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					                                                  Table of Contents
1      Executive Summary ........................................................................................................ - 2 -
2      Introduction ..................................................................................................................... - 4 -
    2.1     Meaning of Securitization ....................................................................................... - 4 -
    2.2     Meaning of Security ................................................................................................ - 6 -
    2.3     Need for Securitization ........................................................................................... - 6 -
    2.4     Securitization of Receivables .................................................................................. - 7 -
    2.5     Historical Background ............................................................................................ - 9 -
    2.6     Features of Securitization...................................................................................... - 10 -
    2.7     Securitization leads to Financial Disintermediation ............................................. - 12 -
    2.8     Securitization and Structured Finance .................................................................. - 15 -
    2.9     Securitization as a Tool of Risk Management ...................................................... - 15 -
    2.10 Economic impact of securitization ........................................................................ - 15 -
3      Securitization ................................................................................................................ - 17 -
    3.1     Parties Involved ..................................................................................................... - 17 -
    3.2     Securitization Process ........................................................................................... - 19 -
    3.3     Features of Securitization of Receivables ............................................................. - 22 -
    3.4     Types of Securitization ......................................................................................... - 29 -
    3.5     Forms of Securitization Structures ........................................................................ - 32 -
4      Advantages and Limitations.......................................................................................... - 36 -
    4.1     Advantages of Securitization ................................................................................ - 36 -
    4.2     Limitations of Securitization ................................................................................. - 41 -
5      Role of Regulators and Other Agencies ........................................................................ - 42 -
    5.1     Role of Regulators................................................................................................. - 42 -
    5.2     Role of Administrator/Servicer ............................................................................. - 46 -
    5.3     Role of Credit Enhancers ...................................................................................... - 47 -
    5.4     Role of Structurer .................................................................................................. - 49 -
    5.5     Role of Rating Agency .......................................................................................... - 49 -
6      Impediments to Securitization ...................................................................................... - 50 -
7      Securitization in India ................................................................................................... - 55 -
    7.1     Need for Securitization in India ............................................................................ - 55 -
    7.2     Examples of Securitization Deals in India ............................................................ - 56 -
    7.3     Features of Securitization in India ........................................................................ - 58 -
    7.4     General Observations ............................................................................................ - 59 -
    7.5     The Future ............................................................................................................. - 60 -
8      References ..................................................................................................................... - 63 -




                                                                    -1-
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 of the
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.

India’s 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.




                                               -2-
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 from
royalty payments.

The Indian market is still waiting for the sun.




                                                  -3-
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 services
industry 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 of
acquisition 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 relations
have 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.




                                               -4-
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.




                                                -5-
 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




                                                -6-
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 to those 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.




                                                  -7-
Though the general meaning of securitization is every such process whereby financial claims
are transformed into marketable securities, one can also say that securitization 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 of
debenture, 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.




                                               -8-
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



                                             -9-
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 naïve to believe that it is not permitted.


                                                - 10 -
   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 distribution leads 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.




                                              - 11 -
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 into slices 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 involves any
   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?




                                              - 12 -
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 company’s 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
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.




                                              - 13 -
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 the
above 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




                                             - 14 -
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.
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



                                               - 15 -
   should not underrate the significance of this factor just because institutional investors 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.




                                              - 16 -
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 of
the 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.




                                                - 17 -
   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 Originator’s 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.



8. Legal Advisors: They are the legal counsels who draft the securitization documents and
   provide legal opinions.



                                             - 18 -
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



                                      Credit Enhancement
             Obligors                      Providers


                   Collections                 Credit enhancement
 Original                                                     Issue of securities
 Loan                    Cash flows
                                             SPV         Servicing               Investors
             Servicer
                                                         of securities
                          Sale of
                          asset
                                               Rating          Subscription to securities
            Originator    Purchase         Rating Agency
                          consideration                                         Arranger

                                                                             Contracts
                                                                             Ongoing cash flows
                                          Structurer                         Initial cash flows




                           Figure 2: Typical Securitization Structure




                                             - 19 -
Table 1: Basic process of Securitization of Receivables




             The Basic Process of Securitization of Receivables

 Step 1
 Step 1     The originator either has or creates the underlying assets, that is, the
            The originator either has or creates the underlying assets, that is, the
            transaction receivables out of which he will securities.
            transaction receivables out of which he will securities.
 Step 2
 Step 2     The originator selects the receivables to be assigned.
            The originator selects the receivables to be assigned.
 Step 3
 Step 3     A special purpose entity is formed.
            A special purpose entity is formed.
 Step 4
 Step 4     The special purpose company acquires the receivables at their discounted
            The special purpose company acquires the receivables at their discounted
            value (or nominal value if originator's profit is to be retained).
            value (or nominal value if originator's profit is to be retained).
 Step 5
 Step 5     The special purpose vehicle issues securities to investors- either debt type
            The special purpose vehicle issues securities to investors- either debt type
            securities or beneficial interest certificates. These are publicly offered or
            securities or beneficial interest certificates. These are publicly offered or
            privately placed as found conducive.
            privately placed as found conducive.
 Step 6
 Step 6      The servicer for the transaction is appointed, normally the originator. The
             The servicer for the transaction is appointed, normally the originator. The
            company may still continue to act as the servicer,
            company may still continue to act as the servicer,
 Step 7
 Step 7     The debtors are/ are not notified depending on the legal requirements.
            The debtors are/ are not notified depending on the legal requirements.
 Step 8
 Step 8     The servicer collects the receivables, usually in an escrow mechanism, and
            The servicer collects the receivables, usually in an escrow mechanism, and
             pays off the collection to the SPV.
             pays off the collection to the SPV.
 Step 9
 Step 9      The SPV either passes the collections to the investors, reinvests the same
             The SPV either passes the collections to the investors, reinvests the same
             to pay off to investors at stated intervals.
             to pay off to investors at stated intervals.
 Step 10
 Step 10     In case of any default, the servicer takes action against the debtors as the
             In case of any default, the servicer takes action against the debtors as the
             SPV's agent.
             SPV's agent.
 Step 11
 Step 11     When only a small amount of outstanding
             When only a small amount of outstanding           receivables are left to be
                                                               receivables are left to be
             collected, the originator usually cleans up the
             collected, the originator usually cleans up the   transaction by buying back
                                                               transaction by buying back
             the outstanding receivables.
             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.




