INDIAN INSTITUTE OF MANAGEMENT AHMEDABAD

Securitization: Risks and Prospects

A report submitted to Instructor

Prof. Gopi Suvanam

In partial fulfillment of the requirements of the course

Financial Risk Management

On 16thDecember 2012

By

Amit Das (6612008) Nitin Khanna (6612054)

Securitization: Risk and Prospects

The basic motivation behind any Securitized transaction is: Efficient Financing Better Risk Management through risk transfers and delinking of credit risk of originator from credit risk of asset Improved Balance Sheet Structure removes illiquid assets, improves capital structure and capital adequacy The figure above depicts pictorially how various stake holders are involved and in very simple language, securitization can be understood as conversion of existing illiquid assets like loans, advances and receivables into tradable security. The basic benefit as highlighted above is that illiquid assets are converted into marketable securities and thus provide alternate funding source. Any type of assets with a reasonably predicted cash flow can be securitized. The nature and amount depends on the risks of the securitization as determined by the Rating Agencies, Underwriters/Placement Agents and Investors. The intention is to reduce the risks to the Investors and thereby increase the rating of the securities ultimately lowering the costs to the Originator.

Current Indian Scenario on Securitization Globally the securitization market is huge and for the financial year 2011-12, the numbers of transactions were around 620 with issuance volume around $366 Bn. [1] In comparison to global markets, Indian markets are miniscule, amounting to Rs 36,603 crore in FY2011-12 even after growth of over 15% as compared the fiscal 2010-11, according to ICRA Ratings. [2]

The detailed guidelines for securitization were issued in Feb 2006, which is where RBI provided details and criteria for true sale of assets in securitization. There were provisions for credit

enhancements to be provided either by banks or by third party credit enhancers. Post regulations, the typical originators were transport companies, commercial vehicle and commercial equipment companies. Main asset classes in India securitization market: The main asset classes used in Indian markets are: 1. ABS (CV/CE) - Commercial Vehicle (CV) and Construction Equipment (CE) loans are the key asset class accounting for two-thirds of the total ABS volumes. The main reason for such high volume is long and comparatively stable track record of CV / CE lending in the country (also demonstrated through good performance of the past pools). In addition the relatively larger size of CV / CE loan portfolios in the industry have been the key factors for the popularity of this asset segment in securitization. 2. RMBS- The number of Resident Mortgage- Backed Securitization (RMBS) issuances are the other products which consist of major securitization market. The considerable jump in the volume in the last financial year in overall securitized issuances was primarily due to the 26% surge in securitisation of retail loans, which consists of asset-backed securitisation (ABS) as well as residential mortgage backed securitisation (RMBS). As per ICRAASSOCHAM study during the financial year (FY) 2012, while the asset-backed securitization (ABS) issues have increased by 58%, the residential mortgage-backed securitization (RMBS) registered increase of 53%.

The main mechanisms used by investing banks have been direct assignments i.e., direct sale of a selected loan pool by the Originator to the Purchaser (or Assignee) together with limited credit support, as against securitisation which involves the sale of receivables to a special purpose vehicle (SPV) and issuance of Pass Through Certificates (PTCs) by the SPV. Over the past four years i.e. since FY2009, about 75-80% of the total number of ABS and RMBS transactions has been in the nature of direct assignment transactions, wherein no specific instrument is issued even as the

assignee payouts are rated. The main reason investing banks used securitized bilateral transactions to acquire loan pools was to meet their Priority Sector Lending (PSL) targets. Another motivation for outright purchase of loan by banks is the treatment on balance sheet, since PTCsby virtue of them being investmentswould need to be marked to market, and loans and advances do not have this requirement. A major factor of concern though is no participation by mutual funds investments. For instance, while MFs can invest only in instruments, unlike banks which prefer to acquire loan portfolios outright. There is some ambiguity regarding taxation on returns earned on these investments by MFs, which is detailed further in the document. Accordingly, banks were typically the investors in these transactions.

Despite higher issuances seen in the year, the traditional obstacles to RMBS in India, viz., long tenure of RMBS paper, the lack of secondary market liquidity, high stamp duty on transfer of security, tenure uncertainty, interest rate risk and prepayment risk, continued to hinder the growth of this segment. Nevertheless, regulatory requirements certain category of home loans qualify as priority sector lending provide the motive for trading in home loans too. Some of these issues are detailed again further in the document. Though limited, but it is worth mentioning Indian governments efforts in terms of developing the securitization at least for RMBS through National Housing Board. NHB has been playing a lead role in starting up Mortgage Backed Securitisation and development of a secondary mortgage market in the country. NHB launched the pilot issues of Mortgage Backed Securities (MBS) in August 2000 in the Indian financial market. Support to Mortgage Backed Securitisation has been a major policy initiative of the Government as manifested in its National Housing and Habitat Policy announced in 1998. The policy has enjoined upon National Housing Bank (NHB) to play a lead role in starting mortgage backed securitisation and development of a secondary mortgage market in the country.

