a trustee or custodian for the several

investors who

thereafter acquire such claim. Imagine the idea of securitisation being

carried further, and not only financial claims but claims in physical assets



being securitised, in which case the entity needing the use of physical assets

acquires such use without owning the property. The property is diffused over

investors. In this sense, securitisation process assumes the role of a trustee

of resources and not the owner.

Social benefits of Securitisation:

Securitisation does is to break a company, a set of various assets, into

various

subsets of classified assets, and offer them to investors. In situation without

securitisation: each investor would be taking a risk in the unclassified,composite

company. How can we call this as serving economic benefit if the company is

made into

different parts and sold to different investors?

consider an imaginary holding company ABCLtd. It has on its balance sheet

three wholly-owned subsidiaries, A, B, and C. The process of securitisation

can be thought of as treating distinguishable pools of assets as if they were

the wholly-owned subsidiaries, A, B and C.

Lets make the following assumptions about the subsidiaries A, B and C.A is

100% debt financed (5-year debentures issued at 9%) with its only asset a

single 5-year

loan to an AAA-rated borrower paying 10%. B is a software company with no

earnings or performance history, but with projections for attractive, volatile,

future earnings. C is a

well-known manufacturing company with predictable earnings.

If ABC goes to the debt markets seeking additional unsecured funding,

potential



investors would face the difficult task of evaluating its assets and assessing

its debt

repaying abilities. The assessed cost of marginal ABC borrowing might

consist of an

"average" of the calculated returns on the assets of the segments that

comprise ABC. This average would necessarily reflect known and unknown

synergies, and costs and

associative risks arising from the collective ownership parts (i.e., the group's

imputed

contribution for credit support, insolvency risk and liability recourse) and

would likely

include an "uncertainty" discount.

Now consider the probable outcomes if ABC are to legally sell the ownership

of

one or more of its "parts." In exchange for the exclusive rights to the cash

flows from A,

investors would return to ABC maximum equivalent value in the form of

cash. Such anoffering appeals to a wide range of investors. This includes investors with a

preference

for, and having superior information regarding the risk represented by A's

obligors.

Those new investors who have had an aversion for the risk presented by the

associated

costs and risks represented by B and C. This new arrangement returns to

ABC is the full

value the market attaches to the certainty of the information concerning A,

without

uncertainty of the information regarding Band C. The value of the resulting

ABC shares



depends in part on the disposition of the cash received from the spin-off. If

ABC retains

the cash, there may be a discount or revaluation resulting from the market's

assessment of

ABC's ability to achieve a return equal or better than it would have earned

from keeping

the asset. There is always one clear collateral benefit to the resulting ABC

that derives

from any divestment. The perceived value of the remaining components are

relieved of

any previously imposed discount for the disposed component's credit

support and

insolvency risk. Holding aside separate considerations of corporate strategy

and internal

synergies, to the extent that the consideration received from the divestment

improves (in the perception of the market) the capital structure of the

resulting ABC and/or reduces the marginal funding cost for the resulting

organization ABC. The decision to divest or securitise is simplified. If the

information held by ABC concerning any of its segments is not or cannot befully disclosed, or when disclosed will not be fully or accurately valued, the

correct decision is to retain the asset. Without securitisation, ABC's bank

faces significant and largely irreducible costs of evaluating the marginal

impact on ABC's borrowing cost from ABC's pledging of assets (receivables)

and of evaluating similar information for each other borrower that the lender

or finances. If the imposed cost of borrowing is to be judged solely on the

assets as we have seen, the most efficient way to assess the true cost of

asset based borrowing). Evaluating each pool of assets and assessing the

likelihood that the cash flows from them will be uninterrupted must be

repeated for each borrowing.

By developing a market for asset-specific expertise (not the least of which is



represented by the expertise of the rating agencies), and by relying on the

capital markets to determine the best price for the rated asset-backed

securities (such rating representing the expression of the information

provided by the developed expertise), the cost of borrowings for issuers

using properly organized securitisation structures has steadily decreased and

is well below the cost of borrowing from a lending institution.

DISADVANTAGES;

Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrower’s 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 security’s 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 subordinated classes receiving correspondingly

lower credit ratings.

