term loans & securitisation

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By Prof Sameer Lakhani By Prof Sameer Lakhani Term Loans, Debentures/Bonds Term Loans, Debentures/Bonds and Securitisation and Securitisation

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Page 1: Term loans & securitisation

By Prof Sameer LakhaniBy Prof Sameer Lakhani

Term Loans, Debentures/Bonds Term Loans, Debentures/Bonds and Securitisationand Securitisation

Page 2: Term loans & securitisation

TERM LOANS, DEBENTURES/BONDS AND SECURITISATION

Term Loans

Securitisation

Debentures/Bonds/Notes

Solved Problem

Page 3: Term loans & securitisation

Bonds/ debentures have emerged as substantial source of debt finance to corporate in India in the context of (I) absence of term loan support by financial institutions, (ii) freedom to corporate to design debt instruments, (iii) withdrawal of interest ceilings on debt instruments, (iv) credit rating of debt instruments, and (v) setting up of the wholesale debt market (WDM) segment by the NSE.

Term (long-term) loan is a loan made by a bank/financial institution to a business having an initial maturity of more than 1 year. Term loans are also known as term/project finance. The financial institutions provide project finance for new projects as also for expansion/diversification and modernization

Term LoansTerm Loans

Page 4: Term loans & securitisation

Features of Term Loans

Maturity  

The maturity period of term loans is typically longer in case of sanctions by financial institutions in the range of 6-10 years in comparison to 3-5 years of bank advances. However, they are rescheduled to enable corporates/borrowers tide over temporary financial exigencies.

Negotiated

The term loans are negotiated loans between the borrowers and the lenders. They are akin to private placement of debentures in contrast to their public offering to investors

Security  

All term loans are secured. While the assets financed by term loans serve as primary security, all the other present and future assets of the company provide collateral/secondary security for the term loan.

Page 5: Term loans & securitisation

Covenants

To protect their interest, the financial institutions reinforce the asset security stipulation with a number of restrictive terms and conditions. These are known as covenants. They are both positive/affirmative and negative in the sense of what the borrower should and should not do in the conduct of its operations and fall broadly into four sets as respectively related to assets, liabilities, cashflows and control.

Page 6: Term loans & securitisation

Negative CovenantsNegative Covenants

Asset-Related Covenants are intended to ensure the maintenance of a minimum asset base by the borrowers. Included in this set of covenants are:

Maintenance of working capital position in terms of a minimum current ratio,

Restriction on creation of further charge on asset, Ban on sale of fixed assets without the lenders

concurrence/approval.

Liability-Related Covenants  may, inter alia, include:

Restrain on the incurrence of additional debt/repayment of existing loan, say, without the concurrence/prior approval of the lender/financial institution,

Reduction in debt-equity ratio by issue of additional capital, and Prohibition on disposal of promoters shareholding.

Page 7: Term loans & securitisation

Cashflow Related Covenants  which are intended to restrain cash outflows of the borrowers may include:

Restriction on new projects/expansion without prior approval of the financial institution,

Limitation on dividend payment to a certain amount/rate and prior approval of the financial institutions for declaration of higher amount/rate,

Arrangement to bring additional funds as unsecured loans/deposits to meet overrun/shortfall, and

Ceiling on managerial salary and perks.

Control Related Covenants  aim at ensuring competent management for the borrowers. This set of covenants may include

Boroadbasing of board of directors and finalisation of management set-up in consultation with the financial institution,

Effective organisational changes and appointment of suitable professional staff, and

Appointment of nominee directors to represent the financial institutions and safeguard their interests.

Page 8: Term loans & securitisation

Positive Covenants

In addition to the foregoing negative covenants, certain positive/affirmative covenants stating what the borrowing firm should do during the term of a loan are also included in a loan agreement. They provide, inter alia, for

1) furnishing of periodical reports/financial statements to the lenders,

2) maintenance of a minimum level of working capital,

3) creation of sinking fund for redemption of debt and

4) maintenance of certain net worth.

Page 9: Term loans & securitisation

Repayment Schedule/Loan Amortisation 

The term loans have to be amortised according to predetermined schedule. The payment/repayment has two components:

1) Interest and

2) Repayment of principal.

The interest component of loan amortisation is a legally enforceable contractual obligation. The borrowers have to pay a commitment charge on the unutilised amount.

Typically, the principal is repayable over 6-10 years period after an initial grace period of 1-2 years. Whereas the mode of repayment of term loans is equal semi-annual instalments in case of institutional borrowings, the term loans from banks are repayable in equal quarterly instalments.

Page 10: Term loans & securitisation

TABLE 1  Loan Amortisation Schedule (Equal Principal Repayment)

(Rs thousands)

Year Beginning loan

Principal repayment

Interest (0.14)

Loan payment

Ending loan 

(1) (2) (3) (4) (5) (6)

1 60.00 7.50 8.40 15.90 52.50

2 52.50 7.50 7.35 14.85 45.00

3 45.00 7.50 6.30 13.80 37.50

4 37.50 7.50 5.25 12.75 30.00

5 30.00 7.50 4.20 11.70 22.50

6 22.50 7.50 3.15 10.65 15.00

7 15.00 7.50 2.10 9.60 7.50

8 7.60 7.50 1.05 8.55 0.00

Page 11: Term loans & securitisation

The debt servicing/loan amortisation pattern involving equal instalment (interest + repayment of principal) is portrayed in Table 2.

TABLE 2  Loan Amortisation Schedule (Equal Instalment)

Year Beginning loan

Payment instalment

@

Interest (0.14)

Principal repayment

[3 – 4]

Ending loan 

[2 – 5]  

(1) (2) (3) (4) (5) (6)

1 Rs 60,000 Rs 12,934 Rs 8,400 Rs 4,535 Rs 55,466

2 55,466 12,934 7,776 5,168 50,298

3 50,298 12,934 7,042 5,896 44,406

4 44,406 12,934 6,216 6,718 37,688

5 37,688 12,934 5,276 7,658 30,030

6 30,030 12,934 4,204 8,730 21,300

7 21,300 12,934 2,982 9,952 11,348

8 11,348 12,934 1,588 11,346 0

@ Payment instalment = (Rs 60,000/PVIFA 8,14) = (Rs 60,000/4.6389) = Rs 12,934

Page 12: Term loans & securitisation

Term Loan Procedure  The procedure associated with a term loan involves the following principal steps:

The borrower submits an application form which seeks comprehensive information about the project. The application form covers the following aspects:

1) Promoters’ background,

2) Particulars of the industrial concern,

3) Particulars of the project (capacity, process, technical arrangements, management, location, land and buildings, plant and machinery, raw materials, effluents, labour, housing, and schedule of implementation),

4) Cost of project,

5) Means of financing,

6) Marketing and selling arrangements,

7) Profitability and cash flow,

8) Economic considerations, and

9) Government consents.

Page 13: Term loans & securitisation

Term Loan Procedure  When the application is considered complete, the financial institution prepares a 'Flash Report' which is essentially a summarization of the loan application. On the basis

of the 'Flash Report', it is decided whether the project justifies a detailed appraisal or not.

The detailed appraisal of the project covers the marketing, technical, financial, managerial, and economic aspects. The appraisal memorandum is normally prepared within two months after site inspection. Based on that, a decision is taken whether the project will be accepted or not.

If the project is accepted, a financial letter of sanction is issued to the borrower communicating the assistance sanctioned and the terms and conditions relating thereto.

