By: Dr.

Neelam Tandon

 Securitization of debt, or asset securitization as is

more often referred to, is a process by which identified pools of receivables, which are usually illiquid on their own, are transformed into marketable securities through suitable repackaging of cash flows that they generate.

 One of the most prominent developments in

international finance in recent decades and the one that is likely to assume even greater importance in future, is securitisation. Securitisation is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors.

 Securitization, in effect, is a credit arbitrage

transaction that permits for more efficient management of risks by isolating a specific pool of assets from the originator's balance sheet. These assets are generally secured by personal or real property (e.g. automobiles, real estate, or equipment loans), but in some cases are unsecured (e.g. credit card debt, consumer loans).

 In concept, all assets generating stable and predictable

cash flows can be taken up for securitization. In practice however, much of the securitised paper issued have underlying periodic cash flows secured through contracts defining cash flow volumes, yield and timing.

STEPS IN A SECURITISATION
There are four steps in a securitisation:
(i) SPV is created to hold title to assets underlying securities;

(ii) the originator or holder of assets sells the assets

(existing or future) to the SPV; (iii) the SPV, with the help of an investment banker, issues securities which are distributed to investors; and (iv) the SPV pays the originator for the assets with the proceeds from the sale of securities.

 Typically, asset portfolios that are relatively

homogeneous with regard to credit, maturity and interest rate risk could be pooled together to create a securitization structure.

 However, to make reasonable estimates of the credit

quality and payment speed of the securitised paper, it would be essential to analyse the historical data on portfolio performance over some reasonable length of time.

 Securitization effort will call for considerable

investments in time and resources. Hence, on a comparative cost scale it can even be somewhat more expensive than other types of debt financing that may be available to a borrower, at least in the initial stages.

 However, it has been demonstrated that a continuing

securitization program rather than a single deal often goes to reduce the costs, as economies of scale and expertise pick up over a period of time. Bearing this in mind, many securitization programs are run with a long-term strategic perspective.

 Being distinct and different from the originator's own

obligations, a well structured ABS stands on its own credit rating and thus generates genuine incremental funding.

 Securitization can also generate matched funding for

balance sheet assets. Further, it may also enable the disposal of non-core assets through suitable structuring.

 Securitization transfers much of the credit risk in the

portfolio to the ABS investors and helps to quantify the residual credit risk that the originator is exposed to. This is very useful, as the originator can then take larger exposure to individual obligors as well as provide a higher degree of comfort to his creditors.

 Securitization also transfers the originator's market

risks, i.e., liquidity, interest rate and prepayment risks, to ABS investors and reduces risk capital requirement. This can lead to more competitive pricing of the underlying asset products.

Securitization Participants
A securitisation transaction generally involves some or

all of the following parties: (i) the initial owner of the asset (the originator or sponsor) who has a loan agreement with the borrowers (obligors);

 (ii) the issuer of debt instruments who also is the SPV.

The structure keeps the SPV away from bankruptcy of the originator, technically called bankruptcy remote; (iii) the investment bankers who assist in structuring the transaction and who underwrite or place the securities for a fee;

 (iv) the rating agencies, who assess credit quality of

certain types of instruments and assign a credit rating;

(v) the credit enhancer, possibly a bank, surety

company, or insurer, who provides credit support through a letter of credit, guarantee, or other assurance;

 (vi) the servicer, usually the originator, who collects

payments due on the underlying assets and, after retaining a servicing fee, pays them over to the security holders; (vii) the trustee, who deals with issuer, credit enhancer and servicer on behalf of the security holders; (viii) the legal counsel, who participates in the structuring of the transaction1; and (ix) the swap counterparty who provides interest rate / currency swap, if needed.

 The extent of portfolio analysis and information

demanded by securitization programs often lead to serious re-examination and consequent reengineering of operating processes within the originator organisation. Further, specialist handling of various functional components, such as origination, funding, risk management and administration, often achieved through outsourcing, promotes efficiency across operating processes.

The Originator
The Originator: This is the entity on whose books the

assets to be securitised exist. It is the prime mover of the deal i.e. it sets up the necessary structures to execute the deal. It sells the assets on its books and receives the funds generated from such sale. In a true sale, the Originator transfers both the legal and the beneficial interest in the assets to the SPV.

SPV
The SPV: The issuer also known as the SPV is the

entity, which would typically buy the assets (to be securitised) from the Originator. The SPV is typically a low-capitalised entity with narrowly defined purposes and activities, and usually has independent trustees/directors

SPV
As one of the main objectives of securitisation is to

remove the assets from the balance sheet of the Originator, the SPV plays a very important role in a s much as it holds the assets in its books and makes the upfront payment for them to the Originator.

The Investors
The Investors: The investors may be in the form of

individuals or institutional investors like FIs, mutual funds, provident funds, pension funds, insurance companies, etc. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per agreed pattern.

Other Parties Involved in Securitisation Deal are:

a) The Obligor(s): The Obligor is the Originator's

debtor (borrower of the original loan). The amount outstanding from the Obligor is the asset that is transferred to the SPV. The credit standing of the Obligor(s) is of paramount importance in a securitisation transaction.

 b) The Rating Agency: Since the investors take on the

risk of the asset pool rather than the Originator, an external credit rating plays an important role.