However, the credit crisis of 2007-2008 has exposed a potential flaw in the

Securitisation process - loan originators retain no residual risk for the loans they make,

but collect substantial fees on loan issuance and Securitisation, which doesn't

encourage improvement of underwriting standards. The subprime mortgage crisis

that began in 2007 has given the decades-old concept of securitization a bad

name. Securitization is the process in which certain types of assets are

pooled so that they can be repackaged into interest-bearing securities. The

interest and principal payments from the assets are passed through to the

purchasers of the securities. Securitization got its start in the 1970s, when

home mortgages were pooled by U.S. government-backed agencies. Starting

in the 1980s, other income-producing assets began to be securitized, and in

recent years the market has grown dramatically.In some markets, such as

those for securities backed by risky subprime mortgages in the United

http://en.wikipedia.org/wiki/Liquidity_risk

http://en.wikipedia.org/wiki/Liquidity_risk



States, the unexpected deterioration in the quality of some of the underlying

assets undermined investor confidence. Both the scale and persistence of

the attendant credit crisis seem to suggest that securitization—together with

poor credit origination, inadequate valuation methods, and insufficient

regulatory oversight—could severely hurt financial stability. Increasing

numbers of financial institutions employ securitization to transfer the credit

risk of the assets they originate from their balance sheets to those of other

financial institutions,such as banks, insurance companies, and hedge

funds.They do it for a variety reasons. It is often cheaper to raise money

through securitization, and securitized assets were then less costly for banks

to hold because financial regulators had different standards for them than for

the assets that underpinned them. In principle, this “originate and distribute”

approach brought broad economic benefits too—spreading out credit

exposures, thereby diffusing risk concentrations and reducing systemic

vulnerabilities.

Until the subprime crisis unfolded, the impact of securitization appeared

largely to be positive and benign. But securitization also has been indicted

by some for compromising the incentives for originators to ensure minimum

standards of prudent lending, risk management, and investment, at a time

when low returns on conventional debt products, default rates below the

historical experience,and the wide availability of hedging tools were

encouraginginvestors to take more risk to achieve a higher yield. Many of the

loans were not kept on the balance sheets of those who securitized them,

perhaps encouraging originators to cut back on screening and monitoring

borrowers, resulting possibly in a systematic deterioration of lending and

collateral standards.



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. Home equity 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.

Contractual agreements

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

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 involvedin the transaction.



Securitisation and financial disintermediation:

Securitisation used to result into financial disintermediation. If we imagine a

financial world without intermediaries, all financial transactions will be

carried only as

one-to-one relations. For example, if a company needs a loan, if will have to

seek such

loan from the lenders, and the lenders will have to establish a one-to-one

relation with the company. Each lender has to understand the borrowing

company, and to look after his loan. This is difficult process in modern worldof business. There is a financial

intermediary, such as a bank, pools funds from many such investors. It uses

these funds to lend to the company. If the company securitises the loan, and

issue debentures to the investors eliminating the need for the intermediary

bank. Since the investors may now lend to the company directly in small

amounts each, in form of a security, which is easy to appraise, and which is

liquid.

Utilities added by financial intermediaries:

A financial intermediary initially came into existence to avoid the difficulties

in a

direct lender-borrower relation between the company and the investors. the

difficulties that will be addressed by the financial intermediary are as follows;



(a) Difficulty of transactions: An average small investor would have a small

amount of

sum to lend whereas the company's needs would be massive. The

intermediary bank

pools the funds from small investors to meet the needs of the company. The

intermediary may issue its own security, of smaller value.

(b) Non availability of information: An average small investor would

either not be

aware of the borrower company or would not know how to appraise or

manage the loan.

The intermediary fills this gap.

(c) Risk perception of Risk : The risk as investors perceive in investing in a

bank may be much lesser than that of investing directly in the company,

though in reality, the financial risk of the company is transposed on the

bank. However, the bank is a pool of several such individual risks, and hence,

the investors' preference of a bank to the borrower company can be

understood easily.