On receiving the letter of sanction from the financial institution, the borrowing unit convenes its board meeting at which the terms and conditions associated with the letter of sanction are accepted and an appropriate resolution is passed to that effect.

The agreement, properly executed and stamped, along with other documents as required by the financial institution, must be returned to it. Once the financial institution also signs the agreement, it becomes effective.

Page 14: Term loans & securitisation

Monitoring of the project is done at the implementation stage as well as the operational stage. During the implementation stage, the project is monitored through: (i) regular reports, furnished by the promoters, which provide information about placement of orders, construction of buildings, procurement of plant, installation of plant and machinery, trial production, and so on, (ii) periodic site visits, (iii) discussion with promoters, bankers, suppliers, creditors, and other connected with the project, (iv) progress reports submitted by the nominee directors, and (v) audited accounts of the company.

During the operational stage, the project is monitored with the help of (i) quarterly progress report on the project, (ii) site inspection, (iii) reports of nominee directors, and (iv) comparison of performance with promise. The most important aspect of monitoring, of course, is the recovery of dues represented by interest and principal repayment.

Page 15: Term loans & securitisation

Project Appraisal  

Financial institutions appraise a project from the marketing, technical, financial, economic, and managerial angles. The principal issues considered and the criteria employed in such appraisal are discussed below.

Market Appraisal  

The importance of the potential market and the need to develop a suitable marketing strategy cannot be over-emphasised. Hence, efforts are made to (i) examine the reasonableness of the demand projections, (ii) assess the adequacy of the marketing infrastructure in terms of promotional effort, distribution network, transport facilities, stock levels and so on, and (iii) judge the knowledge, experience, and competence of the key marketing personnel.

Technical Appraisal  

The technical review done by the financial institutions focuses mainly on the following aspects: (i) product mix, (ii) capacity, (iii) process of manufacture, (iv) engineering know-how and technical collaboration, (v) raw materials and consumables, (vi) location and site, (vii) building, (viii) plant and equipment, (ix) manpower requirements, and (x) break-even point.

Page 16: Term loans & securitisation

Financial Appraisal  The financial appraisal seeks to assess the following:

Reasonableness of the Estimate of Capital Cost  While assessing the capital cost estimates, efforts are made to ensure that (i) padding or under-estimation of costs is avoided, (ii) specification of machinery is proper, (iii) proper quotation are obtained from potential suppliers, (iv) contingencies are provided, and (v) inflation factors are considered.

Reasonableness of the Estimate of Working Results  The estimate of working results is sought to be based on (i) a realistic market demand forecast, (ii) price computations for inputs and outputs that are based on current quotations and inflationary factors, (iii) an approximate time schedule for capacity utilization, and (iv) cost projections that distinguish between fixed and variable costs.

Page 17: Term loans & securitisation

Adequacy of Rate of Return  The general norms for financial desirability are as follows: (i) internal rate of return, 15 per cent, (ii) return on investment, 20-25 per cent after tax, (iii) debt-service coverage ratio, 1.5 to 2. In applying these norms, however, a certain degree of flexibility is shown on the basis of the nature of the project, the risks inherent in the project, and the status of the promoter.

Appropriateness of the Financing Pattern  The institutions consider the following in assessing the financial pattern: (i) a general debt-equity ratio norm of 1.5:1, (ii) a requirement that promoters should contribute a certain percentage of the project cost, (iii) stock exchange listing requirements, and (iv) the means of the promoter and his capacity to contribute a reasonable share of the project finance.

Page 18: Term loans & securitisation

Managerial Appraisal  In order to judge the managerial capability of the promoters, the following aspects are considered:

Resourcefulness This is judged in terms of the prior experience of the promoters, the progress achieved in organising various aspects of the project, and the skill with which the project is presented.

Understanding This is assessed in terms of the credibility of the project plan (including, inter alia, the organisation structure, the staffing plan, the estimated costs, the financing pattern, the assessment of various inputs, and the marketing programme) and the details furnished to the financial institutions.

Commitment This is gauged by the resources (financial, managerial, material, and other) applied to the project and the zeal with which the objectives of the project, short-term as well as long-term, are pursued. Managerial review also involves an assessment of the calibre of the key technical and managerial personnel working on the projects, the schedule for training them, and the remuneration structure for rewarding and motivating them.

Page 19: Term loans & securitisation

Debentures/Bonds/NotesDebentures/Bonds/Notes

Debenture/bond is a debt instrument indicating that a company has borrowed certain sum of money and promises to repay it in future under clearly defined terms.

Page 20: Term loans & securitisation

Attributes

As a long-term source of borrowing, debentures have some contrasting features compared to equities .

Trust Indenture  When a debenture is sold to investing public, a trustee is appointed through an indenture/trust deed.

Trust (bond) indenture is a complex and lengthy legal document stating the conditions under which a bond has been issued.

Trustee is a bank/financial institution/insurance company/ firm of attorneys that acts as the third party to a bond/debenture indenture to ensure that the issue does not default on its contractual responsibility to the bond/ debenture holders.

Interest The debentures carry a fixed (coupon) rate of interest, the payment of which is legally binding/enforceable. The debenture interest is tax-deductible and is payable annually/semi-annually/quarterly.

Page 21: Term loans & securitisation

Maturity 

It indicates the length of time for redemption of par value. A company can choose the maturity period, though the redemption period for non-convertible debentures is typically 7-10 years. The redemption of debentures can be accomplished in either of two ways:

(1) Debentures redemption reserve (sinking fund)

A DRR has to be created for the redemption of all debentures with a maturity period exceeding 18 months equivalent to at least 50 per cent of the amount of issue/redemption before commencement of redemption.

(2) Call and put (buy-back) provision.

The call/buy-back provision provides an option to the issuing company to redeem the debentures at a specified price before maturity. The call price may be more than the par/face value by usually 5 per cent, the difference being call premium. The put option is a right to the debenture-holder to seek redemption at specified time at predetermined prices.

Page 22: Term loans & securitisation

Security 

Debentures are generally secured by a charge on the present and future immovable assets of the company by way of an equitable mortgage

Convertibility  

Apart from pure non-convertible debentures (NCDs), debentures can also be converted into equity shares at the option of the debenture-holders. The conversion ratio and the period during which conversion can be affected are specified at the time of the issue of the debenture itself. The convertible debentures may be fully convertible (FCDs) or partly convertible (PCDs). The FCDs carry interest rates lower than the normal rate on NCDs; they may even have a zero rate of interest. The PCDs have two parts:

1) Convertible part,

2) Non-convertible part.

Page 23: Term loans & securitisation

Credit Rating  

To ensure timely payment of interest and redemption of principal by a borrower, all debentures must be compulsorily rated by one or more of the four credit rating agencies, namely, Crisil, Icra, Care and FITCH India.

Claim on Income and Assets 

The payment of interest and repayment of principal is a contractual obligation enforceable by law. Failure/default would lead to bankruptcy of the company. The claim of debenture-holders on income and assets ranks with other secured debt and higher than that of shareholders–preference as well as equity.

Page 24: Term loans & securitisation

Evaluation

Advantages  

The advantages for company are (i) lower cost due to lower risk and tax-deductibility of interest payments, (ii) no dilution of control as debentures do not carry voting rights. For the investors, debentures offer stable return, have a fixed maturity, are protected by the debenture trust deed and enjoy preferential claim on the assets in relation to shareholders.

Disadvantages 

The disadvantages for the company are the restrictive covenants in the trust deed, legally enforceable contractual obligations in respect of interest payments and repayments, increased financial risk and the associated high cost of equity. The debenture-holders have no voting rights and debenture prices are vulnerable to change in interest rates.

