CA S.S.

RAJAGOPAL SECURITISATION KSA

SECURITIZATION

BIRDS EYE VIEW OF DEBT SECURITISATION

1. Background

Companies or firms which are involved in lending the money or making

credit sale must have a huge balance of receivables in their Balance
Sheet. Though they have a huge receivable but still they may face
liquidity crunch to run their business. One way may to adopt
borrowing route, but this results in changing the debt equity ratio of
the company which may not only be acceptable to some stakeholders
but also put companies to financial risk which affects the future
borrowings by the company. To overcome this problem ‘securitization’
process is adopted.

2. Meaning

Securitization is a financial transaction in which assets are pooled and

securities representing interests in the pool are issued.

3. Example

A finance company has issued a large number of car loans. It desires

to raise further cash so as to be in a position to issue more loans.

The company pools a large number of these loans and sells the claim
in the pool to investors.

This process helps the company to raise finances and get the loans off
its Balance Sheet. These finances shall help the company disburse
further loans. Similarly, the process is beneficial to the investors as it
creates a liquid investment in a diversified pool of auto loans, which
may be an attractive option to other fixed income instruments.

The whole process is carried out in such a way, that the ultimate
debtors- the car owners- may not be aware of the transaction. They
shall continue making payments the way they were doing before,
however, these payments shall reach the new investors instead of the
company.

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4. Securitization Process
 Securitization can take the form of ‘debt securitization’ in which the
underlying pool of assets (debt) is sold to a company or a trust for
an immediate cash payment.
 The company to which the underlying pool of assets is sold is
known as a ‘Special Purpose Vehicle’ (SPV) and the company which
sells the underlying pool of assets is known as the originator.
 The SPV which buys these pool of assets issues securities and
utilizes the regular cash flows arising out of the underlying pool of
assets for servicing such issued securities.
 Thus securitization follows a two way process, (1) the sale of a pool
of assets to SPV for immediate cash payment and (2) the
repackaging and selling by the SPV, the security interests
representing claims on incoming cash flows from the pool of assets
to third party investors by issuance of tradable securities.
 The process of securitization is generally without recourse i.e. the
investor bears the credit risk or risk of default and the issuer is
under an obligation to pay to investors only if the cash flows are
received by him from the collateral. The issuer however, has a right
to legal recourse in the event of default.
 The risk run by the investor can be further reduced through credit
enhancement facilities like insurance, letters of credit and
guarantees.
 In a simple pass through structure, the investor owns a
proportionate share of the asset pool and cash flows when
generated are passed on directly to the investor. This is done by
issuing pass through certificates.
 In mortgage or asset backed bonds, the investor has a lien on the
underlying asset pool. The SPV accumulates payments from the
original borrowers from time to time and makes payments to
investors at regular predetermined intervals.
 The SPV can invest the funds received in short term instruments
and improve yield when there is time lag between receipt and
payment.
 In India, the Reserve Bank of India had issued draft guidelines on
securitization of standard assets in April 2005. These guidelines
were applicable to banks, financial institutions and non banking
financial companies. The guidelines were suitably modified and
brought into effect from February 2006.

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QUESTIONS AND ANSWERS

Question 1: Who are the participants in Securitization process

PRIMARY PARTICIPANTS
1 Originator It is the initiator of deal or can be termed as
securitizer. It is an entity which sells the assets
lying in its books and receives the funds generated
through the sale of such assets. The originator
transfers both legal as well as beneficial interest to
the Special Purpose Vehicle.
2 Special Also, called SPV is created for the purpose of
purpose executing the deal. Since issuer originator
vehicle transfers all rights in assets to SPV, it holds the
legal title of these assets. It is created especially
for the purpose of securitization only and normally
could be in form of a company, a firm, a society or
a trust.

The main objective of creating SPV is to remove

the asset from the Balance Sheet of Originator.
Since, SPV makes an upfront payment to the
originator; it holds the key position in the overall
process of securitization. Further, it also issues the
securities (called Asset Based Securities or
Mortgage Based Securities) to the investors.
3 Investors Investors are the buyers of securitized papers who
may be an individual, an institutional investor such
as mutual funds, provident funds, insurance
companies etc.

Since, they acquire a participating in the total pool

of assets/receivable, they receive their money
back in the form of interest and principal as per
the terms agreed.
SECONDARY PARTICIPANTS
1 Obligors Actually they are the main source of the whole
securitization process. They are the parties who
owe money to the firm and are assets in the
Balance Sheet of Originator. The amount due from
the obligor is transferred to SPV and hence they
form the basis of securitization process and their

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credit standing is of paramount importance in the

whole process.

2 Credit rating Since the securitization is based on the pools of

agencies assets rather than the originators, the assets have
to be assessed in terms of its credit quality and
credit support available.

