3 - securitization

7/29/2019 3 - Securitization

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Table of Contents1 Executive Summary .................................................................................................................. 22 Introduction ............................................................................................................................... 4

2.1 Meaning of Securitization .................................................................................................. 42.2 Meaning of Security ........................................................................................................... 62.3 Need for Securitization .......................................................................................................62.4 Securitization of Receivables ............................................................................................. 72.5 Historical Background ........................................................................................................92.6 Features of Securitization .................................................................................................102.7 Securitization leads to Financial Disintermediation ........................................................122.8 Securitization and Structured Finance ..............................................................................152.9 Securitization as a Tool of Risk Management ..................................................................152.10 Economic impact of securitization .................................................................................15

3 Securitization ...........................................................................................................................173.1 Parties Involved ...............................................................................................................17

3.2 Securitization Process .......................................................................................................193.3 Features of Securitization of Receivables .......................................................................223.4 Types of Securitization .....................................................................................................293.5 Forms of Securitization Structures ...................................................................................32

4 Advantages and Limitations ....................................................................................................364.1 Advantages of Securitization ............................................................................................364.2 Limitations of Securitization ............................................................................................42

5 Role of Regulators and Other Agencies ..................................................................................435.1 Role of Regulators ............................................................................................................435.2 Role of Administrator/Servicer ........................................................................................475.3 Role of Credit Enhancers ................................................................................................. 48

5.4 Role of Structurer .............................................................................................................505.5 Role of Rating Agency .....................................................................................................50

6 Impediments to Securitization .................................................................................................517 Securitization in India ............................................................................................................. 56

7.1 Need for Securitization in India .......................................................................................567.2 Examples of Securitization Deals in India .......................................................................577.3 Features of Securitization in India ....................................................................................597.4 General Observations .......................................................................................................607.5 The Future .......................................................................................................................61

8 References ...............................................................................................................................64

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1 Executive Summary

With the capital market going through a lean phase and companies increasingly facing funding

problems, the focus is now on raising money through securitization. Securitization is one ofthe many new tools, which finance managers will have to use to ride uncertainty.

A versatile financing tool, securitization enables customization to meet client needs across a

wide range of industries in a variety of financing situations with existing or future receivable

cash flows. It offers many unprecedented benefits - the most significant being that the

transaction can enjoy a credit rating much higher than that of the originator.

Originating in the mortgage markets in the USA in 1970s, an established financing tool in

developed economies, securitization has quickly developed to become one of the most

important financial innovations of our time. Securitization is fast becoming an increasingly

important source of financing in emerging markets. Across the world, securitization is being

perceived as a means of providing access to diversified sources of funds.

Securitization is particularly relevant in the Indian context, especially since growth in

securitization would add more high quality assets to the fixed income market and would also

provide the much-needed fillip to infrastructure financing.

There is a lot to learn from developed markets like the US, which is the largest securitization

market in the world. Approximately 75% or more of the global volumes in securitization are

originated from the US. The US markets have historically been more liquid, innovative and

sophisticated. Enabling laws and regulations in France, Italy, Spain and Belgium have been the

leading factors in the growth and spread of European securitization since the early 1990s.

Developing markets on the other hand, are fragmented and small. Nevertheless, the

imperatives that acted as principal drivers in these markets have to arrive soon.

Indias securitization is in a nascent stage, exhibiting only elements of established

securitization. But the few deals that have taken place in India represent only a fraction of the

potential.

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When it was launched securitization was hailed as a financial innovation, which would release

assets from the portfolio and provide instant liquidity of issuers and at the same time give

investors the choice of trading in another type of instrument.

Legislative and legal changes, however, leave much to be desired. The market is seasoned for

such products, but the ball is firmly in the court of the regulators and the government for

spelling out the rules of the game.

Once the enabling legal provisions and institutions fall in place, the economic logic for

securitization is so powerful that the trend towards securitization knows no limits. India is still

a long way from the saturation point that has been reached in other economies like the UK

where even aged rock artists have raised funds by securitising the future receivables fromroyalty payments.

The Indian market is still waiting for the sun.

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2 Introduction

Just as the electronics industry was formed when the vacuum tubes were replaced by

transistors, and transistors were then replaced by integrated circuits, the financial servicesindustry is being transformed now that securitized credit is beginning to replace traditional

lending. Like other technological transformations, this one will take place over the years, not

overnight. We estimate it will take 10 to 15 years for structured securitized credit to replace to

displace completely the classical lending system -not a long time, considering that the

fundamentals of banking have remained essentially unchanged since the middle ages. -

Lowell L Bryan

Technological advancements have changed the face of the world of finance. Today, it is more

a world of transactions than a world of relations.

Transactions mean the coming together of two entities with a common purpose, whereas

relations mean keeping together of these two entities. For example, when a bank provides a

loan of a sum of money to a user, the transaction leads to a relationship: that of a lender and a

borrower. However, the relationship is terminated when the very loan is converted into a

debenture. The relationship of being a debenture holder in the company is now capable ofacquisition and termination by transactions.

2.1 Meaning of Securitization

"Securitization" in its widest sense implies every such process, which converts a financial

relation into a transaction.

History of evolution of finance, and corporate law, is replete with instances where relationshave been converted into transactions. In fact, the earliest, and by far unequalled, contribution

of corporate law to the world of finance is the ordinary share, which implies piecemeal

ownership of the company. Ownership of a company is a relation, packaged as a transaction by

the creation of the ordinary share. This earliest instance of securitization was instrumental in

the growth of the corporate form of doing business, and hence, industrialisation. The very

concept of securitization is as important to the world of finance as motive power is to industry.

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Asset Securitization

The sense in which the term is used in present day capital markets, securitization has acquired

a typical meaning of its own, and is at times, called asset securitization. It is taken to mean a

device of structured financing where an entity seeks to pool its interest in identifiable cash

flows over time, transfer the same to investors either with or without the support of further

collaterals, and thereby achieve the purpose of financing.

For example: If I want to own a car to run it for hire, I could take a loan with which I could

buy the car. The loan is my obligation and the car is my asset, and both are affected by my

other assets and other obligations. This is the case of simple financing.

On the other hand, if I were to analytically envisage the car, my asset, as having the ability to

generate a series of hire rentals over a period of time, I might sell a part of the cash flow by

way of hire rentals for a stipulated time and thus raise enough money to buy the car. The

investor is happier now, because he has a claim for a cash flow, which is not affected by my

other obligations; I am happier because I have the cake and eat it too, and the obligation to

repay the financier is taken care of by the cash flows from the car itself.

Blend of Financial Engineering and Capital Markets

The present-day meaning of securitization is a blend of two forces that are critical in today's

world of finance: structured finance and capital markets. Securitization leads to structured

finance, as the resulting security is not a generic risk in the entity that securitises its assets but

in specific assets or cash flows of such entity. Two, the idea of securitization is to create a

capital market product, i.e., it results in the creation of a "security" - a marketable product.

This meaning of securitization can also be expressed as follows:

Securitization is the process of commoditisation.The basic idea is to

take the outcome of this process into the capital market. Thus, the result of every

securitization process is to create certain instruments, which can be placed in the market.

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Securitization is the process of integration and differentiation.

The entity that securitises its assets first pools them (assuming it is not one asset but

several assets, as is normally the case) [integration]. Then, the pool is broken into

instruments of fixed denomination [differentiation].

Securitization is the process of de-construction of an entity. If

one envisages an entity's assets as being composed of claims to various cash flows, the

process of securitization would split these cash flows into different buckets, classify them,

and sell these classified parts to different investors according to their needs. Thus,

securitization breaks the entity into various sub-sets.