Page 25: Term loans & securitisation

Innovative Debt Instruments

In order to improve the attractiveness of bonds/debentures, some new features are added. As a result, a wide range of innovative debt instruments have emerged in India in recent years. Some of the important ones among these are discussed below.

Zero Interest Bonds/Debentures (ZIB/D)  

Also known as zero coupon bonds/debentures, ZIBs do not carry any explicit/coupon rate of interest. They are sold at a discount from their maturity value. The difference between the face value of the bond and the acquisition cost is the gain/return to the investors. The implicit rate of return/interest on such bonds can be computed by Equation 1.

Acquisition price = Maturity (face) value/(1 + i)n (1)Where I = rate of interest

n = maturity period (years)

Page 26: Term loans & securitisation

Deep Discount Bond (DDB)  

A deep discount bond is a form of ZIB. It is issued at a deep/steep discount over its face value. It implies that the interest (coupon) rate is far less than the yield to maturity. The DDB appreciates to its face value over the maturity period.

The DDBs are being issued by the public financial institutions in India, namely, IDBI, SIDBI and so on.

The merit of DDBs/ZIDs is that they enable the issuing companies to conserve cash during their maturity. They protect the investors against the reinvestment risk to the extent the implicit interest on such bonds is automatically reinvested at a rate equal to its yield to maturity. However, they are exposed to high repayment risk as they entail a balloon payment on maturity.

Secured Premium Notes (SPNs) 

The SPN is a secured debenture redeemable at a premium over the face value/purchase price. The SPN is a tradeable instrument. A typical example is the SPN issued by TISCO in 1992. Its salient features were

Each SPN had a face value of Rs 300. No interest would accrue during the first year after allotment.

During years 4-7, principal will be repaid in annual instalment of Rs 75. In addition, Rs 75 will be paid each year as interest and redemption premium.

A warrant was attached to the SPN entitling the holder to acquire one equity share for cash by payment of Rs 100.

The holder was given an option to sell back the SPN at the par value of Rs 300.

Page 27: Term loans & securitisation

The before tax rate of return on the SPN = 13.65 per cent, that is

Floating Rate Bonds (FRBs)  

The interest on such bonds is not fixed. It is floating and is linked to a benchmark rate such as interest on treasury bills, bank rate, maximum rate on term deposits.

Callable/Puttable Bonds/Debentures/Bond Refunding 

Beginning from 1992 when the Industrial Development Bank of India issued bonds with call features, several callable/puttable bonds have emerged in the country in recent years. The call provisions provide flexibility to the company to redeem them prematurely. Generally, firms issue bonds presumably at lower rate of interest when market conditions are favourable to redeem such bonds.

Evaluation  

The bond refunding decision can be analysed as a capital budgeting decision. If the present value of the stream of net cash savings exceeds the initial cash outlay, the debt should be refunded.

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Page 28: Term loans & securitisation

Example 1 : The 22 per cent outstanding bonds of the Bharat Industries Ltd (BIL) amount to Rs 50 crores, with a remaining maturity of 5 years. It can now issue fresh bonds of 5 year maturity at a coupon rate of 20 per cent. The existing bonds can be refunded at a premium (call premium) of 5 per cent. The flotation costs (issue expenses + discount) on new bonds are expected to be 5 per cent. The unamortised portion of the issue expenses on existing bonds is 1.5 crore. They would be written off as soon as the existing bonds are called/refunded.

If the BIL is in 35 per cent tax bracket, would you advise it to call the bond?

Solution  

(Amount in Rs crore)

Annual net cash savings (Working note 2) 0.71

PVIFA (10,13) (Working note 3) 3.517

Present value of annual net cash savings 2.497

Less: Initial outlay ((Working note 1) 3.600

NPV (bond refunding) (1.103)

It is not advisable to call the bond as the NPV is negative.

Page 29: Term loans & securitisation

Working Notes

(1)(a)Cost of calling/refunding existing bonds   Face value      Plus: Call premium (5 per cent) (b)Net proceeds of new bonds   Gross proceeds   Less: Flotation costs (c)Tax savings on expenses    Call premium   Plus: Unamortised issue costs   Initial outlay [(1a) – (1b) – (1c)] (2)(a)Annual net cash outflow on existing bonds  Interest expenses Less: Tax savings on interest expenses and amortisation of issue costs : 0.35 [11.0 + (1.5/5)] (b)Annual net cash outflow on new bonds   Interest expenses Less: Tax savings on interest expenses and amortisation of issue costs : 0.35 [10.0 + (2.5/5)]     Annual net cash savings [(2a) – (2b)]

2.51.5

4.0 × (0.35 tax)

50.02.5

50.02.5

11.00

3.96

10.00

3.67

52.5

47.5

1.40 3.60

7.04

6.330.71

(3)Present value interest factor of 5 year annuity, using a 13 per cent after tax [0.20 (1 – 0.35)] cost of new bonds = 3.517

Page 30: Term loans & securitisation

Issue of Debt Instruments

A company offering convertible/non-convertible debt instruments

through an offer document should, in addition to the other relevant

provisions of these guidelines, comply with the following provisions.

Requirement of Credit Rating  

A public or rights issue of all debt instruments (i.e. convertible as

well as non-convertible) can be made only if credit rating of a

minimum investment grade is obtained from at least two registered

credit rating agencies and disclosed in the offer document .

Requirement in Respect of Debenture Trustees  

A company must appoint one/more debenture trustee(s) in

accordance with the provisions of the Companies Act before issuing

a prospectus/letter of offer to the pubic for subscription of its

debentures.

Page 31: Term loans & securitisation

Creation of Debenture Redemption Reserves (DRR)  A company has to create DRR as per the requirements of the Companies Act for redemption of debentures in accordance with the provisions given below:

If debentures are issued for project finance, the DRR can be created up to the date of com-mercial production, either in equal instalments or higher amounts if profits so permit. In the case of partly convertible debentures, the DRR should be created with respect to the non-convertible portion on the same lines as applicable for fully non-convertible debenture issue. In the case of convertible issues by new companies, the creation of DRR should commence from the year the company earns profits for the remaining life of debentures.

Distribution of Dividends  

In case of companies which have defaulted in payment of interest on debentures or their redemption or in creation of security as per the terms of the issue, distribution of dividend would require approval of the debenture trustees and the lead institution, if any.

Redemption  The issuer company should redeem the debentures as per the offer document.

Page 32: Term loans & securitisation

Disclosure and Creation of Charge  

The offer document should specifically state the assets on which the security would be created as also the ranking of the charge(s). In the case of second/residual charge or subordinated obligation, the associated risks should also be clearly stated.

Requirement of Letter of Option  

Where the company desires to rollover the debentures issued by it, it should file with the SEBI a copy of the notice of the resolution to be sent to the debenture-holders through a merchant bank prior to despatching the same to the debenture-holders. If a company desires to convert the debentures into equity shares (according to the procedure discussed subsequently), it should file with the SEBI a copy of the letter of option to be sent to the debenture-holders through a merchant bank prior to despatching the same to the debenture-holders.

