Securitisation: An Indian Perspective TABLE OF CONTENTS

S. No. I II III IV V VI VII VIII IX X XI

Topic Executive Summary Concept and Origin Entities involved in Securitisation Benefits of Securitisation Asset Classes and Applications of Securitisation The Securitisation Process The Experience so far Issues in India Future Trend Conclusion Bibliography

Page No. 02 03 05 09 11 19 24 29 46 48 49

EXECUTIVE SUMMARY

Just as the electronics industry was formed when the vacuum tubes were replaced by transistors, and transistors were then replaced by integrated circuits, the financial services industry is being transformed now that securitised credit is beginning to replace traditional lending. Like other -1-

Securitisation: An Indian Perspective technological transformations, this one will take place over the years, not overnight. We estimate it will take 10 to 15 years for structured securitised credit to replace to displace completely the classical lending system -not a long time, considering that the fundamentals of banking have remained essentially unchanged since the Middle Ages. - Lowell L Bryan

The above quote sums up the transformations and technological advancements taking place in the world of finance. While securitisation has been in existence in the western world for more than 25 years now and is a well-developed instrument trading both in the primary and secondary markets, it is in a nascent stage in India with the legal backing still missing. Further, the debt market is still undeveloped and investor awareness is missing.

This paper deals with the analysis of the securitisation of assets. It describes key elements of a typical asset securitisation; outlines the reasons for securitising assets, discusses the types of assets that can be securitised, describes the requirements for a successful asset securitisation, examines whether Indias taxation, legal and financial infrastructure presents any barriers to securitisation and tries to explore the direction that the securitisation shall take in the future.

II

CONCEPT AND ORIGIN

Securitisation has been one of the most important developments in the financial markets in the developed countries. The historical use of financial intermediaries to gather deposits and lend them to those seeking funds was supplemented and even replaced by securitisation processes that bypass -2-

Securitisation: An Indian Perspective traditional intermediaries and link borrowers directly to money and capital markets. Securitisation began in early seventies in the United States with residential mortgages. Restrictions with regard to lending by mortgage banks across States within America created a lot of regional imbalances with some States being short of funds to meet the housing needs and some others having surplus funds without an attractive investment opportunity. Securitisation corrected this imbalance effectively by directly linking the savers with the borrowers.

Securitisation is the process of pooling and packaging Financial Assets, usually relatively illiquid, into liquid marketable securities. Securitisation allows an entity to assign (i.e. sell) its interest in a pool of financial assets (and the underlying security) to other entities.

Simply stated, securitisation refers to conversion of cashflows into marketable securities. Such securities are referred to as Asset Backed Securities (ABS), which are typically highly rated and carry a variety of credit enhancement mechanisms. ABS are primarily serviced by the securitised cashflows and the credit enhancements available. When housing loans are securitised, the resulting securities are referred to as Mortgage Backed Securities (MBS). The securities are also referred to as the Pass Through Certificates (PTCs) sometimes.

Typically, a lender advances a loan to a borrower and gets repayment along with interest over a period of time. Traditionally, the lender would collect the periodic instalments and wait till the final maturity of the loan to recover his full principal and interest. Securitisation allows the lender to sell his right to receive the future payments from the borrowers to a third party and receive consideration for the same much ahead of the maturity of the loan.

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Securitisation: An Indian Perspective Securitisation need not be confined to lender-borrower relationships. It can be applied to supplierbuyer relationships also. Manufacturer-sellers could supply goods to their high quality customers on instalment basis and raise funds by securitising these instalments. If the customers are of high quality, it is possible to have a high rating for the securitised paper leading to interest cost savings. Thus, this may be cheaper than traditional sources of funding like bank finance.

III

ENTITIES INVOLVED IN SECURITSATION

Rating Agency

-4Borrowers Consideration Assigns loans

Trustee

Securitisation: An Indian Perspective Lender (Originator / Servicer)

SPV Issuer Consideration Investors ABS

Flows at the time of securitisation Periodic cashflows post securitisation (repayment by borrowers passed on to Investors)

The various entities in the structure and their brief role are given below:

Originator: The original lender or the entity, which has generated the receivables to be securitised. The originator is the seller of the receivables. Typically, the originator is a Bank, a Non Banking Finance Company (NBFC), a Housing Finance Company or even a manufacturing/service company.

Special Purpose Vehicle (SPV): SPVs are the issuers of securities. The main purpose of creating SPV is to alienate the assets securitised from the originator and to ensure that the creditors of the originator do not have any claim on the securitised assets. In the event of bankruptcy of the originator, the repayments on the ABS depend only on the asset performance no entity other than the investors in the ABS has a claim on -5-

Securitisation: An Indian Perspective the receivables. The SPV should not have any borrowings. SPVs are typically companies with small capital or trusts formed for the specific purpose of issuing securities in securitisation transactions. SPV uses the proceeds of the issue to buy the receivables from the originator.

Investors: Investors are the purchasers of ABS. Banks, Financial Institutions, NBFCs, Mutual Funds, Foreign Institutional Investors (FIIs) and even individuals could invest in ABS.

Servicer: The Servicer collects the periodic instalments due from individual borrowers in the pool, makes payouts to the investors and follows up on delinquent accounts. Servicer also furnishes periodic information to the rating agency and the trustee on pool performance. There is a service fee payable to the servicer.

Trustee: Trustees tend to be reputed Banks, Financial Institutions or Firms of Chartered Accountants or Solicitors. The trustees have a fiduciary role to oversee the performance of the transaction till maturity with a view to protect investors interests. The trustee is vested with the necessary powers for the same. For example, the trustee could change the servicer, if necessary.

Rating Agency: As most ABS are rated, rating agencies play an important role in the entire structure. Rating agencies typically get involved right from the beginning of the transaction and help the originator with the pool selection and structuring of the transaction. Finally, the rating agency specifies the level and form of credit enhancement that is needed for the required rating. The agency also monitors the pool -6-

Securitisation: An Indian Perspective performance based on the monthly reports from the servicer and revises the collateral level downward if it deems fit. Rating agencies also make presentations to and hold conferences with merchant bankers and investors to provide information and clarifications on the securitisation programme.

Example A finance company with a portfolio of car loans can raise funds by selling these loans to another entity. But this sale can also be done by securitising its car loans portfolio into instruments with a fixed return based on the maturity profile (the period for which the loans are given). If the company has Rs 100 crore worth of car loans and is due to earn 17 per cent income on them, it can securitise these loans into instruments with 16 % return with safeguards against defaults. These could be sold by the finance company to another if it needs funds before these loan repayments are due. The principal and interest repayment on the securitised instruments are met from the assets which are securitised, in this case, the car loans. Selling these securities in the market has a double impact. One, it will provide the company with cash before the loans mature. Two, the assets (car loans) will go out of the books of the finance company once they are securitised, a good thing as all risk is removed.