Rating agency assesses the following:

• Strength of the Cash Flow.
• Mechanism to ensure timely payment of interest
and principle repayment.
• Credit quality of securities.
• Liquidity support.
• Strength of legal framework.

Although rating agency is secondary to the process

of securitization but it plays a vital role.
3 Receiving Also, called Servicer or Administrator, it collects
and Paying the payment due from obligor(s) and passes it to
Agent [RPA] SPV. It also follow up with defaulting borrower and
if required initiate appropriate legal action against
them. Generally, an originator or its affiliates acts
as servicer.
4 Credit Since investors in securitized instruments
Enhancer are directly exposed to performance of the
underlying and sometime may have limited or no
recourse to the originator, they seek additional
comfort in the form of credit enhancement.

In other words, they require enhancement of

credit rating of issued securities which also
empowers marketability of the securities.

Originator itself or a third party say a bank may

provide this additional context called Credit
Enhancer.

While originator provides his comfort in the form of

over collateralization or cash collateral, the third
party provides it in form of letter of credit or
surety bonds.
5 Trustees Trustees are appointed to oversee that all parties
to the deal perform in the true spirit of terms of

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agreement. Normally, it takes care of interest of

investors who acquires the securities.
6 Structurer It brings together the originator, investors, credit
enhancers and other parties to the deal of
securitization. Normally, these are investment
bankers also called arranger of the deal. It
ensures that deal meets all legal, regulatory,
accounting and tax laws requirements.

Question 2: Discuss briefly the steps in Securitization

mechanism

1. Creation of Pool of Assets

The process of securitization begins with creation of pool of assets by

segregation of assets backed by similar type of mortgages in terms of
interest rate, risk, maturity and concentration units.

2. Transfer to SPV

Once assets have been pooled, they are transferred to Special Purpose
Vehicle (SPV) especially created for this purpose.

3. Sale of Securitized Papers

SPV designs the instruments based on nature of interest, risk, tenure

etc. on the pool of assets. These instruments can be Pass Through
Security or Pay Through Certificates.

4. Administration of Assets

The administration of assets in subcontracted back to originator which

collects principal and interest from underlying assets and transfer it
to SPV, which works as a conduct.

5. Recourse to Originator
Performance of securitized papers depends on the performance of
underlying assets and unless specified in case of default they go back
to originator from SPV.

6. Repayment of funds

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SPV will repay the funds in form of interest and principal that arises
from the assets pooled.

7. Credit Rating to Instruments

Sometime before the sale of securitized instruments credit rating can
be done to assess the risk of the issuer.

Question 3: Discuss the Features of Securitization

1 Creation of The process of securitization can be viewed as

Financial process of creation of additional financial
Instruments products or securities in market backed by
collaterals.
2 Bundling and When originator pools all the assets it is
Unbundling bundling and when these are broken by SPV
into instruments of fixed denomination it is
unbundling.
3 Tool of Risk In case where the assets are securitized on
Management non-recourse basis, then securitization process
acts as risk management tool, as the risk of
default is shifted.
4 Tranching Portfolio of different receivable or loan or asset
are split into several parts based on risk and
return they carry called ‘Tranche’. Each Trench
carries a different level of risk and return.
5 Homogeneity Under each tranche the securities issued are of
homogenous nature and even meant for small
investors who can afford to invest in small
amounts.
6 Structured Due to tranche in the process of securitization,
Finance financial instruments are tailor structured to
meet the risk return trade of profile of investor,
and hence, these securitized instruments are
considered as best examples of structured
finance.

Question 4: What are the benefits of Securitization to the

Originator and Investor?

Benefits to Originator
1 Off-Balance When loan/receivables are securitized it
sheet financing releases a portion of capital tied up in these
assets resulting in off Balance Sheet financing
leading to improved liquidity position which
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helps in expanding the business of the

company.
2 More By transferring the assets the entity could
specialization in concentrate more on core business as
the main collection of loan is transferred to SPV.
business Further, in case of non- recourse arrangement
even the burden of default is shifted.
3 Helps to improve Especially in case of Financial Institutions and
financial ratios Banks, it helps to manage Capital –To-
Weighted Asset Ratio effectively
4 Reduced Since securitized papers are favorably rated
borrowing cost due to credit enhancement, they can be
issued at reduced rate yield and hence the
originator earns a spread, resulting in reduced
cost of borrowings.
Benefits to Investor
1 Diversification of Purchase of securities backed by different
risk types of assets provides the diversification of
portfolio resulting in reduction of risk.
2 Regulatory Acquisition of asset backed securities, backed
requirement by assets belonging to a particular industry
say micro industry helps banks to meet
regulatory requirement of investment of fund
in specific industry.
3 Protection In case of recourse arrangement if there is
against default any default by any third party then originator
shall make good the lost amount. Moreover,
there can be insurance arrangement for
compensation for any such default. Similarly
credit enhancement facility may mitigate the
default risk.