Latest RBI Guidelines (May 2012): The RBI, on 7 May 2012, has put out the final guidelines on securitisation and direct assignment of loan receivables. This is the first time the RBI has issued separate guidelines for Direct Assignment transactions. These guidelines are largely similar to the draft guidelines released in September 2011, other than some differences the key ones pertain to Minimum Holding Period (MHP) requirement and credit enhancement reset. Under the Guidelines, no credit enhancement is permitted for these transactions. Given the prohibition on credit enhancement, the investing banks will be exposed to the entire credit risk on the assigned portfolio, which most banks may not be comfortable with. Hence the volume of such assignment transactions is expected to be severely affected in coming times. As

mentioned previously almost 75% of the market of securitized products was through direct assignments last year and the trend was similar in previous years. But, with new regulation on prohibition of credit enhancement through these transaction would impact the future market. On the upside, the new MHP and MRR guidelines are slightly helpful. The MHP is a credit positive event as it will establish some payment track record and provide some credible information on ability as well as willingness of original borrowers. It is therefore expected that keeping in view the new Guidelines, bilateral assignments are likely to be far fewer, as parts of erstwhile bilateral assignments market would move to Securitisation route.

Risks related to securitization in India Risks: Typical risks associated with any securitized transaction are listed below. The risks particular to Indian market are detailed further in this section. Risk retention rules Conflict of Interest Disclosure and Transparency Credit ratings Regulatory Capital Compensation

Tax issues relating to PTC: The seemingly lack of clarity on true sale criteria set by RBI imposes taxation issues. The regulation mandates that all risk and rewards related to securitized asset shall be effectively transferred and originator has no control of assets. The main issue in securitisation is can the originator derecognize the transferred assets? The RBI guidelines contradict with the accounting guidelines laid by Indian GAAP and IFRS, RBI proposes gain to be amortized over the life of securities issued or to be issued by the SPV, whereas accounting standards suggest recognizing gains immediately along with some other complications, which exactly opposite of RBI treatment. Another issue related to taxation is regarding income from pass through certificates (PTCs). The tax authorities contest that interest income should be regarded as business income of the trust and taxed at maximum marginal rate. The SPVs in turn pass tax to investors i.e. mutual funds that are basically exempt from tax. The mutual fund houses contested it with the courts and the Mumbai high court issues a stay providing a huge relief to the investors but its a matter of concern for MFs to invest in securitized products. Some industry experts believe that determinate trust structure and

revocable trust structure as the twin defenses to the current tax issues facing securitisation. The explanation of such structure is beyond the scope of this document.

Legal Issues: As applicable to tax consideration, the categorization of securitized transaction as true sale has many legal impacts and along with it, the next major question is what is the applicable stamp duty and other taxes. Stamp Duties on transfer of assets in such transactions can often make a transaction impractical. The Working Group of RBI has recommended a uniform rate of 0.1% duty on all transactions, which is still not approved.

Listing of PTC: Another big open ended challenge is whether PTCs can be listed or not and it still remains an unresolved issue. The debt security as defined under FII Regulations, include Securitisation instruments or not too needs clarification and these uncertainties will always hinder growth of securitized transactions in India.

Lack of Debt Secondary Market: The demand for trades for PTCs as well as other securitized securities can be seen as a proxy of corporate bond market. The primary market for corporate debt is mainly dominated by private placements (93 per cent of total issuance in 2011-12) as corporates prefer this route to public issues because of operational ease, i.e., minimum disclosures, low cost, tailor made structures and speed of raising funds. This has impact on other fixed income products and unless this market grows, other products will not see further growth. Corporate bonds issued in India usually carry a rating of AAA indicating lack of interest in bonds of lower rated borrowers in the debt market. One way to further develop this market is to come up with different products for different investors. Tranching is one mechanism to create products for different appetite customers, where a specific class of bonds within an offering wherein each tranche offers varying degrees of risk to the investor. Most ABS and RMBS transactions in FY2012 had simple structures with a single tranche (while some transactions had two tranches), and the credit enhancement in the structures was primarily in the form of cash collateral. Further details of tranching is discussed in Annex-I.

