SECURITISATION ACT

Submitted By
Arun Raj Gautham M Magesh Kumar C Nandhini K Saravana Krishnan P Suganya R (28006) (28016) (28027) (28030) (28040) (28052)

3/9/2012

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TABLE OF CONTENTS

S. No.

CONTENTS

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INTRODUCTION SECURITISATION PARTIES INVOLVED WORKING OF SECURITISATION BENEFITS OF SECURITISATION SECURITISATION ACT CASES OF SECURITISATION MARDIA CHEMICALS LTD AND OTHERS VS UNION OF INDIA CONCLUSION REFERENCES

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INTRODUCTION:

Normally in a transaction, there is a lender who gives money to the borrower and the lender collects the money with interest. In some cases the borrower may be unable or unwilling to repay the loan. This is when the concept of secured loans came into picture. The borrower offers collateral such as real estate or other fixed assets which are acquired by the lender in case of any contingencies. The lender may sell the asset and recover the money. But in India this seizing of assets within a specific time limit is very hard. The legal system makes it nearly impossible to seize the assets of the borrowers who default. There are numerous hearings which can go on for decades. Borrowers can afford to ignore the creditors and pay the legal fees. These will result in bad debts across the entire financial system. These will drive up the cost of loans and will make it difficult to attain capital by the lenders. These bad debts are not good for the financial institutions. These are called Non Performing Assets.

SECURITISATION:
Securitisation is the process of collecting and packing of illiquid financial assets into marketable securities that can be sold to investors. It has become an important means of financing. A Securitisation transaction will involve the following steps 1. Creating a special purpose vehicle which will hold the financial assets underlying the securities. 2. Sale of the financial assets by the originator or holder of the assets to the special purpose vehicle, which will hold it and realize it in time. The advantage of this is that it will remove the creditors from the balance sheet of the lender which may become a bad debt and provides them immediate liquidity to the lenders. The need for Securitisation is very old. This Securitisation will make the cost of capital reasonable for the borrowers and also there will be lot of lenders in the market. SPVs are also homogenous which can be easily credit rated by the credit rating agencies.

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PARTIES INVOLVED:
1. Origination and Servicing

The assets used in Securitisations are createdor originatedin a number of ways. When a lender extends a loan or acquires another revenue-producing asset such as a lease, they are creating assets that can be securitized. Other assets, such as the balances due on credit card accounts or a corporation's accounts receivable can also be securitized. Because they initiate the Securitisation chain, the lenders, credit card companies and others are also called originators. Originators often retain a connection to their assets following a Securitisation by acting as a servicerthe agent collecting regular loan or lease payments and forwarding them to the SPV. Servicers are paid a fee for their work. Some originators contract with other organizations to perform the servicing function, or sell the servicing rights. 2. Asset Transfer or the "True Sale" In the vast majority of Securitisations, it is critical that the transfer of assets from the originator to the SPV is legally viewed as a sale, or "true sale." The proceeds of the securities are remitted to the originator as the purchase price for the assets. If the asset transfer is not a "true sale," investors are vulnerable to claims against the originator of the assets. The cash flows backing the securities or the assets themselves could be ruled a part of the originator's estate and used to satisfy creditors' claims if a true sale did not occur. Legally separating the assets also protects the originator. Investors can turn only to the SPV for payments due on the ABS and MBS, not to the general revenues of the originator. 3. Special Purpose Vehicle and the Trust The SPV can either be a trust, corporation or form of partnership set up specifically to purchase the originator's assets and act as a conduit for the payment flows. Payments advanced by the originators are forwarded to investors according to the terms of the specific securities. In some Securitisations, the SPV serves only to collect the assets which are then transferred to another entityusually a trustand repackaged into securities. Individuals are appointed to oversee the issuing SPV or trust and protect the investors' interests. The originator, however, is still considered the sponsor of the pool. 4. Underwriter Underwritersusually investments banks serve as intermediaries between the issuer (the SPV or the trust) and investors. Typically, the underwriter will consult on how to structure the