 The rating process would assess the strength of the

cash flow and the mechanism designed to ensure full and timely payment by the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework.

 c) Administrator or Servicer: It collects the payment

due from the Obligor/s and passes it to the SPV, follows up with delinquent borrowers and pursues legal remedies available against the defaulting borrowers. Since it receives the instalments and pays it to the SPV, it is also called the Receiving and Paying Agent.

 d) Agent and Trustee: It accepts the responsibility for

overseeing that all the parties to the securitisation deal perform in accordance with the securitisation trust agreement. Basically, it is appointed to look after the interest of the investors.

 e) Structurer: Normally, an investment banker is

responsible as structurer for bringing together the Originator, credit enhancer/s, the investors and other partners to a securitisation deal. It also works with the Originator and helps in structuring deals.

 The different parties to a securitisation deal have very

different roles to play. In fact, firms specialise in those areas in which they enjoy competitive advantage.

 The entire process is broken up into separate parts

with different parties specialising in origination of loans, raising funds from the capital markets, servicing of loans etc. It is this kind of segmentation of market roles that introduces several efficiencies securitisation is so often credited with.

Benefit to the originator

Excess servicing, i.e., the difference between the asset

yield and the cost of funds, is also normally extracted by the originator. These income streams can push up the operating leverage of the originator generating income from a larger asset base than what may be otherwise possible for a given capital structure.

 Through appropriate structuring, an ABS can be

tailored to meet investor standards on credit quality, yield and maturity. Working with a pool of receivables gives the originator the needed flexibility to be able to offer investors a menu of options around which issuances could be made.

Securitization : Participants
Securitization programs usually involve several

participants, each carrying out a specialist function, such as, creating and analysing the asset pool, administration, credit rating, accounting, legal negotiation, etc.

The Originator also interchangeably referred to as the Seller is the entity whose receivable portfolio forms the basis for ABS issuance, Special Purpose Vehicle (SPV), which as the issuer of the ABS ensures adequate distancing of the instrument from the originator,

 The Servicer, who bears all administrative

responsibilities relating to the securitization transaction, The Trustee or the Investor Representative, who act in a fiduciary capacity safeguarding the interests of investors in the ABS,

 The Credit Rating Agency, which provides an objective

estimate of the credit risk in the securitization transaction by assigning a well-defined credit rating, The Regulators, whose principal concerns relate to capital adequacy, liquidity, and credit quality of the ABS, and balance sheet treatment of the transaction,

 Service providers such as Credit Enhancers and

Liquidity Providers, and, Specialist functionaries such as legal and tax counsels, accounting firms, pool auditors, et al. However, more important than all the aforementioned are the investors in the securitised paper.

 Investors are the ultimate judges of any securitization

effort. Originators should therefore interact actively with the investor community to get to know investor preferences and concerns for effective structuring and distribution of ABS. Such knowledge would also make the origination process more efficient.

Essential features of a securitization Transaction

.Creation of asset pool and its sale
The originator/seller (of assets) creates a pool of assets

and executes a legal true sale of the same to a special purpose vehicle (SPV). An SPV in such cases is either a trust or a company, as may be appropriate under applicable law, setup to carry out a restricted set of activities, management of which would usually rest with an independent board of directors.

Issuance of the securitised paper

This activity is usually performed by the SPV. Design

of the instrument however would be based on the nature of interest that investors would have on the asset pool.

Credit Risk
It must be made abundantly clear at the very outset

that the accretions on the asset-backed security, i.e., interest, amortisation and redemption payments, are entirely dependent on the performance of the pooled assets, and will have nothing to do with the credit of the originator.

 The process of selecting assets to build a securitization

pool would take into careful consideration, loan characteristics that are important from a cash flow, legal, and credit points of view, such as type of asset, minimum and maximum loan size, rate, maturity and concentration limits (geographic, single-borrower, etc.).

 Formal delineation of duties and responsibilities

relating to administration of securitised assets, including payment servicing and managing relationship with the final obligors must be spelt out clearly through a contractual agreement with the entity who would perform those functions.

Additional features of securitization Transaction:

Credit enhancement to support timely payments of

interest and principal and to handle delinquencies, Independent credit rating of the securitised paper from a well known credit rating agency, and, Providing liquidity support to investors, such as appointment of market makers.

Documentation
In documentation lies the heart of all securitization.

An appropriate set of documentation, perfected against the applicable legal framework, is fundamental to structuring transactions. While the specifics may vary from one jurisdiction to another, there is a generic body of documentation that is normally applicable in most cases.

 Service documentation specifying the duties and

responsibilities of the servicer or servicing agent would also be a key one. In practice, originators often double up as servicers.

 Related documentation in addition to the above would

typically comprise those relating to credit enhancement, liquidity and market-making, listing agreements with stock exchanges, as well as transaction prospectus or information memoranda, as may be appropriate.

 Credit enhancement of the ABS would also be an

important structuring consideration, as it strives to strike a balance between the investor and the issuer needs on the credit quality of the instrument.

 In the medium to longer term, the securitization

process could upgrade the level of sophistication of banking and finance in the country. This, combined with an appropriate regulatory framework, can make securitization an important catalyst in mobilising domestic savings as well as attracting foreign capital, which can be of immense value, particularly in the context of capital requirements to develop the country's infrastructure sector.

 Securitizing project finance, telecom, toll road and

other similar receivables could well become reality in the medium term future.

THANKS