UNIT 2: SECURITIZATION

Definition of securitization
Securitization is the process of pooling and repackaging of homogenous illiquid assets into
liquid marketable securities that can be sold to the investors.
Introduction and meaning of securitization
Securitization refers to conversion of illiquid assets into liquid assets. It is a process of selling
of assets by the person holding them, to an intermediary who in turn will break such assets
into marketable securities. Securitization is a process used by banks to create securities from
loans and other income producing assets. The securities are sold to investors. This removes
the loans from the banks’ Balance sheets and enables the banks to expand their lending faster
than they would otherwise be able to do.
The process of securitization leads to the creation of financial instruments that represent
ownership interest in, or are secured by a segregated/separate income producing asset or pool
of assets consisting of collateralizes securities which are secured properties or assets such as
automobiles, real estate, or equipment loans but in some cases are unsecured, for example
credit card debt and customer loans.

Reserve Bank of India, in its Guidelines on Securitization, has defined securitization as a

process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in
return for an immediate cash payment. Securitization thus follows a two stage process.
 In the first stage there is sale of single asset or pooling and sale of pool of assets to a
'bankruptcy remote' special purpose vehicle (SPV) in return for an immediate cash
payment.
 In the second stage repackaging and selling the security interests representing claims on
incoming cash flows from the asset or pool of assets to third party investors by issuance
of tradable debt securities.

If the assets are secured by real property such as automobiles or real estates, then these are
called mortgage backed securities. And if the assets are credit card receivables than these are
unsecure and the investor has to rely on the performance of the assets that collateralize these
securities then These are known as assets backed securities.

Need for securitization

1. For the requirement of Funds, as securitization is a mode if financing.
2. Enhancing Liquidity.
3. Off balance sheet financing - removal of accounts.
4. Need for Asset-liability management of Financial institutions.
5. To connect capital markets and financial markets.
6. To replace traditional lending.
7. Funding resource for infrastructure sector.

Securitization asset classes

I. Mortgage-Backed securities
Mortgage backed securities is a type of securities that are secured by a mortgage or
collection of mortgages. The mortgages are sold to a group of individuals that securitizes
the loan together into a security that investors can buy. Mortgage backed securities can also
be traded in a secondary market. The type of mortgage loans are:
1. Residential Mortgage Loans.
2. Commercial Mortgage Loans.

II. Asset-Backed Securities (ABS)

Asset backed securities is a security whose income payments are derived from and
collateralized by a specified pool of underlying assets. The pool of assets is basically a of
a small and illiquid assets which are unable to be sold individually. The types of assets
backed securities are:
1. Credit card Receivables
2. Auto Loan Receivables
3. Personal Loan Receivables
4. Lease Receivables
5. Trade Receivables
6. Export Receivables

Benefits of securitization

The benefit of securitization can be viewed from the point of originator and investor.

Benefits of securitization to originator

Originator is an entity which sells the assets collectively to special purpose vehicle (SPV) and
achieves the following benefits:

1. Off balance sheet financing

When loans/receivables are securitized it release a portion of capital tied up in these
assets resulting in off balance sheet financing leading to improved liquidity position
which helps in expanding the business of the company.

2. Concentrate on the core business

By transferring the bad assets to SPV for recovery the entity could concentrate more on
core business and be specialized in their main business activities without taking any
burden on them.

3. Greater profitability
 Securitization helps financial institutions to get liquid cash from medium term and long
term assets immediately rather than over a longer period of time. It leads to greater
recycling of funds which, in turn leads to higher business turnover and profitability.
Again, the cash flow could be recycled for investment in higher yielding assets. This
means greater profitability.

4. Additional source of fund

The originator (i.e. the lending institution) is much benefited because securitization
provides an additional source of funds by converting an otherwise illiquid asset into
ready liquidity. As a result, there is an immediate improvement in the cash flow of the
originator. Thus, it acts as a source of liquidity.

5. Spreading of credit risk

Securitization facilitates the spreading of credit risk to different parties involved in the
process of securitization. In the absence of securitization, the entire credit risk associated
with a particular financial transaction has to be borne by the originator himself. Now,
the originator is able to diversify the risk factor among the various parties involved in
securitization. Thus, securitization helps to achieve diversification of credit risk which
are greater in the case of medium term and long term loans. Thus, it is used as tool for
risk management.

6. Higher rate of return

When compared to traditional debt securities like bonds and debentures, securitized
securities offer better liquidity. These instruments are rated by good credit rating
agencies and hence more attractive. Being structured assets based securities, they offer
more protection and yield a good return.

Benefits of securitization to investors

1. Diversification of risk
Securitization offers investor a diversification of risks, since the exposure is to pool of
assets. Most issuances are highly rated by independent credit rating agency and have
credit support built into the transactions.

