Securitization

INTRODUCTION TO BANKING

The banking sector is the lifeline of any modern economy. It is one of the important financial
pillars of the financial sector, which plays a vital role in the functioning of an economy. It is very
important for economic development of a country that it’s financing requirements of trade,
industry and agriculture are met with higher degree of commitment and responsibility. Thus, the
development of a country is integrally linked with the development of banking. In a modern
economy, banks are to be considered not as dealers in money but as the leaders of development.
They play an important role in the mobilization of deposits and disbursement of credit to various
sectors of the economy. The banking system reflects the economic health of the country. The
strength of an economy depends on the strength and efficiency of the financial system, which in
turn depends on a sound and solvent banking system. A sound banking system efficiently
mobilized savings in productive sectors and a solvent banking system ensures that the bank is
capable of meeting its obligation to the depositors.
In India, banks are playing a crucial role in socioeconomic progress of the country after
independence. The banking sector is dominant in India as it accounts for more than half the assets
of the financial sector. Indian banks have been going through a fascinating phase through rapid
changes brought about by financial sector reforms, which are being implemented in a phased
manner.
The current process of transformation should be viewed as an opportunity to convert Indian
banking into a sound, strong and vibrant system capable of playing its role efficiently and
effectively on their own without imposing any burden on government. After the liberalization of
the Indian economy, the Government has announced a number of reform measures on the basis of
the recommendation of the Narasimhan Committee to make the banking sector economically
viable and competitively strong.
The current global crisis that hit every country raised various issue regarding efficiency and
solvency of banking system in front of policy makers. Now, crisis has been almost over,
Government of India (GOI) and Reserve Bank of India (RBI) are trying to draw some lessons.
RBI is making necessary changes in his policy to ensure price stability in the economy. The main

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objective of these changes is to increase the efficiency of banking system as a whole as well as of
individual institutions. So, it is necessary to measure
the efficiency of Indian Banks so that corrective steps can be taken to improve the health of
banking system.

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HISTORY OF BANKING

The history of banking refers to the development of banks and banking throughout history, with
banking define by contemporary sources as an organization which provide facilities for
acceptance of deposit and provision of loan. The photo type banks where the merchants of the
world, who made gain loan to farmer and traders who carried goods between cities. Banking in
India, in the modern sense, originated in the last decades of the 18th century. Among the 1stbanks
were the banks of Hindustan, which was establishing in 1770 and liquidated in 1829-32; and the
general bank of India, establish in 1786 but failed in 1791.the largest bank, and the oldest still in
existence, is the state bank of India. It originated as the bank of culcutta in June 1806.Bank is a
financial institution that performs several functions like accepting deposits, lending loans,
agriculture and rural development etc. Bank plays an important role in the economic development
of the country. It is necessary to encourage people to deposit their surplus funds with the banks.
These funds are used -for providing loans to the industries thereby making productive
investments.
A bank is a financial intermediary that accepts deposits and channels those deposits into lending
activities. They are the active players in financial market. The essential role of a bank is to
connect those who have capital with those who seek capital. After the post economic
liberalization and globalization, there has been a significant impact on the banking industry.

Banking in India originated in the 18th century. The oldest bank in existence in India is the State
Bank of India, a government-owned bank in 1806. SBI is the largest commercial bank in the
country.

After the independence, Reserve Bank of India was nationalized and given wide powers.
Currently, India has 96 Scheduled Commercial Banks, 27 public sector banks, 31 private banks
and 38 foreign banks.

Today, banks have diversified their activities and are getting into new products and services that
include opportunities in credit cards, consumer finance, wealth management, life and general

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insurance, investment banking, mutual funds, pension fund regulation, stock broking services,
etc.

Further, most of the leading Indian banks are going global, setting up offices in foreign countries,
by themselves or through their subsidiaries.

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STRUCTURE OF BANKING

Banking in India in the modern sense originated in the last decades of the 18th century. The first
banks were Bank of Hindustan (1770-1829) and The General Bank of India, established 1786 and
since defunct. The largest bank, and the oldest still in existence, is the State Bank of India, which
originated in the Bank of Calcutta in June 1806, which almost immediately became the Bank of
Bengal. This was one of the three presidency banks, the other two being the Bank of Bombay and
the Bank of Madras, all three of which were established under charters from the British East India
Company. The three banks merged in 1921 to form the Imperial Bank of India, which, upon
India's independence, became the State Bank of India in 1955. For many years the presidency
banks acted as quasi-central banks, as did their successors, until the Reserve Bank of India was
established in 1935.

In 1969 the Indian government nationalized all the major banks that it did not already own and
these have remained under government ownership. They are run under a structure know as
'profit-making public sector undertaking' (PSU) and are allowed to compete and operate as
commercial banks. The Indian banking sector is made up of four types of banks, as well as the
PSUs and the state banks, they have been joined since the 1990s by new private commercial
banks and a number of foreign banks. Banking in India was generally fairly mature in terms of
supply, product range and reach-even though reach in rural India and to the poor still remains a
challenge. The government has developed initiatives to address this through the State Bank of
India expanding its branch network and through the National Bank for Agriculture and Rural
Development with things like micro finance.

Established in 1935 Apex body of Indian banking system Headquarters is in Mumbai India’s
monetary authority Supervisor of financial system Issuer of currency Banker to bank Banker to
government Maintains financial stability.

SCHEDULED BANKS Scheduled banks are those banks whose name appears in the 2nd
schedule of Reserve Bank Of India Act, 1934. NON-SCHEDULED BANKS Non-scheduled

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banks are those banks whose name doesn’t appear in the 2nd schedule of Reserve Bank Of India
Act, 1934.

BANKS UNDER SCHEDULED BANKS COMMERCIAL BANKS They are the banks mainly
deal with commercial banking operations like acceptance of deposits and granting loans to the
public. They are mainly classified into four:- Scheduled banks Commercial banks Co-operative
banks.

PUBLIC SECTOR BANKS Public sector banks are those banks which are owned and controlled
by the government. All the nationalized banks and regional rural banks are public sector banks.
Examples: State Bank of India and it’s 7 Subsidiaries. Bank Of Baroda Syndicate Bank Vijaya
Bank Canara Bank etc.

PRIVATE SECTOR BANKS These banks are owned and controlled by private institutions or
individuals and not by the government. Examples: South Indian Bank ICICI HDFC Axis bank
etc.

FOREIGN BANKS These banks are formed and registered in foreign countries and have their
head office in foreign country. as far as India is concerned, any bank registered outside India and
have a branch in India is a foreign bank. Examples Yes Bank Citi Bank HSBC Deutsche Bank
etc.

REGIONAL RURAL BANKS Regional Rural Banks (RRBs) were established by Regional
Rural Banks Act, 1976 with a view to satisfy the banking facilities and credit needs of the rural
people. Examples; Andhra Pradesh GrameenaVikas Bank, Chaitanya Godavari Grameena Bank,
Kerala Grameen Bank etc.

