Nimkar (2000) Securitisation Of Assets

Securitisation of Assets Rahul Nimkar PGDIM, NITIE. [email protected]

CONTENTS Title Executive Summary What is Securitisation? History of Securitisation Securitisation Process Special Purpose Vehicle Structure of Asset Backed Securities Securitisation Structure RBI Regulations and Guidelines Impact on Banks Benefits of Securitisation Securitisation in India: Obstacles and Future References

2

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 securitisation. Securitisation, in its most basic form, is the repackaging of asset cash flows into securities. It means legally isolating sources of cash flow from avoidable risk, and issuing debt backed by this revenue. This debt can then be placed in the public-listed debt security market or privately. The increasing focus on securitisation has been furthered by the announcement from the finance ministry that the Government has plans to fund power companies through receivables due from State Electricity Boards (SEB). Given the size of SEB dues owed to power companies – running into thousands of crores – the deals, when they are through, could create a huge base of securitised instruments. The National Housing Bank is taking the initiative so that housing finance companies can raise money by issuing bonds backed by future loan receivables. And with the capital market in dumps, it could be the answer for large corporations that are facing funding problems. However, the picture is not yet so clear and time alone will tell if Indian markets make the best utilization of securitisation and reap rich benefits from it. But there is hope of great improvements in the market place. Worldwide, anything that can generate a cash flow can be securitised. If you can imagine an asset that produces a cash flow, or can be made to produce a cash flow, it is probably supporting an asset-backed security (ABS) somewhere right now. WHAT IS SECURITISATION? Definition Securitisation is a pooling of “homogeneous”, “financial”, “cash flow producing”, “illiquid” assets and issuing claims on those assets in the form of marketable securities. The higher yield associated with these securities attracts investors who are willing to bear incremental credit, prepayment and liquidity risk. The fundamental principle in securitisation is specific identification of risks and allocation of the same to various parties who are best able to manage those risks. As defined by the recent Ordinance: “Securitisation” means acquisition of financial assets by any securitisation company or reconstruction company from any originator, whether by raising of funds by such securitisation company or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise.

3

Securitisation is the process by which, financial assets such as household mortgages, credit card balances, hire-purchase debtors and trade debtors, etc., are transformed into securities. In present day capital market usage, the term is implied to include securities created out of a pool of assets such as household mortgages, credit card balances, hirepurchase debtors and trade debtors, other receivables, etc., transferred, fully or partially, which are put under the legal control of the investors by the owner (the Originator) in return for an immediate cash payment and/or deferred consideration through a Special Purpose Vehicle(SPV) created for this purpose. The Special Purpose Vehicle finances the assets transferred to it by the issue of debt securities such as loan notes or Pass Through Certificates, which are generally monitored by trustees. Pass Through Certificates are certificates acknowledging a debt where the payment of interest and/or the repayment of principal are directly or indirectly linked or related to realisations from securitised assets. Arrangements are made to protect the holders of the debt securities issued as above by the Special Purpose Vehicle from losses occurring on the securitised assets by a process termed as ‘credit enhancement’, which may take the form of a third party insurance, a third party guarantee of the Special Purpose Vehicle’s obligations or an issue of subordinated debt. The Originator may continue to service the securitised assets (i.e., to collect amounts due from borrowers, etc.) and receive servicing fees for the same. The Originator may also securitise the future receivables, i.e., the receivables that do not exist at the time of agreement but would be arising in future. The original concept of securitisation was to create securities based on financial assets, say, receivables on mortgage loans, auto loans, credit cards, etc. However, later innovation has extended application of securitisation to cover non-financial assets such as aircraft, buildings, and on the other hand, the same device has also been applied to securitise risk, such as insurance risk, weather risk, etc. Innovation is constantly extending securitisation applications. Let us consider an example: A finance company with a portfolio of car loans can raise funds by selling these loans to another entity. But this sale can also be done by “securitising” its car loans portfolio into instruments with a fixed return based on the maturity profile (the period for which the loans are given). If the company has Rs 100 crore worth of car loans and is due to earn 17 per cent income on them, it can securitise these loans into instruments with 16 % return with safeguards against defaults. These could be sold by the finance company to another if it needs funds before these loan repayments are due. The principal and interest repayment on the securitised instruments are met from the assets which are securitised, in this case, the car loans. Selling these securities in the market has a double impact. One, it will provide the company with cash before the loans mature. Two, the assets (car loans) will go out of the books of the finance company once they are securitised, a good thing as all risk is removed.

