Securitisation The Indian Perspective

Presented By : Amit Kumar -334 Gowrishankar-NUMBA Jagdish Agarwal-371 Pritish Chaudhary-406 Priyaranjan Singh-408 Puneet Singh Bhatia-409 Sujeet Kumar-461 Tirthankar Ghosh 467

Friday, 04 April 2014

Agenda
Introduction Hindsight Securitization issuance in emerging market Parties Involved and different Cases Issues and Prevention Strategies Conclusion

Introduction

Securitisation is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors. Through it illiquid assets are converted into trade able security with a secondary market. It is measure of replenishing the funds by recourse to the secondary market. Securitisation is a process by which the originators of assets like loans which are illiquid are able to transfer such assets to a special purpose vehicle ('SPV') which, in turn, issues tradable liquid securities to investors. In a typical securitisation transaction, the company seeking to raise funds transfers certain of its assets to an SPV that is organized in such a way that minimizes the likelihood of bankruptcy.

Hindsight

1991 saw a large number of reforms in the financial side The government ensued upon a policy for larger economic reforms allowing foreign direct and indirect investment . This needed for the legal framework on securitization The enactment of the SARFAESI Act, 2002 The Act encompasses the areas of: securitization of financial assets; reconstruction of financial assets; recognition to any security interest created for due repayment of a loan as security interest under the Securitization Act, irrespective of its form; banks and financial institutions have the power to enforce the security without intervention of the courts; setting up the Central Registry for registration of the transaction of securitization, reconstruction and creation of security interests.

Hindsight

Securitisation of financial assets became a financial tool for the lenders to securitise their future cash flows thus releasing their funds blocked in them. The secured assets become a market commodity having financial returns on their realisation. This aspect brought in the much-needed expertise in adept handling in realisation of the secured assets. The Act has made an attempt to streamline the legal impediments of normal civil law procedures to foreclose the mortgaged assets by empowering the enforcement of the secured assets by flexible mechanism provided in the Act. The Act made provision for :

Incorporation of Special Purpose Vehicles Securitisation of Financial Assets. Establishment of Central Registry for regulating and registering securitisation transactions Enforcing security interest i.e. taking over the assets given as security for the loan.. Funding of securitisation. Asset Reconstruction. Offences & Penalties.

Securitization issuance in emerging markets

Country Issuance in $bn Country Issuance in $bn Country Issuance in $bn Asia Latin America EEMEA Taiwan 1.9 Brazil 4.8 Turkey 4.5 South Korea 26 Mexico 4.3 South Africa 2.2 India 6.67 Argentina 1.5 Egypt 1.7 Singapore 1.2 Chile 0.9 Russia 0 Malaysia 0.4 Peru 0.7 Others 0.2 Indonesia 0.6 Columbia 0.5 Japan 81 Others 1.3 Asia 117.77 Latin America 14 EEMEA 8.6

Total securitization of Emerging markets total was $ 53 billion in 2005. Securitization market in US alone was 5 times of this.

Securitization issuance in emerging markets

Timeline

Major Parties Involved

The initial owner of the asset (the originator or sponsor) who has a loan agreement with the borrowers (obligors). The issuer of debt instruments who also is the SPV. The structure keeps the SPV away from bankruptcy of the originator, technically called 'bankruptcy remote. The investment bankers who assist in structuring the transaction and who underwrite or place the securities for a fee. The rating agencies that assess credit quality of certain types of instruments and assign a credit rating. The credit enhancer, possibly a bank, surety company, or insurer, who provides credit support through a letter of credit, guarantee, or other assurance. The servicer, usually the originator, who collects payments due on the underlying assets and, after retaining a servicing fee, pays them over to the security holders. The trustee, who deals with issuer, credit enhancer and servicer on behalf of the security holders. The legal counsel, who participates in the structuring of the transaction. The swap counterparty who provides interest rate/currency swap, if needed

Some Examples of Securitization First securitisation deal in India between Citibank and GIC Mutual Fund in 1991 for Rs

160 mn L&T raised Rs 4,090 mn through the securitisation of future lease rentals to raise capital for its power plant in 1999. Indias first securitisation of personal loan by Citibank in 1999 for Rs 2,841 mn Indias first MBS of Rs 597 mn by NHB and HDFC in 2001. Securitisation of aircraft receivables by Jet Airways for Rs 16,000 mn in 2001 through offshore SPV. Indias first sales tax deferrals securitisation by Govt of Maharashtra in 2001 for Rs 1,500 Million. Indias first deal in the power sector by Karnataka Electricity Board for receivables worth Rs 1,940 mn and placed them with HUDCO. Indias first Collateralised Debt Obligation (CDO) deal by ICICI bank in 2002 Indias first floating rate securitisation issuance by Citigroup of Rs 2,810 mn in 2003. The fixed rate auto loan receivables of Citibank and Citicorp Finance India included in the securitisation Indias first securitisation of sovereign lease receivables by Indian Railway Finance Corporation (IRFC) of Rs 1,960 mn in 2005. The receivables consist of lease amounts payable by the ministry of railways to IRFC Indias largest securitisation deal by ICICI bank of Rs 19,299 mn in 2007. The underlying asset pool was auto loan receivables.