2. Protection against default

If there is any default on the part of the borrower, the investor can sell the securities and
recover his/her investment amount as the securities are asset backed and make profit.

3. Performance track record

Securitization instrument have demonstrated consistently good performance with no
downgrades or defaults on any instrument in India.

4. Yields
 Yields of assets backed securities and mortgage backed securities are higher than those
of other debt instrument with comparable rating of AAA grade.

5. Flexibility
An important advantage of securitization is flexibility to tailor the instrument to meet
the investor risk. Flexibility is achieved by:
 Setting the duration ranging from few months to many years.
 Making a repayment on a monthly basis but can be structured on a quarterly or
semi-annually basis.
 Fixing the interest rate on the basis fixed or floating depending upon investors
preferences.

Players/parties involved in securitization

1. Originator
A firm that wants to securitised its assets is called originator. It is the entity in whose
books assets are securitised. It sells the assets on its books and receives funds generated
from such sales. It is the creditor of the obligor. It transfers both legal and beneficial
interest in the assets to the SPV.

2. Obligor
He is the original borrower who has raised the loan from the originator. It is his
outstanding loan amount that is transferred to the SPV. The credit standing of the obligor
is most important in the securitisation transaction.

3. Special purpose vehicle (SPV)

The issuer is also known as SPV, is the entity, which would typically buy the assets (to
be securitised) from the originator. SPV is an entity specially created for the purpose of
executing the deal. The originator transfers the assets in its book to the SPV which
holds the legal title to the asset. It makes the payment to the originator for the assets
purchased.

4. Investor
Normally, the investors are financial institutions, mutual fund, provident fund, pension
fund, insurance companies, etc. The investors receive the interest and principal amount
as per the agreement.

5. Credit enhancer
The credit enhancer provides the required amount of credit enhancement to reduce the
overall credit risks of a security issue. The purpose of credit enhancement is to improve
the credit rating thereby improve the marketability of the instrument.

6. Credit rating agency

 The investors take on the risk of the asset pool rather than the originator. The rating
agency therefore assess the strength of the cash flow and the mechanism designed to
ensure timely payment to the investors.

7. Conduits
They buy assets from different originator or sellers. They pool the assets and then sells
to the investors. Conduits are useful for firms that do not have enough assets to package
as assets backed security themselves.

8. Investment bankers
An investment bankers act as structurers. Their role is to bring together all the parties to
the deal and structure the deal.

9. Servicer
It collects the payment due from the obligor and passes it to the SPV, follows up with
delinquent borrowers and pursues legal remedies available against the defaulting
borrowers. Since it receives the instalments and pays it to the SPV, it is also called
Receiving and Paying Agent(RPA).

Stages in Securitization Process (Multi-Stage Process)

Stage 1: Asset Identification
• The Originator (the institution which wishes to take securitization route)
• First identifies the assets or pool of assets that have to be securitized.
• Cash flows from the reference assets should be reliable.
• Pool of assets should carry identical dates of interest payments.
• Quantity of the assets should be huge enough to spread over securitization assets.
• The asset should be standardized so that the risk is diversified.
Stage 2: Structuring Asset Backed Securities
• Asset originator creates a SPV and sells reference assets to SPV.
• SPV is the legal entity designed to isolate receivables and associated cash flows from
the risk of the originator bankruptcy.
• SPV structures the asset backed securities based on the preferences of the originator and
the investor.
• After structuring asset backed securities, they are offered to investors through Merchant
Banker.
Stage 3: Investor Servicing
• The investor is serviced by periodic payments depending on the nature of asset backed
securities.
• According to the terms of issues, the investor may be paid interest periodically and the
principal at the end of the maturity as bullet payment or they may be paid both interest
and principal periodically.

Process of securitization
(for diagram refer note book)
1. Obligor approaches for the loan to Originator.
2. Originator sanctions the loan to Obligor.
3. Originator appoints SPV and transfers assets/beneficial interest.
4a. SPV appoints investment banker (Timing of issue and structuring of instrument).
4b. SPV appoints Credit Enhancer (Guarantee, Letter of Credit – enhances credit in case of
default).
4c. SPV appoints CRA (Gives rating to the instrument/Assigns ratings).
5. SPV Issues instrument to the investors.
6. Investors give cash amount to SPV.
7. SPV issues share certificate to investors.
8. SPV transfers funds to originator.
9. SPV approaches servicer.
10. Servicer approaches Obligor to collect money.
11. Obligor pays money to Servicer.
12. Servicer transfers amount to SPV (Make final payment of Principal and Interest).
13. SPV makes payment to investors on future date.

