INSTITUTE OF MANAGEMENT STUDIES D.A.V.V., INDORE
TERM PAPER ON SECURITIZATION – CHALLENGES IN INDIAN MARKET
SUBMITTED TO:
SUBMITTED BY: SMRITI AWASTHI MBA (FA) - III SEM
CONTENTS
PART ‘A’
1. 2. 3. 4. 5. 6. What is securitization? Purpose of securitization Process of securitization Parties involved Motivations for using securitization Risks involved
PART’B’ 7. Securitization and liquidity 8. Securitization and recession PART ‘C 9. Securitization in India and market participants with examples of securitization in Indian context 10.Issues facing Indian securitization market ( challenges ) 11.Update on Indian securitization market with reference to new RBI guidelines 12.Summary 13.Outlook on new RBI Guidelines 14.Bibliography
1. What is securitization?
Securitization as a financial instrument has had an extremely significant impact on the world’s financial system. First, by integrating capital markets and the uses of resources such as mortgage originators, finance companies, governments, etc. it has strengthened the trend towards disintermediation. Having been able to mitigate agency costs, it has made lending more efficient? Evidence of this can be observed in the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of securitization techniques with credit derivatives and risk transfer devices continues to develop innovative methods of transforming risk into a commodity and allow various market participants to tap into sectors which were otherwise not open to them. In its broadest sense, the term “securitization” implies a process by which a financial relationship is converted into a transaction. A financial transaction is the coming together of two or more entities? A financial relationship is their staying together
2. Purpose of securitization
Securitization is one way in which a company might go about financing its assets. There are generally seven reasons why companies consider securitization:
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to improve their return on capital, since securitization normally requires less capital to support it than traditional on-balance sheet funding; to raise finance when other forms of finance are unavailable (in a recession banks are often unwilling to lend - and during a boom, banks often cannot keep up with the demand for funds); to improve return on assets - securitization can be a cheap source of funds, but the attractiveness of securitization for this reason depends primarily on the costs associated with alternative funding sources; to diversify the sources of funding which can be accessed, so that dependence upon banking or retail sources of funds is reduced; to reduce credit exposure to particular assets (for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitization can remove some of the assets from the balance sheet); to match-fund certain classes of asset - mortgage assets are technically 25 year assets, a proportion of which should be funded with long term finance; securitization normally offers the ability to raise finance with a longer maturity than is available in other funding markets; to achieve a regulatory advantage, since securitization normally removes certain risks which can cause regulators some concern, there can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitization as a means of managing the restriction on their wholesale funding abilities).
3. Process of securitization
1. Assets are originated by a company, and funded on that company's balance sheet. This company is normally referred to as the “Originator". 2. Once a suitably large portfolio of assets has been originated, the assets are analyzed as a portfolio, and then sold or assigned to a third party which is normally a special purpose vehicle company (an " SPV") formed for the specific purpose of funding the assets. The SPV is sometimes owned by a trust, or even, on occasions, by the Originator. 3. Administration of the assets is then sub-contracted back to the Originator by the SPV. 4. The SPV issues tradable "securities" to fund the purchase of the assets. The performance of these securities is directly linked to the performance of the assets - and there is no recourse (other than in the event of breach of contract) back to the Originator. 5. Investors purchase the securities, because they are satisfied (normally by relying upon a rating) that the securities will be paid in full and on time from the cash flows available in the asset pool. A considerable amount of time is spent considering the different likely performances of the asset pool, and the implications of defaults by borrowers on the corresponding performance of the securities. The proceeds upon the sale of the securities are used to pay the Originator. 6. The SPV agrees to pay any surpluses which arise during its funding of the assets back to the Originator - which means that the Originator, for all practical purposes, retains its existing relationships with the borrowers and all of the economics of funding the assets (i.e.: the Originator continues to administer the portfolio, and continues to receive the economic benefits (profits) of owning the assets). 7. As cash flows arise on the assets, these are used by the SPV to repay funds to the investors in the securities
4. Parties involved
Securitization normally involves a wide variety of counterparties and advisers. On one particularly complex transaction a few years ago there were 6 law firms, 3 firms of accountants, 1 insurance broker, 1 investment bank, 1 consultant and 12 principals (banks, originators, administrators, credit enhancers, underwriters and so on). A transaction normally involves the following parties:
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Originator and Administrator Lead Underwriter who purchases the debt issued by the SPV (and sells it to euro bond investors) Structuring Team either involving personnel from the lead underwriter and/or other advisers Two sets of lawyers, at least one of whom is a securitization specialist Trustee and Trustee's lawyers representing the interests of the note holders in the event that there is (a) an enforcement event (things go wrong) or (b) any requirement to change or amend the documents or procedures after the transaction completes; Rating Agencies required to undertake an analysis of the risks associated with the transaction and to award a credit rating to the debt issued Originator's accountants to agree accounting treatment for the transaction, to verify the analysis and existence of the assets involved and to confirm work undertaken to show solvency Credit Enhancement Providers and their lawyers transactions often involve a third party fronting some of the risks associated with the assets Standby Servicer and their lawyers a third party prepared to administer the assets in the event that the existing servicer fails or is incompetent; this is now becoming a requirement for all transactions where the administrator does not already have at least an A1/P1 short term rating Clearing Bank and its lawyers running the originator's and the Issuer's bank accounts, all of which normally require new mandates and a Bank Agreement is also set up to regulate the operation of all aspects of the accounts Banking Facility Providers and their lawyers often there are requirements for additional banking facilities, e.g.: liquidity facilities or guaranteed deposit arrangements ("GICs") Hedging Providers and their lawyers assets often need some form of hedging, either using swaps, caps or both Paying Agents, Agent Banks, Common Depositary etc.. a whole host of organizations with mysterious Euro market responsibilities
Printer to produce the prospectus (choosing the wrong printers can cause the transaction to fail)
5. Motivations for using securitization
Securitization appeals to both nonfinancial and financial corporations. The four primary reasons for raising funds via securitization are reviewed below: Potential for reducing funding costs The cost of funding depends on the credit rating assigned to a debt obligation issued by an entity. In the case of a corporate bond, the rating will depend on the credit quality of the corporation. In the case of an SPV, because of legal preference and deference, the rating agencies will assign a rating to each security in a securitization based on the expected performance of the asset pool and the priority of a security in the structure. What is key is that the rating assigned to each security issued by the SPV will be independent of the financial condition of the originator company. Consequently, the originator company can have a speculative grade rating but the SPV can issue one or more securities with a much higher credit rating. The rating agencies evaluating the securities in the structure will advise the originator company on how the transaction must be structured in order to obtain a specific rating for each security in the securitization. Diversifying funding sources Corporations seeking funding in the asset backed securities market must be frequent issuers in the market in order to get their name recognized in the asset backed securities market and to create a reasonably liquid after market for trading their securities. Once an issuer establishes itself in the market, it can look at both the corporate bond market and the asset backed securities market to determine its best funding source by comparing the cost of funds in the two markets, as well as non quantifiable benefits associated with securitization. Managing corporate risk Securitization is one of several corporate risk management tools available to management. When assets are sold in a securitization, the originating company no longer bears the interest rate or credit risk of those assets. Ford Motor Credit offers a good example of this. Since 2000, management has employed securitization to reduce the credit risk of its car loan portfolio Achieving off balance sheet financing If properly structured, securitizations remove assets and liabilities off the balance sheet of the originator company. The argument put forth by those who employ securitization is that the reduction in the amount of the originator company’s on balance sheet leverage can help enhance its return on equity and other key financial ratios.
6. Risks Involved in securitization
The key risks in a typical securitization transaction are: 1. Credit Risk and Ability of the entity to pay its obligations and survive Bankruptcy Risk as a viable entity. 2. Performance Risk: Ability to perform and fulfill contractual obligations. 3. Asset/ Collateral Risk: Variation in the value of the underlying asset. 4. Payment / Counterparty Risk: Ability of other parties to the transaction, like swap provider, paying bank etc., to meet their obligations. 5. Interest Rate Risk: Risk arising out of variation in interest rates. 6. Exchange Rate Risk: Risk arising out of variation in exchange rates of various currencies. 7. Liquidity Risk: Ability to liquidate the underlying assets or collateral and generate liquidity to Service the Investors in a timely manner. 8. Commingling Risk: When a Servicer is appointed to collect moneys from the Obligors, the funds collected may be retained by the Servicer with itself for a short period of time before remitting to the SPV. The risk of loss of such moneys due to a credit event or bankruptcy of the Servicer is called commingling risk. 9. Prepayment Risk: The obligors of the underlying assets may repay their obligations ahead of schedule. This affects the maturity of the investments made by the investors. The variation in the maturity due to pre-payment by the obligors is the pre-payment risk. 10. Reinvestment Risk: Some structures (typically pay-through ones) may have the SPV reinvesting the funds received from the obligors and the originator and paying out to investors only on prespecified dates. The variability in the returns earned on such investment is reinvestment risk. 11. Legal / regulatory / tax Risk : As structured finance deals involve interpretation of various laws (including that of income tax laws) and regulations as also complex documentation, there is a significant level of legal and regulatory risk.
