Securitization

Concept of Securitization

λ 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.
λ 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.
λ In securitization, homogeneous pool of assets are identified and then
they are packaged into a new instrument that can be sold to investors,
whose payments are supported by the cash flows from that pool.
Continued…
λ Securitization is a structured financing arrangement.
λ The term structured finance implies that a financial instrument
is structured or custom made to suit the risk-return, and maturity
needs of the investor, rather than being a simple claim against an
entity.
λ In a structured finance arrangement, the essential characteristic
of promise to repay the investor in a security is backed by
1.) The value of the underlying financial asset
2.) The credit support of a third party to the transaction
λ The firm that securitizes the debt, fixes the terms of the
instrument in such a way that it suits the various risk-return
preferences of investors.
 Continued…

λ For example, in case of housing loans, there could be a portfolio of

loans with different maturities. When these loans are bundled
together for the purpose of securitization, an investor could choose a
securitized paper with a specific maturity period that suits his needs.
λ In Securitization, the servicing of the securitized paper is tied up
with the cash flows of the specific asset pools identified for the
purpose.
Securitizable Assets
Mortgage-Backed Securities
1. Residential Mortgage Loans
2. Commercial Mortgage Loans
θ Asset-Backed Securities
1. Credit card Receivables
2. Auto Loan Receivables
3. Personal Loan Receivables
4. Lease Receivables
5. Trade Receivables
6. Export Receivables
Continued…
λ Any resource with predictable cash flows can be securitized as
follows:
¬ Bills that are made at a five star hotel.
¬ Tickets that are to be solved at a cinema hall. Future billings
¬ of an airline.
¬ Hire Purchase receivables.
¬ Non-performing assets of a financial entity.
Need For Securitization

λ For the requirement of Funds, as securitization is a mode of

financing.
λ Enhancing Liquidity.
λ Off balance sheet financing - removal of accounts.
λ Need for Asset-liability management of Financial institutions.
 Process of securitization

Borrowers Investors
(Rating-B 12% p/a) (Rating-AAA, 7-9% P/A)
Credit
Cherry Picking SERVICER rating
Senior
Senio
r

The The
TheSpecial
Special
The
Originator Purpose
PurposeVehicle
Vehicle
Originato Mezzanine
Mezzanin
(Pay
(Paythrough/Pass
through/Pass
r
through certificates)
through e
certificates)

Subordinate
Subordinat
Credit Enhancement
Structurer e
Or
Structural Credit Enhancement
Arranger
The Waterfall in Securitization

Cash
Flows

Senior

Mezzanine

Equity or Subordinate
Participants in the Securitization Process

λ The Originator: A firm that wants to securitize its assets

is called originator.
λ The servicer or Administrator: It collects the payment
due from the Obligor/s and passes it to the SPV, follows
up with delinquent borrowers and pursues legal remedies
available against the defaulting borrowers. Since it
receives the installments and pays it to the SPV, it is also
called the Receiving and Paying Agent.
 Continued…
• The Special Purpose Vehicle: The issuer also known as the
SPV is the entity, which would typically buy the assets (to
be securitized) from the Originator. SPV is an entity
specially created for the purpose of executing the deal. The
originator transfers the assets in its books to the SPV which
holds the legal title to the assets. It makes the payment to the
• oTrhigeinaIntovrefsotrorths:e aNssoertsmpaullryc, hat sheed
investors are financial institutions, mutual funds, provident
funds, pension funds, insurance companies etc. The
investors receive the interest and principal amount as per the
agreement.
Continued…