Question 5: What are the problems faced in growth of

Securitization instruments in Indian context?

1 Stamp duty Stamp Duty is one of the obstacle in India.

Under Transfer of Property Act, 1882, a
mortgage debt stamp duty which even goes
upto 12% in some states of India and this
impeded the growth of securitization in India.
It should be noted that since pass through
certificate does not evidence any debt only
able to receivable, they are exempted from
stamp duty.
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Moreover, in India, recognizing the special

nature of securitized instruments in some
states has reduced the stamp duty on them.
2 Taxation Taxation is another area of concern in India. In
the absence of any specific provision relating
to securitized instruments in Income Tax Act
experts’ opinion differ a lot. Some are of
opinion that SPV as a trustee is liable to be
taxed in a representative capacity then others
are of view that instead of SPV, investors will
be taxed on their share of income. Clarity is
also required on the issues of capital gain
implications on passing payments to the
investors
3 Accounting Accounting and reporting of securitized assets
in the books of originator is another area of
concern. Although securitization is slated to be
an off-balance sheet instrument but in true
sense receivables are removed from
originator’s balance sheet. Problem arises
especially when assets are transferred without
recourse.
3 Lack of Every originator following his own format for
standardization documentation and administration. This lack of
standardization hampers the growth of this
market.
4 Inadequate debt Lack of existence of a well-developed debt
market market in India is another obstacle that
hinders the growth of secondary market of
securitized or asset backed securities.
5 Ineffective For many years efforts are on for effective
foreclosure laws foreclosure but still foreclosure laws are not
supportive to lending institutions and this
makes securitized instruments especially
mortgaged backed securities less attractive as
lenders face difficulty in transfer of property in
event of default by the borrower.

Question 6: Discuss the categories of Securitization

instruments

There are three categories of Securitization Instruments namely a.

Pass through Certificates [PTC] b. Pay through securities [PTS] and c.
Stripped Securities.

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a. Pass through Certificates

 A pass through certificate (PTC) is a certificate that is given to an

investor against certain mortgaged-backed securities that lie with
the issuer i.e SPV.

 The certificate can be compared to securities (like bonds and

debentures) that may be issued by banks and other companies to
investors. The only difference being that they are issued against
underlying securities.

 The interest and Principal repayment from the underlying securities

is directly passed on to the investors of PTC on proportionate basis.
The SPV simply acts as a Conduit pipe to transferring cash flows
from underlying securities to investors in PTCs. No restructuring is
done by the SPV on the cash flows.

b. Pay through structures [PTS]

 The nature of the investors’ interest in the underlying assets

determines whether a securitisation structure is a ‘Pass Through’ or
‘Pay Through’ structure.

 In a pass through structure, the SPV issues ‘Pass Through

Certificates’ which are in the nature of participation certificates that
enable the investors to take a direct exposure on the performance
of the securitized assets.

 In the pass through structure, investors are serviced as and when

cash is actually generated by the underlying assets. Prepayments
are passed on to the investors who then have to tackle re-
investment risk.

Pay through structures permit de-synchronization of servicing of the
securities from the underlying cash flows. In the pay through
structure, the SPV is given discretion to re-invest short term
surpluses - a power that is not available to the SPV in the case of
the pass through structure.

 In PTS in case of early retirement of receivables suplus cash can be

used for short term yield. This structure also provides the freedom
to issue several debt tranches with varying maturities.

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 A further advantage of the pay through structure is that different

issues of securities can be ranked and hence priced differentially.

c. Stripped Securities

 A stripped bond is a bond that has had its coupon payments and
principal repayment "stripped" into two separate components that
are then sold individually.

 One party will receive the principal at maturity (zero-coupon bond)

and the other party will receive the fixed-interest payment over the
life of the bond in the form of a stream of coupons.

 Example of a Stripped Bond

 Let's take a look at a simplified stripped bond example. Suppose

the originator sells its debt at a face value of Rs 1000 carrying
coupon of 5% for 5 yrs to SPV in the securitization process.

 The SPV in the process of bond stripping, buys the bond or Debt
for Rs 1,000 and then strips out the coupons. It then sells two
securities to investors. Say it sells the principal-stripped bond for
Rs 800 to an investor and the coupon payments to another
investor for Rs 200. The Rs 200 and the Rs 800 received will
make SPV break even on the purchase of the debt from
originator. The individual with the coupon-stripped bond will get
the par value of Rs 1,000 at the end of the five years, making a
profit of Rs 200. And the purchaser of the coupons will pay Rs
200 to receive Rs 50 coupon for five years.

 The interest stripped bond is called as Principal only security

[PO] and the other bond is called Interest only security [IO].

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