2.2 Meaning of Security

In the future, financial relations will be converted into and be transferable as "securities".

In connection with securitization, the word "security" does not mean what it traditionally

might have meant under corporate laws or commerce: a secured instrument. Here it means a

financial claim, generally manifested in form of a document, and its essential feature being

marketability. To ensure marketability, the instrument must have general acceptability as a

store of value. Hence, it is either rated by credit rating agencies, or secured by charge over

substantial assets. Further, to ensure liquidity, the instrument is generally made in homogenous

lots.

2.3 Need for Securitization

The generic need for securitization is as old as that for organised financial markets. Financial

markets developed in response to the need of involving a large number of investors in the

market place. As the number of investors increases, the average size per investors comes

down. As the small investor is not a professional investor, he needs a liquid instrument, which

is easier to understand. This sets the stage for evolution of financial instruments which would

convert financial claims into liquid, easy to understand and homogenous products, at times

carrying certified quality labels (credit-ratings or security), which would be available in small

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denominations to suit everyone's wallets. Thus, securitization generically is basic to the world

of finance.

Following are the reasons as to why the world of finance prefers a securitised financial

instrument to the underlying financial claim in its original form:

1. Financial claims often involve sizeable sums of money, beyond the reach of the small

investor. The initial response to this was the development of financial intermediation: an

intermediary such as a bank would pool the resources of small investors and use the same

for the larger investment need of the user.

2. As small investors are typically not in the business of investments, liquidity of investments

is most critical for them.3. Generally, instruments are easier understood than financial transactions. An instrument is

homogenous, usually made in a standard form, and containing standard issuer obligations.

Besides, an important part of investor information is the quality and price of the

instrument, and both are easier known in case of instruments than in case of financial

transactions.

In short, the need for securitization was almost inescapable, and present day's financial

markets would not have been what they are, unless some standard thing that market players

could buy and sell, that is, financial securities, were available.

2.4 Securitization of Receivables

One of the applications of securitization has been in the creation of marketable securities out

of or based on receivables. The intention of this application is to afford marketability to

financial claims in the form of receivables. Obviously, this application has been applied tothose entities where receivables form a large part of the total assets of the entity. Besides, to be

packaged as a security, the ideal receivable is one, which is repayable over or after a certain

period of time, and there is contractual certainty as to its payment. Hence, the application was

traditionally principally directed towards housing/ mortgage finance companies, car rental

companies, leasing and hire purchase companies, credit card companies, hotels, etc. Soon,

electricity companies, telephone companies, real estate hiring companies, aviation companies,

insurance companies etc. joined as users of securitization.

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Though the general meaning of securitization is every such process whereby financial claims

are transformed into marketable securities, one can also say thatsecuritization is a process by

which cash flows or claims against third parties of an entity, either existing or future, [that are

illiquid], are identified, consolidated, separated from the originating entity, and then

fragmented into securities to be offered to a broad range of investors through the capital

markets.

Kenneth Cox says, Securitization is a process under which pools of individual loans or

receivables are packaged, underwritten and distributed to investors in the form of securities.

Securitization of receivables is a unique application of securitization. For most other

securitizations, a claim on the issuer himself is being securitised. E.g.: in case of issuance ofdebenture, the claim is on the issuing company. In case of receivables, a claim on the third

party, on whom the issuer has a claim, is securitised. Hence, what the investor in a receivable-

securitised product gets is a claim on the debtors of the originator. This may at times further

include, by way of recourse, a claim on the originator himself.

The involvement of the debtors in the receivables securitization process adds unique

dimensions to the concept. One is the legal possibility of transforming a claim on a third party

as a marketable document. It is easy to understand that this dimension is unique to

securitization of receivables, since there is no legal difficulty where an entity creates a claim

on itself, but the scene is totally changed where rights on other parties are being turned into a

tradable commodity. Two, it affords to the issuer the rare ability to originate an instrument

which hinges on the quality of the underlying asset. Hence, it allows the issuer to make his

own credit rating insignificant or less significant and the intrinsic quality of the asset more

critical.

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2.5 Historical Background

Asset securitization began with the structured financing of mortgage pools in the 1970s. For

decades before that, banks were essentially portfolio lenders; they held loans until they

matured or were paid off. These loans were funded principally by deposits, and sometimes by

debt, which was a direct obligation of the bank (rather than a claim on specific assets). But

after World War II, depository institutions simply could not keep pace with the rising demand

for housing credit. Banks, as well as other financial intermediaries sensing a market

opportunity, sought ways of increasing the sources of mortgage funding. To attract investors,

investment bankers eventually developed an investment vehicle that isolated defined mortgage

pools, segmented the credit risk, and structured the cash flows from the underlying loans.

Although it took several years to develop efficient mortgage securitization structures, loan

originators quickly realized the process was readily transferable to other types of loans as

well."

In February 1970, the U.S. Department of Housing and Urban Development created the

transaction using a mortgage-backed security. The Government National Mortgage

Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.

To facilitate the securitization of non-mortgage assets, businesses substituted private credit

enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved

third-party and structural enhancements. In 1985, securitization techniques that had been

developed in the mortgage market were applied for the first time to a class of non-mortgage

assets automobile loans. A pool of assets second only to mortgages in volume, auto loans

were a good match for structured finance; their maturities, considerably shorter than those of

mortgages, made the timing of cash flows more predictable, and their long statistical histories

of performance gave investors confidence.

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank

and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).

The first significant bank credit card sale came to market in 1986 with a private placement of

$50 million of outstanding bank card loans. This transaction demonstrated to investors that, if

the yields were high enough, loan pools could support asset sales with higher expected losses

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and administrative costs than was true within the mortgage market. Sales of this type with

no contractual obligation by the seller to provide recourse allowed banks to receive sales

treatment for accounting and regulatory purposes (easing balance sheet and capital

constraints), while at the same time allowing them to retain origination and servicing fees.

After the success of this initial transaction, investors grew to accept credit card receivables as

collateral, and banks developed structures to normalize the cash flows.

Starting in the 1990s with some earlier private transactions, securitization technology was

applied to a number of sectors of the reinsurance and insurance markets including life and

catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions

in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of

activity in the broad area of Alternative Risk Transfer include catastrophe bonds, Life

Insurance Securitization and Reinsurance Sidecars.

The first public securitization of Community Reinvestment Act (CRA) loans started in 1997.

CRA loans are loans targeted to low and moderate income borrowers and neighbourhoods.

2.6 Features of Securitization

A securitised instrument, as compared to a direct claim on the issuer, will generally have the

following features:

1. Marketability: The very purpose of securitization is to ensure marketability to

financial claims. Hence, the instrument is structured to be marketable. Marketability

involves two postulates: (a) the legal and systemic possibility of marketing the instrument

(b) the existence of a market for the instrument.

In most jurisdictions of the world, well-coded laws exist to enable and regulate the

issuance of traditional forms of securitised claims, such as shares, bonds, debentures

(negotiable instruments). Most countries do not have legal systems pertaining to securitised

products, of recent or exotic origin, like securitization of receivables. It is imperative on

part of the regulator to view any securitised instrument with the same concern as in case of

traditional instruments, for investor protection. However, where a law does not exist to

regulate such issuance, it is nave to believe that it is not permitted.