λ The 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.
λ The 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.
λ Credit Enhancer: The credit enhancer provides the required
amount of credit enhancement to reduce the overall credit risk
of a security issue. The purpose of credit enhancement is to
improve the credit rating and thereby improve the
marketability of the instrument.
Continued…
λ Arranger or Structurer: An investment bankers act as
structurers. Their role is to bring together all the parties to the
deal and structure the deal.
λ Trustee: It accepts the responsibility for overseeing that all the
parties to the securitization deal perform in accordance with
the trust agreement. An agent is appointed essentially to look
after the interests of the investors.
Mechanism of Securitization
Pass-Through Certificates:
λ In a PTC, the SPV issues PTCs which are essentially
participation certificates that enable the investors to take a direct
exposure on the performance of the securitized assets. These
certificates imply that the investors hold a proportional beneficial
interest in the assets held by the SPV.
λ Investors are serviced as and when cash flows are
generated from the underlying assets.
λ Any delay or disruption in cash flows is shielded to the
extent of the credit enhancement available.
λ In PTCs, the securities are serviced directly
from the cash flows or the installment of the
loans.
λ Car loans and housing loans are some of the cases where
Continued…
Pay-Through structure:
λ A pay through structure gives only a charge against the cash
flows arising from the securitized assets while the ownership of
the assets lies with the SPV.
λ In a pay-through arrangement, cash flows of the underlying
assets and the services of the securitized papers are delinked.
λ The SPV issues a secured debt instrument to the investors as a
securitized paper.
Continued…
λ The SPV invests all the cash flows received form
the asset pools in govt. securities or other securities.
λ Later, the proceeds from such investments are used to service
the investors.
λ The SPV has to do effective cash management to service the
investors.
Benefits of Securitization
λ
• For Originator
1. Off-balance sheet financing.
2. Improves capital requirements.
3. Enhances Liquidity
4. Concentrate on core business.
5. Reduction in borrowing costs.
6. Another mode of Financing.
Continued…
λ For Investors
1. Advantage to earn a high return on risk adjusted basis.
2. Opportunity to invest in a pool of high quality
credit- enhanced assets
3. Portfolio diversification – alternate investment vehicle.
4. Bankruptcy Remoteness – Investors are not affected by the
insolvency of the originator.
Risk Assessment
in Securitization
λ Collateral Risk: Extent to which the borrowers of underlying
assets will default.
λ Structural Risk: Risk involved in
passing on the cash flows from
asset pools and credit enhancement to the investors.
λ Legal Risk: Extent to which the regulatory action can delay or
prevent the payment to investors.
λ Third Party Risk: Failure of performance of third parties such
as servicer, trustees, bankers etc.
Problems in Securitization in
India
λ Stamp Duty: is heavy in some states.
λ Accounting Treatment: No clear guidelines
λ Lack of Standardization: Format of the mortgage loan
agreement is not uniform.
λ Foreclosure Laws: No separate Law for securitization.
Regulation of Securitization in India
λ There is no specific regulatory framework for securitization in
India.
λ The enactment of securitization and Reconstruction of Financial
Assets and Enforcement of Security interest Act (SARFAESI
Act)-2002 was the first legislative step that enabled the
securitization of the NPAs of Banks and FIs.
λ The High Level Committee on corporate Debt and
Securitization (Patil Committee) constituted in 2005 is an
important development in the Indian Financial system.
λ The RBI guidelines for securitization of standard assets by
banks was issued in 2006 on certain key aspects of
securitization such as the true sale criteria, capital treatment
etc.
Continued
…
λ In 2007, SCRA (Securities Contract Regulation Act) was
amended to include the securitized instruments in the
definition of the term securities.
λ This has lead to listing and trading of securitized papers in the
stock exchanges.
λ SEBI has released draft regulations for public offering and
listing of securitized debt instruments in June 2007, which is
yet to be formalized as a regulation.
 Glossar
y
λ Asset Backed Securities: Securities backed by receivables other
than those arising out of real estate.
λ Mortgage Backed Securities : Securities carved out of
receivables from mortgage funding
λ Bankruptcy Remote : SPV or investors are not affected by
insolvency of originator
λ Seasoning: Seasoning refers to monitoring the performance of
the selected assets over a period of time, say 6 months, to
ensure that all the cherry picked assets are sound assets.
λ Cherry Picking : Picking up selected high quality assets for the
purpose of securitization leaving behind low grade assets.
λ Co-mingling Risk : The risk that the cash flow from securitized
assets merging or mingling with other cash flows of the
originator
λ Credit Enhancement : A mechanism by which the credit rating
of the packaged pool of assets is improved. This can be
achieved through provision of bank guarantee / security bond,
formation of a cash collateral account, creating a reserve fund,
arranging a liquidity provider, getting a letter of credit or by
getting credit insurance ( credit default swap), besides the
more common form of credit enhancement through over
collateralization
λ Pass Through : SPV makes payments to the investors on the
same periods and subject to the same fluctuations as are
actually received
λ Pay Through : SPV pays on stipulated dates irrespective of
collection dates and amount actually collected or likely to be
collected.
λ SPV: A conduit or pass through organization or corporation
created for limited purpose or life. A qualified SPV (SPV) is
an entity which maintains an arm length relationship with the
originator. A SPV can be a company, trusty or a mutual fund /
AMC.
λ Structural Credit Enhancement : A technique of credit
enhancement by creation of senior and junior securities,
thereby enhancing the credit rating of the senior securities.
λ Over-collateralization : A form of credit enhancement in which
the originator transfers extra collateral to the SPV to serve as
security in the event of delinquencies
λ Waterfall : Cash flow streams, in a structured credit
enhancement process, which are shared by senior, junior and
equity class of investors in order of priority. Sometimes cash
flow streams are segregated as interest only received during
the life of the deal and principal only category received on
maturity.
Meaning
• A derivative is a financial instrument whose value derives from the
value of something else.
• It is a contract between two parties derives from its value/price from
an underlying asset.
Features of Derivative Contract
• Financial Derivative is a contract.
• It derives value from underlying assets.
• It has specified obligation as per the contract which
means there are parties involved with specified
conditions.
• Financial Derivatives are carried off-balance sheets.
• Trading of underlying assets is not involved.
• Financial Derivatives are mostly secondary market
instruments.
Functions of Derivative market
• Price Discovery: Derivatives assist in defining prices of
underlying assets and future spot rates for the
commodity.
• Transfer of risks: Derivative is a contractual
investment tools hence, transfer the risk from one
party to another i.e. buyer to the seller.
• Maintaining liquidity from derivative association with
the cash market.
• Check on Speculation:Derivative helps in hedging the
risk against unfavorable price movements of assets
with the help of future and forward contracts.
• Encourage young investors and entrepreneurs.
• Motivates and increases savings and investments.
Types of derivatives
The four major types of derivative contracts are:
• Options
• Forwards
• Futures
• Swap
Types of Derivatives