Case I Citibank Case

Citibank assigned a cherry-picked auto loan portfolio to Peoples Financial Services Ltd. (PFSL), an SPV floated for the purpose of securitisation by paying the required amount of stamp duty (0.1%) to ensure true sale. This is a limited company and can act only as SPV for asset securitisation. This SPV is owned and managed by a group of distinguished legal counsels. PFSL then proceeded to issue Pass Through Certificates to investors. These certificates were rated by CRISIL and listed on the wholesale debt market of the National Stock Exchange (NSE), with HG Asia and Birla Marlin as the market makers. Global Trust Bank acted as the Investors Representative. Citibank played the role of servicer. The certificates are freely transferable and each of the transfer will have a stamp cost of 0.10%. Besides Citibank, NBFCs like Ashok Leyland Finance, 20th Century Finance etc. have securitized their auto loan portfolio, though, of course, these transactions involved assignment of receivables only and not issuance of securities. The asset portfolios were bought by one or two large institutions. TELCO has also reportedly sold over Rs 550 crore of its auto loan portfolio in multiple tranches through this route.

Another important asset class for the purpose of securitisation pertains to the power sector. The Government is keen to securitise the outstanding dues of various State Electricity Boards (SEBs) and the total market of such receivables is estimated at around Rs.10, 000 crore4. However, securitisation of these receivables is feasible provided they are sufficiently credit enhanced, preferably with Government guarantee. The initiative in this regard was taken by Karnataka Electricity Board (KEB) who,securitized around Rs 210 crore of their outstanding dues from various State owned public enterprises. The outstanding dues of KEB are being assigned to another State owned subsidiary, Karnataka Renewable Energy Development Ltd. (KREDL) which is acting as the SPV and in turn issuing securities. The securities are being credit enhanced by way of a guarantee from the Karnataka Government with a structured payment mechanism. HUDCO has agreed to be the investor and subscribe to the securities in full.

Case II Karnataka Electricity Board case

Case III L& T Case( Future Receivable)

The recent case of a power plant construction being financed through the capital markets is an example of future flow securitisation. Although Larsen & Toubro bagged the Build, Lease and Operate contract for a 90MW captive power plant for Indian Petrochemical Corporation Ltd. (IPCL), it preferred to transfer it to an SPV India Infrastructure Developers Ltd. (IIDL) which issued debentures in the private placement market. The debentures would be serviced out of the lease rentals due to IIDL from IPCL. L&Ts guarantee was also available to a limited extent. The novelty of this transaction was that instead of a plain loan with say, 3:1 debt equity ratio, the project was financed in the form of a securitisation like structure through the capital market with a much higher gearing ratio.

Case IV RICCO Case

This was the first attempt at issue of structured debt paper backed by the cash flows arising out of future receivables of a utility. Rajasthan State Electricity Board (RSEB) proposed to raise resources to the tune of Rs.250 crore, but, on account of its weak balance sheet, was not able to access the market directly. A structure was, therefore, devised whereby a pool of receivables comprising RSEBs high value customers was selected based on their payment history. The pool was then rated and credit enhancements were built. While no SPV was set up specifically for the purpose of the transaction, an existing profitmaking Government Company, viz. Rajasthan State Industrial Development and Investment Corporation Ltd. (RIICO), was selected as the borrowing entity and the future cash flows and underlying receivables were charged to RIICO. The bonds backed by cash flows were issued by RIICO to various investors by means of a privately placed issue. The investors continued to have recourse to the issuer i.e. RIICO in the event of shortfall in cash flows. The high stamp duties then prevalent, as also certain legal and market-related hurdles, delayed the introduction of full-fledged securitisation at that juncture.