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The second issue is of having a market for the instrument. Securitization is a fallacy unless

the securitised product is marketable. The purpose will be defeated if the instrument is

loaded on to a few professional investors without any possibility of having a liquid market

therein. Liquidity is afforded either by introducing it into an organised market (securities

exchanges) or by one or more agencies acting as market makers, i.e., agreeing to buy and

sell the instrument at pre-determined or market-determined prices.

2. Merchantable Quality:To be market-acceptable, a securitised product has to have

merchantable quality. Merchantable quality in case of financial products means the

financial commitments embodied in the instruments are secured to the investors'

satisfaction. To the investors satisfaction is a relative term, and therefore, the originator

of the securitised instrument secures the instrument based on the needs of the investors.

The general rule is: the broader the base of the investors, the less is the investors ability to

absorb the risk, and hence, the more the need to securities.

For widely distributed securitised instruments, quality evaluation, and its certification by

an independent expert, viz., rating is common. The rating is for the benefit of the lay

investor, who is otherwise not expected to be able to appraise the degree of risk involved.

Securitization is a case where a claim on the debtors of the originator is being bought by

the investors. Hence, the quality of the claim of the debtors assumes significance, which at

times enables investors to rely purely on the credit-rating of debtors and so, makes the

instrument totally independent of the originators own rating.

3. Wide Distribution:The basic purpose of securitization is to distribute the product.

The extent of distribution, which the originator would like to achieve, is based on a

comparative analysis of the costs and the benefits achieved thereby. Wider distributionleads to a cost-benefit, as the issuer is able to market the product with lower financial cost.

But a wide investor-base involves costs of distribution and servicing.

In practice, securitization issues are still difficult for retail investors to understand. Hence,

most securitizations have been privately placed with professional investors. However, in

time to come, retail investors could be attracted to securitised products.

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4. Homogeneity: To serve as a marketable instrument, the instrument should be

packaged into homogenous lots. Most securitised instruments are broken into lots,

affordable to the marginal investor, and hence, the minimum denomination becomes

relative to the needs of the smallest investor. Shares in companies may be broken intoslices as small as Rs.10 each, debentures and bonds are sliced into Rs.100 to Rs.1000 each.

Designed for larger investors, a commercial paper may be in denominations as high as Rs.

5Lac. Other securitization applications may also follow this logic.

The integration of several assets into one lump, and then their differentiation into uniform

marketable lots often invites the next feature: an intermediary for this process.

5. Special Purpose Vehicle (SPV):In case, the securitization transaction involvesany asset or claim which needs to be integrated and differentiated, unless it is a direct and

unsecured claim on the issuer, the issuer will need an intermediary agency to act as a

repository of the asset or claim being securitised. Thus, the issuer will bring in an

intermediary agency to hold the security charge on behalf of the investors, and then issue

certificates to the investors of beneficial interest in the charge held by the intermediary. So,

the charge continues to be held by the intermediary, but the beneficial interest becomes a

marketable security.

2.7 Securitization leads to Financial Disintermediation

If one imagines a financial world without securities, all financial transactions will be carried

only as one-to-one relations. If a company needs a loan, it will have to seek such loan from the

lenders, who will have to establish a one-to-one relation with the company. Each lender has to

understand the borrowing company, and look after his loan. This is often difficult, and hence, a

financial intermediary, such as a bank, pools funds from many such investors, and uses these

pooled funds to lend to the company. If the company securitises the loan, and issues

debentures to the investors, will this eliminate the need for the intermediary bank, since the

investors may now lend to the company directly in small amounts each, in form of a security

which is easy to appraise, and which is liquid?

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Utilities Added By Financial Intermediaries

A financial intermediary initially came into the picture to avoid the difficulties in a direct

lender-borrower relation between the company and the investors. The difficulties could have

been one or more of the following:

1. Transactional difficulty: An average small investor would have a small sum to

lend whereas the company's needs would be large. The intermediary bank pools the

investors funds to meet the companys needs. The bank may issue securities of smaller

value.

2. Informational difficulty: An average small investor may not be aware of the

borrower company or may not know how to appraise or manage the loan. The intermediary

fills this gap.

3. Perceived risk: The risk that investors perceive in investing in a bank may be much

lesser than that of investing directly in the company, though in reality, the financial risk of

the company is transposed on the bank. However, as the bank is a pool of several such

individual risks, the investors' preference of a bank to the company is reasonable.

Securitization of the loan into bonds or debentures solves all the three difficulties in direct

exchange, and hence, avoids the need for a direct intermediary. It avoids the transactional

difficulty by breaking the lumpy loan into marketable lots. It avoids informational difficulty

because the securitised product is offered generally by way of a public offer, and its essential

features are well disclosed. It avoids the perceived risk difficulty, as the instrument is usually

well secured and rated for investor satisfaction.

Securitization: Changing The Function Of Intermediaries

Disintermediation is an important aim of a present-day corporate treasurer, since by leap-

frogging the intermediary; the company reduces the cost of its finances. Hence, securitization

has been employed to disinter mediate.

However, it does not eliminate the need for the intermediary: it merely redefines the

intermediary's role. E.g.: if a company is issuing debentures to the public to replace a bank

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loan, it may be avoiding the bank as an intermediary, but would still need the services of an

investment banker to successfully conclude the issue of debentures.

Traditionally, financial intermediaries made a transaction possible by performing a pooling

function, and contributed to reduce the investors' perceived risk by substituting their own

security for that of the end user. Securitization puts these services of the intermediary in the

background. E.g.: where the bank being the earlier intermediary was eliminated and instead the

services of an investment banker were sought to distribute a debenture issue, the focus shifted

from the pooling utility provided by the banker to the distribution utility provided by the

investment banker.

Securitization seeks to eliminate funds-based intermediaries by fee-based distributors. In theabove example, the bank was a fund-based intermediary, a reservoir of funds, but the

investment banker was a fee-based intermediary, a catalyst, and a pipeline of funds.

In case of a direct loan, the lending bank was performing several intermediation functions

noted above: it was a distributor as it raised its own finances from a large number of small

investors; it was appraising and assessing the credit risks in extending the corporate loan, and

having extended it, it was managing the same. Securitization splits each of these intermediary

functions, each to be performed by separate specialised agencies. Distribution will be

performed by the investment bank, appraisal by a credit-rating agency, and management

possibly by a mutual fund that manages the portfolio of security investments of investors.

Hence, securitization replaces fund-based services by several fee-based services.

Figure 1: Traditional Banking and Securitization

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2.8 Securitization and Structured Finance

Securitization is a "structured financial instrument". "Structured finance" has become a

buzzword in today's financial market. It means that a financial instrument is structured or

tailored to the risk-return and maturity needs of investors, rather than a simple claim against an

entity or asset.

On the investors side, securitization seeks to structure an investment option to suit the needs

of investors. It classifies the receivables or cash flows not only into different maturities but

also into senior, mezzanine and junior notes. Therefore, it also aligns the returns to the risk

requirements of the investor.

2.9 Securitization as a Tool of Risk Management

Securitization is more than just a financial tool. It is an important tool of risk management for

banks. It primarily works through risk removal but also permits banks to acquire securitised

assets with potential diversification benefits. When assets are removed from a bank's balance

sheet, without recourse, all the risks associated with the asset are eliminated. Credit risk is a

key uncertainty that concern domestic lenders. By passing on this risk to investors, or to third

parties when credit enhancements are involved, financial firms are better able to manage their

risk exposures.

2.10 Economic impact of securitization

Securitization is as necessary to the economy as any organised markets are. While this single

line sums up the economic significance of securitization, the following can be seen as the

economic merits of securitization:

1. Facilitates creation of markets in financial claims: By creating tradable

securities out of financial claims, securitization helps to create markets in claims. It makes

financial markets more efficient by reducing transaction costs.

