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INDEX
Sr.No. CONTENTS PAGE NO.
1 INTRODUCTION 3
2 EXECUTIVE SUMMARY 4
3 OBJECTIVE OF PROJECT 7
4 TYPES OF FINANCIAL INSTRUMETNS 8
5 LIFE CYCLE OF SECURITIZATION
6 SECURITIZATION MEANING 227 SECURITIZATION CONCEPT 24
8 HISTORY OF SECURITIZATION 26
9 FEARURES OF SECURITIZATION 29
10 USES OF SECURITIZATION 33
11 SECURITIZATION AND STRUCTURED
FINANCE
35
12REASON WHY ORGANISATION GO FOR SECURITIZATION 36
13 PROCESS OF SECURITIZATION 3814 PLAYER INVOLVED IN SECURITIZATION 43
15 CREDIT ENHANCEMENT 46
16 TYPES OF SECURITIES 49
17 ADVANTAGE & DISADVANTAGES OF
SECURITIZATION
51
18 SECURITIZATION IMPACT ON BANKING 60
19 ECONOMIC IMPACT OF SECURITIZATION 63
20 SPECIAL PURPOSE VEHICLE 66
21 ACCOUNTING FOR SECURITIZATION 6722 SECURITIZATION OF STANDARD ASSETS 70
23 FUTURE FLOW SECURITIZATION 74
24 NEED FOR SECURITIZATION IN INDIA 82
25 SAFERSI ACT 2002 84
26 SECURITIZATION GUIDELINESS OF RBI 87
27 ISSUES FACING SECURITIZED MARKET 94
28 SECURTIZATION ACTIVITY IN INDIA 98
29 RECOMMENDATIONS 114
30 CONCLUSION 126
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INTRODUCTION
Technological advancements have changed the face of the world of
finance. It is today more a world of transactions than a world of relations.
Most relations have been transactionaliesed. Transactions mean coming
together of two entities with a common purpose, whereas relations mean
keeping together of these two entities. For example when a bank provides
a loan of a sum of money to a user, the transaction leads to a relationship:that of a lender and a borrower. However, the relationship is terminated
when the very loan is converted into a debenture. The relationship of
being a debenture holder in the company is now capable of acquisition
and termination by transactions.
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EXECUTIVE SUMMARY
The financial-services industry is in a state of flux in which the
only constant is change. The introduction of financial sector reforms in
India has led to innovation in financial markets and instruments. the
phenomena of computerization (technology), globalization,
institutionalization and privatization capture the dynamic innovations
occurring in the financial world, and suggest the isation of the industry.
One of the most prominent developments in international finance in
recent times. That is likely to assume even greater importance in the
future, is securitization. Securitization is the process of pooling and
repackaging homogenous illiquid loans and distributing them as
marketable securities. Increased pressure on operating efficiency, market
niches, competitive advantages and capital strength, all provide fuel for
rapid changes. Securitization is one of the solutions to these challenges.
In this report, I have attempted to explore the intricacies of securitization
as process of financial engineering and its applicability to the Indian
financial system.
Firstly, securitization has been defined, and its features such as
Marketablility, merchantable quality, wide distribution, homogeneity, etc
have been noted. Securitization has lead to disintermediation and has
changed the face of banking and financial institution. Along with this, the
economic impact of securitization has also been talked about. Advantages
and motivations in the form of lower cost, capital relief, improvement in
return on equity and return on assets, off balance sheet financing, asset
liability management, improved liquidity, etc. have been highlighted.
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Securitization is a costly source and is uneconomical for small
requirements these are some of its limitations.
The scope of securitization in India has been looked at and
emphasis is laid on three potential areas of securitization in India
Mortgage-backed securities, Asset-Backed Securities and the
Infrastructure Sector. True sale characteristics of securitization
transactions are required to be reflected in the books of accounts,
statements to be furnished to the concerned regulators as also to the tax
authorities. Since there are no guidelines for accounting treatment of
these transactions, the accounting procedures with appropriate guidelines
need to be framed by Institute of Chartered Accountants of India for the
sake of uniformity.
The recommendations have been categorized into short-term,
medium-term and long-term. The Reserve Bank of Indias Working
Group has suggested that securitization should be appropriately defined
to lend uniformity of approach and restrict the benefits provided by
law/regulation for genuine securitization transactions. The
recommendations also include rationalization/reduction of stamp duties,
Inclusion of securitized instruments in Securities Contract Regulation
Act. Medium-term measures would include increased flow of information
through credit bureau, standardization of documents, improvement in the
quality of assets, up gradation of computer skills and exploring the
possibilities of securitizing non-performing assets.
The need to develop some insurance/guarantee institutions to give
comfort to investors, especially in infrastructure and mortgage sectors has
been underscored as a long-term measure. According to RBIs Working
Group, there is also a need for developing a host of financial
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intermediaries with specialized skills and sophistication to provide the
building blocks for market growth. The Government of India should
consider bringing out an umbrella legislation covering all aspects of
securitization.
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OBJECTIVES OF THE PROJECT
To have an overview of securitization concept and its practices,
processes, players.
To evaluate whether securitization provide users with adequate
solution to their asset management.
To assess the types and level of risk associated with securitization
and the solutions over those risks. To determine whether securitization and enhancements to existing
concepts adequately support corporate goals.
To determine if securitization is being carried out in compliance
with an approved Government policy or practice statement.
To determine if resources needed to develop the required
securitization process adequately. To determine if companies are operating according to established
guidelines.
To evaluate the scope and adequacy of securitization in Indian
scenario.
To determine if the RBI norms are being referred to while carrying
out securitization activity.
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TYPES OF FINANCIAL INSTRUMENTS
EQUITY ROUTE
Equity funding
Stock or other security representing an ownership interest.
On the balance sheet, the amount of the funds contributed by the
owners (the stockholders) plus the retained earnings (or losses).
Also referred to as Shareholders equity.
In the context of margin trading, the value of securities in a
margin account minus what has been borrowed from the
brokerage.
In the context of real estate, the difference between the current
market value of the property and the amount the owner still owes
on the mortgage. Thus, it is the amount, if any; the owner would
receive after selling a property and paying off the mortgage
Equity is a term whose meaning depends very much on the context.
In general, you can think of equity as ownership in any asset after all
debts associated with that asset are paid off. For example, a car or house
with no outstanding debt is considered the owner's equity since he or she
can readily sell the items for cash. Stocks are equity because they
represent ownership of a company, whereas bonds are classified as debt
because they represent an obligation to pay and not ownership of assets.
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Preference sharesA preferred stock, also known as a preferred share or simply a preferred,
is a share of stock carrying additional rights above and beyond those
conferred by common stock.
Unlike common stock, preferred stock usually has several rights attached
to it:
The core right is that of preference in dividends. Before a dividendcan be declared on the common shares, any dividend obligation to
the preferred shares must be satisfied.
The dividend rights are often cumulative, such that if the dividend
is not paid it accumulates from year to year.
Preferred stock has a liquidation value associated with it. This
represents the amount of capital that was contributed to thecorporation when the shares were first issued. Par value may be the
liquidation value, or it may be a token amount such as a dollar or a
penny to minimize the issuer's tax.
