Securitization of Debt

Introduction
 Securitization is the financial practice of pooling various types of
contractual debt such as residential mortgages, commercial
mortgages, auto loans or credit card debt obligations and selling said
debt as bonds, pass-through securities or Collateralized Mortgage
Obligation (CMOs) to various investors.
 The principal and interest on the debt, underlying the security, is paid
back to the various investors regularly. Securities backed by mortgage
receivables are called Mortgage-Backed Securities while those backed
by other types of receivables are Asset-Backed Securities.
 Securitization has evolved from its tentative beginnings in the late
1970s to a vital funding source with an estimated outstanding of
$10.24 trillion in the United States and $2.25 trillion in Europe as of the
2nd quarter of 2008. In 2007, ABS issuance amounted to $3.46 trillion
in the US and $652 billion in Europe.
 WBS (Whole Business Securitization) arrangements first appeared in
the United Kingdom in the 1990s and became common in various
Commonwealth legal systems where senior creditors of an insolvent
business effectively gain the right to control the company.
 Introduction
 Securitization is the process in which the underlying pool of assets are
structured or packaged and sold as financial instruments to investors
either directly or through a Special Purpose Vehicle (SPV).
 Typically in India, the originators or sellers are Banks, NBFCs, HFCs &
others. The underlying assets are mainly secured loans like housing
loans, auto loans, commercial vehicle loans, construction equipment
loans, two wheeler loans, tractor loans, three wheeler loans and
unsecured loans like personal loans, consumer durable loans.
 The SPV is formed in the form of trust, settled and managed by a
trustee. The trust purchases the pool for a consideration either at par
or premium. The investors subscribes to the Pass through Certificates
(PTCs) issued by the trust. These PTCs are backed by the underlying
loan receivables and the beneficial interest lies with investors.
 The Servicer (typically, Originator in India) is appointed by the trust to
service the loans. Servicer passes on the periodic collections from the
underlying borrowers to the trust which is further passed on to the
investors as per scheduled payouts.
 Theme of Securitization
 Loan installments are receivables for such Banks, NBFCs,
HFCs & others. It can make a pool of such receivables and get
them rated from rating agencies.
 Ratings would ascertain the quality of these receivables. These
pooled and rated receivables can be sold to some other party
for cash.
 The party which buys these receivables would also be in
interest business or it could be a simple individual investor
having investible funds thereby making cash available to these
institutions upfront.
 These institutions would assign future receivables to these
investors . In this process, these institutions get its desired
differential rate of interest for the risk it has taken.
 Investors would get their desired rate of interest. All future
receivables (for these institutions) would be received by the
investors. This is more popularly called as securitization of
future receivables.
 Definition

 Securitization is a device of structured financing

where an entity seeks to pool together its interest
in identifiable future cash flows over time, transfer
the same to investors either with or without the
support of further collaterals, and thereby achieve
the purpose of financing.
 Securitization is a kind of financing but different
from traditional financing as the entity securitizing
its assets is not borrowing money but rather selling
a stream of its future cash flows that would’ve
otherwise got accrued.
 Process of Securitization

 Involving the Originator (entity (ie) NBFC that

securitizes its assets), Obligors (entities who owe
money to NBFC), SPV (intermediary between
originator and investors) and Investors (entities or
people who buy securitized instruments)
 Supporting parties are the Rating Agency and
Merchant Banker
 The securitization process basically involves 3
stages – Asset Identification, Structuring the
Securities (activities like Credit Enhancement,
Independent Credit Rating and Documentation) and
Investor Servicing (Interest and Principal Payment
and Providing liquidity support via appointment of
Market Makers)
 Assets for Securitization

 Real Estate Loans – mother of all securitizations and

popularly called as MBS, RMBS, CMBS, IMBS
 Auto Loans / Equipment Leases/Hire in Hire
Purchase – Loans for vehicles having repayment
periods from 3-7 years and popularly called as ABS
 Bank Loans Receivables – Banks’ term loan
receivables are securitized and popularly called as
CDOs and are usually by Pay Through Certificates
 Credit Cards Receivables – shortest duration
amongst all assets that are securitized and so it is
difficult to securitize
 Non Performing Assets/Loans – very unique class of
assets. 2 parts involved (ie) loss plus the other
recoverable part through legal process
 Parties involved in Securitization
 Originators
 Servicer’s – usually the originators or their affiliates
 Merchant Bankers – role of Underwriter in public offering, role
of Agent in private placement, Structuring the transaction and
Placing the securities for a fee
 SPV (ie) Issuer – Performs the tasks like being an intermediary,
pooling of receivables, holding of assets of investors and
issuing its own securities, issuer from the investors’ point of
view and bankruptcy remote transfer.
 Credit Enhancers – usually provided by the SPV (Issuer) or
third party in form of LC from a bank or issuance bond from a
firm with high credit rating
 Rating Agencies
 Trustees – intermediary between the servicer and investors and
credit enhancer and investors
Partial Guarantee (PG) Structures

 These are pay through or pass through certificates with

partial guarantee of the originator in case of default.
 This enhances credit quality and rating and so are
preferred by big financial institutions as opposed to full
guarantee.
 Such securities or instruments are usually listed on
exchanges and so are marketable in easy tradable lots,
secured by future cash flows with ratings from rating
agencies.
 In India, the investors are not familiar with securitized
instruments and thus such markets are not developed.
 Hence, such instruments are not listed and are only
sold through private placement.
 Benefits of Securitization to
Originators

 Liquidity
 Reduced Cost of Capital
 Profitability
 Risk Stripping
 Higher Capital Turnover
Benefits of Securitization to Investors

 New Avenue of Investment

 Diversified Risk
 Better Rate of Return
 Benefits & Demerits of Securitization
to the Economy