CO-OPERATIVE BANKS These are banks where co-operative societies that are formed at a
state or district level have a share of more than 51%. these are primarily set-up for the purpose of
services the farming community or to aid in land or infrastructure development at the state or
district level. They are of two:- 1. URBAN CO-OPERATIVE BANKS The term Urban Co-
operative Banks (UCBs), though not formally defined, refers to primary cooperative banks

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located in urban and semi-urban areas. These banks, till 1996, were allowed to lend money only
for non-agricultural purposes. This distinction does not hold today. These banks were
traditionally centred around communities, localities work place groups. They essentially lent to
small borrowers and businesses examples: - Maharashtra state apex co-operative bank Karnataka
state apex co-operative bank.

STATE CO-OPERATIVE BANKS State co-operative banks are the apex co-operative institution
in a state . They are federations of district co- operative banks, and they monitor the activities of
all co- operative banks in the state. Examples:- Kerala state co-operative bank Orissa state co-
operative bank x West Bengal state co-operative bank.

National bank for agriculture and rural development (NABARD) National bank for agriculture
and rural development (NABARD) was established as an apex bank that provides finance for
agriculture and rural development.

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INTRODUCTION TO SECURITIZATION

A lot has been written and spoken about securitization in recent times. Indeed, one has been
hearing about it in India since the early 1990s, but with increasing regularity in recent times. This
concept note is intended to place the concept of securitization in the right perspective, and
importantly, set aside some myths and misconceptions associated with it.

The ‘deals’ that have been talked about are Citibank’s sale of its car loan portfolio, among others.
With only this much information provided on this deal, it may be concluded that such
transactions are only in the nature of refinancing arrangements, since no new marketable
securitization, in our meaning, is explained in the following paragraph.

Consider the case of a limited company and its financing advantages over a partnership firm. A
partnership firm is based on relationships, which cumbersome to handle, and whose changes in
composition could affect the firm’s liquidity. In the case of limited company, share is issued to
each ‘partner’ and the company’s capital structure does not change with a change in the
composition of its ‘partner’. Shareholder come and goes as they please. This is because the
shareholder’s stake is concurrent with their holdings of share certificates, which are transferable
pieces of paper, called securities. Securitization therefore is the process of converting relationship
into transactions. The trend of debentures and bonds replacing illiquid loans by a bank is also a
step in the direction of converting relationship into transactions.

Securitization is an innovation of the home loan financing segment of banking, called residential
mortgage financiers. These organizations typically lend over a 20-year period, and need to raise
finance of sufficiently long tenors. A major asset they hold are the receivables in respect of loans
already granted.

Thus, these receivables are sold in order to garner receivable for a whole new round of fresh
loans. Therefore, the advantages of securitization are in the forms of.
1) Making illiquid receivable liquid

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2) Getting loans of long tenors, thereby withstanding the shocks that could come from short term
funding (asset-liability management or ALM) and
3) Lock on to a long-term, low-cost source of finance, enhancing their credit planning efforts.

Apart from the stated advantages, securitization also in enhancing the Capital Reserve Adequacy
Ratio (CRAR) and reduces the overall cost of capital due to transfer of risk off its balance sheet,
as explained later. Thus, securitization involves financial engineering with several associated
credit derivatives.

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HISTORY OF SECURITIZATION

Securitization may be said to have originated in Denmark. Loans were granted when bonds of an
equal amount and tenor were sold. This is form of asset-liability matching, resource management,
and even the interest margins are protected. Therefore seems to be sound policy. In Prussia,
bonds backed by mortgage loan were issued by some banks, the instrument, and a bond
symbolizing the underlying cash flows called pfandbrief. Interestingly, over its 200 years history,
no pfandbriefs has ever been defaulted upon. However, standardization and liquidity seem to
pose a problem, otherwise tradability of such instrument will be only in restricted markets.

Securitization in its modern form really took off in Chicago. Chicago is also a home to many
seminal developments in finance. Mortgage bankers would deploy their initial capital in creating
mortgages. Fresh borrowers would have to turn away. Chicago mortgages banker struck upon the
idea of selling the loan portfolios to larger mortgages banker. The largest mortgage bankers
carved of the stream of underlying receivables into tradable denominations as in equity and bonds
in order to attract investors and facilitate trading in these bonds. Other innovation followed. First,
the interest and principle portions were separately traded. These are called STRIPS, the acronym
for Separately Traded Interest Only (IO) and principal only (PO) Segments. Other innovation
included the splitting up of the bonds to sort investors having an appetite for varied lengths of
time. The details are explained elsewhere in this paper. To sum up, the underlying receivables
were carved in a process known as slicing and dicing, analogous to the beef cuts that were sold as
a marketable commodity, as opposed to trading in the whole animal itself. Securitization
instruments shorn of such innovations are known as plain vanilla securitization instruments.
The concept of securitization is rapidly spreading in several countries in various stages of
development. From the Danish origins and the pfandbriefs, securitization has spread and evolved
in the US. Policy makers in several developing countries are keen that securitization takes off,
since these are capital deficit countries. Securitization in these markets will strengthen lending
agencies and improve their linkages with the capita markets.

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SECURITIZATION TRANSACTION PROCESS

The successful execution of a securitization depends on the investor’s uncontested right to

securitized cash flows. Hence, securitized loan need to be separated from the originator of the
loan. In order to achieve this separation, a securitization is structured as a three-step frame work:

1. A pool of loan is sold to an intermediary by the originator of the loans. This intermediary (called
a special purpose vehicle or SPV) is usually incorporated as trust. The SPV is an entity formed
for the specific purpose of transferring the securitized loans out of the originator’s balance sheet,
and does not carry out any other business.
2. The SPV issues securities, backed by the loan, and by the payment streams associated with these
loans. These securities are purchase by investors. The proceeds from the sale of the securitized
are paid to the originator as a purchase consideration for the loan receivables.
3. The cash flows generated by the loans over a period of time are used to repay investors. There
could also be some credit support built into the transaction to protest investors against possible
losses in the pool. However, the investors will typically have no recourse to the originator.

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Diagrammatic representation of a securitization transaction

Issues
Transfer/sells PTC
loans SPV Investors
Originator (Trust managed by
(Owner of the assets) Consideration the trust)
Consideration
Payment
from Payment
borrower Collection account made to
deposit (Operated by the trusty) investors
from
originator

Loans Installment
(Assets) Payment
Borrowers Credit Support
(Given by the originator or
third party)

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PARTIES INVOLVED IN SECURITIZATION TRANSACTION

Originator: originator is the original lender and the seller of the receivables. Typically, the
originator is a Bank, a Non Banking Finance Company (NBFC), or a Housing Finance Company
(HFC). Some of the larger originator in India includes ICICI Bank, HDFC Bank and Citigroup.

Seller: The seller pools the assets in order to securitize them. Usually, the originator and the
seller are the same but in some cases originator sell their loans to the other companies that
securities them.

Obligors/borrowers: The borrower is the counter party to whom the originator makes the
loan. The payments made by borrowers are the sources of cash flows used for making investor
payments.

Issuer: The issuer in a securitization deal is the special purpose vehicle (SPV) which is typical
set up as a trust. The trust issues securities which investors subscribe to.

Investors: Investors are the purchase of the securities. Banks, Financial Institution, NBFC and
Mutual Fund are the main investors in securitized paper.