                                              - 20 -
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 or asset-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.


                                               - 21 -
3.3 Features of Securitization of Receivables


Mode of Asset-based Financing

As financing markets have become more organised and investing more institutionalised and
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




                                              - 22 -
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 is a 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.



                                                 - 23 -
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.




                                               - 24 -
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 become
acceptable, 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.




                                                - 25 -
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. The contract
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.




                                                 - 26 -
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:

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



                                               - 27 -
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.




                                                - 28 -
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 real
estate 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 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.



                                              - 29 -
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 Government’s attempt at attracting private investment into infrastructure
funding, 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

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.




                                                 - 30 -
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 would normally 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.




                                           - 31 -
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 Securitization

Securitization 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.




                                                - 32 -
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 be
passed 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 Securitization

This 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




                                               - 33 -
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 Originator’s 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 Teléfonos de México 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, whose
offshore 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.




                                               - 34 -
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 way
of 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.




                                              - 35 -
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 on
generic 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 originator’s 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 intermediary’s 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.




                                               - 36 -
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
originator’s rating -there should be adequate legal protection against the originator’s
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 returns on 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,
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.



                                                 - 37 -
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 firm with
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

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.




                                                 - 38 -
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
products. Rating agencies have helped in promoting these interest levels since most securitised



                                               - 39 -
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 emerging market and developed market
offerings has been able to come out with good rates of return.




                                              - 40 -
4. Lesser regulation

If there are any regulations or taxes applicable on investment products, it is unlikely that they
will apply to securitization products. E.g., investments by non-financial companies may be
limited by a statute, such as Sec372A of the Companies Act in India: but this limitation will
not apply to a securitization transaction.


4.2 Limitations of Securitization

1. Costly source

The aggregate cost of securitising assets is theoretically expected to be lower than the cost of
mainstream funding. However, securitization has been shown to be a costly source, primarily
in emerging markets. Being a new product, investors pay a penalty for their own lack of
understanding. Also, the costs of rating and legal fees tend to be huge.

2. Uneconomical for lower requirements

The huge upfront costs in the form of rating fees and legal costs, including stamp duties where
applicable, would add up to a heavy initial payment. Securitization in order to be cost effective
has to be limited to large sourcing.

3. Passes on data-base to investors

One of the most important limitations of securitization is that the entire data about the
receivables is passed on to the SPV. The SPV may technically be under the control of the
originator himself, but beneficiaries have a legal right to inspect the books of the SPV. Hence,
in a competitive environment, a competitor may corner the company's portfolio and push the
originator out of the market.

4. Leaves the entity with junk assets

If the investors prefer cherry-picked assets, securitization will leave the originator with junk
assets. If one imagines an entity as a composite of good, medium and poor assets, if the good
assets are chipped off, what remain are junk assets.




                                              - 41 -
5 Role of Regulators and Other Agencies
5.1 Role of Regulators
Securitization essentially involves moving the assets from the balance sheet of the Originator
to an SPV. The SPV then proceeds to issue securities in which various entities invest their
funds. At each stage regulators have a crucial role to play, to ensure that the objectives of
securitization are achieved with the larger interests of the financial system always held
uppermost. The role of the regulators emerges, vis-à-vis their regulatory interest in the various
facets of the transaction. Since securitization lends itself primarily to financial assets, more
often than not, the Originator would be a FI in which case, the Central Bank of the country
would have valid concerns relating to the transaction. These may be related to determination of
whether the assets have actually moved off the balance sheet or calculation of any residual
risks that may remain with the Originator. An additional aspect may be regarding the health of
the Originator's balance sheet subsequent to the cherry picking that normally goes along with
securitization. The regulators would also be concerned with treatment to be accorded to any
credit enhancement or other ancillary facilities provided by the FIs to securitization
transactions either of their own assets or to outside transactions. RBI being the Regulator of
the major components of the Indian financial system, viz., banks, development financial
institutions and NBFCs has a special role to ensure that the financial intermediaries prudently
engage themselves in securitization activities. This is more so because despite the fact that
clear benefits accrue to the organisations that engage in securitization, these activities have the
potential to increase the overall risk profile if they are not carried out prudently. For the most
part, the types of risks that financial institutions encounter in the securitization process are
identical to those that they face in traditional lending transactions including credit risk,
concentration risk, interest rate risk, operational risk, liquidity risk, rural recourse risk and
funding risk.   However, since the securitization process separates the traditional lending
function into several limited roles such as originator, servicer, credit enhancer, trustee,
investor, the type of risks that our institutions will encounter will differ depending on the roles
they assume. There is, therefore, a need for the RBI to design an appropriate regulatory
framework / prudential guidelines to ensure that these institutions participate in the process of
securitization more prudently and derive the benefits it offers more objectively.
Another major category would be the securities regulator like SEBI and the Stock Exchanges
who normally stipulate the disclosure norms about listed and tradable securities. At times,