How is it different from financing through straight bond or debenture issue? Unlike a traditional bond issue, the repayment of funds raised through securitisation is not an obligation of the originator, or the finance company issuing the securitised instrument. In a straight bond or debenture issue, in the event of the company going bust, the investors would have a tough time getting their funds back, if at all. However, if one invests in a securitised instrument, investors -7-

Securitisation: An Indian Perspective are assured of interest payments even if the finance company goes bust, as the securitised loans are separated from the finance companys books through a SPV, which holds these assets. At the same time, as securitised instruments can be traded, the investor is provided with liquidity as the securitised bond can be sold in the market.

IV

BENEFITS OF SECURITISATION

Securitisation offers a wide range of benefits to both originators and investors. The prominent among these are encapsulated below:

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Securitisation: An Indian Perspective Originator's Perspective

Securitisation offers an effective and relatively quick alternative-funding source. Securitisation is an off-balance sheet-funding alternative. It generates cash for the originator without any addition to borrowings thus without increasing the debt to equity ratio. Companies that have capital adequacy pressures can undertake securitisation to raise funds.

Securitisation helps in up-fronting profits. In case of high yielding portfolios like car loans and truck loans, there is a profit on sale, as the inherent yield in the portfolio is typically higher than the coupon rate on ABS. Hence, there is a boost to bottom-line and Earnings Per Share (EPS) in the year of securitisation

As securitised papers are highly rated, cost of borrowing is relatively lower. Even for originators rated in the AA category, there is likely to be a price advantage in securitisation as AAA has a price premium. This is all the more attractive for borrowers whose own credit ratings are lower.

Since securitisation helps to undertake larger business with the same capital, profitability and return on investment ratios improve post-securitisation.

After securitisation, medium term assets are replaced by cash leading to mitigation of tenor mismatch and improved asset liability management.

Banks, financial institutions (FIs) and non banking finance companies (NBFCs) who are fully exposed to certain industries, corporates or groups can do further business without violating exposure norms by securitising a part of the existing exposure.

After securitisation, credit and prepayment risks are eliminated as these are passed on to the investors.

With the advantage of a high rating, there is access to a wider base of investors.

Investors perspective

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Securitisation: An Indian Perspective

Traditionally, investors look at safety, liquidity and yield before making any investment decisions. ABS is relatively more safe as they are typically highly rated. ABS could be listed in stock exchanges like any other debt instrument thereby enhancing secondary market liquidity in them.

Securitised instruments also provide the flexibility to structure the instrument to suit the investors needs, in terms of tenor or periodicity of payment. In developed markets, several classes of securities are issued from one asset pool to suit the varying investor preferences. Essentially these classes of securities differ in structure, tenure, priority of payment and yield so that the investors could choose the class that fits their requirement best.

Investors in ABS also get the benefit of a payment structure, which is closely monitored on a monthly basis by the rating agency and the trustees, which is not available in case of other instruments like traditional debt.

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Securitisation: An Indian Perspective

ASSET CLASSES AND APPLICATIONS OF SECURITISATION

All assets that generate funds over time can be securitised. These include repayments under car loans, money due from owners of credit cards, airline ticket sales, toll collections from roads or bridges, and sales of petroleum-based products from oil refineries. In fact, artists have even raised funds by securitising the royalty they will get out of future sales of their records.

The characteristics of the most readily securitisable assets are:

Predictable cash flows Consistently low delinquency and default experience Total amortization of principal at maturity Many demographically and geographically diverse obligors and Underlying collateral with high liquidation value and utility to the obligors

Securitisation works well if the securitised asset (say, the pool of car loans) is homogenous (the same kind) with regard to credit risk (how sound the borrower is) and maturity. Ideally, there should be historical data on the portfolios performance and that of the issuing company with regard to credit quality and repayment speed. Some of the asset classes that have been securitised and other applications of securitisation are as under:

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Securitisation: An Indian Perspective Residential Mortgages

Residential mortgage-backed securities (RMBS) are generally pass through securities or bonds based on cash flows from residential home loans, as opposed to commercial real estate loans. Evidently enough, the residential mortgage market was one of the most appropriate applications of securitisation. That is why, for good reasons, some or the other way of refinancing mortgages has been found in most parts of the world. If in USA, it was securitisation, in Europe, a traditional mortgage funding instrument, Pfrandbriefe has been in vogue for almost 200 years. There are two very strong reasons for RMBS being tuned to securitisation: one, the long maturities of residential mortgages, and two, the fact that mortgage lending is backed by charge over real estate, which is a strong asset-backing enabling the investors to take an independent exposure on the receivables. The Govt. support to development of secondary markets in mortgages has also been a strong reason, and the governments easily took this as one of their major welfare activities.

Home Equity Loans Home equity is basically a second loan against the mortgage of a house. The possibility of such a loan arises when the value of a house is more than the outstanding value of a mortgage - quite likely situation after the first mortgage has been partly amortized. The second lender takes a second mortgage over the house, normally secondary in priority over the rights of the first lender, and provides funding. Normally, the home equity loans do not find its application in the same house: application of the money borrowed is normally not controlled. A home equity loan could either be a close-end loan: meaning the loan is paid off over a stated period, or it may be a line of credit, that is, one where the borrower pays regular interest but continues to enjoy the line of credit as an overdraft against the value of the house.

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Securitisation: An Indian Perspective Reverse Mortgages As in a mortgage, the borrower pays a regular instalment to lender, in a reverse mortgage, it is the lender who pays a regular instalment to the borrower. How it works is as follows: if I have a house which I own, and I am old and retired, then, unless I want my posterity to enjoy my house after me, it can turn the house to a source of a regular pension till I live. A reverse mortgage lender will agree to give me a loan in regular monthly instalments, as long as I live, and confiscate the house when I die. That is to say, the so-called lender is buying the house for an unspecified amount, which can be low if I die soon enough, or could be high if I live long.

Auto loans Ever since the emergence of the ABS market, auto loans have formed an important segment. The interesting features of auto loan markets are high asset quality and ease in liquidation of delinquent receivables. The emergence of an alternative in form of asset-backed commercial paper has reduced the significance of auto loan securitisations, but the activity in this segment is still important.

Commercial Mortgages Securitisation of commercial mortgages is one of the earliest applications of securitisation, next only to residential mortgage securitisation. Commercial mortgage-backed securities (CMBS) are bonds or other debt instruments secured by commercial real estate, as opposed to residential real estate. Commercial property means property let out or managed for economic benefit as opposed to that for self-occupation, and includes multi-family dwelling units (apartments or condominiums), retail centers, hotels, restaurants, hospitals, warehouses, and office buildings. In generic sense, CMBS also includes securitisation of real estate leases.

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Securitisation: An Indian Perspective

Equipment leases Securitisation of equipment leases forms an increasing proportion of the total ABS market. In USA alone, in 1997, more than $7 billion of equipment lease-backed deals were completed. The features of equipment leases will depend upon the type of leased product, transaction size etc. Asset backed commercial paper The distinction between asset-backed securities and asset-backed commercial paper is primarily one of the tenure of the paper - commercial paper by definition is short-term funding, and is therefore mostly used for short-term assets such as trade receivables. Asset backed commercial paper (ABCP) is a device used by banks to get operating assets such as trade receivables funded by issuance of securities. Traditionally, banks devised ABCP conduits as a device to put their current asset credits off their balance sheets and yet provide liquidity support to their clients.