4

HOW IS IT DIFFERENT FROM FINANCING THROUGH STRAIGHT BOND OR DEBENTURE ISSUE? Unlike a traditional bond issue, the repayment of funds raised through securitisation is not an obligation of the originator, or the finance company issuing the securitised instrument. In a straight bond or debenture issue, in the event of the company going bust, the investors would have a tough time getting their funds back, if at all. However, if one invests in a securitised instrument, investors are assured of interest payments even if the finance company goes bust, as the securitised loans are separated from the finance company’s books through a SPV which holds these assets. At the same time, as securitised instruments can be traded, the investor is provided with liquidity as the securitised bond can be sold in the market. WHAT ARE BENEFITS TO THE ISSUER? The issuer can raise funds of longer maturities than he would have been able to through the conventional routes like bonds or term loans. For instance, in the case of toll roads, the financing costs can normally be recovered only over a very long period of time. A loan where repayments can be made over a long period may not be easily available. Here, securitisation can provide a solution. For instance, conventional loans are generally backed by the borrower’s existing assets. In many cases, the borrower may not be in a position to offer the required collateral. The process of securitisation allows the borrower to raise funds against future cash flows rather than existing assets. WHAT CAN BE SECURITISED? All assets that generate funds over time can be securitised. These include repayments under car loans, money due from owners of credit cards, airline ticket sales, toll collections from roads or bridges, and sales of petroleum-based products from oil refineries. In fact, artists have even raised funds by securitising the royalty they will get out of future sales of their records. The most readily securitisable assets are those which display the following characteristics: • Predictable cash flows; • Consistently low delinquency and default experience; • Total amortization of principal at maturity; • Many demographically and geographically diverse obligors; and • Underlying collateral with high liquidation value and utility to the obligors

5

Securitisation works well if the securitised asset (say, the pool of car loans) is homogenous (the same kind) with regard to credit risk (how sound the borrower is) and maturity. Ideally, there should be historical data on the portfolio’s performance and that of the issuing company with regard to credit quality and repayment speed. HISTORY OF SECURITIZATION Securitisation in its present form originated in the mortgage markets in USA. It was promoted with the active support of the government. The government wanted to promote secondary markets in mortgages to allow liquidity for mortgage finance companies. GNMA was the first one to buy mortgages from mortgage companies and to convert them into pass through securities - this was 1970. Other US government agencies, FNMA and Freddie Mac jumped in later. The first securitisation of receivables outside the mortgage markets happened in 1975 when Sperry Corporation securitised its computer lease receivables. The European model: pfandbriefe and mortgage bonds: Another mortgage funding device, slightly different from the US-type pass throughs, has existed in Europe for almost two centuries in the past. In Denmark, for example, mortgage bonds are more than 200 years old. Germany also has a long history of pfandbriefes and it is stated that there have been no defaults on these instruments for all these years! DEVELOPMENT IN SECURITISATION Domestic In India CITIBANK pioneered in securitization by executing the first securitized transaction in 1991. Since that date CRISIL has rated over 100 transactions with the volume exceeding Rs. 8500 Crores (USD 1700 MM) since 1991. Over the last 2-3 years, there have been 35 issuances of securitized debt for a total of Rs.4200 Crores (USD 860 MM) distributed to a wide range of investors. International The international market is well acquainted with securitization transaction. Till date, the outstanding securitized debt in international market is above $ 5 trillion. The Mortgaged Backed Securitization (MBS) market is above $ 4 trillion. Also outstanding Securitized debt for ABS is 25% of total outstanding borrowings in the United States.

6

SECURITISATION PROCESS Following are the steps typically involved in a securitisation process: 1.

Identify and/or accumulate assets: These assets could include anything from airline ticket receivables, hire-purchase rental receivables, sales cash flows of any commodity, et al. Values are represented by future cash flows and it is essential to recognize a specific timeframe for this purpose. The market for each security will define what is investor-relevant information. This information is normally checked through credit-rating agencies that verify the credibility of the projected cash flows and the stability of their sources.