Preferred stock has a claim on liquidation proceeds of a stock
corporation, equivalent to its par or liquidation value. This claim is
senior to that of common stock, which has only a residual claim. Almost all preferred shares have a fixed dividend amount. The
dividend is usually specified as a percentage of the par value or as
a fixed amount. For example Pacific Gas & Electric 6% Series A
preferred. Unlike debt securities, however, a company is not
legally required to pay preferred dividends, and omission of
preferred dividends is not an event of default for the company's
debt.
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Variable preferred dividends are rare exceptions; their changing
dividends depend on prevailing interest rates, or varying as apercentage of net income.
Some preferred shares have special voting rights to approve certain
extraordinary events (such as the issuance of new shares or the
approval of the acquisition of the company) or to elect directors,
but most preferred shares provide no voting rights associated with
them. Some preferred shares only gain voting rights when thepreferred dividends are in arrears for a substantial time.
Usually preferred shares contain protective provisions, which
prevent the issuance of new preferred shares with a senior claim.
Individual series of preferred shares may have a senior, pari-passu
or junior relationship with other series issued by the same
corporation.
The above list, although including several customary rights, is far from
comprehensive. Preferred shares, like other legal arrangements, may
specify nearly any right conceivable. Preferred shares normally carry a
call provision, enabling the issuing corporation to repurchase the share at
its (usually limited) discretion.
Some corporations contain provisions in their charters authorizing the
issuance of preferred stock whose terms and conditions may be
determined by the board of directors when issued. These "blank check"
preferred shares are often used as takeover defense. These shares may be
assigned very high liquidation value that must be redeemed in the event
of a change of control or may have enormous super voting powers.
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LOAN ROUTE
Certificate of deposit
A saving certificate entitling the bearer to receive interest. A CD bears a
maturity date, a specified fixed interest rate and can be issued in any
denomination. CDs are generally issued by commercial banks and are
insured by the FDIC. The term of a CD generally ranges from one month
to five years.
How CD work
The consumer who opens a CD may receive a passbook or paper
certificate, but it now is common for CD to consist simply of a book entry
and an item shown in the consumer's periodic bank statements; that is,
there is usually no "certificate" as such.
At most institutions, the CD purchaser can arrange to have the interest
periodically mailed as a check or transferred into a checking or savings
account. This reduces total yield because there is no compounding. Some
institutions allow the customer to select this option only at the time the
CD is opened.
Commonly, institutions mail a notice to the CD holder shortly before the
CD matures requesting directions. The notice usually offers the choice of
withdrawing the principal and accumulated interest or "rolling it over"
(depositing it into a new CD). Generally, a "window" is allowed after
maturity where the CD holder can cash in the CD without penalty. In the
absence of such directions, it is common for the institution to "roll over"
the CD automatically, once again tying up the money for a period of time
(though the CD holder may be able to specify at the time the CD is
opened to not "roll over" the CD).
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Commercial papers
An unsecured, short-term debt instrument issued by a corporation,typically for the financing of accounts receivable, inventories
and meeting short-term liabilities. Maturities on commercial paper rarely
range any longer than 270 days. The debt is usually issued at a discount,
reflecting prevailing market interest rates. Commercial paper is
not usually backed by any form of collateral, so only firms with high-
quality debt ratings will easily find buyers without having to offer a
substantial discount (higher cost) for the debt issue. A major benefit of
commercial paper is that it does not need to be registered with the
Securities and Exchange Commission (SEC) as long as it matures before
nine months (270 days), making it a very cost-effective means of
financing. The proceeds from this type of financing can only be used on
current assets (inventories) and are not allowed to be used on fixed assets,
such as a new plant, without SEC involvement.
Treasury bill
Treasury bills (or T-bills) mature in one year or less. They are like zero-
coupon bonds in that they do not pay interest prior to maturity; instead
they are sold at a discount of the par value to create a positive yield to
maturity. Treasury bills are considered by many to be the most risk free
investment for U.S. investors. Treasury Bills are commonly issued with
maturity dates of 28 days (~1 month), 91 days (~3 months), and 182 days
(~6 months). Treasury Bills are issued each Friday after weekly auctions,
which are held on Wednesday at about noon. Purchase orders at Treasury
Direct must be entered before 11:30 on the Monday of the auction.
Mature T-bills are also redeemed on each Thursday. Banks and financial
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institutions, especially primary dealers, are the largest purchasers of T-
Bills. They are quoted for purchase and sale in the secondary market on
an annualized percentage yield to maturity, or basis. With the advent of
Treasury Direct, individuals can now purchase T-Bills online and have
funds withdrawn and deposited directly to their personal bank account
and earn higher interest rates on their savings.
Treasury Bills are short term GOI Securities. They are issued for different
maturities viz. 14-day, 28 days (announced in Credit policy but yet to be
introduced), 91 days, 182 days and 364 days. 14 days T-Bills had been
discontinued recently. 182 days T-Bills were not re-introduced.
Repurchase agreement
A form of short-term borrowing for dealers in government securities. The
dealer sells the government securities to investors, usually on an
overnight basis, and buys them back the following day.
Reverse repurchase agreement
The purchase of securities with the agreement to sell them at a higher
price at a specific rate .For the party selling the security (and agreeing to
repurchase it in the future) it is a repo; for the party on the other end of
the transaction (buying the security and agreeing to sell in the future) it is
a reverse repurchase agreement.
Repos are classified as a money-market instrument. They are usually used
to raise short-term capital.
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CREDIT MARKET
The bond market, also known as the debt, credit, or fixed income market,is a financial market where participants buy and sell debt securities
usually in the form of bonds.
References to the "bond market" usually refer to the government bond
market because of its size, liquidity, lack of credit risk and therefore,
sensitivity to interest rates. Because of the inverse relationship between
bond valuation and interest rates, the bond market is often used to
indicate changes in interest rates or the shape of the yield curve.
Types of bond markets
The Bond Market Association classifies the broader bond market into five
specific bond markets:
Corporate
Government & Agency
Municipal
Mortgage Backed, Asset Backed, and Collateralized Debt
Obligation
Funding
Debentures
In finance, a debenture is a long-term debt instrument used by
governments and large companies to obtain funds. It is similar to a bond
except the securitization conditions are different. A debenture is usually
unsecured in the sense that there are no liens or pledges on specific assets.
It is however, secured by all properties not otherwise pledged. In the caseof bankruptcy debenture holders are considered general creditors.
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Debentures are divided into different categories on the basis of:
(1) Convertibility of the instrument
(2) Security Debentures can be classified
On the basis ofconvertibility into:
Non Convertible Debentures (NCD): These instruments retain the
debt character and cannot be converted in to equity shares
o Partly Convertible Debentures (PCD): A part of these
instruments are converted into Equity shares in the future at notice
of the issuer. The issuer decides the ratio for conversion. This is
normally decided at the time of subscription.
o Fully convertible Debentures (FCD): These are fully convertible
into Equity shares at the issuer's notice. The ratio of conversion isdecided by the issuer. Upon conversion the investors enjoy the
same status as ordinary shareholders of the company.
o Optionally Convertible Debentures (OCD): The investor has the
option to either convert these debentures into shares at price
decided by the issuer/agreed upon at the time of issue.
