Securitization of Debt

IntroductionSecuritization 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.

IntroductionSecuritization 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 SecuritizationLoan 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.

DefinitionSecuritization 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 wouldve otherwise got accrued.

Process of SecuritizationInvolving 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 BankerThe 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 SecuritizationReal Estate Loans mother of all securitizations and popularly called as MBS, RMBS, CMBS, IMBSAuto Loans / Equipment Leases/Hire in Hire Purchase Loans for vehicles having repayment periods from 3-7 years and popularly called as ABSBank Loans Receivables Banks term loan receivables are securitized and popularly called as CDOs and are usually by Pay Through CertificatesCredit Cards Receivables shortest duration amongst all assets that are securitized and so it is difficult to securitizeNon Performing Assets/Loans very unique class of assets. 2 parts involved (ie) loss plus the other recoverable part through legal process

Parties involved in SecuritizationOriginatorsServicers usually the originators or their affiliatesMerchant Bankers role of Underwriter in public offering, role of Agent in private placement, Structuring the transaction and Placing the securities for a feeSPV (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 ratingRating AgenciesTrustees intermediary between the servicer and investors and credit enhancer and investors

Partial Guarantee (PG) StructuresThese 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 OriginatorsLiquidityReduced Cost of CapitalProfitabilityRisk StrippingHigher Capital Turnover

Benefits of Securitization to InvestorsNew Avenue of InvestmentDiversified RiskBetter Rate of Return

Benefits & Demerits of Securitization to the EconomyGrowth in TransactionsPromotes SavingsPromotes Socialism over CapitalismLess Importance to Banks & NPAs (Demerits)

Benefits of Securitization to the BanksBankers 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 CLOsAchieves greater liquidity

Securitization and BanksBankers 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 MarketsSecuritization 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 MarketsAs 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 19952004, 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 IndiaSecuritization 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 IndiaThe 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 IndiaExisting Assets v/s Future FlowsRated Asset Backed SecuritiesFuture Flow Backed Securities

Regulatory Scenario for Securitization in IndiaSecuritization 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 IndiaStamp DutyTaxationAccounting RulesEligible InvestorsLack of sophisticated Debt MarketLack of Investor Awareness and Risk Appetite

Scope of Securitization in IndiaImprovements in Legal FrameworkStamp DutyDevelopment of Institutional Back-up for Liquidity and Rating