2. Transfer or insulate assets from transferor’s creditors: Assets are isolated usually through a ‘true sale’ or ‘clean transfer’ by the originator to a bankruptcy-remote SPV that will issue the securitised bonds. The issuing SPV may be either a limited purpose company, or a trust established under a restrictive deed. In both cases the SPV will be manage by an independent trustee, so that the issuer ahs no conflict of interest with the security. Also acceptable is the assignor retaining legal title to the underlying asset but holding such a title subject to the equitable interest of the assignee. This effectively means that the title to the asset will be held by the borrower (assignor) subject to the first change in favour of the lender (assignee). 3. Issuing bonds: The issue of debt bonds is how the anticipated cash flows from the assets are transformed into cash in hand either by an SPV offering bonds to the public or the private investor market. The FI as an underwriter will take an initial investment position in the debt and later offload it in the market, thus making a margin. This creates a huge market for term lending and improves the performance of the FIs. Every securitisation requires the appointment of a servicer or administrator to collect and distribute obligor payments from the asset’s performance, manage the collection of recoveries for defaulted monitor and report on receivables. The administrator is entitled to receive a fee for the services, paid out of the collections on the assets. This fee represents one of the methods to compensate an originator for transferring its rights to the assets.

7

4. Enhance and support assets and/or securities The advantages of isolating cash flows and using them to service issued debt obligations may justify securitisation. Nevertheless, ABS and MBS investors may prefer structures to contain explicit enhancements that may improve the asset’s performance. Others may boost the performance of the structure, or guarantee payments to investors. Credit enhancement can be divided into two main types: external (third party or seller’s guarantee) or internal (structural or cash flow driven). Typical credit enhancement structures are: o Third party insurance o Structural credit support such as providing a margin over the value of the asset, and o Providing guarantees, letters of credits or third party corporate guarantees. SPECIAL PUROSE VEHICLE As opposed to a general purpose vehicle or a trading corporation, a Special purpose vehicle, as the name suggests, is formed for a special purpose: therefore its powers are limited to what might be required to attain that purpose and its life is destined to end when the purpose is attained. When a corporation, call it the sponsor of the SPV, wants to achieve a particular purpose, for example, funding, by isolating an activity, asset or operation from the rest of the sponsor's business, it hives off such asset, activity or operation into the vehicle by forming it as a special purpose vehicle. This isolation is important for external investors whose interest is backed by such hived-off assets, etc., but who are not affected by the generic business risks of the entity of the originating entity. Thus SPVs are housing devices - they house the assets etc transferred by the originating entity in a legal outfit, which is legally distanced from the originator, and yet self-sustained as not to be treated as the baby of the originator. By its very nature, an SPV must be distanced from the sponsor both in terms of management and ownership, because if the SPV were to be owned or controlled by the sponsor, there is no difference between a subsidiary and an SPV. Being an independent, an SPV is responsible for its own funding, risk capital and management decisions. Most SPVs, for example, securitisation SPVs, run on a prepunched program and do not have to take any management decision: they are almost "brain dead".

8

Typical structures of Asset Backed Securities (ABS): There are different types of ABSs, each utilizing a slightly different structure: •

Asset-backed certificates are pass-through certificates issued by a trust representing undivided fractional interests in a pool of receivables such as automobile loans or credit card receivables. Except for any recourse provision, the assets are sold outright by the selling company to the trust.

•

Asset backed obligations (ABOs) are debt securities of a special purpose corporation, owned either by the selling company or by unaffiliated third parties, and collateralized by a pool of financial assets. They are similar to collateralized mortgage obligations (CMOs) because they often utilize multiple tranches, but, unlike CMOs, they may issue either pay through or fixed pay securities (i.e. prepayment risk is eliminated for investors).

•

Asset backed preferred stock is issued by a special purpose, bankruptcy-proof subsidiary which purchases assets such as trade and consumer receivables or intercompany notes from its parent or affiliates. The assets are often supported by a direct pay letter of credit or surety bond in favour of the subsidiary issued by a AAA rated commercial bank wit the result that the subsidiary’s preferred stock is able to obtain the highest credit ratings.

•

Asset backed commercial paper involves the sale of financial assets to a SPV which, in turn, issues commercial paper. Proceeds from the issuance of the commercial paper finance the purchase of the assets. The commercial paper is supported by the cash flow from the assets, the issuance of new collateralizes commercial paper or from borrowings under a liquidity facility.