On basis ofSecurity, debentures are classified into:
o Secured Debentures: These instruments are secured by a charge on the fixed assets of
the issuer company. So if the issuer fails on payment of either the principal or interest amount, his
assets can be sold to repay the liability to the investors
o Unsecured Debentures: These instrument are unsecured in the sense that if the issuer
defaults on payment of the interest or principal amount, the investor has to be along with other
unsecured creditors of the company.
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Mutual funds
An investment vehicle, which is comprised of a pool of funds, collectedfrom many investors for the purpose of investing in securities such as
stocks, bonds, money market securities and similar assets. Mutual funds
are operated by money managers, who invest the fund's capital and
attempt to produce capital gains and income for the fund's investors. A
mutual fund's portfolio is structured and maintained to match the
investment objectives stated in its prospectus.
One of the main advantages of a mutual fund is that it gives small
investors access to a well-diversified portfolio of equities, bonds and
other securities, which would be quite difficult (if not impossible) to
create with a small amount of capital. Each shareholder participates
proportionally in the gain or loss of the fund. Mutual fund units, or
shares, are issued and can typically be purchased or redeemed as needed
at the current net asset value per share (NAVPS).
PSU Bonds
Public Sector Undertaking Bonds (PSU Bonds): These are Medium or
long term debt instruments issued by Public Sector Undertakings (PSUs).
The term usually denotes bonds issued by the central PSUs (i.e. PSUs
funded by and under the administrative control of the Government of
India). Most of the PSU Bonds are sold on Private Placement Basis to the
targeted investors at Market Determined Interest Rates. Often investment
bankers are roped in as arrangers to this issue. Most of the PSU Bonds are
transferable and endorsement at delivery and are issued in the form of
Usance Promissory Note.
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Government Dated Securities
Like Treasury Bills, the Reserve Bank of India on behalf of the
Government of India issues G-Securities. These form a part of the
borrowing program approved by the parliament in the union budget. G-
Securities are normally issued in dematerialized form (SGL). When
issued in the physical form they are issued in the multiples of Rs.
10,000/-. Normally the dated Government Securities have a period of 1
year to 20 years. Government Securities when issued in physical form are
normally issued in the form of Stock Certificates. Such Government
Securities when are required to be traded in the physical form are
delivered by the transferor to transferee along with a special transfer form
designed under Public Debt Act 1944.The transfer does not require stamp
duty. The G-Securities cannot be subjected to lien. Hence, is not an
acceptable security for lending against it?
Some Securities issued by Reserve Bank of India like 8.5% Relief Bonds
are securities specially notified & can be accepted as Security for a loan.
Earlier, the RBI used to issue straight coupon bonds i.e. bonds with a
stated coupon payable periodically. In the last few years, new types of
instruments have been issued. These are: -
Inflation linked bonds:
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These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time -
the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at
the total coupon rate.
Zero coupon bonds
Zero coupon bonds are bonds that do not pay interest during the life of
the bonds. Instead, investors buy zero coupon bonds at a deep discount
from their face value, which is the amount a bond will be worth when it
"matures" or comes due. When a zero coupon bond matures, the investor
will receive one lump sum equal to the initial investment plus interest that
has accrued. The maturity dates on zero coupon bonds are usually long-
termmany dont mature for ten, fifteen, or more years. These long-term
maturity dates allow an investor to plan for a long-range goal, such as
paying for a childs college education. With the deep discount, an
investor can put up a small amount of money that can grow over many
years. Investors can purchase different kinds of zero coupon bonds in the
secondary markets that have been issued from a variety of sources,
including the U.S. Treasury, corporations, and state and local government
entities. Because zero coupon bonds pay no interest until maturity, their
prices fluctuate more than other types of bonds in the secondary market.
In addition, although zero coupon bonds do not pay any interest until they
mature, investors may still have to pay federal, state, and local income tax
on the imputed or "phantom" interest that accrues each year. Some
investors avoid paying the imputed tax by buying municipal zero coupon
bonds (if they live in the state where the bond was issued) or purchasing
the few corporate zero coupon bonds that have tax-exempt status.
Floating rate notes
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Floating rate notes (FRNs) are bonds that have a variable coupon, equal
to a money market reference rate, like LIBOR or federal funds rate, plus a
spread. The spread is a rate that remains constant. Almost all FRNs have
quarterly coupons, i.e. they pay out interest every three months, though
counter examples do exist. At the beginning of each coupon period, the
coupon is calculated by taking the fixing of the reference rate for that day
and adding the spread. A typical coupon would look like 3 months USD
LIBOR +0.20%.
Example
Suppose a new 5-year FRN pays a coupon of 3 months LIBOR +0.20%,
and is issued at par (100.00). If the perception of the credit-worthiness of
the issuer goes down, investors will demand a higher interest rate, say
LIBOR +0.25%. Therefore, a dealer would then make a market of 27 /
25. This means, that he would buy bonds at the equivalent of LIBOR
+0.27%, and sell at the equivalent of LIBOR +0.25%. If a trade is agreed,
the price is calculated. In this example, LIBOR +0.27% would be roughly
equivalent to a price of 99.65. This can be calculated as par, minus the
difference between the coupon and the price that was agreed (0.07%),
multiplied by the maturity (5 year).
Deep discount bond
A bond that sells at a significant discount from par value. A bond that is
selling at a discount from par value and has a coupon rate significantly
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less than the prevailing rates of fixed-income securities with a similar risk
profile.
Typically, a deep-discount bond will have a market price of 20% or more
below its face value. These bonds are perceived to be riskier than similar
bonds and are thus priced accordingly. These low-coupon bonds are
typically long term and issued with call provisions. Investors are attracted
to these discounted bonds because of their high return or minimal chance
of being called before maturity.
External Commercial Borrowing
External Commercial Borrowings (ECB) is defined to include:
1) Commercial bank loans,
2) Buyers credit,3) Suppliers credit,
4) Securitized instruments such as floating rate notes, fixed rate bonds
etc.,
5) Credit from official export credit agencies,
6) Commercial borrowings from the private sector window of
multilateral financial institutions such as IFC, ADB, AFIC, CDC
etc. and
7) Investment by Foreign Institutional Investors (FIIs) in dedicated
debt funds.
Applicants will be free to raise ECB from any internationally
recognized source like banks, export credit agencies, suppliers of
equipment, foreign collaborations, foreign equity - holders,
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international capital markets etc. Offers from unrecognized sources
will not be entertained.
BASIC MEANING OF SECURITIZATION
Securitization" in its widest sense implies every such process which
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converts a financial relation into a transaction.
History of evolution of finance, and corporate law, the latter being
supportive for the former, is replete with instances where relations have
been converted into transactions. In fact, this was the earliest, and by far
unequalled, contribution of corporate law to the world of finance, viz.,
and the ordinary share, which implies piecemeal ownership of the
company. Ownership of a company is a relation, packaged as a
transaction by the creation of the ordinary share. This earliest instance of
securitization was so instrumental in the growth of the corporate form of
doing business, and hence, industrialization, that someone rated it as one
of the two greatest inventions of the 19th century -the other one being the
steam engine. That truly reflects the significance of the ordinary share,
and if the same idea is extended, to the very concept of securitization: it
as important to the world of finance as motive power is to industry.