Case IV RICCO Case

This was the first attempt at issue of structured debt paper backed by the cash flows arising out of future receivables of a utility. Rajasthan State Electricity Board (RSEB) proposed to raise resources to the tune of Rs.250 crore, but, on account of its weak balance sheet, was not able to access the market directly. A structure was, therefore, devised whereby a pool of receivables comprising RSEBs high value customers was selected based on their payment history. The pool was then rated and credit enhancements were built. While no SPV was set up specifically for the purpose of the transaction, an existing profitmaking Government Company, viz. Rajasthan State Industrial Development and Investment Corporation Ltd. (RIICO), was selected as the borrowing entity and the future cash flows and underlying receivables were charged to RIICO. The bonds backed by cash flows were issued by RIICO to various investors by means of a privately placed issue. The investors continued to have recourse to the issuer i.e. RIICO in the event of shortfall in cash flows. The high stamp duties then prevalent, as also certain legal and market-related hurdles, delayed the introduction of full-fledged securitisation at that juncture.

Trends in structured finance volumes (Rs. Billion):

Type ABS MBS CDO/LSO OTHERS TOTAL
700
600 500 400 300 200 100 0 200102 200203 200304 200405 200506

Trends in Structured Finance Volumes

200102 12.9 0.8 19.1 4 36.8 200203 36.4 14.8 24.3 2.3 77.8 200304 80.9 29.6 28.3 0.5 139.3 200405 222.9 33.4 25.8 26 308.1 200506 178.5 50.1 21 249.6 200607 234.2 16.1 119 369.3 200708 313.2 5.9 318.2 13 650.3 200809 135.8 32.9 364.4 11.6 544.7 200910 209.7 62.5 145.8 7.9 425.9

ABS MBS CDO/LSO OTHERS TOTAL

200607

200708

200809

200910

Asset Class-wise distribution of ABS Pools

Present Scenario

Though the securitisation market in India is marked by relatively simple structures and stable ratings, concerns over asset quality have affected investor appetite for securitisation in the post-crisis scenario. Much of the securitisation activity is driven on the supply side by growth of retail loan portfolio in banks and NBFCs and the prevalent liquidity conditions. On the demand side, the key factors have been the requirements of mutual funds, particularly at the short end, insurance companies and banks to meet priority sector lending targets. Most of the securities are acquired with the intention to hold to maturity. As per the data compiled by major rating agencies, the year 2009 10 has witnessed an overall moderation in the volumes in securitisation market. Total issuance volume saw a decline of 22% in 200910 over the previous fiscal. The dip in the overall securitisation volumes owed mainly to the 60% reduction in loan sell-off (LSO) issuances, which were mostly short-term in nature. In the case of retail loan-backed transactions, with the overall growth in retail loan portfolios being subdued and the liquidity position of most financiers being comfortable, the need to securitise as a funding source was limited. Nevertheless, securitisation of retail loans, both ABS and RMBS reported a 61% increase in volume in 200910. While the securitisation market has remained concentrated with a handful of originators and limited investors, the asset classes have continued to diversify, the latest additions being gold loans, microfinance loan receivables and loan against property.

Issues facing the Indian Securitisation Market:

Stamp Duty: One of the major hurdles facing the development of the securitisation market is the stamp duty structure. In India, stamp duty is payable on any instrument which seeks to transfer rights or receivables. Therefore, the process of transfer of the receivables from the originator to the SPV involves an outlay on account of stamp duty, which can make securitisation commercially unviable in states that still have a high stamp duty. Few states have reduced their stamp duty rates, though quite a few still maintain very high rates ranging from 5-12 per cent. To the investor, if the securitised instrument is issued as evidencing indebtedness, it would be in the form of a debenture or bond subject to stamp duty, and if the instrument is structured as a Pass Through Certificate (PTC) that merely evidences title to the receivables, then such an instrument would not attract stamp duty. SEBI has suggested to the government on the need for rationalisation of stamp duty with a view to developing the corporate debt and securitisation markets in the country, which may going forward be made uniform across states as also recommended by the Patil Committee.

Issues facing the Indian Securitisation Market:

Foreclosure Laws: Lack of effective foreclosure laws also prohibits the growth of securitisation in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default. Taxation related issues: There is ambiguity in the tax treatment of mortgage-based securities, SPV trusts, and NPL trusts. Presently, the investors or the buyers (PTC and SR holders) pay tax on the earnings from the SPV trust. As a result the trustee makes income payouts to the investors without any payment of tax. The Income Tax law envisages the taxation of an unincorporated SPV either at the trust SPV level or the investor level in order to avoid double taxation. Therefore, any tax pass through regime merely represents a stance that the investors in the trust will bear the tax liability instead of the Trust being held liable to tax the investors on their respective earnings.