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2. Disperses holding of financial assets:The basic intention of securitization

is to spread financial assets amidst as many investors as possible. Thus, the security is

designed in minimum size marketable lots. Hence, it results into dispersion of financial

assets. One should not underrate the significance of this factor just because institutionalinvestors have lapped up most of the recently developed securitizations. Lay investors need

a certain cooling-off period before they understand a financial innovation.

3. Promotes savings:The availability of financial claims in a marketable form, with

proper credit ratings, and with double safety nets in form of trustees, etc., securitization

makes it possible for lay investors to invest in direct financial claims at attractive rates.

This promotes savings.

4. Reduces costs: As securitization tends to eliminate fund-based intermediaries, and

leads to specialisation in intermediation functions, it saves the end-user company from

intermediation costs, since the specialised-intermediary costs are service-related, and

generally lower.

5. Diversifies risks:Financial intermediation is a case of diffusion of risk because of

accumulation by the intermediary of a portfolio of financial risks. Securitization further

diffuses such diversified risk to a wide base of investors.

6. Focuses on use of resources, and not their ownership: Once an

entity securitises its financial claims, it ceases to be the owner of such resources and

becomes merely a trustee or custodian for the several investors who thereafter acquire such

claim. Securitization in its logical extension will enable enterprises to use physical assets

even without owning them, and to disperse the ownership to the real owner thereof: the

society.

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3 Securitization

Securitization of receivables is one of the latest applications of the generic device of

securitization. This device has, for the first time, brought to the fore the unlimited potential ofthe applicability of securitization to a diverse variety of assets.

Securitization of receivables is the first application of the device to securities and market

assets; hence, it is also referred to as asset securitization. In present day capital market usage,

the term includes securities created out of a pool of assets, normally receivables, which are put

under the legal control of the investors through a special intermediary created for this purpose.

The securities are liquidated on the primary strength of the assets in the pool, but may be

supported by "credit enhancements" provided by the originator or organised through external

agencies.

3.1 Parties Involved

1. The Originator:The Originator is the entity that securitises its assets. He is the

original lender/supplier who sells the receivables due from its debtors (the Obligors).

Typically, the Originator is a Development Financial Institution, a Bank, Non-Banking

Financial Company, Housing Finance Company or a Manufacturing/ Service Company.

This is the entity on whose books the assets to be securitised exist. It is the prime mover of

the deal i.e. it sets up the necessary structures to execute the deal. It sells the assets on its

books and receives the funds generated from such sale, the Originator transfers both legal

and the beneficial interest in the assets to the Special Purpose Vehicle (SPV).

2. The Special Purpose Vehicle (SPV): Since securitization involves a

transfer of receivables from the Originator, it would be inconvenient, to the extent of being

impossible, to transfer such receivables to the investors directly, since the receivables are

as diverse as the investors themselves. Besides, the base of investors could keep changing,

as the security is marketable. Thus, it is necessary to bring in an intermediary that would

hold the receivables on behalf of the end investors. This entity is created solely for the

purpose of the transaction: therefore, it is called a special purpose vehicle.

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The function of the SPV could stretch from being a pure conduit or intermediary vehicle,

to a more active role in reinvesting or reshaping the cash flows arising from the assets

transferred to it, which would depend on the end objectives of the securitization exercise.

Thus, the originator transfers the assets to the SPV, which holds the assets on behalf of the

investors, issues to the investors its own securities and makes the upfront payment to the

Originator. Therefore, the SPV is also called the Issuer.

3. The Investors:They may be in the form of individuals or institutional investors

like financial institutions, mutual funds, provident funds, pension funds, insurance

companies, etc. They buy a participating interest in the total pool of receivables and

receive their payment in the form of interest and principal as per the agreed pattern.

4. The Obligator(s)/ Obligor(s):The Obligator is the Originators debtor (the

borrower of the original loan). The amount outstanding from him is the asset that is

transferred to the SPV. His credit standing is of paramount importance in a securitization

transaction.

5. Principal Structuring Advisor: He has no legal or necessary role, but is

generally the principal advisor on the structure.

6. Underwriter/Merchant Banker: This is the dealmaker who undertakes to

get the issuance subscribed.

7. The Rating Agency:Since the investors take on the risk of the asset pool rather

than the Originator, an external credit rating is important. The rating process would assess

the strength of the cash flow, the mechanism designed to ensure full and timely payment

by selection of loans of appropriate credit quality, the extent of credit and liquidity support

provided and the strength of the legal framework.

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8. Legal Advisors: They are the legal counsels who draft the securitization

documents and provide legal opinions.

9. Credit Enhancers: One or more agencies provide guarantee/ insurance or other

credit enhancement to the transaction.

10. Banker: A banker to operate the lock-box/escrow account where the

collections will be deposited; where the guaranteed reinvestment contract will be

maintained

3.2 Securitization Process

Figure 2: Typical Securitization Structure

19

SPV Investors

Originator

Obligors

RatingAgency

Structurer

Issue ofsecurities

Collections

Creditenhancement

Rating

Subscription tosecurities

Cashflows Servicing

ofsecurities

ContractsOngoing cashflows

Initial cash flows

Servicer

OriginalLoan

Sale ofasset

Purchaseconsideration Arranger

CreditEnhancement

Providers


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Table 1: Basic process of Securitization of Receivables

20

Step 1 The originator either has or creates the underlying assets, that is, the

transaction receivables out of which he will securities.

Step 2 The originator selects the receivables to be assigned.

Step 3 A special purpose entity is formed.

Step 4 The special purpose company acquires the receivables at their discounted

value (or nominal value if originator's profit is to be retained).

Step 5 The special purpose vehicle issues securities to investors- either debt type

securities or beneficial interest certificates. These are publicly offered or

privately placed as found conducive.

Step 6 The servicer for the transaction is appointed, normally the originator. The

company may still continue to act as the servicer,

Step 7 The debtors are/ are not notified depending on the legal requirements.

Step 8 The servicer collects the receivables, usually in an escrow mechanism, and

pays off the collection to the SPV.

Step 9 The SPV either passes the collections to the investors, reinvests the same

to pay off to investors at stated intervals.

Step 10 In case of any default, the servicer takes action against the debtors as the

SPV's agent.

Step 11 When only a small amount of outstanding receivables are left to be

collected, the originator usually cleans up the transaction by buying back

the outstanding receivables.

Step 1 The originator either has or creates the underlying assets, that is, the

transaction receivables out of which he will securities.

Step 2 The originator selects the receivables to be assigned.

Step 3 A special purpose entity is formed.

Step 4 The special purpose company acquires the receivables at their discountedvalue (or nominal value if originator's profit is to be retained).

Step 5 The special purpose vehicle issues securities to investors- either debt type

securities or beneficial interest certificates. These are publicly offered or

privately placed as found conducive.

Step 6 The servicer for the transaction is appointed, normally the originator. The

company may still continue to act as the servicer,

Step 7 The debtors are/ are not notified depending on the legal requirements.

Step 8 The servicer collects the receivables, usually in an escrow mechanism, and

pays off the collection to the SPV.

Step 9 The SPV either passes the collections to the investors, reinvests the same

to pay off to investors at stated intervals.

Step 10 In case of any default, the servicer takes action against the debtors as the

SPV's agent.

Step 11 When only a small amount of outstanding receivables are left to becollected, the originator usually cleans up the transaction by buying back

the outstanding receivables.