Bank Loans, CBOs / CLOs There is no basic distinction between generic securitisations and the CBO/ CLO issuance at the instance of banks, except that here, the originating bank is trying to parcel out a pool of loans or bonds held by the bank. Banks would resort to securitisation essentially with four motives, in different combinations: sourcing cheaper funds, attaining higher regulatory capital, better assetliability management, and reduced non-performing or under-performing assets. CLOs Where the originating bank transfers a pool of loans, the bonds that emerge are called collateralised loan obligations or CLOs.

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Securitisation: An Indian Perspective

CBOs Where the bank transfers a portfolio of bonds and securitises the same, the resulting securitised bonds could be called collateralised bond obligations or CBOs. CDOs A generic name given to the two is collateralised debt obligations or CDOs, as in a number of cases, the portfolio transferred by the bank could consist of loans as well as bonds, and at times, even ABS.

Credit Cards The cult of the credit card has become well -accepted world over. The dramatic increase in the acceptability of credit cards is revealed in the following data about outstanding credit card receivables in the USA: from $234 billion of total receivables outstanding in 1990 to $356 billion outstanding as at May, 31, 1998.

Hedge fund investments Collateralised financial obligations (CFOs) use the CDO/ CLO device to securitise investments in private equity, hedge funds or similar non-debt-type investments. The typical structure of a private equity securitisation is by owners of limited partnership interests in private equity funds transferring their interests in those funds to a special purpose vehicle, or SPV. The SPV then issues debt type securities. These obligations of the SPV are backed by financial assets, hence the term CFO. Hedge fund investments and private equity investments are investments in equity-type instruments. By repackaging such investments into debt securities, CFOs create debt out of equity. The hedge fund industry itself has grown rapidly over the past 10 years or so. Securitisation of hedge fund investments seemed like a brilliant idea, a bit outlandish at once, but now it seems there are

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Securitisation: An Indian Perspective several transactions. It is certainly a new flavour in the structured finance market, but it seems it is here to stay at least for a while.

Non-performing loans During the 1990s, the problem of non-performing loans with banks became particularly acute [in 1997, Japanese banks had an estimated USD 1 trillion in nonperforming assets], and with securitisation technology with structuring options finding increased acceptability, bankers worldover have been looking at financial restructuring options through securitisation. It was not until late 1999 that securitisation of non-performing loans became a reality. On 25th November, 1999, Morgan Stanley Dean Witter (MSDW) launched and priced a JPY 21.0 billion issue of floating rate structured notes for an SPV called International Credit Recovery - Japan One Ltd., a Cayman Islands-domiciled. This was the first time a capital markets solution had been applied to the problem of non-and-sub-performing loans. The MSDW deal was backed by non-performing loans backed on Japanese real estate, a total of 700 real estate assets of various types located throughout Japan. MSDW had been buying these loans over time. How does it actually happen: The real miracle that securitisation does to non-performing loans is not to turn bad into good. It is not that the bad apple becomes a good apple when sliced, but that the good portion of the bad apple is sliced and given to outsiders, while the bad part is retained by the originator or other enhancers. Most non-performing loans securitisations have been supported by substantial over-collateralisation or subordinated interests retained by the originating banks. Most of the Italian securitisations, for example, are credit-enhanced by a substantial extent of subordinated notes, which are retained by the originator. In case of the Korean non-performing loan securitisation, it is the put option with the Korea Development Bank that enhances the acceptability of the bonds.

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Securitisation: An Indian Perspective

Aircraft leases Aircraft lease securitisations can take two forms - either securitisation of receivables out of leases with the aircrafting remaining the legal property of the originator, or those where the aircraft itself is sold to the SPV. The latter follows the device of Equipment Trust certificates (ETCs). While the aircraft lease receivable securitisation (aircraft lease portfolio securitisation - ALPS) is similar to any other securitisation, the ETC method is a unique technology applied mostly to the aircraft segment only.

Future flow securitisation The distinguishing feature of future flows securitisation is the fact that the asset being transferred by the originator is not an existing claim against existing obligors, but a future claim against future obligors. In other words, the claims are yet to be created, against obligors who are yet to be identified. Examples can be export receivables (normally crude exports), future royalties, hotel revenues, sports receivables, etc. Future flow securitisation essentially aims at piercing the rating of the sovereign and having a security of the originator rated above the rating of the sovereign. If, in the example above, the originator is an exporter, say exporting oil to US buyers, and if he securitises the oil exports such that the receivables are trapped and deposited in an account in New York, which is assigned to the SPV, the investors would:

not be subject to exchange risk, as the receivables are in foreign exchange not be subject to sovereign risk as the receivables have been assigned by way of a true sale outside the country of the originator.

The only right the sovereign has is the right of redirecting the exports, which can always be rated.

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Securitisation: An Indian Perspective

Whole business securitisation The whole business securitisation is a concept that emerged essentially in the UK. Given the ability to apply this device to the cashflows of any business, the concept virtually breaks down all limitations of securitisation and extends it to almost any business, new or old, having predictable cashflows or otherwise. Objectively, there is not much of difference between a plain secured borrowing and whole business securitisation. In a plain borrowing, the borrower obliges himself to pay to the lender, and the obvious source of payment is the cashflows of the borrower. The lender might have security interest in all or some of the assets of the borrower to secure the loan so granted. In a securitisation, on the other hand, the investor is given a legal right over some of the assets of the originator, which are legally isolated from the originator. In whole business securitisation, since the idea is to make the whole of the cashflows of the business available for liquidating the securities, there is no question of isolating the assets of the originator. In other words, the investors are though given a claim over all the cashflows of the originator, the cashflows remain within the legal and contractual control of the originator, and so do the assets from which the cashflows arise. The only difference between a secured lending and a whole business securitisation is that in the latter case, the investors acting through the SPV will have greater legal control over the originator, such that they can even effectively assume the control of the originator's business in an event of default.

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Securitisation: An Indian Perspective

VI

THE SECURITISATION PROCESS

We shall now look into the various steps and structures involved in a securitisation deal: 1. Identification and / or Accumulation of Assets These assets could include anything from airline ticket receivables, hire-purchase rental receivables, sales cash flows of any commodity, et al. Values are represented by future cash flows and it is essential to recognize a specific timeframe for this purpose. The market for each security will define what is investor-relevant information. This information is normally checked through credit-rating agencies that verify the credibility of the projected cash flows and the stability of their sources.

2. Transfer or Insulation of Assets from Transferors creditors: Assets are isolated usually through a true sale or clean transfer by the originator to a bankruptcy-remote SPV that will issue the securitised bonds. The issuing SPV may be either a limited purpose company, or a trust established under a restrictive deed. In both cases the SPV will be manage by an independent trustee, so that the issuer ahs no conflict of interest with the security. Also acceptable is the assignor retaining legal title to the underlying asset but holding such a title subject to the equitable interest of the assignee. This effectively means that the title to the asset will be held by the borrower (assignor) subject to the first charge in favour of the lender (assignee).