LIFE CYCLE OF SECURITIZATION
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CONCEPT
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Quasi-financial deals
Early-stage securitization
Advanced-stage securitization
Synthetics stage
Operating Risk transfers/Index risk transfers
? (Possibly, reinvention stage)
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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, et cetera and future cash flows like ticket sales, credit card
payments, car rentals or any other form of future receivables.
Securitization can also be defined as a device of structured financing
where an entity seeks to pool together its interest in identifiable future
cash flows over time and transfer the same to investors either with or
without support of further collaterals and thereby achieve the purpose of
financing.
Suppose Mr. X wants to open a multiplex and is in need of funds for the
same. To raise funds, 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.
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This meaning of securitization can be expressed in various dramatic
words:
Securitization is the process of commoditization: The basic idea
is to take the outcome of this process into the market, the capital
market. Thus, the result of every securitization process, whatever
might be the area to which it is applied, is to create certain
instruments which can be placed in the market.
Securitization is the process of integration and differentiation:
The entity that securitizes its assets first pools them together into a
common hotchpot (assuming it is not one asset but several assets,
as is normally the case). This is the process of integration. Then,
the pool itself is broken into instruments of fixed denomination.
This is the process of differentiation.
Securitization is the process of de-construction of an entity: If
one envisages an entity's assets as being composed of claims to
various cash flows, the process of securitization would split apart
these cash flows into different buckets, classify them, and sell these
classified parts to different investors as per their needs. Thus,
securitization breaks the entity into various sub-sets.
HISTORY
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Securitization as a tool of structured finance developed in the U.S. real
estate financing market. However, in Europe a form to mortgage funding
has existed for many years that have remarkable similarities to the present
form of securitization, although the two are not the same. This
instrument has existed in Denmark for more than 200 years. It remains
interesting that securitization in Denmark has a history of 200 years,
much longer than the U.S. mortgage market.
The first efforts towards securitizing financial assets were made in the
U.S., originating in the mortgage financing markets of the country. The
instrument was developed with a need to create a secondary market in
mortgage financing. In the process the catalysts were government
agencies formed for buying and selling federally insured mortgages.
The history of U.S. government efforts to introduce a secondary market
in mortgages goes back to the 1930s. Originally, mortgages in the U.S.
were originated by savings and loan associations that financed their
operations through retail deposits. During the Depression, deposit
markets collapsed. To allow originators to fund mortgages, the Congress
enacted the National Housing Act to create a secondary market in
mortgages. Subsequently, it created the Federal Housing Administration
(FHA). The FHA insured housing loans made by private lenders and thus
absorbed the inherent risks in housing finance. In 1938, the Federal
National Mortgage Association was created to buy and sell federally-
insured mortgages. In 1968, the erstwhile Federal National Mortgage
Association (FNMA) was split into two parts-a new FNMA and the
Government National Mortgage Association (GNMA)
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It was these agencies, FNMA (colloquially called Fannie Mae) and
GNMA (colloquially called Ginnie Mae, which was responsible for the
present-day development of securitization markets.
Ginnie Maes first securitization initiative
In 1970, GNMA did its first securitization transaction on a pass-
through structure. GNMAs pass-through were securities backed by
mortgages insured by FHA. These pass-through had the full credit and the
backing of the U.S. government, as GNMA guaranteed both the
repayment of principal and timely payment of interest.
The 1970 (GNMA-I) is still in operation. In 1983, GNMA
launched another pass-through program called GNMA-II. GNMA II had
a range of interest rates and sellers, while GNMA-I was designed for a
single seller and a single rate of interest. These programs are further
classified based on the type of mortgages pooled therein, such as single
family (SF) loans and multifamily (MF) loans.
Fannie Maes securitization deals
Though the FNMA was the oldest of all the U.S. government agencies, it
was the last to enter the securitization market. In 1968, the original
FNMA was split into a new FNMA and GNMA, with FNMA privately
owned and its shares quoted on the New York Stock Exchange. However,
due to implicit support from and historical affiliation with, the U.S.
government, the credit standing of FNMA is seen as better than private
corporation, although slightly inferior to government agencies like
GNMA.
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The first FNMA mortgage-backed security (MBS) was issued in
1981. The agency played a crucial role in promoting securitization of
adjustable rate-rate mortgages (ARMs) and variable rate mortgages
(VRMs).
Spreads over to non-mortgage assets
Securitization spread to non-mortgage assets in 1985. The first non-
mortgage securitization deal was in March 1985, when Sperry
Corporation issued $192.5million in securities backed by computer lease
receivables.
FEATURES OF SECURITIZATION
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A securitized instrument, as compared to a direct claim on the issuer,
Will generally have the following features:
Marketability: The very purpose of securitization is to ensure
marketability to financial claims. Hence, the instrument is
structured to be marketable. Marketability involves two postulates:
(a) The legal and systemic possibility of marketing the instrument
(b) The existence of a market for the instrument.
In most jurisdictions of the world, well-coded laws exist to enable and
regulate the issuance of traditional forms of securitized claims, such as
shares, bonds, debentures (negotiable instruments). Most countries do not
have legal systems pertaining to securitized products, of recent or exotic
origin, like securitization of receivables.
It is imperative on part of the regulator to view any securitized instrument
with the same concern as in case of traditional instruments, for investor
protection. However, where a law does not exist to regulate such
issuance, it is nave to believe that it is not permitted.
The second issue is of having a market for the instrument. Securitization
is a fallacy unless the securitized product is marketable. The purpose will
be defeated if the instrument is loaded on to a few professional investors
without any possibility of having a liquid market therein. Liquidity is
afforded either by introducing it into an organized market (securities
exchanges) or by one or more agencies acting as market makers, i.e.,
agreeing to buy and sell the instrument at pre-determined or market-
determined prices.
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Merchantable Quality: To be market-acceptable, a securitizedproduct has to have merchantable quality. Merchantable quality in
case of financial products, means the financial commitments
embodied in the instruments are secured to the investors'
satisfaction. To the investors satisfaction is a relative term, and
therefore, the originator of the securitised instrument secures the
instrument based on the needs of the investors. The general rule is:
the more broad the base of the investors, the less is the investors
ability to absorb the risk, and hence, the more the need to
securitise. For widely distributed securitised instruments, quality
evaluation, and its certification by an independent expert, viz.,
rating is common. The rating is for the benefit of the lay investor,
who is otherwise not expected to be able to appraise the degree of
risk involved. Securitization is a case where a claim on the debtors
of the originator is being bought by the investors. Hence, the
quality of the claim of the debtors assumes significance, which at
times enables investors to rely purely on the credit-rating of
debtors and so, makes the instrument totally independent of the
originators own rating.
Wide Distribution: The basic purpose of securitization is to
distribute the product. The extent of distribution, which the
originator would like to achieve, is based on a comparative analysis
of the costs and the benefits achieved thereby. Wider distribution
leads to a cost-benefit, as the issuer is able to market the product
with lower financial cost. But a wide investor-base involves costs
of distribution and servicing. In practice, securitization issues are
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still difficult for retail investors to understand. Hence, most
securitizations have been privately placed with professional
investors. However, in time to come, retail investors could be
attracted to securitized products.
