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Structured Finance
January 2006

Credibility. Independence. Analytical Rigour.

dickenson

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CRITERIA - Structured Finance

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 Contents
Evaluating risks for securitisation
transactions - A Primer .......... 03

Rating methodology
for ABS transactions .......... 09

Rating methodology
for RMBS transactions .......... 19

Commercial Mortgage Backed Security -

A viable option for financing commercial real estate .......... 30

Rating Criteria for

Collateralised Debt Obligations .......... 35

Rating Criteria for Instruments with

Partial Guarantee .......... 43

Rating Criteria for Future Flow Securitisation .......... 46

Securitisation - Legal Issues and

Compliance Requirements .......... 52
CRITERIA - Structured Finance
 Foreword
For almost two decades, CRISIL has helped shape the evolution of the debt
markets in India, by developing criteria and standards to facilitate rapid
market growth. In its role as the pioneer in the ratings business, CRISIL has
always set the standards in rigour of analysis, transparency, and disclosure,
and has firmly established its position as the provider of the `most reliable
opinion on risk'.

In continuation of its pioneering role, CRISIL is pleased to present its criteria for
structured finance ratings. This publication, part of our series of publications
on our rating criteria, brings out the detailed criteria CRISIL uses for its ratings
on structured instruments, including securitisation across all asset classes.

This volume will supplement the four earlier volumes in this series, which
cover rating criteria in general, and specifically address criteria for rating
issuers in the manufacturing, financial, and infrastructure sectors.
By publishing this criteria series, CRISIL hopes to contribute further to the
growth of the debt markets, through a better understanding of its rating criteria
and process amongst issuers and investors.

This is the first time that any rating agency in India has brought out such
comprehensive rating criteria, especially in the structured finance space. This
effort would not have been possible without the support of the issuer and
investor communities. We would like to take this opportunity to thank all of
you for your support so far; we look forward to working with you in further
developing the Indian debt markets.

The CRISIL Ratings team welcomes your comments and questions regarding
the issues discussed in this publication. Please email us with any comments and
questions at CRISILratingdesk@crisil.com, or call any of the contacts listed in
this booklet.
CRITERIA - Structured Finance

Roopa Kudva
Executive Director and Chief Rating Officer
 Evaluating risks for
securitisation transactions - A Primer
Investments in securitised paper have increased rapidly in recent times and
“pass through certificates” or PTCs are fast becoming part of mainstream
financial markets. The nature of such investments is however very different
from conventional corporate lending where traditional tools of business and
financial analysis could be used to gauge creditworthiness. Risk analysis in
PTCs requires a vastly different framework of analysis, and the focus of this
article is to provide investors with an “easy to understand” step-by-step
introduction to understanding risks in securitised paper. In addition, the article
also throws light on CRISIL's analytical framework in evaluating securitisation
transactions, and the steps taken by CRISIL in identifying, assessing and
mitigating risks.

UNDERSTANDING SECURITISATION
Generally speaking, a securitisation transaction involves sale of receivables by
the originator (a bank, non-banking finance company, housing finance
company, or a manufacturing/service company) to a special purpose vehicle
(SPV), typically set up in the form of a trust (see chart below). Investors are
issued rated pass through certificates (PTCs), the proceeds of which are paid as
consideration to the originator. In this manner, the originator, by selling his
loan receivables to an SPV, receives consideration from investors much before
the maturity of the underlying loans. Investors are paid from the collections of
the underlying loans from borrowers. Typically, the transaction is provided
with a limited amount of credit enhancement (as stipulated by the rated agency
for a target rating), which provides protection to investors against defaults by
the underlying borrowers. (For a more detailed understanding of the
securitisation process, refer CRISIL's Securitisation Handbook)

Trust and
Retention
Borrowers
Account

Scheduled
CRITERIA - Structured Finance

payments Deposit of collections

Monthly
Servicing agent Payouts
Sale/Assignment
of pool receivables
Originator/seller
PTCs
SPV Trust Investors
Consideration
Trustee Consideration

3
CRITERIA - Structured Finance

RISK ANALYSIS OF SECURITISATION Servicing risk

TRANSACTIONS Servicing agent is not capable of collecting. Thus
Before we commence a risk analysis of borrowers may have ability to pay, but servicing
securitisation transactions, a brief summarisation has not been able to convert ability into cash flows
of the basics of securitisation transactions would for investors (Servicing risk).
be useful.
+ There is a sale of receivables to the SPV and Commingling risk
receivables belong to the SPV. Borrowers are paying and servicer is collecting,
+ Investors have invested in the SPV and can but funds are being passed onto investors only at
therefore be repaid only out of collections from the end of a collection month. Is there a potential for
underlying receivables. diversion of these funds by the servicer (commingling
+ As the originator has SOLD the receivables, risks).
there is no additional recourse to originator
besides one time credit enhancement provided Bank counterparty risk
initially.
Borrowers are paying; funds are being collected
+ Rating is based on the expected performance of and paid into the trustee's account. Credit
the receivables along with the credit enhancements (typically available as bank fixed
enhancement. deposit with trustee) are being used to make up
for defaults. What if the designated bank where the
trustee account is located or the cash collateral bank
A good step towards a robust analysis of risks
goes into default?
begins with the answer to the questions
“What can go wrong? How can I lose money?”
Legal Risk
In this particular context of securitisation, let us
consider the structure of the transaction, and The cash flow chain from borrower to investor is
analyse potential source of risks. A schematic smooth presently. However in an extreme
diagram of the securitisation transaction from a situation assuming the originator goes bankrupt,
cash flow perspective provides a clear view of the is there a possibility that the judicial courts would
possible risk areas. attach these receivables, and cash flows would be
lost?
Trustee &
Designated
Credit bank
Risk
Interest rate risk
Trust and
Servicing
Borrower
agent
retention Investor Interest rates are rising or falling. Bond markets
account
are becoming illiquid. Will this impact the value
Servicing &
Commingling
of the investment in PTCs?
Risk
Credit
Enhancement The discussion on potential risks in securitisation
transactions as discussed above provides the
starting steps for meaningful analysis. CRISIL's
Legal risk, market risk
evaluation and structuring of securitisation
transactions mitigates most of these risks and
What can go wrong and how the investor can protects investors from any potential downsides
lose money on these counts. Nevertheless, investors continue
Fundamental credit risk to remain exposed to certain risks, which form
part and parcel of investing in securitisation
Underlying borrowers lack either ability or
transactions.
willingness to pay.

4
 EVALUATING RISKS FOR SECURITISATION TRANSACTIONS - A PRIMER

CRISIL'S FRAMEWORK FOR ANALYSING AND MITIGATING RISK

CRISIL, in its analysis of securitisation transactions, uses a four-quadrant framework to identify, classify,
and mitigate risk.

The four quadrants represent the fundamental

sk Le
t Ri ga uncertainties in any securitisation transaction
and include
i

lR
ed

Originator

is
Cr

True Sale

k
Asset
Credit Risk, or the risk of underlying assets
Bankruptcy defaulting
Portfolio remoteness
Pool Counterparty Risks on account of the
dependence on several counterparties in the
Macro economic Servicer transaction
Prepayment Commingling Legal Risks as the transaction is centred around a
Swap
k

Interest Rate sale and transfer of receivables from the

Ris

counterparty
originator to the SPV
rty

Miscellaneous
Ma

pa

Market Risks which could impact the value of the

rk

er

t
et

Ri
sk un PTCs given changing debt and capital market
Co
conditions

The four quadrants represent the fundamental Legal Risks as the transaction is centred around a
uncertainties in any securitisation transaction sale and transfer of receivables from the
and include originator to the SPV
Credit Risk, or the risk of underlying assets Market Risks which could impact the value of the
defaulting PTCs given changing debt and capital market
Counterparty Risks on account of the conditions
dependence on several counterparties in the 1. Credit Risk
transaction Credit risk forms a crucial element in the
analysis of securitisation transaction. Typically,
sizing credit enhancements adequately to cover
defaults, even under stress scenarios, covers
this risk. In the sizing of the enhancements, the
key factors evaluated include:
Asset Risk Continuum

Car LCV Promoter Unsec. Equity

Financing Finance 2-wheelers Plant & m/c Bill disc. funding Loans Trading

Mortgage HCV Earth Cons. Dealer Loans against ICDs IPO Financing
Finance Moving durable financing shares

Low Risk Moderate Risk High Risk

5
CRITERIA - Structured Finance
1.1 Asset risk
The nature of underlying assets plays a crucial
element in performance. For instance,
receivables backed by car loans, display a
completely different collection pattern as
compared to receivables backed by commercial
vehicles loans. CRISIL's risk continuum
provides an accurate indication of the relative
risk levels in the underlying assets, which is
duly factored into the credit enhancements for
various asset classes. Everything else remaining
equal, low risk assets would need lower credit
enhancements as compared to high-risk assets.
1.2 Originator risk
The originator plays a key role in the
transaction, having originated the asset in the
first place. By and large, the quality of
origination impacts the performance and it is
possible to eliminate poor quality assets
through strong systems and processes. A robust
risk control mechanism and the availability of
strong MIS are other pre-requisites for the
creation of a strong portfolio. CRISIL
undertakes a detailed analysis of the
originator's processes right from lead
generation to post disbursal documentation
and collection which helps provide insights into
the fundamental quality of asset creation, which
is duly factored into the evaluation of the pool
under consideration.
1.3 Portfolio risk
The pool to be securitised is to be carved out of
the universe of contracts available with the
originator, and is called the portfolio. The
originator's track record in this asset class, past
delinquency patterns on the portfolio, etc. could
provide pointers on the possible performance of
the securitised pool. For example, if the
historical losses in an originator's car
receivables portfolio are around 0.5%, this
number could be used as a leading indicator of
possible future losses in the pool. In addition,
this number could be compared with
comparable delinquency numbers for other
originators, providing an effective
benchmarking of various originators.
1.4 Pool risks
The quality of the pool is a crucial element in
assessing credit risk. In the Indian context,
6
generally, pools are 'cherry-picked' using
positive selection criteria. To protect the
investor from adverse selection of pool
contracts, CRISIL takes into consideration pool
characteristics such as pool seasoning
(seasoning represents the number of
installments paid by borrower till date: higher
seasoning represents better quality), over dues
at time of selection, and LTVs. To assess its risk
profile vis-à-vis the overall portfolio, the pool is
analysed with regard to geographical location,
borrower profile, LTV, and tenure.
2. Counterparty risk
There are several counterparties in a
securitisation transaction, and their
performance is crucial. Unlike in the case of
credit risks, where the risks emanate from a
diversified pool of retail assets, counterparty
risks are digital, resulting in either performance
or non-performance. Thus, credit risk can be
sized into credit enhancements, counterparty
risks are too large to be sized into the
enhancement. CRISIL generally mitigates such
risks through the usage of stringent
counterparty selection and replacement criteria
to reduce the risk of failure.
2.1 Servicer risk
The servicer is the most crucial counterparty in
a securitisation transaction, especially in the
Indian context. In the nascent Indian
securitisation markets, there is a lack of
independent third party servicers, who would
collect the receivables for a fee. Consequently,
the sustained performance of the servicer over
the tenor of the pool becomes a crucial element
of the securitisation process. CRISIL's servicer
risk criteria links servicer rating to the tenor of
the pool. In other words, for a given target
rating on the PTCs, the longer the tenor, the
higher is the minimum required servicer rating.
This ensures that long tenor papers need to be
backed by servicers of very high credit quality;
the criteria are gradually relaxed as one
considers transactions of lower tenor.
2.2 Commingling risk
This risk arises on account of the time lag
between pool collections and investor payouts,
during which the servicer continues to hold the
pool collections. In this interim period,
collections from the securitised loans may

mingle with other funds of the servicer. In such
an event, if the servicer goes bankrupt, the
investor is unlikely to recover the collected cash
flows for that month.
CRISIL's commingling criteria takes into
account the relevant short-term credit rating of
the servicer for a given target rating on the PTC.
If the rating is below requisite level, the
quantum of credit enhancement is adjusted so
as to adequately cover the risk.
2.3 Miscellaneous other counterparty risks
Swap counterparties (who provide floating or
fixed rate cash flows depending on the terms of
the swap) as well as banks where the cash
collateral is deposited represent other
miscellaneous parties whose credit quality
becomes important in the overall evaluation of
the securitisation transaction. A downward
revision in the rating of the counterparty below
the threshold becomes a trigger for a change in
the counterparty to restore the transaction to
stability.
4. Market risks
3. Legal risks
In several developed securitisation markets,
there is securitisation specific legislation,
besides a long track record of judicial decisions
on securitisation transactions. Both of these
bring a high degree of predictability to the legal
position on such transactions, and facilitate the
creation of transparent and well-established
legal criteria for securitisation transactions. In
the Indian context, there is a lack of judicial
precedence on the subject, besides a short track
record of securitisation transactions. This gives
rise to a dependence on external legal opinions.
The key legal issue under consideration is that
in any securitisation transaction, it is essential
that the transfer of receivables be a 'true sale',
indicating that the originator cannot retain
control over receivables or any claim over
receivables that could override the claims of the
investors. A true sale makes the assets
securitised 'bankruptcy remote', i.e. the
bankruptcy of the originator will not impact the
investors' claim on the pool's cash flows. In the
absence of a judicial precedence on 'true sale' in
India, any dispute over the legal ownership of
the assets is likely to diminish the return on
investments, with the entire loss being borne by
the investor. Further, an unfavourable ruling
EVALUATING RISKS FOR SECURITISATION TRANSACTIONS - A PRIMER
could result in a complete loss of the entire cash
flows generated by the pool.
CRISIL conducts a detailed study of the legal
documents to ensure that the investors' interest
is not compromised and relevant protection
and safeguards are built into the transaction.
An independent opinion from eminent external
legal counsels is also obtained on each
individual transaction to ensure a high level of
due diligence on legal issues. Typically, the
legal opinion covers the following issues:
+ Assignment of receivables to the trust is valid.
+ Transfer of receivables to the trust constitutes
a true sale.
+ Cash collateral is bankruptcy remote from
originator.
+ Documentation has been executed in
accordance with stamp duty and registration
laws.
+ Transaction specific issues, if any.
Market risks represent risks not directly related
to the transaction, but other market related
factors, which could have an impact on
transaction performance, or the value of the
investments to the investors. A change in the
interest rates impacts the value of the
instruments besides impacting prepayments
rates for assets. Similarly changing real estate
prices could impact the performance of
securitisation transactions backed by home
loans.
4.1 Macro-economic risks
The performance of underlying loan contracts
depends on macro-economic factors like
industry downturns or adverse price
movements of underlying assets. For instance,
increase in fuel prices may trigger a truckers'
strike, which may in turn impact the
repayments on commercial vehicle loans.
Similarly, a steep fall in the prices of underlying
assets will increase chances of default. The
borrower may prefer selling the low-value
asset, rather than retaining it and repaying
instalments on the same. Typically, CRISIL
factors in such risks into the initial sizing of
credit enhancements for the transaction.
7
CRITERIA - Structured Finance

4.2 Prepayment risks pool and outflows to investors are mismatched,

A combination of prepayments and volatile
interest rates represents a difficult situation for
investors. Typically prepayments of retail loans
increase with a reduction in interest rates and
vice versa leading to reinvestment risk for
investors. Structurally, it may not always be
possible to eliminate this risk, but in several
cases, separate prepayment strips have been
carved out of the pool cash flows. The
prepayment strip ensures that investors (other
than those who have invested in the
prepayment strip) are protected from volatility
in cash flows till such time that cumulative
prepayments exceed the prepayment strip.
4.3 Interest rate risks
All debt and debt like investments suffer from
interest rate risks, as a movement in interest rate
has a direct linkage to the value of the security.
Swaps are a good mitigation for this risk as the
risk of fixed rate cash flows can be swapped out
to provide floating cash flows to investors.
CRISIL has also rated transactions with
substantial “basis risk” where inflows into the
i.e. floating rate inflows against fixed rate
outflows and vice versa. In almost all cases, this
would lead to negative cash flows on the
transaction, which would need to be sized into
the credit enhancements. In this analysis,
CRISIL assumes extremely conservative
assumptions on interest rates, to factor the
interest rate risk into the credit enhancement.
While the discussions above provide a
conceptual construct for the evaluation of
securitisation transactions, the true test of a
framework lies in performance in the real
world. In this context, CRISIL rated pools have
demonstrated strong and stable performance,
with no downgrades or defaults till date.
Utilisations of credit enhancements have also
been low. Counterparty performance has also
been stable largely on account of stringent
selection criteria as discussed previously.
Notwithstanding the strong performance,
CRISIL monitors and fine-tunes its criteria and
frameworks on a continual basis to maintain
their relevance in a rapidly evolving market.

A quick checklist for a securitisation 3. Coverage provided by the credit-cum-

transaction liquidity enhancement vis-à-vis the historical
trend of losses in that asset class for the
The CRISIL rating rationale and the information
originator
memorandum for the transaction provide a
comprehensive overview of the transaction, risks
involved and mitigants for the same. A brief Counterparty risk:
checklist, which investors can use for quickly
1.Track record and past experience of
understanding the risks involved in a securitised
counterparties.
paper, is provided below for reference.
2. Credit quality of counterparties
3.Past experience in handling securitisation
Credit risk:
transactions.
1. Analysis of the originator
+ Past track record
Legal risks:
+ Systems and processes
1. Presence of independent legal counsel
+ Past performance of similar pools by the
2. Reputation of legal counsel
originator
3. Coverage of all the relevant issues in the
+ Disclosures by originator with respect to the
opinion
above
2. Analysis of the pool
Market risks:
+ Nature of asset class backing the underlying
loans 1. Extent of prepayment and interest rate risks.
Level of mitigation of these risks structurally
+ Pool quality in terms of parameters like
or through credit enhancement.
seasoning, geographic diversity, loan sizes,
etc.