7. Securitization and liquidity
Liquidity has been traditionally understood as asset’s capability over time of being realized in the form of funds available for immediate consumption or reinvestment, proximately in the form of money. It is also construed as a high level of trading activity, allowing buying and selling with minimum price disturbance. It can be defined as a market characterized by the ability to buy and sell with relative ease as well. Another classification seeks to divide liquidity into funding liquidity and market liquidity. Funding Liquidity as defined by Brunnermeier is “the ease at which the financial institutions can borrow short term against some asset or security”. In this system of borrowing short term, only a part of the asset’s value can be borrowed as the same is used only as collateral. The difference between the value of the asset and its subsequent borrowable value in the process of securitization is the margin which technically, is insurance for the investor. It is therefore clear that the value of the asset is the determining factor when it comes to creation of funding liquidity. Market liquidity on the other hand is the ease at which the asset or security can be liquidated in the market. It is noteworthy that market liquidity has a tendency to fluctuate depending upon the price of the asset and funding liquidity which therefore become decisive factors when it comes to creation of market liquidity. By definition, securitization is a process of creating liquid financial instruments out of assets that could be too cumbersome or expensive to sell individually. The process of securitization is used by the banks to transfer the risks to the investors who hold the same giving due regard to risk ratings whereby the balance sheet is eased from risk-weighted loans, thereby reducing the regulatory capital charge, thus expanding the source of funding liquidity. Securitization enhances market liquidity by converting illiquid assets on the balance sheets of originators into marketable securities. Further, since the said securities are backed by assets, the ease at which they are liquidated is relatively high thus contributing to the creation on market liquidity. As understood previously the SPV structure in addition to creating regulatory arbitrage also created a cheap source of funding liquidity through a simple process of buying illiquid claims and then transforming the same as tradable securities. As securitization proliferated, the structure of the SPV’s had a dynamic addition wherein they were created solely for the purpose of trading securities without directly participating in the process of securitization. Since funding liquidity is the ease at which borrowing against securities may occur, therefore greater the frequency of asset trading, greater would be the funding liquidity. On the other front, increase in the trading frequency accompanied by positive asset price change, results in the creation of market liquidity whereby assets are successfully liquidated without a decline, or in more economic terms, loss in the price of the asset. It is also significant to note that both funding liquidity and market liquidity are highly dependent on the quality of the collateral as the latter decisively determines the ability to generate securities and a subsequent trading of the same. It is therefore clear that there exists a correlation between securitization and liquidity. In the wake of the economic crisis of 2007, it is also momentous to discuss the concept of liquidity illusion. Liquidity illusion introduces the idea that though securitization was theoretically meant to boost liquidity, it was, in reality, a mere illusion. According to theorists there has been a shift
in the general understanding of liquidity from being a property of assets to a mere indicator of the vitality of the market. In addition to this one dimensional conceptualization, the mainstream finance theory has taken the role of financial institutions to a whole new level. Simply put, the mainstream finance theory introduces a three ponged function of financial institutions which are firstly, the identification and pricing of risks, secondly, parceling the same into specific financial vehicles and then finally redistributing risks to people who are most capable to hold them.36 Theorists argue that this conceptualization of liquidity is based on certain fallacies. The first fallacy is the assumption that liquidity is created by the market making capacity of the financial intermediaries implementing the three pronged functions. The second fallacy is the notion that market liquidity is nothing but the general market trade and turnover and the third fallacy is the view that market liquidity itself when multiplied across many markets ultimately is synonymous with the liquidity (and financial robustness) of the economic system as a whole. According to Minsky, this mesh of financial innovations has twin effects on the liquidity of the system. On one hand, velocity of money increases as financial innovations gain ground while on the other hand, every institutional innovation which results in both new ways to finance business and new substitutes for cash decreases the liquidity of the economy. As securitization propelled the belief that the financial innovation of the originate and distribute model would create additional and plentiful liquidity, in actuality it drove the financial system into a structurally illiquid, and crisis-prone, state by introducing an incredibly complex and obscure hierarchy of credit instruments, whose liquidity was assumed but never guaranteed.40 The liquidity illusion therefore held the belief of the market for long, before the inevitable crash. This liquidity illusion in fact made banks substitute their traditional liquid assets with highly rated structured credit products which in the longer run proved to be a demolishing factor in various economies across the globe. The concept of liquidity illusion presents securitization as a reaction to the Basel Accords as under the those financial regulations, holding safe and liquid assets on the balance sheets would mean the banks would not be able to lend as much as they wanted to. The changing role of financial intermediaries in the era of securitization, leading to a proliferation of financial innovations and financial engineering through Ponzi mode of finance, led to the idea of abundance of liquidity in the market and to its subsequent downfall. Securitization, according this concept is a glorified term for validating bad debts. Credit rating agencies play a pivotal role in the process. They not only manipulate regulations by isolating the originator from the products they sell but also effectively layer securitization structures. The rule was simple, obtain an AAA rating and the deal would be profitable. Obtaining such a rating required a strategic layering of assets on the basis of their seniority. The credit rating agencies miserably failed in their task of risk analyses. Thus by creating a market for bad quality debts, a grand liquidity illusion was created and the market sunk into the same.
8. Securitization and recession
The summer of 2007 was marked by a contagious liquidity meltdown that hit the world markets. The meltdown, that initiated due to the sub-prime mortgage fiasco in the United States of America and was characterized by financial panic and unknown asset values, destabilized not only the American financial system, but also spread globally to affect the European and Asian markets. Subsequently, the next eighteen months, witnessed the transformation of the contagious financial crisis and ultimately with the bursting of the “housing bubble”, the rush for liquidity, and the following credit squeeze, the world plunged into a global recession, whose effects prevail till date. The credit crunch affected well established financial institutions like Bear Sterns, Lehman Brothers and AIG insurance firms in America, and Northern Rock and Lloyds in the United Kingdom and caused significant monetary losses. The financial crisis has been attributed to a multitude of reasons, most of which centre around Securitization. Firstly, as stated earlier, securitization enhanced the funding liquidity which provided the banks with an opportunity to attract more borrowers. Moreover, the fees paid to the originators for carrying out various responsibilities in the securitization chain, proved to be an additional incentive for them to securitize more and more. However, since most of the prime borrowers already had loans, the originators lowered lending standards to attract as many new borrowers as possible which consequently included sub-prime ones45. The originators not only relaxed the criterion for advancing loans, they also created loans which initially looked attractive but were actually toxic for the borrowers. As a result, the overall fragility of the financial system increased and the seeds of recession in the credit cycle were sown. Secondly, the originators increasingly adopted the “originate and distribute” model i.e. they created loans that they did not plan to retain on their balance sheets. This model induced a reckless approach in assessing the quality of the loans with the originators being largely unconcerned about the quality of the loans and underlying assets that were eventually going to be securitized. As estimated by a few analysts, 50% of the mortgages backing new private-labeled mortgage backed securities in the years 2005 and 2006 and 77% in 2006 had improper and incomplete documentations. These inadequately evaluated loans -termed as hot potatoes- were passed through the financial chain to unsuspecting investors as each party relied on others to investigate the loans comprehensively. However, what is pertinent is that securitization did not eliminate the risk or completely transfer the risk down the financial chain, it issued liabilities backed by the hot potatoes to which all the intermediaries in the securitization process were exposed. Thirdly, the manner in which the credit rating agencies executed their responsibility of assessing the securities was probably one of the most significant factors that brought about the financial crisis. The rating agencies neither examined the credit worthiness of the borrowers nor the underlying assets that backed the securities while judging their credit risks. Owing to the unavailability of details of the securities, the agencies used proxy data on default rate and recovery rate of to arrive at a classification of the securities. Further, the conflict of interest crated due to the commissions paid to the agencies by the security issuers and the level of competition between, induced the agencies to adopt sloppy methods of rating securities. On the other hand, the SPE approached only specific agencies in order to obtain favorable ratings. As a result, the very rationale behind involving credit agencies in the securitization process was defeated with securities being graded AAA even though they were backed by junk financial claims. The inappropriate rating left the investors with unsound evaluation of credit risks involved in the securities which offered a false sense of security to the investors who willingly took on the risks. It is certainly
arguable that investors, as reasonable men involved in financial system, would be apt judges of risks that they undertook. However, as explained by Tymoigne, investors judge risk from a social rationality where they chose to follow the majority. Besides, the complete lack of transparency left the creditors with no means of evaluating the risks since it was believed that releasing information would bring about selective investments that would reduce the market liquidity. Fourthly, the various counterparties in the securitization process have become increasingly interdependent for cash flow which has increased the systemic risk considerably. This implies that investors depend on the SPE to sell the securities to them, the SPE depends on the originator to provide assets and the originator ultimately depends upon the borrowers. Yet, what actually worsened the scenario was the growing opacity of transactions between the counterparties that rendered them incapable of judging their own financial strength since they were unaware of the actual counterparties or the effect of default by any one of them. This threatened the financial stability since the banks become reluctant to lend to each other60. Further, not only was the clarity in transactions reduced, the complexity of the process was gradually increased. Since the number of economic activities is limited, it is understandable that the illiquid receivables are finite. To meet their demands, financial institutions carried out second-level” securitization, “third level” securitization and “fourth-level” securitization by securitizing securities which further reduced the possibility of counterparties in the chain except the issuer, and is some cases the credit rating agencies, to comprehend the relation between the value of the securities and the underlying assets. However banks and other firms are artificial entities that only in contemplation of law. The past decades were also characterized by a period of de-regulation, when the regulators where under the misconception those financial institutions were self-sufficient and interference would impair the growth of the economy. On the contrary, deregulation only provided the financial institutions to take increasing risks and the absence of checks and balances only degraded the quality of the loans.
