Securitization: A useful Financing Tool

The Securitization: Useful Financing Option

Selecting financing is one of the most important decisions any NBFC does but the choice of option to raise the capital becomes rather important. Among various options like equity fund raising, term loan and securitization, securitization is emerging as an efficient tool in the growing economy like India. There are pros and cons associated with all options and it is true for securitization as well. When securitization is the right choice, remains the biggest question for any originator. For an NBFC, affordable funding can mean the difference between being in the black or the red, and for the employees of that company, an annual bonus or layoffs. NBFCs are always in the market for new ways to acquire funds they need to grow and lower the cost the better it is. Securitizationconsolidating loans into securities and selling them to investorsis one way to keep the cash flowing at a relatively lower rate. Securitization has been around, in India, for more than 19 years now, and according to market participants, its around Rs.500 bn per year industry. For the industry leaders like Tata Motor Finance, Magma Fincorp and Shriram Transport Finance Company, securitization has been the biggest contributor to their funding. Why is it the biggest contributor? Because the companies that have completed securitization issuances also have sales that comprise a largeand growingshare of the overall Indian market. This inspires continuous securitization issues in the capital market. The outcome, today is, securitization market becomes more open for new entrants even though the number of investor is still same. Heres a nuts-and-bolts rundown on one of the most common types of securitization known as a term offering. Pros and Cons Just how large does an NBFC need to be before a securitization makes sense? The legal demands of private placement markets, arranging fees, accounting costs, and fees charged by ratings agencies and other service providers add up to a significant cost of entry for NBFCs considering a securitization. The deal must be large enough for an NBFC to achieve economies of scale. A term securitization is usually feasible only when theres a loan portfolio of INR 200 million or more. Once an NBFC assemble a large enough portfolio, they generally have a significant advantage: lower interest rates. Youll pay 2 to 3 percent more in interest for a hypothecation loan (Term Loan) than a securitization. Doing the Deal Whats involved in doing a securitization? Lots of data, paperwork, and lawyers. The NBFC is going to be spending money with accountants, legal advisors, and ratings firms.

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Securitization: A useful Financing Tool

The arranger puts the deal together, marketing the securities to investors. The arranger of the deal negotiates with rating agencies, structures the transaction, and answers investors questions. The arranger also provides help to put the analytical data together. In addition to the arranger, the originator (NBFC) will need attorneys and accountants with a track record in securitization issuances. They will create the legal structure for the deal, including setting up a special purpose entity, or SPE, or SPV, just for the securitization issuance. Ownership of the portfolio of loans is transferred to the new company, which issues the bonds. The SPV is set up so that if the originator has financial problems in the future, the originators creditors cant put a claim on the loan pool collateralizing the securitization. This bankruptcy remoteness protects the investors. An SPV may be set up so it doesnt affect the originators balance sheet, which some see as an advantage. Tata Motor Finance, Shriram Transport Finance Company, Magma Fincorp and some other big players have formed a number of SPVsspecial purpose bankruptcy-remote designed to comply with, among other things, strict rating-agency requirements. The SPVs are not permitted to engage in any activities other than those directly related to securitization for which they were formed. The affairs of the SPV are managed by their respective boards, which generally must consist of at least one outside director. Next, the team examines the collateral poolthe loans placed in the SPV. This is where the originator needs which is the most important predictor of success: data, data, data. The more data, the better is the deal rating. Everyone involved in the deal, from the rating agency to the final investors, wants to know the originators are going to continue making their payments on time. The originators portfolio payment history is critical in convincing investors that their underwriting and servicing mechanisms are adequate. Historical loan performance data is one of the best predictors of how you will do in the future. Rating the Deal Standard & Poors firm, CRISIL, and other firms, such as CARE, and ICRA rate the likelihood of repayment for investors, usually from AAA to single B, with AAA being the best. A better rating translates to a lower cost of capital for the originator. The ratings process is one of the major expenses of a securitization. The rating cost would be some percentage of the deal size or so, and typically one of the three major firms will rate the deal. In India there is no concept like multiple rating for a single deal so rating from any one of them is adequate. In addition, there are ongoing surveillance fees, as the ratings firms monitor the securities after they are issued. The ratings firms look at everything the originator company does. They want to know what is their origination process, what type of training its salespeople have, what is their collection process, who are their recovery agents, and if the sales team is responsible for collection as well.

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Securitization: A useful Financing Tool

The arranger, the originators management team, and the accountants will all work with the ratings firm to obtain the best possible rating. Part of the process is a negotiation to determine exactly how the deal will be structured, including the amount of credit enhancement needed. Credit enhancement is protection for the investor and can take many forms, including cash reserves, bond issuance, and overcollateralization, which is a cushion of more loans in the portfolio than would otherwise be required. To Market Once the deal is structured, attorneys draft the legal and disclosure documents, and then its time for the arranger to present the security to potential investors. As part of the marketing process for securitization, the originators management team, along with their arranger, will meet with potential investors to answer questions about the companys operations. Its also common for companies issuing securities to attend securitization industry conferences. Then its time for the closing, where the legal documents are finalized, the rating letters are delivered, the loans are transferred into the SPV, and the bonds are issued to investors. The ultimate success of the securitization depends on the next step in the process, the servicing. Taking Care of Business Loan servicing can be done by the originator that originally issued the loans or by a servicing company. Generally, in the Indian market, the originator himself remains the servicer. Servicing is collecting the money from borrowers and making sure that money is distributed according to the rules of the securitization and that all needed data is collected on the portfolio. A good servicer does everything possible to ensure that all buyers pay according to their loan agreements. If a payment delinquency or default occurs, the servicer is responsible for enforcing the terms of the loan agreement and taking the necessary actions to collect the amounts due. Strong collection efforts mean loans wont be dropping out. Good servicing process makes the investor more comfortable in investing money in the securitization deal.

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Securitization: A useful Financing Tool

A Financing Glossary: Securitization: A term securitization is usually only economically feasible with a loan portfolio of INR 200 million or more. The originator, with the help of an arranger, forms a bankruptcy- remote special purpose entity (SPV), issues securities or bonds backed by a portfolio of loans, and sells the securities to investors. Credit enhancement: The process of reducing credit risk by requiring additional collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the transaction defaults. Hypothecation: The pledging of securities or other assets as collateral to secure a loan, such as a debit balance in a margin account. Ratings agency: An independent company that evaluates the creditworthiness and probability of default for a debt issue. Recourse: The right to demand payment from the maker or endorser of a negotiable instrument. Servicer: An organization that collects principal and interest payments from borrowers and manages their escrow accounts. Special purpose entity: A bankruptcy-remote company or trust formed solely in order to accomplish a specific task, such as a securitization. In a securitization, the SPE purchases the assets and issues the bonds to investors. Arranger: An intermediary between an issuer of a security and the investing public, usually an arranger facilitates the whole origination process.

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