                                              - 42 -
these institutions also lay down norms restricting the type of securities or the class of investors
to which they can be issued.          Similarly, there would be regulatory issues related to
incorporation of the SPV, its capitalisation, tax treatment etc. Accounting standards and tax
rulings related to treatment of the up fronted profit in the books of the Originator or the income
accruing to the SPV on behalf of the investors in the securitization issues will also come into
play. Thus, Institute of Chartered Accountants of India as well as the tax authorities would
have to put into place a system of clear and unambiguous rules, which would serve as guidance
for various situations. Regulation thus would be impacting specified activities as well as the
entities that perform these specific activities.


Moving assets off the Originator's balance sheet
Securitization necessarily involves assignment of assets by the Originator to an SPV. This has
implications for Originators in the areas of capital adequacy (for financial intermediaries),
accounting treatment and taxation. The regulator's role in each of these is discussed below:
Capital Relief
Financial intermediaries can use securitization to free a portion of their regulatory capital. RBI,
which prescribes capital adequacy requirements for these entities, would hence be required to
lay down norms for "true sale" and the capital relief. The norms would aim at preventing
Originators from getting the benefit of capital relief in events where they either retain asset risk
or provide recourse to the investors. These norms would be purely from the point of view of
capital adequacy and independent of what "true sale" may mean in the legal, accounting or
taxation context.
Post-securitization financial health of Originators
The pool assets that are securitised are picked and chosen out of an Originator's total portfolio.
In securitization parlance, good assets are "cherry-picked" to make the securities issued
attractive to investors. This exercise carries with it the risk that (post-securitization) the
Originator's balance sheet would be left with assets of poorer quality, except in the cases where
it can generate fresh assets of the quality of the securitised assets. The RBI would hence be
concerned that the financial health of Originators could be in jeopardy, if securitization is
resorted to in too large a scale.




                                                   - 43 -
Accounting and Taxation Treatment:
Keeping gearing low does have a significant bearing on the risk perception that lenders/
investors have about a corporate. Securitization in its true form achieves an off-balance sheet
effect, and hence has a positive impact on the debt-equity ratio of the Originator. There is thus
a requirement for clear standing definitions for a True Sale, which if adhered to would qualify
the transaction as an off-balance sheet funding. Since accounting norms / standards are laid
down by the Institute of Chartered Accountants of India (ICAI), they would be required to
come out with an accounting standard/ guidance note on accounting for securitization. Clarity
would also need to emerge on the tax treatment that would be accorded to the assets moving
off the balance sheet or the income being up-fronted. In many cases, it will so happen that the
True Sale criteria for one purpose may be different from the criteria for any of the other
purposes. Availability of a clear and reliable set of criteria for each purpose would serve as a
source of tremendous comfort to both issuers and regulators.


Issuance related Regulation:
The activity of issuance of securitised paper would bring into play the role of regulators such
as SEBI and Stock Exchanges. These bodies stipulate the information that must be disclosed
publicly about listed securities. In some cases, they may also dictate investor classes to which a
particular type of security may or may not be sold. An added area of regulation may be on the
nature of entities, whose assets can be securitised or the asset classes, which can be securitised.


Disclosure Norms:
The nature of securitised paper being considerably different from traditional securities, the
nature of disclosure norms on its issuance would also differ. Most of these disclosures are
fundamentally different from what is required for normal issues of equity and debt. As the
regulator of the capital market, SEBI may have to examine and come out with detailed
disclosure norms for issuance of securitised paper, by way of a public issue. In case of private
placement also some best practice norms may need to be put in place. These norms would
cover the issuance of such securities as well as ongoing disclosure requirements over the life of
the instruments. Some of the areas on which disclosure would be required are:
      The characteristics of the underlying assets (factual information about the selected pool
       on various parameters, representations on past performance, etc.)




                                              - 44 -
      Agreed procedure for administration / servicing
      Nature and extent of credit enhancement, other ancillary services
      Broad purpose and contents of legal documents involved
      Legal and financial disclosures on the Originator and SPV, disclaimer of their liability
       except to the extent explicitly specified
      Nature and structure of instrument


Listing Requirements:
Stock Exchanges ordinarily lay down the listing requirements for various securities. They
would necessarily have a role to play in this regard. The structures of securitised paper would
need to keep in mind various parameters, some of these could be:
      Names of exchanges, which permit listing of securitised paper, e.g. only NSE permits
       listing of securitised debt at the moment in India.
      Minimum issue size.
      Availability of listing in Demat mode and consequent stamp duty concessions. Steps
       are already being taken by the Ministry of Finance to extend the benefits of demat
       trading, presently available only to equity, also to debt securities. A point of concern
       here would be the possible omission of securitised paper in the proposed notification,
       which would permit dematerialised listing and trading in Debt Securities.