Prospects of Securitization:

As briefly mentioned in the beginning of this write-up, the biggest benefit of securitization is spreading of risk and greater market participation. Once the securities are available for trade it helps to not only increase the liquidity but also helps to determine the market price. 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 i.e. 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. Another major benefit is lowering of mortgage rates, while individual rates are still largely tied to a person's credit rating; mortgage rates as a whole are made lower because securitization allows lenders to reduce costs. Therefore the advantage of securitization for mortgage holders is that a more liquid mortgage market and a spreading out of risk eventually lead to lower interest rates on home loans. In order to further develop and build a successful securitisation environment, the major requirements are: Robust financial infrastructure The Legal Environment The Accounting Environment The Regulatory Environment The Taxation Environment Back-office Systems

Legal issues concerning Stamp Duty, Registration Act, Tax law, RBI Regulations, SEBI rules which are not addressed in the current regulations sufficiently. The coordination between these laws is very important to encourage the securitization transactions in India. Hence, the regulatory framework must be framed to be a workable scheme of law. Apart from domestic legal issues, it is important to have the law feasible and in coherence with the international standards, so that in future when the law on securitization widens its horizon, there will be no difficulty in its transition.

It can be concluded that a well-developed securitization market can help in many ways including but not limited to: (i) (ii) (iii) (iv) enabling efficient allocation of funds, facilitating infrastructure financing, improving the health of the corporate balance sheets, promoting financial inclusion for the Small and Medium Enterprises (SMEs) and the retail investors

Therefore securitization can play a huge role in financial markets for diversifying risk, enhancing financial stability, and for better matching of risk-return preferences of the borrowers.

Annexure - I Tranching A primer 1. Objective

Financial institutions and investors can realise many benefits by using securitized products provided that proper regulation and monitoring mechanism is in place. Hence, Indian financial institution should actively trade in securitized products. Objective of this exercise is to find out how securitization can be made more attractive to Indian investors and crate primary as well as secondary market of securitized products in India. Though there are few extrinsic bottlenecks like regulations, taxation etc., banks and SPVs can use tranching as a tool to make securitize product attractive to different kind of investors by fulfilling specific needs of target investor group.

Through tranching, asset classes with different level of risk and return parameters can be created to fulfil investor needs. Senior tranch can have higher credit rating suitable for pension fund, insurance companies etc., who are required to invest in investment grade securities by law. In this exercise a pool of home loan was taken as underlying asset and divided the risk and return in three (3) tranches. Return of most senior tranch resembles return of fixed deposit products. The middle tranch resemble risk and return parameter of equity investment and the most junior tranch got highest credit risk with return higher than equity investment, something in which Hedge funds might be interested.

Through this exercise analysis is performed to match risk-return profile expected by different types of investors and assign appropriate credit rating to tranches to make securitized product more attractive to Indian Investors. 2. Approach

The attached excel demonstrates the analysis of risk and return from a pool of mortgage backed asset as divided it into 3 tranches resembling return form fixed deposit (Tranch A), equity (Tranch-B) and high risk investment (Tranch C). For the purpose of quantitative analysis, following variables are used. Variables can be altered to analyse their impact on overall tranching framework. Net Loan: The total loan amount of underlying mortgage asset at the beginning of the contract. It is assumed initial loan amount to be $10 Million. Maximum Loss Giving Default: This is the maximum principal amount which might be written off due to credit default. Though the default rates are high, banks usually recover 60%

of the defaulted principal and rest 40% principal is written off. This variable represent the actual loss happened during the lifetime of loan. Interest Rate: It is the interest rate paid by the borrower of the underlying asset. Assumed 12.5 % interest as typical interest rate of mortgage in India. Percentage of Principal Amount: This variable indicates % principal contributed by every tranch. This has been taken so that sum of the % of all 3 tranch should equal to 100% always. For calculation it is assumed that 50% principal contributed by Tranch-A, 30% by Tranch-B and rest 20% by Tranch-C. Tranch Interest Rate: Interest rate promised to investors of different tranch depending on their risk profile. The interest is calculated every month on principal outstanding at the beginning of the month after accounting for pre-payment and default. 3. Assumptions

Following Assumptions are made for the purpose of quantitative analysis The underlying loan will be re-paid fully within 5 years. Any pre-payment will be repaid to all 3 tranches equally. So all 3 tranches assume equal reinvestment risk. Pre-payment amount will be deducted from principal every month. Tranch C (the most junior Junk Bond tranch) assumes initial default risk. Principal of TranchB will be impacted only after principal of Tranch-C cease to exist. Similarly principal of TranchA will be impacted only after Tranch-Bs principal is exhausted. Defaults are assumed to be uniformly spread over 60 months. SPV charges 15 basis point as service fees for facilitating the securitized transaction. Originator charges 20 basis point as service fees for facilitating collections etc. 4. Analysis 4.1 Tranches To depict how principal, interest etc. are changing in every period due to pre-payment and defaults, calculation of every tranch for all the periods during life(60 months in this case) of the loan are depicted. Change in every tranch is shown in a set of columns. Meaning of each column and approach used for calculation is given bellow Period: This is the indicator of age of the loan in months. As our security period is 60 months, period starts from 0 (beginning of the security) and ends at 59. A row corresponding to a period indicates status of the tranch at that period.