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ABS and MBS based on the perception of investor demand. The underwriter may, for example, advise the SPV to issue different tranches each with specific characteristics attractive to different segments of the market. Underwriters also help determine whether to use their sales network to offer the securities to the public or to place them privately. Perhaps most importantly, underwriters assume the risk associated with buying an issue of bonds in its entirety and reselling it to investors. 5. Credit Enhancement Credit enhancement is common in Securitisation transactions. Depending on the nature of the transaction and the type of assets, the Securitisation pool may need such support to attract investors. Enhancement or support can come from the assets themselves or from an external source. Examples of internal enhancements include subordinating one or more tranche, or portion, of the securities issued. This practice places the claims of one tranche over another. Any defaults affecting the securities must be absorbed by a subordinate tranche before the senior tranche is affected. Over-collateralization of asset pools is also used to enhance credit. This occurs when the amount of assets placed in a Securitisation pool exceeds the principal amount of bonds issued. External credit enhancements can include a surety bond or a letter of credit from a financial institution. Both options serve as guarantees that investors will receive the payments associated with the securities. GSEs enhance the credit of the MBS they issue by guaranteeing the timely repayment of principal and interest. 6. Credit Rating Virtually all ABS and MBS are rated by independent rating agencies whose analyses is watched closely by investors as a guide to the credit quality of the securities. In almost all cases, rating agencies monitor the performance of the securities on an ongoing basis. 7. Dealers Just as in other bond markets, dealers play an important role once an issue is initially distributed. For most bond investors, liquiditythe ability to easily buy or sell a securityis an important characteristic. By offering prices at which they will buy or sell bonds to the investment community, dealers provide this service. Bonds typically trade more actively closer to their date of issue. Because bond investorsusually institutional investors such as pension funds and insurance companieshold most bonds to maturity, trading in bonds declines as they draw nearer to their stated maturity date. The issuance volume of a certain bond, a bond's credit rating and whether it was issued publicly or privately can also affect liquidity. All ABS and MBS are traded on the dealer-based, over-the-counter markets so liquidity depends in part on

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the ability and willingness of dealers to maintain an inventory, or make a market, in a certain bond.

WORKING OF SECURITISATION:
ABS and MBS represent an interest in the underlying pools of loans or other financial assets securitized by issuers who often also originate the assets. The fundamental goal of all Securitisation transactions is to isolate the financial assets supporting payments on the ABS and MBS. Isolation ensures payments associated with the securities are derived solely from the segregated pool of assets and not from the originator of the assets. By contrast, interest and principal payments on unsecuritized debt are often backed by the ability of the issuing company to generate sufficient cash to make the payments.

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Though there is no basic difference in terms of the essential structure, some differences arise by the very nature of the collateral and the motives of the issuer. The important points of difference are:

The number of obligors in the collateral pool is not many: unlike mortgage portfolios or auto loans portfolios having thousands of obligors, CDO pools will have 100 -200 loans. The loans/ bonds are mostly heterogeneous. The originator might try to bunch together loans which do not exhibit any mutual correlation, to provide benefits of a diversified portfolio. Most CDO structures use a trenched, multi-layered structure with a substantial amount of residual interest retained by the originator. Generally, CDO issues will use a reinvestment period and an amortization period. Some tranches might have a "soft bullet" repayment (meaning a bullet repayment that is not guaranteed by any third party). A common practice in CDO market is arbitraging, where larger banks buy out loans from smaller ones and securitize them, making arbitrage revenues in the process.

Securities issued by Special Purpose Entity 1. Asset Backed Securities Securities issued by SPV in a Securitisation transaction are referred to as Asset Backed Securities (ABS) because investors rely on the performance of the assets that collateralize the securities. They do not take an exposure either on the previous owner of the assets (Originator) or the entity issuing the securities (the SPV). 2. Mortgage Backed Securities (MBS) these securities are the same as the ABS except they are backed by the mortgages.