Issues facing the Indian Securitisation Market:

Issues under the SARFAESI Act:

A security receipt (SR) gives its holder a right of title or interest in the financial assets included in securitisation. This definition holds good for securitisation structures where the securities issued are referred to as pass through certificates. However, the rationale fails in the case of pay through certificates with different classes of primary and secondary rights to the cash flow. Also, the SARFAESI Act has been structured such that SRs can be issued and held only to Qualified Institutional Buyers (QIBs). There is a need to expand the investor base by including NBFCs, nonNBFCs, private equity funds, etc.

Issues facing the Indian Securitisation Market:

Legal Issues:

Investments in PTCs are typically held-to-maturity. As there is no trading activity in these instruments, the yield on PTCs and the demand for longer tenures especially from mutual funds is dampened. Till recently, Pass through Certificates (PTC) were not explicitly covered under the Securities Contracts (Regulation) Act, definition of securities. This was however ammended with the Securities Contracts (Regulation) Amendment Act, 2007 passed with a view to providing a legal framework for enabling listing and trading of securitised debt instruments. This will bring about listing of PTCs which in turn will support market growth.

Issues facing the Indian Securitisation Market:

Foreclosure Laws: Lack of effective foreclosure laws also prohibits the growth of securitisation in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default. Taxation related issues: There is ambiguity in the tax treatment of mortgage-based securities, SPV trusts, and NPL trusts. Presently, the investors or the buyers (PTC and SR holders) pay tax on the earnings from the SPV trust. As a result the trustee makes income payouts to the investors without any payment of tax. The Income Tax law envisages the taxation of an unincorporated SPV either at the trust SPV level or the investor level in order to avoid double taxation. Therefore, any tax pass through regime merely represents a stance that the investors in the trust will bear the tax liability instead of the Trust being held liable to tax the investors on their respective earnings.

Areas for Improvement

Presently, SPVs are not eligible as counter-parties in an interest rate swap and derivative contract with a bank. In a transaction with significant interest rate risk, like a long tenure MBS, there is critical need to mitigate it through tools such as interest rate swap. It is recommended that RBI many consider amendments to the General Guidelines on Derivatives and Swap, allowing SPVs to be included as counter-party. RBI should converge with SEBI to prescribe a more comprehensive standard set of disclosures, similar to the guidelines for listed PTC as recommended by SEBI. This could be benchmarked against what is required internationally, that are required to be made by the seller/originator to all the parties involved in the transaction, both at origination and post-issuance. This will go a long way in enhancing the transparency and build investors confidence. Presently, SPVs are not eligible to enter into interest rate swap. In a transaction with significant interest rate risk, like a long tenure MBS, there is critical need to mitigate it through tools such as interest rate swap. Long term investors like Insurers, Pension Funds, Provident Funds etc are required to play a key role in the market. The Ministry of Finance should formulate a policy to allow these players to invest in long-term PTC/Securitized Assets.

Case Study

Say banks A and B originated and securitized their assets. Further, bank A invested in the securitized assets of bank B while bank B invested in the securitized assets of bank A. So, clearly, neither bank A nor bank B has a comparative advantage in the origination of assets (loans). Further, bank A was taking a view on bank Bs securitized assets relative to its own securitized assets. Why else would bank A go short (securitize its own assets) and go long (invest directly or through an SIV) in the securitized assets of bank B. Bank B, too, was doing something similar. So were banks C, D, E... This began a race to the bottom. And the race was rewarded perverselybecause to short ones assets and to long on the others made sense if you are worse at originating assets! And that is something securitization should never reward. The rating agencies played the role of a catalyst in the originators race to the bottom. The rating agencies did so by attracting gullible investors on the basis of their spurious ratings.

Prevention Strategies

No relationship between a originator/sponsor and SPV/ SIV should be allowed- not even temporary liquidity support. An originator should not invest (or service) the securitized assets of another originator. The rating agencies should be nationalized. Worldwide, rating agencies paid less than 2% of the $687 billion in taxes paid by the commercial banks and savings institutions in the US alone during 1992-2007 (source: US Federal Deposit Insurance Corp.). Surely, the rating agencies caused more than just 2% of the damage. They are perhaps the most extreme manifestation of privatizing profits and socializing losses.

Conclusion

The dramatic growth in the use of securitization to fund corporate loan assets suggests that this is a form of financing that is here to stay. However, the process of securitizing complex and non-homogenous assets gives rise to a number of legal and structural complexities. There is a requirement to strengthen & regularize the securitization market because it is still in the blooming stage and if went awry, it could lead to catastrophic financial implications.

29