1. Forwards
• Agreement between buyer and seller to buy or sell an asset at a
predetermined price at a specified future date.
• Agreed price is called forward price.
• It is not traded on a recognized stock exchange.
• It does not require initinal payment.
• Forward contract is a zero-sum game.ie., gain for one and loss for
other.
2.Future Contract
• Agreement between buyer and seller to buy or sell a
commodity, security or currency at a predetermined
future date at a price agreed upon today. Provides
both right and obligation to perform the contract. It
requires to deposit of margin to avoid default risk.
 Types of Futures:
• Commodity Futures
• Financial Futures
(a)Currency Futures
(b)Stock Futures
(c)Interest Rate
(d)Index Futures
3. Options
• Options provide the buyer of the contracts the right,
but not the obligation, to purchase or sell the
underlying asset at a predetermined price.
• One who is selling is called option writer
• One to buy the goods called option holder.
4. SWAP contract
• Swaps are derivative contracts that allow the
exchange of cash flows between two parties. The
swaps usually involve the exchange of a fixed cash
flow for a floating cash flow. The most popular types
of swaps are interest rate swaps.
• Interest Rate Swap: An interest rate swap is a
derivative contract through which two counterparties
agree to exchange one stream of future interest
payments for another, commodity swaps, and
currency swaps.
Types of SWAP
1. Interest Rate Swaps.
2. Currency Swaps.
3. Commodity Swaps.
4. Credit Default Swaps.
5. Zero Coupon Swaps.
6. Total Return Swaps.
7. The Bottom Line.
Purpose of Derivatives
• The key purpose of a derivative is the management and especially
the mitigation of risk. When a derivative contract is entered, one
party to the deal typically wants to free itself of a specific risk, linked
to its commercial activities, such as currency or interest rate risk, over
a given time period.
Advantages of Derivatives
Unsurprisingly, derivatives exert a significant impact on modern
finance because they provide numerous advantages to the
financial markets:

1. Hedging risk exposure

➢Since the value of the derivatives is linked to the value
of the underlying asset, the contracts are primarily used
for hedging risks. For example, an investor may purchase a
derivative contract whose value moves in the opposite
direction to the value of an asset the investor owns. In this
way, profits in the derivative contract may offset losses in
the underlying asset.
➢It is also said as reducing risk in one investment by
making another investment.
2. Underlying asset price determination