BENEFITS OF SECURITISATION:
Less Expensive, More Broadly Available Credit The public benefits of Securitisation are evident in a number of ways. Chief among these is the contribution of Securitisation to lower borrowing costs both for individuals and corporations. The existence of a liquid secondary market for home mortgages increases the availability of capital to make new home loans. Financial institutions that realize the full value of their loans immediately can turn around and re-deploy that capital in the form of a new loan. This is often the most efficient way to raise new funds in the capital markets and the savings are passed on to the borrower.

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Consumers other than homebuyers also benefit from lower borrowing costs. Securitisation can lower a firm's financing costs as well. MBS and ABS are often designed to carry a higher credit rating than the originating firm would otherwise realize for other types of bonds. Higher credit ratings mean the security is less risky and translates into a lower interest rate for the originator as investors do not demand the same risk premium. The originator passes the savings on to the consumer in the form of lower lending rates. Securitisation also aids in the geographic dispersion of capital to areas that may otherwise be deprived of credit options. Traditionally, depository institutions have provided credit in the areas where they accepted deposits. By securitizing loans, however, the lender generates capital for new loans that may come from a different location. This linkage to the capital markets broadens the range of regions where depository institutions obtain capital to provide credit. By subjecting the lending decisions of financial institutions to valuation by the capital markets, Securitisation also encourages an efficient allocation of capital. Financial institutions and others who securitize assets depend, of course, on investors. Investors seek an appropriate return based on a level of risk. If the asset pools are not of a sufficient quality, for example, investors will demand a higher interest rate as compensation. At its most basic level, Securitisation is the process of isolating risk and repackaging it for investors. This increases efficiency in the capital market by removing intermediary steps between investors and the risk they are assuming. A money manager, for example, may be interested in a mortgage-backed bond that pays interest and principle on a monthly basis, but not in the debt securities issued by the originator of the securitized assets. Securitisation reallocates risk at many levels. By shifting the credit risk of the securitized assets (for a price) to ABS and MBS investors, financial institutions can reduce their own risk. As the risk level of an individual institution declines, so does systemic risk, or the risk faced by the financial system overall. More Options for Investors As noted above, investors benefit from the legal segregation of the securitized assets. The segregation protects the payment stream on the MBS and ABS from a bankruptcy or insolvency. Higher-rated securitized instruments generally offer higher yields than similar sovereign government issues. The actual size of this yield premium, the yield the securities pay in excess of similar government securitieswill depend on the credit quality of the assets and the structure of the transaction. Pension fundswhich comprise much of the market for MBS and ABSpay close attention to this premium as they seek a wide variety of safe fixed income products with attractive yields. Insurance companies, money managers and other institutional investors with needs for fixed-income securities with specific features are also large ABS/MBS investors.

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The ability of issuers to vary the terms of securities backed by the same asset pool through different Securitisation techniques also makes MBS and ABS attractive to investors. In a sense, issuers can tailor the coupon, maturity and seniority of a security according to particular investor's needs. This flexibility not only boosts investor interest in ABS and MBS, but also contributes to more efficient capital markets by ensuring investors and money managers have access to the most appropriate securities. Flexibility for the Originator Securitisation also benefits the financial institution or corporation that originates the securitized asset. Without Securitisation, a bank making a home loan usually would hold that loan on its books, recognizing revenue as payments are made over time. To realize the value of the loan immediately, the bank can sell the whole loan to another institution, though this is generally not economical unless the loan is very large. The more efficient option is to pool similar loans together, as discussed above, and enters into a Securitisation transaction. The process makes even more sense for originators with assets considered illiquid, such as equipment leases or the balance due on a credit card. The latter comprises an asset class called credit card receivables that account for approximately 20 percent of outstanding ABS. Similar to banks securitizing home loans, credit card companies are able to use the Securitisation process to provide more credit and manage their balance sheets. Originators realize another benefit from Securitisation as the transfer of the asset to an SPV removes it from the firm's balance sheet. This can help the originator improve certain measures of financial performance such as return-on-assets (ROA). A way to gauge a firm's efficiency, ROA tells observers how many dollars are earned for every dollar of assets. Moving an asset off of the balance sheet while simultaneously increasing income has a positive effect on ROA and demonstrates to investors a more efficient use of capital. Banks realize a unique advantage from Securitisation. Removing loans from their balance sheet can lower regulatory capital requirements, or the amount and type of capital banks must hold given the size of their loan portfolio, to reflect lowered risk. The segregation of assets that takes place in a Securitisation can also effectively lower the firm's financing costs. This occurs when the securities issued by the SPV carry a lower overall interest rate than the originating firm pays on its debt. As the firm receives the proceeds from the Securitisation it has, in effect, achieved cheaper financing than might have been extended to the firm based solely on its own credit rating.