Service: The service collects the periodic installments due from individual borrowers in the
pool, make s payouts to investors, and follows up on delinquent accounts. The service also
furnishes periodic information to the rating agency and the trustee on pool performance. There is
a service fee payable to the service. In most cases, the originator acts as the service.

Trustee: Trustees are normally reputed Banks, Financial Institutions or independent trust
companies set up for the purpose of settling trusts. Trustees oversee the performance of the
transaction till maturity and are vested with necessary powers to protest investor’s interests.

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Arrangers: These are Investment banks responsible for structuring the securities to be issued,
and liasoning with other parties such as investors, credit enhancers and rating agencies to
successfully execute the securitization transaction.

Rating agencies: Independent rating agencies analyze the risks associated with a
securitization transaction and assign a credit rating to the instrument issued.

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VARIOUS STAGES INVOLVED IN WORKING OF

SECURITIZATION

 Identification Process: The lending financial institution either a bank or any other institution
for that matter which decides to go in for securitization of its assets is called the ‘originator’. The
originator might have got assets comprising of a variety of receivables like commercial
mortgages, lease receivables, hire purchase receivables etc. The originator has to pick up a pool
of assets of homogeneous nature, considering the maturities, interest rates involved frequency of
repayments and marketability. This process of selecting a pool of loans and receivable from the
asset portfolios for securitization is called ‘identification processes.

 Transfer Process: After the identification process is over the selected pool of assets are then
‘passed through’ to another institution which is ready to help the originator to convert those pools
of assets onto securities. This institution is called special purpose vehicle (SPV) or the trust. The
pass through transaction between the originator and the SPV is either by way of outright sale
basis. This process of passing through the selected pool of assets by the originator to a SPV is
called transfer process and once this transfer process is over the assets are removed from the
balance sheet of the originator.

 Issue Process: After this process is over the SPV takes up the onerous task of converting these
assets to various type of different maturities. On this basis SPV will issue securities to investors.
The SPV actually splits the packages into individual securities of smaller values and they are sold
to the investing public. The SPV gets itself reimbursed out of the sale proceeds. The securities
issued by the SPV are called by different names like ‘Pay through Certificates’, ‘Pass through
Certificates’. Interest only Certificate, Principal only Certificate. The securities are structured in
such a way that the maturity of these securities may synchronies with the maturity of the
securitized loans or receivables.

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 Redemption Process: The redemption and payments of interest on these securities are
facilitated by the collections by the SPV from the securitized assets. The task of collection of
dues is generally entrusted to the originator or a special service agent can be appointed for this
purpose. This agency paid certain commission for the collection service rendered. The servicing
agent is responsible for collecting the principal and interest payments on assets pooled when due
and he must pay a special attention to delinquent accounts. Usually the originator is appointed as
the service. Thus under securitization the role of the originator gets reduced to that of the
collection agent on behalf of SPV in case he is appointed as a collection agent. A pass through
certificate may be either ‘with recourse’ to the originator or ‘without recourse’. The usual
practice is to make it ‘without recourse’. Hence the holder of a pass through certificate has to
look the SPV for payment of the principal and interest on the certificate held by him. Thus the
main task of the SPV is to structure the deal raise proceeds by issuing pass through certificates
and arrange for payment of interest and principal to the investors.

 Credit Rating Process: The passed through certificate have to be publicly issued, they
required credit rating by a good credit rating agency so that they become more attractive and
easily acceptable. Hence these certificates are rated at least by one credit rating agency eve of the
securitization. The issues could also be guaranteed by external guarantor institutions like
merchant bankers which would enhance the credit worthiness of the certificates and would be
readily acceptable to investors. Of course this rating guarantee provides to the investor with
regard to the timely payment of principal and interest by the SPV.

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VARIOUS CATEGORIES OF SECURITIZATION

INSTRUMENT:

Asset Backed Securities (ABS) are instruments backed by receivable from financial assets like
vehicle loans, credit cards, personal loans and other consumer loan but excluding receivables
from housing loans. Mortgage Backed Securities (MBS) are the instruments backed by
receivables from housing loans. Collateralised Debt obligation (CDO) is instruments backed by
various types of debt including corporate loans or bonds.

Different types of securities:

Pass through and pay through certificates: In case of pass through certificates
payments to investors depend upon the cash flow from the assets backing such certificates. In
other words as and when cash (principal and interest) is received from the original borrower by
the SPV it is passed on to the holders of certificates at regular intervals and the entire principal is
returned with the retirement of the assets packed in the pool. Thus, pass through have a single
maturity structure and the tenure of these certificates is matched with the life of the securitized
assets.
On the other hand pay through certificates has a multiple maturity
structure depending upon the maturity pattern of underlying assets. Thus, two or three different
types of securities with different maturity patterns like short term, medium term and long term
can be issued. The greatest advantage is that they can be issued depending upon the investor’s
demand for varying maturity pattern. This type of is more attractive from the investor’s point of
view because the yield is often inbuilt in the price of the securities themselves i.e. they are offer
at a discount to face value as in the casa of deep-discount bonds

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Preferred stock certificate: Preferred stocks are instruments issued by a subsidiary

company against the trade debts and consumer receivables of its parent company. In other words
subsidiary companies buy the trade debts and receivables of parent companies to enjoy liquidity.
Thus trade debts can also be securitized through the issue of preferred stocks. Generally these
stocks are backed by guarantees given by highly rated merchant banks and hence they are also
attractive from the investor’s point of view. These instruments are mostly short term in nature.

Asset-based commercial papers: This type of structure is mostly prevalent in mortgage

backed securities. Under this the SPV purchases portfolio of mortgages from different sources
(various lending institution) and they are combined into a single group on the basis of interest
rate, maturity dates and underlying collaterals. They are then transferred to a Trust which in turn
issued mortgage backed certificate to the investors. These certificates are issued against the
combined principal value of the mortgages and they are also short term instrument. Each
certificate is entitled to participate in the cash flow from underlying mortgages to his investments
in the certificates.

Other type

Apart from the above there is also other type of certificate namely
i. Interest only certificates
ii. Principal only certificate.

In the case of interest holding certificate payments are made to investors only from the interest
incomes earned from the assets securitized. As the very name suggest payment are made to the
investors only from the repayment of principal by the original borrower. In the case of principal
only certificates these certificate enables speculative dealings since the speculators know well
that the interest rate movements would affect the bond value immediately. For instance the
principal only certificate would increase the value when interest rate go down and because of
these it becomes advantageous to repay the existing debts and resort to fresh borrowing at lower
cost. This early redemption of securities would benefit the investors to a greater extent. Similarly
when the interest rate goes up, interest holding certificate holders stand to gain since more

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interest is available from the underlying assets. One cannot exactly predict the future movements
of interest and hence these certificates give much scope for speculators to play the game.

Need of Special Purpose Vehicle (SPV) in securitization:

The investor’s return in securitization transaction should depend purely on the securitized cash
flows and should be insulated from the financial risks associated with the originator. Hence, it is
necessary to have legal separation of these assets from the estate of the originator. This is
achieved by means of sale of the assets to SPV. The SPV is set up solely for the purpose of the
securitization transaction and does not engage in any other business activity. The SPV does not
borrow or lend any money and hence cannot go bankrupt. Most SPV follow a set of pre-
determined activities clearly identified by the securitization documents. Without the flexibility of
taking any management decision. This mode of structuring the transaction ensures that
securitized assets become bankruptcy remote from the originator.

