Banking Industry and the Issue of NPAs NPA Management Need for Asset Reconstruction Companies Global Scenario Interaction with Banks' Executives    Introduction to Securitisation: The Framework Global Securitisation Market Securitisation in india SARFAESI ACT 2002: An Assessment Impact of Basel II on Securitisation PREFACE | FOREWORD | EXECUTIVE SUMMARY | SECURITISATION - AN OVERVIEW | THE INDIAN BANKING INDUSTRY AND NPA's NPA MANAGEMENT AND ARC's| THE BANKING PERSPECTIVE| COMPANY LISTING & PROFILES| LAUNCH EVENT| SPONSORS Alphabetical Listing Total Advances Net NPAs Amount Net NPA Advances Ratio Profiles

Securitisation, also termed as structured finance, is the creation and issuance of debt securities, or bonds, whose payments of principal and interest derive from cash flows generated by separate pool of assets. Simply stated, it is a form of secured funding through issuance of bonds in a specific pool of assets. Credit performance is directly linked to the cash flow generation of the pool of these assets. This financial tool, that was almost non-existent till the 1970s, is used by financial institutions and businesses to immediately realise the value of cash-producing assets like loans, or leases or trade receivables. It allows originators to unlock the value of upfront assets.

The idea of Securitisation was born in the 1970s when government mortgage agencies in the United States - Freddie Mac, Fannie Mae, and Ginnie Mae – issued mortgage based pass-through securities to investors; thus fostering a secondary market in home mortgages. This idea evolved as an outcome of the financial institutions’ inability to keep pace with the growing demand for housing finance. Traditionally, these were funded either by way of bank deposits and other financial institutions or by debt. Financial innovations towards increasing the availability of mortgage finance led to investment bankers coming up with an investment vehicle, which isolated the mortgage pools, segmented the credit risk, and structured the cash flows from underlying loans. Subsequently, this vehicle caught the eye of the investors and the concept of asset securitisation came into existence. What developed as a technique for the mortgage market was applied for the first time in 1985 to auto loans which proved to be a better match for structured finance as their maturities were shorter compared to mortgage loans that made these pods of assets more ammendable to the structured products.

Initiating securitisation requires the creation of a Special Purpose Vehicle (SPV), which is legally separate from the original holder of the assets. The SPV can either be a trust, corporation or a partnership firm set up specifically to purchase the originators assets which also acts as a conduit for the payment flows. In a typical transaction, the owner sells its assets to the SPV. The payment streams generated by the assets can then be repackaged to back an issue of bonds. In some cases, the SPV serves only to collect the assets, which are then transferred to a trust. The trust inturn becomes the nominal issuer of the bonds/ securities. In both cases, the bonds are exchanged with an underwriter for cash. The underwriter then sells the securities to investors.

The final outcome of a securtitisation transaction is upfront funding of the originator via selling a stream of cash flows that was otherwise to accrue to a entity over a period of time. Alternatively, the financial asset is completely taken off from the balance sheet of the originator, thus not only providing immediate liquidity but also mitigate the strain on capital adequacy. In the United States, the success of securitisation allowed many individuals with sub-prime credit histories to access credit. It allowed more sub-prime loans to be made because it provided lenders an efficient way to manage credit risk. Securitisation in recent years has also emerged as a new means of financing bad debts.

Asset Classes

Typically, any asset that produces a predictable stream of cash flows can be securitised. The types of assets that are securitised today include:

• Mortgage-backed
  
  
• Residential mortgage-backed securities (RMBS)
• Commercial mortgage-backed securities (CMBS)
  
  
• Retail Loan Pools
  
  
• Credit card receivables
• Auto loan receivables
• Student loan receivables
• Equipment lease / loan receivables
• Trade receivables
• Toll receipts
  
  
• Risk Transfers
  
  
• Insurance risk
• Weather risk
• Credit risk

Mortgage Backed Securities i.e. RMBS and CMBS, form the largest two segments of the securitisation market in the world.