9. Securitization in India
Securitization in India began in the early nineties, with CRISIL rating the first securitization program in 1991-92. Initially it started as a device for bilateral acquisitions of portfolios of finance companies. These were forms of quasi-securitizations, with portfolios moving from the balance sheet of one originator to that of another. Originally these transactions included provisions that provided recourse to the originator as well as new loan sales through the direct assignment route, which was structured using the true sale concept. Through most of the 90s, securitization of auto loans was the mainstay of the Indian markets. But since 2000, Residential Mortgage Backed Securities (RMBS) have fuelled the growth of the market. The need for securitization in India exists in three major areas – Mortgage Backed Securities (MBS), the infrastructure Sector and other Asset Backed Securities (ABS). It has been observed that Financial Institutions/banks have made considerable progress in financing of projects in the housing and infrastructure sector. It is therefore necessary that securitization and other allied modalities get developed so that Financial Institutions/Banks can offload their initial exposure and make room for financing new projects. With the introduction of financial sector reforms in the early nineties, Financial Institutions/banks, particularly the Non-Banking Financial Companies (NBFCs), have entered into the retail business in a big way, generating large volumes of homogeneous classes of assets (such as auto loans, credit cards). This has led to attempts being made by a few players to get into the ABS market as well. However, still a number of legal, regulatory, psychological and other issues need to be sorted out to facilitate the growth of securitization in India the growth in the Indian securitization market has been largely fuelled by the repackaging of retail assets and residential mortgages of banks and FIs. This market has been in existence since the early 1990s, though has matured significantly only post-2000 with an established narrow band of investor community and regular issuers. According to Industry estimates, the structured issuance volumes have grown considerably in the last few years; though still small compared to international volumes. Asset backed securitization (ABS) is the largest product class driven by the growing retail loan portfolio of banks and other FIs, investors’ familiarity with the underlying assets and the short maturity period of these loans. The mortgage backed securities (MBS) market has been rather slow in taking off despite a growing housing finance market due to the long maturity periods, lack of secondary market liquidity and the risk arising from prepayment/ reprising of the underlying loan. In the early 1990s, securitization was essentially a device of bilateral acquisitions of portfolios of finance companies. There were quasi-securitizations for sometime, where creation of any form of security was rare and the portfolios simply got transferred from the balance sheet of the originator to that of another entity. These transactions often included provisions, which offered recourse to the originator as well. In recent years, loan sales have become common through the direct assignment route, which is structured using the true sale concept. Though securitization of auto loans remained the mainstay throughout the 1990s, over time, the market has spread into several asset classes – housing loans, corporate loans, commercial mortgage receivables, future flow, project receivables, toll revenues, etc that have been securitized. Within the auto loan segment, the car loan segment has been more successful than the commercial vehicle loan segment, mainly because of factors such as perceived credit risk, higher volumes and homogenous nature of receivables. Other a type of receivables for which securitization has been
attempted in the past includes property rental receivables, power receivables, telecom receivables, lease receivables and medical equipment loan receivables. Revolving assets such as working capital loans, credit card receivables are not permitted to be securitized. In India, issuers have typically been private sector banks, foreign banks and non-banking financial companies (NBFCs) with their underlying assets being mostly retail and corporate loans. The key motivations for Indian banks include:
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Liquidity: Securitization is an easy route than raising deposits that are subject to reserve requirements Regulatory issues: Constrains arising out of Provisions, priority sector norms, etc Capital Relief: Major investors are mostly mutual funds (money market/liquid schemes), closeended debt schemes and banks. Long term investors like insurance companies and provident funds are currently not active due to regulatory constraints. Foreign institutional investors are also missing due to regulatory ambiguity. As per guidelines, mutual funds are required to declare their NAV’s on a daily basis due to which they prefer the structure/asset classes which involve low pre-payment rates. The lack of domestic non-traditional hedge fund style investors to participate in equity and mezzanine tranches has led to originators holding them.
Some examples of securitization in the Indian context are:
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First securitization deal in India between Citibank and GIC M F in 1991 for Rs 160 mn L&T raised Rs 4,090 mn through the securitization of future lease rentals to raise capital for its power plant in 1999. India’s first securitization of personal loan by Citibank in 1999 for Rs 2,841 mn. India’s first mortgage backed securities issue (MBS) of Rs 597 mn by NHB and HDFC in 2001. Securitization of aircraft receivables by Jet Airways for Rs 16,000 mn in 2001 through offshore SPV. India’s first deal in the power sector by Karnataka Electricity Board for receivables worth Rs 1,940 mn and placed them with HUDCO. India’s first Collateralized Debt Obligation (CDO) deal by ICICI bank in 2002 India’s first floating rate securitization issuance by Citigroup of Rs 2,810 mn in 2003. The fixed rate auto loan receivables of Citibank and Citicorp Finance India included in the securitization India’s largest securitization deal by ICICI bank of Rs 19,299 mn in 2007. The underlying asset pool was auto loan receivables.
10. Issues facing Indian securitization market
1. Regulatory issues Stamp Duty: One of the biggest hurdles facing the development of the securitization market is the stamp duty structure. Stamp duty is payable on any instrument which seeks to transfer rights or receivables, whether by way of assignment or by any other mode. Therefore, the process of transfer of the receivables from the originator to the SPV involves an outlay on account of stamp duty, which can make securitization commercially unviable in several states. If the securitized instrument is issued as evidencing indebtedness, it would be in the form of a debenture or bond subject to stamp duty. On the other hand, if the instrument is structured as a Pass Through Certificate (PTC) that merely evidences title to the receivables, then such an instrument would not attract stamp duty, as it isn’t an instrument provided for specifically in the charging provisions. Among the regulatory costs, the stamp duty on transfers of the securitized instrument is again a major hurdle. Some states do not distinguish between conveyances of real estate and that of receivables, and levy the same rate of stamp duty on the two. Stamp duty being a concurrent subject, specifically calls for a consensual legal position between the Centre and the States. 2. Foreclosure Laws: Lack of effective foreclosure laws also prohibits the growth of securitization in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default. 3. Taxation related issues Tax treatment of MBS SPV Trusts and NPL Trusts is unclear. Currently, the investors (PTC and SR holders) pay tax on the income distributed by the SPV Trusts and on that basis the trustees make income pay outs to the PTC holders without any payment or withholding of tax. The view is based on legal opinions regarding assessment of investors instead of trustee in their representative capacity. It needs to be emphasized that the Income Tax Law has always envisaged taxation of an unincorporated SPV such as a Trust at only one level, either at the Trust SPV level, or the Investor/Beneficiary Level to avoid double taxation. Hence, any explicit tax pass thro regime if provided in the Income Tax Act does not represent conferment of any real tax concession or tax sacrifice, but merely represents a position that the Investors in the trust would be liable to tax instead of the Trust being held liable to tax on the income earned. Amendments need to be made to provide an explicit tax pass thro treatment to securitization SPVs and NPA Securitization SPVs on par with the tax pass thro treatment applied under the tax law to Venture Capital Funds registered with SEBI. To make it certain that investors as holders of Mutual Fund (MF) schemes are liable to pay tax on the income from MF and ensure that there is no tax dispute about the MBS SPV Trust or NPA Securitization Trust being treated as an AOP(Association of Persons), SEBI should consider the possibility of modifying the Mutual Fund Regulations to permit wholesale investors (investors who invests not less than Rs. 5 million in scheme) to invest and hold units of a closed-ended
passively managed mutual fund scheme. The sole objective of this scheme is to invest its funds into PTCs and SRs of the designated MBS SPV Trust and NPA Securitization Trust. Recognizing the wholesale investor and Qualified Institutional Buyers (QIB) in securitization Trusts, there should be no withholding of tax requirements on interest paid by the borrowers (whose credit exposures are securitized) to the securitization Trust. Similarly, there should be no requirement of withholding tax on distributions made by the securitization Trust to its PTC and/or SR holders. However, the securitization Trust may be required to file an annual return with the Income-tax Department, Ministry of Finance, in which all relevant particulars of the income distributions and identity of the PTC and SR holders may be included. This will safeguard against any possibility of revenue leakage. 4. Legal Issues Listing of PTCs on stock exchange: Currently, the SCRA definition of ‘securities’ does not specifically cover PTCs. While there is indeed a legal view that the current definition of securities in the SCRA includes any instrument derived from, or any interest in securities, the nature of the instrument and the background of the issuer of the instrument, not being homogenous in respect of the rights and obligations attached, across instruments issued by various SPVs, has resulted in a degree of discomfort among exchanges listing these instruments. To remove any ambiguity in this regard, the Central Government should consider notifying PTCs and other securities issued by securitization SPV Trust as ‘securities’ under the SCRA 5. Lack of Investor Appetite Investor awareness and understanding of securitization is very low. RBI, key drivers of securitization in India like ICICI and Citibank and rating agencies like CRISIL and ICRA should actively educate corporate investors about securitization. Mandatory rating of all structured obligations would also give investors much needed assurance about transactions. Once the private placement market for securitized paper gathers momentum, public retail securitization issuances would become a possibility.