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Transfer of Risk

The transfer of assets to SPV will transfer all the risk associated with it. The risk may be currency risk, default risk, inherent risk.

SECURITISATION ACT:
The Securitisation And Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act) is a mix of three different things - Securitisation, Asset management companies and enforcement of security interests on loan defaults to banks. The basic intention behind this act is to strengthen creditor rights through foreclosure and enforcement of securities by banks and financial institutions. By conferring on lenders the right to seize and sell assets held as collateral in respect of overdue loans, it allows banks and financial institutions to recover their dues promptly without going through a costly and timeconsuming legal process. The Act contains VI chapters and 42 sections. It came into force on 21st June 2002. It is applicable to the whole of India.

CASES OF SECURITISATION:
First deal in India between Citibank and GIC Mutual Fund, in1990 for Rs. 160 million. Securitisation of cash flow of high value customers of Rajasthan State Industrial and Development Corporation in 1994-95, structured by SBI cap. NHB-HDFC Securitisation deal of Rs. 597 million based on the receivables of 8330 housing loans in August 2001. Securitisation of overdue payments of UP government to HUDCO by issue of tax- free bonds worth Rs. 500 million NHB entered into a securitisation deal with HDFC, LIC Housing Finance, Canfin Homes and Dewan Housing. Securitisation of Sales Tax deferrals by Government of Maharashtra in August 2001 for Rs. 1500 million with a green shoe option of Rs. 75 million. First deal in power sector by Karnataka Electricity Board for receivables worth Rs. 1940 million and placed them with HUDCO. The second MBS transaction through HUDCO. Mega securitisation deal of Jet Airways for Rs. 16000 million through offshore SPVs. ILFC sponsored securitisation of receivables by Varun Shipping. Data indicate that ICICI had securitised assets to the tune of Rs.27500 million in its books at end March 1999. Securitisation of lease receivables on power project by L&T

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MARDIA CHEMICALS LTD AND OTHERS VS UNION OF INDIA:

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We will deal with one case in detail, Mardia Chemicals Ltd and Others vs Union of India and Others. Now as regards constitutional validity of this Act, several aspects of the Act were highlighted in the case of Mardia Chemicals Ltd. v/s. Union of India (2004) 4 SCC 311. In this case dispute arose between Mardia and ICICI Bank. Under the provisions of this Act once a borrower turns a defaulter the lending bank has to give a 60 days notice enforcing the secured assets. Then after responding to the borrowers query, the bank has to wait for another 45 days before selling the assets. Meanwhile, if the borrower obtains a DRT stay the sale process will be stalled. In the instant case the lenders of Mardia Chemicals had taken possession of the Companys Vatva Plant in Surendra Nagar district of Gujarat in December 2002. Mardias outstanding dues were close to 1500 crore of which the principal amount was Rs.800 crore of this, company owes around 300 crore to ICICI Bank. The principal dues of ICICI Bank were Rs.190 crore. The Court had earlier restrained banks from selling the secured assets that has been attached. Several borrowers had also stalled banks and institutions from disposing off assets, which were attached under the SRAFESI Act. Mardia had challenged the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, which allows lenders to attach and sell secured assets of defaulters. The Bench of the Supreme Court comprising CJ V.N. Khare, Justice Brijesh Kumar and Justice Arun Kumar upheld the Constitutional validity of this Act on 8.4.2004 but the Court struck down Section 17(2) of the Act which made it mandatory for borrowers to deposit 75% of the claim amount as a precondition to challenging the lenders action at Debt Recovery Tribunals. This will of-course encourage borrowers to move DRTs against the lenders delaying the entire process because till now banks could realize at least 75% of their claim had they won the case without selling assets as the money would have already been deposited with the DRTs. Lenders would now be required to actually sell the seized assets to realize their money. This is one of the offshoots of this verdict. The Supreme Court, in its judgment in the matter of case upheld the constitutional validity of the SARFAESI Act but struck down a section which state that a deposit of 75% of the claimed amount before the appeal is admitted by DRT. The Supreme Court also held that after the service notice, if the borrower raises any objection or places facts for consideration of the creditor, the same may be considered with due application of mind and reasons for accepting the objection must be communicated to the borrower. However, the borrower will be able to move the secured creditor has taken the DRT only after the possession of secured asset. To bring the provisions of the act in conformity with the judgment of the honble supreme court order, to dissuade the borrower from indulging in dilatory tactics with a view to postpone the repayment of dues and to enable secured creditors to make speedy recovery by

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enforcement of securities, the Securitisation and reconstruction of financial assets and enforcement of security interest act, 2002 has been amended by promulgation of the enforcement of security interest and recovery of debt laws (Amendment) ordinance, 2004 on 11.11.2004. In its final verdict the court also gave DRTs power to not only stall banks from selling secured assets but also to give an interim relief to borrower and that borrowers no longer need to deposit up to 75% of the outstanding dues to move the DRT. These things were favorable to borrowers. However, Mardia Chemicals has recently got stay order against ICICI Bank from the Ahmedabad Debt Recovery Tribunal, which has restrained the bank from attaching the companys property at Surendra Nagar in Gujarat. It is just an ex-partee stay and it looks that the bitterest battle would be a long drawn one. In this fiercely contested matter, we come across a rare intellectual and judicial dexterity in conceptualizing a public interest concept.

CONCLUSION:
Securitisation reflects innovation in the financial markets at its best. Pooling assets and using the cash flows to back securities allows originators to unlock the value of illiquid assets and provide consumers lower borrowing costs at the same time. MBS and ABS securities offer investors with an array of high quality fixed-income products with attractive yields. The success of the Securitisation industry has helped many individuals with subprime credit histories obtain credit. Securitisation allows more subprime loans to be made because it provides lenders an efficient way to manage credit risk. Efforts to curb predatory lending that inhibit the legitimate use of Securitisation by assigning liability to the purchaser of a loan or some other means, threaten the success of the beneficial subprime market. Secondary market purchasers of loans, traders of securitized bonds and investors are not in a position to control origination practices loan-by-loan. Regulation that seeks to place disproportionate responsibilities on the secondary market will only succeed in driving away the capital loan purchasers provide in the subprime market. The Act and the notice could be primarily used as a powerful bargaining tool while negotiating with the defaulter. This puts banks on stronger ground in salvaging sticky loans. The banks will now have a clear edge in negotiations and also of recovering most of the dues particularly from willful defaulters.

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REFERENCES 1. SRAFESI Act 2002 passes the test by B M Mundra 2. Securitisation an Overview by Rajkumar S Adukiad

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3. SARFAESI Act-An Effective Remedy for Secured Creditors by Shantanu Jugtawat 4. http://www.thehindubusinessline.in/2005/02/18/stories/20050218024602 00.htm 5. http://www.thehindubusinessline.in/2004/06/07/stories/20040607001608 00.htm 6. http://www.articlesbase.com/national-state-local-articles/mardiachemicals-v-idbi-case-study-onset-of-Securitisation-in-india-532377.html