Securitized instruments v/s Debentures v/s factoring

An investor in a debenture issued by a bank or a loan originator will be on official liquidator’s list
in the event of its winding up. However, a PTC holder has access to the obligor’s asset, and is
hence saved from winding up. Liquidation or bankruptcy proceedings. PTC therefore, is
understood to be bankruptcy-remote.
Secondly, credit perception of PTC is based on the strength of the obligor and not the balance
sheet of the originator. This is the feature that enhances the credit rating of the PTC, which is not
the case in Debentures, which is based on the originator’s own balance sheet.
For the above reasons, coupon rates on securitized instruments are lower than coupon rates on
plain vanilla bonds.
Thirdly, securitization can result in the return of a fraction of principal loan along with interest, as
part of each installment. In the case of debentures and other bonds, the initial stream of payments
is in respect of interest only, with entire repayment in bullet form on a specified maturity date. At
period intervals, say monthly installments, every rupee of the installment amount is adjusted
against a fraction of principal and balance against interest.

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There have also been interesting comparisons between securitization and factoring services. The
similarities are in the refinancing aspect, as both the processes result in exchange of receivables
for cash inflows. There are however, significant differences. Factoring is predominantly a
service, collection mechanism. With financing (in the case of advance factoring). Securitization is
essentially a financing mechanism, with several other powerful financial engineering
implications. Additionally, in factoring, no marketable financial instrument comes into existence.
To sum up, it may be stated that an organization engaged in advance factoring may resort to
securitization as a source of finance!

Securitization different from traditional debt instruments:

Securitized instrument have some distinct features which distinguish them from traditional debt:
 Isolation of pool of assets: In the securitization the securitized assets are separated from the
original lender through a sale to a separated legal entity called as a Special Purpose Vehicle
(SPV) which acts as an intermediary.
 Claims against a pool of assets: Traditional debt instrument represent claim against the
company that issue the debt. Investors rely entirely on the borrower company’s credit quality for
repayment of their debt. In securitization transaction, investor payout is made from collection of
securitized assets and the instruments are thus claims on the assets securitized. Investor does not
typically recourse to the originator.
 Credit enhancement: Credit enhancement is an additional source of funds that can be used if
collections on the assets are insufficient to pay investors their dues in full. Credit enhancement
thus support the credit quality of the securitized instrument and enable it to achieve a higher
credit rating than the pool of assets on its own, in many cases the rating would also be higher than
that of the originator. This is not possible in conventional debt.
 Payment Mechanisms: securitized instrument typically incorporate structural features to
ensure that scheduled payment reach investor in a timely manner.
 Operational and administrative requirements: as the SPV is the only shell entity the
administration of the pools of securitized loans involves multiple parties performing various

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functions. These functions include collection, accounting, and loan servicing, legal compliances
etc which need to be performed through out the life of transaction.

Economic benefit of securitization:

Securitization creates tangible economic benefits. These benefits are more visible in US and other
developed countries where securitization markets have matured over the past two decades.

Market Efficiency: Through securitization process the companies holding financial assets like
loans have ready access to low cost sources of fund and can reduce their dependence on financial
intermediaries for their capital requirement. This translates into lower interest cost the benefits of
which are also passed to the end consumers.

Specialisation: The classic bank/financial institution model of Origination-Funding-Credit

administration of loans has led to an unbundling of roles and greater specialization as various
player can now concentrate on their core function, be it origination, funding or credit
administration.

Streamlined system and process: Securitization demand high levels of data transparency and
requires robust system. This enhances the overall monitoring and control of asset portfolios.
Why securitize? An originator’s perspective.

 Efficient Financing: In securitization it is possible to achieve much higher target rating for
instrument than the originator’s credit raring by providing credit rating enhancements for the
transaction. Thus the borrower can obtain fund at lower interest rates applicable to highly rated
instrument and gain a pricing advantage.

 Off balance sheet funding: For accounting purposes securitization is treated as a sale of
assets and not as financing. Therefore the originator does not record the transaction as a liability
on its balance sheet. Such off balance sheet raise funds without increasing the originator’s or debt
equity ratio.

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 Lower capital requirement: Securitization enables banks and financial institutions to

meet regulatory capital adequacy norms by transferring assets and their associated risks off the
balance sheet. The capital support the assets is released and the proceeds from securitization can
be used for further growth and investment.

 Liquidity management: Tenor mismatch due to long term assets funded by short term
liabilities can be rectified by securitization as long term assets are converted into cash. Thus
securitization is a tool of asset liability management.

 Improvement in financial ratios: Since securitization help in undertaking larger

transaction volumes with the same capital profitability and return on investment ratios increase
post securitization.

 Profit on sale: Securitization helps in up-fronting profits. This would otherwise accrue
over the tenor of the loans. Profits arise from the spread is booked as profit leading to increased
earnings in the year of securitization.

Why invest? An investor’s perspective.

Securitization instrument offer investors an attractive investment proposition since they combine
above average yields with a strong credit performance. Potential investors in this instrument in
India should consider the following factors:

 Size of investment opportunity: The securitization market in India is growing leap

and bound. In the financial year 2004-05, securitization volumes are expected to reach Rs
250billion with 15% of retail loans (excluding MBS) currently funded through securitization.

 Safety Features: Securitization offers investors a diversification of risks, since the

exposure is to a pool of assets. Most issuances are highly rated by independent credit rating
agency and have credit support built into the transactions. Investors get the benefit of the

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payment structure closely monitored by an independent trustee which may not always be in the
case of traditional debt instruments.

 Performance track record: Securitization instruments have demonstrated

consistently good performance with no downgrades or defaults on any instrument in India.

 Yields: Yields of ABS/MBS/CDO are higher than those of other debt instrument with
comparable rating. Spreads of securitized instrument are typically in the range of 50-100 basis
points over comparable AAA corporate bonds.

 Flexibility: An important advantage of securitization is the flexibility to tailor the

instrument to meet the investor’s risk and tenor appetite.
Durations can range from few months to many years.
Repayment are usually made on monthly basis but can be structured on a quarterly or semi
annually basis
Interest rate can be fixed or floating depending upon investor preferences.

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UNDERSTANDING RISKS IN SECURITIZATION

Risk investors face in securitization:

Investors in securitized instruments can take advantage of the benefits that these instrument offer,
however they also need to be aware of the inherent risks in these transaction. These risks
classified into:
 Asset pool risks which arise due to the unpredictable behavior of the underlying
borrowers. The payment behavior of underlying borrowers can be estimated with a reasonable
degree of accuracy based on historical data.
 Legal risks due to lack of judicial precedence on securitization legislation and regulation.
 Counter party risk arise as a securitization transaction involved multiple parties
throughout the tenure of the instrument. The investor’s returns can be impacted by non-
performance or bankruptcy of any of these counterparties.
 Investment risks like all other investment securitized instruments are subject to market
related risks.

