ASSIGNMENT OF WORKSHOP ON INNOVATIVE FINANCIAL PRODUCTS TOPIC: SECURITIZATION A FUNDING MECHANISM

Submitted To Mrs. Kuldeep Kaur (Asst. Professor) GNKCW Submitted By Avneet Kaur M.Com IInd (3rd Sem.) Roll No. 2516 2011- 12

SECURITIZATION
Securitization is the process of conversion of existing assets or future cash flows into marketable securities. In other words, securitization deals with the conversion of assets which are not marketable into marketable ones. For the purpose of distinction, the "conversion of existing assets into marketable securities is known as asset-backed securitization and the conversion of future cash flows into marketable securities is known as future-flows securitization.

Some of the assets that can be securitized are loans like car loans, housing loans, and future cash flows like ticket sales, credit card payments, car rentals or any other form of future receivables. Suppose Mr. X wants to open a multiplex and is in need of funds for the same. To raise fluids, Mr. X can sell his future cash flows (cash flows arising from sale of movie tickets and food items in the future) in the form of securities to raise money.

This will benefit investors as they will have a claim over the future cash flows generated from the multiplex. Mr. X will also benefit as loan obligations will be met from cash flows generated from the multiplex itself.

SECURITIZATION - A FUNDING MECHANISM

Section 5 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, mandates that only banks and financial institutions can securities be financial assets In the traditional lending process, a bank makes a loan, maintaining it as an asset on its balance sheet, collecting principal and interest, and monitoring whether there is any deterioration in borrower's creditworthiness. This requires a bank to hold assets (loans given) till maturity. The funds of the bank are blocked in these loans and

to meet its growing fund requirement a bank has to raise additional funds from the market. Securitization is a way of unlocking these blocked funds. For example: Consider a bank, ABC Bank, the loans given out by this bank are its assets. Thus, the bank has a pool of these assets on its balance sheet and so the funds of the bank are locked up in these loans. The bank gives loans to its customers. The customers who have taken a loan from the ABC bank are known as obligors. To free these blocked fends the assets are transferred by the originator (the person who holds the assets, ABC Bank in this case) to a special purpose vehicle (SPY). The SPY is a separate entity formed exclusively for the facilitation of the securitization process and providing funds to the originator. The assets being transferred to the SPV need to be homogenous in terms of the underlying asset, maturity and risk profile. What this means is that only one type of asset (eg: auto loans) of similar maturity (eg: 20 to 24 months) will be bundled together for creating the securitized instrument. The SPV will act as an intermedian which divides the assets of the originator into marketable securities.

These securities issued by the SPV to the investors and are known as passthrough-certificates (FTCs).The cash flows (which will include principal repayment, interest and prepayments received ) received from the obligors are passed onto the investors (investors who have invested in the FTCs) on a pro rata nj basis once the service fees has been deducted. The difference between rate of interest payable by the obligor and return promised, to the investor investing in PTCs is the servicing fee for the SPV.

The investors can be banks, mutual fluids, other financial institutions, government etc. In India only qualified institutional buyers (QIBs) who posses the expertise and the financial muscle to invest in securities market are allowed

to invest in PTCs. Mutual funds, financial institutions (FIs), scheduled commercial (j banks, insurance companies, provident funds, pension funds, state industrial tj development corporations, fall under the definition of being a QTB. The reason for the same being that since PTCs are new to the Indian market only informed big players are capable of taking on the risk that comes with this type of investment.

Thus, Securitization acts as a funding mechanism, because the foods generated from it can foe used by the banks for other profitable purposes. For example: For an originator (ABC bank in the example), securitization is an alternative to corporate debt or equity for meeting its funding requirements. As the securitized instruments can have a better credit rating than the company, the originator can get funds from new investors and additional funds from existing investors lower cost than debt.

STEPS FOLLOWED IN SECURITIZATION PROCESS

1. The steps involved in the securitization process are following: The originator or lending institution identifies the asset out of its portfolio for securitization. The identification of assets has to be done in a manner so that an optimum mix of homogeneous -assets having almost same maturity forms the portfolio. 2. The aforementioned pool of identified assets is then 'passed through' to another institution, called a special purpose vehicle (SPV) usually by way of trust. Such trust, which is usually an investment banker, issues the securities to investors. So once the assets transferred they are no longer held in the originator's portfolio. 3. After acquisition of the assets, the SPY splits the pool into individual shares or securities and reimburses itself by selling these to investors. These securities are known as pay or pass through certificates. These securities are normally

without, recourse to the originator.. Thus investor can hold only SPV liable for principal repayment and interest recovery. 4. In order to make issue attractive, the SPV enters into credit enhancement procedures either by obtaining an insurance policy to cover the credit losses or by arranging a credit facility from a third party lender to cover the delayed payments. To increase marketability of securitized assets in the form of securities, these may be rated by some reputed credit rating agencies. Credit rating increases the trading potentials of the certificate thus its liquidity is enhanced. The investors' confidence is heightened owing to third party objectivity of the rating agencies. The pass through certificates before maturity are tradable in a secondary market, to ensure liquidity for the investors. Once the end investor gets hold of these instruments created out of securitization, he is to hold it for a specific maturity period, which is well defined, with all other related terms and conditions on maturity, the end investors gets redemption amount from the issuer along with interest due on the amount.

THE SECURITIZATION ACT, 2002

The securitization and reconstruction of financial assets and enforcement of security interest act, 2002 has come into force w.e f. 21, Junb 2002. The act aims to regulate |securitization and reconstruction of financial assets and enforcement of security interest and for the matters connected therewith or incidental thereto. Background: Before the enactment of the act , banks and financial institutions had only one option available to recover their non performing assets (NPAs) i.e. by way of filling the cases against the borrower in the debt recovery tribunals(DRTs) set up under the recovery of debts due to banks and financial institutions act ,1993 or in civil courts.