Types of securitization
Pay-through structure
• Receivables payment are assigned to the SPV.
• Obligors usually make payment to the originators and originators to the SPV.
• Cashflows received by the SPV are used to make the required payments of interest and
principal to the investors.
 • Securities are collaterized debt obligations of issuers.
• Assets remain the originator’s Balance Sheet.
• Payments of interest are passed through to the investors.
• It is of multiple security structure.
• Securities are classified as Senior, Junior, etc according to their maturity.
• Credit Rating is compulsory here as assets are on Originator’s Balance Sheet.
• Senior debt holders are paid first with surplus funds after meeting interest payable to all
the investors.
• The cashflows emerging from various assets are pooled together and then distributed
among security holders according to the maturity patterns of securities held by investors.
• Involves no servicer. Originator collects funds from Obligor.
(for diagram refer note book)

Pass-through structure
• pass through structure is an instrument which gives investors a direct undivided
ownership interest in the underlying pool of assets.
• The investors actually has credit ownership on the asset.
• It is a single security structure.
• Securities are not classified as Senior, Junior, etc.
• Each investor is paid some return on principal along with interest every month.
• Appointment of Credit Rating Agency is not compulsory.
• Pass through certificates involves matching the tenure of the security with the life of
cash flows from the underlying assets.
• Assets are removed from the Originator’s Balance Sheet.
• Securities represent ownership in underlying pool of assets.
• Payment of principal and interest is passed through to the investors.
• SPV acts primarily as a servicer.
(for diagram refer note book)
Different between Pass-Through and Pay-Through Certificate.
Sr. Content Pay-through certificate Pass-through certificate
no
1. Meaning Pay through security is a When a corporation or
mortgage backed bond government agency buys a loan
collateralized by a pool of from lenders to pool and packages
mortgages. It is also called as of security for resale to investors is
cash flow bond. known as pass through certificate.
2. Security Pay Through is usually Pass through Certificate is a
structure considered as Multiple security Single security structure.
structure.
3. Ownership In Pay Through the investors do In pass through, investor have a
not have a direct exposure to direct ownership interest in the
ownership interest in the underlying pool of assets. i.e.
underlying pool of assets. i.e. cash flow move directly from
since cash flows are transferred obligor to investors.
from SPV.
4. Credit Rating In a pay through credit rating is Credit rating is not compulsory
very essential in form of rate the since the ownership of assets/cash
quality of instrument since flows are hold by investors.
ownership is not transferred to
investor.
5. Flow of Payment is made in the form of Regular payment of interest and
receivables interest and principal amount are return of principle that borrower
from obligor directly passed to the investors. make on the original loan are
i.e. from obligor to special directly furnished or passed to the
purpose vehicle and then to investor.
investor.
6. Structure of It is usually considered as a It is a single security structure
security multiple security structure.
7. Originator In a pay through assets remains In pass through assets effect are
balance sheet on the originators balance-sheet. usually treated as off-balance
sheet, since assets are removed
from originators balance-sheet.
8. Parties Here parties involved are obligor, Parties involved here are
involved SPV, investment banker, credit originator, obligor and SPV.
rating agency, servicer and credit
enhancer.
9. Classification Securities are classified as senior In pass through there is no
of security & junior and payment of benefits classification is done on the basis
are also done accordingly. of senior and junior.
 Legal issues in securitization
SARFAESI Act
Introduction
The Securitization and Reconstruction of Financial Assets and Enforcement of Security
Interest Act, of 2002, allows banks and financial institutions to auction properties (residential
and commercial) when borrowers fail to repay their loans. Though SARFAESI Act was
introduced in 2002 but it was Amended in 2004. It enables banks to reduce their non-
performing assets (NPAs) by adopting measures for recovery or reconstruction. Upon loan
default, banks can seize the securities (except agricultural land) without intervention of the
court.
SARFAESI is effective only for secured loans where bank can enforce the underlying security
(eg. hypothecation, pledge and mortgages). In such cases, court intervention is not necessary,
unless the security is invalid or fraudulent. However, if the asset in question is an unsecured
asset, the bank would have to move the court to file civil case against the defaulters.
Before introduction of SARFAESI Act, there existed civil court to solve the problem of bad
loans or NPAs. But due to the failure of the civil court in solving the cases, in 1993 the special
court came into existence to only solve the problem of bad recoveries. Under special courts
there was Debt Recovery Tribunals and Debt Recovery Appellate Tribunals. But this system
also failed and due the failure of the special court SARFAESI came into existence.