Investors are protected against these risks by means of structural features and credit
enhancement which enable the instrument to achieve high credit ratings.

Assets pool risk in a securitization and mitigation:

Assets pool risks are classified into credit risks and prepayment risks.

 Credit risks: Investors have a direct exposure to the repayment ability of the underlying
borrowers whose loans have been securitized. If borrower default on payment of installments or
make delay payment collection will be inadequate to scheduled investors payouts. Thus timely
investor payments will depend on the credit quality of the pool borrower.

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 Mitigation: Credit enhancement provide for PTC is sizes to cover the expected levels of payment
default and delays. In case there is short falls in the collection the credit enhancement is used to
make timely payment to the investors. However, in the event of short falls over and above credit
enhancement levels investors will incur losses on their investment.

 Risk of prepayment: Investors face the risks that underlying borrowers may prepay all or part of
the principal outstanding of their loans. When prepayment occurs they are passed on to the
investor (unless the instrument structure provides for a separate class of PTC to absorb
prepayments). This can affect investor in two ways:
o Reinvestment risk: If there are heavy prepayment in the pool the average tenure of the
instrument reduces resulting in reinvestment risk for the investor.

o Prepayment loss: If the investor has paid an additional consideration to receive excess
interest spreads generated by the pool the investor principal outstanding is greater than the pool
principal outstanding. Hence when the contract is prepaid this excess interest spread payable to
the investor from that contract is lost. Hence prepayments can result in the shortfalls in payments.

 Mitigation: Reinvestment risks can be mitigated by carving out a separate class of PTC from pool
cash flows to absorb prepayments occurring in the pool. This class of PTC is called a
‘prepayment strip’ and commonly found in securitized instruments. Prepayment loss is mitigated
as the credit enhancement is sized to cover such losses. However in case of excessive prepayment
losses greater than the credit enhancement amount will be borne by the investor.

 Property/asset price risk: Assets backing securitized instruments may be prepossessed and sold
post securitization. The proceeds and loss on sale depends upon market values of the assets,
which fluctuate.

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LEGAL ISSUES WITH SECURITIZATION

Documents that are used in securitization transaction:

Following document is part of the securitization transaction and represents current practice in the
securitization market. Some or all of these would be used in any securitization transaction.
 Trust deed: This document settles a trust for the purpose of purchasing the receivables. The
right and duties of the trustee are spelt in this document.
 Deed of assignment of receivables: This document evidences the transfer of receivables to the
trust for the consideration. It is made by the originator in the favors of SPV.
 Declaration of trust: The unilateral document prepaid by the originator, where the originator
acts as the SPV/trustee, declaring that it holds the receivables in trust for the investors.
 Information memorandum: The offer document that provides details of the proposed
securitization of receivables to the potential investors.
 Service agreement: Outlines the terms and conditions of the securitization transaction and the
right and the duties involved. It also lays down the right and duties of servicing agents.
 Cash collateral agreement: Spells out the termed and conditions under which the cash
collateral and yield reserve can be utilized/released. This agreement is executed between the
seller/service and a designated bank where the cash collateral will be maintained.
 Power of attorney: This authorizes the trustee to execute acts and deeds with regards to the
securitization contracts, including the enforcement of security.
 Collection and payout account agreement: This document spells out the operational details
of the collection account.

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Stamp duty impact securitization transaction:

Stamp duty can be described as a tax levied on all documents of a commercial nature. Stamp duty
is an important issue for securitization transaction executed in India due to:
 Serious consequences of stamp duty evasion: Inadequately stamp documents attract an
enormous penalty, sometimes as much as ten times the deficiency in stamp duty paid. Documents
that are inadequately stamped are also not recognized in court as evidence and are therefore
unenforceable.
 Bearing the cost of stamp duty: The general is that the person claiming the benefit of a
document should bear the stamp duty or any penalties/fines levied on that document.
 Differential role of stamp duty: All states in India are empowered to determine their own
stamp duties and these vary from state to state.
In most of the states sale of asset attracts high stamp duty, sometimes up to 12% of the value of
the assets transferred. This result in prohibitive transaction costs. Only the states of Maharashtra,
Gujarat, Tamil Nadu, West Bengal, Andhra Pradesh and Karnataka have enacted stamp duty law
favorable to the transfer of assets. Legal expert believe that a consequence of the differential
stamp duty is that if document executed in one state is taken into another state, the document is
liable to be stamped in the second state if the stamp duty in the latter is higher.

True sale of assets relevant in securitization:

True sale ensures that the sale of assets in a securitization is absolute and binding and effectively
removes the financial assets from the balance sheet of the originator. It is relevant since the
investor’s return in asset securitization depends purely on cash flows from the securitized assets.
A ‘true sale’ will ensure that the investor’s rights and entitlements in respect of these cash flows
are not affected in case of bankruptcy or liquidity of the originator.
There is no statutory definition or judicial interpretation of true sale as yet in India. However, the
following issues are pertinent in evaluating a transaction for ‘true sale’:
 Extent of recourse to and risk retained by the originator in the securitized assets: Generally
company is of the opinion that in cases where the originator retains a high level of risk in the
assets, the courts are likely to recognize the transaction as a secured borrowing.

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 Options and obligations to repurchase assets: The presence of an option to repurchase does not
by itself negate true sale. However, company treats an originator’s obligation to repurchase assets
on account of deteriorating asset quality as inconsistent with true sale.
 Extent of control retained by the originator over the assets: Company will acknowledge a
transfer as a true sale only if the transferee gains unrestricted rights to the assets.

Company like CRISIL, CARE also bases its analysis of a securitization transaction on
professional opinion from an independent legal counsel, confirming that the transfer of assets is
consistent with a true sale.

NHB role in Mortgage Backed Securitization (MBS):

The National Housing Bank (NHB) is a regulatory body to promote and support Indian housing
finance companies (HFC and the housing portfolios of banks). NHB has played a lead role in
starting up MBS and developing a secondary mortgage in India by:
 Setting up Special Purpose Vehicle (SPV) for MBS and acting as a trustee to the issuance on
behalf of investors.
 Acting as a guarantor and facilitating MBS transactions.
 Acting as a refinancing arm for HFC by making loans and advances as well as rendering
financial assistance to scheduled banks and HFC.
 Making continual efforts to generate awareness about residential MBS among market
participants.

Risk applicable on MBS investments for Banks:

To improve the flow of credit housing sector, RBI has liberalized the prudential requirement on
risk weight for housing finance by Banks. Accordingly, Banks extending housing loan to
individual against the mortgage of residential housing properties will be permitted to assign risk
weight of 75% instead of the earlier requirement of 100% provided certain condition are met.
However,

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Loans against the security of commercial real estate will continue to attract 100% risk weight.
Moreover, bank investments in MBS of residential assets of HFC will also be eligible for risk of
75% for the purpose of capital adequacy, subject to certain terms and condition.
 The loans should be securitized under the ‘true sale’ of assets to the SPV.
 The loans to be securitized should be loans advanced to individuals for
acquiring/constructing residential houses, which should have been mortgaged to HFC
by way of exclusive first charge.
 The loans to be securitized should be accorded an investment grade credit rating by a
credit rating agency at the time of the assignment of SPV.
 The securitized loans should be originated from housing finance company/banks.