3. Issuance of Bonds:

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Securitisation: An Indian Perspective The issue of debt bonds is how the anticipated cash flows from the assets are transformed into cash in hand either by an SPV offering bonds to the public or the private investor market. The FI as an underwriter will take an initial investment position in the debt and later offload it in the market, thus making a margin. This creates a huge market for term lending and improves the performance of the FIs. Every securitisation requires the appointment of a servicer or administrator to collect and distribute obligor payments from the assets performance, manage the collection of recoveries for defaulted monitor and report on receivables. The administrator is entitled to receive a fee for the services, paid out of the collections on the assets. This fee represents one of the methods to compensate an originator for transferring its rights to the assets.

4. Enhancement and Support to the Assets and / or Securities The advantages of isolating cash flows and using them to service issued debt obligations may justify securitisation. Nevertheless, ABS and MBS investors may prefer structures to contain explicit enhancements that may improve the assets performance. Others may boost the performance of the structure, or guarantee payments to investors. The amount of credit enhancement that is required for any securitisation transaction is determined by a number of factors, such as:

Desired credit rating Estimated delays in collections from the pool Estimated collection efficiencies ( Collections/Billings) Estimated level of delinquent assets in the pool Cash flow pattern of the pool Estimated prepayment levels

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Securitisation: An Indian Perspective There are various forms of credit enhancements that are used in securitisation transactions. In order to arrive at the most efficient and most cost-effective structure, it is common for a transaction to employ several different credit enhancement techniques.

There are two distinct classes of credit enhancement techniques. Internal credit enhancements rely solely on the pool of receivables being securitised to provide support while External credit enhancements look to the credit of an independent third party. The choice among the various techniques of credit enhancement will depend on a number of considerations. Chief among these are:

Relative costs of enhancement mechanisms Excess spread available on assets Investor preference Sellers cost of capital Availability of suitably rated third party credit enhancement suppliers Complexity of structure/time available to complete transaction.

The various forms of internal and external credit enhancement techniques are listed below: Internal Credit Enhancement Overcollateralisation Cash collateral/Liquidity Reserve Credit tranching Excess Interest Spread Reserve funds Amortization triggers External Credit Enhancement - Related party guarantee - Letter of credit - Monoline Insurance - Multiline Insurance

The Special Purpose Vehicle - 21 -

Securitisation: An Indian Perspective As opposed to a general purpose vehicle or a trading corporation, a Special purpose vehicle, as the name suggests, is formed for a special purpose: therefore its powers are limited to what might be required to attain that purpose and its life is destined to end when the purpose is attained. When a corporation, call it the sponsor of the SPV, wants to achieve a particular purpose, for example, funding, by isolating an activity, asset or operation from the rest of the sponsor's business, it hives off such asset, activity or operation into the vehicle by forming it as a special purpose vehicle. This isolation is important for external investors whose interest is backed by such hived-off assets, etc., but who are not affected by the generic business risks of the entity of the originating entity. Thus SPVs are housing devices - they house the assets etc transferred by the originating entity in a legal outfit, which is legally distanced from the originator, and yet self-sustained as not to be treated as the baby of the originator.

By its very nature, an SPV must be distanced from the sponsor both in terms of management and ownership, because if the SPV were to be owned or controlled by the sponsor, there is no difference between a subsidiary and an SPV. Being an independent, an SPV is responsible for its own funding, risk capital and management decisions. Most SPVs, for example, securitisation SPVs, run on a pre punched program and do not have to take any management decision: they are almost "brain dead".

Typical structures of Asset Backed Securities (ABS): There are different types of ABSs, each utilizing a slightly different structure:

Asset-backed certificates are pass-through certificates issued by a trust representing undivided fractional interests in a pool of receivables such as automobile loans or credit card receivables. Except for any recourse provision, the assets are sold outright by the selling company to the trust.

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Securitisation: An Indian Perspective

Asset backed obligations (ABOs) are debt securities of a special purpose corporation, owned either by the selling company or by unaffiliated third parties, and collateralised by a pool of financial assets. They are similar to collateralised mortgage obligations (CMOs) because they often utilize multiple tranches, but, unlike CMOs, they may issue either pay through or fixed pay securities (i.e. prepayment risk is eliminated for investors).

Asset backed preferred stock is issued by a special purpose, bankruptcy-proof subsidiary which purchases assets such as trade and consumer receivables or inter-company notes from its parent or affiliates. The assets are often supported by a direct pay letter of credit or surety bond in favour of the subsidiary issued by a AAA rated commercial bank wit the result that the subsidiarys preferred stock is able to obtain the highest credit ratings.

Asset backed commercial paper involves the sale of financial assets to a SPV which, in turn, issues commercial paper. Proceeds from the issuance of the commercial paper finance the purchase of the assets. The commercial paper is supported by the cash flow from the assets, the issuance of new collateralises commercial paper or from borrowings under a liquidity facility.

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Securitisation: An Indian Perspective

VII

THE EXPERIENCE SO FAR

The US Scenario

Securitisation in its present form originated in the mortgage markets in USA. Till 2002, the outstanding securitised debt in international market was above $ 5 trillion. The Mortgaged Backed Securitisation (MBS) market was above $ 4 trillion. The US alone accounted for $435 billion of the total ABS issuance. Also outstanding Securitised debt for ABS is 25% of total outstanding borrowings in the United States.

In the US, securitisation was promoted with the active support of the government. The government wanted to promote secondary markets in mortgages to allow liquidity for mortgage finance companies. GNMA was the first one to buy mortgages from mortgage companies and to convert them into pass through securities - this was 1970. Other US government agencies, FNMA and Freddie Mac jumped in later. The first securitisation of receivables outside the mortgage markets happened in 1975 when Sperry Corporation securitised its computer lease receivables.

The federal agencies purchase mortgages from banks and thrift institutions, repackage them in the form of securities, and sell them to investors as mortgage pools. Investors in mortgage-backed securities are, in fact, purchasing a piece of a mortgage pool, taking into consideration such factors as maturity and the spread between the yield on the mortgage security and the yield on 10-year treasuries. Investors in mortgage backed securities assume little default risk because most mortgages are guaranteed by one of the government agencies. However, these securities present investors with

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Securitisation: An Indian Perspective uncertainty because they can receive varying amounts of monthly payments depending on how quickly homeowners pay-off their mortgages. Although the stated maturity can be as long as 40

years, the average life of these securities to date has been much shorter. Ginnie Mae a wholly owned government agency issues fully backed securities (i.e., they are full faith and credit obligations of the US Government) in support of the mortgage market. The GNMA passthrough securities have attracted considerable attention in recent years because the principal and interest payments on the underlying mortgages used to collateralise them are passed through to the bondholder monthly as the mortgages are repaid.