Regulation of the SPV:
The SPV may be incorporated in any one of the many legal forms possible. The structure
adopted may be that of a Firm, a Company, a Trust or Mutual Fund etc. Consequently, the
provisions of the parent law for incorporation of such entity, i.e. the Partnership Act, the
Company Law or Trust Act would need to be adhered to while setting up the entity. In
addition, when the SPV is set up as a Mutual Fund Trust, specialised regulators like the SEBI
would also come into the picture. It would, however, be pertinent to maintain here that the RBI
being the regulator would need to lay down criteria which would determine that the SPV
should remain exempt from NBFC guidelines.
There would be another two aspects of the activity of the SPV, which would attract regulation.
These would be the tax treatment and the accounting treatment to be accorded to the
transaction being routed through its books. The tax authorities of the country would therefore,



                                              - 45 -
need to put into place a clear set of taxation rules which would avoid or prevent double
taxation merely because an activity is being routed through an SPV. Similarly, the accounting
standards would need to be developed regarding the format of the SPV balance sheet,
treatment of the up fronted profit, liability display regarding future performance obligations
against securitised assets etc.


Investment related areas:
For securitization to take off in big way, investor acceptability would be of paramount of
importance.     The investor for securitised instruments, to begin with, is likely to remain
confined to the private placement market amongst institutions. The investment policies of most
institutional investors are influenced by the prescriptions relating to asset-liability
management, prudential exposure and risk weights for various categories of instruments that
they may invest in. Specific quantitative limits in each area would have to be laid down in this
regard by the concerned regulators for individual institutions

5.2 Role of Administrator/Servicer
The task of the administrator is to collect the receivables, take appropriate enforcement action
when necessary to pursue their payment and to pass them over to the SPV. The Originator's
familiarity with the assets and the Obligors makes it the obvious party to administer them. In
many cases, to keep the collection efficiency uniform, the staffs of the Originator who are
involved with administration do not know which assets out of the total portfolio have been
securitised and which remain with the Originator. Although most transactions provide for an
option to change the administrator, it could prove impractical to affect this, especially where
retail loans have been securitised. There is urgent need to segregate the assets with the
administrator from other assets of Originator.
As the market for securitization matures, it is expected that specialised entities that would
provide administration services for a fee would emerge. Even today, entities providing
factoring services could take up the task of administration provided they have the necessary
infrastructure and skills.




                                             - 46 -
5.3 Role of Credit Enhancers
Credit enhancement is an integral part of any securitization transaction, plays an important role
in investor acceptability and widening of the securitization market. Although credit
enhancements internal to the transaction structure play an important role, their impact could be
limited. (Internal credit enhancements frequently resorted to are cherry-picking of the asset
pool to be securitised, over-collateralization, provision of cash collateral by the Originator,
etc).
When the intrinsic credit quality of the Originator is not very high, it becomes essential to
obtain some sort of external credit enhancement in the form of a guarantee / insurance from a
third party. External credit enhancements can usually take form of:
   Letter of Credit / Guarantee
   Monoline Insurance
   Multiline Insurance
Each technique can provide full or partial support depending upon the credit quality of the
portfolio. In general, the quantum of credit enhancement would vary inversely with the
inherent credit quality of the portfolio.


Letter of Credit / Guarantee may be provided by a commercial bank / financial institution for
a specified nominal amount or as a full cover of the SPV's obligations. Such enhancements
serve the intended purpose only if supplied by a Triple ‘A’ rated bank.


Monoline Insurance Companies are engaged in the single line of business of writing financial
guarantees. These are mostly US-based companies who in the last decade have entered OECD
countries and more recently are entering Emerging Markets. Their most common function is
as 100 percent guarantor of transactions' principal and interest payments. They all hold Triple
'A' insurance claims paying ability ratings.


Multiline Insurance Companies are general insurance companies who are in the larger
business of insurance and provide risk cover to specific aspects of securitization transactions
also. Those normally provide risk cover up to a percentage of portfolio value.




                                               - 47 -
While a structurer may chose any one of credit enhancement techniques, it is essentially
ensured that the fee paid for the credit enhancement is offset by the economic benefit of better
rating and consequent price advantage made available to the Originator.
In the Indian context, LIC and GIC (including subsidiaries) along with the private participants
need to be encouraged to provide pool insurance to asset-backed structures and play the role of
multiline insurers. FIs could also be encouraged to engage in the activity either on the strength
of their existing balance sheets or through independently managed subsidiaries floated
specifically for monoline insurance. The subsidiary route could be the preferred option because
the parent-bank / FI may be an active investor in the market for securitised paper or may have
other exposures to the Originator and would in either case face a conflict of interest.


Liquidity Support:
Apart from the credit quality of the asset pool, investors in securitised paper also need to be
shielded against delays in repayment. Investors look to liquidity support providers to bridge
time lags between collections from the Obligors and servicing of investors. Liquidity support
covers the following:
Reserve account: A certain amount is set aside in a reserve account to provide liquidity in the
event of delay in collections from the underlying assets. Once the collections are received they
are used to top up the reserve account to the extent to which it was previously drawn.


Revolving line of credit: The Originator arranges for a bank to provide a revolving line of
credit for a specified limit. Delays in collections are bridged by drawing upon this line of
credit, which is repaid on receipt of collections.


Lien: A lien marked on any collection account of the Originator (other than the account
pertaining to collections from the securitised assets) can also be a source of liquidity support.
The mechanism of using funds and topping up the account on realising collections is similar to
the other forms of liquidity support.