Homogeneity: To serve as a marketable instrument, the instrument
should be packaged into homogenous lots. Most securitized
instruments are broken into lots, affordable to the marginal
investor, and hence, the minimum denomination becomes relative
to the needs of the smallest investor. Shares in companies may be
broken into slices as small as Rs.10 each, debentures and bonds are
sliced into Rs.100 to Rs.1000 each. Designed for larger investors, a
commercial paper may be in denominations as high as Rs. 5Lac.
Other securitization applications may also follow this logic.
The integration of several assets into one lump, and then
their differentiation into uniform marketable lots often invites the
next feature: an intermediary for this process.
Special Purpose Vehicle (SPV): In case, the securitization
transaction involves any asset or claim which needs to be integrated
and differentiated, unless it is a direct and unsecured claim on the
issuer, the issuer will need an intermediary agency to act as a
repository of the asset or claim being securitized. Thus, the issuer will
bring in an intermediary agency to hold the security charge on behalf
of the investors, and then issue certificates to the investors of
beneficial interest in the charge held by the intermediary. So, the
charge continues to be held by the intermediary, but the beneficial
interest becomes a marketable security.
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USES OF SECURITIZATION
Securitization leads to Financial Disintermediation
If one imagines a financial world without securities, all financial
transactions will be carried only as one-to-one relations. If a company
needs a loan, it will have to seek such loan from the lenders, who will
have to establish a one-to-one relation with the company. Each lender has
to understand the borrowing company, and look after his loan. This isoften difficult, and hence, a financial intermediary, such as a bank, pools
funds from many such investors, and uses these pooled funds to lend to
the company. If the company securitizes the loan, and issues debentures
to the investors, will this eliminate the need for the intermediary bank,
since the investors may now lend to the company directly in small
amounts each, in form of a security which is easy to appraise, and which
is liquid?
Securitization: Changing The Function Of Intermediaries
Disintermediation is an important aim of a present-day corporate
treasurer, since by leap-frogging the intermediary; the company reduces
the cost of its finances. Hence, securitization has been employed to
disintermediate.
However, it does not eliminate the need for the intermediary: it
merely redefines the intermediary's role. E.g.: if a company is issuing
debentures to the public to replace a bank loan, it may be avoiding the
bank as an intermediary, but would still need the services of an
investment banker to successfully conclude the issue of debentures.
Traditionally, financial intermediaries made a transaction possible by
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performing a pooling function, and contributed to reduce the investors'
perceived risk by substituting their own security for that of the end user.
Securitization puts these services of the intermediary in the background.
E.g.: where the bank being the earlier intermediary was eliminated and
instead the services of an investment banker were sought to distribute a
debenture issue, the focus shifted from the pooling utility provided by the
banker to the distribution utility provided by the investment banker.
Securitization seeks to eliminate funds-based intermediaries by fee based
distributors. In the above example, the bank was a fund-based
intermediary, a reservoir of funds, but the investment banker was a fee
based intermediary, a catalyst, and a pipeline of funds.
In case of a direct loan, the lending bank was performing several
intermediation functions noted above: it was a distributor as it raised its
own finances from a large number of small investors; it was appraising
and assessing the credit risks in extending the corporate loan, and having
extended it, it was managing the same. Securitization splits each of these
intermediary functions, each to be performed by separate specialized
agencies. Distribution will be performed by the investment bank,
appraisal by a credit-rating agency, and management possibly by a
mutual fund that manages the portfolio of security investments of
investors. Hence, a securitization replaces fund-based services by several
fee-based Services.
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Securitization and Structured Finance
Securitization is a "structured financial instrument". "Structured finance"
has become a buzzword in today's financial market. It means that a
financial instrument is structured or tailored to the risk-return and
maturity needs of investors, rather than a simple claim against an entity
or asset. On the investors side, securitization seeks to structure an
investment option to suit the needs of investors. It classifies thereceivables or cash flows not only into different maturities but also into
senior, mezzanine and junior notes. Therefore, it also aligns the returns to
the risk requirements of the investor.
Securitization as a Tool of Risk Management
Securitization is more than just a financial tool. It is an important tool of
risk management for banks. It primarily works through risk removal but
also permits banks to acquire securitized assets with potential
diversification benefits. When assets are removed from a bank's balance
sheet, without recourse, all the risks associated with the asset are
eliminated. Credit risk is a key uncertainty that concern domestic lenders.
By passing on this risk to investors, or to third parties when credit
enhancements are involved, financial firms are better able to manage their
risk exposures.
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REASON WHY ORGANISATION GO FOR SECURITISATION.
Securitization is one way in which a company might go about financing
its assets.
There are generally seven reasons why companies consider securitization:
1. To improve their return on capital, since securitization normally
requires less capital to support it than traditional on Balance-sheet
funding
2. To raise finance when others forms of finance are unavailable ( in
recession banks are often unwilling to lend and in a boom, banks
often cannot keep up with the demand for funds)
3. To improve return on assets securitization can be a cheap source
of funds, but the attractiveness of securitization for this reason
depends primarily on the costs associated with alternative funding
sources.
4. To diversify the sources of funding which can be accessed, so that
dependence upon the banking or retail sources of fund is reduced.
5. To reduce credit exposure to particular asset ( for instance, if a
particular class of lending become large in relation to the balance
sheet as a whole, then securitization can remove some of the assets
from balance sheet)
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6. To match-fund certain classes of assets-mortgage assets are
technically 25 year assets, a proportion of which should be funded
with long term finance; securitization normally offer the ability to
raise finance with a longer maturity than is available in other
funding markets
7. To achieve a regulatory advantage , since securitization normally
removes certain risks which can cause regulators some concern,
there can be a beneficial result in terms of availability of certain
forms of finance ( for example, in UK building societies consider
securitization as a means of managing the restriction on their
wholesale funding abilities)
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PROCESS OF SECURITIZATION
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 their 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'screditworthiness.
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.
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STAGE 1: ASSET IDENTIFICATION:-
The originator, first identifies the asset or a pool of assets that have to
be securitized. There must be some basic conditions that must be satisfied
by an asset, which is to be securitized. The cash flows from the reference
asset should be reliable and payments should be periodically obtained.
This means that the asset portfolio should have a documented history
showing default and delinquency experience. This record should be
credible. The assets have to be of good quality that in turn facilitates the
marketability to be quick and easy. This could be either on assets own
strength or with some sort of credit enhancement. This is to ensure that
default risks are brought down considerably. The pool of assets should
carry identical dates of interest payment and maturities. To make the
transaction meaningful, the total quantity of assets to be securitized
should be huge enough to spread over the securitization costs.
Assets that stand a chance of being sold to investors with only the
minimum layer of additional credit enhancement should ideally have the
following characteristics:
be well diversified
Have a statistical history of loss experience
be homogenous in nature
be broadly similar in repayment and final maturity structures
be to some extent liquid
STAGE 2: STRUCTURING THE SECURITIES
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The SPV 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 (egg: auto loans) of similar
maturity (egg: 20 to 24 months) will be bundled together for creating the
securitized instrument. The SPV will act as an intermediary which
divides the assets of the originator into marketable securities.