9

SECURITISATION STRUCTURE

Originator

Sale of Pool

Credit Enhancement

Original pool: HP/Loan agreements

Purchase consideration for pool

Specified Account

SPV

Issuance Subscrip. of PTCs Proceeds

Investors

Obligors

PTC Payments Investor’s Trustee

•

Originator sells pool of lease / hire purchase / loan receivables to a Special Purpose Vehicle (SPV)

•

SPV issues Pass Through Certificates (PTCs) to investors to raise funds for payment of purchase consideration to the Originator

•

PTCs represent the beneficial interest of investors in the pool of receivables and credit enhancement

•

Investor’s Trustee would be appointed to manage the transaction and act in the interest of the investors

•

Originator would be appointed as the servicer to continue to collect moneys from the Obligors and monitor the underlying contracts

Specified Account would be set up where collections from the Obligors would be deposited by the service on a monthly basis.

10

RBI REGULATIONS AND GUIDELINES (1) Acquisition of Financial Assets i.

The Asset Acquisition Policy shall provide that the transactions take place in a transparent manner and at a true price in a well informed market, and the transactions are executed at arm’s length in exercise of due diligence;

ii.

The Policy so framed should provide for checks in the matter of acquiring assets from a single Bank/FI, own sponsors and any single entity upto a desirable level of ceiling so that possible departures from desirable practices are avoided;

iii.

The percentage of financial assets to be acquired should be appropriately and objectively worked out keeping in view the fact that the percentage of ownership stake has a bearing on the speed with which security interest rights can be enforced in accordance with the provisions of the Ordinance;

iv.

For easy and faster realisability, financial assets due from a single debtor to various banks / FIs may be considered for acquisition. Similarly, financial assets having linkages to the same collateral may be considered for acquisition to ensure relatively faster and easy realisation ;

v.

Both fund and non-fund based financial assets may be included in the list of assets for acquisition. Standard Assets likely to face distress prospectively may also be acquired;

vi.

Acquisition of funded assets should not include takeover of outstanding commitments, if any, of bank / FI to lend further. Terms of acquisition of security interest in non-fund transactions, should provide for the relative commitments to continue with bank/FI, till demand for funding arises;

vii.

Loans not backed by proper documentation should be avoided;

viii.

The valuation process should be uniform for assets of same profile and a standard valuation method should be adopted to ensure that the valuation of the financial assets is done in scientific and objective manner. Valuation may be done internally and or by engaging an independent agency, depending upon the value of the assets. Ideally, valuation may be entrusted to an asset acquisition committee, which shall carry out the task in line with an Asset Acquisition Policy laid down by the Board in this regard;

ix.

A record indicating therein the details of deviations made from the prescriptions of the Board in the matter of asset acquisition, pricing, etc. should be maintained;

x.

To ensure functioning of Securitisation Companies/ Reconstruction Companies on healthy lines, the operations and activities of such companies may be subjected to periodic audit and checks by internal / external agencies.

11

(2) Engagement of Outside Agency

Securitisation Companies/ Reconstruction Companies may engage the services of reputed specialised external agencies to handle the task of taking possession of secured assets in pursuance of its right to enforce security interest. (3) Sale Committee It is desirable that the Sale Committee authorises in case of joint / consortium financing, the secured creditor with the highest outstanding, or more preferably, the Securitisation Company/ Reconstruction Company as the designated secured creditor to arrange for the sale of secured assets. (4) Issue of security receipts (i)

The parties in question may finalise the price at which security receipt will be issued as per the mutually agreed terms and on assessment of the risks involved;

(ii)

In cases where security receipts are issued involving transfer of risks to the full extent and rewards to a limited extent, there could be a possibility of sharing of surplus between the issuer and the investors;

(iii)

The issuer may consider obtaining credit rating from any of the recognised credit rating agencies.

The matters relating to charging of ‘management fee’ by the Securitisation Company/ Reconstruction Company, for managing schemes floated by it, may be as per the mutually agreed terms. IMPACT ON BANKS The securitisation process is complex and involves banks playing a wide range of roles. Banks may act as the originator of the assets to be transferred, as the servicing agent to the securitised assets, or as sponsors or managers to securitisation programs that securitise third party assets. In addition, banks may act as a trustee for third-party securitisations, provide credit enhancement or liquidity facilities, act as a swap counter party, underwrite or place the ABS, or invest in the securities.