Step 12 At the end of the transaction, the originator's profit, if retained and subject

to any losses to the extent agreed by the originator, in the transaction is

paid off.

The Basic Process of Securitization of Receivables


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Points to be Noted in a Securitization Deal

Since it is important for the entire exercise to be a case of transfer of receivables by the

originator, not a borrowing on the security of the receivables, there is a legal transfer of the

receivables to a separate entity. In legal parlance, transfer is called assignment of receivables.

One must ensure that the transfer of receivables is respected by the legal system as a genuine

transfer. It has to be a true sale, and not merely financing against the security of the

receivables.

Another word commonly used, is bankruptcy remote transfer. It means that the transfer of

the assets by the originator to the SPV is such that even if the originator goes bankrupt, the

investors rights on the assets held by the SPV are not affected.

While the originator selects the receivables to be securitised, a set of discriminants can be

used; but it is not advisable that the company cherry-picks assets, i.e., selects assets of the best

quality leaving behind poor quality assets with the company.

The SPV issues certificates to the investors indicating the money-value of their beneficial

interest in the pool of receivables. Alternatively the SPV may issue debt instruments that pay

off on stipulated dates, the payment for such debt securities to come out of the sums received

by the SPV. These may be called asset-backed notes orasset-backed securities. Sometimes,

these securities may also be traded on organised exchanges or second-tier exchanges.

The transfer of receivables to the investors through the vehicle of trust may be with or without

recourse, or with limited recourse to the issuer.

As the servicing is mostly done by the originating company, the debtors may often not even

know of the fact of securitization, unless they are notified,

In addition, the following features may be included as part of a securitization transaction:

-Credit enhancement to support timely payments of interest and principle and to handle

delinquencies

-Independent credit rating of the securitised paper from a well-known rating agency

-Providing liquidity support to investors, such as appointment of market makers.

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3.3 Features of Securitization of Receivables

Mode of Asset-based Financing

As financing markets have become more organised and investing more institutionalisedand

hence, professionalized, there is a clear trend towards asset-based financing, rather than user-

based financing. Traditional financing is user- based. For example, where X gives a loan of a

certain amount to Y, he looks at the credibility and the worth of commitment made by Y as the

basis of his credit.

However, as investing becomes professionalized, the professional investor has the ability to

understand the application of the sum borrowed. Hence, he will place more weightage to the

use of the money rather than who the user of the money is.

The user of money is still a source of comfort of the lender. However, the institutional investor

for several reasons cannot afford strictly user-based risks:

The professional investor invests based on a logical assessment of the credit- risks and

not merely based on hunches.

User-based financing is necessarily subjective, since the user is an entity and not an

asset, and the credit-assessment of an entity is as subjective as face- reading. The

professional investor cannot go by subjective appraisal.

Asset is a store of intrinsic value. Therefore, one who looked at the asset and not the user

stands a better chance of recovering his finances

It is difficult to say with certainty that asset-based financing is superior to user-based

financing, but there is a world-over drift towards such financing. The latest financial

innovations- leasing, factoring, leveraged buyouts, securitization- confirm this move

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Mode of Structured Financing

Once financing is asset-based, the originator can structure the financing based on the assets or

based on the needs of the investor. As the investor is anyway looking at the asset rather than

the entity, the investor's claim is against specific assets, and so, it becomes possible for the

user entity to offer assets, which would suit the needs of the investor.

Investor needs can be expressed in various ways based on

Attitude towards risks

Length of Investment

Securitization structure can, accordingly carve out securities that are rated at the best possible

level, and those that are junior, or speculative, though they carry a very high rate of return.

Securitization expands the structuring flexibility, since it splits the same asset into many

assets. Thus, it can create different classes of securities linked to the same asset: E.g.: different

maturity periods, different preferential rights, etc. Securitization has been used even for

creating purely risk-based structures, such as catastrophe bonds carrying substantially high

rates of return but inherent risk for a total loss of principal.

Securitization of Claims against Third Parties

From the legal and investor point of view, the single most important difference between

securitization of receivables and any other security issuance is that the former seeks to market

claims against third parties and not claims against the originator.

This poses unique problems for the law. Though the right of receiving a certain sum under a

contract is a property, since it is a claim against third parties, there might be a specific

procedure prescribed for its transfer. Securitization transactions, in most countries tend to get

complicated on account of these legal procedures.

That securitised instrument isa claim against third parties is also relevant from the point of

view of investors. Each investor acquires a claim over a receivable or a pool of receivables.

There may not be any claim on the issuer entity. Hence, the quality of the security is entirely

dependent upon a credit assessment of the receivable or the pool.

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Recourse Features

Being a case of asset-based financing, most originators would ideally like the investor to look

at the asset only, and hence, not have any recourse to the originator. That is, the investor gets a

legally tenable right over the receivable, and hence, he has to recover his money only from the

debtor. In case of failure on the part of the debtor to pay, the investor has to exercise his rights

through the special purpose intermediary, viz., the trust holding rights over the receivables.

Non-recourse securitization as far as the originator is concerned should not be taken as a

means of financing, but as a means of financial restructuring. The originator incurs no

obligation to the investors, except to a pre-defined extent. Hence, the securitization does not

appear as a balance-sheet liability.

However, in most securitizations, the originator is required to add an element of his own

liability to the structure, as a tool of credit enhancement. This is by way of limited recourse

provisions, or by way of participation as an investor himself, with his rights subordinated to

those of the other investor. Unlimited recourse is foreign to the concept of securitization,

because if the originator continues to carry the same risk in the transferred portfolio as he did

prior to securitization, the entire transaction may be re-characterised as a financial transaction

rather than a securitization transaction.

Asset Features

Any asset that produces a cash flow over time is a securitisable asset. Given this basic

attribute, securitization applications have been taken to extremely exotic and unimaginable

extents. However, securitisable assets have some basic attributes:

1. Asset should represent cash flows:

The asset in question should give rise to cash flows over a period of time. Normally, the cash

flows should be steady and easy to identify.

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2. Quality of Receivables:

Securitization is primarily meant to create a derivative asset (the security) out of a basic asset

(the receivables). The originator expects the derivative asset to stand on its own worth, and

hence, make the credit rating of the originator insignificant. Thus the receivables being

securitised should be of high quality. Past payment statistics are taken as a yardstick of quality.

However, if the securitised receivables have any collateral protection, the backing adds up to

the quality of the receivable.

If the cash flow pool by itself does not have underlying collateral, it may be necessary to back

up the cash flows with extraneous securities or provide for over-collateralisation.

Quality is to be decided based on the needs and perception the investors. At times, the investor

might lay more stress on a recourse provision rather than on asset-quality.

3. Diversification of the portfolio:

If the quality of the components of the portfolio is extremely good, diversification becomes

unnecessary. Generally, securitization is resorted to market rights in several small-ticket items,

each of which individually may not be an acceptable risk, but all taken together becomeacceptable, because of the diversification of risk.

The degree of distribution of the portfolio is an important issue in its rating. A rating agency

would like to ensure that the portfolio is so diversified that the contagious effect of decay in a

single asset, is not likely to affect the health of the portfolio. No individual asset should have a

significant value relative to the size of the portfolio.

4. Size of individual receivable:

Diversification and size or quality of the individual receivable act as mutually offsetting

factors: small size and relatively poor quality of the receivable is offset by greater

diversification, and vice versa.

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5. Periodicity of payments:

The payment on account of the underlying assets should be periodic and not one time.