8
 Rating methodology
for ABS transactions
Asset backed securitisation (ABS) refers to the securitisation of non-mortgage
retail loans. Till the late 1990s, asset classes securitised under ABS in India
included only car loans and commercial vehicle loans. Thereafter, construction
equipment loans, two-wheeler loans, utility vehicle loans, and personal loan
pools, have also been securitised. This paper describes CRISIL's approach to
the rating of ABS instruments.

The primary focus of CRISIL's ABS analysis is to:

+ project the base cash flows and
+ 'Stress' the cash flows, in order to arrive at appropriate enhancement levels
for a target rating

CRISIL's ABS rating methodology involves:

1. Portfolio analysis
2. Pool characteristics analysis
3. Pool v/s portfolio analysis
4. Analysis of originator's operations
5. Counterparty risk analysis
6. Legal risk analysis
7. Cash flows analysis and assessment of appropriate enhancement

1. Portfolio analysis
Portfolio analysis involves a detailed analysis of historical asset
performance. The analysis can take two forms:
A. Static pool analysis
B. Dynamic portfolio analysis

CRISIL believes that cash flow projections based on static pool analysis are
more appropriate for rating purposes than dynamic portfolio analysis,
CRITERIA - Structured Finance

because rated pools are also static in nature. Static pool analysis serves as a
very good reference point to project the performance of the pool to be
securitised. CRISIL will use a dynamic portfolio-based approach only if
adequate static pool data is not available, or if the characteristics of the pool
to be rated are quite different from those of available static pools. CRISIL
will nevertheless study portfolio data in all cases, since this data can provide
insights into recent performance and trends in the originator's portfolio;
these insights may not always be available in static pool data.

9
CRITERIA - Structured Finance
1.A. Static Pool Analysis
A static pool refers to a pool of contracts
originated in a particular period of time, say a
month or a quarter. There is no addition of
contracts in the static pool over time. This pool
is distinct from the portfolio, to which contracts
are added every day. Static pool analysis
entails a study of the behaviour of a static pool
over time.
To carry out an analysis of static pools, CRISIL
takes data on the performance of all the
contracts originated over several years by an
originator. CRISIL then analyses contracts
originated in a particular month or quarter as
one static pool. CRISIL also looks at the
performance of earlier rated pools of the same
originator, since these pools are static in nature.
CRISIL analyses static pool performance based
on various parameters such as type of asset (for
instance commercial vehicle loans, car loans,
etc), whether the assets are new or pre-owned,
original tenure, loan amount, geographical
distribution of borrowers, loan to value ratio
(LTV) etc.
The collection performance of a sample retail
static pool is shown in the graph below:
Collection Performance of Sample Retail Pool
CCR
Current collection efficiency
Arrears collection efficiency
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1 4 7 10 13 16 19 22
Seasoning (months)
CCR denotes cumulative collection ratio Collections till date / Billings till
date.
Current collection efficiency (CCE) Collections from current month's
billing / current month's billing.
Arrears collection efficiency (ACE) Collections from month beginning
opening overdues / month beginning opening overdue.
1
POS in 180 dpd (Rs. 10 millions) divided by principal outstanding as at six months prior to the current date which is March 31, 2005
(Rs. 800 millions).
10
It must be noted that static pool performance
may be affected by changes in several micro
and macro factors such as economic
environment, characteristics of the asset class
(for instance, the behaviour of the new car loan
segment has changed after the emergence of
used car market), underwriting policies, etc.
These factors, along with the characteristics of
the pool being securitised and the volatility of
the CCR curve, are used to determine the base
CCR curve.
1.B. Dynamic portfolio analysis
CRISIL's dynamic portfolio analysis
comprises:
Days-past-due (dpd) analysis
Dpd analysis provides a quick measure of
portfolio quality. Most lenders use this
parameter to monitor the performance of their
portfolios. Under dpd analysis, principal
outstanding (POS) on the total portfolio is
classified into 'buckets' based on overdue
status. The principal outstanding on current
contracts belongs to the 'current' bucket, the
principal outstanding on contracts that are 1
month overdue belongs to '30 dpd' bucket, and
so on. This is then divided by the total POS, as
shown in the table below:
(Rs. million)
dpd
As at Total
Current 30 60 90 120 150 180
POS 640.0 80.0 39.2 16.0 4.8 13.6 6.4 800
31-Mar-05
Dpd 80.0% 10.0% 4.9% 2.0% 0.6% 1.7% 0.8% 100%
POS 800.0 100.0 39.0 20.0 11.0 20.0 10.0 1000
30-Sep-05
Dpd 80.0% 10.0% 3.9% 2.0% 1.1% 2.0% 1.0% 100%
In a rapidly-growing portfolio, dpd levels may
25 28 31 34
be understated due to the fact that, in most
cases, contracts perform relatively well in the
initial months. Further, recently-disbursed
contracts cannot move to higher dpd buckets.
In such cases, CRISIL calculates 'lagged' dpd:
instead of taking the principal outstanding of
the current month as the denominator, the
principal outstanding in some previous month
is considered. In the example above lagged 180
dpd as at September 30, 2005 is 1.25 per cent1,
against an un-lagged 180 dpd of 1 per cent.

Though lagging does overcome some of the
limitations of dpd analysis, it is still marred by
the fact that this analysis does not consider
write-offs. Thus, all other things being equal,
originators adopting aggressive write-off
policies will show better dpds than others.
To factor this into its analysis, CRISIL obtains
historic write-off data, net of recoveries from
previously written-off contracts. The
cumulative write-offs can then be seen at
various points of time. This cumulative figure
can be seen as a percentage of portfolio
principal, say, 12 months prior to the current
date. This could give a proxy for net losses on a
static pool basis.
Portfolio collection efficiencies
CRISIL studies monthly portfolio collection
efficiencies in two forms - current collection
efficiency (CCE) and arrear collection
efficiency (ACE). CCE indicates how much is
collected out of the current month's billings,
and ACE indicates how much is collected out
of overdues at the beginning of the period.
CRISIL considers the average levels and
standard deviations of both parameters. Based
on this, CRISIL assumes base case initial
collection efficiencies on the pool. CRISIL then
factors in a gradual decline in collection
efficiencies, as this pattern has been observed
by CRISIL in most static pools.
Prepayments data
Prepayments are increasingly becoming
important in ABS transactions (refer to
CRISIL's opinion piece 'Prepayment matters in
ABS too!!!’). CRISIL studies monthly
prepayments on the originator's portfolio, and
average prepayment levels in that asset class
across originators, for this purpose. The
interest rate scenario, and the interest rate at
which the contracts to be securitised were
entered into, are also factored in while
calculating stress scenarios for the pool.
RATING METHODOLOGY FOR ABS TRANSACTIONS
2. Pool characteristics analysis
2.A. Pool selection criteria
Pool selection criteria play a very important
role in determining the quality of the pool.
Securitised pools are typically 'cherrypicked',
i.e. the pool quality is expected to be better than
the portfolio quality.
Sample pool selection criteria could be as
follows:
+ Minimum seasoning of 'A' months: this
ensures that loans have a minimum level of
borrower's equity (which typically increases
as loans are repaid) and eliminates cases of
fraud to a large extent.
+ Overdues should not be more than 'B'
months.
+ Maximum LTV should be 'C' per cent.
+ No single geographical location (say a state)
should account for more than 'D' per cent of
cash flows.
+ Originator should not have initiated nor
should it propose to initiate repossession
proceedings or legal proceedings against
any of the borrowers in the pool.
+ Contracts in the pool are free from any
encumbrances/charge on the date of selection.
2.B. Pool characteristics
They are a good indicator of the expected
future performance of the pool. CRISIL studies
the following characteristics:
+ Asset class
+ Loan to value (LTV) ratio
+ Geographical distribution
+ Borrower profile
+ Instalment to income ratio
+ Borrower diversification
+ Original tenure
+ Seasoning profile
+ Interest rate
+ Loan amount
+ Overdue profile
11
CRITERIA - Structured Finance
+ Asset class
Asset class has been discussed in detail in
CRISIL opinion piece 'Evaluating Risks for
securitisation transactions: A primer'.
Broadly, CRISIL analyses various segments
within a given asset class if they have
different characteristics (e.g. new and used
vehicles) or have shown different
performance levels (e.g. vehicles
manufactured by different manufacturers).
Apart from the asset segment, other factors
such as the originator's familiarity with its
customers, and the efficiency and rigour of
the originator's collection mechanism, are
also studied. CRISIL then bases its analysis
on the specific factors affecting the
performance of a particular lender.
+ Loan to value (LTV) ratio
LTV ratio is the loan amount advanced as a
percentage of the value of the asset. This
parameter is important for all asset-backed
lending. The higher the LTV, the higher the
risk of loss on the loan. A low ratio indicates a
higher initial equity of the borrower in the
asset, and hence disincentivises default on
loan repayment. As the loan gets repaid in
instalments, the borrower's equity in the asset
builds up.
In the initial months of a loan for a new
vehicle, the value of the vehicle declines
much faster than the outstanding loan
amount, since the principal forms a small part
of the first few instalments of the loan. Thus,
the outstanding loan amount often becomes
greater than the market value of the vehicle.
This may partly explain the rise in credit loss
during this period, since the borrower has
little to lose by defaulting. After some months
have passed, the value of the vehicle declines
at comparatively slower pace, but still
remains lower than the outstanding loan
amount. However there comes a point of time
when the value of the vehicle becomes higher
than the outstanding loan amount, as the
depreciation in the vehicle's value tapers off.
The length of the three phases mentioned
12
above will vary based on loan characteristics
such as the type of vehicle, value of the
vehicle, tenure, LTV etc. A sample chart is
provided below-
Loan Value versus resale value
POS on loan
Resale value of the asset
Low risk
period
High risk
period
Medium risk
Value
period
Seasoning
+ Geographical distribution
The geographical concentration of the pool
can affect pool performance, due to the
influence of regional socio-economic
conditions in a particular geographical area.
In CRISIL's analysis, a concentrated pool is
subjected to more extreme stress scenarios
than a diversified pool is. What constitutes
concentration is decided based on factors
such as overall geographical spread of the
pool, the geographical diversification within
a particular state in which there is
concentration, the economic stability of the
region in question, the type of industries
located in the region etc.
+ Borrower profile
CRISIL analyses borrower profile since the
characteristics of the particular borrower
segment might be distinctly different from
those of other segments. For instance, in a
pool of commercial vehicle loans, CRISIL
studies the proportion of the small truck
operator segment and the large fleet operator
segment. Similarly, in a pool of car loans or
personal loans, the proportion of salaried
and self-employed segments in the pool asset
is analysed. This analysis provides valuable
indications about the pool's likely repayment
behaviour.

+ Instalment to income ratio (IIR)
As the name suggests, IIR signifies the
coverage over debt levels i.e. monthly debt
outflows as a proportion of monthly inflows.
Lower the IIR, lower the risk of default.
However one must consider the net income
(i.e. net of all other debt obligations) for the
calculation of this ratio.
+ Borrower diversification
Borrower diversity ensures that the pool's
performance is not overly dependent on the
performance of a few borrowers. The
proportion of cash flows form the top 10
borrowers is an important parameter in
CRISIL's assessment of borrower
concentration. Again, CRISIL applies more
extreme stress scenarios if the top 10
borrowers account for a large proportion of
the pool's assets, say more than 5 per cent.
CRISIL also looks at the overall granularity of
the pool.
+ Original tenure
It has been generally observed that all else
being equal, the higher the original tenure of
contracts, the higher the risk of losses: longer
tenure implies higher uncertainty.
This can be related to the concept of LTV as
well. For any given loan amount, a longer
tenure contract will see slower amortisation
of the loan than a contract of short tenure.
Thus the value of the asset will remain lower
than the outstanding loan amount for a
longer period of time; therefore there is risk of
higher loss. Given below is a chart similar to
the one given above for the LTV ratio, but this
time with a loan of longer tenure:
Loan Value versus resale value
POS on loan
Resale value of the asset
Medium risk
period
High risk
period
Value
Seasoning
2
Moratorium period is the initial period of the loan tenure where the installments are not payable by the borrower e.g. some borrowers may be
given loan for 36 months; however there may be only 34 installments to be collected from the borrower with first few months being moratorium
period.
RATING METHODOLOGY FOR ABS TRANSACTIONS
As would be apparent, there is a longer high-
risk period in this case. A pool dominated by
long-tenure loans would therefore be
significantly riskier for a considerable part of
its tenure than a pool with shorter maturity
loans.
+ Seasoning profile
Seasoning refers to months elapsed since
disbursements. CRISIL considers net
seasoning of the contract as an important
performance driver. Net seasoning refers to
the number of instalments paid by the
borrower (total seasoning minus overdue
status minus moratorium period2). As the
instalments are paid, borrower's equity
increases. Further a few months minimum
seasoning also eliminates cases of fraud to a
large extent. CRISIL takes into account
weighted average seasoning of the pool at
the time of securitisation and the seasoning
profile of the contracts in the pool. All else
being equal, CRISIL subjects the pool with
higher weighted average seasoning to lower
stress levels.
+ Interest rate
Higher interest rates are typically charged
from riskier customers. A comparison of the
weighted interest rate of the pool, with the
market interest rate scenario at the time of
origination of the pool, can therefore be a
reasonable indicator of the credit quality of
customers. However this needs to be seen in
light of the geographies the originator
operates in, and the level of competition
prevalent in those geographies. Further,
certain asset types might be charged higher
interest rates than others. CRISIL takes into
account these aspects while determining
stress levels to be applied on such pool
collections.
Low risk
+ Loan amount
period
A large loan is generally perceived to be
riskier than a small one, especially in the car
finance market. Typically, the loss severity
13
CRITERIA - Structured Finance

for high-value vehicle contracts is large An example of pool v/s portfolio analysis
because of the rapid depreciation in vehicle - Geographical distribution
resale prices. However, the credit quality of Portfolio Pool
Region Deviation
the target customer needs to be considered Proportion 90+dpd Proportion
East 30% 1.0% 10% Negative
before arriving at any conclusion; for 20% 1.5% 25%
West Positive
instance, a large loan might reflect lending to South 25% 2.0% 30% Negative
a large and highly creditworthy fleet North 25% 3.0% 35% Negative
Total 100% 1.9% 100%
operator: large operators typically have the Negative
Weighted average pool 90+dpd 2.1%
advantage of diversification of the end use of
the vehicles, and hence have a lower
probability of default. CRISIL draws on its We can see from the above table that the pool
base of data and experience of the Indian has a negative deviation from the portfolio,
market to correctly ascertain the underlying since the pool derives a greater proportion of
credit implications of portfolio its cash flows from the worse-performing
characteristics. regions (North and South) than the portfolio
does. Likewise, CRISIL performs this analysis
for all other parameters.
+ Overdue profile
Current contracts are expected to perform
better than overdue contracts. CRISIL takes Stress Factor for securitisation transactions
into account the extent of overdue contracts backed by Retail loan receivables
along with the weighted average seasoning Securitisation transactions achieve the
of the pool. A poorly-seasoned pool with a target rating based on the credit
high proportion of overdue contracts enhancement. The credit enhancement
signifies a significant risk of losses. sizing involves comprehensive cash flow
modeling, projecting inflows and outflows.
3. Pool v/s portfolio analysis CRISIL initially projects base case cash
flows and shortfalls based on, amongst
Since, pool performance is projected based on other things-static pool performance,
past portfolio performance, CRISIL portfolio performance and pool
benchmarks pool characteristics against the characteristics. These base case cash flows
portfolio. This analysis shows whether the pool and shortfalls are subsequently stressed
is likely to perform better or worse than the appropriately for various rating categories.
portfolio; stress assumptions are accordingly The stress applied by CRISIL is expressed as
determined. Based on the comparative pool- a factor of expected base peak shortfalls.
portfolio analysis, CRISIL uses an appropriate
stress factor over the expected shortfalls in the
pool to ascertain the level of credit Typical stress factors used by CRISIL while
enhancement required to achieve the target assigning rating on asset backed
rating ( For details refer to the box “Stress securitisation (ABS) issuances (i.e. backed
Factor for securitisation transactions backed by by car loans, commercial vehicle loans,
Retail loan receivables “) For the purpose of personal loans, two wheeler loans etc.) are:
this analysis, CRISIL compares the pool and the + AAA: at least 250% of expected base
portfolio characteristics on key parameters peak shortfalls
such as geography, loan to value ratio (LTV),
+ AA Category: at least 170% of expected
original tenure, borrower profile, income to
base peak shortfalls
instalment ratio, and asset category. The
portfolio performance is benchmarked with + A Category: at least 140% of expected
dpd status such as 90+dpd and 180+ dpd. Thus, base peak shortfalls
one can ascertain whether the pool has a + BBB Category: at least 120% of expected
negative deviation, similarity, or positive base peak shortfalls
deviation, relative to the portfolio, for a
particular characteristic.