12

Banks that securitise assets are able to accomplish several objectives. First, in selling or otherwise transferring, rather than holding, the originated assets, banks are able to 1) reduce their regulatory capital requirements; 2) obtain an additional source of funding, generally at a lower cost; 3) enhance financial ratios; and 4) manage their portfolio risk, e.g. reduce large exposures or sectoral concentrations. As investors, banks are able to diversify their portfolios by acquiring different asset types from different geographic areas. While benefits accrue to banks that engage in securitisation activities, these activities have the potential of increasing the overall risk profile of the bank if they are not carried out in a prudent manner. Generally, the risk exposures that banks encounter in securitisation are identical to those that they face in traditional lending. These involve credit risk, concentration risk, operational risk, liquidity risk, interest rate risk (including prepayment risk), and reputational risk. However, since securitisation unbundles the traditional lending function into several limited roles, such as originator, servicer, sponsor, credit enhancer, liquidity provider, swap counterparty, underwriter, trustee, and investor, these types of risks may be less obvious and more complex than when encountered in the traditional lending process. Accordingly, supervisors should assess whether banks fully understand and adequately manage the full range of the risks involved in securitisation activities. BENEFIT OF SECURITISATION Economic benefits: Securitisation benefits the economy as a whole by bringing financial markets and capital markets together. Financial assets are created in the financial markets, e.g., banks or mortgage financing companies. These assets are traditionally refinanced on on-balance sheet means of funding of the respective banks. Securitisation connects the capital markets and financial markets by converting these financial assets into capital market commodities. The agency and intermediation costs are thereby reduced. Securitisation converts loan relationships into capital market commodities and therefore, increases the power of the capital market. The shift to marketable from non-marketable assets brought about by securitisation has stretched credit creation. It tends to sustain borrowers longer in economic expansion and probably to expose them more in contractions. It also has had the important side effect of removing the illusion of price stability for non-marketable assets. Some of the new securitised instruments have therefore magnified the volatility of financial asset prices.

13

Securitisation and cost of funding It is a clear proposition that the stronger the security rights of the creditor, the lesser is the risk he faces, and the lower, therefore, is the risk premium he translates into cost of lending. If securitisation means lesser credit risks for the originator, obviously this should lead to lower funding costs. Benefits to investors Investor experience of investing in securitised paper has internationally been quite good, for primarily 3 reasons: •

Securitisation being a structured finance instrument can be more closely aligned to investor needs. Investors can invest in exactly what suits their investment policy the best.

•

Securitisation asset classes have shown much higher rating resilience. Rating transition histories have been published by both Moody's and Standard and Poor's depicting this. Recently, Fitch also came out with a rating transition history of ABS to prove this point.

Default history of securitisation tranches is much safer - there have been very few defaults over the past 16 years. Default recovery rate of securitisation tranches has been significantly higher than in case of defaulted corporate bonds. SECURITISATION IN INDIA: OBSTACLES AND FUTURE Securitisation of assets has been immensely successful in developed capital markets. In India, however, very few transactions of small value have taken place so far. Several obstacles are hindering the growth of securitisation in India: •

Stamp duty on transfer of assets by originator to the SPV, as high as up to 13%.

•

If PTC issued in form of a receipt, it is not transferable by endorsement and delivery; if PTC is issued in form of a promissory note it will attract stamp duty.

•

Ambiguity on whether PTCs can be regarded as negotiable promissory notes.

•

Unresolved tax issues – who will be taxed?

•

Weak foreclosure laws failing to provide adequate comfort to investors in ABSs.

Given the importance of securitisation in modern economy, concerted efforts are required to develop it. Hopefully, initiatives will be taken to overcome the obstacles that are hindering the growth of securitisation.

14

References 1. Joseph Norton and Paul Spellman - Asset Securitisation: International Financial and Legal Perspectives, Blackwell Finance, U.K. 2. Prasanna Chandra - Financial Management, 5th edition, Tata McGraw Hill, India 3. www.vinodkothari.com 4. R.B.I. notifications on their website. 5. Basel committee on banking supervision: Report on Asset Securitisation.

15