11. Update on Indian securitization market With reference to new RBI guidelines
Guidelines on Securitization and Direct Assignment Transactions (May 2012) The RBI, in May 2012, put out the final guidelines on securitization and direct assignment of assets by banks. This is the first time the RBI has issued separate guidelines for Direct Assignment transactions. Amongst the important new prescription in the guidelines is the prohibition of credit enhancement for direct assignment transactions. The other key stipulations are a Minimum Holding Period (MHP) for Originators before off-loading the receivables and a Minimum Retention Requirement (MRR) through the tenure of the transaction. Income tax authorities’ notice for taxation of SPVs During FY2012, the income tax authorities sent notices to trustees of several securitization transactions—which the trustees in turn passed on to the investors, i.e., mutual fund houses—asking them to pay tax on income generated through pass through certificates (PTCs). Following this move, the MFs filed petitions in the Bombay HC, seeking a relief from the tax claim and attachment of their accounts—given that MFs are exempt from income tax. The Bombay High Court passed a stay order on the I-T department notice till the commissioner I-T disposes off the appeal filed by the mutual funds against its notice. Though the matter is sub-judice, the fund houses have been skeptical about investing in securitized instruments till the matter is sorted out. Securitization transactions in India basically operate on the premise that the beneficiaries of the SPV—typically a trust—will offer the income earned from the investment to tax, and thus the income should not be taxed at the level of the trust. The IT department’s stance effectively challenges this premise and thus, a resolution to this issue could be an important factor for determining the future of securitization going forward. Most market participants are of the view that the most immediate and severe obstacle to securitization is this unresolved issue of taxation of the securitization SPV. RBI has been mulling over the Securitization Guidelines for almost 2 years now. Dealing with the worldover tabooed structured finance instrument, RBI had released the first draft of the guideline in April, 2010 and the next in September, 2011. The industry has been kept on tenterhooks ever since awaiting the final version to be released soon. The draft guidelines had created uproar amongst the industry players that the regulators were trying to throttle direct assignment and RBI has taken good time to come out with the final guidelines on 7th May, 2012.
The highlights of the guidelines are as below:
1. Asset Eligibility – All asset except the following can be securitized : a. Revolving credit facilities b. Asset purchased from other entities c. Securitization exposure d. Loans with bullet repayment of both principal and interest 2. Minimum Holding Period and Minimum Risk Retention requirement - As an offspring of the originate-to-distribute model, in several countries such regulations have been imposed to ensure that the loan underwriting standards are not lax and no compromise is made on due diligence of assets generated in the books of the originators. RBI has followed the international trend requiring minimum lock-in for bank loans and requiring some ‘skin in the game’ before they can be securitized. The criteria set down for determining the minimum holding period is that the pool should have demonstrated minimum recovery performance to ensure good underwriting standards and should not pass the project implementation risk to the investors. The purpose of securitization is to diversify the risk. Risk in securitization is passed to the investors, but the criteria laid down above are ambiguous. RBI does not explain what “minimum” recovery performance it is looking at, this would leave market to have its own norms for minimum recovery performance of the pool before securitizing. Further the minimum holding period requirement has been pegged to the seasoning in terms of repayment frequency and tenor which in our view is appropriate. The minimum risk retention requirements are similar to the earlier draft with an addition that in case of bullet repayment loans/ receivables, the risk retained would be 10%. 3. Retained Exposure – In light of the Basel II requirements, the total exposure of the originator shall not exceed 20% of the total securitized instruments issued but shall not include interest rate swaps/currency swaps entered into with the SPV. 4. Booking of profits upfront - While earlier the profits were to be amortized over the life of the securities issued, the current guidelines allow the recognition of cash profits arising out of securitization profits adjusted against the marked-to-market losses suffered by the originator due the exposure in the securitization transaction. Booking of upfront profits, that is the sale consideration exceeding the carrying value of the assets, is in line with international practices and is favorable. 5. Due Diligence standards – The overseas branches of Indian banks cannot invest or assume exposure in securitization in such jurisdictions where minimum risk retention (MRR) requirement is not laid down/ prescribed. This in our view is not appropriate. Securitization exposures should be permitted to overseas branches, as long as the originators are adhering to the MRR requirement as prescribed by RBI whether or not other sovereign has prescribed such requirements. 6. Direct Assignments – The earlier guidelines did not include direct assignments and led to market moving from PTC structure to bilateral assignment, the September, 2011 draft guidelines strangulated their existence. As per the 2011 draft guidelines in case of direct assignments, banks were not allowed
to offer credit enhancements and liquidity facilities, in the wider sense even retention of excess spread was not permissible and the risk retention was pari passu with that of the transferee. However the final guidelines have provided a sort of relaxation here. The MRR requirements are not explicitly stated to be pari passu to the investors and RBI has taken a detour to allow risk retention by requiring the originator to obtain a legal opinion, wherein the opinion should confirm that the arrangement is not interfering with the risks and rewards associated with the loans to the extent transferred to the assignee. The risk retention requirement is on a percentage of the transferred asset. If by way of a legal opinion, the originator needs to confirm that the transferee’s risks are protected, it is nothing but a credit enhancement provided in the garb of MRR requirement. Where risk is protected, rewards automatically get protected. 7. True Sale criteria – RBI has very explicitly mentioned in the guidelines that securitization transactions should meet the true sale criteria and that they shall be beyond the reach of the creditors of the originator, in the event of bankruptcy as well. This is very thoughtful. However, most transactions at the time of structuring are said to have met the true sale criteria, but the substance of the transaction is exposed when such transactions face judicial review. So while it is thoughtful to ring fence assets securitized at the inception, the claw back of such assets would depend when the structures are put to test before the eyes of law. The originator carrying out the servicing function shall not affect the true sale criteria are again in line with international practices. 8. Securitization not permitted in certain cases – Securitization is not permitted in case of 1) resecuritization of assets, 2) synthetic structures and 3) revolving structures. These structures have been prohibited for the time being, but RBI has expressed intent to revisit their appropriateness in due course. While the revolving structures have been barred we still hold the view that intention of RBI is to bar the revolving structures where the borrower is under a line of credit, such as credit card receivables and cash credit facilities are barred, not microfinance pools as there is no line of credit provided there. There is a difference between reinstating structures and revolving structures. In reinstating structures, the repayment of the loan is by way of EMIs, but these loans are sold on regular basis, whereas in case of revolving structures as used in credit card receivables, repayments are within an agreed limit under a line of credit and the exposure varies. The intent of the RBI, it so seems is to put a bar on the revolving type structures and not against reinstating structures.
What all can be securitized? 4 Only performing assets: Transfers of non-performing assets are covered by separate guidelines Homogenous pool: The oft-repeated references to homogenous pool in the Guidelines cannot be Stretched beyond a point ? ? ? Every homogenous pool is heterogeneous ? it contains assets which are diversified The meaning of homogenous is only same type of collateral : For example car loans, home loans, corporate loans. Homogenous meaning loans sharing similar risk characteristics from viewpoint of Internal classification by the bank Assets that cannot be securitized: Single loans Revolving credit facilities: Note there is no bar on revolving structure of securitization Purchased assets ABS/ MBS Loans with bullet payment of principal and interest
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What is eligible and what is not ? ? ? ? ? ? ? ? ? ? ? ? ? Ineligible assets are the same as in case of securitization Revolving credits Purchased loans Bullet repayment loans Guidelines do not apply to the following: Transfers that happen with the request of the borrower This would mean novation transactions will also be excluded Inter-bank participants Arguably, also the transferable participation rights envisaged by Nair committee Trading in bonds: Guidelines will promote issue of bonds as a replacement of loans, particularly in case of corporate lending Bonds become an easy route to escape the entire Guidelines Sale of entire portfolio upon exit decision Entire portfolio Once again, should mean a portfolio sharing risk features
Indian Securitization Market (2012)
ABS continues to form a major part of transactions in FY2012 During FY2012, the securitization market in India grew by 15% over the previous year, in value terms. The number of transactions was also 32% higher in FY2012 than in the previous fiscal. The number and volume of retail loan securitization (both ABS and RMBS together), was the highest in FY2012 compared to previous fiscals, while the LSO issuance was the lowest ever.