14

4. Analysis of originator's operations
CRISIL's rating methodology involves both
qualitative and quantitative analysis. The
analysis of the originator's operations is an
important qualitative factor. This involves an
analysis of management quality, length of
experience of the originator in the concerned
business, goals and strategies of the
management, and the size, market position and
reach of the entity. In addition, the method of
origination (such as directly or through
agents), underwriting standards, sanctioning
authority and process, and pre- and post-
disbursement documentation, also provide
indications of the quality of the originator's
operations.
5. Counterparty risk analysis
This primarily includes the following:
5.A. Servicer Risk
The servicer is the most crucial counterparty in
a securitisation transaction, especially in the
Indian context. In the Indian securitisation
markets, there are hardly any independent
third-party servicers, who would collect the
receivables for a fee. Consequently, even after
securitising the pool, the originator typically
continues as the servicer of the pool.
The sustained performance of the servicer over
the tenure of the pool is a crucial element of the
securitisation process. To assess servicer risk,
CRISIL analyses qualitative factors such as:
+ Management quality of the servicer - length
of experience in the concerned business,
goals and strategies of the management.
+ Size, market position and reach of the
servicer.
+ The collection process and structure of the
servicer - collection strategies and follow-up
mechanism.
+ The quality of management information
system (MIS). This is critical for good
monitoring of the securitised pool.
Apart from these qualitative factors, CRISIL
looks at the servicer's credit rating in the
context of the pool tenure. For a given target
RATING METHODOLOGY FOR ABS TRANSACTIONS
rating on the PTCs, the longer the tenure, the
higher is the minimum servicer rating that
CRISIL requires. This ensures that long-tenure
papers need to be backed by servicers of very
high credit quality; the criteria are gradually
relaxed while considering transactions of
lower tenure.
Servicer risk analysis also indicates whether
there is a need for a back-up servicer. In case a
back-up servicer is required, CRISIL will carry
out the same analysis for the back-up servicer.
The following additional factors will also be
considered:
+ Familiarity of back-up servicer with
primary servicer's operations.
+ Underlying asset class of the pool.
+ Back-up servicer's track record/past
experience in that asset segment.
+ Size and geographical spread of the pool
vis-à-vis backup servicer's operations.
In such cases, CRISIL will appropriately factor
in the cost of bringing in a back-up servicer,
including the temporary deterioration in
collection performance.
5.B. Commingling Risk
This risk refers to the mixing of pool cash flows
with the servicer's cash flows. In Indian
securitisation transactions, the servicer
typically collects money from the underlying
borrower in the pool in a particular month, and
deposits the money into the 'Trust and
Retention Account' in the next month. In the
interim, the collected money lies with the
servicer, and as do its own cash flows. If the
servicer were to become insolvent while
holding such amounts, these amounts may get
attached with the insolvency estate. This could
result in partial or total loss of commingled
amounts, or delayed recovery due to legal
proceedings. CRISIL assesses the risk of
bankruptcy of the servicer, and accordingly
sizes the risks arising from the commingled
amount in the enhancement calculation. The
credit rating of the servicer is a good proxy to
determine the risk of the servicer's bankruptcy.
15
CRITERIA - Structured Finance
6. Legal risk analysis
Legal risk assumes great importance in
securitisation transactions. The main attribute
that allows different ratings to be assigned to
the ABS instrument (or any other securitised
instrument), and to the plain vanilla
instrument issued by the originator, is that the
SPV (trust) is bankruptcy remote from the
originator. Bankruptcy remoteness requires
that the assets belonging to the SPV will not be
attached with the assets of the originator in
case the originator becomes bankrupt.
Legal risk analysis consists of an analysis of:
+ True sale of the pool receivables to the SPV.
+ Bankruptcy remoteness' of the pool and cash
collateral.
+ Compliance with local laws such as stamp
duty, registration etc.
To mitigate the legal risk, CRISIL relies on a
legal opinion by a reputed firm of lawyers.
Apart from this, CRISIL also requires a set of
warranties from the seller to mitigate some
legal risks. CRISIL also evaluates the draft
documents before issuing a provisional rating.
Subsequently, executed documents are
analysed before issuing a compliance letter.
For detailed criteria on legal risk, please refer to
CRISIL's opinion piece 'Securitisation Legal
Issues and Compliance Requirements'.
7. Cash flow analysis and enhancement
7.A. Cash flow analysis
After the above analysis, CRISIL creates a
customised cash flow model for the
transaction. The steps in creating the cash flow
model are:
3
For understanding a 'waterfall', please refer to the topic 'How is a typical waterfall mechanism structured?' in CRISIL's Securitisation Handbook,
Section 3, Page 26.
16
7.A.1. Projection of pool inflows - To begin with,
pool inflows are projected based on the base
case assumptions on collection and
prepayment. Stressed cases are then built up
on the base assumptions to derive the stressed
inflows from the pool. Stresses are determined
keeping in mind the following factors:
+ Target rating for the instrument.
+ Negative deviation of the pool from the
portfolio.
+ Volatility in historical asset performance or
rated pools.
+ Track record of the originator (or lack
thereof).
+ Sufficiency or otherwise of information.
+ Geographical concentration.
+ Borrower concentration.
7.A.2. PTC payouts (outflows) - Depending upon
the instrument structure and the priority of
payment (waterfall mechanism3), the PTC
payouts are calculated. These payouts
represent the total outflows that the pool will
have to bear to service the PTCs.
7.A.3. Comparison of inflows with outflows -
Pool inflows and outflows are compared on a
monthly basis to derive monthly surpluses or
shortfalls. These monthly shortfalls/surpluses
are cumulated to find out the cumulative
shortfalls in every month. The peak of these
monthly cumulative shortfalls is the
enhancement requirement for the PTCs since it
represents the maximum enhancement
required during the transaction tenure.

RBI's draft guidelines on 'Securitisation of
Standard Assets'
RBI issued draft guidelines on 'Securitisation
of Standard Assets' in April 2005. These
guidelines recommend separation of credit
and liquidity enhancement, and segregation
of total enhancement into first and second
loss facilities. Though the final guidelines are
yet to be issued, as a pro-active measure,
issuers have incorporated these features in
their securitisation transactions. Under these
structures, a shortfall is classified as credit or
+ Subordinate instrument / over-collateral
liquidity shortfall based on the overdue
status of the contract the shortfall pertains to;
the respective enhancement is accordingly
drawn upon. Further, in the absence of
regulatory clarity, issuers have had the first
loss facility sized at investment grade rating,
with second loss facility being the balance
enhancement. For the purpose of analysis,
CRISIL studies separate credit and liquidity
shortfall curves on static pools to size
separate enhancements.
7.B. Forms of Enhancement
In the Indian context, credit enhancement is
typically provided by the originator. The
various forms of credit enhancement are as
follows:
+ Excess interest spread (EIS)
+ Cash collateral (CC)
This is cash deposited by the originator in a
designated cash collateral account. This
account can only be operated by the Trustee.
Any shortfall in the collection can be met by
the Trustee by drawing on the cash collateral
account. This is the best form of credit
enhancement since its availability does not
depend upon the pool performance.
+ Corporate undertaking
In some cases, originators give a corporate
undertaking as enhancement for a particular
amount instead of cash collateral; this
reduces the carrying cost. A corporate
undertaking works exactly like a cash
collateral. For meeting shortfalls, the Trustee
will send a notice to the originator invoking
the undertaking, instead of withdrawing
RATING METHODOLOGY FOR ABS TRANSACTIONS
cash from the account. CRISIL allows
originators to provide corporate
undertakings instead of cash collateral only if
CRISIL's rating/internal credit view on the
originator's unsecured debt is as good as or
better than the rating of highest-rated
instrument in the transaction.
In every transaction, CRISIL requires at least
some part of the credit enhancement as either
cash collateral or corporate undertaking.
A subordinate instrument, normally retained
by the originator, represents the originator's
ownership interest in the underling pool cash
flows. This means that the scheduled pool
cash flows are more than the total senior
payouts. Thus, the balance cash flows
represented by the subordinate interest
provides over-collateral for the senior
instrument. For instance, if the pool cash
flows in a month are Rs. 100 and senior
payouts are Rs. 90, the subordinate strip
accounts for the remaining Rs. 10. The
collection from Rs. 100 will first be allocated
to the senior instrument; only the balance, if
any, will be paid to the subordinate
instrument.
EIS represents the difference in interest yield
on the pool assets vis-à-vis the yield on the
PTC. EIS in a par structure is typically
subordinated to senior PTCs. The effect of
EIS is therefore similar to that of over-
collateral. However, EIS can get reduced
substantially due to repricing and
prepayments in the pool.
7.C. Minimum cash collateral requirement
CRISIL believes that a minimum amount of
cash collateral / corporate undertaking is
needed in the structure for any
contingencies. One such contingency is a
system failure/breakdown on the servicer's
part. The performance of a securitisation
transaction depends solely on the collections
from the pool. These collections are
deposited by the servicer in the collection
17
CRITERIA - Structured Finance
and payout account, a few days before the
payout date. The amount to be put into the
collection and payout account is ascertained
by the servicer through the MIS
(management information system) report,
typically generated at the beginning of the
month subsequent to collections. If the
servicer faces a system failure or breakdown,
MIS generation can get delayed.
Consequently, the servicer will not be able to
ascertain the amount to be put into the
collection and payout account. Hence,
collections will not be deposited into the
account on time. In such a case the payouts
can only be made through the utilisation of
cash collateral/corporate undertaking.
The primary factor considered for the amount
of minimum cash/corporate undertaking
needed is the adequacy of the servicer's
disaster recovery system.
Evaluation of disaster recovery system of the
servicer
CRISIL believes that given the importance of
MIS in an ABS transaction, the originator
must have adequate disaster recovery
systems. CRISIL considers following for
evaluation of disaster recovery system:
18
+ Adequacy of contingency plans
+ Frequency of testing and audit
+ Risk of permanent loss of information
+ Time taken to recover normal functioning
+ Any untoward incident in the past
If CRISIL concludes that the disaster
recovery system is adequate, and that there is
sufficient time between the MIS generation
date and the payout date to enable recovery
from any system failure, CRISIL reduces the
amount of minimum cash
collateral/corporate undertaking required in
the transaction.
CRITERIA EVOLUTION AN ONGOING
PROCESS
CRISIL's ABS criteria reflect the fact that CRISIL
has had longer and wider experience in the
securitisation market than any other Indian rating
agency. In line with its past practice, and in
keeping with the evolution of the market, CRISIL
is committed to continuously updating and
disseminating its criteria. CRISIL believes that
this is an essential component of its role of
working proactively to develop the Indian
securitisation market.
Rating methodology
for RMBS transactions
Mortgage-backed securitisation (MBS) refers to the securitisation of mortgage
loans. These loans can be against residential properties (residential mortgages)
or commercial properties (commercial mortgages). The securitisation of
residential mortgage loans is called residential mortgage-backed securitisation
(RMBS), and the securitisation of commercial mortgage loans is called
commercial mortgage-backed securitisation (CMBS). This paper describes
CRISIL's approach to the rating of RMBS instruments1.

INTRODUCTION AND STRUCTURING CONCEPTS

To understand the context of CRISIL's rating methodology for RMBS issuances,
it is pertinent to define and explain some key terms. This section assumes that
the reader is familiar with basic securitisation concepts; an explanation of these
concepts can be found in CRISIL's Securitisation Handbook2.

Par structure
Under a par structure, investors in Pass-Through Certificates (PTCs) pay a
consideration that is equal to the pool's principal. Thus, there is a one-to-one
correspondence between the principal amounts outstanding on the PTCs and
the principal amounts outstanding on loans in the pool. Investors are paid the
principal portion of the pool's monthly cash flows, and receive a yield on the
outstanding PTC principal.

Premium structure
Under a premium structure, investors in PTCs pay a consideration equal to the
discounted value of the pool cash flows. The PTC yield is generally lower than
the pool yield; therefore the value of the cash flows, discounted at this yield,
will be higher than the pool principal. The excess of the discounted value over
the pool principal represents the premium paid by investors.

Excess interest spread (EIS) under par structure

EIS represents the difference between the interest payable on the PTCs and the
CRITERIA - Structured Finance

interest receivable on the loans securitised. For example, if loans in the

securitised pool yield, on average, 8 per cent per annum, and the PTCs are
issued at a yield of 7 per cent per annum, the difference of 1 percentage point
between the pool yield and the PTC yield represents the EIS for the transaction.
EIS occurs only in par structures, and is generally paid back to the originator
after ensuring that the PTC payouts are made in full.

1
To understand CRISIL's approach to rating CMBS instruments, please refer to CRISIL's opinion piece
'Commercial Mortgage Backed Security A viable option for financing commercial real estate'.
2
Please refer to Section 1, 'Getting Started with Securitisation’

19
CRITERIA - Structured Finance
RATING CRITERIA
The primary focus of CRISIL's RMBS analysis is to:
+ Project the base cash flows and
+ 'Stress' the cash flows in order to arrive at
appropriate enhancement levels for a target
rating
CRISIL's RMBS rating methodology involves:
1. Assessment of interest rate and prepayment
risk
2. Portfolio analysis
3. Pool characteristics analysis
4. Pool v/s portfolio analysis
5. Analysis of originator's operations
6. Counterparty risk analysis
7. Legal risk analysis
8. Cash flows analysis and assessment of
appropriate enhancement
1. Assessment of interest rate and
prepayment risk
+ Assessment of interest rate risk
Housing loans are of two types fixed-rate
and floating-rate. In India, floating-rate
housing loans are not based on a transparent
market benchmark; they refer instead to an
internal benchmark of the lender called the
retail prime lending rate (RPLR). In addition,
borrowers can switch from floating-rate to
fixed-rate, and vice versa, at any point of time,
usually at a cost. Thus the interest inflows
from housing loans can change frequently
and unpredictably, and these changes may
not be linked to changes in market
benchmark rates such as MIBOR, G-Sec
yields etc. On the other hand, the outflows to
investors are predetermined, or (in case of
floating-rate PTCs) are arrived at based on
transparent market benchmarks. This de-
linked movement of the interest inflows and
outflows gives rise to interest rate risk, also
called 'basis risk'. Normal interest rate risks
can be mitigated through appropriate swaps,
but there is no swap available for this basis
risk, since it arises primarily on account of the
3
Repricing of a contract from higher interest rate to a lower interest rate is reflected either by reduction in the EMI amount for the balance tenure
of the contract, or by reduction in the number of instalments to be paid by the borrower, thus amortising the principal faster.
20
unpredictability of when and by how much a
lender will change RPLR. Assessing this risk,
and building it into the computation of the
enhancement levels, is a critical step in
CRISIL's RMBS rating process.
Interest rate movements impact par
structures and premium structures
differently. This is explained below:
Interest rate risk under a par structure
Assume that housing loans in a pool yield, on
average, 9 per cent per annum, and that PTCs
carry a fixed coupon of 7 per cent per annum.
Thus, there is an EIS of 2 per cent per annum.
If the loans in the pool get repriced3 to an
average of 8 per cent per annum, the EIS is
reduced to 1 per cent. If the interest rates on
the housing loans were to drop to a level
below the PTC yield, the transaction would
be subjected to a 'negative carry', as the
income earned on the assets would be
insufficient to pay the interest due on the
liabilities. The likelihood and magnitude of
these potential shortfalls has to be assessed
and built into the enhancement available for
the transaction.
Interest rate risk under a premium structure
In a premium structure, if the RPLR falls, the
cash flows earned by the SPV reduce. The
assets will thus earn lower cash flows than
are payable to the PTCs. The resulting
mismatch will need to be met out of the
enhancement available.
+ Assessment of Prepayment risk
One feature that distinguishes a residential
loan from other loans is the embedded
prepayment option. Borrowers have the
flexibility to prepay their housing loans at
any point of time, usually at a cost.
Prepayments may be for a variety of reasons
such as refinancing at lower rates, higher
income levels, or sale of property.
Prepayments constitute a risk because they
result in a reduction of the outstanding pool
principal, and change the timing of cash
inflows.

Prepayments impact par and premium
structures differently.
Prepayment risk under a par structure
Prepayments do not have a significant impact
on par transactions since the principal
prepaid by the borrower (equal to the
investor's principal) will be passed on to the
investor. However, if loans being prepaid are
at rates higher than the weighted average
interest rate of the pool, there will be a
reduction in EIS.
Prepayment risk under a premium structure
In the case of a premium structure, the
principal outstanding against the borrower's
name on a particular loan is lower than the
corresponding PTC principal; the difference
represents the premium outstanding. Thus,
when a loan is prepaid by the borrower, there
is a shortfall on the corresponding PTC
liability. In such a case, the shortfall equal to
the outstanding premium on that contract
will need to be paid out of the available
enhancement.
+ How CRISIL analyses these risks
Repricing and prepayment play a critical role
in an RMBS transaction. To analyse these
risks, CRISIL considers following factors:
= The interest rate profile of the pool being
securitised, compared to the interest rate
scenario at the time of securitisation.
= Historical movement of fixed and floating
interest rates offered by the originator,
compared to those offered by its
competitors.
= Historical movement of the originator's
RPLR compared to market benchmarks
such as MIBOR and G-Sec yields.
= Monthly prepayments and repricing in
pools rated in the past, and in the
originator's portfolio.
= Historical and current geographical spread
of the originator's operations.
Based on the above factors, and the target
rating on the instrument, CRISIL generates
various stressed interest rate and prepayment
RATING METHODOLOGY FOR RMBS TRANSACTIONS
scenarios. CRISIL then carries out a
sensitivity analysis, to estimate pool inflows
and payouts under each of these scenarios.
The enhancement required is accordingly
calculated.
2. Portfolio analysis
Portfolio analysis involves a detailed analysis
of historical asset performance. The analysis
can take two forms:
A. Static pool analysis
B. Dynamic portfolio analysis
CRISIL believes that cash flow projections
based on static pool analysis are more
appropriate for rating purposes than dynamic
portfolio analysis, because rated pools are also
static in nature. Static pool analysis serves as a
very good reference point to project the
performance of the pool to be securitised.
CRISIL will use a dynamic portfolio-based
approach only if adequate static pool data is
not available, or if the pool characteristics are
quite different from those of available static
pools. CRISIL will nevertheless study portfolio
data in all cases, since this data can provide
insights into recent performance and trends in
the originator's portfolio; these insights may
not always be available in static pool data.
A. Static pool analysis
A static pool refers to a pool of contracts
originated in a particular period of time, say a
month or a quarter. There is no addition of
contracts in the static pool over time. This
pool is distinct from the portfolio, to which
contracts are added every day. Static pool
analysis entails a study of the behaviour of a
static pool over time.
To carry out an analysis of static pools for a
housing loan portfolio, CRISIL takes data on
the performance of all the contracts
originated over several years by an
originator. CRISIL then analyses contracts
originated in a particular month or quarter as
one static pool. CRISIL also looks at the
performance of earlier rated pools of the
same originator, since these pools are static in
nature.
21
CRITERIA - Structured Finance

As housing loans are long-tenure loans, and
the market has grown rapidly only in the past
few years, there are a number of cases where
detailed static pool data is simply not
available. In such instances, CRISIL has to
rely only on the results of dynamic portfolio
analysis.
B. Dynamic portfolio analysis
CRISIL's dynamic portfolio analysis
comprises:
Days-past-due (dpd) analysis
Dpd analysis provides a quick measure of
portfolio quality. Most lenders use this
parameter to monitor the performance of
their portfolios. Under dpd analysis,
principal outstanding (POS) on the total
portfolio is classified into 'buckets' based on
overdue status. The principal outstanding on
current contracts belongs to the 'current'
bucket, the principal outstanding on
contracts that are 1 month overdue belongs to
'30 dpd' bucket, and so on. This is then
divided by the total POS, as shown in the
table below:
As at
dpd
Current 30 60 90 120 150
POS 640.0 80.0 39.2 16.0 4.8 13.6 6.4
31-Mar-05
Dpd 80.0% 10.0% 4.9% 2.0% 0.6% 1.7% 0.8% 100%
31-Sep-05
POS 800.0 100.0 39.0 20.0 11.0 20.0 10.0
Dpd 80.0% 10.0% 3.9% 2.0% 1.1% 2.0% 1.0% 100%
Though lagging does overcome some of the
limitations of dpd analysis, it is still marred
by the fact that this analysis does not consider
write-offs. Thus, all other things being equal,
originators adopting aggressive write-off
policies will show better dpds than others.
To factor this into its analysis, CRISIL obtains
historic write-off data, net of recoveries from
previously written-off contracts. The
cumulative write-offs can then be seen at
various points of time. This cumulative
figure can be seen as a percentage of portfolio
principal, say, 12 months prior to the current
date. This could give a proxy for net losses on
a static pool basis.
Portfolio collection efficiencies
CRISIL studies monthly portfolio collection
efficiencies in two forms - current collection
efficiency (CCE) and arrear collection
efficiency (ACE). CCE indicates how much is
collected out of the current month's billings,
and ACE indicates how much is collected out
of overdues at the beginning of the period.
CRISIL considers the average levels and
standard deviations of both parameters.
(Rs. million) Based on this, CRISIL assumes base case
Total initial collection efficiencies on the pool.
180
CRISIL then factors in a gradual decline in
800
collection efficiencies, as this pattern has
1000 been observed by CRISIL in most static pools.