Periodically paying assets are more conducive to securitization as they have a smooth regular

cash flow, and give enough money for regular servicing of investors.

6. Homogeneity of the assets:

The underlying assets should by and large be homogenous. E.g.: car loans of the same or

similar type- say, for the same maturity, similar risk features etc. The advantage in

homogenous assets is that the pooling and the analysis of the pool will be easier, since

historical data can be applied to project the risks in the portfolio. E.g.: car loans and equipment

leases will not be fit to be pooled, as their features are totally different.

7. No Executory clauses:

The contracts to be securitised must work, even if the originator goes bankrupt. Thecontract

should not contain an obligation on the part of the originator or issuer.

8. Capacity to assign:

Securitization involves transfer of a right to receive - it is a transfer of a right against a third

party to the assignee. Thus, it is required that the law or the contract between the parties should

not prohibit the right to assign. Normally, the right to assign a receivable is an inherent

property right, but legal formalities may be required.

9. Independence from the originator:

The on-going performance of the assets and the making of claims against the debtors must be

independent of the existence of the Originator. As far as possible, the underlying contracts

should not require something to be done by the originator or should not depend upon the

originator being a running concern.

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10. Assets should preferably be free of withholding taxes/ pre-

paid taxes:

If withholding taxes were applicable on payments to be made by the debtors, who would take

the credit for the withholding tax? The originator collects the payment, but on behalf of the

SPV, which in turn collects it on behalf of the investors. It would be logistically impossible to

allow the benefit to set off to the investors directly: thus, the SPV/ originator will be forced to

take the credit for the pre-paid tax, which may be technically objectionable. Also, as withheld

taxes qualify for a refund only after the tax assessment is complete, a residuary receivable,

which may be collected much after the expiry of the scheme, may be created.

Issuer Features

1. Receivables as major assets:

Securitization of receivables presupposes that the issuer has a bulk of its assets or future assets

in form of receivables. Besides, the receivables must satisfy the features discussed,

significantly, that the receivable should not be for a very short term to frustrate the

securitization exercise. Generally the following companies find securitization a viable option:

a) Real estate finance companies

b) Non-mortgage finance companies

c) Car rental companies

d) Credit card companies

e) Hoteliers and real-estate renters

f) Electricity and telephone companies

g) Banks

Wherever a reasonably certain sum of money will be received over a certain time period, not

very short, securitization possibility exists. Some of the latest applications include

securitization of intellectual property rights, sports earnings, music royalties, etc.

2. Financial and organisational strength:

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As such, in securitization, the financial strength of the issuer is not important. However, no

securitization (except those guaranteed by external agencies) is completely independent of the

originator. Originator rating casts a shadow on the securitization transaction. Hence, the

originator should be a reasonably strong entity. While the financial strength of the originator

may not be very significant, his organisational strength certainly is, since the originator would

continue to service the product.

SPV Features

The following are necessary from the legal viewpoint and to safeguard investor interests:

1. Sub-contracting services required for maintaining the SPV and its assets e.g.:

administering its receivables, company secretarial work, so that SPVs do not have an

administrative infrastructure of their own and do not have obligations that could take them

to bankruptcy.

2. SPVs are not permitted to have any employees (normally) or to have

general fiduciary responsibilities to third parties (e.g.: acting as a trustee)

3. Any person who contracts with the SPV must agree not to sue it in event of failure

of the SPV to perform under the contract (unless he is senior and effectively rated)

4. All of the SPVs liabilities (present and future) should be

quantifiable, and shown to be capable of being met out of the resources available to it;

funds, which are due to the SPV, have to be separated as soon as they are received.

Investor Features

1. Professional and fixed, regular income investor: Most investors in

securitised products, except for mortgage-backed securities, are institutional investors.

2. Investor for a fixed period: In view of limited common-investor interest,

secondary markets in securitization may not be vibrant. Hence, securitised products may

not be very liquid. Because of accounting rules, the issuer is discouraged from giving any

buy-back facility for securitised products, unless the off-balance-sheet treatment is not a

serious concern. Hence, investors must have the ability to keep investments locked over a

term.

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3.4 Types of Securitization

Mortgage Backed Securities (MBS)

Securitization of assets began with, and in sheer volume remains dominated by residential

mortgages. The receivables are secured by mortgage over the property being financed, thereby

enhancing the comfort for investors (because mortgaged property does not normally suffer

erosion in value like other physical assets through depreciation). It is more likely that realestate appreciates in value over time. Further,

The receivables are medium to long-term, catering to the needs of different investors;

The receivables consist of a large number of individual homogenous loans that have been

underwritten using standardised procedures, hence suitable for securitization;

In USA, where it originated, mortgages were also secured by Government guarantees;

The receivables also satisfy investor preference for diversification of risk, as the

geographical spread and diversity of receivable profile is very large.

In the Indian context, the funds requirement in the housing sector is immense, estimated at Rs.

150,000 icrore during the current five-year plan. Of this, it is envisaged that about Rs 52,000

crore would be financed by the formal sector. It is unlikely that this gap can be filled out of

budgetary allocation or regular bank credit. Securitization allows this gap to be bridged by

directly accessing the capital markets without intermediation. Securitization tends to lower the

cost at which the housing sector accesses funds. It also facilitates a sufficiently deep long term

debt market. It is estimated that about Rs 2,500 crore would be mobilised through

securitization during the current five-year plan.

Asset Backed Securities (ABS) Existing assets

1. Auto loans: In India, the auto sector has been thrown open to international

participation, greatly expanding the scope of the market. The security in this case is

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considered good, because of title over a utility asset. The development of a second hand

market for cars in India has also meant that foreclosure is an effective tool in the hands of

auto loan financiers in delinquent cases. Originators are NBFCs and auto finance divisions

of commercial banks.

2. Investments: Investments in long dated securities as also the periodical interest

instruments on these securities can be pooled and securitised. This is considered relevant

for India where financial institutions are carrying huge portfolios in Government securities

and other debt instruments, which are creating huge asset-liability mismatches.

3. Others: Financiers of consumer durable, corporate whose deferred trade receivables are

not funded by working capital finance, etc are Originators of other asset classes amenable

to securitization. Corporate loans, in a homogeneous pool of assets, are also subject to

securitization.

Despite the fact that the markets for ABS are exceptionally large, there is virtually no known

instance so far, of an ABS transaction having failed. Industry experts attribute this to three

factors. ABS transactions are always planned, prepared and carried out with great care.

Second, the intrinsic value of the paper and particularly the high level of transparency on the

quality of the underlying assets. Third, ABS transactions are sponsored generally by large and

well-known institutions that cannot afford to jeopardize their reputation with investors, the

majority of which are institutional investors.

Securitization of Infrastructure Receivables

The India Infrastructure Report 1995 estimated that a total outlay of Rs 400,000 450,000

crore would be required for infrastructure financing.

Along with the Governments attempt at attracting private investment into infrastructurefunding, the role of innovative funding like securitization is vital. The suitability of

securitization for infrastructure funding stems from the fact that cash flows are stable and

concession driven, and the ultimate credit risk is partly guaranteed by the Government.

Future Receivables

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Providers of utilities such as electricity and telephone services have an excellent opportunity of

securitizing electricity meter rentals and telephone rentals. The receivables in these cases are

very widely spread, and delinquency record very favorable.

1. Export Receivables:Such securitization can be considered by (i) financing FIs or

(ii) exporters themselves. The receivables must have a reasonable span of life so that

they can be segregated and covered by a market instrument. Among the Institutional

lenders, EXIM Bank may be able to undertake securitization since they are involved in

financing exporters on deferred terms.