Source: ICRA’s estimates
Source: ICRA’s estimates
As can be seen from table 1, given the increase in both the ABS and RMBS products coupled with a reduction in LSO issuance, the overall share of retail loan securitization increased during FY2012. The average deal size was lower in FY2012 compared to the previous two fiscals, mainly due to the greater share of microfinance loan1 pools. LSO3 issuance has been witnessing a sharp decline since H2 of FY2011. LSO transactions were largely short-term in nature and the Originator would typically disburse the loan with the specific intention of securitizing it soon after the disbursement. RBI’s draft guidelines issued in the first quarter of FY2011, specially the requirement of Minimum Holding Period (MHP) of 9 to 12 months, created a potential interest rate risk for the Originator and adversely affected the LSO issuance volume 2. Moreover, the lackluster demand from mutual funds (MFs)—the key investor segment in LSOs3 in the past—owing to low secondary market liquidity for PTCs, and the prohibition on investment by liquid funds in debt with tenure longer than 91 days further impacted LSO issuance volume.
1. Nevertheless the guidelines are at a draft stage and some issuances did happen 2. Loans smaller than Rs. 30,000, typically given to women below poverty line for income generating purpose 3. Securitization of individual corporate loans or loan sell-off (LSO)
Asset-Backed Securitization
ABS remains major asset class; number of transactions rise significantly in FY2012 The number of ABS issues increased significantly by 58% in FY2012 to 178 transactions. However, in value terms, the increase was only 19% over FY2011. The average deal size was lower at Rs. 146 crore in FY2012 compared to Rs. 193 crore in FY2011. This was on account of higher number of Microfinance transactions executed in FY2012 at 65 that was about twice the issuance in FY2011 at 34.
Source: ICRA’s estimate The total number of issuers in the ABS space increased from 23 to 33 as some microfinance entities entered the securitization (or assignment) market. Shriram Transport Finance Company, SREI
Equipment Finance, Indiabulls Financial Services Ltd., Sundaram Finance and Shriram City Union Finance were the largest Originators in FY2012, altogether contributing to over 60% of the total number of ABS issuances. Banks continued to be absent from the securitization market as Originators (although they continue to be a key investor segment).
Residential Mortgage-Backed Securitization
RMBS issuance grows in FY2012 The number of RMBS issuances increased to 22 in FY2012 along with an increase of 53% in value terms. However, the average deal size marginally reduced to Rs. 349 crore in FY2012 from Rs. 359 crore in FY2011. RMBS segment continued to be highly concentrated with HDFC and Dewan Housing Finance, which together contributed to about 85% of all issuances.
Figure 4: Issuance Volumes in Indian RMBS Market
Source: ICRA’s estimates 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. Accordingly, banks were typically the investors in these transactions.
12.Summary
Though retail loan securitization improved in FY2012, the issuance volume in India continues to remain subdued and concentrated among few Originators. Around 75% of the market in FY2012 was essentially bilateral loan pool trading, driven by the economics of priority sector lending targets. It follows that the investor segment is largely banks—mainly private sector and foreign banks. Mutual Funds have mostly been absent from the securitization market for a variety of reasons, the latest being the unresolved issue of income tax authorities’ claim on taxing the income from securitized instruments.
13.Outlook on new RBI guidelines
Via these guidelines, the RBI aims to reduce systemic risk through the requirement of a minimum holding period and a minimum retention amount for originators. The RBI has also made an attempt at doing away with the arbitrage opportunity between “assignments” – i.e. a direct sale of assets from one financial institution to another – and securitizations, and in this attempt has created new arbitrage opportunities, this time favoring securitizations. A tantalizing comment that new guideline for amortization of credit enhancement is forthcoming will create hope amongst originators who have long been stifled by the high capital charge imposed by the earlier regulations. We expect the new regulations to be largely positive for the creation of a true securitization market in India. Several long awaited safeguards will enhance the quality of pass through certificates issued in a securitization, with the minimum holding period having the maximum impact on the rating of the securities. Originators have the flexibility of retaining interest at different levels of the capital structure; however their overall interest is capped at 20%, thus enhancing the nature of the ‘true sale’. It is also likely that assignments will now take a back-seat, with the RBI disallowing first loss credit enhancements. Minimum holding period (MHP) RBI has amended the minimum holding period requirements significantly, in line with feedback from market participants, by differentiating the MHP as per tenor and frequency of installment of the underlying asset being securitized. It has imposed a minimum holding period that varies from 3 months to 12 months across loans of different tenors and repayment frequencies. Even within one tenor, the guidelines reward loans with more frequent payouts with a lower minimum holding requirement. The MHP guidelines appear to be largely in line with market practice, with some conservatism built in. The immediate effect of the MHP guidelines will be a sharp reduction in the volume of transactions, as originators will need time to build up portfolios that qualify for a securitization. Further, the residual average life of transactions will reduce, thus increasing the component of fixed costs that are usually applicable for a securitization (e.g. legal fees, trustee charges etc.).
It remains to be seen if rating agencies will improve ratings of securities on account of higher seasoning – which may reduce transaction pricing. At the same time, the MHP guidelines appear to be much better than the drafts released earlier. Microfinance institutions, for one, can heave a collective sigh of relief – these institutions have depended on the securitization market for raising 30-60% of their fund requirements in FY 20121. Some populism has surfaced in the regulations with long term, bullet repayment agricultural loans exempted from the requirement of minimum holding. This may adversely result in an increase in the risk of priority sector portfolios currently held by banks. Minimum retention requirement (MRR) While the RBI has required originators to retain 5-10% of exposure (based on tenor), crucially the RBI has also permitted originators / investors / rating agencies to choose the portion of the capital structure where the originator may retain exposure. This will provide flexibility to originators as their rating improves (or as capital market history of the asset class builds up) to move their exposure from the first loss to a more senior position, i.e. sell down more risk in the market. Significantly, while the RBI has brought assignments under the guidelines, the RBI has also mandated that originators may not provide a first loss in assignment transactions but rather hold pari-passu exposure. For most investors, the assignment route would have limited value from a risk perspective. The assignment route had been earlier actively used by banks to meet priority sector requirements towards the end of the financial year – in many cases these deals are unrated and non-transparent / off-market terms. We believe that this is an excellent development and will assist in the development of a transparent, rated securitization market. Maximum exposure for the originator A further significant change in the guidelines is the cap of exposure of the originator, which now stands at 20% and includes all forms of exposure (excluding excess interest). This has far reaching implications for various asset classes, where the credit enhancement levels required for meeting rating thresholds exceeds 20%. In such cases, the role of a second loss credit enhancer is much more relevant to provide the requisite support for seeing a transaction through. Profit booking and accounting aspects In the 2006 guidelines, the RBI had mandated that originators recognize profit on sale from securitizations on an accrual basis, while requiring originators to recognize costs upfront. This skewed treatment has been partially relaxed with originators permitted to recognize a higher quantum of profits. However, the extent of higher profits permitted to be recognized is not meaningful. The key addition is the treatment of profits from excess interest, which was a grey area and has now been clarified.