Can banks invest in PTC?:

Banks can invest in PTC. The Reserve Bank of India (RBI) issued guidelines in November 2003
prescribing prudential limits for banks on all non-SLR investment, specifically for investments in
unlisted securities. In December 2003, RBI clarified that investment in either security receipts
issued by securitization companies/reconstruction Company registered with RBI, or Assets
Backed Securities (ABS) and Mortgage Backed Security (MBS) which are rated at or above the
minimum investment grade will not be reckoned as unlisted non-SLR securities for computing
compliance with the prudential limits prescribed in the above guidelines. Therefore there is no
impact on the ability of the banks to invest in PTC as issued currently in transaction. It is
expected that the PTC would soon be specifically notified as securities under SCRA and hence
get listed.

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RATING PROCESS IN SECURITIZATION

Rating scale employed by credit rating agency in securitization transaction:

Credit rating agency has developed a framework for rating the debt obligation of Indian corporate
supported credit enhancements. For example CRISIL ratings of structured obligation (SO) factor
the credit enhancement extended by an entity, which could be in the form of guarantees, over
collateral, cash etc. (SO) rating are based on the same scale as CRISIL other rating (AAA
through D for long term debt, and P1 through P5 for short term debt). The rating indicates the
degree of certainty regarding timely payment of financial obligation on the instrument.

Provisional rating:

When any credit rating agency rates a securitized pool of assets, it initially assigns a ‘provisional
rating’. The provisional rating assigned is valid for a period of 90 days, before which the
originator must comply with the following:
 Submit copies of all executed transaction documents to credit rating agency.
 Submit a letter from the trustee confirming that the transaction documents have been executed to
the trustee’s satisfaction.
 Furnish representation and warranties as stipulated by credit rating agency.
 Submit an auditor’s certificate where required.
 Submit the required legal opinion from an independent counsel.

Upon receipt of the above documents, credit rating agency examines if the documents are in line
with the transaction structure as envisaged at the time of assigning provisional rating. If the
documentation and the other compliances are to credit rating agency satisfactions than agency
issues a letter of compliance for the transaction formalizing rating.

Rating process for securitization:

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Initial Mandate letter received from the client

Transaction details and structure communicated to rating company.

Company send its information requirement to the client specifying

Rating details of the information needed for the analysis. Based on
information made available, the rating team has detail managed
meetings to understand the originator business, process, assets quality
parameters, pool characteristics etc.

Team put together a rating report based on its interactions and presents
its report and recommendations to the rating committee.

A provisional rating is assigned to the transaction. If the client accepts

this, Company issues a rating letter with the rationale for the rating
Process
assigned

Post A compliance letter for the rating is issued once the final transaction
issue documents, legal opinion and other compliance documents have been
received by Company legal analyst and compliance team.

Monit
oring
Company does not end with the issue of the initial rating. Company has
a dedicated surveillance team, which monitors the performance of the
securitized pool every month to ensure that it is line with the
outstanding rating

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Typical due diligence done at the time of rating:

Credit rating agency carries out a through due diligence for all rating, before and after the
provisional rating.

 Originator due diligence: The due diligence of originator MIS and the risks control
mechanism give a fairly good idea of the originator assets portfolio vis-à-vis industry
benchmarks, and forms critical inputs in the stipulation of the credit enhancement levels for
transaction.
 Pool due diligence: Agency check if all pool contracts adhere to stipulated selection criteria.
Auditor’s statement are obtained to ensures that all information furnished to rating agency
relating to the pool has been verified and found to be correct and true.
 Transaction structure: Rating agency analyses the structure for each transaction to
adequately assess any risks which investors might face. This is extremely important as the
structure is becoming more complex.
 Legal due diligence: The legal team also checks the draft transaction documents, to identify
any legal issues pr legally untenable clauses. The basic documentation examined is the trust deed,
assignment agreement/deed of assignment, service agreement and cash collateral agreement. The
corporate undertaking or guarantee is also examined where relevant.

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Origination system

Management Credit appraisal and underwriting Risk

Information Control
System Mechanis
(MIS) m

Disbursement and post disbursal

documentation

Collection and recovery mechanism

Due diligence structure

Surveillance process adopted by rating agency:

Rating agency believes it is of vital importance to monitor pool performance so that it is in line
with the outstanding rating. Surveillance is necessary because the receivables from the pool of
assets are used to service investors payouts. The investor’s recourse is thus limited to these
receivable, and to credit enhancements, if any provided by the originator.

Additionally, complex structures have been introduced recent times in the securitization market,
with issuances incorporating staggered payouts mechanisms, floating rate instruments and trigger
based structures. These complexities require close monitoring by the trustee and the rating

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agency to ensures that the instruments adhere to the originally stipulated and appropriate action is
initiated at the right time in case of any deviation.

Rating agency has set up a dedicated surveillance team to monitor the performance of rated
pools. Transaction is monitored on a monthly basis and the key parameter is tracked. This is done
on the basis of monthly servicer reports provided by servicer/trustees. The reports are checked for
accuracy and performance analysed. Thereafter, the team interacts with the concerned parties to
understand the reasons behind the trends, and the likely steps have been or need to be undertaken
to arrest adverse fluctuations in the pools performance.

A comprehensive review is under taken at least once a year, unless warranted more frequently by
deviations in the monitorables from rating agency estimates.

Key monitorables of rating agency surveillance process:

 Collective performance: The collection performance is analysed in terms of monthly

collection ratio (MCR) and cumulative collection ratio (CCR).The MCR gives the
flow element of the pool collection performance and acts as an early warning
indicator. The CCR reflects the stock element of the pool collection performance.
 Delinquency level: Credit rating agency analysis the overdue levels in terms of
various delinquency buckets. This analysis provides an estimate of the credit losses in
the pool to date and gives an indicator of future losses.
 Counter party credit quality: Rating agency also monitors the credit quality of the
counter parties involved in the transaction. These include the servicer, the trust, the
retention account bank, the cash collateral bank or guarantor and the swap counter
party.
 Credit support: The credit enhancement available indicates the level of cushion in
the transaction. This cushion is required to withstand relevant stress levels for the
corresponding rating category. This parameter rounds off the overall analysis and
ensures that the outstanding rating is current.

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In addition the credit rating agency monitors other parameters such as prepayment, collection
efficiencies and collateral utilization.

Indian experience with securitization:

Securitization commenced in India with a car loan transaction originated by Citibank in 1992.
Since then, the market has grown rapidly, with India become the third largest securitization
market in Asia, after Japan and Korea. Proceeds from Asset Backed Securitization (ABS)
transaction account for close to 15% of incremental disbursements in the Indian consumer
finance market, underlining the importance of securitization as a financing tool. Market
sophistication has also increased rapidly in 2004-05 with the advent of new asset classes and
structures.

Breaking new ground:

 1992: First auto loan securitization was done by Citibank.

 2000: First MBS was done by National Housing Bank.
 2001: First offshore transaction backed by aircraft purchase receivable.
 2004: First successful multi asset was done by ICICI Bank.