Purpose/Objectives of SARFAESI Act

• Before introducing the SARFAESI Act what options were available with secured
creditors to recover the loan amount in case of default in repayment by borrower?
• Earlier companies Act 1956 sec 137 which was suggested to secured creditor that go to
court and file the case against the borrower and recover the loan amount. But in case of
borrower go to court and “tell to my load I m not in a position to repay the loan amount
but I will pay in near future”. In that critical situation bank was unable to recover the
loan amount from borrower.
• For the solution of this, the government introduced RECOVERY OF DEBTS DUE
TO BANKS AND FINANCIAL INSTITUITIONS ACT (RDDBFI) in 1993 that was
used for recovery of default loans.
• It had various features such as Debt Recovery Tribunals and Debt Recovery Appellate
Tribunals.
• However there were several loopholes that were misused by the borrowers as well as
the lawyers.
• This led to the Govt. to introspect the act and to reform it.
• Hence another committee led by Mr. Andhyarujina was appointed.
 • This committee recommended various new legislations to empower banks and other
financial institutions to take possession of the NPAs.
• Efficient or rapid recovery of non-performing assets (NPAs) of the banks and FIs.
• Allows bank and FIs to take properties (say, commercial/residential) when borrow fail
to repay their loans.

How SARFAESI Act works

• The SARFAESI Act, 2002 gives powers of "seize and desist" to banks.
• Banks can give a notice in writing to the defaulting borrower requiring it to discharge
its liabilities within 60 days.
• If the borrower fails to comply with the notice, the Bank may take recourse to one or
more of the following measures:
– Take possession of the security for the loan
– Sale or lease or assign the right over the security
– Manage the same or appoint any person to manage the same.
• The SARFAESI Act also provides for the establishment of Asset Reconstruction
Companies (ARCs) regulated by RBI to acquire assets from banks and financial
institutions.
• The Act provides for sale of financial assets by banks and financial institutions to asset
reconstruction companies (ARCs).
• RBI has issued guidelines to banks on the process to be followed for sales of financial
assets to ARCs.

Powers conferred on Secured Creditor under the SARFAESI Act

• The SARFAESI Act provides for the manner for enforcement of security interests by a
secured creditor without the intervention of a court or tribunal.
• If any borrower fails to discharge his liability in repayment of any secured debt within
60 days of notice from the date of notice by the secured creditor, the secured creditor is
conferred with powers under the SARFAESI Act to
– take possession of the secured assets of the borrower, including transfer by way
of lease, assignment or sale, for realizing the secured assets
– takeover of the management of the business of the borrower including the right
to transfer by way of lease, assignment or sale for realizing the secured assets,
– appoint any person to manage the secured assets possession of which is taken by
the secured creditor, and
 – Require any person, who has acquired any of the secured assets from the borrower
and from whom money is due to the borrower, to pay the secured creditor so
much of the money as if sufficient to pay the secured debt.

Methods of recovery/ banks utilize for effective tool for bad loans (NPA) recovery
The Act provides three methods for recovery of NPA, i.e.:
1. Securitization
Securitization is the process of pooling and repackaging of financial assets into
marketable securities that can be sold to investors. In case of the bad asset management.
securitization is the process of conversion of existing illiquid assets into liquid
marketable securities. The securitization company takes custody of the underlying
mortgage assets of the borrower, it can initiate the following steps:
 Acquisition of financial assets from any originator.
 Raising of funds from qualified institutional buyers by issue of security.
 Raising of funds in any prescribed manner.
 Acquisition of financial asset may be coupled with taking custody of the martgage
land, building etc.

2. Assets Re-Construction company

Assets reconstruction is the activity of converting bad or non-performing assets into
performing assets. Reconstruction is to be done with the regulations from RBI and the
SARFAESI Act gives the following components for reconstruction of assets:
 Getting the possession of the asset.
 Sale or lease of a part or whole of the asset of the borrower.
 Rescheduling of payment of debts.
 enforcement of security interest.
 Settlement of dues payable by the borrower.

3. Enforcement of security
here the legal notice is sent to the borrower to repay the debt within 60 days from the
notice by the lender. If the borrower fails to comply with the notice the lender may
enforce the security interest by following the provision of the act:

 Take the possession of the security.

 Sale or lease the right over the security.
 Appoint manager to manage the security.
Rights of the borrowers
• The borrowers can at any time before the sale is concluded, remit the dues and avoid
loosing the security.
• In case any unhealthy/illegal act is done by the Authorized Officer, he will be liable for
penal consequences.
• The borrowers will be entitled to get compensation for such acts.
• For redressing the grievances, the borrowers can approach firstly the Debts Recovery
Tribunal (DRT) and thereafter the Debts Recovery Appellate Tribunal (DRAT) in
appeal.
• The limitation period is 45 days and 30 days respectively.