Page 33: Term loans & securitisation

Rollover of Non-Convertible Portions of Partly Convertible Debentures (PCDs)/Non-Convertible Debentures (NCDs) By Company Not Being in Default

The non-convertible portions of PCDs/NCDs issued by a listed company, the value of which exceeds Rs 50 lakh, can be rolled over without change in the interest rate subject to (i) Section 121 of the Companies Act and (ii) the following conditions, if the company is not in default: (i) passing of a resolution by postal ballot, having assent of at least 75 per cent of the debentures; (ii) redemption of debentures of all the dissenting holders, (iii) obtaining at least two credit ratings of a minimum investment grade within six months prior to the date of redemption and communicating to the debenture-holders before rollover, (iv) execution of fresh trust deed, and (v) creation of fresh security in respect of roll over debentures.

Rollover of NCDs/PCDs By a Listed Company Being in Default  

The non-convertible portion of PCDs/NCDs by listed companies exceeding Rs 50 lakh can be rolled over without change in the interest rate subject to Section 121 of the Companies Act and the following conditions, namely, (a) a resolution by postal ballot, having assent of at least 75 per cent of the debenture-holders,(b) along with the notice for passing the resolution, send to the debenture-holders auditor’s certificate on the cash flow of the company with comments on its liquidity position, (c) redemption of debentures of all the dissenting debenture-holders, and (d) decision of the debenture trustee about the creation of fresh security and execution of fresh trust deed in respect debentures to be rolled over.

Page 34: Term loans & securitisation

Additional Disclosures in Respect of Debentures  The offer document should contain:

a) premium amount on conversion, time of conversion;

b) in case of PCDs/NCDs, redemption amount, period of maturity, yield on redemption of the PCDs/NCDs;

c) full information relating to the terms of offer or purchase, including the name(s) of the party offering to purchase, the (non-convertible portion of PCDs);

d) the discount at which such an offer is made and the effective price for the investor as a result of such discount;

e) the existing and future equity and long-term debt ratio;

f) servicing behaviour on existing debentures, payment of due interest on due dates on term loans and debentures and

g) a no objection certificate from a financial institution or banker for a second or charge being created in favour of the trustees to the proposed debenture issues has been obtained.

Page 35: Term loans & securitisation

Secondary Market for Corporate Debt Securities  Any listed company making issue of debt securities on a private placement basis and listed on a stock exchange should comply with the following:

1) It should make full disclosures (initial and continuing) in the manner prescribed in Schedule II of the Companies Act, 1956, SEBI (Disclosure and Investor Protection) Guidelines, 2000 and the Listing Agreement with the exchanges.

2) The debt securities should carry a credit rating of not less than investment grade from a credit rating agency registered with the SEBI.

3) The company should appoint a debenture trustee registered with the SEBI in respect of the issure of debt securities.

4) The debt securities should be issued and traded in demat form.

5) The company should sign a separate listing agreement with the stock exchange in respect of debt securities and comply with the conditions of listing.

6) All trades with the exception of spot transactions, in a listed debt security, should be ex-ecuted only on the trading platform of a stock exchange.

7) The trading in privately placed debts should only take place between qualified QIBs and high networth individuals (HNIs), in standard denomination of Rs 10 lakhs.

8) The requirement of Rule 19(2)(b) of the Securities Contract (Regulation) Rules, 1957 would not be applicable to listing of privately placed debt securities on exchanges, provided all the above requirements are complied with.

9) If the intermediaries with the SEBI associate themselves with the issuance of private placement of unlisted debt securities, they will be held accountable for such issues.

Page 36: Term loans & securitisation

Rating of Debt Instruments

Credit rating of debentures by a rating agency is mandatory. It provides a simple

system of gradation by which relative capacities of borrowers to make timely

payment of payment and repayment of principal on a particular type of debt

instrument can be noted. A rating is specific to a debt instrument and is intended

to grade different and specific instruments in terms of the credit risk associated with

the particular instruments. Although it is an opinion expressed by an independent

professional organization, on the basis of a detailed study of all the relevant factors,

the rating does not amount to any recommendation to buy, hold or sell an instrument

as it does not take into consideration factors such as market prices, personal risk

preferences of an investor and such other considerations, which may

influence an investment decision The main elements of the rating methodology are

(1) Business risk analysis

(2) Financial risk analysis

(3) Management risk.

The rating agencies in India are CRISIL, ICRA, CARE and Fitch India.

Page 37: Term loans & securitisation

Rating Methodology

A rating is assigned after assessing all the factors that could affect the credit

worthiness of the entity. Typically, the industry risk assessment sets the stage for

analyzing more specific company risk factors and establishing the priority of these

factors in the overall evaluation.

For instance, if the industry is highly competitive, careful assessment of the issuer's

market position is stressed. If the company has large capital requirements, the

examination of cash flow adequacy assumes importance. The ratings are based on

the current information provided by the issuer or facts obtained from reliable

sources. Both qualitative and quantitative criteria are employed in evaluating and

monitoring the ratings.

Page 38: Term loans & securitisation

Business Risk Analysis  

The rating analysis begins with an assessment of the company’s environment focusing on the strength of the industry prospects, pattern of business cycles as well as the competitive factors affecting the industry. The vulnerability of the industry to Government controls/regulations is assessed.

The nature of competition is different for different industries based on price, product quality, distribution capabilities, image, product differentiation, service and so on. The industries characterized by a steady growth in demand, ability to maintain margins without impairing future prospects, flexibility in the timing of capital outlays, and moderate capital intensity are in a stronger position

The main industry and business factors assessed include:

Industry Risk  Nature and basis of competition, key success factors, demand and supply position, structure of industry, cyclical/seasonal factors, government policies and so on.

Market Position of the Issuing Entity Within the Industry  Market share, competitive advantages, selling and distribution arrangements, product and customer diversity and so on.

Operating Efficiency of the Borrowing Entity  Locational advantages, labour relationships, cost structure, technological advantages and manufacturing efficiency as compared to competitors and so on.

Legal Position  Terms of the issue document/prospectus, trustees and their responsibilities, systems for timely payment and for protection against fraud/forgery and so on.

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Financial Risk Analysis  

After evaluating the issuer’s competitive position and operating environment, the analysts proceed to analyse the financial strength of the issuer. Financial risk is analysed largely through quantitative means, particularly by using financial ratios. While the past financial performance of the issuer is important, emphasis is placed on the ability of the issuer to maintain/improve its future financial performance. The areas considered in financial analysis include:

Accounting Quality  Overstatement/understatement of profits, auditors qualifications, method of income recognition, inventory valuation and depreciation policies, off Balance sheet liabilities and so on.

Earnings Protection  Sources of future earnings growth, profitability ratios, earnings in relation to fixed income charges and so on.

Adequacy of Cash Flows  In relation to debt and working capital needs, stability of cash flows, capital spending flexibility, working capital management and so on.

Financial Flexibility  Alternative financing plans in times of stress, ability to raise funds, asset deployment potential and so on.

Interest and Tax Sensitivity  Exposure to interest rate changes, tax law changes and hedging against interest rates and so on.

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Management Risk  

A proper assessment of debt protection levels requires an evaluation of the management philosophies and its strategies. The analyst compares the company’s business strategies and financial plans (over a period of time) to provide insights into a management’s abilities with respect to forecasting and implementing of plans. Specific areas reviewed include:

1) Track record of the management: planning and control systems, depth of managerial talent, succession plans;

2) Evaluation of capacity to overcome adverse situations; and

3) Goals, philosophy and strategies.

Rating Symbols

Rating symbol is a symbolic expression of opinion of the rating agency regarding the investment/credit quality/grade of the debt instrument/obligation.

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EXHIBIT 1  CRISIL Rating Symbols

The rating of debentures is mandatory. CRISIL assigns alpha-based rating scale to rupee-denominated debentures. It categorises them into three grades namely, high investment, investment and speculations.

