SECURITISATION – AN OVERVIEW

By : Parul Khanna on 08 September 2009

http://www.lawyersclubindia.com/articles/SECURITISATION-AN-OVERVIEW-1567.asp

SECURITISATION – AN OVERVIEW

Introduction to Securitisation

Securitization has emerged globally as an important technique for

bundling assets and segregating risks into marketable securities.
Securitization can be regarded as an incentive for banks to become
more efficient in order to offer the most competitive financial product.
The basic purpose of securitisation is to reward the comparative
advantage of a bank to originate loans, compared with its ability to
service the loans and its ability to bear the risk associated with those
loans.

Ιn theory, a loan is a simple transaction where a borrower wants money,

and a lender advances it and collects interest on it and this arrangement
continues until the loan is repaid by the borrower. In practice, however,
it is observed that every fifth borrower is a defaulter which ruins the
lenders financials. While in case of secured loans the borrower offers
collateral such as real estate or machinery which serves as a security to
the lender, authorizing it to seize and sell the asset to recover its
money, in the event of default in repayment of loan by the borrower.
However, this simple transaction collapses when the seizure of an asset
becomes impossible within a reasonable time. Our slow and tardy legal
system with endless hearings and appeals keep things in limbo for
decades and as a result, there are bad debts across the entire financial
system.

Securitisation Process

Securitisation is the process of pooling and repackaging of homogenous

illiquid financial assets into marketable securities that can be sold to
investors. The assets may be anything ranging from credit card
receivables, auto loans, equipment leases, hire purchase deals to
housing loans and non-performing assets (NPAs).
Securitisation has emerged as an important means of financing in recent
times. The process of Securitisation involves the following steps:

First, an entity with loans or other income-producing assets

("Originator") identifies the assets that it wants to remove from its
balance sheet.

Second,a special legal entity or Special Purpose Vehicle ("SPV") is

created, which usually is established as a Trust and the Originator sells
the assets to that SPV. This effectively separates the risk related to the
original entities operations from the risk associated with collection.

Third, to raise funds to purchase these assets the SPV issues asset-
backed securities ("Asset-backed security is a security whose value and
income payments are derived from and collateralized (or "backed") by a
specified pool of underlying assets i.e. illiquid assets") to investors in the
capital markets in a private placement or pursuant to a public offering.
The SPV uses the proceeds of the sale to pay back the Originator that
created, or originated, the underlying assets. The SPV is responsible for
"bundling" the underlying assets into a specified pool that will fit the risk
preferences and the needs of investors. These securities are structured
to provide maximum protection from anticipated losses using credit
enhancements like letters of credit or reserve accounts. The securities
are also reviewed by the credit rating agencies that conduct extensive
analyses of bad-debts experiences, cash flow certainties and rate of
default.

Finally, Investors are paid through the money received in the form of
loan repayments by those borrowing loans through the Originator.
Originators are in turn paid certain service charges by the SPV for the
servicing of the loan. The services generally include: mailing monthly
statements, collecting payments, and remitting them to the investors,
investors reporting, accounting, foreclosure proceedings and the
like.

This process leads to the financial asset being taken off the balance
sheet of the Originator, thereby relieving pressures of capital adequacy,
and provides immediate liquidity to the Originator.

Regulatory Framework

There is no clear regulatory framework for the securitisation market per

se. However, securitisations originated by RBI regulated entities like
Banks, FIs and NBFCs are governed by guidelines issued by the RBI.
Enactment of the Securitisation and Reconstruction of Financial Assets
and Enforcement of Security Interests Act, 2002 ("SARFAESI Act")
enabled securitisation of the non-performing assets ("NPAs") of Banks,
which could sell off their NPAs to asset reconstruction companies
registered with RBI. The SARFAESI Act laid the framework to the
constitution of asset reconstruction companies (ARCs) specialising in
securitising distressed assets purchased from banks.

Securitisation Act

The SARFAESI Act is a significant legislative initiative to address the

malaise of mounting NPAs. The Act addresses the interests of secured
creditors. Its purpose is to promote the setting up of asset
reconstruction/securitisation companies to takeover the NPAs
accumulated with the banks and public financial institutions. The
Supreme Court, in its judgment in the case of Mardia Chemicals Ltd.
and Others vs. Union of India and Others upheld the constitutional
validity of SARFAESI Act.