Securitisation of the loan into bonds or debentures addresses all the three

difficulties in

direct exchange between borrower and lender. It avoids the transactional

difficulty by

breaking the lumpy loan into marketable lots. It avoids informational

difficulty because

the securitised product is offered generally by way of a public offer, and its

essential

features are disclosed. It avoids the perceived risk difficulty, since the

instrument is

generally well secured and generally rated for the investors' satisfaction.



Securitisation changes the function of intermediation:

It is true to say that securitisation leads to better disintermediation for its

advantage. Disintermediation is one of the important aims of present-day

organizations,

since by skipping the intermediary, the company intends to reduce the cost

of its finances.

Securitisation has been employed to disintermediate.

However, it is important to note that securitisation does not eliminate theneed for

the intermediary. It redefines the intermediary's role. In the above example,

if the

company in the above case is issuing debentures to the public to replace a

bank loan, is it

eliminating the intermediary altogether? No. Would be avoiding the bank as

an

intermediary in the financial flow, but would still need the services of an

investment

banker to successfully conclude the issue of debentures.

Therefore, securitisation changes the basic role of financial intermediaries.

Financial intermediaries have emerged to make a transaction possible by

performing a

pooling function, and have contributed to reduce the investors' perceived

risk by

substituting their own security for that of the end user. Securitisation puts

these services

of the intermediary in a background by making it possible for the end-user to

offer these



features in form of the security. In this case, the focus shifts to the more

essential function

of a financial intermediary. That is distribution a financial product. For

example, in the

above case, where the bank being the earlier intermediary was eliminated

and instead the

services of an investment banker were sought to distribute a debenture

issue. Thus, the

focus shifted from the pooling utility provided by the banker to the

distribution utility

provided by the investment banker.

Securitisation seeks to eliminate funds-based financial intermediaries by fee-

based

distributors. In the above example, the bank was a fund-based intermediary,

a reservoir of

funds, whereas the investment banker was a fee-based intermediary, a

catalyst, and a

pipeline of funds. Hence, with increasing trend towards securitisation, the

role of feebasedfinancial services has been brought into the focus. In case of a direct loan,

the

lending bank was performing several intermediation functions. It is a

distributor in the

sense that it raised its own finances from a large number of small investors.

It is

appraising and assessing the credit risks in extending the corporate loan,

and having

extended it, it manages the same. Securitisation splits each of these

intermediary



functions apart, each to be performed by separate specialized agencies. The

investment bank, appraisal function, will perform the distribution function by

a credit-rating agency

and management function possibly by a mutual fund that manages the

portfolio of

security investments by the investors. Hence, securitisation replaces fund-

based services

by several fee-based services.

Securitisation: changing role of banking systems

Banks are increasingly facing the threat of disintermediation. In a world of

securitized assets, banks have diminished roles. The distinction between

traditional bank lending and securitized lending clarifies this situation.

Traditional bank lending has four functions:

originating;

funding,

servicing and

monitoring.

Originating means making the loan, funding implies that the loan is held on

the balance sheet. Servicing means collecting the payments of interest and

principal, and monitoring refers to conducting periodic surveillance to ensure

that the borrower has maintained the financial ability to service the loan.



Securitized lending introduces the possibility of selling assets on a bigger

scale and eliminating the need for funding and monitoring. The securitized

lending function has only three steps: originate, sell, and service. This

change from a four-step process to a three-step function has been described

as the fragmentation or separation of traditional lending.

Securitisation of Loans

The concept of Securitisation of loans has been codified through the

Securitization Act 2002 and this has proved to be the engine—room in the

present day financial market. With this apparatus the banks and financial

institutions can pass off their risks of unpaid debts but the risk only goes off

from the individual institutions and not from the financial system. Therefore

there is a possibility that the same might strike back again.

The banking sector in India is growing very fast and its escalation has

contributed substantially in the progress of the country’s financial market.

Basic function of banks is to work as a financial intermediary by accepting

deposits and giving out loans, Lending is part and parcel of the banking

industry. loan is an amount of money advanced to the borrower for a

stipulated time period and while repaying the amount the borrower is

required to pay certain additional amount which is termed as interest. Such

interest is nothing but the cost of money being used for that time period.

kinds of loans, secured and unsecured. Unsecured loans are advanced

without any security but in case of secured loans banks retain securities in

the order of real estate, machinery and the like. The main object of keeping

hold of security is to ensure that if the borrower makes a default then such

security can be realized at the meeting of the deficiency.