Size of the market: Rating agency estimates that over 330 transactions, involving a cumulative
volume of Rs 530 billion, have been placed in the market. Issuance has grown exponentially with
ABS volumes growing at a CAGR of 51% and MBS volumes growing at a CAGR of 65% since
2000.

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Originator and investor in securitization market:

Securitization has gained popularity over the years as reflected in the increasing number of
originator entering in the market. Some key originator in the market includes ICICI Bank, HDFC
Bank, Citigroup, and Tata group.
The predominant investors in securitized instrument are mutual funds, public sector
bank, foreign bank, private sector banks and insurance company.

Asset classes securitized in India:

Assets Backed Securities Collateralized Loan

Obligation
Cars Corporate bonds
Commercial vehicles Municipal bonds
Two wheelers W.C. & term loan facilities
Construction equipment Sales tax loan receivable
Aircraft purchase receivable Corporate loans
Personal loans Oil receivable
Utility vehicles Lease receivable
Used cars
Three vehicles Mortgage Backed
Securities
Office equipment receivable Residential loans

Forms of Special Purpose Vehicle used in India market:

In India, an SPV is typically in the nature of trust. The trust is usually settled by the third party
who is appointed as the trustee, to manage the trust properties (the securitized assets) and
distribute the income from the same. The trustee is the legal owner of the assets, whereas investor
is entitled to all the benefit arising from the trust properties. An SPV can also be formed by

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declaring trust over the assets. In such cases, the originator holds the assets are transferred to the
investors, while the legal ownership of the assets continues to vest with the originator in its
capacity as the trustee.

Common structure used in the Indian market to securitise assets:

Structures have evolved in India based on investor risk, tenor preferences, and issuer
requirement.
 Fully amortising structure: In India, we see fully amortising instrument (i.e. principal is repaid to
the investors along with the interest over the tenor of the PTC). This is different from bullet
structure, where the entire principal is repaid at maturity. Fully amortising structure is designed to
closely reflect the full repayment of the underlying loans through the interest and principal
payment.
 Par and premium structure: In par structure, the investor pays a consideration equal to the
principal outstanding (par value) of future cash flows. In return the investor is entitled to receive
scheduled principal repayment from the pool of receivable along with a pre decide rate of
interest. Par structure also has an element of Excess Interest Spread (EIS) generated if the yield
on the pool is higher than the yield on the PTC. The originator has the right to receive the EIS
amount.
A premium structure is one where the investor pays a consideration greater than the principal
outstanding of future cash flows, for the additional right to receive EIS arising from the
securitized assets. Predominantly, par structure is used in MBS and premium structure is used in
ABS.
 Senior subordinate structure: Cash flows from the securitized assets can be carved into multiple
classes of securities having different tenors and risk profiles. The senior class is accorded the first
claim on the cash flows from the pool, whereas the subordinate class has a lower claim. Thus, the
subordinate class is ‘first loss price’ and the support payment to the senior classes. Typically in
India, senior classes are highly rated instruments while subordinate classes are unrated and
retained by the originator.
 Fixed and floating rate structures: PTC is issued at both fixed and floating rates of interest.
The motivation for fixed or floating rates depends on interest rate trends in the economy. Investor

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preferences and other such parameters. Recently there have been many issuances at floating rates,
where the rates are benchmarked to a designated index like the NSE, MIBOR. If underlying
assets are fixed rate loans, floating coupon rates introduce the element of interest rate risk in the
transaction. This risk can be mitigated by using an interest rate swap with a swap provider who
exchange rate payouts made by the trust for floating rate payout to the investors.

Credit enhancement found in India:

The most common forms of credit enhancement found in the Indian market are listed below.
They are not mutually exclusive a combination of two or more forms of credit support is often
used.
 Cash collateral: This is an external form of credit support. The originator or the third party
provides a predetermined amount of cash, which is put into the reserve account. Withdrawals can
be made from this account to off set losses on the securitized assets. The cash collateral is held by
the trustee in the favor of investors.
 Excess interest spread: This is an internal form of credit enhancement available in transactions
where the interest rate received on underlying loans is higher than the interest rate paid on the
PTC backed by those loans. This give rise to excess margin or spread that can be applied to offset
in the pool collection.
 Subordinate tranches: One of the common methods of credit enhancement is senior subordinate
tranches structure, where the subordinate tranches acts as a credit enhance for the senior tranches.
 Over collateralization: This is the form of credit enhancement where the principal outstanding of
securitized assets is greater then the principal outstanding of the PTC. For example, if Rs 150
million of assets backs Rs 100 million of PTC, then Rs 50 million is the over collateral in the
transaction. After the PTC redeemed, the over collateral assets belong to the residual beneficiary
in the transaction.
 Guarantees: A legally valid and enforceable guarantee from the higher rated entity for funding
shortfalls in collections is external form of credit enhancement. Such guarantee if present are
usually limited to predetermined amount.

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Waterfall mechanism structured:

The term ‘waterfall’ is used to describe the order of priority in which proceeds realized from
securitized assets will be utilized. Payments to stake holders in the securitization will be made as
per the term and conditions laid out in the ‘waterfall’.
 Statutory or regulatory dues pertaining to the securitized receivable.
 Expenses incurred by service provider like the trustee agent, rating agency, auditor and
legal advisors.
 Senior PTC holder’s payment.
 Top up cash collateral.
The residential amount. If any is paid to subordinate PTC holders, if there are no subordinate
PTC, the residual amount flows back to the residual beneficiary in the transaction, usually the
originator.

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INNOVATION IN SECURITIZATION

Strips

STRIPS are the acronym for Separately Traded Interest and Principal Segments. The interest and
principal steam of cash flow are deterministic and are known in advance. These are sold at their
present values as deep discount bonds. The principal only (PO) and interest only (IO) segments
represent two synthetic instruments that are excellent hedging instruments. By investing in
various combinations, investors can create their own risk-return profile, something not enabled
by holding plain-vanilla puts. The strip reacts differently to changes in interest rate behavior. To
understand this better, think of strips to be the present values of a stream of cash flows, denoted
by Where C represents the cash flow from the underlying receivables T Represents the timing of
the cash flow, R Represents the current rate discounting, the market yield The price movements
of strips are impacted the repayment effect, discounting effect and their combined effect.
In the case of PO, a fall in market interest rates would induce mortgage borrowers to prepay
existing loans and borrow a fresh at lower rates. This will accelerate the cash flows appearing in
the numerator, and reduce the discounting factor in the denominator; both effect together leading
to a value appreciation and hence price of a PO. Reserve is the case for a rise in the interest rates
where borrowers would stay put and tend to prepay, and the denominator rising, leading to a fall
in the price of a PO.

In the case of the IO, a fall in the markets interest rates would reduce the denominator to lift the
price. However, due to repayment, large section of outstanding would be bereft of future interest
inflows. This represent losses in the interest income to service the IO. The magnitude of interest
rates shift and prepayments would determine the combined effect and final value of the IO. A rise
in the interest rates would protect the numerator, but there will also be a rise in the denominator.
Here again, the combined effect and the impact on the final valuation depends on the magnitudes
of the rate shift.

