Quadrant II- Transcript and Related Materials

Programme: Bachelor of Commerce (Third Year)

Subject: Commerce
Paper Code: COD128
Paper Title: Financial Services
Unit IV – Credit Rating and Securitization services
Module Name: Benefits of Securitization, Process
of Securitization, Issues in Securitization
MODULE NUMBER: 19
Name of the Presenter: Ms. Sandra Fernandes

BENEFITS OF SECURITISATION

Debt securitisation provides many benefits to all the parties, such as, the originator, investors
and the regulatory authorities. Some of the important benefits are the following:

(i) Additional source of fund: The originator, (i.e., the lending institution) is much benefitted
because securitisation 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.

m) Greater profitability: Securitisation helps financial institutions to get liquid cash from
medium-term and long-term assets immediately rather than over a longer period. 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. Moreover, economies of scale can be achieved since securitisation offers
scope for the fuller utilisation of the existing capabilities by providing liquid cash
immediately. It results in additional business turnover.

Again, the originator can also act as the receiving and paying agent. If so, it gets additional
income in the form of servicing fee.
(iii) Enhancement of capital adequacy ratio: Securitisation enables financial institutions to
enhance their capital adequacy ratio by reducing their assets volume. The process of
securitisation necessitates the selection of a pool of assets by the financial institutions to be
sold or transferred to another institution called SPV. Once the assets are transferred, they are
removed from the balance sheet of the originator. It results in the reduction of assets volume,
thereby increasing the capital adequacy ratio. Capital adequacy ratio can also be improved by
replacing the loan assets with the lesser risk weighted assets. Thus, the removal of assets
from the Balance Sheet under a true sale improves the capital adequacy norms.

(iv) Spreading of credit risk: Securitisation facilities the spreading of credit risk to different
parties involved in the process of securitisation. In the absence of securitisation, 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 factors among the various parties
involved in securitisation. Thus, securitisation helps to achieve diversification of credit risks
which are greater in the case of medium-term and long-term loans. Thus, it is used as tool for
risk management

(v) Lower cost of funding: In view of enhancement of cash flows and diversification of risk
factors, securitisation enables the originator to have an easy access to the securities market at
debt ratings higher than its overall corporate rating. It means that companies with low credit
rating can issue asset backed securities at lower interest cost due to high credit rating on such
securities.

(vi) Provision of multiple instruments: From the investor's point of securitisation provides
multiple new investment instruments so as to at the varying requirements of the investing
public. It also offers varieties instruments for other financial intermediaries like mutual funds,
insurance companies, pension funds, etc., giving them many choices.

(vii) Higher rate of return: When compared to traditional debt securities like bonds and
debentures, securitised securities offer better rate of return along with better liquidity. These
instruments are rated by good credit rating agencies and hence more attractive. Being
structured asset-based securities, they offer more protection and yield a good return. The
bankruptcy/winding up of the originator does not affect the investors since the payment is
guaranteed by the SPV.

(viii) Prevention of idle capital: In the absence of securitisation, capital would remain idle in
the form of illiquid assets like mortgages, term loans, etc., in many of the lending institutions.
Now, securitisation helps recycling of funds by converting these assets into liquidity,
liquidity into assets, assets into liquidity and so on by means of issuing tradable and
transferable securities against these assets. Thus, it provides impetus for capital formation.

(ix) Better than traditional instruments: Certificates are issued to investors against the backing
of assets securitised. The underlying assets are used not only as a collateral to the certificates
but also to generate the income to pay the principal and interest to the investors. It does not
entail any servicing needs and hence does not require much costs. It is better that even mutual
fund units because it is issued against the backing of collateral securities, whereas there is no
such backing for mutual fund certificates. Thus, these Instruments, being structured asset-
backed securities, afford a greater protection to investors.

Again, there is much transparency from the investor's point of view. they can very well see
the collateral pool that a particular issue represents and this transparency reduces uncertainty
as to the risk element.