The Act provides three alternative methods for recovery of NPAs,

namely: (i) Securitisation; (ii) Asset Reconstruction; and (iii)
Enforcement of Security without the intervention of the Court. The main
objective behind this Act is to strengthen creditor rights through
foreclosure and enforcement of securities by banks and financial
institutions. By conferring on lenders the right to seize and sell assets
held as collateral in respect of overdue loans, it allows banks and
financial institutions to recover their dues promptly without going
through a costly and time-consuming legal process.

Salient features of the Act

Incorporation & Registration of Special Purpose Vehicles - The SARFAESI

Act proposes to securitise and reconstruct the financial assets through
two SPVs viz. Securitisation Company and Reconstruction Company.
Securitisation Company and Reconstruction Company ought to be a
company incorporated under the Companies Act, 1956 having
securitisation and asset reconstruction respectively as main object.

The SARFAESI Act requires compulsory registration of Securitisation

Company and Reconstruction Company with the RBI under the
SARFAESI Act before commencing its business. Further a minimum
financial stability requirement is also provided by requiring Securitisation
Company and Reconstruction Company to possess owned fund of not
less than Rs.2 crore or up to 15% of the total financial assets acquired
or to be acquired.

Securitisation companies who are registered with RBI cannot make

substantial change in the management or location without prior approval
of RBI. The expression “substantial change in management” means the
change in the management by way of transfer of shares or
amalgamation or transfer of the business of the company.
Funding of securitisation - The Securitisation Company or Reconstruction
Company may raise the necessary funds, for the acquisition of financial
assets, from the QIBs by issuing a security receipt. Security receipt is
exempted from compulsory registration under the Registration Act.
Security receipts issued by any Securitisation Company or
Reconstruction Company are the "securities" within the meaning of
Section 2(h)(ic) of the Securities Contracts (Regulation) Act, 1956.

A Scheme of acquisition has to be formulated for every acquisition

detailing therein the description of financial assets under acquisition, the
quantum of investment, rate of return assured etc. Further separate and
distinct accounts have to be maintained in respect of each scheme of
acquisition. Realizations made from the financial assets have to be held
and applied towards the redemption of investments and payment of
assured returns. In the event of non-realization of financial assets, the
QIB holding not less than 75% of the total value of the security receipts
issued, are entitled to call a meeting of all QIB and pass resolution and
every such resolution is binding on the Securitisation Company or
Reconstruction Company, as the case may be.

Enforcement of security interest - As discussed already the main

objective of the Securitisation Act is to provide for the enforcement of
security interest i.e. taking possession of the assets given as security for
the loan. The Act empowers the lender, in the event of default by a
borrower, to issue demand notice to the defaulting borrower and
guarantor, calling upon them to discharge their dues in full within 60
days from the date of the notice. If the borrower fails to comply with the
notice, the bank or the financial institution may take recourse to one or
more of the following measures:
Take possession of the security;
Sale or lease or assign the right over the security;
Appoint Manager to manage the security;
Ask any debtors of the borrower to pay any sum due to the borrower.

If there are more than one secured creditors, the decision to make
provisions of this Act will be made applicable only when 75% of them
are agreeable.

Transaction to which the Act is not applicable - The provision of this Act
shall not apply to:
• A lien on any goods;

• A pledge on movable property;

• Creation of any security in an Aircraft;

 • Creation of any security interest in any vessel;

• Any conditional sale, hire purchase or lease or any other contract

in which no security interest is created;

• Any right of unpaid seller under Section 47 of the sale of Goods

Act. Any property not liable to attachment;

• Any security interest for repayment of any financial asset not

exceeding one lakh rupees;

• Any case in which the amount due is less than 20% of the
principal amount and interest thereon.

• Any security interest created on agricultural land.

Offences & Penalties - Following are the offences prescribed under the
Securitisation Act:

• Default in filing particulars of transactions relating to asset

securitisation, asset reconstruction and creation of security
interest.

• Default in filing particulars of modification.

• Default in giving intimation of particulars satisfaction.

• Non-compliance of RBI directives by Securitisation Company and

Reconstruction Company.

• Contravention, including attempt to contravene and abetting in

contravention, of any