Derivatives are frequently used to determine the

price of the underlying asset. For example, the spot
prices of the futures can serve as an approximation of a
commodity price.
3. Market efficiency
It is considered that derivatives increase the
efficiency of financial markets. By using derivative
contracts, one can replicate the payoff of the assets.
Therefore, the prices of the underlying asset and the
associated derivative tend to be in equilibrium to
avoid arbitrage.
Arbitrage: Arbitrage is the strategy of taking advantage of
price differences in different markets for the same asset.
For it to take place, there must be a situation of at least two
equivalent assets with differing prices. In essence, arbitrage
is a situation that a trader can profit from opportunities.
4. Access to unavailable assets or markets
Derivatives can help organizations get access to
otherwise unavailable assets or markets. By employing
interest rate swaps, a company may obtain a more
favorable interest rate relative to interest rates
available from direct borrowing.
Disadvantages of Derivatives
Despite the benefits that derivatives bring to the financial markets, the
financial instruments come with some significant drawbacks.
1. High risk
The high volatility of derivatives exposes them to potentially
huge losses. The sophisticated design of the contracts makes the
valuation extremely complicated or even impossible. Thus, they bear a
high inherent risk.
2. Speculative features
Derivatives are widely regarded as a tool of speculation.
Due to the extremely risky nature of derivatives and their
unpredictable behavior, unreasonable speculation may lead to
huge losses.

3. Counter-party risk
Although derivatives traded on the exchanges generally
go through a thorough due diligence process, some of the
contracts traded over-the-counter do not include a benchmark
for due diligence. Thus, there is a possibility of counter-party
default.
 Definitions of Different Types of Risk

• Speculative risks: Those that offer the chance of a

gain as well as a loss.
• Pure risks: Those that offer only the prospect of a
loss.
• Demand risks: Those associated with the demand
for a firm’s products or services.
• Input risks: Those associated with a firm’s input
costs.

(More...)
• Financial risks: Those that result from financial
transactions.
• Property risks: Those associated with loss of a firm’s
productive assets.
• Personnel risk: Risks that result from human actions.
• Environmental risk: Risk associated with polluting the
environment.
• Liability risks: Connected with product, service, or
employee liability.
• Insurable risks: Those which typically can be covered
by insurance.
• Ram Sam
• Buyer Seller
• LAnd
• 1 Lakh advance
• Underlying asset – Land
• Derivative – Agreement
• Option Buyer – Ram
• Option seller also called Writer – Sam
• Premium Amount = Initial payment
over-the-counter (OTC)
• An over-the-counter (OTC) derivative is a financial contract that does
not trade on an asset exchange, and which can be tailored to each
party's needs. A derivative is a security with a price that is dependent
upon or derived from one or more underlying assets.
Advantages Of OTC Derivatives
The benefits of over-the-counter trading include:
• It allows small companies to engage in trade without being listed on stock exchanges. These
companies can also stand to benefit from lesser financial and administrative costs compared to
companies listed on stock exchanges.
• It can be used for hedging, transferring trading risks, and as leverage for business operations.
• It can allow for increased flexibility as the companies don’t have to abide by the standardised
norms vis-a-vis exchange-traded derivatives.
• It can allow companies to provide stable prices to their customers.
Disadvantages Of OTC Derivatives
Over-the-counter trading has some disadvantages as well. Here’s a look:
• Any OTC contract runs the associated risk of credit or default as there is no
central mechanism to clear and settle the transactions.
• Any OTC contract is fraught with inherent and systemic risks in the absence of
standardised regulations and norms.
• OTC contracts are inherently speculative, thus having the possibility of creating
market integrity issues and forcing traders to make losses.
Exchange based derivatives
• An exchange traded derivative is a financial contract that is listed and
trades on a regulated exchange. Simply put, these are derivatives
that are traded in a regulated fashion.
 What is the difference between exchange traded
and OTC derivatives?

• OTC or over the counter is the method of trading for the companies
that are not listed formally. Exchange is the method of trading
commodities and derivatives for the well-established companies in an
organized manner. Securities that are traded over the counter are
traded through the dealer.
Differences
Over-The-Counter Derivatives
Particulars Exchange-Traded Derivatives
(OTDs)
(ETDs)
The stock exchange facilitates
This is a private transaction
Nature of transaction bilateral trading by acting as an
between two or more parties.
intermediary.

The collateral is negotiated

Margin is set according to the stock
Margin in trade between the parties that can be
exchange rules.
any amount or asset.

A simple liquidation process is
Process of liquidation
followed.
Liquidation is subject to
negotiation and agreement
between the two parties.

This involves credit/ default risk

Risk exposure No default risk.
between the involved parties.

Price transparency Price transparency. No price transparency.

Listed on stock exchanges with
Regulation
standardised terms and conditions.
Minimal regulation owing to no
involvement of stock exchanges or
any formal intermediary.