(x) Other benefits: Securitisation, if carried out in true spirit, leads to greater economy in the
use of capital with efficiency and cost-effectiveness in oth funding and lending. This is a
great boon to the regulating authorities well since their primary objective is to prevent the
accumulation of capital where it is not needed.

ASSET SECURITIZATION-MECHANISM

Asset securitization works through a Special Purpose Vehicle (SPV). The SPV acts as a
crucial link in the securitization chain, intermediating between the primary market for the
underlying asset and the secondary market for the asset-backed security. Following are the
steps involved in the securitization process

Origination

Assets are originated by a company, and funded on that company's balance sheet. This
company is normally referred to as the Originator".

Asset Identification and Pooling

The asset to be securitized by the institution is identified, which comprises of the loans
advanced by the institution. The identification of the assets is done in such a manner as to
ensure an optimum mix of homogeneous assets having almost the same maturity.

Security Creation

Securitas of uniform maturity are created out of the assets that are identified. These are then
passed on to another institution called "Special Purpose Vehicle" (SPV). The SPV is a Trust,
which, like an investment hanker, manages the issue of securities to investors. These
securities are known as pay or pass through certificates. The SPV becomes liable to the
investor for principal repayment and interest recovery.

SPV's Task
The SPV engages itself in the task of enhancing its credibility in order to make the issue
attractive. For this purpose, the SPV obtains an insurance policy to cover the credit losses, or
arranges a credit facility from a third party lender to cover delayed payments.

Security Issue

The SPV issues tradeable "securities" to fund the purchase of assets directly linked to the
performance of the assets, and there is no recourse contract) back to the originator.

Security Purchase

Investors purchase the securities, because they are satisfied (normally by replying upon a
rating) that the securities will be paid in full, and on time, from the cash flows available in the
asset pool.. A considerable amount he is spent considering the different likely performances
of the asset pool, and the implications of default by borrowers. The proceeds from the sale of
the securities are used to pay the originator.

Receipt of Benefits

The SPV agrees to pay any surplus which arises during its funding of the assets back to the
originator. This means that the originator, for all practical purposes, retains its existing
relationship with the borrowers and all the economics of funding the assets (ie, the originator
continues to administer the portfolio, and continues to receive the economic benefits (profits)
of owning the assets).

Rating and Trading

The SPV gets the securities rated by some reputed credit rating agencies so as to enhance the
marketability of the Securitized assets. In addition, credit rating increases the trading
potential of the certificate in a secondary market, thus augmenting its liquidity potential.

Redemption

On maturity of the security, the investors get a redemption amount from the issuer along with
interest due on the amount.

ISSUES IN SECURITIZATION
1. Heavy stamp duty and Registration fees:
Securitization requires the transfer of various illiquid and non-performing assets to a
central agency called Special Purpose vehicle. This transfer involves heavy stamp
duty and registration fees. These costs are so exorbitant that people are
automatically discouraged to go in for this innovative technique of financing.
2. Cumbersome transfer procedures
 The transfer of assets involves very complicated and cumbersome legal procedures
which stand as a real impediment in the way of securitization.
3. Absence of standardised loan documentation
There is no uniformity between different financial institutions regarding loan
documentation even for the same type of loans. In such a case , it becomes very
difficult for an agency like Special Purpose Vehicle(SPV) to pool the similar assets of
the various financial institutions for securitisation.
4. Inadequate credit rating agencies
The credit rating agencies are not adequately available in India at present to take up
the stupendous task of credit rating instruments for securitization purposes.
5. Absence of proper accounting procedures
Creation of a proper Special Purpose vehicle or Trust is a must for securitization and
as such there is no accounting procedure for the recognition of this trust. Again,
Securitization paves way for the removal of the securitized assets from the balance
sheet of the originator.
6. Absence of proper guidelines
One can find a lot of guidelines issued by the regulatory authorities to deal with mutual
funds, non-banking companies, etc..But, they are conspicuously absent in the field of
securitization. There are various processes involved in securitization right from the
identification process to the redemption process. Hence, proper guidelines must be issued
covering all these aspects so that financial intermediaries can go for securitization without
any hesitation and thus securitization becomes a smooth affair.