These securities issued by the SPV to the investors and are known as
pass-through-certificates (PTCs).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 PTCs) on a pro rata basis once the service fees has been deducted.
STAGE 3: INVESTOR SERVICING
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 way the PTCs are structured the cash flows are unpredictable as there
will always be a certain percentage of obligors who won't pay up and this
cannot be known in advance. Though various steps are taken to take care
of this, some amount of risk still remains.
There is no uniform name for the securities issued by the SPV as such
securities take different forms. These securities could either represent a
direct claim of the investors on all that the SPV collects from the
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receivables transferred to it: in this case, the securities are called pass
through certificates or beneficial interest certificates as they imply
certificates of proportional beneficial interest in the assets held by the
SPV. Alternatively, the SPV might be re-configuring the cash flows by
reinvesting it, so as to pay to the investors on fixed dates, not matching
with the dates on which the transferred receivables are collected by the
SPV. In this case, the securities held by the investors are called pay
through certificates. The securities issued by the SPV could also be
named based on their risk or other features, such as senior notes or junior
notes, floating rate notes, etc.
The investors can be banks, mutual funds, other financial institutions,
government etc. In India only qualified institutional buyers (QIBs) who
possess the expertise and the financial muscle to invest in securities
market are allowed to invest in PTCs.
Mutual funds, financial institutions (FIs), scheduled commercial banks,
insurance companies, provident funds, pension funds, state industrial
development corporations, et cetera fall under the definition of being a
QIB. 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.
In order to facilitate a wide distribution of securitized instruments,
evaluation of their quality is of utmost importance. This is carried on by
rating the securitized instrument which will acquaint the investor with the
degree of risk involved.
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The rating agency rates the securitized instruments on the basis of asset
quality, and not on the basis of rating of the originator. So particular
transaction of securitization can enjoy a credit rating which is much better
than that of the originator.
High rated securitized instruments can offer low risk and higher yields to
investors. The low risk of securitized instruments is attributable to their
backing by financial assets and some credit enhancement measures like
insurance/underwriting, guarantee, etc used by the originator.
The administrator or the servicer is appointed to collect the payments
from the obligors. The servicer follows up with the defaulters and uses
legal remedies against them. In the case of ABC bank, the SPV can have
a servicer to collect the loan repayment installments from the people who
have taken loan from the bank. Normally the originator carries out this
activity. Once assets are securitized, these assets are removed from the
bank's books and the money generated through securitization can be used
for other profitable uses, like for giving new loans.
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 at a lower cost than debt.
PLAYERS INVOLVED IN SECURITISATION
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The primary participants involve in the issuance of asset-backed
securities are the originator, servicer, issuer, credit enhancer, trustee, and
investors. The originator creates the underlying assets that are sold or
used as collateral, the merchant banker and the originator establish the
structure and the issuing vehicle, the rating agencies set the rating, credit
enhancer improve the credit quality, and the trustees create the trust and
issue certificates.
Originators
Originators create the assets that are sold or used as collateral for asset-
backed securities. Originators include finance companies, financial
institutions, commercial banks, and insurance companies, thrift
institutions and securities firms.
Servicers
Servicers who are usually the originators or affiliates of the originators
of the assets, are responsible for collecting principal and interest
payments on the assets when due and for pursuing the collection of
delinquent accounts. They also provide the trustee and the certificate
holders with monthly and annual reports about the portfolio of assets sold
or used as collateral. The reports details the sources collected and the
distributed funds, the remaining principal balance, the remaining
insurance amount, the amount of fees payable out of the trust and
information necessary for certificate holders to prepare their financial
statements and to assess their tax liability.
Issuers
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The originator does not usually sell assets to third-party investors directly
as asset- backed securities. Instead, they are sold first to either a conduit
or a bankruptcy remote finance company. Such companies, known as
limited purpose corporations, are subsidiaries or affiliates of the
originator or the merchant banker that were separately incorporated to
facilitate the sale of assets or to issue collateralized debt instruments.
Issuers become bankruptcy remote by limiting their activities to issue
asset-backed securities and using the proceeds to buy the assets that back
the securities. Conduits are issuers of asset-backed securities that do not
originate or necessarily service the assets that underlie the securities.
They buy assets from different originators or sellers, pool the assets and
then sell them to investors. Conduits are particularly useful for firms that
do not have enough assets to package as asset-backed securities
themselves.
Merchant Bankers
As asset-backed securities issue involves a merchant banker, who either
underwrites the securities for public offering or privately places them. As
an underwriter, the merchant banker purchases the securities from the
issuer for resale. In a private placement, the merchant banker does not
purchase the securities and resell them, rather the merchant banker acts as
an agent for the issuer, matching the seller with a handful of buyers. In an
asset-backed security issue the merchant banker, whether functioning as
an underwriter or privately placing the securities is instrumental in
structuring the issue. The issuer and merchant banker work together to
see that the structure of the issue meets all the legal, regulatory,
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accounting and tax objectives. The merchant banker also works with the
credit enhancers, rating agencies and trustees.
Rating agencies
Credit rating agencies assigns rating to asset-backed securities issues just
as they do for corporate bonds. Credit rating is based on three criteria: the
probability of the issuer defaulting on the obligation, the nature and
provisions of the obligation and the relative position of the obligation in
the event of bankruptcy.
Trustees
A Trustee in asset-backed security is the intermediary between the
servicer and the investors and between the credit enhancer and the
investors. A trustee is used whether the issue is a sale of assets by the
issuer or a collateralized debt obligation of the issuer. The responsibilities
of the trustee include buying the assets from the issuer on behalf of the
trust and issuing certificates to the investors. As the obligors make
principal and interest payments on the assets, the servicer deposits the
proceeds in a trust account, and the trustees passes them on the investors.
The trustee should be willing to take over the Servicers role if the
servicer withdraws or is unable to perform.
CREDIT ENHANCEMENT
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Credit enhancements are required in every Securitization. The nature and
amount depends on the risks of the Securitization as determined by the
Rating Agencies, Underwriters/Placement Agents and Investors. They are
intended to reduce the risks to the Investors and thereby increase the
rating of the Securities and lower the costs to the Originator. Typical
forms of credit enhancement are:
1. Over-collateralization - transferring to the Issuer, Receivables in
amounts greater than required to pay the Securities if the proceeds of the
Receivables were received as anticipated). The amount of over-
collateralization (usually 5% to 10%) is determined by the Rating
Agencies and the Underwriters/Placement Agents, and this in turn will
depend upon the quality of the Receivables, other credit enhancement that
may be available, the risk of the structure (such as the possible
bankruptcy of the Originator/Servicer), the nature and condition of the
industry in which the Receivables are generated, general economic
conditions and, in the case of foreign-based Securitizations, the
"Sovereign risk". If all goes well, it is repurchased at the end of the
transaction or returned as part of the residual interest. This form of credit
enhancement is required in virtually all Securitizations.