In a rapidly-growing portfolio, dpd levels

may be understated due to the fact that, in
most cases, contracts perform relatively well
in the initial months. Further, recently-
disbursed contracts cannot move to higher
dpd buckets. In such cases, CRISIL calculates
'lagged' dpd: instead of taking the principal
outstanding of the current month as the
denominator, the principal outstanding in
some previous month is considered. In the
example above lagged 180 dpd as at
September 30, 2005 is 1.25 per cent4, against
an un-lagged 180 dpd of 1 per cent.

4
POS in 180 dpd (Rs. 10 millions) divided by principal outstanding as at six months prior to the current date which is March 31, 2005
(Rs. 800 millions).

22
 RATING METHODOLOGY FOR RMBS TRANSACTIONS

A sample of current and arrears collection 3.B. Pool characteristics

efficiencies for a housing loan static pool is They are a good indicator of the expected
shown in the graph below: future performance of the pool. CRISIL studies
Collection efficiencies of a sample housing loan pool the following characteristics:
Current + Asset class
Arrears
90%
80%
+ Interest rate
70%
60% + Loan to value (LTV) ratio
50%
40% + Geographical distribution
30%
20%
10% + Borrower profile
0%
+ Instalment to income ratio
1

61
13

37

49

73

97

109
25

85

Seasoning (months)
Current collection efficiency (CCE) Collections from
current month billing / current month billing
Arrears collection efficiency (ACE) Collections from
month beginning opening overdues /
month beginning opening overdue
Repricing and prepayment analysis
This has been discussed above in detail.
3. Pool characteristics analysis
3.A. Pool selection criteria
Pool selection criteria play a very important
role in determining the quality of the pool.
Securitised pools are typically 'cherrypicked',
i.e. the pool quality is expected to be better than
the portfolio quality.
Sample pool selection criteria could be as
follows:
+ Minimum seasoning of 'A' months: this
ensures that loans have a minimum level of
borrower's equity (which typically increases
as loans are repaid) and eliminates cases of
fraud to a large extent.
+ Overdues should not be more than 'B'
months.
+ Maximum LTV should be 'C' per cent.
+ No single geographical location (say a state)
should account for more than 'D' per cent of
cash flows.
= Originator should not have initiated nor
should it propose to initiate repossession
proceedings or legal proceedings against any
of the borrowers in the pool.
= Contracts in the pool are free from any
encumbrances/charge on the date of
selection.
+ Borrower diversification
+ Original tenure
+ Seasoning profile
+ Loan amount
+ Overdue profile
+ Asset class
Asset class has been discussed in detail in
CRISIL opinion piece 'Evaluating Risks for
securitisation transactions: A primer'.
+ Interest rate
If the weighted average interest rate of the
pool is higher than the general market rate,
the possibility of the repricing and
prepayment is high; conversely, a pool with a
low rate runs a much lower risk on these
counts. The mix of floating-rate and fixed-
rate contracts in the pool, and whether the
contracts are based on monthly rest or
annual rest, are also important factors.
Higher interest rates are typically charged
from riskier customers. A comparison of the
weighted interest rate of the pool, with the
market interest rate scenario at the time of
origination of the pool, can therefore be a
reasonable indicator of the credit quality of
customers. However this needs to be seen in
light of the geographies the originator
operates in, and the level of competition
prevalent in those geographies. Further,
certain asset types might be charged higher
interest rates than others. Thus, a pool with

23
CRITERIA - Structured Finance
contracts at higher interest rates may be
inferior in credit quality to one with contracts
having lower interest rates, but is not
necessarily so. CRISIL's extensive experience
in the Indian market allows it to make these
distinctions accurately.
+ Loan to value (LTV) ratio
LTV ratio is the loan amount advanced as a
percentage of the value of the asset. This
parameter is important for all asset-backed
lending. The higher the LTV, the higher the
risk of loss on the loan. A low ratio indicates a
higher initial equity of the borrower in the
asset, and hence disincentivises default on
loan repayment. As the loan is gradually
repaid in instalments, the borrower's equity
in the asset builds up.
+ Geographical distribution
The geographical concentration of the pool
can affect pool performance, due to the
influence of regional socio-economic
conditions in a particular geographical area.
In CRISIL's analysis, a concentrated pool is
subjected to more extreme stress scenarios
than a diversified pool is. What constitutes
concentration is decided based on factors
such as overall geographical spread of the
pool, the geographical diversification within
a particular state in which there is
concentration, the economic stability of the
region in question, the type of industries
located in the region etc.
+ Borrower profile
CRISIL analyses borrower profile since the
characteristics of the particular borrower
segment might be distinctly different from
those of other segments. For instance,
salaried and self-employed borrowers have
different characteristics which may result
into different performance.
5
Moratorium period is the initial period of the loan tenure where the installments are not payable by the borrower e.g. some borrowers may be
given loan for 36 months; however there may be only 34 installments to be collected from the borrower with first few months being moratorium
period.
24
+ Instalment to income ratio (IIR)
As the name suggests, IIR signifies the
coverage over debt levels i.e. monthly debt
outflows as a proportion of monthly inflows.
Lower the IIR, lower the risk of default.
However one must consider the net income
(i.e. net of all other debt obligations) for the
calculation of this ratio.
+ Borrower diversification
Borrower diversity ensures that the pool's
performance is not overly dependent on the
performance of a few borrowers. The
proportion of cash flows form the top 10
borrowers is an important parameter in
CRISIL's assessment of borrower
concentration. Again, CRISIL applies more
extreme stress scenarios if the top 10
borrowers account for a large proportion of
the pool's assets, say more than 5 per cent.
CRISIL also looks at the overall granularity
of the pool.
+ Original tenure
It has been generally observed that, all else
being equal, the higher the original tenure of
contracts, the higher the risk of losses: longer
tenure implies higher uncertainty.
+ Seasoning profile
Seasoning refers to months elapsed since
disbursements. CRISIL considers net
seasoning of the contract as an important
performance driver. Net seasoning refers to
the number of instalments paid by the
borrower (total seasoning minus overdue
status minus moratorium period5). As the
instalments are paid, borrower's equity
increases. Further, a few months minimum
seasoning also eliminates cases of fraud to a
large extent. CRISIL takes into account
weighted average seasoning of the pool at
the time of securitisation and the seasoning
profile of the contracts in the pool. All else
being equal, CRISIL subjects the pool with
higher weighted average seasoning to lower
stress levels.
 RATING METHODOLOGY FOR RMBS TRANSACTIONS

+ Loan amount An example of pool v/s portfolio analysis

- Geographical distribution
A large loan is generally perceived to be
riskier than a small one. This reflects the fact Portfolio Pool
Region Deviation
Proportion 90+dpd Proportion
that the target segment for a high-value East 30% 1.0% 10% Negative
property is small. Thus if a high-value West 20% 1.5% 25% Positive
contract defaults, there is a lesser likelihood South 25% 2.0% 30% Negative
North 25% 3.0% 35% Negative
of quickly getting a buyer. Total 100% 1.9% 100%
Negative
Weighted average pool 90+dpd 2.1%

+ Overdue profile
Current contracts are expected to perform
better than overdue contracts. CRISIL takes
into account the extent of overdue contracts
along with the weighted average seasoning
of the pool. A poorly-seasoned pool with a
high proportion of overdue contracts
signifies a significant risk of losses.
4. Pool v/s portfolio analysis
Since, pool performance is projected based on
past portfolio performance, CRISIL
benchmarks pool characteristics against the
portfolio. This analysis shows whether the pool
is likely to perform better or worse than the
portfolio; stress assumptions are accordingly
determined. Based on the comparative pool-
portfolio analysis, CRISIL uses an appropriate
stress factor over the expected shortfalls in the
pool to ascertain the level of credit
enhancement required to achieve the target
rating ( For details refer to the box “Stress
Factor for securitisation transactions backed by
Residential mortgage loan receivables “) For
the purpose of this analysis, CRISIL compares
the pool and the portfolio characteristics on
key parameters such as geography, loan to
value ratio (LTV), original tenure, borrower
profile, income to instalment ratio, and asset
category. The portfolio performance is
benchmarked with dpd status such as 90+dpd
and 180+ dpd. Thus, one can ascertain whether
the pool has a negative deviation, similarity,
or positive deviation, relative to the
portfolio, for a particular characteristic.
We can see from the above table that the pool
has a negative deviation from the portfolio,
since the pool derives a greater proportion of
its cash flows from the worse-performing
regions (North and South) than the portfolio
does. Likewise, CRISIL performs this analysis
for all other parameters.
Stress Factor for securitisation transactions
backed by Residential mortgage loan
receivables
Securitisation transactions achieve the
target rating based on the credit
enhancement. The credit enhancement
sizing involves comprehensive cash flow
modeling, projecting inflows and outflows.
CRISIL initially projects base case cash
flows and shortfalls based on, amongst
other things-static pool performance,
portfolio performance and pool
characteristics. These base case cash flows
and shortfalls are subsequently stressed
appropriately for various rating categories.
The stress applied by CRISIL is expressed as
a factor of expected base peak shortfalls.
Typical stress factors used by CRISIL while
assigning rating on residential mortgage
backed securitisation (RMBS) issuances are:
+ AAA: at least 350% of expected base
peak shortfalls
+ AA Category: at least 210% of expected
base peak shortfalls
+ A Category: at least 160% of expected
base peak shortfalls
+ BBB Category: at least 130% of expected
base peak shortfalls

25
CRITERIA - Structured Finance
5. Analysis of originator's operations
CRISIL's rating methodology involves both
qualitative and quantitative analysis. The
analysis of the originator's operations is an
important qualitative factor. This involves an
analysis of management quality, length of
experience of the originator in the concerned
business, goals and strategies of the
management, and the size, market position and
reach of the entity. In addition, the method of
origination (such as directly or through
agents), underwriting standards, sanctioning
authority and process, and pre- and post-
disbursement documentation, also provide
indications of the quality of the originator's
operations.
6. Counterparty risk analysis
This primarily includes the following:
6.A. Servicer risk
The servicer is the most crucial counterparty in
a securitisation transaction, especially in the
Indian context. In the Indian securitisation
markets, there are hardly any independent
third-party servicers, who would collect the
receivables for a fee. Consequently, even after
securitising the pool, the originator typically
continues as the servicer of the pool.
The sustained performance of the servicer over
the tenure of the pool is a crucial element of the
securitisation process. To assess servicer risk,
CRISIL analyses qualitative factors such as -
= Management quality of the servicer - length
of experience in the concerned business,
goals and strategies of the management.
= Size, market position and reach of the
servicer.
= The collection process and structure of the
servicer - collection strategies and follow-up
mechanism.
= The quality of management information
system (MIS). This is critical for good
monitoring of the securitised pool.
Apart from these qualitative factors, CRISIL
looks at the servicer's credit rating in the
context of the pool tenure. For a given target
rating on the PTCs, the longer the tenure, the
26
higher is the minimum servicer rating that
CRISIL requires, without identifying a back-
up servicer upfront. This ensures that long-
tenure papers need to be backed by servicers of
very high credit quality; the criteria are
gradually relaxed while considering
transactions of lower tenure.
Servicer risk analysis also indicates whether
there is a need for a back-up servicer. In case a
back-up servicer is required, CRISIL will carry
out the same analysis for the back-up servicer.
The following additional factors will also be
considered:
= Familiarity of back-up servicer with primary
servicer's operations.
= Underlying asset class of the pool.
= Back-up servicer's track record/past
experience in that asset segment.
= Size and geographical spread of the pool vis-
à-vis backup servicer's operations.
In such cases, CRISIL will appropriately factor
in the cost of bringing in a back-up servicer,
including the temporary deterioration in
collection performance.
6.B. Commingling risk
This risk refers to the mixing of pool cash flows
with the servicer's cash flows. In Indian
securitisation transactions, the servicer
typically collects money from the underlying
borrower in the pool in a particular month, and
deposits the money into the 'Trust and
Retention Account' in the next month. In the
interim, the collected money lies with the
servicer, and as do its own cash flows. If the
servicer were to become insolvent while
holding such amounts, these amounts may get
attached with the insolvency estate. This could
result in partial or total loss of commingled
amounts, or delayed recovery due to legal
proceedings. CRISIL assesses the risk of
bankruptcy of the servicer, and accordingly
sizes the risks arising from the commingled
amount in the enhancement calculation. The
credit rating of the servicer is a good proxy to
determine the risk of the servicer's bankruptcy.

7. Legal risk analysis
Legal risk assumes great importance in
securitisation transactions. The main attribute
that allows different ratings to be assigned to
the RMBS instrument (or any other securitised
instrument), and to the plain vanilla
instrument issued by the originator, is that the
SPV (trust) is bankruptcy remote from the
originator. Bankruptcy remoteness requires
that the assets belonging to the SPV will not be
attached with the assets of the originator in case
the originator becomes bankrupt.
Legal risk analysis consists of an analysis of:
= True sale of the pool receivables to the SPV.
= 'Bankruptcy remoteness' of the pool and cash
collateral.
= Compliance with local laws such as stamp
duty, registration etc.
To mitigate the legal risk, CRISIL relies on a
legal opinion by a reputed firm of lawyers.
Apart from this, CRISIL also requires a set of
warranties from the seller to mitigate some
legal risks. CRISIL also evaluates the draft
documents before issuing a provisional rating.
Subsequently, executed documents are
analysed before issuing a compliance letter.
For detailed criteria on legal risk, please refer to
CRISIL's opinion piece 'Securitisation Legal
Issues and Compliance Requirements'.
8. Cash flow analysis and enhancement
8. A. Cash flow analysis
After the above analysis, CRISIL creates a
customised cash flow model for the
transaction. The steps in creating the cash flow
model are:
1. Projection of pool inflows - To begin with, pool
inflows are projected based on the base case
assumptions on collection, interest rate and
6
For understanding a 'waterfall', please refer to the topic 'How is a typical waterfall mechanism structured?' in CRISIL's Securitisation Handbook,
Section 3, Page 26.
RATING METHODOLOGY FOR RMBS TRANSACTIONS
prepayment. Stressed cases are then built up
on the base assumptions, with various
scenarios of interest rate and prepayment, to
derive the stressed inflows from the pool.
Stresses are determined keeping in mind the
following factors:
= Target rating for the instrument
= Negative deviation of the pool from the
portfolio
= Volatility in historical asset performance or
rated pools
= Track record of the originator (or lack
thereof)
= Sufficiency or otherwise of information
= Geographical concentration
= Borrower concentration
2. PTC payouts (outflows) - Depending upon the
instrument structure and the priority of
payment (waterfall mechanism6), the PTC
payouts are calculated. These payouts
represent the total outflows that the pool will
have to bear to service the PTCs. The outflows
are calculated for each scenario of interest rate
and prepayment.
3. Comparison of inflows with outflows - For each
scenario of interest rate and prepayment, pool
inflows and outflows are compared on a
monthly basis to derive monthly surpluses or
shortfalls. These monthly shortfalls/surpluses
are cumulated to find out the cumulative
shortfalls in every month. The peak of these
monthly cumulative shortfalls is the
enhancement requirement for the PTCs under
that scenario, since it represents the maximum
enhancement required during the transaction
tenure. The maximum enhancement obtained
among various scenarios is stipulated as the
final enhancement for the PTCs.
27
CRITERIA - Structured Finance

Corporate undertaking
RBI'S DRAFT GUIDELINES ON
'SECURITISATION OF STANDARD In some cases, originators give a corporate
ASSETS’ undertaking as enhancement for a particular
amount instead of cash collateral; this
RBI issued draft guidelines on
reduces the carrying cost. A corporate
'Securitisation of Standard Assets' in April
undertaking works exactly like a cash
2005. These guidelines recommend
collateral. For meeting shortfalls, the Trustee
separation of credit and liquidity
will send a notice to the originator invoking
enhancement, and segregation of total
the undertaking, instead of withdrawing
enhancement into first and second loss
cash from the account. CRISIL allows
facilities. Though the final guidelines are
originators to provide corporate
yet to be issued, as a pro-active measure,
undertakings instead of cash collateral only if
issuers have incorporated these features in
CRISIL's rating/internal credit view on the
their securitisation transactions. Under
originator's unsecured debt is as good as or
these structures, a shortfall is classified as
better than the rating of highest-rated
credit or liquidity shortfall based on the
instrument in the transaction.
overdue status of the contract the shortfall
pertains to; the respective enhancement is In every transaction, CRISIL requires at least
accordingly drawn upon. Further, in the some part of the credit enhancement as either
absence of regulatory clarity, issuers have cash collateral or corporate undertaking.
had the first loss facility sized at minimum
investment grade rating, with second loss
Subordinate instrument / over-collateral
facility being the balance enhancement. For
the purpose of analysis, CRISIL studies A subordinate instrument, normally retained
separate credit and liquidity shortfall by the originator, represents the originator's
curves on static pools to size separate ownership interest in the underling pool cash
enhancements. flows. This means that the scheduled pool
cash flows are more than the total senior
payouts. Thus, the balance cash flows
8.B. Forms of enhancement represented by the subordinate interest
In the Indian context, credit enhancement is provides over-collateral for the senior
typically provided by the originator. The instrument. For instance, if the pool cash
various forms of credit enhancement are as flows in a month are Rs. 100 and senior
follows: payouts are Rs. 90, the subordinate strip
Cash collateral (CC) accounts for the remaining Rs. 10. The
collection from Rs. 100 will first be allocated
This is cash deposited by the originator in a
to the senior instrument; only the balance, if
designated cash collateral account. This
any, will be paid to the subordinate
account can only be operated by the Trustee.
instrument.
Any shortfall in the collection can be met by
the Trustee by drawing on the cash collateral
account. This is the best form of credit
enhancement since its availability does not
depend upon the pool performance.