 Growth in Transactions
 Promotes Savings
 Promotes Socialism over Capitalism
 Less Importance to Banks & NPAs
(Demerits)
Benefits of Securitization to the Banks

 Bankers improve their CAR by securitizing

their future receivables as these receivables
get knocked-off from the balance sheet after
they are securitized.
 Bankers’ reduce NPAs by issue of CLOs
 Achieves greater liquidity
 Securitization and Banks

 Bankers are better placed to be originators because

they have so many assets in the form of mortgage
receivables and loan receivables.
 Where the originating bank transfers a pool of loans,
the bonds that emerge are called CLOs.
 Where the bank transfers a portfolio of bonds and
securitizes the same, the resulting securitized bonds
could be called as CBOs.
 A generic name given to both is CDOs as in a
number of cases, the portfolio transferred by the
bank could consist of loans as well as bonds and at
times, even ABS.
 Key Factors for successful securitization – SPV,
Marketability and Wide Distribution.
 Securitization Markets
 Securitization started in the US when in February 1970, the U.S.
Department of Housing and Urban Development created the
transaction using a mortgage-backed security. The Government
National Mortgage Association (GNMA or Ginnie Mae) sold securities
backed by a portfolio of mortgage loans.
 In 1985, securitization techniques that had been developed in the
mortgage market were applied for the first time to a class of non-
mortgage assets — automobile loans.
 This early auto loan deal was a $60 million securitization originated by
Marine Midland Bank and securitized in 1985 by the Certificate for
Automobile Receivables Trust.
 The first significant bank credit card sale came to market in 1986 with
a private placement of $50 million of outstanding bank card loans.
 Starting in the 1990s, securitization technology was applied to a
number of sectors of the reinsurance and insurance markets including
life and catastrophe. This activity grew to nearly $15 billion of issuance
in the year 2006.
 Securitization Markets
 As estimated by the Bond Market Association, in the US, total amount
outstanding at the end of the year 2004 was $1.8 trillion.
 This amount is about 8% of total outstanding in bond market debt
($23.6 trillion), about 33% of mortgage-related debt ($5.5 trillion) and
about 39% of corporate debt ($4.7 trillion) in the US.
 In nominal terms, from 1995–2004, ABS amount outstanding has
grown about 19 percent annually, with mortgage-related debt and
corporate debt each growing at about 9 percent. Gross public issuance
of asset-backed securities remains strong, setting new records in
many years. In 2004, issuance was at an all-time record of about $0.9
trillion.
 At the end of 2004, the larger sectors of this market are credit card-
backed securities (21%), home-equity backed securities (25%),
automobile-backed securities (13%), and collateralized debt
obligations (15%).
 Among the other market segments are student loan-backed securities
(6%), equipment leases (4%), manufactured housing (2%), small
business loans (such as loans to convenience stores and gas stations)
and aircraft leases.
 Securitization in India
 Securitization began with the sale of consumer loan pools.
Originators directly sold loans to buyers.
 Originators acted as Servicers and collected installments due
on the loans. Creation of transferable securities backed by pool
receivables (PTCs) became common in late 1990s.
 In 1990s, there were only 6-7 issuances per year. Average
issue size was about Rs.450 million. The volume of issuances
grew rapidly beginning in the year 2000 due to rapid growth of
consumer finance.
 Investors acceptance of securitized instruments also improved.
There were approximately 75 issuances each year. Average
issue size increased to about Rs.1900 million.
 There was pressure on the resources of large originators due to
continued growth in consumer credit. From 2004 to 2005, 40%
of vehicle finance was funded through ABS backed by auto
loans.
 Securitization in India
 The growth of debt funds, the largest investors in securitized paper,
also supported the expansion of the market.
 The first deal in India was in 1992 when Citibank securitized auto
loans and placed a paper with GIC Mutual Fund worth about Rs. 16
Crores.
 In 1994-95, SBI Caps structured an innovative deal where a pool of
future cash flows of high value customers of RSIDC were securitized.
 ICICI had securitized assets to the tune of Rs.2,750 crores in its books
as at March 1999.
 Another novel move was by the Maharashtra government to securitize
sales tax. The Maharashtra Vikrikar Rokhe Pradhikaran (MVRP) is the
SPV to undertake this first of its kind transaction in the country.
 Securitization of rated transactions increased from less than Rs.1,000
crores in the year 1998 to over Rs.30,000 crores in 2004-05.
 An oil monetization deal has also been structured where the future
flows of oil receivables accruing to a company were securitized.
 Types of Assets Securitized in India

 Existing Assets v/s Future Flows

 Rated Asset Backed Securities
 Future Flow Backed Securities
Regulatory Scenario for Securitization
in India

 Securitization and Reconstruction of Financial Assets and

Enforcement of Security Interest Act, 2002 (SARFAESI) is an
important regulation applicable to securitization in India.
 The Securities Contracts (Regulation) Amendment Bill, 2005
was introduced in the Lok Sabha in December 2005. It is
regarding provision of a legal framework for trading of
securitized debt including mortgage backed debt.
 This Bill was passed and the Securities and Exchange Board of
India (Public Offer and Listing of Securitized Debt Instruments)
Regulations, 2008 came into effect on May 26, 2008. This now
allows the listing of securitized debt on stock exchanges.
 SEBI is the market regulator for securitization transactions in
India.
 Hurdles to Securitization in India

 Stamp Duty
 Taxation
 Accounting Rules
 Eligible Investors
 Lack of sophisticated Debt Market
 Lack of Investor Awareness and Risk
Appetite
 Scope of Securitization in India

 Improvements in Legal Framework

 Stamp Duty
 Development of Institutional Back-up for
Liquidity and Rating