Unfortunately, the judicial process is often lengthy one, with the result that DRTs have not been able to recover the huge burden of NPAs amounting to Rs.70000 crores. The banking sector always wanted that they be granted some additional power to recover their NPAs on their own, either by direct auction or through specialized agencies. The securitization and reconstruction of financial assets and enforcement of security interests act, 2002 finally has met their long standing demand. Purpose of the act: it gives power to secured creditor such as banks or financial institutions. It gives them option to either: (a) Transfer securities, interest to a securitization company or reconstruction company or (b) to enforce the provisions of its own. Under section 13(4), the secured creditors may, after 60 days notice;
(1) Take (2) Take

possession of the assets and dispose them of. over the management of the assets. . an amount from the acquirer of the security who owes a sum on that

(3) Claim

account to the borrower. Non-performing assets defined 1. Interest and /or instalment of principal remain over due for a period of more than 90 days in respect of term loan 2. The account remains out of order for a period of more than 90 days, in respect of an Overdraft/cash credit. 3. The bill remains overdue for a period of more than 90 days in the case of bill purchased and discounted. 4. Any amount to be received remains overdue for a period of more than 90 days in respect of other accounts.

Short summary of the act: 1. Pre-requisstes to form registered securitization company/asset

Reconstruction Company. A securitization company can commence the business of securitization of asset reconstruction if: It is registered under this act. Any existing securitization company shall make an application for registration to RBI within 6 months from the commencement of this act. It has owned foods of at least Rs. 2 crores or an amount not exceeding 15% of total financial assets acquired/to be acquired by the company. The form and manner of the application are to be prescribed by the RBI The RBI shall for the purpose of considering the application for registration shall conduct the inspection of books and records of the company to satisfy itself about the compliance with terms and conditions laid down in the act. The company should not have incurred losses in any of three preceding financial years. The company has made adequate arrangements for the realization of financial assets and shall be able to pay periodical returns and redeem the investment made in the company. The directors have adequate professional experience related to finance. 2. Rejection of application: the registration to the securitization company shall on such, term and conditions as RBI may deem fit. The RBI may reject the application 3 after giving the applicant a reasonable opportunity of being heard. 3. Prior approval: RBIs prior approval shall be required in case of any substantial change in management of the company or change in the registered office or change in its name. 4. Cancellation of certificate of registration. The RBI may cancel the certificate if the company: Ceases to carry on business of securitization

 Ceases to receive or hold any investment from a qualified institutional buyer (investor of the company). Fails to follow any of the other prudential norms of the RBI; Fails to maintain accounts in accordance with the requirements of any law or any direction or order issued by the RBI under this act. Fails to submit or offer for inspection its books of accounts or other relevant documents when so demanded by the RBI 5. Filing of an appeal: on cancellation of the registration above, the company may file an appeal with the central government within a period of 30 days from the date of the service of the notice. The application may be rejected but only after giving the applicant reasonable opportunity if being heard.

Positive aspects of the act 1. Development of securitization market: the ordinance would help in the development of securitization market in India. It brings clarity on some of the important areas in the securitization deals. In effect, laws governing securitization have become clear. This would help in the growth of securitization market in India, which so far has been very small. 2. Speedy recovery of NPA's: the act by empowering the bank/FIs to unlock their NPA's on their own has united their hands. There are hopes the empowerment will go a long way in bringing back into circulation the massive amount of locked up funds in the form of NPAs. 3. Boost to private sector: the act opens up completely new areas of private sector in the form of securitization companies or asset reconstruction companies.

4. Reconstruction of sick mills: it will lead to the reconstruction of decaying, financial assets, a large number of which are sick industrial units, which will give| boost to the overall health of the economy.

The gaps and the complications/some issues: In spite of many good objects and merits, the act is subject to following gaps and complications: 1. Misuse of the act: any legislation that empowers one party to a dispute (in case o f the creditor) to take action without due judicial process against the other party (borrower) has an in-built tendency for misuse. In their eagerness to recover their NPAs, the banks/FIs or asset reconstruction companies may violate the fundamental rights of the borrowers which may lead to unnecessary disputes. 2. Narrow in approach: it is narrow in approach as it is applicable only to financial assets and that too by banks and financial institutions. The investment is permitted only to qualified institutional buyers (QIBs). 3. Double protection to the creditor: the banks/FIs have been empowered to act on their own to recover their dues out of court and simultaneously through judicial process which amounts to double protection of the creditor. Whereas the borrower has .been left with almost no remedy except to challenge the action in courts which seems to be unreasonable 4. Involves additional expenditure: the recovery through securitization! company/asset Reconstruction Company involves extra expenditure which the act stipulates to be an additional burden on the borrower whereas by way of recovery through DRT/civil courts this expenditure could be saved. 5. Entry barrier: the ordinance also imposes an entry barrier in terms of 'owned foods. Every entity wanting to do the business of securitization have to have minimum owned fund of Rs. 2 crores.

6. No immediate recovery: the act provides that the securitization company may: acquire financial assets of banks/FIs by issuing a debenture or bond. Thus the actual recovery of dues will not take effect immediately.

SECURITIZATION IN INDIA
The process of securitization had its beginning in India in February, 1991 when city bank securitized its own ear loans, portfolios in may 1992. Beside this bank, country wide consumer financial service and ICICI credit corporation are other major players in the field. Some new entrants such as SBI, bank of India, and standard charted bank 'have shown keen interest.

CONCLUSION
Only time would tell how effective the ordinance really is and how quickly the banks and financial institutions would be able to recover the bad loans from the borrowers. The experts found that securitization of assets could be a new source for recycling in addition to the usual recovery method.