28

Excess interest spread (EIS)
EIS in a par structure is typically
subordinated to senior PTCs. The effect of EIS
is therefore similar to that of over-collateral.
However, EIS can get reduced substantially
due to repricing and prepayments in the pool.
8.C. Minimum cash collateral requirement
CRISIL believes that a minimum amount of
cash collateral / corporate undertaking is
needed in the structure for any contingencies.
One such contingency is a system
failure/breakdown on the servicer's part. The
performance of a securitisation transaction
depends solely on the collections from the
pool. These collections are deposited by the
servicer in the collection and payout account,
a few days before the payout date. The
amount to be put into the collection and
payout account is ascertained by the servicer
through the MIS (management information
system) report, typically generated at the
beginning of the month subsequent to
collections. If the servicer faces a system
failure or breakdown, MIS generation can get
delayed. Consequently, the servicer will not
be able to ascertain the amount to be put into
the collection and payout account. Hence,
collections will not be deposited into the
account on time. In such a case the payouts
can only be made through the utilisation of
cash collateral/corporate undertaking.
The primary factor considered for the amount
of minimum cash/corporate undertaking
needed is the adequacy of the servicer's
disaster recovery system.
RATING METHODOLOGY FOR RMBS TRANSACTIONS
Evaluation of disaster recovery system of the
servicer
CRISIL believes that given the importance of
MIS in an RMBS transaction, the originator
must have adequate disaster recovery
systems. CRISIL considers following for
evaluation of disaster recovery system:
= Adequacy of contingency plans.
= Frequency of testing and audit.
= Risk of permanent loss of information.
= Time taken to recover normal functioning.
= Any untoward incident in the past.
If CRISIL concludes that the disaster recovery
system is adequate, and that there is
sufficient time between the MIS generation
date and the payout date to enable recovery
from any system failure, CRISIL reduces the
amount of minimum cash
collateral/corporate undertaking required in
the transaction.
CRITERIA EVOLUTION - AN ONGOING
PROCESS
CRISIL's RMBS criteria reflect the fact that CRISIL
has had longer and wider experience in the
securitisation market than any other Indian rating
agency. In line with its past practice, and in
keeping with the evolution of the market, CRISIL
is committed to continuously updating and
disseminating its criteria. CRISIL believes that
this is an essential component of its role of
working proactively to develop the Indian
securitisation market.
29
 Commercial Mortgage Backed Security -
A viable option for financing
commercial real estate
CRISIL believes that Commercial Mortgage Backed Security (CMBS) can
become an important financing tool to cater to the growing capital needs of the
real estate market. This is driven by the rapidly growing real estate market and
the consequent increase in funding needs of the industry. This commentary
analyses the key analytical issues with respect to CMBS and articulates
CRISIL's framework for such analysis.

INTRODUCTION
The Indian real estate market is growing rapidly driven by a buoyant economy,
and a favourable regulatory environment. As a result of this growth, the
funding requirement for commercial real estate is increasing substantially.
Though the real estate exposure of banks has grown significantly, only five
banks accounted for over half of the total banking exposure to the real estate
sector as at March 31, 2005. This highlights the fact that funding sources for
developers within the banking sector are highly concentrated.
In order to enable healthy growth of the commercial real estate market, more
diversified sources of funding is needed. CRISIL believes that Commercial
Mortgage Backed Security (CMBS) provides a good alternative funding tool for
the developer. It is also an effective way for banks to manage their risks in the
real estate sector.

WHAT IS A COMMERCIAL PROPERTY?

Commercial property refers to property let out for economic benefit, and not
used for self-occupation. It includes retail centres, office premises, restaurants,
hotels, and warehouses. Globally, even multi-family dwelling units (in the
form of apartments or condominiums) are classified as commercial properties.

WHAT IS A CMBS?
CMBS is a financial instrument secured by receivables from commercial real
estate. CMBS is a popular fund-raising source for developers and banks
worldwide. A CMBS instrument is created by pooling together one or more
CRITERIA - Structured Finance

commercial mortgages, and securitising the pool.

30
 COMMERCIAL MORTGAGE BACKED SECURITY - A VIABLE OPTION FOR FINANCING COMMERCIAL REAL ESTATE

HOW A CMBS TRANSACTION WORKS

A diagrammatic representation of CMBS (where a bank is securitising its commercial mortgage) is
shown below:

Right to use the

Developer property
(Owner of the property) Tenants

Repayment Secured
Loan Lease
Mortgage obligations
rentals

Excess
cashflows
Security trust Bank

Sale of
Price
loan

Holds security on
behalf of CMBS
investors
Trust and
SPV (trust)
retention account

Issue of
Purchase
CMBS
consideration
One time flow
Debt
Repeated flow payment
Rated CMBS holders

STEPS IN A TYPICAL CMBS + The debt servicing is met out of these net lease
TRANSACTION ARE: rentals on a periodic basis, and the balance is
apportioned towards various expenses and
+ A loan is given to the owner of the property,
reserves needed for maintenance of property.
usually the developer, by a finance entity. This
Any residual cashflows then flow back to the
loan is secured by a mortgage on the specified
borrower.
property.
+ The principal repayment on the loan is in the
+ Repayment terms of the loan are structured as
form of a balloon payment at the end of the
follows:
tenure.
+ Net lease rentals (charges such as
+ The finance entity sells this loan to an SPV. The
maintenance costs, TDS, service tax, property
SPV funds the purchase of the loan through
tax etc. are deducted from the gross rentals to
issue of one or more CMBS instruments. The
arrive at the net rentals available to service
mortgage on the property now belongs to the
debt) are paid into a designated account
SPV.
charged with the lender.
+ The developer normally acts as the servicer for
the securitisation transaction.

31
CRITERIA - Structured Finance
+ The account into which the lease rentals flow is
converted into a trust and retention account
(TRA) charged with the trustee.
+ The trustee draws the debt servicing amount
pertaining to the loan, and uses it to meet the
payment obligation on the CMBS.
+ The scheduled maturity of the CMBS
instrument is the same as the maturity of the
loan to the borrower.
+ Since the principal payment on the loan has to
be made either through refinancing or through
sale of the property, the developer must obtain a
refinancing commitment by a specified time, in
advance of the scheduled maturity date. This is
to ensure that balloon payment can be made on
the maturity date of the loan. Alternatively, the
developer may choose to make the balloon
payment from its own cashflows.
+ In case the developer is not able to obtain a
refinancing commitment as stipulated, the
documents empower the SPV to do the same on
behalf of the borrower. The SPV may appoint an
investment banker for this purpose.
+ If the loan is not redeemed by the maturity date,
the SPV can enforce the security and sell the
property. The proceeds from the sale are used to
redeem the CMBS instrument. The excess if any
will normally flow back to the borrower. This
process has to be completed by the 'legal final
maturity date', which is set at a date some time
after the 'schedule maturity date'. The gap
between the 'legal final maturity date' and the
'schedule maturity date' depends on the typical
time it takes for taking legal possession,
completing the sale and realising the proceeds.
This time gap is different in different
countries/regions.
Thus, to summarise, in a typical CMBS
transaction-
+ Lease rentals from the property are used to
pay the interest on the CMBS.
+ The principal is normally repaid at the end of
the tenure.
+ Lease rentals alone are normally not sufficient
to repay principal.
+ Thus, all or almost all of the principal
repayment is through refinance, or sale of
property.
32
RISK ANALYSIS FOR CMBS
TRANSACTIONS
CRISIL has developed a detailed framework for
analysing the risk in CMBS transactions. CRISIL's
analytical framework comprises detailed analysis
of the following primary risk factors.
+ Risk of reduction in the lease rentals
As articulated earlier, the interest on the CMBS
are to be serviced out of the lease rentals from
the underlying property. Thus any reduction in
the lease rentals from the level assumed poses a
risk factor. This reduction can arise due to any
of the following factors.
+ Credit risk - if the existing tenant defaults on
lease rental obligations.
+ Vacancy risk - Lease tenures in India are
typically very short (about three years). If the
CMBS tenure is longer than the lease tenure,
then the leases have to be renewed. Vacancy
risk refers to a situation where such renewals
are not done in a timely manner.
+ Reduction in market lease rental rates at the
time of renewal of the lease.
+ Risk of fall in property prices
Property price is the second key risk element in
a CMBS transaction. Since the principal amount
due on the CMBS is to be serviced out of
refinancing or sale of property, the price of the
property prevalent close to the 'schedule
maturity period' assumes importance. CRISIL
will carry out detailed analysis of the historical
movement of property prices and then
prescribe coverage (called LTV) for the
transaction, depending on the target rating.
+ Risk of insufficient time between scheduled
maturity and legal final maturity dates
The third key variable in a CMBS transaction is
the time gap between the two maturity dates.
This time has to be long enough for the security
enforcement and sale of property to take place,
so that the CMBS is fully redeemed before the
legal final maturity. For this purpose, CRISIL
would assess the nature of the mortgage, the
 COMMERCIAL MORTGAGE BACKED SECURITY - A VIABLE OPTION FOR FINANCING COMMERCIAL REAL ESTATE
impact of bankruptcy of the developer (in case
he continues to be the owner of the property),
title disputes, risk of litigation by the developer
etc. CRISIL will assess these risk factors
primarily from the point of view of the
prevalent regulatory and judicial system. An
appropriately designed structure can mitigate
the above risks to a substantial extent, and reach
a desired rating level.
The above risk factors represent the primary
risk factors in a CMBS transaction. In addition,
CRISIL will analyse several other risk factors
include developer specific and property specific
risk before rating a CMBS transaction.
BENEFITS OF CMBS
CMBS has numerous benefits, from the
perspectives of various players in the system:
+ Benefits of CMBS for issuers
+ CMBS helps in transforming relatively
illiquid real estate loans into liquid and
tradable capital market instruments.
+ CMBS acts as an additional source of funding
for the bank/developer.
+ The rating of the bank/developer can be de-
linked from the rating on CMBS, thereby
making it possible to achieve a desired rating
on the CMBS instrument.
+ CMBS reduces the overall cost of funds and
optimises the funds raised, as compared to
bank lending, due to the possibility of having
rated tranches of different maturities to suit
different investor classes.
+ CMBS helps lenders manage risk, by
securitising selected commercial mortgages
and buying or selling suitable CMBS papers.
Thus, lenders can achieve their target
exposures to the overall sector, and/or
segments within the sector.
+ Benefits of CMBS for investors
+ Investors are able to participate in real estate
lending in amounts that are smaller than the
principal balance of the mortgage loans in the
pool.
+ It is possible to choose contracts in such a
manner that the credit and maturity
preferences of investors can be met.
+ Investors can gain access to segments of the
sector at low transaction and information
costs.
+ Internationally, defaults experienced on
CMBS are much lower than on other types of
securities.
+ Benefits for the commercial real estate sector as
a whole
+ CMBS leads to diversification of exposure
among market participants. Thus the current
situation, where over half of the system-wide
real estate exposure is on the books of only
five banks, will not arise.
+ Capital inflows into the real estate market
become more evenly spread, as compared to
the traditional bank lending system.
+ Monitoring of CMBS by rating agencies will
enable lending to the sector become more
risk-sensitive.
+ CMBS can help in reducing the severity of
cyclicality in commercial real estate, since it
enables the raising of funds from a diversified
base of investors. This means that developers
will not lack funds to undertake projects,
even when markets are depressed.
CONCLUSION
Globally, CMBS are a very popular form of
financing real estate development. CRISIL
believes that in India too, CMBS can be an
effective way to fulfil the commercial real estate
sector's growing need for capital. The
development of the CMBS market will pave the
way for orderly growth of the commercial real
estate market.
33
CRITERIA - Structured Finance

BOX: REIT AND CMBS

In the context of CMBS it is imperative to know a little about Real Estate Investment Trusts (REITs).
REITs own, and in most cases operate income-earning real estate. Some REITs are also engaged in
financing real estate. REITs are incorporated as limited liability companies, making it possible for
retail investors to have beneficial ownership of thin slices of real estate.

REITs in essence operate like mutual funds. For a detailed understanding of REITs, please refer to
CRISIL's opinion piece 'Real Estate Investment Trust - An untapped investment opportunity'.
REITs are the major source of capital for the real estate industry in developed countries, especially
USA. REITs can play a huge role in the growth of the CMBS market, since they have diversified a pool
of real estate which, if offered as mortgage on borrowing by the REIT, can benefit everyone in the
transaction. Moreover the growth of the real estate sector itself can be driven by such vehicles, since
REITs allow capital to flow in from a large base of equity investors.

REIT shares can be listed on stock exchanges and traded freely, just like shares of any other company.
This develops a liquid secondary market for real estate, allowing smooth refinancing of CMBS
transactions.

34
 Rating Criteria for
Collateralised Debt Obligations
WHAT IS A CDO?
Collateralised debt obligation, or CDO1, is a security that is issued by a
bankruptcy-remote entity against receivables from a specified set of debt
obligations. CDOs are typically originated by banks or wholesale financial
institutions. The pool assets in a CDO typically include corporate loans,
debentures, and bonds. A pool consisting entirely of debentures and bonds is
called a Collateralised Bond Obligation (CBO), and a pool consisting entirely of
loans is called a Collateralised Loan Obligation (CLO); these instruments are
collectively referred to as Collateralised Debt Obligations (CDOs).
A CDO issuer pools these debt instruments together, and typically issues two
or more classes of securities, with differing seniority. The cash flows collected
from the underlying receivables are paid out in the order of seniority of each
class of instrument. Thus, each class act as a credit enhancement for all classes
that ranks above it. The credit quality of any given class is therefore a function
of the credit quality of the underlying debt obligations, and of the extent and
nature of credit enhancement (in the form of either subordinate tranches or
cash collateral).
The basic principle of CDO is that, in a pool of diversified assets, the chances of
all of them defaulting simultaneously is significantly lower than the chances of
any one or few defaulting. Hence, from a given pool of assets, different classes
of cash flows can be segregated, based on the certainty of these cash flows, and
assigned corresponding rating. Thus, a target rating of AAA can be achieved
with a pool of lower rated (say A or BBB) assets, by appropriately structuring
the cash flows.
CRITERIA - Structured Finance

1
Please refer to CRISIL's opinion piece 'The ABCs of CDOs', available on www.crisil.com, for a brief overview of
the international and Indian CDO markets, different types of CDOs, and the advantages of CDOs.

35
CRITERIA - Structured Finance

SNAPSHOT OF A TYPICAL CDO STRUCTURE

A typical CDO transaction is depicted in the diagram below:

2 3
Transfer/sells Issues PTCs
assets SPV
Seller/ (managed by a
Originator Trustee) Investors
5 4
Consideration Consideration

Servicing Payment to
1 Agent Trust and Retention investors
Loans 8
Account (maintained and
given by operated by the Trustee)
seller Receivables collected
and deposited by
servicing agent
6 7

External credit enhancement in the form

Obligors of Cash Collateral Account/Guarantee
(Borrowers) (drawn in event of shortfall)

Legend: Transaction prior to CDO

Initial cash flows while issuing CDO

Periodic cash flows

The steps in a CDO transaction are:

1. The originator pools together a portfolio of existing loans, bonds and/or debentures (assets)
(Step 1 in diagram above).
2. The originator sells these assets to a bankruptcy-remote SPV (Step 2).
3. The SPV issues Pass Through Certificates (PTCs) representing beneficial ownership of the assets
(Step 3).
4. Investors subscribe to these PTCs by paying a consideration that is passed on to the originator
(Step 4 and Step 5).
5. Investors appoint a Trustee to act as their representative. The trustee ensures that the parties
involved act in accordance with the transaction documents.
6. The servicing agent (usually the originator) collects periodic payments from obligors and makes
payment to the investors (Step 6 and Step 8). The trustee invokes guarantee / draws down cash
collateral to meet shortfall if any (Step 7).
7. The trustee also coordinates with investors to enforce the security (if any) in the event of default
by any obligor in the pool.