Here, the rights to receive future dollar cash flows can be transferred to an SPV outside

India. The offshore vehicle issues the securities. As a result, the cash flows are first

received outside India for payment to investors. Thus, it is possible to receive a rating

on the securities higher than the India sovereign ceiling. Consequently, these

transactions are not affected by the legal issues in India. Such transactions have been

done in Mexico.

2. Credit Card Receivables:As mentioned earlier, although the average tenure of

credit available to a credit card holder is generally very short (less than two months), it is

revolving in nature. Originators are credit card divisions/subsidiaries of commercial

banks, including a number of foreign banks.

3. Airline Ticket Receivables: Future sales of airline tickets can be securitized

considering the predictability of their cash flows.

4. Future Oil Sales: Oil sales from confirmed oilfields can form a large pool of

assets, suitable for securitization, especially considering that the Obligors wouldnormally be high quality corporate

5. Lease Rentals:Equipment and real estate leases exhibit characteristics amenable to

securitization, particularly in respect of a fixed payment schedule for the lease rentals. In

the Indian context, there is ample scope for securitization of future flows in this asset

class in view of the impressive growth of hire purchase and leasing finance companies.

Originators are NBFCs and leasing divisions of commercial banks.

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3.5 Forms of Securitization Structures

Securitization structures refer to the way the investors have a right to share the cash flows

arising out of the pool of receivables beneficially owned by them. None of these structures are

universal and the suitability for different classes differs.

Pass-Through or Non-Tranched SecuritizationSecuritization originated in the USA in mortgage financing markets, and the earliest

securitization technique used was a pass-through. The issuer (SPV) passes to the investors the

entire interest in the securitised portfolio. All that the SPV does is collects the receivables and

pays them over. The investors have a direct beneficial, proportional interest in the pool of

receivables, as also in the collections based on the pool.

The greatest difficulty with the pass-through structure is the erratic, unpredictable cash flow

structure, and the periodicity of the cash flows. So, if the underlying receivables are payable

every month, investors get repaid every month, imposing heavy servicing costs. Pass-throughs

have therefore been largely confined to the agency-facilitated mortgage market.

Pay-Through Structure

The difficulty with pass-through structure was the direct association of recoveries with

payments to the investors. Monthly repayments may not suit retail investors, who prefer

quarterly or half-yearly receipts. That requires dissociation between recoveries and

repayments.

This led to the super-imposition of a loan structure on a securitization device: the SPV instead

of transferring undivided interest on the receivables would issue debt securities, normally

bonds, repayable on fixed dates, but such debt securities in turn would be backed by the

mortgages transferred by the originator to the SPV. The word "pay through, indicates that as

against pass throughs, where the payment on account of the mortgages is simply passed

through the SPV to the investors, in the present case, it is paid through the SPV to the

investors. Here the SPV is not merely a passive conduit, but it receives, reinvests and pays

money.

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Collateralised Mortgage Obligation Bonds

Though the pay-through mechanism solved one of the difficulties of the pass-through: that is,

mismatching the recoveries and repayments, it still did not allow the investors the facility of

differing tenure choice and differing repayment choices. Passing on equal payment to all is

ignoring their differing needs. The CMO bonds solved this difficulty.

The CMO structure breaks the investors into different tranches, based on the duration for

which they want to invest. E.g.: the A series of investors would be repaid first- so the entire

principal collected, is first used to fully pay off the A class investors. Once A class is fully

retired, repayments are made to B class. The last is the Z class, which would receive a bullet

payment right at the end of the transaction. In the meantime, the interest collected may bepassed on to all the investors as per their outstanding investment.

Thus, this structured investment option allows the investors to invest according to their

investment objectives. CMO bonds are a hybrid between pay-through and pass-through

structures. The payments received by the SPV from the underlying mortgages are passed

through to the investors. However, the cash flows are repaid in tranches to different investors

and the risks are being divided- thus, there is the re-configuration element also.

Variations, based on the same concept are Collateralised Bond Obligations (CBO)

Collateralised Loan Obligation (CLO) and Collateralised Debt Obligation (CDO).

Revolving Assets SecuritizationThis is used for short-lived assets such as credit card receivables, short-term lease rentals, etc.

Here, the originator passes interest to the investors in a revolving pool of assets, where assets

pay off, but are re-instated by fresh stock of receivables.

Credit card receivables typically pay off within a month or so. The entire principal along with

the interest is paid off within this time. On the other hand, the investors would like to lock in

their money for a reasonably long period, say 3 years or so. The money is pooled with the

SPV, which buys the requisite amount of credit card receivables from the originator, and once

these receivables are paid off, it retains the interest for servicing the investors. When it is time

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to amortise the receivables, the principal collected is used to pay off the principal to the

investors either in several instalments or in a bullet payment.

Most revolving assets securitization have a right to acceleration of principal repayment: in case

of certain events, the SPV may use the principal repayments in any month not for acquiring

fresh receivables but for paying off the investors before the scheduled repayment date. This

may be done to enhance the Originators credibility.

Future Flows Securitization

Securitization of future flows is an exciting application of securitization, particularly for

emerging market countries. Mexico was the first country to securities future flows in 1987-

securitization by Telfonos de Mxico S.A. de C.V. of telephone receivables.

Here, the asset being transferred by the originator is not an existing claim against existing

obligors, but a future claim against future obligors. The claims are yet to be created, against

obligors who are yet to be identified. Examples can be: export receivables (normally crude

exports), future royalties, hotel revenues, sports receivables.

Most of the future flow securitizations are by originators from emerging markets, whoseoffshore borrowing abilities are stymied by the sovereign rating of the country where the

originator is stationed.

Future flow securitization essentially aims at piercing the rating of the sovereign and having a

security of the originator rated above the rating of the sovereign. If, in the example above, the

originator is an exporter, exporting oil to US buyers, and if he securitises the oil exports such

that the receivables are trapped and deposited in an account in New York, which is assigned to

the SPV, the investors would:

Not be subject to exchange risk, as the receivables are in foreign exchange

Not be subject to sovereign risk as the receivables have been assigned by way of a true

sale outside the country of the originator.

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A future flow securitization may allow the originator to borrow more, since, while a typical

traditional lender looks at the assets on the balance sheet (receivables which have fallen due), a

future flow investor looks at receivables that are not on the balance sheet.

A future flow transaction may even allow the originator to borrow at lesser costs, for reasons

discussed above, particularly in case of cross border financing.

Asset-Backed Commercial Paper Conduits

They are essentially asset-backed funding devices, usually for trade receivables. These are

specialised conduits/ intermediate agencies that acquire trade receivables of several

originators, and issue commercial paper (CP) backed by such receivables. Most ABCP

conduits are organised by banks, as liquidity is important for a CP program.

The template for the present-day ABCP conduits was created by Citibank in 1983. Banks view

ABCP programs as a substitute for direct working capital funding to their clients.

The motivation of the bank is simple: it keeps the bank's balance sheet light. The bank has to

keep lower capital for the assets, to the extent of the off-balance sheet commitment for

liquidity. For the corporate borrowers, this would be a more efficient and perhaps cheaper wayof working capital funding as it disintermediates the bank. Because of the existence of a

specialized conduit, the costs of setting up conduits or coming out with a commercial paper

issue of one's own are avoided. Hence, the ABCP conduit is an efficient alternative to

commercial paper issuance. Larger borrowers with good ratings have set up their own single-

seller conduits.