Disclosures from originators and diligence by investors The RBI requires originators to disclose the extent of MHP and MRR in a transaction in the disclosure memorandum, and in addition provide sufficient information for investors to conduct stress test on their exposures. Additional disclosures are welcome and will only enhance transparency. Bank investors would need to demonstrate that they have a sound understand of the inherent risk in securitization investments, an understanding of the underlying assets, extent of possible loss arrived at through stress tests, credit enhancements available etc. These requirements are quite standard and an insistence on such minimum standard may well inhibit pure ‘priority-sector purchases’ by banks. It is also good that the RBI has not mandated that banks undertake field audits of the underlying assets, implying that the investor may rely on the originator to maintain the credit risk of the portfolio as long as the originator has sufficient skin in the game. Treatment of assignments It is very welcome that the RBI has brought an unregulated assignment market into the realm of these guidelines. While it is not clear why the RBI has not permitted originators to retain first loss in assignments, the consequence of this guideline may well be the end of the bilateral assignment market. The stringent due diligence and credit monitoring requirements on investors of assignment transaction may well inhibit this market. Further, the RBI has disallowed capital benefits on the basis of rating for investors in assignment transactions, Further, this will also end the undesirable market practice of building recourse back to the originator via bilateral assignment transactions (via routes such as replacement of non-performing assets, representations taken on a continual basis, servicer liabilities etc.). The ‘true sale’ criteria for assignments are quite unequivocal and in line with the true sale requirements for securitization. Re-securitizations not permitted In line with the earlier draft regulations, the RBI has not permitted re-securitizations, synthetic securitizations and securitization of revolving loans. It is therefore clarified that there is no bar on revolving securitizations where underlying loans are amortizing in nature. Further, securitization of short term trade finance receivables (even bullet in nature) has been explicitly permitted as long as there is adequate credit history of the borrower with the originator (minimum of two cycles). This is a good and meaningful step and may help in developing the trade receivable securitization market
14.BIBLIOGRAPHY
ARTICLES:
? ? ? ? ? ? Anshu S. K. Pasricha, On Financial Sector Reform in Emerging Markets: Enhancing Creditors’ Rights and Securitizing Non-Performing Loans in the Indian Banking Sector—An Elephant’s Tale, 55 Buff. L. Rev. 325 (2007) Barbara Ridpath, Arvind Sivaramakrishnan, Securitization Must Take the Centre Stage Again, (2010) Markus K. Brunnermeier, Lasse Heje Pedersen, Market Liquidity and Funding Liquidity ,Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(6), 2201 (2009) Michael R. Scott , The Subprime Mortgage Crisis: Securities Litigation (2009) The Road to Reform, The Report of the CRMPG III, p.19, (retrieved from http://www.crmpolicygroup.org/docs/CRMPG-III.pdf (last accessed on 18.01.2011) Indian securitization summit report (2009) –Improving Indian securitization markets
BOOKS:
? ? ? Robert F. Reilly, Robert P. Schweihs, Valuing intangible assets, McGraw-Hill Professional (2008) Tamar Frankel, Securitization: Structured Financing, Financial Assets Pools, and Asset-Backed Securities, 2nd Edition, Fathom Publishers (2006) Vinod Kothari, Securitization: The Financial Instrument of the Future, John Wiley & Sons (2007)
WEB SOURCES: ? http://www.financialstabilityboard.org/publications/r_0804.pdf (last accessed on 18.06.2012) ? http://www.stanford.edu/~mckinnon/papers/zero_interes_in_bank_lending.pdf (last accessed on 14.06.2012) ? Farlex Free Dictionary, http://financial-dictionary.thefreedictionary.com/Liquidity (last accessed on 12.07.2012) ? Ghosh, T P, “Innovations in asset-backed securities”, http://www.financialexpress.com/fe/daily/19990331/fex31002.html ? Standard and Poor, “Global CBO/CLO Criteria”, http://www.standardandpoors.com/ResourceCenter/RatingsCriteria/Struc turedFinance/articles/pdf/globalcboclo99.pdf
doc_865801005.docx
TERM PAPER ON SECURITIZATION – CHALLENGES IN INDIAN MARKET
SUBMITTED TO:
SUBMITTED BY: SMRITI AWASTHI MBA (FA) - III SEM
CONTENTS
PART ‘A’
1. 2. 3. 4. 5. 6. What is securitization? Purpose of securitization Process of securitization Parties involved Motivations for using securitization Risks involved
PART’B’ 7. Securitization and liquidity 8. Securitization and recession PART ‘C 9. Securitization in India and market participants with examples of securitization in Indian context 10.Issues facing Indian securitization market ( challenges ) 11.Update on Indian securitization market with reference to new RBI guidelines 12.Summary 13.Outlook on new RBI Guidelines 14.Bibliography
1. What is securitization?
Securitization as a financial instrument has had an extremely significant impact on the world’s financial system. First, by integrating capital markets and the uses of resources such as mortgage originators, finance companies, governments, etc. it has strengthened the trend towards disintermediation. Having been able to mitigate agency costs, it has made lending more efficient? Evidence of this can be observed in the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of securitization techniques with credit derivatives and risk transfer devices continues to develop innovative methods of transforming risk into a commodity and allow various market participants to tap into sectors which were otherwise not open to them. In its broadest sense, the term “securitization” implies a process by which a financial relationship is converted into a transaction. A financial transaction is the coming together of two or more entities? A financial relationship is their staying together
2. Purpose of securitization
Securitization is one way in which a company might go about financing its assets. There are generally seven reasons why companies consider securitization:
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to improve their return on capital, since securitization normally requires less capital to support it than traditional on-balance sheet funding; to raise finance when other forms of finance are unavailable (in a recession banks are often unwilling to lend - and during a boom, banks often cannot keep up with the demand for funds); to improve return on assets - securitization can be a cheap source of funds, but the attractiveness of securitization for this reason depends primarily on the costs associated with alternative funding sources; to diversify the sources of funding which can be accessed, so that dependence upon banking or retail sources of funds is reduced; to reduce credit exposure to particular assets (for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitization can remove some of the assets from the balance sheet); to match-fund certain classes of asset - mortgage assets are technically 25 year assets, a proportion of which should be funded with long term finance; securitization normally offers the ability to raise finance with a longer maturity than is available in other funding markets; to achieve a regulatory advantage, since securitization normally removes certain risks which can cause regulators some concern, there can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitization as a means of managing the restriction on their wholesale funding abilities).
3. Process of securitization
1. Assets are originated by a company, and funded on that company's balance sheet. This company is normally referred to as the “Originator". 2. Once a suitably large portfolio of assets has been originated, the assets are analyzed as a portfolio, and then sold or assigned to a third party which is normally a special purpose vehicle company (an " SPV") formed for the specific purpose of funding the assets. The SPV is sometimes owned by a trust, or even, on occasions, by the Originator. 3. Administration of the assets is then sub-contracted back to the Originator by the SPV. 4. The SPV issues tradable "securities" to fund the purchase of the assets. The performance of these securities is directly linked to the performance of the assets - and there is no recourse (other than in the event of breach of contract) back to the Originator. 5. Investors purchase the securities, because they are satisfied (normally by relying upon a rating) that the securities will be paid in full and on time from the cash flows available in the asset pool. A considerable amount of time is spent considering the different likely performances of the asset pool, and the implications of defaults by borrowers on the corresponding performance of the securities. The proceeds upon the sale of the securities are used to pay the Originator. 6. The SPV agrees to pay any surpluses which arise during its funding of the assets back to the Originator - which means that the Originator, for all practical purposes, retains its existing relationships with the borrowers and all of the economics of funding the assets (i.e.: the Originator continues to administer the portfolio, and continues to receive the economic benefits (profits) of owning the assets). 7. As cash flows arise on the assets, these are used by the SPV to repay funds to the investors in the securities
4. Parties involved
Securitization normally involves a wide variety of counterparties and advisers. On one particularly complex transaction a few years ago there were 6 law firms, 3 firms of accountants, 1 insurance broker, 1 investment bank, 1 consultant and 12 principals (banks, originators, administrators, credit enhancers, underwriters and so on). A transaction normally involves the following parties:
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Originator and Administrator Lead Underwriter who purchases the debt issued by the SPV (and sells it to euro bond investors) Structuring Team either involving personnel from the lead underwriter and/or other advisers Two sets of lawyers, at least one of whom is a securitization specialist Trustee and Trustee's lawyers representing the interests of the note holders in the event that there is (a) an enforcement event (things go wrong) or (b) any requirement to change or amend the documents or procedures after the transaction completes; Rating Agencies required to undertake an analysis of the risks associated with the transaction and to award a credit rating to the debt issued Originator's accountants to agree accounting treatment for the transaction, to verify the analysis and existence of the assets involved and to confirm work undertaken to show solvency Credit Enhancement Providers and their lawyers transactions often involve a third party fronting some of the risks associated with the assets Standby Servicer and their lawyers a third party prepared to administer the assets in the event that the existing servicer fails or is incompetent; this is now becoming a requirement for all transactions where the administrator does not already have at least an A1/P1 short term rating Clearing Bank and its lawyers running the originator's and the Issuer's bank accounts, all of which normally require new mandates and a Bank Agreement is also set up to regulate the operation of all aspects of the accounts Banking Facility Providers and their lawyers often there are requirements for additional banking facilities, e.g.: liquidity facilities or guaranteed deposit arrangements ("GICs") Hedging Providers and their lawyers assets often need some form of hedging, either using swaps, caps or both Paying Agents, Agent Banks, Common Depositary etc.. a whole host of organizations with mysterious Euro market responsibilities
Printer to produce the prospectus (choosing the wrong printers can cause the transaction to fail)
5. Motivations for using securitization
Securitization appeals to both nonfinancial and financial corporations. The four primary reasons for raising funds via securitization are reviewed below: Potential for reducing funding costs The cost of funding depends on the credit rating assigned to a debt obligation issued by an entity. In the case of a corporate bond, the rating will depend on the credit quality of the corporation. In the case of an SPV, because of legal preference and deference, the rating agencies will assign a rating to each security in a securitization based on the expected performance of the asset pool and the priority of a security in the structure. What is key is that the rating assigned to each security issued by the SPV will be independent of the financial condition of the originator company. Consequently, the originator company can have a speculative grade rating but the SPV can issue one or more securities with a much higher credit rating. The rating agencies evaluating the securities in the structure will advise the originator company on how the transaction must be structured in order to obtain a specific rating for each security in the securitization. Diversifying funding sources Corporations seeking funding in the asset backed securities market must be frequent issuers in the market in order to get their name recognized in the asset backed securities market and to create a reasonably liquid after market for trading their securities. Once an issuer establishes itself in the market, it can look at both the corporate bond market and the asset backed securities market to determine its best funding source by comparing the cost of funds in the two markets, as well as non quantifiable benefits associated with securitization. Managing corporate risk Securitization is one of several corporate risk management tools available to management. When assets are sold in a securitization, the originating company no longer bears the interest rate or credit risk of those assets. Ford Motor Credit offers a good example of this. Since 2000, management has employed securitization to reduce the credit risk of its car loan portfolio Achieving off balance sheet financing If properly structured, securitizations remove assets and liabilities off the balance sheet of the originator company. The argument put forth by those who employ securitization is that the reduction in the amount of the originator company’s on balance sheet leverage can help enhance its return on equity and other key financial ratios.