                                               - 48 -
5.4 Role of Structurer
The structurer is involved in an advisory role throughout the transaction. Its involvement
spreads across the entire gamut of sub-processes in securitization covering pool selection,
decisions regarding credit enhancement and other ancillary services, structuring the instrument
and payment mechanism, documentation, systems analysis and development, forecasting
investor acceptability, etc. Internationally, this role is played by investment bankers and a
similar trend is already visible in India.

5.5 Role of Rating Agency
Like any other capital market debt security, securitised paper also needs to be rated by
recognised rating agencies. In India, the existing rating agencies have already acquired a fair
degree of expertise through rating of structured obligations and other issues that are quite
similar to securitization. The circumstances under which the assignment of assets to the SPV
may become vulnerable to the insolvency of the originator are, inter-alia, a) the transaction is
not done at fair market value: b) the risks and rewards in the assets are not transferred to the
SPV; c) the security is not properly perfected under the relevant law. The rating agencies could
be enjoined upon to gear up to evaluate such risks.




                                             - 49 -
6 Impediments to Securitization
The environment for securitization in Emerging Markets (EM) is different from that in
developed markets for various reasons like (i) Narrow investor base; (ii) Cultural factors; (iii)
Poor capital market infrastructure; (iv) Regulatory environment; (v) Legal hurdles; (vi) Lack of
proper accounting standards; (vii) Taxation burden; (viii) Poor asset-quality; (ix) System
deficiencies and (x) Lack of standardization. The following paragraphs discuss these issues:

1. Investor Base

They may be domestic or foreigners; individuals or institutions – financial or non-financial,
regulated or non-regulated; sovereign or non-sovereign. Investors look for (i) Asset
performance - Lack of historical or meaningful performance data may make it difficult to
predict performance; (ii) Third party performance- Reliance on asset servicers, credit support
providers etc.; (iii) Currency exposure and the availability of swap opportunities at reasonable
cost; and (iv) Secondary market liquidity. Investors also look towards the services of the
independent rating agencies to get confidence. An underdeveloped secondary market for
securitized assets that lacks liquidity is an obvious problem to an FI in EM that is attempting to
find investor acceptance. In India, the following issues need further clarifications:

- The status of ‘Pass Through Certificates’ as ‘Securities’ under the SCRA is not clear;

- Investment in securitized paper (whether as PTCs or debt instruments) needs to be
specifically permitted for FIs

- Adequate disclosures about the assets need to be made to facilitate the investor to make
his/her view on the security.

2. Cultural Factors

In many EMs, decisions for loans are 'compromised' decisions rather than 'rational' decisions.
The process generates loans, which are less homogeneous and are not of high quality. Further,
nature of ‘participation certificates’ as distinct from traditional securities such as shares and
debentures needs to be recognized. In practice, the FIs as investors look forward to security in
the form of creation of charge over physical assets. The mindset against unsecured investments


                                              - 50 -
has to undergo a significant change to accept financial claims in the case of securitization of
future flows as collateral.

3. Capital Market Infrastructure

Debt markets are at their infancy in many of the EMs due to the underdevelopment of
institutions and the instruments. Further,

- Foreclosure norms need to be simplified to facilitate speedy recovery;

- Securitized paper is not specifically included in proposed notification exempting stamp duty
on transfer of debt instruments in the depository mode. This would act as a negative feature
vis-à-vis standard debt instruments

- The market requires the emergence of back-up servicers to protect against any negligence by
the Originator (as Administrator)

4. Regulatory Environment

The regulations in a country for capital adequacy requirements are important motivators for the
Originators to undertake securitization. Clear guidelines for the treatment of true sale and off
balance-sheet items can pave the way for securitization. Further, many financial experts
believe that by diminishing the pivotal role of FIs in financial intermediation, securitization
lessens the effectiveness of monetary policy. FIs and regulators in many countries are
concerned that the weakening of close ties between FIs and their corporate customers may
undermine not only traditional patterns of financial intermediation, but patterns of corporate
governance as well. In the Indian scenario, the following issues need further attention:

- The guidelines for investments by insurance companies need to be clarified for investments in
securitized instruments

- Mutual funds are not permitted to invest in MBS

- The application of current NBFC norms to the Special Purpose Vehicle will render the entire
process inefficient.




                                             - 51 -
5. Legal Provisions

Since all legal provisions connected to securitization are not consolidated under a single
statute, the task of developing a set of sound documents becomes much more tedious. The
legal issues in India (including recommendations) are discussed in detail in Chapter 6. They
include:

- The Stamp duty on assignment of receivables is not uniform across states and also too high in
most states rendering securitization unviable. While some State Governments have reacted
positively by reducing stamp duty on assignment of assets for securitization, resistance has
been met within other States because of the loss of revenue

- Compulsory registration on transfer of assets involves registration fees, which adds to the
cost of securitization

- Absence of clear legal provisions on partial assignment of assets and assignment of future
receivables

6. Accounting

If the Originator provides credit enhancements in the form of a limited guarantee or pool
substitution to a certain extent, there is said to be some recourse back to the Originator. In the
absence of clear accounting guidelines, accountants find it difficult to classify such
transactions as a sale treatment.

In case of financial intermediaries securitizing their assets, the treatment of the over
collateralized assets in their books needs clarity.