2. Senior/subordinated structure - issuance of subordinated or
secondary classes of Securities, which are lower-rated (and bear higher
interest rates) and sold to other Investors or held by the Originator. In the
event of problems, the higher rated (senior) Securities receive payments
prior to the lower rated (subordinated) Securities. It is not uncommon for
there to be a number of classes of Securities that are each subordinated to
the more highly rated, resulting in a complex "waterfall" of payments of
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principal and interest. In the common structure described above, senior
and subordinated classes of Notes would be paid, in order of priority,
prior to classes of Certificates, and Certificates prior to any residual
interest in the Issuer. This form of credit enhancement has become
routine, but cannot be used in a grantor trust structure, which is why the
owner trust has become most common.
3. Early amortization - if certain negative events occur, all payments
from Receivables are applied to the more senior securities until paid.
4. Cash collateral account - the Originator deposits funds in account
with Trustee to be used if proceeds from Receivables are not sufficient.
Adjustable depending upon events. May be in the form of a demand
"loan" by the Originator to the account.
5.Reserve fund - subordinated Securities retained by the Originator or
Trustee and pledged for the benefit of the Trust (and, therefore, the
Investors).
6. Security bond - guarantee (or wrap) of all payments due on the
Securities. Issued by AAA-rated monoline insurance companies (if
available).
7. Liquidity provider - in effect, a guarantee by the Originator (or its
parent) or another entity of all or a portion of payments due on the
Securities.
8.Letter of credit (for portion of amounts due on Securities) - not used
much anymore because of costs. These were common in the late 1980's
when issued by Japanese banks at low rates.
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TYPES OF SECURITIES
The appropriate structure for securitization depends on a variety offactors like quality of assets securitized, default experience of original
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borrowers, amount of amortization at maturity, financial reputation and
soundness of the originator. The general principle is that the securities
must be structured in such a way that the maturity of these securities may
coincide with the maturity of the securitized loans. However, there are
three important types of securities as listed below:
a. Pass through and pay through certificates .In the case of pass
through certificates, payments to investors depend upon the cash flow
from the assets backing such certificates. In other words, as and when
cash is received from the original borrower by the SPV, it is passed on to
the holders of certificates at regular intervals and the entire principal is
returned with the retirement of the assets packed in the pool. Thus, pass
through certificates have a single maturity structure and the tenure of
these certificates is matched with the life of the securitized assets. On the
other hand pay through certificates has a multiple maturity structure
depending upon the maturity pattern of underlying assets.
b. Preferred stock certificates Preferred stocks are instruments issued
by a subsidiary company against the trade debts and consumer
receivables of its parent company. In other words, subsidiary companies
buy the trade debts and receivables of parent companies to enjoy
liquidity. Thus trade debts can also be backed through the issue of
preferred stocks. Generally these stocks are backed by guarantees given
by highly rated merchant banks and hence they are also attractive from
the investors point of view. These instruments are mostly short term in
nature.
c. Asset based commercial papers This type of structure is mostlyprevalent in mortgage backed securities. Under this type SPV purchases
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portfolio of mortgages from a single group on the basis of interest rates,
maturity dates and underlying collaterals. They are, then, transferred to a
trust which in turn issues mortgage backed certificates to the investors.
ADVANTAGES
A. Issuer's View of Securitization
Advantages
Reduces funding costs
Through Securitization, a company rated BB but with AAA Worthy cash
flow would be able to borrow at possibly AAA rates. This is the number
One reason to securitize a cash flow and can have tremendous impacts on
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borrowing costs. The difference between BB debt and AAA debt can be
multiple hundreds of basis points. For example, Moody's downgraded
Ford Motor Credit's rating in January 2002, but a Senior automobile
backed securities issued by Ford Motor Credit in January 2002 and April
2002 continue to be rated AAA, because of the strength of the underlying
collateral, And other credit enhancements
Reduces asset-liability mismatch
"Depending on the structure chosen, securitization can offer perfect
matched funding by Eliminating funding exposure in terms of both
duration and pricing basis
Lower capital requirements
Some firms, due to legal, regulatory, or other reasons, have a limit orrange that their leverage is allowed to be. By securitizing some of their
assets, which qualify as a sale for accounting purposes, these firms will
be able to lessen the equity on their balance sheets while maintaining the
"earning power of the asset.
Locking in profits
For a given block of business, the total profits have not yet emerged and
thus remain uncertain. Once the block has been securitized, the level of
profits has now been locked in for that company, thus the risk of profit
not emerging, or the benefit of super-profits, has now been passed on.
Transfer risks:
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Credit, liquidity, prepayment, reinvestment, asset concentration;
Securitization makes it Possible to transfer risks from an entity that does
not want to bear it, to one that does. Two good example of this are
Catastrophe Bonds and Entertainment Securitizations. Similarly, by
securitizing a block of business (thereby locking in a degree of profits),
the company has effectively freed up its balance to go out and write more
profitable Business.
Off-Balance Sheet
Derivatives of many types have in the past been referred to as off balance
sheet. This term implies that the use of derivatives has no balance sheet
impact. While there are differences among the various accounting
standards internationally, there is a general trend towards the
Requirement to record derivatives at fair value on the balance sheet.
There is also a Generally accepted principle that, where derivatives are
being used as a hedge against Underlying assets or liabilities, accounting
adjustments are required to ensure that the Gain/loss on the hedged
instrument is recognized in the income statement on a similar Basis as the
underlying assets and liabilities. Certain credit derivatives products,
particularly Credit Default Swaps, now have more or less universally
accepted market standard Documentation. In the case of Credit Default
Swaps, this documentation has been formulated by the International
Swaps and Derivatives Association (ISDA) who have for long time
provided documentation on how to treat such derivatives on balance
sheets.
Earnings
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This is the one benefit that is never talked about in the Asset-Backed and
Structured Finance Worlds. Securitization makes it possible to record an
earnings bounce without any real addition to the firm. When a
securitization takes place, there often is a "true sale" that takes place
between The Originator (the parent company) and the SPV. This sale has
to be for the market value of the Underlying assets for the "true sale" to
stick and thus this sale is reflected on the parent companies Balance
sheet, which will boost earnings for that quarter by the amount of the
sale. While not Illegal in any respect, this does distort the true earnings of
the parent company.
Admissibility
Future cash flows may not get full credit in a company's accounts (life
insurance companies, For example, may not always get full credit for
future surpluses in their regulatory balance sheet),And a securitization
effectively turns an admissible future surplus flow into an admissible
Immediate cash asset.
Liquidity
Future cash flows may simply be balance sheet items which currently are
not available for spending, Whereas once the book has been securitized,
the cash would be available for immediate Spending or investment.
Strategic tool
Securitization benefits the FIs in different ways by:
providing strategic choices;
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reducing funding costs;
Developing core competencies in certain areas.
For example, some institutions specialize in originating and servicing, not
financing at all. Other institutions expand business volume without
expanding their capital base in the same proportion. The process helps in
identifying cost pools of various activities in the value chain. As can be
seen from Figure, securitization is changing the horizons of traditional
banking significantly:Traditional Banking
BookingOriginationCredit
undertakingFunding
Securitization
Originate StructureCredit
enhancementPlace Trade Service
Many new lines of business grow out of securitization - insurance of
assets, clearance services, custodial services and master servicing of
securities etc. Depending upon the core competence and trade off
between costs and benefits, institutions may like to retain or divest of
some of these activities. Institutions may develop competitive advantage
through more efficient marketing, tighter credit monitoring, lower cost
servicing, higher volumes (automobiles, credit Cards etc.) And other
ways to outperform competitors
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DISADVANTAGES OF SECURITIZATION
May reduce portfolio quality: If the AAA risks, for example, are being
securitized out, this would leave a materially worse quality of residual
risk.