6. Risks Involved in securitization
The key risks in a typical securitization transaction are: 1. Credit Risk and Ability of the entity to pay its obligations and survive Bankruptcy Risk as a viable entity. 2. Performance Risk: Ability to perform and fulfill contractual obligations. 3. Asset/ Collateral Risk: Variation in the value of the underlying asset. 4. Payment / Counterparty Risk: Ability of other parties to the transaction, like swap provider, paying bank etc., to meet their obligations. 5. Interest Rate Risk: Risk arising out of variation in interest rates. 6. Exchange Rate Risk: Risk arising out of variation in exchange rates of various currencies. 7. Liquidity Risk: Ability to liquidate the underlying assets or collateral and generate liquidity to Service the Investors in a timely manner. 8. Commingling Risk: When a Servicer is appointed to collect moneys from the Obligors, the funds collected may be retained by the Servicer with itself for a short period of time before remitting to the SPV. The risk of loss of such moneys due to a credit event or bankruptcy of the Servicer is called commingling risk. 9. Prepayment Risk: The obligors of the underlying assets may repay their obligations ahead of schedule. This affects the maturity of the investments made by the investors. The variation in the maturity due to pre-payment by the obligors is the pre-payment risk. 10. Reinvestment Risk: Some structures (typically pay-through ones) may have the SPV reinvesting the funds received from the obligors and the originator and paying out to investors only on prespecified dates. The variability in the returns earned on such investment is reinvestment risk. 11. Legal / regulatory / tax Risk : As structured finance deals involve interpretation of various laws (including that of income tax laws) and regulations as also complex documentation, there is a significant level of legal and regulatory risk.
7. Securitization and liquidity
Liquidity has been traditionally understood as asset’s capability over time of being realized in the form of funds available for immediate consumption or reinvestment, proximately in the form of money. It is also construed as a high level of trading activity, allowing buying and selling with minimum price disturbance. It can be defined as a market characterized by the ability to buy and sell with relative ease as well. Another classification seeks to divide liquidity into funding liquidity and market liquidity. Funding Liquidity as defined by Brunnermeier is “the ease at which the financial institutions can borrow short term against some asset or security”. In this system of borrowing short term, only a part of the asset’s value can be borrowed as the same is used only as collateral. The difference between the value of the asset and its subsequent borrowable value in the process of securitization is the margin which technically, is insurance for the investor. It is therefore clear that the value of the asset is the determining factor when it comes to creation of funding liquidity. Market liquidity on the other hand is the ease at which the asset or security can be liquidated in the market. It is noteworthy that market liquidity has a tendency to fluctuate depending upon the price of the asset and funding liquidity which therefore become decisive factors when it comes to creation of market liquidity. By definition, securitization is a process of creating liquid financial instruments out of assets that could be too cumbersome or expensive to sell individually. The process of securitization is used by the banks to transfer the risks to the investors who hold the same giving due regard to risk ratings whereby the balance sheet is eased from risk-weighted loans, thereby reducing the regulatory capital charge, thus expanding the source of funding liquidity. Securitization enhances market liquidity by converting illiquid assets on the balance sheets of originators into marketable securities. Further, since the said securities are backed by assets, the ease at which they are liquidated is relatively high thus contributing to the creation on market liquidity. As understood previously the SPV structure in addition to creating regulatory arbitrage also created a cheap source of funding liquidity through a simple process of buying illiquid claims and then transforming the same as tradable securities. As securitization proliferated, the structure of the SPV’s had a dynamic addition wherein they were created solely for the purpose of trading securities without directly participating in the process of securitization. Since funding liquidity is the ease at which borrowing against securities may occur, therefore greater the frequency of asset trading, greater would be the funding liquidity. On the other front, increase in the trading frequency accompanied by positive asset price change, results in the creation of market liquidity whereby assets are successfully liquidated without a decline, or in more economic terms, loss in the price of the asset. It is also significant to note that both funding liquidity and market liquidity are highly dependent on the quality of the collateral as the latter decisively determines the ability to generate securities and a subsequent trading of the same. It is therefore clear that there exists a correlation between securitization and liquidity. In the wake of the economic crisis of 2007, it is also momentous to discuss the concept of liquidity illusion. Liquidity illusion introduces the idea that though securitization was theoretically meant to boost liquidity, it was, in reality, a mere illusion. According to theorists there has been a shift
in the general understanding of liquidity from being a property of assets to a mere indicator of the vitality of the market. In addition to this one dimensional conceptualization, the mainstream finance theory has taken the role of financial institutions to a whole new level. Simply put, the mainstream finance theory introduces a three ponged function of financial institutions which are firstly, the identification and pricing of risks, secondly, parceling the same into specific financial vehicles and then finally redistributing risks to people who are most capable to hold them.36 Theorists argue that this conceptualization of liquidity is based on certain fallacies. The first fallacy is the assumption that liquidity is created by the market making capacity of the financial intermediaries implementing the three pronged functions. The second fallacy is the notion that market liquidity is nothing but the general market trade and turnover and the third fallacy is the view that market liquidity itself when multiplied across many markets ultimately is synonymous with the liquidity (and financial robustness) of the economic system as a whole. According to Minsky, this mesh of financial innovations has twin effects on the liquidity of the system. On one hand, velocity of money increases as financial innovations gain ground while on the other hand, every institutional innovation which results in both new ways to finance business and new substitutes for cash decreases the liquidity of the economy. As securitization propelled the belief that the financial innovation of the originate and distribute model would create additional and plentiful liquidity, in actuality it drove the financial system into a structurally illiquid, and crisis-prone, state by introducing an incredibly complex and obscure hierarchy of credit instruments, whose liquidity was assumed but never guaranteed.40 The liquidity illusion therefore held the belief of the market for long, before the inevitable crash. This liquidity illusion in fact made banks substitute their traditional liquid assets with highly rated structured credit products which in the longer run proved to be a demolishing factor in various economies across the globe. The concept of liquidity illusion presents securitization as a reaction to the Basel Accords as under the those financial regulations, holding safe and liquid assets on the balance sheets would mean the banks would not be able to lend as much as they wanted to. The changing role of financial intermediaries in the era of securitization, leading to a proliferation of financial innovations and financial engineering through Ponzi mode of finance, led to the idea of abundance of liquidity in the market and to its subsequent downfall. Securitization, according this concept is a glorified term for validating bad debts. Credit rating agencies play a pivotal role in the process. They not only manipulate regulations by isolating the originator from the products they sell but also effectively layer securitization structures. The rule was simple, obtain an AAA rating and the deal would be profitable. Obtaining such a rating required a strategic layering of assets on the basis of their seniority. The credit rating agencies miserably failed in their task of risk analyses. Thus by creating a market for bad quality debts, a grand liquidity illusion was created and the market sunk into the same.