 Initial Principal: Principal amount of a tranch at the beginning of a period after deducting prepayment and default occurred in the previous period. Interest paid to a tranch in a period is calculated on the outstanding principal at the beginning of the period. Initial principal at the following period is same as principal left at the end of previous period. Interest Paid: Amount of interest paid to a tranch at any particular period. Interest amount is calculated according to promised interest rate and the initial principal in the tranch at the beginning of the period. PMT : This is the per month payment (consist of interest as well as principal) as received by a tranch considering initial principal, promised interest rate and number of period left for the security to mature. Excel PMT function is used to calculate this. Principal Paid: This is the amount of principal paid every period as estimated by PMT calculation. This is calculated by deduction interest amount from corresponding PMT value. This column doesnt consider any pre-payment or default. Principal Left: This column contain amount of principal left in every tranch at the end of a period. To calculate this column, deduction of Principal Paid in a period from Initial Principal of that period is done. Also deduction of pre-payment amount assigned to the tranch is done. If principal of subordinate tranches are exhausted due to credit default, then immediate senior tranch start absorbing any further loss due to default. Also the default amount was deducted, as well to calculate principal amount left in a tranch. Investor Got Back: This is the amount that investors of a tranch got back in a period. This was arrived by adding pre-payment amount allocated to a tranch with PMT amount.

4.2 Cash Flow This worksheet matches cash in-flow from the underlying loan with cash out-flow to different tranches for every period. Difference between total cash in-flow and out-flow can be source of revenue for SPV.

4.3 Sensitivity Analysis The worksheet Sensitivity Analysis depicts how net cash flow of a tranch will be impacted due to change in different economic parameters. 3 factors are used Interest Rate, Prepayment Rate and Default Rate as these factors are most susceptible to change in economic climate and will severely impact return realised by a tranch. Sensitivity analysis shows that the most junior tranch start losing money as soon as loss giving default become 7.5% of the original principal.

4.4 Default Rate Poisson distribution is used to calculate probability of default. It is assumed that on an average loan consist of 30% of the principal amount will be defaulted. The first column contain % of principal amount that will be defaulted and Probability of Default column contain cumulative probability that default rate will be less than the said principal %. The last column contains loss giving default as % of original principal amount. Considering 40% of the defaulted principal is written off, it can be concluded with 80% confidence that even with 10% average default rate, the most junior tranch will be able to recover its principal.

5.

Conclusions
Return % IRR Confidence level Loss Giving Default $0 5% 9.20% SPV Return Originator (bps) Return (bps) Tranche A Tranche B Tranche C 15 15 15 15 15 15 10.75% 10.75% 10.65% 13.80% 13.57% 12.55% 17.81% 6.91% -3.43%

Most Optimistic Scenarios Most Likely Worst Case

0% 86% 99.98%

From quantitative analysis (Please refer to the attached excel) it can be conclude that tranching will help to grow securitization market in India by fulfilling appetite of different types of investors even after providing margin to originator / SPV. With realistic assumptions, outcomes of quantitative analysis are In most optimistic scenario with no default and no prepayment the speculative tranch earn as high as 17.8%, equity tranch earns 13.8% and fixed deposit tranch earns 10.75%. In a more likely scenario where it is assumed 5% loss giving default and 10% pre-payment risk, speculative tranch annual IRR drop to 6.38%. This was computed with 86% confidence that loss giving default will be less than 5% and realised return will be higher. In worst case scenario with 99.9% confidence level and 9.2% loss giving default, speculative grade tranch may lose 3.4% while other tranches still realise positive return.

So from the above analysis, it is evident that tranching will help to offer different grades of investment option and will help further grow the securitization market in India.

References

[1] http://www.abalert.com/ranking.php?rid=2648, Accessed on Dec15, 2012 [2] http://icra.in/Files/Articles/Indian%20Securitisation.pdf accessed on Nov 7, 2012 [3] http://www.icra.in/Files/Articles/RBI%20Securitisation%20Guidelines.pdf accessed on Nov 7, 2012 [4] http://rbi.org.in/scripts/NotificationUser.aspx?Id=2723&Mode=0 accessed on Dec 15, 2012 [5] http://www.moneycontrol.com/news/icra-reports/rbis-final-guidelinessecuritisation-

icra_708770.html accessed on Dec 15, 2012