Accounting for securitization transactions is not clear on:

- De-recognition of assets from books of Originator

- Treatment for PTCs and the securitized assets in the books of the SPV where the pass through
structure is adopted

- Assignment of future receivables and their income recognition in the books of the Originator



                                               - 52 -
7. Taxation

To encourage securitization, the SPV needs to be tax neutral. Other impediments include:

- Transfer of income without transfer of underlying assets still makes Originator liable for
taxation

- It is not clear whether HFCs can continue to issue certificates to borrowers to claim income
tax benefits under Sec24 (1)(vi) and 88, after the receivables have been assigned

- Taxation of parties involved in securitization is not clear, for example

  * Capital gains implications on assignment of receivables by the Originator to the SPV

  * Possibility of entity taxation of SPV

  * TDS on passing on of cash flows by SPV to the investors

8. Quality of assets

The Originators need to have a minimum viable amount of quality assets to make the
securitization transaction attractive in view of some minimum expenses to be incurred for fees
for structurer, rating agencies, lawyers, auditors, road shows, etc.

9. System Deficiencies

- Securitization requires the Originator to have an efficient information capturing and delivery
system.    Due to the heavy capital cost involved, both individual Originators and the Indian
financial system as a whole are not geared to meet these requirements

- Information on historical data is generally not available

- Very little information is available on the demographics of potential asset pools (auto loans,
individual housing loans, credit card dues, etc) that are amenable to securitization

- Credit information on Originators and potential Originators is also not readily available




                                               - 53 -
- Participation from credit bureaus in the process of securitization is required.

10. Standardization

This refers to FIs and other lenders adopting common formats, practices and procedures in loan
origination, documentation, application and administration (servicing).

The Indian financial system is presently characterized by a lack of standardization in all
aspects of loan origination with the exception of Government-sponsored loans or housing
loans granted by some of the large housing finance institutions. Each bank or institution uses
its own form of contract

Standardization does not necessarily mean that all lenders must extend credit using the same
criteria or on the same terms but rather that certain fundamental aspects of the lending process
are standardized among lenders. For instance, lenders may adopt a standard form of mortgage
loan agreement that provides adequate legal protection to all lenders. It ensures that investors
in a pool of loans (or the rating agencies) do not have to analyze the risk of several different
legal documents.

Lenders may also agree to use loan applications that request the same information from
borrowers. This does not mean that each lender must grant credits on the same criteria but that
each lender is obtaining the same basic information from the borrowers making it easier for
investors to compare loans originated by different lenders. If applications ask different
questions, it is more difficult for investors to evaluate loans originated by one lender against
loans originated by another lender.

Standardization of servicing typically involves the standardization of the type of information
that is monitored (i.e. balance, payment history, address, etc.). In addition, there can be
standardization of the documents and information that are maintained in each loan file. There
can be standardized data processing systems and software. It can also facilitate a new servicer
to take servicing, if required.

These impediments may have to be addressed by the Indian financial community in a phased
manner in order to make securitization successful in the Indian financial system.




                                               - 54 -
7 Securitization in India
Securitization is a relatively new concept in India but is gaining ground rapidly. CRISIL rated
the first securitization deal in India in 1991 when Citibank securitised a pool of Rs.16crore
from its auto loan portfolio and placed the paper with GIC Mutual Fund. Since then,
securitization of assets has begun to emerge as a clear option of fund raising by corporate.
Many manufacturing companies and service industries too are increasingly looking towards
securitising their deferred receivables and future flows also. CRISIL has rated transactions
worth over Rs 4,500 crore to date. Other rating agencies in India, viz., ICRA, DCR and CARE
have also been actively involved in the process. The majority of these being in the nature of
outright sales of auto loan portfolios without subsequent issue of securities and do not amount
to securitization in the real sense. There has till date been no instance of downgrading of the
rating assigned to any of these transactions. Securitization has also been attempted for property
rental receivables, power receivables, telecom receivables, lease receivables etc.


7.1 Need for Securitization in India


In the Indian context, securitization is the only ray of hope for funding resource starved
infrastructure sectors like Power. For power utilities burdened with delinquent receivables
from state electricity boards (SEBs), securitization seems to be the only hope of meeting
resource requirements. As on December 31, 1998, overall SEB dues only to the central
agencies were over Rs. 184 billion. Securitization can help Indian borrowers with international
assets in piercing the sovereign rating and placing an investment grade structure. An example,
albeit failed, is that of Air India’s aborted attempt to securitize its North American ticket
receivables. Such structured transactions can help premier corporates to obtain a superior
pricing than a borrowing based on their non-investment grade corporate rating. A market for
Mortgage backed Securities (MBS) in India can help large Indian housing finance companies
(HFCs) in churning their portfolios and focus on what they know best – fresh asset origination.
Indian HFCs have traditionally relied on bond finance and loans from the National Housing
Bank (NHB). MBS can provide a vital source of funds for the HFCs. After the merger of
India’s largest financial institution ICICI with ICICI Bank, ICICI, faced with SLR and other
requirements, is actively seeking to launch a CLO to reduce its overall asset exposure.




                                              - 55 -
It appears to be only a matter of time before other Public Financial Institutions merge with
other banks. Such mergers would result in the need for more CDOs in the foreseeable future.

7.2 Examples of Securitization Deals in India

Some of the pioneering transactions that have either been concluded or are being structured in
this regard are described in the following sections.

1. Housing Loans: In India, of late there has been a positive orientation of Government
   policies towards securitization for the housing sector. The five-year Plan documents have
   repeatedly emphasised the need for developing a secondary mortgage market (SMM) for
   bridging the resource constraint confronting the housing sector.