As a result of the trend to securitisation, other asset-backed securities have proliferated as financial institutions have rushed to securitise various types of loans. Car loans, credit-card receivables, railcar leases, small-business loans, photocopier leases, aircraft leases, and so forth have backed marketable securities. New asset types include royalty streams from films, student loans, mutual fund fees, tax liens, monthly electric utility bills, and delinquent child support payments. Examples of recently securitised assets include: Auto loans, leases and installment sales contracts Home equity loans, Home improvement loans, Manufactured housing installment sales contracts, Credit card receivables, Tax liens, Future royalty income and Equipment leases and Utility charges.

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Securitisation: An Indian Perspective Asset Class Breakup

Asset Class Breakup in US
Equipment 2% Mid housing 1% Other 10%

St udent Loan 4% CDOs 12%

Credit Card 16%

Home Equity Loan 36%

Auto 19%

Source: Thomson Financial Securities Data

The Indian Scenario Securitisation began in India in the early nineties. The first securitisation deal took place in 1991 when Citibank securitised a pool from its autoloan portfolio and placed the paper with GIC Mutual Fund. The volume involved was about Rs. 16 crore. Since then, much hype and hoopla has surrounded the securitisation market in India.

The securitisation market in India is about Rs.100 bn with a meager 1.6% of the total debt. There has been a lot of discussion about the potential of securitisation in India, actual deal activity has never reached the potential. ICICI, TELCO and Citibank have been actively pursuing securitisation, but most of their transactions are privately placed with a majority of them being bilateral fully bought out deals.

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Securitisation: An Indian Perspective Asset Class Breakup

Asset Class Breakup In India

Oil & Gas Receivable 14% Aircraft Receivables 5% Auto 16% Telecom 6% M BS 6% Others 17% CBO & CLO 35%

Sales Tax receivables 1%

In terms of the asset profile, in the securitisation of hire purchase receivables from vehicles, truck hire-purchase receivables account for most of the transactions with the rest being accounted for by car loan / hire purchase receivables. Higher yields and relatively low delinquencies in autoloans in general are the main reasons for this asset category being preferred for securitisation. Because of the inherent higher yields in autoloans, the originators could offer attractive yields to the investor and still book profits on securitisation.

Securitisation of housing loan receivables has also taken off in India in 2000 with National Housing Bank issuing mortgage backed securities (MBS) backed by housing loan receivables of Housing Development Finance Corporation Limited (HDFC) and LIC Housing Finance Limited (LICHFL). Both the issues were rated by CRISIL and successfully placed resulting in LICHFL and HDFC going in for second tranches of MBS were also rated by CRISIL.

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Securitisation: An Indian Perspective Originators The originators in the rated auto-loan securitisation transactions include Citibank, several NBFCs and a few financial institutions. Balance sheet management, alternate funding, tenure mis-match correction, exposure and NPA management and profit booking have been the main motivating factors for these originators.

Investors Investors in ABS in the past have been FIs, NBFCs, Multinational Banks, Insurance companies and Mutual Funds.

Costs of securitisation Different costs involved in a securitisation transaction are the interest rate (discount rate) on ABS, cost of maintaining cash collateral, stamp duty, SPV expenses, legal fee and the rating fee. The interest rate is the rate used to discount the future cashflows of the pool to arrive at the consideration to be paid to the originator. The cost of maintaining cash collateral is the interest income foregone due to blocking of funds in the collateral. Stamp duty differs among States. In Maharashtra, Gujarat, West Bengal, Karnataka and Tamil Nadu, stamp duty on securitisation involving certain asset classes has been reduced to 0.1%. SPV expenses would be the fees payable to the SPV. Often it may not be necessary to form a company to act as the SPV, if one of the existing investment companies could be used as the SPV. The legal fee is normally a lump sum, not directly related to the volume of the transaction. Rating fee has two components viz. initial rating fee and surveillance fee. CRISILs initial rating fee is currently 0.1% of future receivables for the first year and the surveillance fee is 0.05% of remaining receivables for every year of surveillance. If other forms of credit enhancement like over-collateralisation is used, interest loss on cash collateral could be reduced thereby reducing the overall cost. - 28 -

Securitisation: An Indian Perspective

Extent and form of credit enhancement The level of credit enhancement has usually varied between 5% and 30% of the receivables securitised for an AAA rating depending upon the quality of the portfolio and the pool. The extent of credit enhancement has shown a decline over the years. The form of credit enhancement has been cash collateral, over collateralisation, sub-ordination and guarantee.

Liquidity Some of the recently rated securitisation programs were listed in the National Stock Exchange and a mechanism of market making was also incorporated. Liquidity in general for all debt instruments could be better in India. Lack of awareness could further reduce the liquidity in case of ABS.

VIII

ISSUES IN INDIA

Tax Issues

The tax incidence would usually depend on how the documents relating to the transaction are structured. The main entities involved in the securitisation transaction are the Originator, the SPV and the Investors.

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Securitisation: An Indian Perspective

Taxability of the Originator It would depend on: 1. Whether the securitisation transaction results in the legal transfer of property in the assets being securitised; and 2. Whether the gain or loss (in the case where there is a transfer of the property) is treated as a business gain or a capital gain by the tax authorities

Where there is a legal transfer of property (true sale) in the assets to be securitised Tax depends on whether the tax authorities construe it as a capital gain or as a business gain. If the tax authorities construe the securitisation transaction as a transfer of capital assets or as a conversion of the assets into stock-in-trade: Capital Gains tax would be applicable. On the other hand, where the profit/gain on the securitisation transaction is treated as profit/gain of business, it would be chargeable to tax under the head Profits and Gains of Business under Section 28(i) of the Act.

Where there is no legal transfer of property in the assets to be securitised The tax authorities may characterize the securitisation transaction as a method of financing on the security of the receivables and levy tax on the Originator, on the gains if any, under the head Profits and Gains of Business" under Section 28(i) of the Act. The discount charged by the SPV on the receivables would be allowable as a type of a finance expense and deducted from the net amount received by the Originator, which would be liable to tax as business income. - 30 -

Securitisation: An Indian Perspective

Where the income in the assets has been transferred without a transfer of the property Section 60 of the IT Act Where only the receivables in the securitisation transaction and not the asset is transferred : (e.g. in securitisation of lease receivables, housing rent or hotel receipts):The income would be deemed to accrue to the asset-owner (Originator) and he would be liable to tax thereon. However, the asset-owner could claim capital allowances on the asset, and Where the asset itself is transferred: (e.g. in securitisation of hire purchase receivables, where the only asset claimed by the asset-owner is the right to receive installments and such asset is transferred):On transfer, the income generated from the receivable would be deemed to have been transferred to the transferee and he would be liable to pay tax on such income. The gain, i.e. the difference between the sum received from the transferee and the value of the asset at which it is outstanding, less any expenses incurred by the asset-owner would be considered as either business profit of the asset-owner or capital gains of the asset-owner, depending on whether the asset being transferred is a non-capital or capital asset.