However this system was not satisfactory as the convulsion of those real

estates and translation into liquid assets seemed impossible because of the

legal complicatedness as well as the sloth of our judicial system. It took

years for the banks to liquefy the security assets and appreciate the sum of



deficiency. Hence to trounce this difficulty the Parliament had enacted

Recovery of Debts Due To Banks and Financial Institutions Act, 1993

(hereinafter referred to as Debt Recovery Act). This Act created a separate

apparatus in the order of Debt Recovery Tribunals which were devolved with

the responsibility of administering disputes pertaining non payment of debts.

However one may say that this legislation was generic in nature and could

not adjust with every corner of the changing trends of financial market.

Hence it was imperative for the legislature to devise an even more

unconventional device for the enforcement of rights of bankers and financial

institutions as lenders.

Consequently the Parliament acted out Securitisation and

Reconstruction of Financial Assets and Enforcement of Security

Interest Act, 2002 (hereinafter referred to as Securitization Act). The Act is

nothing but the fructification of Securitisation and Reconstruction of

Financial Assets and Enforcement of Security Interest Ordinance

which was promulgated by the president in the year 2002 itself. This Act

came into existence when in the financial market loans are started being

treated like tradable securities. This Act has been passed in the year 2002.

Section 2(f) of this Act defines ‘borrower’ as a person who has taken financial

assistance form any bank or financial institution in exchange of certain

security in the order of mortgage, pledge or guarantee. Under section 2(j)

‘default’ would mean non payment of any principal debt or interest thereon.

Under section 2(zd) of this Act the banks and financial institutions as well as

any consortium arrangement are regarded as secured creditors.

Securities are generally classified into three categories

1.directly tradable in the market in a profitable manner

2. not directly tradable but the banks however can sell them in

lesser profit and

3. not at all tradable.



The use of securitization process is meant for the third group of assets.

In securitization process there are mainly two crafts: the original lender

and a Special Purpose Vehicle (SPV). The SPV helps the original lender in

liquefying the assets. The SPV converts these assets into marketablesecurities for investment and the cash flows to the original lender. This helps

the original lender in meeting up the deficiency which arose out of the

borrowers default. Apart from original lender and SPV, other parties involved

in securitization process are merchant or investment banker, credit rating

agency, servicing agency and the buyers of securities.

INCLUDE IN DE CONCLUSION (As far as India is concerned the

advantages that securitization of loans may accrue is interesting. In aneconomy which is growing and in need of more capital, securitization helps

in managing the limited capital efficiently. The commercial banks can

reallocate their risks in a planned manner improving their credit and

operating system. The investors are in an incessant enthusiasm for having

more assets and this hunger can be bespoken by asset securitization. In long

and medium stages securitization method is at the prospect of advancing the

classiness standards of the banking as well as the financial institutions. In

short the system of securitization can prove to be a vehicle for the

augmentation of domestic savings as well as attracting overseas

investments which might be imperative in the infrastructural enlargement of

the country.

The process of securitization of loans has led India to witness a vogue in

the banking sector. This fad may be termed something like belligerent

banking. This is presently the guiding gospel of the banking sector. This is so

because banks earn profit mainly form loans and lending involves a great

deal of risk. Before providing loans the banker has to think twice, take a lot

of factors into contemplation and apprise a lot of things. Furthermore there is

always an atmosphere of worry about the repayment and finally a lot of

accountability as these institutions are to deal with the public money. But



with the surfacing of securitization of loans there is a feeling of security in

the banking sector and it has tutored the banks not to behave like their

traditional brothers and to expand instead. The driving force behind this

changing concept is loans being treated like tradable securities to be

packaged, sold and forgotten about. In this way securitization has emerged

as the as the engine room of the financial market.