 High Investment Grade  includes:

AAA - (Triple A) Highest Security  The debentures rated AAA are judged to offer the highest safety against timely payment of interest and principal. Though the circumstances providing this degree of safety are likely to change, such changes as can be envisaged are most unlikely to affect adversely the fundamentally strong position of such issues.

AA - (Double A) High Safety  The debentures rated AA are judged to offer high safety against timely payment of interest and principal. They differ in safety from AAA issues only marginally.

 Investment Grades  are divided into:

A - Adequate Safety  The debentures rated A are judged to offer adequate safety against timely payment of interest and principal; however, changes in circumstances can adversely affect such issues more than those in the higher rated categories.

BBB - (Triple B) Moderate Safety  The debentures rated BBB are judged to offer sufficient safety to against timely payment of interest and principal for the present: however, changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for debentures in higher rated categories.

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 Speculative Grades  comprise:

BB - (Double B) Inadequate Safety  The debentures rated BB are judged to carry inadequate safety of the timely payment of interest and principal; while they are less susceptible to default than other speculative grade debentures in the immediate future, the uncertainties that the issuer faces could lead to inadequate capacity to make interest and principal payments on time.

B - High Risk  The debentures rated B are judged to have greater susceptibility to default; while currently interest and principal payments are met; adverse business or economic conditions would lead to a lack of ability or willingness to pay interest or principal.

C - Substantial Risk  The debentures rated C are judged to have factors present that make them vulnerable to default; timely payment of interest and principal is possible only if favourable circumstances continue.

D - Default  The debentures rated D are in default and in arrears of interest or principal payments or are expected to default on maturity. Such debentures are extremely speculative and returns from these debentures may be realised only on reorganisation or liquidation.

Note: (1) CRISIl may apply ‘+’ (plus) or ‘–’ (minus) signs for ratings from AA to C to reflect comparative standing within the category. The contents within parenthesis are a guide to the pronunciation of the rating symbols.

CONTD.

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EXHIBIT 2  ICRA Rating Symbols

ICRA symbols classify them into eight investment grades.

LAAA Highest Safety  This indicates a fundamentally strong position. Risk factors are negligible. There may be circumstances adversely affecting the degree of safety but such circumstances, as may be visualised, are not likely to affect the timely payment of principal and interest as per terms.

LAA+, LAA, LAA– High Safety  Risk factors are modest and may vary slightly. The protective factors are strong and the prospects of timely payment of principal and interest as per the terms under adverse circumstances, as may be visualised, differs from LAAA only marginally.

LA+, LA, LA– Adequate Safety  Risk factors vary more and are greater during economic stress. The protective factors are average and any adverse change in circumstances, as may be visualised, may alter the fundamental strength and affect the timely payment of principal and interest as per the terms.

LBBB+, LBBB, LBBB– Moderate Safety  This indicates considerable variability in risk factors. The protective factors are below average. Adverse changes in the business/economic circumstances are likely to affect the timely payment of principal and interest as per the terms.

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LBB+, LBB, LBB- Adequate Safety  The timely payment of interest and

principal are more likely to be affected by the present or prospective changes

in business/economic circumstances. The protective factors fluctuate in case

of economy/business conditions change.

LB+, LB, LB– Risk Prone  Risk factors indicate that obligations may not be met

when due. The protective factors are narrow. Adverse changes in the

business/economic conditions could result in the inability/unwillingness to

service debts on time as per the terms.

LC+, LC, LC- Substantial Risk  There are inherent elements of risk and timely

servicing of debts/obligations could be possible only in the case of continued

existence of favourable circumstances.

LD Default Extremely Speculative  Indicates either already in default in

payment of interest and/or principal as per the terms or expected to default.

Recovery is likely only on liquidation or reorganisation.

CONTD.

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Issue Procedure

Debt securities mean non-convertible securities, including bonds/debentures and other securities of a body corporate/any statutory body, which create/acknowledge indebtedness, but excluding bonds issued by Government/other bodies specified by the SEBI, security receipts and securitised debt instruments. Private placement is an offer to less than 50 persons, while public issue is an offer/invitation to public to subscribe to debt securities. The main element of the SEBI regulations relating to issue and listing of debt securities are: issue requirements, listing, conditions for continuous listing and trading, obligations of intermediaries/issuers, procedure for action for violation, and pow ers of the SEBI to issue general order.

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Any issuer who has been restrained/prohibited/debarred by the SEBI from accessing the securities market/dealing in securities cannot make public issue of debt securities. To make such an issue the conditions to be satisfied on the date of filing of draft/final offer document are in-principle approval for their listing, credit rating from at least one SEBI-registered rating agency and agreement with a SEBI-registered depository for their dematieralisation. The issuer should appoint merchant bankers/trustees and not issue such securities to provide loan to, acquisition of shares of, any person who is a part of the same group/under the same management. The issuer should advertise in a national daily with wide circulation on/before the issue opening date. Application forms should be accompanied by a copy of the abridged prospectus. The issue could be fixed-price or book-

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built. The minimum subscription and underwriting arrangement should be disclosed in the offer document and it should not contain any false/misleading statement. A trust deed must be executed and debenture redemption reserve should be created. The creation of security should be disclosed in the offer document.

The listing of debt securities is mandatory. The issuer should comply with the conditions of listing specified in the listing agreement.

The debt securities issued to public or on private placement basis should be traded/cleared/settled in a recognised stock exchange subject to conditions specified by the SEBI including conditions for reporting of all such trades.

The debenture trustees, issuers and merchants bankers should comply with their obligations specified by the SEBI.

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In case of violation of any regulation(s), the SEBI may carry out inspection of books of accounts/ records/documents of the issuers/intermediaries. It can issue such directions as it may deem fit. An aggrieved party may prefer an appeal with the SAT.

In addition to the other requirements, an issuer of CDIs (Convertible debt instruments) should comply with the following conditions: (i) obtain credit rating, (ii) appoint debenture trustees, (iii) create debenture redemption fund, (iv) assets on which charge is proposed are sufficient to discharge the liability and free from encumbrances. They should be redeemed in terms of the offer document.

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The non-convertible portion of the partly CDIs can be rolled over without change in the interest rate if 75 per cent of the holders approve it; an auditors certificate on its liquidity position has been sent to them; the holding of all holders who have not agreed would be redeemed; credit rating has been obtained and communicated to them before rollover.

Positive consent of the holders would be necessary for conversion of optionally CDIs into shares. The holders should be given the option not to convert them if the conversion price was not determined/disclosed to the investors at the time of the issue.

The terms of issue of securities adversely affecting the investors can be altered with the consent/sanction in writing of at least 75 per cent/special resolution of the holders.

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SecuritisationSecuritisation

Securitization is the process of pooling and repackaging of homogeneous illiquid financial assets, such as residential mortgage, into marketable securities that can be sold to investors.

The process leads to the creation of financial instruments that represent ownership interest in, or are secured by a segregated income producing

asset or pool, of assets. The pool of assets collateralizes securities. These assets are generally secured by personal or real property such as automobiles, real estate, or equipment loans but in some cases are unsecured, for example, credit card debt and consumer loans.

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Securitisation Process

1) Asset are originated through receivables, leases, housing loans or any other form of debt by a company and funded on its balance sheet. The company is normally referred to as the “originator”.

2) Once a suitably large portfolio of assets has been originated, the assets are analyzed as a portfolio and then sold or assigned to a third party, which is normally a special purpose vehicle company (‘SPV’) formed for the specific purpose of funding the assets. It issues debt and purchases receivables from the originator.