Taxability of the SPV There are three alternative approaches 2. SPV regarded a conduit between the Originator and the ultimate investor Pass through Structure: In this case, it would receive income flows from the underlying assets and would use the same to service the instruments issued by it. Thus, it would not earn any income nor would it make any profits and would not be liable to pay any tax. - 31 -

Securitisation: An Indian Perspective

2. SPV may be regarded as a representative assessee of the investors: The SPV generally acts as the trustee of the investors, and in such cases, relevant provisions of the Act, dealing with the concept of a representative assessee may apply to the SPV. Accordingly, the SPV may be taxed for the income received by it on behalf of the several investors. However, such tax would be revenue-neutral since the tax payable by the SPV cannot exceed the tax payable by the investors on such income. Under certain circumstances, the SPV would be liable to pay tax at the maximum marginal rate applicable to individuals. The Act enables the representative assessee to recover the tax paid by the representative assessee from the person/s on whose behalf such tax is paid. Thus, ultimately, the SPV, which is regarded as a representative assessee, may have no tax incidence.

3. SPV may be characterized as an independent taxable entity or in case of a Pay through structure: (Example: Where the SPV re-configures the cash flows received by it by reinvesting them, so as to pay the investors on fixed dates, which do not match with the dates on which the transferred receivables are collected by it) Where the SPV is treated as an independent entity, any income received or deemed to be received by the SPV would be deemed to be its income. The income distributed by the SPV in the form of interest would be deemed to be the expense of the SPV and income in the hands of the investors. Where the payments made by the SPV are towards equity or towards distribution or application of income, such payment would not be a tax-deductible expense for the SPV. The SPV would be liable to pay dividend distribution tax on the dividends paid.

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Securitisation: An Indian Perspective

Taxability of the Investors 1. Where the SPV is regarded as a pass through entity: Each individual investor would be liable to pay tax on the income earned in proportion to his investment.

2. Where the SPV is characterized as a representative assessee: The SPV is taxed and the tax paid by it is deemed to have been paid by the investors. Thus, the investors would not be liable to pay tax individually and the SPV would be entitled to recover the tax paid by it, from the investors.

3. Where the SPV is characterized as an independent entity: Investors would be taxed on what they would earn, by holding the instruments issued by the SPV or by transferring the same.

Withholding Taxes The Concept: A person responsible for making payments, which are chargeable to tax, is required to deduct tax as per the applicable rate and remit the same to the Government of India. In a securitisation transaction, there would be three situations when the issue of deducting tax in certain circumstances at source would arise. These are:

1. When the transferee/SPV makes payments to the Originator, for transfer of the assets: No requirement of any withholding tax since the SPV pays for the discounted value of the receivables purchased and there is no income element in the nature, which requires deduction of - 33 -

Securitisation: An Indian Perspective tax at source. If the transaction results in taxable profit or gain, it would be on account of business profit or capital gain, for which the tax would be payable by the Originator

2. When the transferee/SPV collects payments from the debtors in relation to the securitised asset: Withholding taxes may be applicable depending on the nature of payments collected from the debtors. The securitisation transaction does not change the character of the original transaction between the Originator and the debtors and thus any withholding tax applicable to the payment to be made by the debtor to the Originator, under the original transaction would continue to be applicable.

3. When the transferee/SPV makes payments to the investors Withholding tax would be applicable, when such payment is made in the form of interest to the investor. Where the SPV is treated as a mere conduit, it is likely that the payments made by it would not be treated as interest payments and thus not liable to any withholding taxes.

Legal Issues

Stamp Duty Stamp duty is different in various Indian states and ranges from a low of 0.1 per cent of the value of loans transferred in certain states to more than 3 per cent in other states. Most states had stamp duty regimes that were unclear on how exactly a securitised instrument may be classified. In certain circumstances the trust/SPV may also be treated as a non-banking financial company and be subject to the regulations framed by the RBI under the Reserve Bank of India Act, 1948 in this regard. In such a situation, stamp duty may be leviable not only on the assignment of the original - 34 -

Securitisation: An Indian Perspective pool of loans but also on the securitised instrument . However, stamp duty on transfer of securitised assets by the lender can be reduced or avoided by careful structuring of the transaction.

Insolvency Issues True Sale The principal concern in a securitisation transaction is the legal isolation of the assets securitised from the bankruptcy risks associated with the entities involved. To achieve this, the assets securitised must be legally transferred to the SPV, so that the SPV is not affected in a situation where there are any claims against the Originator.

It is thus the key to securitisation transactions that the SPV and the assets are remote from the risk of bankruptcy/insolvency of the originator.

In order to achieve this, the transfer of the assets to the SPV must be regarded as a true sale and not merely as being a transfer for obtaining finance. Where the transaction is not regarded as a true sale, it may be treated as a method of financing or a loan by the SPV, in which case, if the Originator goes bankrupt, the liquidator of the Originator would have rights against the underlying assets.

Bankruptcy of the SPV The bankruptcy risks of the SPV need to be mitigated. This may be achieved by restricting the business activities of the SPV so as to decrease the chances of there being other creditors who could cause the winding up of the SPV. The activities of the SPV should be restricted by incorporating relevant provisions in the constituent and transaction documents.

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Securitisation: An Indian Perspective

Fraudulent preference Certain provisions of the Indian Provincial Insolvency Act, 1920 and the Presidency Towns Insolvency Act, 1909 provide that certain transfers of property, if made immediately before bankruptcy of an entity would be annulled or avoided under law, if it is held that the transfers were made in contemplation of bankruptcy. The Provincial Insolvency Act states that where a transferor is adjudged insolvent, within two years of the property being transferred, then the Court may annul such a transfer of property. However, transfers made in good faith and for valuable consideration are excluded.

There is a preference period whereby any transfer of property moveable or immovable, made, taken or done by, or against a company within six months before the commencement of its winding up, may in the event that the company is wound up, be treated as a fraudulent preference and be invalid accordingly. Generally in establishing a case of fraudulent preference it must be shown that the dominant motive of the debtor must be to prefer a creditor and the motive must also be tainted with an element of dishonesty

Priority of claims There may be a situation where a true sale has been achieved. However, the underlying assets are subject to an overriding interest (prior claims) created in favour of creditors of the Originator. Where such prior claims exist, the SPVs rights would be subject to such prior claims.

In certain situations such as bankruptcy under the Indian law, the liquidator is first required to discharge statutory preferential payments before discharging other claims. Further, the liquidator is

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Securitisation: An Indian Perspective also under an obligation not to part with any of the assets of the company without setting aside an amount equal to the tax which is payable or likely to be payable thereafter by the company.