Form the above forethought one may come to the outlook that

securitization of loans is all right and there is no predicament. However if

analysed in a different manner then there is one potential dilemma. This

quandary comes when we think about securitization not from the perspective

of individual financial instauration but from the standpoint of the financial

system as a whole. We have already discussed previously that now a day

isolationism has no place to function and hence things to be considered

globally. Thus the debate in which we partake is not from the point of view of

our own financial system but the universal one. This is because our country

has already made a take off from isolationism and in the process of being

more integrated with the global economic order. Therefore when one

scrutinizes the concept of securitization of loans then he/she may face with

the difficulty as to securitization of what—the individual institutions or the

financial system as a whole.

The securitization of loans facilitates the original lender thinking that he is

sticking to an opportune position which will abet him to transmit the

jeopardy to the other investors and with this process the originator can

getaway capital sufficiency requirements. But the hazard which

securitization wants to avoid does not disappear from the financial system

altogether. The securitization or reconstruction companies which buy and

invest the securities engage themselves in a highly risk prone business and

hence they have to highly depend again on the commercial banks for the

supply of the required credits. Therefore incongruously the commercial

banks are again driven to foster the business of these investors which



undertake a risky game. Thus an unseemly assessment of risk may result the

peril might knock the door of the originator once again. For this reason the

risk does not ebb from the system on the whole and in the natural course of

financial market the same may trouble again. Therefore the decease that

securitization wants to cure remains as it is and merely changes its position

from one to another actor in the market.

We need to bear this in mind that concept of banking is no longer a new

one. We can find its traces in the medieval history also. However at that time

banking was identified with money lending only. Now a day though banking

is not only institutionalized money lending system but money lending and

profit making forms the base for which the banks are meant for. It is not that

banks have started giving loans only after the advent of securitization

process. Lending was there even though the theme of securitization was

absent. During that time the banks used to follow something what we call

Principles of Good Lending or Fundamental Principles of Banking Business.

These principles were regarded sound in the banking business and included

proper disclosure of documents by the customers so that there is no bar in

proceeding with the loan, actual assessment of customer’s repayment

capability ensuring the due return in due time, rigid regulations to prevent

hoodwinked and corrupt practices, a supervisory monitoring system and

finally less formal techniques to promote best practices.

Therefore to conclude with we must say that though we are standing on a

time where the financial market is at its boom with the fast growth of the

banking sector, we should not forget the basic values that is in continuation

since long. These principles should not be discarded after the danger being

shown. The Securitization Act indeed is a milestone but this is not to be

extended so as to taking away the elementary dogma. In many of the cases

the judges heard stating that the old precedents should not be held

redundant just because they are old. They should be weighed in their own

merits. Such benchmark can only be rejected when it is established that they



can not be borne any more and hence they are out-modeled. This inherent

principle can also be applied to the emerging concept of credit securitization.

It may not be possible to think that the fundamental principles of banking are

of no use today. Hence securitization can be an appendage to these

principles and not all in all a substitute)

Capital markets role in securitisation:

The capital markets have provided the needed impetus to disintermediation

market.

Professional and publicly available rating of borrowers has eliminated theinformational

advantage of financial intermediaries. Let us imagine a market without rating

agencies:

any investor has to take an exposure security has to appraise the entity.

Therefore, only

those who are able to employ analytical skills will be able to survive.

However, the

availability of professionally conducted ratings has enabled small investors to

rely on the

rating company's professional judgement and invest directly in the security

instruments

rather than to go through intermediaries. But this should not be construed as

no role for

banker.The development of capital markets has re-defined the role of bank

regulators. A

bank supervisory body is concerned about the risk concentrations taken by a

bank. More the risk undertaken, more is the requirement of regulatory

capital. On the other hand, if the same assets were to be distributed through

the capital market to investors, the risk is divided, and the only task of the



regulator is that the risk inherent in the product is properly disclosed. The

market sets its own price for risks - higher the risk, higher the return

required. Capital markets tend to align risks to risk takers. Free of constraints

imposed by regulators and risk-averse depositors and bank shareholders,

capital markets efficiently align risk preferences and tolerances with issuers

(borrowers) by giving providers of funds (capital market investors) only the

necessary and preferred

information. Other features of the capital markets frequently offset any

remaining

informational advantage of banks: variety of offering methods, flexibility of

timing and

other structural options. For borrowers able to access capital markets

directly, the cost of capital will be reduced according to the confidence that

the investor has in the relevance and accuracy of the provided information.