3) The administration of the asset is then subcontracted back to the originator by the SPV. It is responsible for collecting interest and principal payments on the loans in the underlying pool of assets and transfer to the SPV.

4) The SPV issues tradable securities to fund the purchase of assets.

5) The investors purchase the securities because they are satisfied that the securities would be paid in full and on time from the cash flows available in the asset pool.

6) The SPV agrees to pay any surpluses which, may arise during its funding of the assets, back to the originator.

7) As cash flow arise on the assets, these are used by the SPV to repay funds to the investors in the securities.

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Credit Enhancement

Investors in securitized instruments take a direct exposure on the performance of the underlying collateral and have limited or no recourse to the originator. Hence, they seek additional comfort in the form of credit enhancement. It refers to the various means that attempt to buffer investors against losses on the asset collateralizing their Investment.

These losses may vary in frequency, severity and timing, and depend

on the asset characteristics, how they are originated and how they are administered. The credit enhancements are often essential to secure a high level of credit rating and for low cost funding. By shifting the credit risk from a less-known borrower to a well-known, strong, and larger credit enhancer, credit enhancements correct the imbalance of information between the lender(s) and the borrowers.

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External Credit Enhancements  

They include insurance, third party guarantee and letter of credit.

Insurance  Full insurance is provided against losses on the assets. This tantamounts to a 100 per cent guarantee of a transaction’s principal and interest payments. The issuer of the insurance looks to an initial premium or other support to cover credit losses.

Third-Party Guarantee  This method involves a limited/full guarantee by a third party to cover losses that may arise on the non-performance of the collateral.

Letter of Credit  For structures with credit ratings below the level sought for the issue, a third party provides a letter of credit for a nominal amount. This may provide either full or partial cover of the issuer’s obligation.

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Internal Credit Enhancements  Such form of credit enhancement comprise the following:

Credit Trenching (Senior/Subordinate Structure)  The SPV issues two (or more) tranches of securities and establishes a predetermined priority in their servicing, whereby first losses are borne by the holders of the subordinate tranches (at times the originator itself). Apart from providing comfort to holders of senior debt, credit tranching also permits targeting investors with specific risk-return preferences.

Over-collateralisation  The originator sets aside assets in excess of the collateral required to be assigned to the SPV. The cash flows from these assets must first meet any overdue payments in the main pool, before they can be routed back to the originator.

Cash Collateral  This works in much the same way as the over-collateralisation. But since the quality of cash is self-evidently higher and more stable than the quality of assets yet to be turned into cash, the quantum of cash required to meet the desired rating would be lower than asset over-collateral to that extent.

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Spread Account  The difference between the yield on the assets and the yield to the investors from the securities is called excess spread. In its simplest form, a spread account traps the excess spread (net of all running costs of securitization) within the SPV up to a specified amount sufficient to satisfy a given rating or credit equity requirement.

Only realizations in excess of this specified amount are routed back to the originator. This amount is returned to the originator after the payment of principal and interest to the investors.

Triggered Amortization  This works only in structures that permit substitution (for example, rapidly revolving assets such as credit cards). When certain preset levels of collateral performance are

breached, all further collections are applied to repay the funding. Once amortization is triggered, substitution is stopped and the early repayment becomes an irreversible process. The triggered amortization is typically applied in future flow securitization

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Parties to a Securitisation Transaction

The parties to securitisation deal are (i) primary and (ii) others. There are three primary parties to a securitisation deal, namely, originators, special purpose vehicle (SPV) and investors. The other parties involved are obligors, rating agency, administrator/servicer, agent and trustee, and structurer.

Originator is the entity on whose books the assets to be securitized exist. It

is the prime mover of the deal, that is, 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. In a true sale, the originator transfers both the legal and the beneficial interest in the assets to the SPV.

SPV (special purpose vehicle) is the entity which would typically buy the assets to be securitised from the originator. An SPV is typically a low-capitalised

entity with narrowly defined purposes and activities, and usually has independent trustees/Directors. As one of the main objectives of securitisation is to remove the assets from the balance sheet of the originator, the SPV plays a very important role in as much as it holds the assets in its books and makes the upfront payment for them to the originator.

Investors  The investors may be in the form of individuals or institutional investors like FIs, mutual funds, provident funds, pension funds, insurance companies and so on.

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Obligors are the borrowers of the original loan. The credit standing of an obligor(s) is of paramount importance in a securitisation transactionRating Agency  Since the investors take on the risk of the asset pool rather than the originator, an external credit rating plays an important role. The rating process would assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework.Administrator or Servicer  It collects the payment due from the obligor(s) and passes it to the SPV, follows up with delinquent borrowers and pursues legal remedies available against the defaulting borrowers. Since it receives the instalments and pays it to the SPV, it is also called the Receiving and Paying Agent (RPA).Receiving and paying agent is one who collects the payment due from the obligors and passes it on to the SPV.Agent and Trustee  It accepts the responsibility for overseeing that all the parties to the securitisation deal perform in accordance with the securitisation trust agreement. Basically, it is appointed to look after the interest of the investors.Structurer  Normally, an investment banker is responsible as structurer for bringing together the originator, the credit enhancer(s), the investors and other partners to a securitisation deal. It also works with the originator and helps in structuring deals.

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Asset Characteristics: The assets to be securities should have the following characteristics

Cash Flow  A principal part of the assets should be the right to receive from the debtor(s) on certain dates, that is, the asset can be analysed as a series of cash flows.

Security  If the security available to collateralise the cash flows is valuable, then this security can be realised by a SPV.

Distributed Risk  Assets either have to have a distributed risk characteristic or be backed by suitably-rated credit support.

Homogeneity  Assets have to relatively homogenous, that is, there should not be wide variations in documentation, product type or origination methodology.

No Executory Clauses  The contracts to be securitised must work even if the originator goes bankrupt.

Independence From the Originator  The ongoing performance of the assets must be independent of the existence of the originator.

The securitisation process is depicted in Figure 1.

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Obligor

Originator

Ancillaryservice provider

Special purposevehicle

Investors

Rating agency

Structure

Consideration for assets purchased

Credit rating of securities

Subscription of securities

Issue of securitiesSales of assets

Interest and principal

Figure 1: Securitisation Process

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Instruments of Securitisation

Securitisation can be implemented by three kinds of instruments differing mainly in their maturity characteristics. They are:

(1) Pass through certificates

The cash flows from the underlying collateral are passed through to the holders of the securities in the form of monthly payment of interest, principal and pre-payments. In other words, the cash flows are distributed

on a pro-rata basis to the holders of the securities.

Some of the main features of PTCs are:They reflect ownership rights in the assets backing the securities.Pre-payment precisely reflects the payment on the underlying mortgage. If it is a home loan with monthly payments, the payments on securities would also be monthly but at a slightly less coupon rate than the loan.As underlying mortgage is self-amortising. Thus, by whatever amount it is amortized, it is passed on to the security-holders with re-payment.Pre-payment occurs when a debtor makes a payment, which exceeds the minimum scheduled amount. It shortens the life of the instrument and skews the cash flows towards the earlier years.

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Instruments of Securitisation

(2) Pay Through Security

A key difference between PTC and PTS is the mechanics of principal repayment process. In PTC, each investor receives a pro-rata distribution of any principal and interest payment made by the borrower. Because these assets are self-amortising assets, a pass through, however, does not occur until the final asset in the pool is retired. This results in large difference between average life and

final maturity as well as a great deal of uncertainty with regard to the timing of the return of the principal.