Set-off One concern related to insolvency risk is whether or not setting-off of exposures would be permitted in India. The law is well settled that a creditor claiming to prove debt against an insolvent company in liquidation, is entitled to set-off its related claims. Dealing with the question of set-off, the Supreme Court has taken the view that section 529 and section 530 of the Indian Companies Act, 1956 must be read together when a creditor seeks to prove his debt against the company in liquidation. The effect of such a reading would permit a creditor to take the benefit of the rule enacted in section 46 of The Provincial Insolvency Act, 1920 whereby only that amount which is ultimately found due from him at the foot of the account in respect of mutual dealings should be recoverable from him and not that the amount due from him should be recovered fully while the amount due to him from the company in liquidation should rank in payment after the preferential claims

Assignment of Actionable Claims Actionable claims refers to a claim to any debt, other than a debt, which is secured by mortgage of immovable property or by hypothecation or pledge of movable property or to any beneficial interest in movable property not in the possession, whether such debt or beneficial interest be existent, accruing, conditional or contingent. For example, receivables on account of leases are actionable claims. In India, receivables are taken as actionable claims. As such, transfer of actionable claims is possible only by execution of an instrument in writing, as per section 130 of the Transfer of Property Act. As per this section, transfer on an actionable claim shall be effected only by the execution of an instrument in writing, signed by the transferor, and such - 37 -

Securitisation: An Indian Perspective transfer shall be complete and effectual upon the execution of such instrument, whether a notice to the debtor is given or not. On the strength of such an instrument, the transferee of an actionable claim gets lawful rights to recover the claim from the debtor, in his own name, without any reference to the transferor. The Indian law differs from the English law, as under the Indian law, notice of assignment (transfer) is not a pre-requisite, although it is advisable.

The Transfer of Property Act states that assignment of a debt should be in whole and not be a part assignment. Further, both the Transfer of Property Act and the Sale of Goods Act hold that only a property currently in existence is capable of being transferred. These laws impede the development of securitisation of future receivables, as transfer of a future property does not fall under the definition of debt.

Accounting for Securitisation In the Books of the Originator The accounting depends upon whether the Originator has lost control of the securitised asset

Loss of control The originator has not lost control where 1. The creditors of the Originator are entitled to attach or otherwise deal with the securitised assets; 2. The SPV does not have the right (to the extent it was available to the Originator) to pledge, sell, transfer or exchange for its own benefit the securitised asset; 3. The Originator has the right to reassume control of the securitised asset except: a) Where it is entitled to do so by a Call Option, where such Call Option can be justified on its own commercial terms as a separate transaction between the SPV and the Originator, for - 38 -

Securitisation: An Indian Perspective instance, where the Call Option is exercisable at fair value of the asset on the date of exercise of the Option; or b) Where it is entitled to do so by a Clean-up Call Option

Some other relevant points:

Where originator is also the servicer: there is loss of control An obligation on the originator to repurchase (as in a recourse obligation): is not an entitlement to ownership and there is a loss of control

An entitlement and obligation of the originator to repurchase: No loss of control

When the Originator looses entire control of the securitised assets:

Securitised asset should be derecognised in the books of the Originator The difference between the book value of the securitised asset and consideration received should be treated as gain or loss arising on securitisation and disclosed separately in the statement of profit and loss

The entire expenses incurred on the transaction, say, legal fees, etc., should be expensed at the time of the transaction and should not be deferred

If the Originator has accepted recourse or similar obligation, e.g., the Originator has granted a Put Option at a predetermined price to the SPV, then the contingent loss arising therefrom, should be accounted for as per Accounting Standard (AS) 4, Contingencies and Events Occurring After the Balance Sheet Date

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Securitisation: An Indian Perspective

When there is no loss of control over the securitised assets

Securitised asset should NOT be derecognised in the books of the Originator Consideration received for the asset so transferred should be accounted for as a borrowing secured there against.

The expenses incurred on the transaction should either be amortised over the term of the secured borrowing or recognised immediately in the statement of profit and loss.

Partial Loss of Control This can be done in two ways: 1. Where a proportionate share of the asset is transferred: Example: the Originator may transfer a proportionate share of loan (including right to receive both interest and principal), in such a way that all future cash flows, profit/loss arising on loan will be shared by the Originator and the SPV in fixed proportions

If the Originator transfers a proportionate part of the asset, the previous carrying amount of the asset is apportioned among the part transferred and the part retained on the basis of proportion transferred and proportion retained. For example, if the originator transfers 75% of an asset to the SPV, 75% of the carrying amount of the asset should be considered as securitised. Where the securitised part of the asset qualifies to be derecognised, the entity would continue to recognise the remaining part of the asset at 25% of the carrying amount

If any new interest has been created as a result of securitisation transaction, such as a Call Option, the new interest should be recognised in the books in accordance with the relevant accounting principles.

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Securitisation: An Indian Perspective 2. Where the asset comprises the rights to two or more benefit streams and one or more of such benefit streams is/are transferred while retaining the others: The carrying amount of such financial asset should be apportioned between the part(s) transferred and the part(s) retained on the basis of their relative fair values as on the date of transfer.

Future Receivables The Originator may securitise or agree to securitise future receivables, i.e., receivables that do not exist at the time of agreement but which would be arising in future.

The future receivables are estimated at the time of entering into the transaction and the purchase consideration for the same is received by the Originator in advance.

Any purchase consideration received is accounted for as an advance, since the assets proposed to be securitised would not be existing at the time of the agreement, but would arise in future.

The cost of bringing these assets into existence would also be incurred in future. In such cases, the criterion for derecognition prescribed should be applied as and when the relevant assets come into existence. Till such time the amounts received, if any, on account of the proposed securitisation should be reflected as an advance.

Revolving Period Securitisation Securitisation can also be in the form of Revolving Period Securitisation where future receivables are transferred as and when they arise or at specified intervals; the transfers being on prearranged terms

All requirements except the one pertaining to future receivables applies

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Securitisation: An Indian Perspective

Measurement of the Consideration When consideration is not in cash: (example in the form of securities issued by the SPV) The consideration should be measured at the LOWEST of: a. the fair value of the consideration; b. the net book value of the securitised assets; and c. the net realisable value of the securitised assets

When the consideration is received partly in cash and partly in a form other than cash The non-cash component of the consideration should be measured at the lowest of the a. the fair value of the non-cash component; b. the net book value of the securitised assets as reduced by the cash received; and c. the net realisable value of the securitised assets as reduced by the cash received.

What is the fair value? The fair value is the price that would be agreed upon between knowledgeable, willing parties in an arms length transaction. Normally we consider the following as fair value:

Quoted market price If quoted market price is not available: an estimate based on the market prices of assets similar to those received as consideration

In case the market prices of similar assets are also not available: an estimate based on generally accepted valuation techniques such as the present value of estimated future cash flows.

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Securitisation: An Indian Perspective

In the Books of the SPV

When the Originator has lost control over the securities assets:

Recognise the asset received under a securitisation transaction only if the Originator loses control over the securitised asset

The asset should be recognised at the amount of consideration, if the consideration has been paid in cash

In case the consideration has been paid in a form other than cash, e.g., securities, the asset so received should be recorded either at its intrinsic value or at the fair value of the consideration, whichever is more clearly evident. If both the values are equally evident the asset should be valued at the lower of the two values.