   The National Housing Bank (NHB) launched the first issue of MBS, based on the assets of
   HDFC and LIC Housing Finance in August ’00 for Rs137 crore. NHB had been working
   for years on its pilot project for creating liquidity from the huge pool of housing mortgages
   in the country.

   Under the scheme, HDFC got Rs 90 crore of its housing loan portfolio securitised, while
   LIC Housing Finance Rs48 crore. The transaction involved the assignment of retail
   housing loans form both housing finance companies to NHB. In April ’01, it launched two
   more issues of MBS, comprising pools of housing loans originated by Canfin Homes and
   LIC Housing Finance to raise Rs.91.6 crore.

   As with the rest of the world, the potential for mortgage securitization is enormous. In the
   case of mortgage securitization there are specific issues that stymie the process. These are
   the long tenure of loans, low spreads, cumbersome foreclosure procedures, and prepayment
   risks etc., all of which have led to its tardy progress. A major hurdle in India is simplified
   foreclosure norms. Once this happens, housing finance institutions (HFIs) will be able to
   tackle delinquencies effectively and will be willing to lend with less stringent credit
   evaluation. This is expected to enlarge volumes in the formal sector, helping a wider
   section of society (who would otherwise have approached the unorganised sector) to
   borrow at lower rates.




                                              - 56 -
2. Auto loans – Citibank Case: Citibank assigned a cherry-picked auto loan portfolio to
   People’s Financial Services Ltd. (PFSL), an SPV floated for the purpose of securitization
   by paying the required amount of stamp duty (0.1%) to ensure true sale. This is a limited
   company and can act only as SPV for asset securitization. This SPV is owned and managed
   by a group of distinguished legal counsels. PFSL then proceeded to issue PTCs to
   investors. These certificates were rated by CRISIL and listed on the wholesale debt market
   of the National Stock Exchange (NSE), with HG Asia and Birla Marlin as the market
   makers. Global Trust Bank acted as the Investors’ Representative. Citibank played the role
   of servicer. The certificates are freely transferable and each of the transfer will have a
   stamp cost of 0.1%.

   The coupon of the security was high in spite of good quality of the underlying asset
   portfolio, because investors expected a premium to compensate for their unfamiliarity with
   the certificates. The investor base was limited mostly to Mutual Funds. FIs were hesitant
   because of the unsecured nature of the instrument and the absence of clarity on whether the
   certificates could be treated on par with other debt securities in their investment policy.
   Although the certificates were listed on the NSE, there was very little secondary market
   activity because there was absence of adequate amount of alternative security of similar
   risk profile.

   Besides Citibank, NBFCs like Ashok Leyland Finance, 20th Century Finance etc. have
   securitized their auto loan portfolio, though, of course, these transactions involved
   assignment of receivables only and not issuance of securities. The asset portfolios were
   bought by one or two large institutions. TELCO has also reportedly sold over Rs 550 crore
   of its auto loan portfolios in multiple tranches through this route.

3. Future Flows: As mentioned earlier, ‘future flow securitization’ is gaining momentum.
   Remittances from overseas workers, international telephone settlements, export
   receivables, future sale of oil and gas and other commodities, project cash flows and toll
   receivables are finding favour with investors. Some illustrations are:




                                              - 57 -
   (i) Future receivables - L&T case: Although Larsen & Toubro bagged the Build, Lease
   and Operate contract for a 90-MW captive power plant for Indian Petrochemical
   Corporation Ltd. (IPCL); it transferred it to an SPV – India Infrastructure Developers Ltd.
   (IIDL) which issued debentures in the private placement market. The debentures would be
   serviced out of the lease rentals due to IIDL from IPCL. L&T’s guarantee was also
   available to a limited extent. The novelty of this transaction is that instead of a plain loan
   with say, 3:1 debt equity ratio, the project was financed in the form of a securitization-like
   structure through the capital market with a much higher gearing ratio.

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


7.3 Features of Securitization in India

On the basis of the Indian experience, the following features of securitization appear
noteworthy.

1. Most deals have involved the transfer of beneficial interest on the asset and not the legal
   title.
2. Most transactions have followed the pass-through mechanism.
3. In fact, many transactions have followed the escrow mechanism where receivables are
   transferred to an escrow account for payment to the buyer.


                                               - 58 -
4. According to Duff & Phelps India, a rating agency, past deals have mostly been direct
   purchases of receivables by institutions and bigger NBFCs.
5. Routing the transaction through a Special Purpose Vehicle is yet to gain popularity.
6. There appears to be no secondary market for securitised debt.
7. The market is unregulated and lacks transparency in terms of volume, price, parties to the
   transaction, etc.
8. The settlement procedures are not clear.
9. There are no standard accounting and valuation norms.


7.4 General Observations

 Emerging Markets (EMs) have high cost of raising funds and look for alternative sources
   for raising funds at cheaper sources. Financial Institutions (FIs) in Asia have large illiquid
   debt to get rid off. These countries have the potential to benefit from securitization.
 There is a huge potential for infrastructure finance in EMs. FIs can securities their loans for
   infrastructure projects and the same can be sold to potential local or foreign investors. This
   presupposes a well-developed secondary debt market.
 Government guaranteed loans may remain excluded from securitization, as they are less
   efficient.
 Privatization is revolutionizing the economic practices in the EMs. Banks are going to the
   markets for raising equity in the wake of reducing State funding. Their shares are being
   quoted in the stock markets. They are being forced to improve ROE and the efficiencies of
   the capital deployed. This gives them the opportunity to consider securitization in an
   aggressive way.
 Market penetration of FIs in the area of origination of loans will be determined more by the
   volume of loans originated during a period than by the amount of loans owned at a
   particular point of time.