36

RATING CRITERIA
This paper explains CRISIL's rating criteria for
CDO transactions. The key components of
CRISIL's rating process for CDOs are:
1. Legal analysis of the transaction and 'true sale'
of assets to the Special Purpose Vehicle (SPV)
2. Credit analysis of the underlying debt
obligations in the pool
3. Analysis of the transaction structure to
ascertain claims on the cash flows
4. Simulation of portfolio loss behaviour using
CRISIL's proprietary CDO model, to estimate
credit enhancement
1. Legal analysis of transaction and 'true sale'
of assets to SPV
The rating process entails a detailed analysis
of the legal structure adopted and the taxation
issues arising in the transaction. As in all
securitisation transactions, it is of primary
importance to ensure that
- the assets are transferable
- the transfer of assets constitutes a 'true sale'
and
- the incidence of tax and its implications on
the transaction structure have been examined
The first step in legal analysis is to determine
whether or not the selected assets are capable
of being transferred. Some loan documents
could prevent a lender from assigning the
right to receive loan repayments. Therefore,
the pool assets' underlying documentation
needs to be examined for clauses that might
restrict such an assignment.
Once transferability is established, the next
step is to establish the 'true sale'. In a CDO
transaction (as in all other securitisation
transactions), the originator transfers the
assets to an SPV. This SPV is created, and
exists, solely for the purpose of the
transaction. The SPV is also prevented from
carrying out any other business.
RATING CRITERIA FOR COLLATERALISED DEBT OBLIGATIONS
The transfer of assets to the SPV has to satisfy
the 'true sale' definition, since only a 'true
sale' will isolate the assets from the
originator's ownership and estate. This is
necessary to ensure that, in the event of the
originator's bankruptcy, its creditors cannot
claim the securitised assets. CRISIL's analysis
of true sale involves scrutiny of the
documents of transfer, and other relevant
documents, by CRISIL's in-house legal team.
In addition, CRISIL also requires the
originator to submit an opinion from an
independent legal counsel. This opinion
should address (with reasoning, and
reference to specific case law, if necessary) the
issues of true sale, transferability of the assets,
imperfections if any in the underlying
security, and any other legal uncertainties in
the structure.
The third step in legal due diligence is to
determine whether there could be an
incidence of income tax or other taxes or
levies on the SPV, impacting the cash flows
from the assets. In addition, in transactions
where post-default recoveries on assets are
given credit in the rating analysis, the
security relating to the underlying debt
instruments is also examined, to determine
whether the security has been perfected, and
whether it remains valid even after the
transfer of the assets. CRISIL also examines
whether the necessary stamp duties and
other dues have been paid.
2. Credit analysis of underlying pool of assets
The ability of any asset in the CDO pool to
generate cash flows depends on the
underlying obligors' capacity to repay. This is
represented by the obligor's credit rating,
which is assessed in the normal course
through an analysis of its business and
financial profile, management quality, and
other relevant parameters in the rating
process.
To determine the rating of each asset in the
CDO pool, CRISIL uses one or a combination
37
CRITERIA - Structured Finance

of the measures listed below, in descending Waterfall mechanism3

order of preference: Generally, CDO structures include waterfall
+ CRISIL's published credit rating on a similar mechanisms that indicate the distribution of
loan obligation of the obligor. pool collections at various points of time
during the CDO's tenure. The key aspects that
+ Shadow rating conducted by CRISIL on the
are examined are the priority of payment
obligor.
across various classes of instruments issued,
+ Quantitative model correlating to CRISIL's and the extent of credit enhancements
rating scale2 available to meet possible shortfalls for each
+ In transactions that involve a large number of class of security. A typical waterfall
loan obligors, the originating bank's internal mechanism in a securitisation transaction
credit scoring system and/or payment track involving two classes senior and subordinate
record of the obligor is mapped to CRISIL's is given below:
rating scale.
Moreover, triggers can be set to alter the
3. Analysis of transaction structure waterfall mechanism in favour of the senior
Although structures vary across CDO instruments in case the pool's actual
transactions, some common issues that need performance is at variance with what was
to be examined include: originally envisaged (see section below,
“Overcollateralisation and interest coverage
+ Waterfall mechanism. tests”). These triggers help in aligning the
+ Overcollateralisation and interest coverage payout expectations on various tranches, by
tests. providing a higher degree of protection to the
+ Interest rate risk. senior instruments than to subordinate ones.

Amounts available in the collection and payout account

Any statutory or regulatory dues

including overdues on these payments

Fees to service providers - Trustee, rating agency,

legal counsel, auditors, bank charges and servicing &
paying agent, including any overdue on such payments

Payment in arrears to senior tranche

Interest amounts payable to senior tranche

Principal amounts payable to senior tranche

Top - up of cash collateral to the stipulated amount

Residual amounts paid to the subordinate instrument in

the order of overdues, interest due and principal due

2
CRISIL has developed 'Quick Rating Model' (QRM), a model that estimates an obligor's ratings based on its financials. This model is based on a
statistical study of financials over 500 manufacturing companies and the corresponding CRISIL ratings.
3
For understanding a 'waterfall', please refer to the topic 'How is a typical waterfall mechanism structured?' in CRISIL's Securitisation Handbook,
Section 3, Page 26

38

Over-collateralisation and interest coverage
tests
Issuers of CDOs generally incorporate
overcollateralisation and interest coverage
tests for all rated class of instruments, to
optimise credit enhancement levels and
improve saleability of the CDOs. These tests
are incorporated so that the senior
instruments can be amortised faster in case a
stress situation, measured by the test, unfolds;
this procedure increases the protection for the
senior instrument, thereby acting as a credit
enhancement for this tranche. The stress
situation is captured in terms of triggers,
which primarily deal with deteriorating asset
quality.
Overcollateralisation (OC) test
OC for any given tranche is the extent of
protection offered to it by subordinate
tranches. The OC test is designed to ensure
that a senior tranche does not suffer due to a
declining OC level. Under this test, if the
available OC for a senior tranche falls below a
particular predetermined level (say 5 per
cent) - a situation that may occur because of
higher-than-expected defaults by underlying
obligors - the payments due to the junior
tranche/s are suspended and the cash flows
are used to pre-pay the senior tranche, till
such time as the OC trigger is cured (i.e. OC
once again exceeds the trigger level, 5 per cent
in this case).
Interest-coverage (IC) test
Under IC test, the cushion between the
interest earned on the asset portfolio (i.e. the
pool's revenues), and the interest to be paid on
the CDO instrument (i.e. the pool's expenses)
is monitored, and is used as a trigger. If, due to
defaults or for other reasons, the interest
inflows on the pool reduce below a certain
predetermined multiple (say 1.1 times) of the
interest outflow to the PTCs, the IC test
accelerates the amortisation of the senior
tranches. This process will result in lower
RATING CRITERIA FOR COLLATERALISED DEBT OBLIGATIONS
interest outflow on PTCs in subsequent
periods. The process is continued till such
time as the trigger is cured, i.e. the interest
inflows into the pool exceed the
predetermined multiple of interest outflow to
PTCs.
Interest rate risk
Interest rate risk arises when there is a
mismatch between the interest terms on the
collateral portfolio and the CDO tranches
issued. The common sources of interest rate
risk are:
+ Differences in periodicity: Collateral
assets paying interest more frequently than
the CDO tranches will lead to negative
carry, if the collected cash sits idle in the
SPV, or generates a lower return than the
coupon payable on the CDO.
+ Difference in payment dates: The
mismatch between the date on which the
interest is received from collateral assets,
and date on which the coupon is paid on the
CDO, can lead to situations of negative
carry or shortfall in the amounts that need
to be paid.
+ Difference in interest rate terms: The
collateral assets may pay a floating interest
rate while the CDO might have a fixed
interest rate, or vice versa.
CRISIL incorporates periodicity and timing
mismatches in its credit enhancement
calculation. Further, unless there is a 'swap'
for the difference in the interest rate terms,
CRISIL applies adequately stressed interest
rate scenarios, and stipulates the credit
enhancement accordingly.
4. Simulation of portfolio loss behaviour
using CRISIL's CDO Model
CRISIL has developed a proprietary SAS4-
based portfolio analytics tool that uses Monte
Carlo simulations incorporating asset default
39
CRITERIA - Structured Finance
probabilities, asset cash flows, asset
correlations, and recovery rate assumptions,
to simulate portfolio default and loss
distribution statistics. The use of this tool to
analyse portfolio quality is the most
important step in the CDO rating process.
Monte Carlo Simulation
Under the Monte Carlo simulation, a number
of independent trials are simulated. Each trial
randomly generates a set of numbers, each
number having a one-to-one correspondence
with an identified cash flow (a specific
interest/principal repayment from a specific
obligor). For example, if the pool consists of 30
loans of five-year tenure with annual
interest/principal payments, 150 numbers
will be generated in each simulation. The first
five numbers correspond to the five annual
cash flows of Asset 1, the next five correspond
to those of Asset 2, and so on.
In a particular trial, each asset is determined to
have either paid on time or defaulted, in a
manner calibrated to be consistent with the
probability of default associated with that
particular asset's credit rating. For instance, if
the probability of default on a given asset is 10
per cent (derived based on its credit rating),
the simulation engine will ensure that, on
average, that particular asset defaults 10 times
in every 100 trials. The accumulation of the
behaviour of each of the assets in the portfolio
in a trial gives the total portfolio default for
that particular trial. The portfolio default
behaviour for the entire set of trials gives the
portfolio loss distribution. The portfolio loss
distribution represents an estimate of various
possible loss levels, and the corresponding
probabilities of occurrence. Based on the
nature of each asset, CRISIL could also
assume some post-default recovery, but only
if it expects recovery to take place within the
maturity of the PTCs issued.
CRISIL's CDO model also incorporates asset
correlation assumptions while simulating
portfolio behaviour. This involves the
generation of an asset correlation matrix for
4
A statistical package: information available at www.sas.com
40
the portfolio based on the industry / sector of
each asset. To simulate portfolio losses with
this correlation behaviour, the set of numbers
randomly generated is multiplied by the
'Cholesky decomposition' of the asset
correlation matrix. This results in a default
distribution with the intended correlation
behaviour.
Inputs for CRISIL's CDO model
The key inputs for CRISIL's CDO model are:
(a) Asset ratings and associated default
probabilities (computed from CRISIL's
default statistics).
(b) Asset cash flows.
(c) Asset correlation assumptions (based on
CRISIL's in-house database of asset
behaviour in the rated and non-rated
universe).
(d) Assumptions on the level and timing of
recoveries expected within the tenure of the
CDO (based on the servicer's past experience
with various asset classes).
(a) Asset ratings and associated default
probabilities
The methodology employed in determining
asset ratings has been discussed above
(section 2, 'Credit analysis of underlying pool
of assets'). Based on the asset rating and asset
tenure, CRISIL assigns a default probability
to each cash flow of each obligor.
CRISIL has comprehensive rating statistics
by virtue of its extensive coverage of the
Indian debt market, of almost two decades.
CRISIL has developed a default matrix based
on the performance of its ratings. This matrix
provides the default probability of each
rating across different tenures.
CRISIL has published its default statistics5.
These default statistics have shown an
unambiguous link between CRISIL's ratings
and default probabilities. The study also
highlights the high 'Gini coefficient' of
CRISIL's ratings, indicating that CRISIL
ratings have performed well as predictors of
default.

(b) Asset cash flows
CRISIL analyses details of the cash flows on
the underlying assets, the availability of
prepayment options, and interest rate
revision options.
(c) Asset correlation assumptions
CRISIL uses surrogate measures to determine
asset correlations, as historical 'asset value
time series' to measure asset correlations
among corporates are not readily available.
Therefore, CRISIL uses equity return
correlation studies as proxy for asset
correlation in the CDO rating process. These
studies are continuous in nature and are
subject to constant refinement.
It is intuitive to expect companies in the same
industry to have a higher correlation than
those in different industries. Accordingly,
assets in the same industry are assumed to
have higher levels of correlation than assets
from different industries. CRISIL applies
even greater stress to the correlation
assumptions if assets belong to the same
corporate group, in order to factor in the
higher degree of inter-linkages.
CRISIL carefully studies correlation in its
CDO model, because of the profound effect
that correlation can have on portfolio loss
distribution. The chart below shows the
effects of correlation on the probability
distribution of losses for a hypothetical pool
of 100 assets.
The two scenarios considered are correlations
of 0 and 0.5 between assets in the pool. A
higher correlation changes the portfolio
default distribution pattern, leading to more
frequent extreme events (generally termed as
“fat tails” in statistical terms), even though
the mean remains unchanged. Both standard
5
“India's first default study validates CRISIL's ratings”, March 2005
RATING CRITERIA FOR COLLATERALISED DEBT OBLIGATIONS
deviation and the extremes (very low and
very high loss levels) increase significantly as
a result of greater correlation (see chart
below).
Loss distribution with different correlation levels
Correlation of 0
Correlation of 0.5
60%
50%
40%
Probability
30%
20%
10%
0%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Loss Levels
(d) Recovery rate assumptions for defaulted
assets
Typically, the rate and timing of recovery is a
function of:
-Liquidity and value of the security pledged,
-Lender's legal seniority (secured or
unsecured) and operational seniority in the
borrower's capital structure (term lender or
working capital lender), and
- The servicer's recovery skills
Till very recently, the legal environment and
practical issues involved in recovering
defaulted loans and bonds implied that
recoveries were delayed and remained low.
This was notwithstanding a clear charge on
the security, and significant recovery efforts
made by lending institutions. Greater
creditor control of bankruptcy and recovery
proceedings, under the Securitisation and
Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI)
Act could, however, improve recoveries
from defaulted assets. CRISIL takes into
account the recoveries on the defaulted assets
but only until the maturity of the CDO.
CRISIL factors in no benefit for recoveries
beyond the scheduled maturity of the CDO.
41
CRITERIA - Structured Finance
Based on the above factors, the Monte Carlo
simulation exercise is carried out. This
simulates the pool collections and shortfalls
(loss levels) under each trial. With a
sufficiently large number of such trials, the
portfolio loss distribution is generated.
Taking into account this loss distribution, the
instrument structure, and the waterfall
42
mechanism, credit enhancement levels are
derived for each tranche to achieve the
desired target rating. These credit
enhancements are stipulated in a manner
such that the credit characteristics of the
various CDO tranches reflect the credit
characteristics of similar rated plain vanilla
instruments.
 Rating Criteria for Instruments with
Partial Guarantee
Debt instruments fully guaranteed by third-party guarantors have been in
vogue for a long time in the Indian debt markets. Given the limited demand in
the Indian market for corporate debt with ratings below 'high safety' (AA
rating), the use of a partial guarantee to improve an instrument's rating, and
thereby its marketability, has the potential to become a handy tool for
corporates, financial institutions and investors.
In a partial guarantee structure, a guarantor rated higher than the issuer,
provides guarantees for payment of some part of the cash flows payable on a
debt instrument, while leaving the rest to the credit risk of the issuer. CRISIL
has developed an approach to assess the credit risk of debt instruments that are
partially guaranteed. This approach analyses the individual probability of
defaults of the two entities - the borrower and the guarantor - as represented by
their credit ratings. It then assesses other critical parameters of the partial
guarantee mechanism such as the extent of guarantee coverage, and the nature
of the guarantee. These analyses form the base of CRISIL's credit opinion on the
instrument.
The rating assigned to a partially guaranteed instrument will be a 'structured
obligation' ('so') rating. This rating can range anywhere between the borrower's
and the guarantor's ratings, based on the extent of guarantee coverage. CRISIL's
approach allows issuers to achieve a significant rating enhancement with a
guarantee whose coverage is less than the issue's total debt-servicing obligation
till maturity.
Prior to the development of CRISIL's methodology, the approach for partial
guarantees used by rating agencies all over the world was the 'weak link
approach', where no credit was given for any coverage less than the full debt-
servicing obligation on the instrument. Hence, an instrument with, say, a 90 per
cent guarantee from a higher-rated credit (i.e. 90 per cent of interest and
principal payments guaranteed) would be rated identically to the same
instrument without a guarantee. Under this approach, the partial guarantee
yielded no benefit from the point of view of the instrument's rating.
The methodology pioneered by CRISIL addresses this issue and is an
improvement over this traditional approach: CRISIL's approach factors in the
benefits that the investor derives from a partial guarantee. The new approach
CRITERIA - Structured Finance

was applied to rate the debt issues of Ballarpur Industries Ltd and Bharti
Mobile Ltd, which were partially guaranteed by the Washington-based
International Finance Corporation (IFC), and were the first partial guarantee
transactions of this nature to be rated globally. This article highlights the criteria
adopted by CRISIL in rating instruments carrying partial guarantees.