When beneficial ownership in the securitised asset has not been transferred to the SPV or the Originator has not lost control over the asset

Do not recognise the asset received. The consideration paid should be recorded as a lending secured against the financial asset received under securitisation transaction

The amount received by the SPV on issue of PTCs or other securities should be shown on the liability side of the balance sheet, with appropriate description, keeping in view the nature of securities issued.

In the Books of the Investor - 43 -

Securitisation: An Indian Perspective Account for the PTCs and/or debt securities acquired by it as an investment in accordance with Accounting Standard (AS) 13, Accounting for Investments.

Disclosures In the financial statements of the Originator

The nature and extent of securitisation transaction(s), including the financial assets that have been derecognised.

The nature and the amounts of the new interests created, if any. Basis of determination of fair values, wherever applicable

In the financial statements of the SPV

The nature of the securitisation transaction(s) including, in particular, a description of the rights of the SPV vis--vis the Originator whether arising from the securitisation transaction or a transaction associated therewith.

Basis of determination of fair values, wherever applicable.

In the financial statements of the Investor The Investor should make disclosure of investments in PTCs and/or debt securities as required by Accounting Standard (AS) 13, Accounting for Investments.

Other issues concerning securitisation transactions

Lack of third party servicers In securitisation transactions, normally, the originator acts as the servicer for the securitised pool of assets. To that extent dependence on the originator continues even after the sale of receivables. - 44 -

Securitisation: An Indian Perspective

Though the agreement provides for the investors to change the servicer in case they are not satisfied with the performance of the servicer, in India, the efficacy of alternate servicer needs to be fully tested.

Lack of data across economic cycles Lack of long track record of performance of assets over economic cycles is not available in India. This is because housing and consumer loans in the organised sector are not as old in India as it is in the developed countries. In the United States for example, the historical performance of mortgages for decades including the great depression of 1930 are available. This kind of database helps one to predict the behaviour of assets in adverse conditions better.

Lack of sophisticated information systems A sophisticated information system is very important for securitisation. The information requirement of rating agencies is fairly detailed both at the time of initial rating and subsequent surveillance. Currently, not all originators systems are fully geared to meet the information requirement.

Co-mingling of cash flows

The risk that the cashflows from the securitised pool would get mixed with those of the originator is referred to as co-mingling risk. If the originators short-term rating is not high this presents a problem. Internationally, a time limit is specified within which the pool cashflows should be transferred to the designated account. This could pose a problem, if the contracts in the securitised pool are geographically dispersed across many states and regions. There is a lack of quick fund transfer systems in India. Hence, more time may have to be allowed for the transfer of funds. - 45 -

Securitisation: An Indian Perspective

Debt market Lack of a sophisticated debt market is always a drawback for securitisation for lack of benchmark yield curve for pricing. The appetite for long ended exposures (above 10 years) is very low in the Indian debt market requiring the Originator to subscribe to the bulk of the long ended portion of the financial flows. The development of the Indian debt market would naturally increase the securitisation activity in India.

Lack of Investor Appetite Investor awareness and understanding of securitisation is very low. RBI, key drivers of securitisation in India like ICICI and Citibank and rating agencies like CRISIL and ICRA should actively educate corporate investors about securitisation. Mandatory rating of all structured obligations would also give investors much needed assurance about transactions. Once the private placement market for securitised paper gathers momentum, public retail securitisation issuances would become a possibility.

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Securitisation: An Indian Perspective

IX

FUTURE TREND

Since late eighties, when securitisation made its beginning in India, the number as well as the size of transactions has grown over the years. This trend is likely to continue and the market would witness considerable growth in the coming years.

It would help in the development of ABS market particularly the mortgage backed securities (MBS) market, if incentives are given to these instruments. For example, MBS could be declared as eligible investments by provident funds and pension funds and the concessions available to infrastructure bonds could be extended to MBS.

So far, companies securitised assets to raise funds without adding to borrowings. This helped companies, which had high gearing levels. The motivating factor in some securitisation transactions in the past was the ability to book profits upfront. While these would continue to be demand drivers for securitisation, securitisation is likely to be increasingly used for better asset liability management. As securitisation replaces long to medium term assets by cash, the weighted average maturity of assets for the company comes down. This is a big comfort, as typically, NBFCs were funding threeyear assets with one year fixed deposits.

Traditionally in the fund based business segment of the financial services sector in India, a single entity was engaged in the entire gamut of activities viz. raising funds, locating borrowers, credit appraisal of the borrowers, servicing of the loans and recovery. Owing to the rapidly changing environment, realignment is likely to happen in this sector. One could see specialisations emerging in the market. In developed markets like USA, particularly in the mortgage market, there is a - 47 -

Securitisation: An Indian Perspective considerable amount of specialisation. Typically, in these markets, a single entity does not perform more than one or two of the activities mentioned earlier. The trend of specialisation is also in line with the increasing emphasis on core competence. Instead of an entity engaging in all the activities, it would make sense to focus on a few areas where it has competitive advantage.

The trend is already visible in the autoloans sector. Owing to the regulatory changes with respect to the quantum of fixed deposits that NBFCs could mobilise and the linking of the same with the credit rating, a number of NBFCs are finding it difficult to raise funds at competitive rates. These NBFCs, however, have a relatively low cost distribution network in place to originate and service loans. On the other hand, large companies and Foreign Banks find that it is not economical to create a large distribution network in terms of extensive branch network across the country due their high cost structure. However, these companies, given their size, parent support, managerial talent and a high credit rating have a much stronger funding capability.

Securitisation could be effectively used to combine these two complementary pools of resources. NBFCs could originate loans and securitise them and sell to large companies. And they could use the proceeds of the sale to originate more loans and the process could go on. The small NBFCs could continue to service the loans, which would ensure a steady flow of fee income.

While many transactions are under way in the auto loan sector, this trend is likely to extend to housing finance sector as well. As regards housing finance, the funding required is of a much longer tenure and thus far more difficult to raise.

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Securitisation: An Indian Perspective

CONCLUSION

The securitisation market in India, though in its infancy, holds great promise especially in the MBS area. While more complex securitisation transactions and public issuance of securitised paper are still a distant dream, appropriate legislation and investor education can give the securitisation market in India a much-needed thrust.

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Securitisation: An Indian Perspective

XI

BIBLIOGRAPHY

Reference to various books and numerous web site searches have led to the successful completion of the paper.

Books and Articles [1] P.P. Vora (2001), NHB - Promoting A Sound, Healthy, Viable And Efficient Housing Finance System [2] Modak, Anand, (2001), Securitisation - A boon for Investors and Borrowers, Investime, September 2001 [3] Thompson, J.K., (1995), Securitisation: An International Perspective, OECD [4] Business India Feb 4-17, 2002) [5] Vinod Kothari. (2002), Securitisation: The Financial Instrument of the New Millennium [6] The Securitisation and Reconstruction of Financial Assets and Enforcement Of Security Interest Act, 2002. [7] ICAI, Guidance Note on Accounting for Securitisation [8] Income tax V.K Singhania Web Sites [1] www.vinodkothari.com [2] www.economictimes.com [3] www.shilpabichitra.com [4] www.valuemoney. com

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