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Costs: Securitizations are expensive due to management and system
costs, legal fees, underwriting fees, rating fees and ongoing
administration. An allowance for unforeseen costs is usually essential in
securitizations, especially if it is an atypical securitization.
Size limitations: Securitizations often require large scale structuring, and
thus may not be cost-efficient for small and medium transactions.
Risks: Since securitization is a structured transaction, it may include par
structures as well as credit enhancements that are subject to risks of
impairment, such as prepayment, as well as credit loss, especially for
structures where there are some retained strips.
To investors
Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)
Opportunity to invest in a specific pool of high quality credit-
enhanced assets: Due to the stringent requirements for corporations (for
example) to attain high ratings, there is a dearth of highly rated entities
that exist. Securitizations, however, allow for the creation of large
quantities of AAA, AA or A rated bonds, and risk averse institutional
investors, or investors that are required to invest in only highly rated
assets, have access to a larger pool of investment options.
Portfolio diversification: Depending on the securitization, hedge funds
as well as other institutional investors tend to like investing in bonds
created through Securitizations because they may be uncorrelated to their
other bonds and securities.
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Isolation of credit risk from the parent entity: Since the assets that are
securitized are isolated (at least in theory) from the assets of the
originating entity, under securitization it may be possible for the
securitization to receive a higher credit rating than the "parent," because
the underlying risks are different. For example, a small bank may be
considered more risky than the mortgage loans it makes to its customers;
were the mortgage loans to remain with the bank, the borrowers may
effectively be paying higher interest (or, just as likely, the bank would be
paying higher interest to its creditors, and hence less profitable).
Risks to investors
Liquidity risk
Credit/default: Default risk is generally accepted as a borrowers
inability to meet interest payment obligations on time. For ABS, default
may occur when maintenance obligations on the underlying collateral are
not sufficiently met as detailed in its prospectus. A key indicator of a
particular securitys default risk is its credit rating. Different tranches
within the ABS are rated differently, with senior classes of most issues
receiving the highest rating, and subordinated classes receiving
correspondingly lower credit ratings.
However, the credit crisis of 2007-2008 has exposed a potential flaw in
the securitization process - loan originators retain no residual risk for the
loans they make, but collect substantial fees on loan issuance and
securitization, which doesn't encourage improvement of underwriting
standards.
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Event risk
Prepayment/reinvestment/early amortization: The majority of
revolving ABS are subject to some degree of early amortization risk. The
risk stems from specific early amortization events or payout events that
cause the security to be paid off prematurely. Typically, payout events
include insufficient payments from the underlying borrowers, insufficient
excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in
the default rate on the underlying loans above a specified level, a
decrease in credit enhancements below a specific level, and bankruptcy
on the part of the sponsor or servicer.
Currency interest rate fluctuations: Like all fixed income securities,
the prices of fixed rate ABS move in response to changes in interest rates.
Fluctuations in interest rates affect floating rate ABS prices less than
fixed rate securities, as the index against which the ABS rate adjusts will
reflect interest rate changes in the economy. Furthermore, interest rate
changes may affect the prepayment rates on underlying loans that back
some types of ABS, which can affect yields. Home equity loans tend to
be the most sensitive to changes in interest rates, while auto loans,
student loans, and credit cards are generally less sensitive to interest rates.
Contractual agreements
Moral hazard: Investors usually rely on the deal manager to price the
securitizations underlying assets. If the manager earns fees based on
performance, there may be a temptation to mark up the prices of the
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portfolio assets. Conflicts of interest can also arise with senior note
holders when the manager has a claim on the deal's excess spread.
Servicer risk: The transfer or collection of payments may be delayed or
reduced if the servicer becomes insolvent. This risk is mitigated by
having a backup servicer involved in the transaction.
IMPACT ON BANKING
Other than freeing up the blocked assets of banks, securitization can
transform banking in other ways as well.
The growth in credit off take of banks has been the second highest in the
last 55 years. But at the same time the incremental credit deposit ratio for
the past one-year has been greater than one.
What this means in simple terms is that for every Rs 100 worth of deposit
coming into the system more than Rs 100 is being disbursed as credit.
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The growth of credit off take though has not been matched with a growth
in deposits.
So the question that arises is, with the deposit inflow being less than the
credit outflow, how are the banks funding this increased credit off take?
Banks essentially have been selling their investments in government
securities. By selling their investments and giving out that money as
loans, the banks have been able to cater to the credit boom.
This form of funding credit growth cannot continue forever, primarily
because banks have to maintain an investment to the tune of 25 per cent
of the net bank deposits in statutory liquidity ratio (SLR) instruments
(government and semi government securities).
The fact that they have been selling government paper to fund credit offtake means that their investment in government paper has been declining.
Once the banks reach this level of 25 per cent, they cannot sell any more
government securities to generate liquidity.
And given the pace of credit off take, some banks could reach this level
very fast. So banks, in order to keep giving credit, need to ensure that
more deposits keep coming in.
One way is obviously to increase interest rates. Another way is
Securitization. Banks can securitize the loans they have given out and use
the money brought in by this to give out more credit.
Not only this, securitization also helps banks to sell off their bad loans
(NPAs or non performing assets) to asset reconstruction companies
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(ARCs). ARCs, which are typically publicly/government owned, act as
debt aggregators and are engaged in acquiring bad loans from the banks
at a discounted price, thereby helping banks to focus on core activities.
On acquiring bad loans ARCs restructure them and sell them to other
investors as PTCs, thereby freeing the banking system to focus on normal
banking activities.
Asset Reconstruction Company of India Limited (ARCIL) was the first
(till date remains the only ARC) to commence business in India. ICICI
Bank, Karur Vyasya Bank, Karnataka Bank, Citicorp (I) Finance, SBI,
IDBI, PNB, HDFC Bank and some other banks have shareholding in
ARCIL.
A lot of banks have been selling off their NPAs to ARCIL. ICICI bank-
the second largest bank in India, has been the largest seller of bad loans to
ARCIL last year. It sold 134 cases worth Rs.8450 Crore. SBI and IDBI
hold second and third positions.
ARCIL is keen to see cash flush foreign funds enter the distressed debt
markets to help deepen it. What is happening right now is that banks and
FIs have been selling their NPAs to ARCIL and the same banks and FIs
are picking up the PTCs being issued by ARCIL and thus helping ARCIL
to finance the purchase. A recent report in a business daily quotes ,
Rajendra Kakkar, ARCIL's Chief Executive as saying, "We have got
a buyer, we have got a seller, it so happens that the seller is the loan
side of the same institutions and buyer is the treasury side."
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So the risk from the balance sheet of banks and FIs is not being
completely removed as their investments into PTCs issued by ARCIL
will generate returns if and only if ARCIL is able to affect recovery from
defaulters.
A recent survey by the Economist magazine on International Banking,
says that securitization is the way to go for Indian banking.
As per the survey, "What may be more important for the economy
is to provide access for the 92% of Indian busi