As capital markets become more complete, financial intermediaries become

less important as touch points between borrowers and savers. They become

more important as specialists that

(1) complete markets by providing new products and services,

(2) transfer and distribute various risks via structured deals, and(3) Use their reputational capital as delegated monitors to distinguish

between high- and

low-quality borrowers by providing third-party certifications of

creditworthiness.

These changes represent a shift away from the administrative structures of

traditional

lending to market-oriented structures for allocating money and capital.

In this sense, securitisation is not really-speaking synonymous to

disintermediation, but

distribution of intermediary functions amongst specialist agencies.

Securitisation and structured finance:



securitization is a "structured financial instrument". It

is a financial instrument structured or tailored to the risk-return and maturity

needs of the

investor, rather than a simple claim against an entity or asset. the term-

structured finance is to refer to such financing instruments where the

financier does not look at the entity as a risk. He tries to align the financing

to specific cash accruals of the borrower. On the investors side,securitisation

seeks to structure an investment option to suit the needs of investors.

Itclassifies the receivables/cash flows not only into different maturities but

also into senior,mezzanine and junior notes. Therefore, it also aligns the

returns to the risk requirements

of the investor.

Securitisation as a tool of risk management:

Securitisation is more than just a financial tool. Banks generally work for risk

removal.

Securitisation but also permits bank to acquire securitized assets with

potential

diversification benefits. When assets are removed from a bank's balance

sheet, all the

risks associated with the asset are eliminated. In the process reduces the

risks of the bank.

Credit risk and interest-rate risk is the essential uncertainties that concern

domestic

lenders. By passing on these risks to investors, or to third parties when credit

enhancements are involved, financial firms are better able to manage their

risk exposures.



In today's banking, securitisation is increasingly being resorted to by banks,

along with

other innovations such as credit derivatives to manage credit risks.

Comparison of Securitisation and credit derivatives:

Credit derivatives are logical extension of the concept of securitisation. A

credit

derivative is a non-fund-based contract when one person agreed to

undertake, for a fee,

the risk inherent in a credit without acting taking over the credit. The risk

either could be

undertaken by guaranteeing against default or by guaranteeing the total

expected returns

from the credit transaction. While the former could be another form of

traditional

guarantees, the latter is the true concept of credit derivatives. Thus, if one

bank has a

concentration in say Iron and Steel segment while another bank has

concentration in

Textiles, the two can diversify their risks, without actually taking financial

exposure, by

engaging in credit derivatives. One can agree to guarantee the returns of

other from a part of its Iron and Steel exposures, and reverse can also take

place. Thus, the first bank is earning both from its own exposure in Iron and

Steel, as also from the fee-based exposure it has taken in Textiles.

Credit derivatives were logically the next step in development of

securitisation.



Securitisation development was premised on credit being converted into a

commodity. In the process, the risk inherent in credits was being

professionally measured and rated. In the second step, one would argue that

if the risk can be measured and traded as a

commodity with the underlying financing involved, why can't the financing

and the credit

be stripped as two different products?

The development of credit derivatives has not reduced the role for

securitisation:

it has only increased the potential for securitisation. Credit derivatives is only

a tool for

risk management: securitisation is both a tool for risk management as also

treasury

management. Entities that want to go for securitisation can easily use credit

derivatives as

a credit enhancement device, that is, secure total returns from the portfolio

by buying a

derivative, and then securitise the portfolio.

.

Bibliography

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Enforcement of Security Interest Act, 2002.

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Edition, 2005.

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Published in Economic and Political Weekly, Sameeksha Trust

Publication, Vol. XLII, No.35.



4. Jain, Shantimal. ‘Securitisation Law—Scrutinized’, (2004) JULY PL

(Jour) 22. Eastern Book Company.

5. Kaufman, Henry. ‘Our Risky New Financial Markets’, Published in

Wall Street Journal, Wednesday, August 15, 2007, page A 13.

6. Adukia, Rajkumar. S. ‘Securitization an Overview’, retrieved from:

http://icai.org/icairoot/publications/complimentary/cajournal_feb05/feb

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2007.

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http://www.federalreserve.gov/newsevents/speech/bernanke20070605

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