43
CRITERIA - Structured Finance
THE NEW APPROACH
The new approach is scientifically designed to
simulate all the possible default scenarios of the
instrument, either due to default by the issuer or
by the guarantor, based on historical default rates
observed by CRISIL in over 15 years of its rating
history. This simulated default pattern on the
partially guaranteed instrument is then compared
with the default pattern of plain vanilla
instruments at various rating levels. The eventual
rating on the partially guaranteed instrument will
be based on the rating of the plain vanilla
instrument demonstrating the closest similarity in
its default pattern to that of the partially
guaranteed instrument.
CRISIL adopts a strict definition of default: it
treats the first rupee of delayed or missed
payment as a default. Therefore, the simulation
assumes that each cash flow can exist in one of two
states: it is either paid fully on time or there is a
default event. Under this approach, the partial
guarantee structure works if it increases the
probability that some instalments will be paid in
full and on time, rather than if it increases the
probability that a part (less than 100 per cent) of all
instalments will be paid on time. In other words,
having a guarantor guarantee a part of all
instalments may not result in any significant
rating enhancement under this approach. On the
other hand, if the same guarantor guarantees full
payment on the same proportion of instalments,
there is likely to be a significant rating benefit.
In line with the above thinking, one can consider a
partially guaranteed instrument as two
independent instruments, carrying the credit risk
of the issuer and guarantor respectively. A
combination of several such instruments would
result in a credit default behaviour that will be
comparable to a plain vanilla bond in a rating
category lying between the rating of the issuer and
guarantor. The partial guarantee, therefore,
enhances the rating on the instrument, up from the
issuer's rating, and towards the guarantor's rating.
The level of enhancement would depend on
several factors, detailed below:
Guarantee Coverage: The extent of coverage is the
most crucial input in assessing the level of rating
enhancement. A higher guarantee cover would
take the rating closer to the guarantor's rating;
needless to say, full coverage would equate the
instrument's rating with the guarantor's rating.
44
A guarantee for a specific cash flow mitigates the
default probability of that cash flow, to the extent
that the guarantor's credit risk is superior to the
issuer's. Thus, as the extent of guarantee coverage
(in terms of the number of instalments covered)
increases, a larger number of cash flows will carry
lower default probabilities, thereby reducing the
instrument's overall default risk. This has been
scientifically measured using CRISIL's
proprietary default statistics, which are a crucial
input in arriving at the instrument's final rating.
Timing of Guarantee: The projected cash flows of
a company often carry varying risk levels at
different points in time due to company-specific
reasons such as project implementation,
cyclicality of the industry, and anticipated capital
infusions. A guarantee for debt repayment
obligations during the weakest expected period of
a company's future cash flows reduces the credit
risk more than a guarantee available during a
period when the issuer is expected to have strong
cash flows and easy access to funds. For instance,
in a toll road project, the initial construction
period might carry the highest risk, whereas in
most other companies, the farthest cash flows
carry the highest risk of default. Thus, the timing
of the guarantee is also important in assigning a
rating based on a partial guarantee.
Nature of Guarantee: A variant of the partial
guarantee, which can effectively address the
timing effect, is called a 'rolling guarantee'. A
rolling guarantee is one that, if not invoked, rolls
over to cover the subsequent repayment
obligation. For a given extent of guarantee
coverage, a rolling guarantee is far better than a
'fixed payment' partial guarantee. This rolling
guarantee will, in effect, address the weakest
period in a company's future cash flows, and will
provide a 'curing period' for the company to
recover and commence regular payments on the
instrument.
Legal and payment structure: Legal and payment
structures assume great importance in partial
guarantee transactions. CRISIL scrutinises the
guarantee document to assess the terms of the
guarantee. CRISIL requires a legal opinion stating
that guarantee is unconditional and irrevocable,

barring certain triggers in the structure. In
addition, CRISIL also requires the guarantee
document to mention:
+ the quantum of the guarantor's obligation for
both principal and interest payment,
+ that the guarantor's liability should continue
even if the issuer makes a reference to the BIFR
or files for winding up or effects a change in its
management, and
+ that the guarantor's liability should be
continuing regardless of a change in the trustee
Further, CRISIL evaluates the nature of guarantor
to stipulate the guarantee invocation date, which
should be adequately distanced from the due
dates for payouts to investors. This is to ensure the
guarantee money is received well before the
relevant payout date. For instance, if the
guarantor is a multilateral agency, CRISIL may
stipulate a much earlier guarantee invocation
date, than if the guarantor is a bank, as the
response time to a guarantee invocation may be
RATING CRITERIA FOR INSTRUMENTS WITH PARTIAL GUARANTEE
higher for a multilateral agency than a bank.
CRISIL will also require the guarantor to confirm
that it will adhere to the stipulated structure.
In addition to the above, CRISIL also looks at
other relevant parameters including cash flows
available to meet non-guaranteed payments,
documentation, and the outlook on the stand-
alone ratings of the borrower and guarantor.
CONCLUSION
CRISIL believes that the ratings assigned through
this partial guarantee methodology meets the
highest standards of rigour, and convey value to
investors. With lenders and investors in the
Indian markets preferring to invest only in highly
rated instruments, CRISIL expects this new
concept to be a powerful financing tool in the
hands of corporate treasurers, while adequately
addressing the concerns of the investing
community.
45
 Rating criteria for Future Flow
Securitisation
INTRODUCTION
Future flow securitisation transactions are transactions in which investor
payments are met out of cash flows that are to be generated in future, such as
property rental receivables, toll receivables, credit card receivables, oil and gas
sale receivables, and the like. Thus in a future flow transaction, collateral used
by the originator is not existing claims against existing obligors, but future
claims against future obligors.
CRISIL has rated several securities backed by future flow structures. CRISIL
expects that the market for future flow securitisation transactions will grow
significantly, as the Indian debt market matures and investments in
sophisticated debt instruments increase. CRISIL assigns ratings for such future
flows transactions that can be up to three notches higher than the credit quality
of the originator of the assets or cash flows. The extent of notch-up is based on
various factors, which have been discussed in detail in this article.

A TYPICAL FUTURE FLOW TRANSACTION

In a typical future flow securitisation transaction, the borrowing entity
(originator) sells its future receivables directly or indirectly to a Special Purpose
Vehicle (SPV), which issues the debt instrument. Designated customers
(obligors) are directed to pay, for the goods or services they purchase from the
originator, directly into a collection account managed by a trustee. The
collection agent makes principal and interest payments to lenders; surplus
funds are forwarded to the originator (see diagram).
Structure of a typical future flow securitisation transaction

Designated Payment 7
customers Trust & Retention
(obligors) Account
Provide
product for
services Excess
Agreement to 2 Principal and
remit to TRA collections 8 interest

6
CRITERIA - Structured Finance

4 Proceeds
Special Purpose
Investor
Vehicle
Securitised 3
notes

Right to collect
Proceeds
1 receivables 9
5

Borrower
(Originator)

Initial Transaction
Periodic payments
over the life of the
instrument

46

ASSESSING RISK IN FUTURE FLOWS
TRANSACTIONS
The rating criteria for future flows transactions
comprise an analysis of the following:
+ Originator's creditworthiness
+ Performance risk of the originator / Linkages
with regular operations
+ Obligors' creditworthiness
+ Impact of the future flows transaction on the
originator's other obligations
+ Structure and payment risk
+ Legal risk
+ Escrow structure
+ Recourse to originator
+ Documentation
+ Originator's creditworthiness
In a future flow securitisation transaction, the
starting point of analysis is the originator's
creditworthiness. Since the cash flows for debt
repayment originate from future receivables to
be generated by the originator, the ability of the
originator to generate these receivables, over the
life of the rated instrument, assumes paramount
importance. The originator's creditworthiness,
measured by the credit rating, is used as a proxy
for the likelihood that a company will be able to
continue operating and generate the designated
receivables.
It must be noted here that a future flow
securitisation structure does not entail
generation of any additional cash flow; it results
only in prioritisation of the total cash flows
available to the originator. Hence, the linkage to
the stand-alone rating assumes priority in all
such transactions. It is also pertinent to note that
the rating on such instruments can in fact be
lower than originator's creditworthiness, if
CRISIL believes additional risks, other than the
risk of generation of receivables, exist in such
transactions.
For transactions where firm take-or-pay
contracts exist reducing the offtake risk, the
notching up could be higher, constrained only
by the performance risk of the originator and the
credit quality of the obligor(s).
RATING CRITERIA FOR FUTURE FLOW SECURITISATION
+ Performance risk of the originator
Unlike asset-backed securitisation, a future
flow transaction requires the originator to
continue to 'perform', so as to deliver the
required goods or services and thereby generate
the receivables necessary to service the rated
instrument. As noted earlier, the probability of
generation of future cash flows to meet the rated
debt obligations may be very different (and in
all likelihood higher) than the probability of
financial default by the originator. CRISIL
analyses the following factors to assess the
originator's ability to generate future
receivables:
A. Degree of linkage between assigned future
cash flows and regular operations:
From a rating perspective, the working premise
is that the more involved the processing
required to achieve the finished
product/service whose sale is necessary to
create the transaction cashflow, the more
closely is the rating linked to that of the entity
rendering the necessary service. CRISIL
assesses the degree of linkage between the
originator's ability to deliver the promised
goods/services (which would in turn generate
the cash flows) and the originator's normal
operations. The following broad matrix is used
as a guiding factor in such evaluation:
Ranking of future flow transactions, in order of performance risk
Association with
Performance Examples
risk originator’s rating
Toll receivables,
rent receivables,
Low Farthest receivables from static
gas pipelines
Crude oil receivables,
Medium Medium utility bills receivables,
credit card receivables
Airline ticket receivables,
High Closet receivables from supply of
auto components
Rent receivables and toll receivables are
examples of weak linkages where minimal
performance such as maintenance or upkeep of
the facilities is required from the originator to
generate the receivables. These receivables are
likely to become due just with passage of time.
On the other hand, airline ticket receivables are
an example of receivables that have a strong
linkage to the operations of the originator. The
airline company would have to continue
47
CRITERIA - Structured Finance
operating its flights, and be able to attract
customers, for ticket receivables to be generated.
The complexity of 'performance' will also be
assessed, and less complex operations (e.g.,
maintenance of a static gas pipeline) will be
viewed favourably compared to very complex
operations (e.g., supply of forged auto
components of specified quality).
B. Factors that could impact originator's ability
to deliver the promised goods/services:
+ Operating performance: The originator's
operating performance is assessed by
studying its operations, labour relations,
managerial competence, regulatory changes,
and the like. The company's track record, and
its ability to generate the identified future
cash flows required to meet the rated debt
obligations, are specially emphasised.
+ Financial performance: The originator's
financial performance is assessed to ensure
that the originator is in a financial position to
continue to operate in future. This involves
studying the originator's past financial
performance, its ability to raise funds, its
expenditure plans, and the like. Although
this parameter is also analysed while
understanding the originator's
creditworthiness, the focus here is on the
originator's ability to meet operational
commitments (such as statutory dues, power
charges, salaries and wages), non-payment of
which can impede the regular operations of
the originator.
C. Ability to continue operations in a financial
distress scenario:
There can be circumstances where the
originator is in financial distress or has
defaulted on its other debt but still continues
to operate. Such an originator can be a
monopoly supplier of any product or services
in the country / region, a para-statal entity
(such as a municipal corporation or SEB), or
an entity viewed as too important to fail (such
as a bank or financial institution). Future
receivables from such entities are viewed
more favourably than those from other
corporates.
48
+ Obligors' creditworthiness
The next important aspect in a future flow
securitisation transaction is the
creditworthiness of the obligors, from whom
the cash flows to service the rated debt originate
such as tenants in the case of rental receivables,
and identified electricity consumers in the case
of state electricity board receivables.
In the case of a single obligor, the rating on the
instrument may be constrained by the rating of
the obligor. In case there are multiple obligors, a
rating view is taken on all the obligors, and the
resultant rating would be a function of the
individual ratings and their contribution to the
future cash flows. In addition to that, the rating
may be enhanced above the weighted average
rating by taking diversity into account. In the
case of retail future flow securitisation
transactions (with a large number of obligors
such as retail credit card holders or telephone
consumers); the obligors' creditworthiness is
assessed by the diversity of the retail pool and
track record of collection efficiencies.
+ Impact of future flow transaction on
originator's other obligations
The future flow securitisation transaction
entails a prioritisation of the total cash flows
available to the originator. Thus, if a large
quantum of future flow receivables is taken out
to meet the rated debt obligation, this may, in
turn, put pressure on the originator's free cash
flows, thereby impacting the ability to meet
other operational and financial obligations. A
sustained non-payment of any of the other
operational or financial obligation might
impact the originator's existing operations and
its future financial position. This in turn could
impair the future cash flows identified for the
rated transaction. CRISIL analyses the
following factors to assess the impact of the
future flow transaction on the originator's other
obligations:
+ Size of the rated transaction in relation to the
originator's size of operations.
+ Application of the proceeds of the rated debt.

+ Residual cash flows after escrowing the
future flows for rated debt and sufficiency of
the same to meet operating commitments.
Thus, CRISIL evaluates whether the future flow
structure impairs the originator's standalone
performance and whether the free revenues of
the originator are sufficient to meet essential
expenses (for example to perform its basic
operations, or pay salaries).
+ Structure and payment risk
The structure and payment risk analysis
involves a detailed study of the structure of the
transaction, the mode of collection, the schedule
of payments to investors, and the like, to assess
the strength of future cash flows. An
examination of the following is carried out:
+ Agreements with the obligors (such as nature
of take-or-pay contract if any, payment
terms).
+ Historical collection pattern.
+ Assumptions made for projecting future
+ Escrow Structure
flows (including pricing agreements, interest
earned on balances).
+ Co-mingling risk (mingling of the identified
future cash flows with the originator's other
cash flows).
+ Other factors that can result in variability in
future flows.
Based on the strength of the cash flows, the
structure of the instrument, and past collection
efficiency, CRISIL specifies a level of credit
enhancement (in terms of cash collateral or over-
collateralisation levels) required to achieve a
desired rating.
+ Legal Risk
If the originator continues to generate sufficient
receivables, the timely payment on the rated
instrument is strongly linked to the robustness
of the transaction's legal framework. There are
differing opinions as to how future flow
structures would be treated in the event of
originator's bankruptcy. The report of RBI's in-
RATING CRITERIA FOR FUTURE FLOW SECURITISATION
house working group on asset securitisation
classifies future flow transactions as executory
contracts. To quote:
“A transfer of property that is not in existence
operates as contract to be performed in future or in
other words as an executory contract. The
implication of this provision is that in case of
bankruptcy of the Originator, the contract can be
treated by the Liquidator as being an executory
contract, which can be therefore terminated by him.
The monies that are paid as consideration by the
investors for the purchase of the receivables, while
recoverable would be as unsecured creditors of the
Originator.”
CRISIL's rating on an originator's ordinary debt
assesses the likelihood of full and timely
payment on the debt and does not necessarily
reflect the probability of continued operations.
CRISIL's rating for the future flow structure
captures this difference. Hence, to that extent,
the higher rating factors in the lower probability
of bankruptcy than of timely payment on other
rated debt.
In future flow transactions, CRISIL stipulates
that the Issuer maintain an escrow account into
which all amounts due on the instrument from
time to time are deposited. As the rating is
dependent on payments from the escrowed
cashflows, it is essential that the cashflows be
accessible to the trustee/investors at all times.
CRISIL requires the escrow account to be a no-
lien account and the account should either be
charged to the trustee or the Issuer should
declare trust over the account. Also the account
should at all times be under the control of the
trustee. CRISIL will ascertain whether the
cashflows are charged in favour of any other
creditors of the Issuer. If prior encumbrances do
exist, then CRISIL will require the Issuer to
obtain the requisite consents/pari passu letters.
Typically, CRISIL will stipulate a payment
structure to be followed by the Issuer and the
trustee. CRISIL requires that the payment
structure be documented and confirmed by all
parties to the transaction, i.e. the Issuer, the
trustee and the account bank. It is also
mandatory that the payment structure be
disclosed in the offer document.
49
CRITERIA - Structured Finance

+ Recourse to originator The documentation has to be to CRISIL's

A future flow transaction can be structured with
or without recourse to the originator. Where the
instrument is with recourse to the originator, the
floor for such a rating is the originator's credit
rating. Such transactions are then viewed
simply as escrow structures and may not qualify
as securitisation transactions. On the other
hand, there is no such 'floor' rating for non-
recourse instruments.
Typically, future flow transactions with high
performance risk tend to be with recourse to the
originator, implying that in the event of a
shortfall in collections under the envisaged
structure, the originator is obliged to make the
debt service payments just like its other
unsecured debt obligations. In such
transactions, the rating assigned to the
underlying securities enjoys a minimum rating
equivalent to the standalone rating of the
originator.
A future flow securitisation transaction can be
structured without recourse to the originator.
This is more common in cases where the linkage
between future receivables and the performance
of the originator is weak (for instance,
receivables from toll road projects or rental
receivables). In such cases, CRISIL stipulates
sufficient cushion in the form of cash collateral
or over-collateralisation to protect investors'
interests from variability in cash flows from the
underlying receivables.
satisfaction and therefore CRISIL may require
documents to be amended or fresh documents
to be executed from time to time.
BENEFITS OF FUTURE FLOW
SECURITISATION TRANSACTIONS
Future flow transactions are gaining prominence
in India, as these structures allow borrowers
(originators) to:
+ Borrow at lower cost than under traditional
funding methods, by obtaining credit ratings
higher than their standalone ratings.
+ Borrow more than under traditional funding
methods: unlike a traditional lender who looks
at the assets on the balance sheet, a future flow
investor looks at receivables that are not on the
balance sheet.
+ Access funds for a term longer than can be
achieved by issuing unsecured debt securities,
typically in cases where long-term contracts
exist (such as collections from a toll road project
or receivables from a long-term take-or-pay
contract for supply of LNG).

+ Documentation
In case of a future flow transaction, CRISIL
requires the following documents to be in place:
+ A tripartite agreement between the trustee the
Issuer and the account bank, incorporating
the payment structure and establishing the
trustee's rights over the cashflows.
+ Trustee agreement.
+ Offer document which should also contain the
stipulated payment mechanism.

50
 RATING CRITERIA FOR FUTURE FLOW SECURITISATION

DIFFERENCE BETWEEN ASSET BACKED AND FUTURE FLOW TRANSACTIONS

Bankruptcy remoteness possible in asset-backed securitisation
Traditionally, structured finance has been associated with assetbacked securitisation wherein the
securities issued are backed by cash flows generated by an existing pool of assets (for instance, auto
loan receivables and mortgage receivables). Here, the receivables have already been generated by
the originator and do not depend on the originator's future performance; they do not therefore entail
any “performance risk”. The transaction can be structured as a true sale of receivables, enabling
remoteness of the structure from the bankruptcy of the originator/seller of receivables. Therefore,
such securities can achieve ratings that are not linked to (and typically much higher than) the ratings
of other debt issued by the originator.

Future flow transactions rely on receivables to be generated

Since future flow transactions are backed by cash flows that must be generated in future and do not
involve any 'sale of assets' but only a claim on future receivables, these transactions are heavily
dependent on the ability of the originator to either produce a product or provide a service. As a result
the likelihood of payment on a future flow transaction is more closely related to the originator's
operating performance than its financial performance. Hence, the rating of a future flow structure
cannot be de-linked entirely from the originator's own rating.

51
 Securitisation - Legal Issues and
Compliance Requirements
This article describes CRISIL's legal and compliance requirements for
securitisation transactions, future flow transactions and guaranteed ratings.