Structured Finance and Securitisation

One of the crucial features of securitisation is the creation of different grades of securities with different ratings assigned to them. The term “structured finance” refers broadly to such rated products that are structured to meet specific needs. The senior most class of securities is often rated triple A, the highest rating given based on largely two factors: isolation of the assets from the bankruptcy risks of the originator, as in being originator independent; and the creation of a credit risk mitigation device by subordination of classes B and C, such that those lower classes provide credit support to class A. It is possible that the size of classes B and C is so computed as to meet the rating objective for class A and similarly, the size of class C is so computed as to have class B accorded the desired rating. In other words, the entire transaction could be engineered or structured, to meet specific investor needs. Thus, use of structured finance principles allows the originator company to create securities that meet investor needs. Rating is not the only basis for structuring of securities though. There are several other features with respect to which securities may differ like interest sensitivity (i.e., duration and convexity), maturity or average life, cash flow pattern and prepayment.

The transfer of assets in turn is also a transfer of risk. There is an element of credit risk, interest rate risk or similar risks for most financial assets, and securitisation transactions transfer these risks in a structured fashion. The one who takes the first loss risk is a junior holder, and the one who takes subsequent risk is the senior. There could also be mezzanine security holders if there are more than three classes of A, B and C securities.

Parties involved in a Securitisation Transaction

Primarily there are three parties to a securitisation transaction:

• The Originator: This is the entity on whose books the assets to be securitised exist and is the prime mover of the deal. The entity designs the necessary structures to execute the deal. In a true sale of the assets, the Originator transfers both the legal and the beneficial interest in the assets to the SPV.
  
  
• The SPV: This entity is the issuer of the bond/security paper and is typically a low-capitalised entity with narrowly defined purposes and activities. It usually has independent trustees / directors. The SPV buys the assets to be securitised from the Originator, holds the assets in its books and makes upfront payment to the Originator.
  
  
• The Investors: The investors could be either individuals or institutions like financial institutions (FIs), mutual funds, pension funds, insurance companies, etc. The investors buy a participating interest in the total pool of assets and receive their payments in the form of interest and principal as per an agreed pattern.

Apart from these three primary players, others involved in a securitisation transaction include:

• The Obligor(s): The obligor is the Originator’s debtor or the borrower of the original loan. The credit standing of the Obligor is very important in a securitisation transaction, as the amount outstanding from the Obligor is the asset that is transferred to the SPV.
  
  
• The Rating Agency: The rating process assesses the strength of the cash flows and the mechanism designed to ensure full and timely payment. In this regard the rating agency plays an important role as it assesses the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework.
  
  
• Administrator or Servicer: Also called as the receiving and paying agent, it collects the payment due from the Obligor(s) and passes it to the SPV. It also follows up with delinquent borrowers and pursues legal remedies available against defaulting borrowers.
  
  
• Agent and Trustee: It oversees that all the parties involved in the securitisation transaction perform in accordance with the securitisation trust agreement. Its principal role is to look after the interests of the investors.
  
  
• External Credit Enhancements: Underwriters sometime resort to external credit enhancements to improve the credit profile of the instruments. There are various types of external credit enhancements such as surety bonds, third-party guarantees, letters of credit (LC) etc.
  
  
• Structurer: Normally, an investment banker is responsible for bringing together the Originator, credit enhancer, the investors and other partners to a securitisation deal. He also helps in structuring the deals along with the Originator.

The segmentation of roles of different parties to the securitisation deal helps in building specialisation and introducing efficiencies. The entire process is broken into distinct parts with different parties concentrating on origination of loans, raising funds from the capital markets, servicing of loans, etc.

The figure given below shows a simple securitisation process.

Types of Securitisation Instruments

• Pass Through Securities: Also know as participation certificates, it represents direct ownership interest in the underlying asset pool. All the periodic payments of principal and interest are collected by the servicer and passed on to the investors. In this structure there is no modification of the cash flow as it is received from the obligor(s).
  
  
• Tranched Securities: In this type of security, the cash flows from the obligors are prioritised into tranches. The first tranche receives the first priority of payment followed by subsequent tranches.
  