Certain potentials for securitization especially in the mortgage sector in India are:

- Increasing share of tertiary sector, urbanization and demand for houses

- Reduction of poverty and fast development of enlightened middle/upper middle classes




                                              - 59 -
- Disappearance of joint family system and demand for new houses

- Housing initiatives

 Presently, investors include FIs, pension funds, insurance companies, mainly from USA or
   Europe. Local investors from Asia look forward for higher returns, as their cost of raising
   funds is high. Saving rates in Southeast Asia have been 32% of GDP versus 21% in Latin
   America. Although the local investors’ appetite is dependent upon the deepening of the
   markets, the huge savings may provide potential as the process for widening and deepening
   of these financial markets is taken up.


7.5 The Future

1. In brief, securitization will grow in future for two significant reasons:

    a) securitized paper is rated more creditworthy than the FI itself
    b) strict capital requirements are imposed on the FIs

  Future trends in securitization of assets will not only be influenced by those FIs who are
  knowledgeable about this process, and therefore, aware of its potential but will also be
  affected by the level of knowledge in the financial community as a whole as well as the
  perception of the regulators. While the benefits that securitization brings in its wake are
  well documented, it may be worthwhile to examine whether the domestic financial markets
  are sufficiently developed to accept the product and utilize it efficiently.

2. The debt market has deepened and widened in recent years in India after the introduction of
   financial sector reforms. The recommendation of the committee on financial sector reforms
   (Narasimhan Committee Phase II) stipulates that the minimum shareholding by
   Government /Reserve Bank of India in the equity of the nationalized banks should be
   brought down to 33%. The same report also emphasizes financial restructuring with the
   objective of, interalia, hiving off non-performing-asset portfolio from the books of the FIs
   through securitization. According to an estimate, Indian banks may be able to raise funds at
   200 basis points (BP) above US Treasury rate for an issue of US$150 mn, with a maturity
   of five years, giving them a gain of 200 to 400 BP over domestic rates after taking care of
   related expenses. The securitized paper can be raised in a period of 16 weeks after signing


                                              - 60 -
   the mandate with advisors/lead manager. The costs involved are advisors’ fee to the tune of
   1.5% of issue size, rating agency fee US$300,000, legal expenses US$500,000 and road
   shows US$100,000. The guidelines of RBI restricting the quantum of the public deposits
   that can be raised by an NBFC have given them further incentive to look for alternative
   sources of funds. The opening of the insurance sector for privatization can create demand
   for the securitized paper.
3. The Indian financial system is sound and well developed. A number of new financial
   products have arrived and been tested in the market during the brief period since the
   reforms began. The past few years have also witnessed a healthy trend towards
   computerization of transaction and information management systems. The availability of
   computer technology would thus permit the capture and manipulation of large databases,
   which are a basic requisite in structuring, securitized products.
4. The debt market is poised for substantial growth with the development of the sovereign
   yield curve across different maturities and the active participation of primary dealers. The
   Indian market has well-developed institutions, specialized regulators in banking, capital
   markets, rating agencies and a well-developed regime of controls and supervision. The
   existence of specialized financing institutions like Housing Finance Companies,
   Urban/Infrastructure development Bodies like Housing and Urban Development
   Corporation (HUDCO), Rural Electrification Corporation (REC) etc. who not only have
   existing securitisable portfolios but also have the capacity to keep creating such assets with
   a view to securitizing them. Since most such institutions are facing resource constraints,
   securitization will enable them to focus on their core competency of supporting
   infrastructure products through the gestation stage and securitizing them later, rather than
   funding them till maturity. The domestic financial institutions are fast reaching their
   prudential limits in various sectors. Further lending by them to these sectors is thus
   dependent upon their being able to securities their existing portfolios.
5. The investors with long-term funds have traditionally favored equity and Government
   securities portfolio and have stayed out of debt. Also the present illiquidity of the loan
   portfolios does not allow FIs to actively manage or manipulate the related sector, interest
   rate or maturity risks. This places a restriction on further asset expansion, as assets once
   taken on the books necessarily need to be carried till maturity. Securitization will provide a
   solution for their requirements.




                                             - 61 -
6. The market is thus at a stage where debt is increasingly going to be offered in a tradable
   form, whether or not secondary market trades take place in individual cases.
   Securitization, by converting debt into tradable financial instruments, provides an
   opportunity for more efficient reallocation of sector specific risks among a more diversified
   set of players. By offering an exit option, it channelises surpluses that have so far remained
   untapped, to capital–deficient sectors of the economy.




                                             - 62 -
8 References
       Securitization by Vinod Kothari
       ICFAI Reader by the Institute of Chartered Financial Analysts of India
       www.vinodkothari.com
       www.nishithdesai.com
       www.rbi.org.in
       www.securitization.net
       www.asset-backed.com
       www.centrumfinance.com
       www.google.com
       www.yahoo.com
       www.altavista.com
       www.wikipedia.org
       www.imf.org




                                          - 63 -

				
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