The PTS structure, on the other hand, substitutes a sequential retirement of bonds for the pro-rata principal return process found in pass through. Cash flows generated by the underlying collateral is used to retire bonds. Only one class of bonds at a time receives principal. All principal payments go first to the fastest pay trance in the sequence then becomes the exclusive recipients

of principal. This sequence continues till the last tranches of bonds is retired.

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Instruments of Securitisation

(3) Stripped Securities

Under this instrument, securities are classifies as Interest only (I0) or Principally only (PO) securities. The I0 holders are paid back out of the interest income only while the PO holders are paid out of principal repayments only.

Normally, PO securities increase in value when interest rates go down because it becomes lucrative to prepay existing mortgagor and undertake fresh loans at lower interest rates. As a result of prepayment of mortgages, the maturity period of these securities goes down and investors are returned the money earlier than they anticipated.

In contrast, I0 increase in value when interest rates go up because more interest is collected on underlying mortgages. However, in anticipation of a decline in the interest rates, prepayments of mortgages declines and maturities lengthen. These are normally traded by speculators who make money by speculating about interest rate changes.

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Types of Securities

The securities fall into two groups:

Asset Backed Securities (ABS)  

The investors rely on the performance of the assets that collateralise the securities. They do not take an exposure either on the previous owner of the assets (the originator), or the entity issuing the securities (the SPV). Clearly, classifying securities as ‘asset-backed’ seeks to differentiate them from regular securities, which are the liabilities of the entity issuing them. An example of ABS is credit card receivables. Securitisation of credit card receivables is an innovation that has found wide acceptance.

Mortgage Backed Securities (MBS)  

The securities are backed by the mortgage loans, that is, loans secured by specified real estate property, wherein the lender has the right to sell the property, if the borrower defaults.

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Issue Procedure

The main elements of the SEBI regulations relating to public offers of securitised debt instruments (SDIs) and listing on a recognised stock exchange are: registration of trustees, constitution/management of special purpose distinct entities (SPDEs), schemes of SPDEs, public offer of SDIs, rights of investors, listing of SDIs, inspection and disciplinary proceedings, and action in case of default.

Public offer and listing of SDIs can be made only by SPDEs if their trustees are registered with the SEBI and it complies with all the applicable provisions of these regulations and the Securities Contracts (Regulation) Act. However, SEBI-registered debenture trustees, RBI-registered securitisation/asset reconstruction companies, NHB and NABARD would not require registration to act as trustees. A SDI means any certificate/instrument issued to an investor by SPDE which possesses any debt/receivables including mortgage debt assigned to it and acknowledging beneficial interest of such investors.

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While considering registration, the SEBI would have regard to all relevant factors, including: (i) track record, professional competence and general reputation of the applicant, (ii) objectives of a body corporate applicant, (iii) adequacy of its infrastructure, (iv) compliance with the provisions of these regulations, (v) rejection by the SEBI of any previous application and (vi) the applicant/promoters/directors are fit and proper person.

The registration of the trustees would be subject to the following conditions: (i) prior approval of the SEBI to change its management/control, (ii) adequate steps for redressal of investors grievances, (iii) abide by the provisions of these regulations/Securities Contracts (Regulation) Act, (iv) forthwith inform the SEBI (a) if information/particulars previously submitted is false/misleading (b) of any material change in the information submitted and (v) abide by the specified code of conduct.

The SPDE should be constituted as a trust entitled to issue SDIs. The trust deed should contain the specified clauses.

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A SPDE may raise funds by offering SDIs through a scheme. The scheme should consist of the following elements: (i) obligation to redeem the SDIs, (ii) credit enhancement and liquidity facilities, (iii) servicers, (iv) accounts, (v) audit, (vi) maintenance of records, (vii) holding of originator and (viii) winding up.

The stipulations relating to the public offer of the SDIs are: (i) offer to the public, (ii) submission of draft offer document and filing of final offer document, (iii) arrangement for dematerialisaion, (iv) mandatory listing, (v) credit rating, (vi) contents of the offer document, (vii) prohibition on misstatements in the offer document, (viii) underwriting of the issue, (ix) offer period, (x) minimum subscription, (xi) allotment and other obligations and (xii) post-issue obligations.

The rights of investors are two-folds: free transferability of the SDIs and their rights in the securities issued by the SPDE.

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The provisions relating to the listing of the SDIs include: (a) application for listing, (b) minimum public offering for listing, (c) continuous listing conditions and (d) trading.

As regards inspection and disciplinary proceedings, the provisions relate to (1) power of the SEBI to call for information, (2) right of inspection by the SEBI, (3) obligations of the SPDE on inspection, (4) appointment of auditor/valuer and (5) submission of report to the SEBI.

Action in case of default would result in suspension/cancellation of registration of the SPDE. The SEBI may also issue the specified directions to the SPDE/trustees. An aggrieved party may prefer an appeal to the SAT.

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FORMAT 1

Particulars Class A PTCs Class B PTCs

(a) Senior/subordinate status(b) Face value(c) Pass through rate

(d) Tenure (e) Schedule payment pattern

(f) Subscribed to by

Senior

Rs 9,94,99811.35% to 11.85% perannum payable monthly

83 months In 83 monthly payouts comprising principal andinterest

Investors

Subordinate

Rs 10,04,062.14No fixed interest rate but would receive all residual cash flows from the pool141 monthsRedemption of principal amount would begin only after class A PTCs are extinguished, except in case of prepaymentsHDFC (the originator)

Principal Terms of the PTCs 

The NHB in its corporate capacity as also in its capacity as a sole trustee of the SPV Trust would issue securities in the form of Class A and Class B PTCs. The Class B PTCs are subordinated to Class A PTCs and act as a credit enhancement for Class A PTC holders. Only Class A PTCs are available for subscription through the issue. The Class B PTCs would be subscribed to by the HDFC itself (i.e. the originator). Their features are listed in Format 1.

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The return on the Class A PTCs would be in the form of monthly pay-outs comprising principal repayments and interest payments. As per the scheduled repayment pattern, Class A PTCs would be redeemed fully, over the first 83 months starting from the deemed date of allotment.

The actual principal repayment on Class A PTCs each months, would correlate to the principal portion of the corresponding EMI realizations from the receivables pool and the tenure of the PTCs is, hence, subject to defaults (over and above the credit enhancements) and prepayments if any. Interest would be paid each month at the pass-through rate, on the outstanding principal of the Class A PTCs as at the beginning of that month.

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Entering Into Memorandum of Agreement  

The HDFC and the NHB entered into a Memorandum of Agreement on July 7, 2000, to entitle the NHB to take necessary steps to securities the said housing loans, including circulation of the Information Memorandum and collection of subscription amount from investors.

Acquisition of the Housing Loans by the NHB  

The NHB would acquire the amount of balance principal of the housing loans outstanding as on the cut-off date, that is, May 31, 2000, along with the underlying mortgages/other securities, under the deed of assignment. There would be absolutetransfer of all risks and benefits in the housing loans to the NHB (through the deed of assignment), and subsequently to the SPV Trust (through the declaration of trust).

Pool Selection Criteria  

The loans in the pool comply with the following criteria:

The loans were current at the time of selection, They have a minimum seasoning of 12 months, The pool consists of loans where the underlying property is situated in the

states of Gujarat, Karnataka, Maharashtra and Tamil Nadu, The borrowers in the pool are individuals, Maximum LTV (loan to value) ratio is 80 per cent, Instalment (EMI) to gross income ratio is less than 40 per cent, EMIs would not be outstanding for more than one month, Loan size is in the range of Rs 18,000 to Rs 10 lakh, Borrowers in the pool have only one loan contract with the HDFC, The HDFC has not obtained any refinance with respect to these loans.