  
• Planned Amortisation (PAC) Tranches: A principal sinking fund is created that takes care of prepayments beyond a certain band. This ensures stability of cash flows and hence offers lower yields compared to similar tranches without a sinking fund.
  
  
• Z-Tranches or Accretion Bonds: No interest is paid during a certain period (lock out period) during which the face value of the bond increases due to accrued interest. After the lock out period, the tranche holders start receiving interest and principal payments.
  
  
• Principal Only (PO) Securities: The PO investors receive only the principal component of the underlying loans. These bonds are usually issued at a deep discount to their face value and redeemed at face value.
  
  
• Interest Only (IO) Securities: The IO investors receive only the interest component of the underlying loans. These securities have no face or par value and its cash flow diminishes as the principal is repaid or prepaid.
  
  
• Floater and Inverse Floater Securities: The floater and inverse floaters are instruments that pay a variable interest rate linked to an index such as LIBOR. The Floater pays an interest rate in the same direction of interest rate movements while a reverse floater pays an interest rate in the opposite direction of the interest rate movements.
  
  
• Amortizing and Non-amortizing Securities: The principal repayment for instruments issued could be done either by a) repaying total amount at maturity, or b) through out the life of the security. The latter refers to a schedule of payments called amortisation schedule and securities issued under this are called amortizing securities. Loans having this feature include, car & home loans.

Types of Securitisation Structures

The SPV pre-designs the type of bonds to be issued depending on the deal structure. The broad type of securitisation structures include:

• Cash vs. Synthetic Structures: Most transactions world over follow the cash structure in which the originator sells assets and receives cash instead. In a synthetic transaction, the seller keeps his title and investment on the assets unaffected. In other words, he does not sell assets for cash but merely transfers risks/rewards relating to the asset by entering into a derivative transaction. When securities are issued by the SPV, they carry such embedded derivative. Synthetic securitisation is gaining popularity in Europe and Asia.
  
  
• True Sale vs. Secured Loan Structures: The true sale structure involves sale of a specific pool of assets where the originator tansfers both the legal and the beneficial interest in the assets. In a secured loan structure, the originator takes a loan similar to any secured lending. Investor rights in this case are protected by creating a fixed and a floating charge over the undertaking of the originator in favour of a security trustee. The assets are generic assets of the originator and the trustee is empowered to take possession of the assets at times of certain trigger events to prevent the assets from being burdened any further. The use of secured loan structure depends on the legal provisions of the country concerned. The secured loan structure is more popular in the UK.
  
  
• Pass Through vs. Collateral Structure: In a pass through structure, the SPV issues participation certificates that enable investors to take a direct exposure on the performance of the securitised assets. Investors are serviced as and when cash is actually generated by the underlying assets. Risks like delay/disruptions in cash flows is mitigated via credit enhancement. (As investors do not have recourse to the Originator, they seek comfort through credit enhancement methods by which risks intrinsic to the transaction are re-allocated.) Pass through structure is the most basic and simplest way of securitisation in mortgage markets. In a collateral structure (also known as pay through structure), the SPV retains the assets to be securitised with it and gives investors only a charge against the securitised assets. The SPV issues debt that is collateralised by the assets that are transferred by the originator. This is also referred to as the Pay through structure and popularly known as collateralised mortgage obligations (CMO).
  
  
• Discreet Trust vs. Master Trust: Discreet trust implies one SPV for a single identified pool of assets where investors participate in the cash flow of the pool. In the creation of a master trust, the Originator sets up a large fund in which large pools of receivables are transferred, much larger than the size of the funding raised by investors. Several security issuances can be created from this fund either concurrently or consecutively. The master trust serves as a tool to create disparities between the repayment structures and the tenure of the securities and assets in the pool. Master trusts are increasingly becoming the preferred mode of securitisation as a result of their flexibility.
  