1. LEGAL AND COMPLIANCE REQUIREMENTS FOR

SECURITISATION TRANSACTIONS
Legal analysis forms an important element in CRISIL's methodology for rating
securitisation transactions. In the absence of judicial precedent or explicit
statutory provisions on securitisation transactions, such transactions in India
are structured within the existing framework of the transfer of property, trust
and contract laws. This section provides an overview of the laws relating to
securitisation transactions as well as CRISIL's legal analysis criteria and
compliance requirements.

Securitisation Legislation and Regulation in India

The two key issues in the legal analysis of a securitisation transaction are 'true
sale' and bankruptcy remoteness. Both these issues have yet to be tackled by
the Indian courts and there still exists some uncertainty regarding the
enforceability of these transactions. However, transactions proceed on the
assumption that the Indian courts will apply internationally accepted
principles. Almost all transactions are backed by legal opinions on true sale and
the enforceability of the transaction documents from the transaction counsels.

The SARFAESI Act

In 2002, the Legislature enacted the Securitisation and Reconstruction of
Financial Assets and Enforcement of Security Interest Act, commonly referred
to as the SARFAESI Act. While the thrust of the legislation is asset
reconstruction for banks and financial institutions, the SARFAESI Act also aims
to provide a well-defined regulatory environment for securitisation.
The act stipulates that, for its provisions to be applicable to a securitisation
transaction, the transaction should have been carried out by a securitisation
company incorporated under the act and regulated by the Reserve Bank of
India (RBI). Pursuant to the SARFAESI Act, RBI issued guidelines in April 2003
CRITERIA - Structured Finance

regarding the sale of assets to an asset management or securitisation company.

The guidelines refer only to the securitisation of non- performing assets as per
SARFAESI Act, with stipulations that the Originator cannot retain any risk in
the asset after it has been transferred to the asset management company.

52

In April 2005 RBI has issued two draft guidelines:
1. 'Securitisation of Standard Assets' and
2. 'Purchase/sale of Non Performing Assets'
where securitisation companies and
reconstruction companies are not involved.
Currently there is no clarity on process of
securitisation of performing assets under the
SARFAESI Act. Further, the Act excludes certain
assets such as receivables from hire-purchase
contracts or receivables backed by the security of
aircraft or ships.
The RBI has permitted originators to carry on
securitisation transactions outside the purview of
the SARFAESI Act and all securitisation
transactions are currently executed outside the
ambit of this Act.
Crisil's legal requirements
CRISIL examines every securitisation transaction
in light of the following issues:
+ True sale
'True sale' is the single most important issue in
any securitisation transaction. A true sale will
establish that the assets transferred to the SPV
are bankruptcy remote from the originator's
estate.
Since there is no statutory definition of true sale
and no judicial interpretation of the same, in
India, when evaluating a transaction for true
sale, CRISIL will examine the following:
+ Extent of recourse to the originator and risk
retained by the originator in the assets
While mere recourse to the originator will not
vitiate true sale, it is important to check the
extent to which the transferee will have
recourse to the originator- this reflects the risk
retained in the assets by the originator.
The higher the level of risk retained by the
originator, the greater the chances that the
assets cannot move off its balance sheet.
Therefore, while the transfer of assets to the
SPV may be valid, the assets themselves may
not be remote from the originator's estate in
bankruptcy.
1
Accounting norms permit the servicer to have a “clean-up call option”, which may be exercised by the servicer if it becomes unviable for it to
service the assets when the value of the assets falls to 10 per cent or less of the original value.
SECURITISATION - LEGAL ISSUES AND COMPLIANCE REQUIREMENTS
Although there are diverse case laws on the
subject of true sale, CRISIL is of the opinion
that in cases where the originator retains a
high level of risk in the assets, the courts are
likely to recharacterize the securitisation as
secured borrowing by the originator.
Therefore, if transactions have unusually
high levels of risk retention by the originator,
CRISIL may regard such transfers as being
inconsistent with a true sale.
+ Option and obligation to repurchase assets
CRISIL will treat an obligation on the part of
the originator to repurchase assets on account
of deteriorating credit quality as being
inconsistent with a true sale. Accounting
guidelines issued by the Council of the
Institute of Chartered Accountants of India,
however, permit the originator to provide the
transferee with a 'put' option for the assets. If
the option is structured as an arms-length
transaction, distinct from the transfer of the
assets, this will not vitiate a true sale.
Where there is a put option, CRISIL will
examine the option contract to determine if
the same can be construed as a transaction
that is distinct from the securitisation.
In most cases, the servicer retains the option
to purchase the assets when they decline to 10
per cent or less than the size of the original
pool, for administrative ease. This is not
inconsistent with a true sale because such a
repurchase is not linked to the credit quality
of the assets1.
+ Intention of the parties
The intention of the parties to a transaction is
often scrutinised by the courts in order to
determine a true sale. Therefore, it is
important that the language used in
transaction documents clearly conveys the
intentions of the parties and that the nuances
of a transaction do not have the potential to
vitiate a true sale. For example, the price at
which the assets are purchased is an
important consideration for establishing the
intention of the parties. An unviable
53
CRITERIA - Structured Finance
purchase price (if the purchase price received
is significantly less than the fair market value
of the assets sold) can have the effect of re-
characterising a securitisation. CRISIL
examines each transaction document to
ensure that there are no discrepancies
between the terms of the proposed
transaction and the execution of the same.
+ Stamp duty and registration laws
+ Extent of control retained by the originator over
the assets
In some transactions, the originator may
retain control over the assets even after they
have been transferred. For example, the
originator may have a call option on the assets
or the transferee may be restricted from
further transferring the assets.
CRISIL will acknowledge a transfer to be a
true sale only if the transferee gains
unrestricted rights to the assets. Covenants
restricting the transferee's ownership of the
assets will be viewed as inconsistent with a
true sale.
+ Appointment of the originator as servicer
While the appointment of the originator as the
servicer is the normal practice in most
securitisation transactions in India, at times
this could be inconsistent with a true sale. For
example, if the servicer indemnifies the
transferee from payment defaults by the
obligors or if the originator takes on servicing
of assets without adequate consideration, this
could vitiate a true sale. CRISIL
acknowledges that even if the documents do
not evidence an adequate servicer fee2 the
servicer consideration may be reflected in the
purchase price.
It is also important that the transferee be given
the right to appoint another servicer if the
originator fails to comply with the terms of
the servicing agreement. This will further
prove that the originator has lost control over
the transferred assets.
2
Most agreements quote a fee of Rs.100, which is obviously not the total consideration for the servicer.
54
Apart from the due diligence conducted by it,
CRISIL also bases its analysis of a transaction on
professional opinion. For each transaction
CRISIL requires the originator to obtain a legal
opinion from an independent counsel
confirming that the transfer of assets is
consistent with a true sale.
Stamp duty can be described as a tax on
transactions, and is a charge levied on all
documents of a commercial nature. Indian
states are empowered to determine their own
stamp duty rates and these rates vary from state
to state, ranging from negligible to astronomical
amounts on the same transaction. Stamp duty is
an important issue unique to securitisation
transactions executed in India.
For reasons mentioned below, CRISIL requires
all transaction documents to comply with the
stamp duty and registration laws. Therefore,
CRISIL examines the executed documents in
each transaction and requires representations
and warranties from the originator and a legal
opinion confirming that the documents adhere
to the relevant stamp and registration laws.
+ Consequences of stamp duty evasion
The consequences of evading stamp duty are
serious. In terms of the Indian Evidence Act,
documents that are required to be stamped
and have not been duly stamped (that is
either unstamped or inadequately stamped)
cannot be adduced as evidence in a court of
law. This renders the documents
unenforceable, unless the deficient stamp
duty is paid at the time of enforcement. The
problem is that an inadequately stamped
document attracts an enormous penalty,
sometimes up to ten times the deficiency in
stamp duty paid.
+ Bearing the cost of stamp duty
The stamp duty payment liability is usually
decided by way of contract between the
parties to any transaction. In the absence of

such an agreement, the general rule under
stamp law is that the person claiming the
benefit of a document should bear the stamp
duty levied on that document. It is important
to note this because the person liable to pay
the stamp duty is liable to pay any penalties or
fines in respect of the same.
+ Differential rates of stamp duty
In most states, the sale of assets attracts high
stamp duty, sometimes up to 12 per cent of
the value of the assets transferred, resulting in
prohibitive transaction costs. Currently there
are few states in India that have enacted
stamp duty laws favourable to the transfer of
assets; states such as Maharashtra, Gujarat,
Tamil Nadu, West Bengal and Karnataka are
instances. In these states, the applicable duty
is comparatively quite low (at 0.1% of the
value of the assets being transferred), and
there is usually a ceiling of Rs.100, 000 on the
duty payable on any transaction.
Even among these states, there are variations
in the stamp duty laws. A consequence of the
differential stamp duty rates is that if a
document executed in one state is taken into
another state, the document is liable to be
stamped in the second state if the stamp duty
in the latter is higher. Therefore, it is essential
that the underlying security (if any) for the
transferred receivables is located in states
with similar or a lower stamp duty than the
state in which the transfer document has been
executed.
CRISIL examines the transaction documents
to ensure compliance with the relevant stamp
duty regulations, so that no future liability
arises on this account to the investors.
+ Registration of documents transferring interest in
immoveable assets
In terms of the Transfer of Property Act, any
document evidencing the transfer of
immoveable property or interest in
immoveable property has to be registered
with the Registrar of land records for the area
in which that property is located. CRISIL
therefore requires any document transferring
legal or beneficial interest in immoveable
property to be registered.
SECURITISATION - LEGAL ISSUES AND COMPLIANCE REQUIREMENTS
+ Cash collateral
CRISIL requires the cash collateral to be
bankruptcy remote from the originator i.e. in
case of default of the originator, the funds in
the cash collateral account may be frozen by
the Trustee and used to pay the investors.
Therefore CRISIL stipulates the following
where the credit enhancement is in the form
of cash collateral:
= The cash has to be maintained in a separate
account. If the account is a current account
then the documents have to expressly state
that the money lying in the account is being
held in trust for the benefit of the Trustee.
The cash collateral can also be maintained
as a fixed deposit, in which case the
maturity proceeds of the deposit have to be
endorsed in favour of the Trustee upfront.
The originator may however be a
beneficiary to the residual amounts, if any,
in the fixed deposit after payments from the
same have been made.
= There should be a separate agreement
entered into between the account bank, the
Trustee and the originator, laying down the
mode of operation of the cash collateral
account and the rights and liabilities of the
respective parties in respect of the account.
CRISIL requires that the legal opinion
furnished by the originator also confirms the
bankruptcy remoteness of the cash collateral
from the originator.
+ Guarantee/corporate undertaking
In cases where the credit enhancement is in
the form of a guarantee or a corporate
undertaking, CRISIL requires that these be
unconditional and irrevocable. CRISIL will
examine the documents to determine this
and also ask for a legal opinion confirming
that the guarantee is unconditional and
irrevocable.
55
CRITERIA - Structured Finance
Legal Opinion
For every transaction CRISIL requires the
originator to obtain a legal opinion from the
transaction counsel3 confirming the following:
(a) That the transfer of the assets is not in
contravention of the underlying loan documents;
(b) That the transfer of the assets to the SPV
constitutes a true sale;
(c) That the credit enhancement:
+ if in the form of cash, is bankruptcy remote
from the credit enhancer/originator
+ if in the form of a guarantee or corporate
undertaking, is enforceable by the Trustee
and is irrevocable and unconditional;
(d) That the transaction documents are valid and
enforceable and not in contravention of any
applicable law currently prevailing;
(e) That all transaction documents have been duly
executed in accordance with the prevailing stamp
duty and registration laws.
Crisil's compliance requirements
CRISIL initially issues a provisional rating. Within
90 days from the date of the provisional rating, the
originator must comply with the following:
+ Submit copies of all executed transaction
documents to CRISIL.
+ Submit a letter from the Trustee confirming that
the transaction documents have been executed
to the Trustee's satisfaction.
+ Furnish representations and warranties as
stipulated by CRISIL.
+ Submit an auditor's certificate where required.
+ Submit the legal opinion obtained from an
independent counsel.
CRISIL examines all the documentation to
determine that it is in line with the transaction
structure as envisaged by us at the time of rating.
3
The content of the opinion will however vary depending on the facts of a transaction.
56
If all documentation and other compliances are to
CRISIL's satisfaction, CRISIL will issue a
compliance letter and final rating for the
transaction. If the compliance requirements are
not fulfilled within the stipulated timeframe,
CRISIL may withhold the final rating and put the
rating on watch.
2. LEGAL AND COMPLIANCE
REQUIREMENTS FOR FUTURE FLOW
TRANSACTIONS
A future flow securitisation transaction
essentially involves prioritisation of the cash
flows of the issuer to meet the rated debt
repayments on a priority and hence, a legally
sound escrow arrangement forms a cornerstone
of this transaction. In all such cases, CRISIL
stipulates that the issuer is required to maintain
an escrow account into which all amounts due on
the instrument from time to time are deposited.
As the rating is dependent on payments from the
escrowed cashflows, it is essential that the
cashflows are accessible to the Trustee/investors
at all times. Therefore, CRISIL requires the escrow
account to be a no-lien account, which should be
charged to the Trustee. Alternatively, the issuer
should declare trust over the account. Further,
CRISIL requires that the account be operated only
in accordance with the Trustee's instructions.
In order to ensure that the investors will have
unrestricted right to the escrowed cashflows,
CRISIL ascertains whether the cashflows are
subject to any prior encumbrances. If such
encumbrances do exist, CRISIL requires the issuer
to obtain the requisite consents/no-
objection/pari passu letters.
Typically, CRISIL stipulates a payment structure
to be followed by the issuer and the Trustee.
Therefore, CRISIL requires that the payment
structure be documented and confirmed by all
parties to the transaction, i.e. the issuer, the
Trustee and the bank which holds the escrow
account. CRISIL also insists that the payment
structure be disclosed in the offer document.

Compliance requirements
CRISIL initially issues a provisional rating. Within
90 days from the date of the provisional rating, the
originator must provide the following documents
to CRISIL:
+ A tripartite agreement between the Trustee, the
issuer and the account bank, incorporating the
payment structure and establishing the
Trustee's rights over the cash flows.
+ Trustee agreement.
+ Offer document, containing the stipulated
payment mechanism.
CRISIL examines all the documentation to
determine that it is in line with the transaction
structure as envisaged at the time of rating.
If all documentation and other compliances are to
CRISIL's satisfaction, CRISIL will issue a
compliance letter and final rating for the
transaction. If the compliance requirements are
not fulfilled within 90 days from the date of the
provisional rating letter, CRISIL may withhold the
final rating and place the rating on watch.
3. LEGAL AND COMPLIANCE
REQUIREMENTS FOR GUARANTEED
RATINGS
CRISIL's ratings on debt instruments carrying a
full or partial guarantee are based on an
unconditional, irrevocable and legally enforceable
guarantee. The legality of the guarantee assumes
paramount importance in such transactions. This
section highlights the legal and compliance
requirements for all guaranteed ratings assigned
by CRISIL.
In all guaranteed transactions, CRISIL examines
the guarantee document4 to ensure inclusion for
the following clauses:
+ The guarantee should specifically state that the
Guarantor's obligations are unconditional and
irrevocable.
+ There should be no ambiguity regarding the
quantum of the Guarantor's obligation; that is
the document should be clear that the
Guarantor will be liable for entire principal as
4
CRISIL provides the option to the issuers to adhere either to CRISIL's standard guarantee format or a format of issuer's choice. A legal opinion
may not be required if the issuer / guarantor chooses to execute the guarantee document as per CRISIL's standard guarantee format.
SECURITISATION - LEGAL ISSUES AND COMPLIANCE REQUIREMENTS
well as interest payments in case of full
guarantee. In case of partial guarantee, extent
of guarantor's liability, on both interest and
principal obligations, should be clearly
mentioned.
+ The Guarantor's liability should continue even
if the Issuer makes a reference to the BIFR or
files for winding up or effects a change in its
management.
+ The Guarantor's liability should continue
regardless of a change in the Trustee
+ If CRISIL has stipulated a payment structure,
CRISIL requires the Guarantor to confirm that it
will adhere to the structure, in the guarantee
document.
In addition to this, CRISIL may require the issuer
to furnish an independent legal opinion
confirming that the guarantee is unconditional
and irrevocable.
Compliance requirements
CRISIL initially issues a provisional rating.
Within 90 days from the date of the provisional
rating, the originator must provide the following
documents to CRISIL:
+ Guarantee deed (if a payment structure has
been stipulated, this document should
incorporate the same)
+ Offer document
+ Trustee agreement
CRISIL examines all the documentation to
determine that it is in line with the transaction
structure as envisaged at the time of rating.
If all documentation and other compliances are to
CRISIL's satisfaction, CRISIL will issue a
compliance letter and final rating for the
transaction. If the compliance requirements are
not fulfilled within 90 days from the date of the
provisional rating letter, CRISIL may withhold
the final rating and place the rating on watch.
57
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Analytical Contacts
Managing Director & Chief Rating Officer
R. Ravimohan

Executive Director & Chief Rating Officer

Roopa Kudva

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G.V. Mani
Director
Tel.: + 91 (22) 5691 3300
Email: gvmani@crisil.com

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Head
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Structured Finance Ratings

Arun Panicker
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CRITERIA - Structured Finance

Sachin Gupta
Head
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Email: sgupta@crisil.com

Hani Jalan
Manager
Tel.: + 91 (22) 5691 3077
Email: hjalan@crisil.com

Design and Production DISCLAIMER

Varsha Tahiliani
CRISIL has taken due care and caution in compilation of the data for this publication. Information has been obtained by CRISIL from sources, which
Manager it considers reliable. However, CRISIL does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any
Email: vtahiliani@crisil.com errors in transmission and especially states that it has no financial liability whatsoever to the users/transmitters/distributors of this publication.
No part of this report, may be reproduced in any form or by any means without the permission of CRISIL. Contents may be used
by news media with due credit to CRISIL.
© CRISIL. All rights reserved.
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January 2006

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Structured Finance
January 2006

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