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Hedging instruments, bank investing in the long end of the market would like interest rates to be
high. They therefore would buy Pos to protect their losses. Bank wanting interest rates to fall to
increase their lending volumes would be interested in getting hedge protection by investing in
Ions. Thus, it is to be understood that PO and IO strip moves in opposite directions in relation to
interest rates shift in order to devise hedging strategies.

Tranched transactions

Tranched transactions are Collateralized Mortgage Obligation (Comes). The normal pass through
mechanism is altered here to mean pay through. In other words, under the pay through structure,
the SPV merely acts as a payment gateway. Under the pay through structure, the SPV plays an
active role in determining which class of securitized instruments gets a priority in the principal
repayment, meaning that the other classes of instrument get only the interest for the time being.
The sequence goes on until, in a phased manner, all classes of instruments are fully redeemed
with interest. This pattern facilitates the attraction of investors with varying appetites of loan
tenors and interest rates.
As an illustration, consider the following tranches:

Type Amount Coupon Repayment

raised % Years
(Rs. p.a.
Lakhs)
A 50.00 8.00 1 to 5
B 50.00 8.25 6 to 10
CAT 50.00 8.50 11 to 15

The A, B and C classes of securities represent different classes of investors. The tranches are
shown as fixed interest bearing securities. The interest rates are hypothetical and illustrative in
nature.

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There could be a variation, where tranches C assume the name Z, where the entire interest is re-
appropriated to the repayments of A, and the amounted temporarily foregone is added back to the
outstanding principal Z. these Z tranches are wildcards and are hedging instruments as well as
catering to the appetite of risk friendly investors. Note that the presence of B, C and Z tranches
serves as cushions to safeguard A. the presence of such cushions raises the credit rating of A
class securities and hence lower there coupons obligation in the risk return matrix.

It is possible to switch from an existing fixed-interest security like A, B or C into a floating rate
mechanism, using financial techniques. The instruments so designed would be called Floaters and
Inverse Floaters. A brief description is provided below.

Floaters

A coupon-bearing bond where the coupon rates is linked to a reference rate. The investors gains
when the reference rates rises. The floating rates are equal to or above the reference rates, the
difference between the two rates being the quality spread (i.e. the risk element embedded in the
interest rate). Floaters are issued on a stand-alone basis or complementary to Inverse Floaters.
Inverse floaters

These are issued complementary to floaters. The coupons rates are pegged at a fixed ceiling rate
minus floating rate. For example, if the floating rate is say 7%, and the ceiling rate is at roughly
double, say, 155 the coupon on the inverse will yield (15-7)% = 8%. When floating rates rise to
say 9%, the inverse will yield less, i.e. (15-9) % = 6% and vise versa. A set of floaters and
inverse floaters can be used to replace fixed coupon bearing bonds. In such situations, class
securities would be split in the ratio 1:1, via Rs. 25 lakhs floaters and other Rs. 25 lakhs inverse
floaters. In many cases the investment bankers assist in designing such instruments.

Variations of this theme are supper-floaters and super –inverse floaters. For example, Rs. 50
lakhs interest at 8.50 could be split in the ratio 2:1, into Rs. 34.5 lakhs floating at say 8% at a
point in time, or say, reference rate of 7% + 1%, at a point in time. This comes with a co-existing
inverse-floating rates of (ceiling of 24% - 2 times the floating rate of say 8%) = 44% at a given
point in time. The inverse-floaters are issued for an amount of Rs. 17.5 lakhs, half the amount of

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the floating securities. Considering the magnitude of the amount and the ceiling interest rate, the
inverse floaters assume the name ‘super-inverse’ floaters.

A close perusal the two schemes outlined will reveals the interest rate hedging mechanism of the
floating rate securitized instruments.

CAT Bonds

Until now, the applicability of the securitization was assumed to be in the banking sector.
However, Catastrophe Bonds as they are called is also an effective risk transfer and risk financing
device in the insurance sector. The mechanism of CAT bonds is explained in the paragraph
below.

Let us assume that there is an insurance company, and it has done well in extending its business
in say, Gujarat. The premium incomes are with the company. It could so happen that a
catastrophe in Gujarat could lead to claim amounts that could wipe out this insurance company.
The conventional method of dealing with such risk would be elements of re-insurance, where part
of the premium would be ceded by the insurer to the reinsurers, taking a proportionate amount of
risk also off its balance sheet. However, it must be appreciated that there could be some
catastrophic events which make even so-called normally anticipated losses are exceeded. To avail
of contingent financing for contingent events, the device of CAT Bonds has been innovated.
Here, CAT Bonds are issued at a high coupon rate for the contingent amount, to cover the
perceived under-financed claim-losses. Catastrophic losses beyond the threshold level trigger the
appropriation of CAT Bonds principal proceeds to settle claims, the principal now not being
repayable to the CAT Bonds investor. If no claim arises on CAT Bonds, the entire proceeds are
refund on expiry of the term of the risk insured against, in which case the interest is a clean profit
for the investors. The redemption amount is secured against stream of premium payments, as
insurance companies gain credibility (hence business and premium inflows) when they
successfully settle claims over a period of time. Thus, CAT Bonds represents the conversion of
risk, packaging them into a tradable commodity and garnering capital markets solutions to
safeguard against losses from natural calamities.

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Notably, all that is an SPV acceptable to the potential investors, the SPV essentially is a trust that
can be wound up once the objectives of the trust are achieved. Its role is only in appropriating
payments in a diligent manner to safeguard the investor’s interest, it is the collective
representation of the investors. Thus reinsurance-type protection as reinsurance can be offered
through the mode of securitization, obviating the need for incorporation as a reinsurance
company and the requisite minimum capital requirement of Rs.200 cores.

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Conclusion:

Securitization in is at the crossroads. A lot has been heard about it since 1990, very little done.
We are familiar with the sad Indian story of minor irritants playing a major role in stalling major
development. But just as the revolution in India was out come of import liberalization for
computers, so also, it is only a matter of time before high quality securitization forms the
backbone of housing, infrastructure and trade finance in India.

Securitization is expected to become more popular in the near future in the banking sector. Banks
are expected to sell off a greater amount of NPAs to ARCIL by 2007, when they have to shift to
Basel-II norms. Blocking too much capital in NPAs can reduce the capital adequacy of banks and
can be a hindrance for banks to meet the Basel-II norms. Thus, banks will have two options-
either to raise more capital or to free capital tied up in NPAs and other loans through
securitization.

In the view of the team, the recommendations that appear below provide an adequate solution to
the regulatory problems that arise in plain vanilla securitization transactions. If these
recommendations are implemented, there will no longer be any regulatory barrier to the creation
of securitized assets that will be sold to the public and to institutional investors, which will
contribute to the efficiency and competition of the capital market. It is hoped that securitization
will make it possible for small banks and nonbank entities to raise capital against economic
activity that produces relatively assured cash flows that can be sold to medium- and long-term
investors. As mentioned, the team is committed to balancing between the development of the
capital market and preserving the financial stability of the capital market in Israel.

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Bibliography:

 www.goggle.com

 www.wikipedia.com

 www.vinodkothari.com

 www.crisil.com

 Vipul prakashan

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