  
• Conduit vs. Standalone Transactions: In conduit transactions, the purchaser or conduit sources the assets from multiple originators and securitises the assets by issuing asset-backed commercial paper. Since commercial papers of short term duration, it becomes necessary for the conduit to avail of short term or bridge financing from banks. In standalone transactions, the conduit purchases the assets from a single originator. In this case the conduit issues securities of a maturity matching the maturity of the underlying asset pool.

Benefits of Securitisation

Globalisation, deregulation of financial markets and growing cross border business transactions has reset the ambience among financial institutions, increasing manifold opportunities for financial engineering. Securitisation increases the lending capacity of an FI without having to find additional capital or deposits. Securitisation facilitates specialisation and is gaining wide acceptance as the most innovative form of asset financing. A significant impact of securitisation is the profiling and placement of different risks and rights of an asset with the most efficient owners. It provides capital relief, improves market allocation efficiency, expands opportunities for risk sharing and risk pooling, increases liquidity, improves the financial ratios of FIs and banks, creates multiple streams of cash flows for the investors, is tailored to the risk profile of a number of customers and facilitates asset-liability management. The requirements for capital adequacy in recent years have also motivated financial institutions and banks to securitise. On the demand side, investors are motivated to buy these securities as they view these as having risk characteristics, compatible with the profile.

Benefits to the Originators, especially FIs

For FIs, securitisation is an opportunity offered in the form of capital relief, capital allocation efficiency, and improvements in financial ratios.

• Lower cost of borrowing: Securitisation reduces the total cost of financing as assets are transferred to a separate bankruptcy-resistant entity. To that extent FIs need not maintain capital to maintain their capital adequacy norms. Also, entities with a riskier credit profile can benefit from lowered borrowing costs.
  
  
• A source of liquidity: FIs could face a liquidity crunch either due to their risky credit profile or delayed receivables. The liquidity provided by securitisation acts as a very powerful tool, that FIs could use to adjust the asset mix quickly and efficiently. Further, the risks in an asset portfolio can be identified and apportioned to arrive at an effective asset mix.
  
  
• Improved financial indicators: Securitisation leads to capital relief that improves the company’s leverage and in turn the Return on Equity. The repercussions of securitisation on the balance sheet of a company can vary depending on the strategy for its capital structure and its appetite for increasing or decreasing leverage.
  
  
• Asset-Liability Management: Securitisation offers the flexibility in structuring and timing cash flows to each security tranche. It provides a means whereby customised securities can be created which helps in matching the tenure of the liabilities and assets.
  
  
• Diversified fund sources: By securitising its receivables, the instrument of which could be sold to global investors, the originator has an opportunity to diversify its funding source.
  
  
• Positive signals to the Capital Markets: Lenders are at times trapped in a situation where they cannot rollover their debt due to downgrading of their ratings, possibly due to economic changes. Under these circumstances, securitisation enables lenders like FIs to increase the rating of debt much higher than that of the issuer through the intrinsic credit value of the asset. This enables the FIs to obtain funding.
  
  
• An avenue for divestiture: Securitisation offers an optimal exit route for entities that wish to exit a business comprising of financial assets without going through the mergers and acquisition route.

Benefits to the Investors

Investors purchase risk-adjusted securities based on its level of maturity and seniority. For instance, an auto loan or credit card receivables backed paper carries regular monthly cash flows, which can match the requirements of investors like mutual funds.

• New Asset Class: Securitised products provide new investment avenues for investors to enhance their return or to diversify their portfolio. For instance, an investor in the United States whose investment is predominantly in US assets can diversify by investing in securities offered by an SPV in Asia.
  
  
• Risk Diversification: As the underlying pool of receivables is spread across diverse customers the investors need not have a thorough understanding of the underlying assets. The investor is insulated from customer specific event risk.
  
  
• Customisation: Securitisation of financial assets allows tailoring of cash flows to the risk profile of the investors. A certain stream of cash flow coming from an underlying asset pool can be broken into tranches and offered as per the investor risk appetite.
  
  
• Decoupling with Originator: The investor is insulated from the credit profile of the Originator. This separation of the Originator and the investor helps at the time of bankruptcy or default or credit downgrades.