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Pool Valuation and Consideration for the Assignment  

The consideration for the pool would be the aggregate balance principal of the housing loans being acquired, recorded as outstanding in the books of the HDFC as on that cut-off date.

Registration of Deed of Assignment and Payment of Stamp Duty  

The trust has been declared, the assets would cease to be reflected in the books of the NHB. The entire process of buying the receivables pool along with the underlying mortgage security and declaring the trust would be legally completed on the same day. The housing loans acquired by the NHB would be registered with the sub-registrar of a district in which one of the properties is located, in accordance with the provisions of the Transfer of Property Act, 1882 and the Indian Registration Act, 1908. The NHB proposed to register the deed of assignment in the State of Karnataka, where the stamp duty is 0.10 per cent ad valorem, subject to an absolute limit of Rs one lakh.

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Declaration of Trust  

After acquiring the housing loans, the NHB would make an express declaration

of trust in respect of the pool, by setting apart and transferring the housing

loans along with the underlying securities.

Issues of Pass Through Certificates  

Once the housing loans have been declared as property held in trust, the NHB

in its corporate capacity as also trustee for the SPV Trust would issue Pass

Through Certificates (PTCs) to investors.

Credit Enhancements 

The structure envisages the following credit enhancements for Class A PTCs:

(i) Subordinated Class B PTC pay-out,

(ii) Corporate guarantee from the HDFC, and

(iii) Excess spread.

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Other Details  The other details of the securitisation transaction are as follows.

Recovery on Defaults and Enforcement of Mortgages  

The HDFC would administer the housing loans given to the borrowers, in its capacity as the S&P Agent. Administering of such loans would include follow-up for the recovery of the EMIs from the borrowers in the event of delays.

The trustee (NHB) would empower the HDFC, under the provisions of the servicing and paying agency agreement, to enforce the mortgage securities where required, and institute and file suits and all other legal proceedings as may necessary, to recover the dues from defaulting borrowers.

Treatment of Prepayments on the Loans 

Borrowers are permitted to prepay their loans in full or in part, and may be charged a prepayment penalty for the same. Such prepayments in the securitised receivables pool are passed on entirely to the two classes of PTC-holdersIn the event of prepayment in a given month, the amount is passed on entirely to the Class A and Class B PTC-holders in proportion to their respective principal balances outstanding as of the beginning of that month.

Treatment of Conversion of Loans  

In case of conversion by the borrowers of a loan from fixed rate to floating rate or vice-versa, or to a lower fixed rate, the loan would continue to remain in the receivables pool. The profit/loss on account of change in the interest rate would accrue to/be borne by the receivables pool and indirectly the Class PTC-holders. The conversion charge received from borrowers who have exercised the option would accrue to the Class B PTC-holders.

Repayment of Loan by the Borrower  

On the borrower having completed repayment in all respects on the loan, the S&P Agent would intimate the trustee and return the documents relating to the mortgage debt to the borrowers.

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SOLVED PROBLEMSOLVED PROBLEM

Page 75: Term loans & securitisation

Hindustan Copper Industries (HCI) manufactures copper pipe. It is contemplating calling Rs 3 crore of 30-year, Rs 1,000 bonds (30,000 bonds) issued 5 years ago with a coupon interest rate of 14 per cent. The bonds have a call price of Rs 1,140 and had initially collected proceeds of Rs 2.91 crore due to a discount of Rs 30 per bond. The initial flotation cost was Rs 3,60,000. The HCI intends to sell Rs 3 crore of 12 per cent coupon interest rate, 25-year bonds to raise funds for retiring the old bonds. It intends to sell the new bonds at their par value of Rs 1,000. The estimated flotation costs are Rs 4,40,000. The HCI is in 35 per cent tax bracket and its after cost of debt is 8 per cent. As the new bonds must first be sold and their proceeds then used to retire the old bonds, the HCI expects a 2-month period of overlapping interest during which interest must be paid on both the old and the new bonds. Analyse the feasibility of the bond refunding by the HCI.

Solution  

Decision analysis for bond refunding decision

Present value of annual cashflow savings (Refer working note 2):

Rs 3,81,460 × 10.675 (PVIF8,25) Rs 40,72,086

Less: Initial investment (Refer working note 1) 32,57,500

NPV 8,14,586

Decision  The proposed refunding is recommended as it has a positive NPV.

Page 76: Term loans & securitisation

Working Notes

1. Initial investment:

(a) Call premium:

Before tax [(Rs 1,140 – Rs 1,000) × 30,000 bonds] Rs 42,00,000

Less: Tax (0.35 × Rs 42,00,000) 14,70,000

After tax cost of call premium Rs 27,30,000

(b) Flotation cost of new bond 4,40,000

(c) Overlapping interest:

Before tax (0.14 × 2/12/ × Rs 3 crore) 7,00,000

Less: Tax (0.35 × 7,00,000) 2,45,000 4,55,000

(d) Tax savings from unamortised discount on old bond

[25/30 × (Rs 3 crore – 2.91 crore) × 0.35] (2,62,500)

(e) Tax savings from unamortised flotation cost of old

bond (25/30 × Rs 3,60,000 × 0.35) (10,5,000)

32,57,500

Page 77: Term loans & securitisation

2. Annual cash flow savings(a) Old bond

(i) Interest cost:

Before tax (0.14 × 3 crore) Rs 42,00,000

Less: Tax (0.35 × Rs 42,00,000)

14,70,000 27,30,000

(ii) Tax savings from amortisation of discount [(Rs 9,00,000@ ÷ 30) × 0.35]

(10,500)

(iii) Tax savings from amortisation of flotation cost [(Rs 3,60,000 ÷ 30) × 0.40)

(4,200)

Annual after tax debt payment (a)

27,15,300

(b) New bond

(i) Interest cost:

Before tax (0.12 × 3 crore) 36,00,000

Less: Taxes (0.35 × Rs 36,00,000)

12,60,000

After tax interest cost 23,40,000

(ii) Tax savings from amortisation of flotation cost [Rs 4,40,000 ÷ 25) × 0.35

(6,160)

Annual after-tax debt payment (b)

23,33,840

Annual cash flow savings [(a) – (b)]

3,81,46

0@Par value – net proceeds for sale.

Page 78: Term loans & securitisation

Dua Manufacturing (DM) has under consideration refunding of Rs 2 crore out- outstanding bonds at Rs 1,000 par value as a result of recent decline in long-term interest rates. The bond-refunding plan involves issue of Rs 2 crore of new bonds at the lower interest and the proceeds to call and retire the Rs 2 crore outstanding bonds. The DM is in 35 per cent tax bracket.

The details of the new bonds are: (i) sale at par value of Rs 1,000 each, (ii) 11 per cent coupon rate,(iii) 20-year maturity, (iv) flotation costs, Rs 4,00,000, and (iv) a 3-month period of overlapping interest.

DMs outstanding bonds were initially issued 10 years ago with a 30-year maturity and 13 per cent coupon rate of interest. They were sold at Rs 12 par bond discount from par value with flotation costs amounting to Rs 1,50,000 and their call at Rs 1,130. Assuming 7 per cent after-tax cost of debt, analyze the bond-refunding proposal. Would you recommend it? Why?

Solution:

As the NPV is positive, the proposed bond-refunding is recommended

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