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4 Advantages and Limitations

4.1 Advantages of Securitization

For the Issuer

1. Lower cost

Cost reduction is one of the most important motivations in securitization. Securitization seeks

to break an originating company's portfolio into echelons of risks, trying to align them to

different investors' risk appetite. This alchemy supposedly works - the weighted overall cost of

a company that has securitised its assets seems to be lower than a company that depends ongeneric funding. One of the most tangible effects of securitization is to reduce the extent of

risk capital or equity required for a given volume of asset creation. Assuming that equity is the

costliest of all sources of capital, lower equity requirements do result into lower costs.

Securitization enables the originator to achieve a rating arbitrage - obtain a rating that a

generic funding could not have. Such a rating is possible due to the structural enhancements in

securitization senior/junior structures, or a Z-bond structure.

In future flows securitization; the objective of the originator is to achieve ratings higher than

the rating of the entity or the rating of the originators country. As securitization makes such

higher ratings possible, it enables the originator to borrow at lower costs.

2. Retail distribution of assets

Securitization enables a financial intermediary to retail-market its assets to a large section of

investors. The intermediarys role is changed from a fund-based intermediary to a distributor

of an asset, while maintaining its spreads. Retail distribution of liabilities remains the aim of

any financial firm. Securitization offsets a retail liability against a retail asset, and hence,

achieves this purpose.

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3. Makes the issuer-rating irrelevant

Being an asset-based financing, securitization may make it possible even for a low-rated

borrower to seek cheap finance, purely on the strength of the asset-quality. One of the common

statements, rating companies make is: in a normal debt issuance, we rate a product.

In structured finance, the issuer dictates the rating, and the structure is worked out

accordingly. It is possible to obtain an AAA rating for securitised products, irrespective of the

originators rating -there should be adequate legal protection against the originators

bankruptcy and adequate credit enhancement.

4. Off-balance sheet financing

Financial intermediaries look at securitization essentially as an off-balance-sheet funding

method. The off-balance sheet feature could be looked at either from the accounting

viewpoint, or from the regulatory viewpoint. The latter is relevant for computation of

regulatory capital or capital adequacy requirements. From the accounting viewpoint: the

tendency, of financial institutions and others, to prefer off-balance sheet funding over on-

balance sheet funding is because the former allows higher returns on assets, and higher returnson equity, without affecting the debt-equity ratio. As tools of managerial performance, these

have a definite relevance.

Securitization allows a firm to create assets, make income thereon, and yet put the assets off

the balance sheet the moment they are transferred through securitization. Thus, the income

from the asset is accelerated and the asset disappears from the balance sheet, leading to an

improvement in both income-related ratios as also asset-related ratios.

5. Helps in capital adequacy requirement

Capital adequacy requirements are requirements relating to minimum regulatory capital for

financial intermediaries. A very strong motivation for securitization is that it allows the

financial entity to sell some of its on-balance sheet assets, and remove them from the balance

sheet, and hence reduce the amount of capital required for regulatory purposes. Alternatively,

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if the amount raised by selling on-balance-sheet assets is used for creating new assets, the

entity is able to increase its asset-creation without a haircut for its capital.

Motivated by this, large commercial banks have made extensive use of securitization. This has

led to formation of some regulations on capital requirements for securitization in different

countries. These regulatory requirements define the conditions subject to which securitization

will be given off-the-balance-sheet treatment, and, if off the balance sheet, the required capital

deduction for the risks retained by the originator.

In spite of these guidelines, it is a common experience that securitization has enabled banks

either to reduce the level of their on-balance sheet assets, or to achieve a higher amount of

asset-generation with a given amount of capital.

6. Improves capital structure

By being able to market an asset outright (while not losing the stream of profits therein),

securitization avoids the need to raise a liability, and hence, it improves the capital structure.

Alternatively, if securitization proceeds are used to pay off existing liabilities, the firm

achieves a lower debt-equity ratio.

The improvement of capital structure as a result of lower debt-equity ratio may not be a mere

accounting gimmick - if securitization results into either transfer of risks inherent in assets, or

capping of such risks, there is a real re-distribution of risks taking place, leaving the firmwith

a healthier balance sheet and reduced risk.

7. Better opportunity of trading on equity with no increased risk

This point is a re-statement of the accounting and capital-adequacy-related benefits, discussed

earlier. The ability to create assets, as a result of off-balance-sheet treatment and regulatory

freedom, results into more profits and hence a stronger firm.

8. Extends credit pool

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Securitization keeps the other traditional lines of credit undisturbed; hence, it increases the

total financial resources available to the firm. Many firms, in addition to regular borrowings

have tried securitization, not in place of it.

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9. Not regulated as a loan

Most countries have laws regulating borrowing abilities of financial companies, since they are

taken as Para-banking companies. Securitization does not suffer borrowing-related fetters, as it

is not taken by regulation to be debt. E.g., a regulation relating to borrowings from public will

not be attracted, since it is not a case of borrowing.

From the point of view of law, often, the distinction between securitization and borrowing is

based on a strict interpretation of the word "borrowing": thus, securitization with recourse may

not qualify for off-balance sheet purposes or for capital adequacy requirements, but when it

comes to a borrowing-related legislation, the same is not to be taken as a debt. In India, for

example, securitization will escape regulation pertaining to raising of deposits by financial

companies; as such regulation is a part of the law not a prudential regulation.

10. Reduces credit concentration

Securitization has also been used by many entities for reducing credit concentration.

Concentration, either sectoral or geographical, implies risk. Securitization by transferring on a

non-recourse basis by an entity has the effect of transferring risk to the investor.

11. Escapes taxes based on interest

For technical purposes, securitization would not be treated as "interest" on loans. Hence, if

there are taxes based on interest earnings, they would not be applicable to investors' earnings

in securitised products. In India, interest-tax on interest income of banks/ financial institutions

will not be applicable in case of investments in securitised products. Besides, withholding

taxes that apply solely to interest payments will not apply in case of a tax-acceptable

securitization.

For the Investors

Needless to emphasise, advantages to the originator would not carry much relevance unless

securitization was an attractive option for investors too. All over the world, investors,

particularly institutional investors, have shown active interest in investing in securitised

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products. Rating agencies have helped in promoting these interest levels since most securitised

products have obtained good ratings, and in several cases, even with the downgrading of the

entity, the structured finance offerings have not been downgraded.

Who are securitization investors?

Securitization has drawn in a large cross-section of investors. The mortgage pass-throughs in

the USA are actively traded in organised markets and have drawn both institutional and retail

investors. But other asset classes resulting in creation of securities are not easy for retail

investors to understand. Besides, being high- grade, low return and fixed income securities,

securitization has basically drawn institutional investors.

Some securitization investors: high net worth individuals looking at diversification and

hedging, pension funds, insurance companies, bank trust departments, investment funds,

commercial banks, finance houses, mortgage banks, etc.

Investor Motivations

1. Good ratings

As already noted, many structured finance offerings have obtained good ratings. With

increasing institutionalisation of investment, investments are being managed by professional

managers who prefer a formally rated instrument to an unrated one.

2. Better matching with investment objectives

Securitised instruments are flexible to match with investors investment objectives. Investors

looking for a safe high-grade investment can pick a senior most A-type product. Those looking

for a mediocre risk with higher rate of return can opt for a B-type option. Investors can also

look at investing over a short term, medium term or long term.

3. Yield premiums

Securitised offerings have offered good yields with adequate security. Empirical data reveal

that an investor who maintained a good balance of

3 - securitization

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