8. Securitization and recession
The summer of 2007 was marked by a contagious liquidity meltdown that hit the world markets. The meltdown, that initiated due to the sub-prime mortgage fiasco in the United States of America and was characterized by financial panic and unknown asset values, destabilized not only the American financial system, but also spread globally to affect the European and Asian markets. Subsequently, the next eighteen months, witnessed the transformation of the contagious financial crisis and ultimately with the bursting of the “housing bubble”, the rush for liquidity, and the following credit squeeze, the world plunged into a global recession, whose effects prevail till date. The credit crunch affected well established financial institutions like Bear Sterns, Lehman Brothers and AIG insurance firms in America, and Northern Rock and Lloyds in the United Kingdom and caused significant monetary losses. The financial crisis has been attributed to a multitude of reasons, most of which centre around Securitization. Firstly, as stated earlier, securitization enhanced the funding liquidity which provided the banks with an opportunity to attract more borrowers. Moreover, the fees paid to the originators for carrying out various responsibilities in the securitization chain, proved to be an additional incentive for them to securitize more and more. However, since most of the prime borrowers already had loans, the originators lowered lending standards to attract as many new borrowers as possible which consequently included sub-prime ones45. The originators not only relaxed the criterion for advancing loans, they also created loans which initially looked attractive but were actually toxic for the borrowers. As a result, the overall fragility of the financial system increased and the seeds of recession in the credit cycle were sown. Secondly, the originators increasingly adopted the “originate and distribute” model i.e. they created loans that they did not plan to retain on their balance sheets. This model induced a reckless approach in assessing the quality of the loans with the originators being largely unconcerned about the quality of the loans and underlying assets that were eventually going to be securitized. As estimated by a few analysts, 50% of the mortgages backing new private-labeled mortgage backed securities in the years 2005 and 2006 and 77% in 2006 had improper and incomplete documentations. These inadequately evaluated loans -termed as hot potatoes- were passed through the financial chain to unsuspecting investors as each party relied on others to investigate the loans comprehensively. However, what is pertinent is that securitization did not eliminate the risk or completely transfer the risk down the financial chain, it issued liabilities backed by the hot potatoes to which all the intermediaries in the securitization process were exposed. Thirdly, the manner in which the credit rating agencies executed their responsibility of assessing the securities was probably one of the most significant factors that brought about the financial crisis. The rating agencies neither examined the credit worthiness of the borrowers nor the underlying assets that backed the securities while judging their credit risks. Owing to the unavailability of details of the securities, the agencies used proxy data on default rate and recovery rate of to arrive at a classification of the securities. Further, the conflict of interest crated due to the commissions paid to the agencies by the security issuers and the level of competition between, induced the agencies to adopt sloppy methods of rating securities. On the other hand, the SPE approached only specific agencies in order to obtain favorable ratings. As a result, the very rationale behind involving credit agencies in the securitization process was defeated with securities being graded AAA even though they were backed by junk financial claims. The inappropriate rating left the investors with unsound evaluation of credit risks involved in the securities which offered a false sense of security to the investors who willingly took on the risks. It is certainly
arguable that investors, as reasonable men involved in financial system, would be apt judges of risks that they undertook. However, as explained by Tymoigne, investors judge risk from a social rationality where they chose to follow the majority. Besides, the complete lack of transparency left the creditors with no means of evaluating the risks since it was believed that releasing information would bring about selective investments that would reduce the market liquidity. Fourthly, the various counterparties in the securitization process have become increasingly interdependent for cash flow which has increased the systemic risk considerably. This implies that investors depend on the SPE to sell the securities to them, the SPE depends on the originator to provide assets and the originator ultimately depends upon the borrowers. Yet, what actually worsened the scenario was the growing opacity of transactions between the counterparties that rendered them incapable of judging their own financial strength since they were unaware of the actual counterparties or the effect of default by any one of them. This threatened the financial stability since the banks become reluctant to lend to each other60. Further, not only was the clarity in transactions reduced, the complexity of the process was gradually increased. Since the number of economic activities is limited, it is understandable that the illiquid receivables are finite. To meet their demands, financial institutions carried out second-level” securitization, “third level” securitization and “fourth-level” securitization by securitizing securities which further reduced the possibility of counterparties in the chain except the issuer, and is some cases the credit rating agencies, to comprehend the relation between the value of the securities and the underlying assets. However banks and other firms are artificial entities that only in contemplation of law. The past decades were also characterized by a period of de-regulation, when the regulators where under the misconception those financial institutions were self-sufficient and interference would impair the growth of the economy. On the contrary, deregulation only provided the financial institutions to take increasing risks and the absence of checks and balances only degraded the quality of the loans.
9. Securitization in India
Securitization in India began in the early nineties, with CRISIL rating the first securitization program in 1991-92. Initially it started as a device for bilateral acquisitions of portfolios of finance companies. These were forms of quasi-securitizations, with portfolios moving from the balance sheet of one originator to that of another. Originally these transactions included provisions that provided recourse to the originator as well as new loan sales through the direct assignment route, which was structured using the true sale concept. Through most of the 90s, securitization of auto loans was the mainstay of the Indian markets. But since 2000, Residential Mortgage Backed Securities (RMBS) have fuelled the growth of the market. The need for securitization in India exists in three major areas – Mortgage Backed Securities (MBS), the infrastructure Sector and other Asset Backed Securities (ABS). It has been observed that Financial Institutions/banks have made considerable progress in financing of projects in the housing and infrastructure sector. It is therefore necessary that securitization and other allied modalities get developed so that Financial Institutions/Banks can offload their initial exposure and make room for financing new projects. With the introduction of financial sector reforms in the early nineties, Financial Institutions/banks, particularly the Non-Banking Financial Companies (NBFCs), have entered into the retail business in a big way, generating large volumes of homogeneous classes of assets (such as auto loans, credit cards). This has led to attempts being made by a few players to get into the ABS market as well. However, still a number of legal, regulatory, psychological and other issues need to be sorted out to facilitate the growth of securitization in India the growth in the Indian securitization market has been largely fuelled by the repackaging of retail assets and residential mortgages of banks and FIs. This market has been in existence since the early 1990s, though has matured significantly only post-2000 with an established narrow band of investor community and regular issuers. According to Industry estimates, the structured issuance volumes have grown considerably in the last few years; though still small compared to international volumes. Asset backed securitization (ABS) is the largest product class driven by the growing retail loan portfolio of banks and other FIs, investors’ familiarity with the underlying assets and the short maturity period of these loans. The mortgage backed securities (MBS) market has been rather slow in taking off despite a growing housing finance market due to the long maturity periods, lack of secondary market liquidity and the risk arising from prepayment/ reprising of the underlying loan. In the early 1990s, securitization was essentially a device of bilateral acquisitions of portfolios of finance companies. There were quasi-securitizations for sometime, where creation of any form of security was rare and the portfolios simply got transferred from the balance sheet of the originator to that of another entity. These transactions often included provisions, which offered recourse to the originator as well. In recent years, loan sales have become common through the direct assignment route, which is structured using the true sale concept. Though securitization of auto loans remained the mainstay throughout the 1990s, over time, the market has spread into several asset classes – housing loans, corporate loans, commercial mortgage receivables, future flow, project receivables, toll revenues, etc that have been securitized. Within the auto loan segment, the car loan segment has been more successful than the commercial vehicle loan segment, mainly because of factors such as perceived credit risk, higher volumes and homogenous nature of receivables. Other a type of receivables for which securitization has been
attempted in the past includes property rental receivables, power receivables, telecom receivables, lease receivables and medical equipment loan receivables. Revolving assets such as working capital loans, credit card receivables are not permitted to be securitized. In India, issuers have typically been private sector banks, foreign banks and non-banking financial companies (NBFCs) with their underlying assets being mostly retail and corporate loans. The key motivations for Indian banks include:
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Liquidity: Securitization is an easy route than raising deposits that are subject to reserve requirements Regulatory issues: Constrains arising out of Provisions, priority sector norms, etc Capital Relief: Major investors are mostly mutual funds (money market/liquid schemes), closeended debt schemes and banks. Long term investors like insurance companies and provident funds are currently not active due to regulatory constraints. Foreign institutional investors are also missing due to regulatory ambiguity. As per guidelines, mutual funds are required to declare their NAV’s on a daily basis due to which they prefer the structure/asset classes which involve low pre-payment rates. The lack of domestic non-traditional hedge fund style investors to participate in equity and mezzanine tranches has led to originators holding them.
Some examples of securitization in the Indian context are:
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First securitization deal in India between Citibank and GIC M F in 1991 for Rs 160 mn L&T raised Rs 4,090 mn through the securitization of future lease rentals to raise capital for its power plant in 1999. India’s first securitization of personal loan by Citibank in 1999 for Rs 2,841 mn. India’s first mortgage backed securities issue (MBS) of Rs 597 mn by NHB and HDFC in 2001. Securitization of aircraft receivables by Jet Airways for Rs 16,000 mn in 2001 through offshore SPV. India’s first deal in the power sector by Karnataka Electricity Board for receivables worth Rs 1,940 mn and placed them with HUDCO. India’s first Collateralized Debt Obligation (CDO) deal by ICICI bank in 2002 India’s first floating rate securitization issuance by Citigroup of Rs 2,810 mn in 2003. The fixed rate auto loan receivables of Citibank and Citicorp Finance India included in the securitization India’s largest securitization deal by ICICI bank of Rs 19,299 mn in 2007. The underlying asset pool was auto loan receivables.
10. Issues facing Indian securitization market
1. Regulatory issues Stamp Duty: One of the biggest hurdles facing the development of the securitization market is the stamp duty structure. Stamp duty is payable on any instrument which seeks to transfer rights or receivables, whether by way of assignment or by any other mode. Therefore, the process of transfer of the receivables from the originator to the SPV involves an outlay on account of stamp duty, which can make securitization commercially unviable in several states. If the securitized instrument is issued as evidencing indebtedness, it would be in the form of a debenture or bond subject to stamp duty. On the other hand, if the instrument is structured as a Pass Through Certificate (PTC) that merely evidences title to the receivables, then such an instrument would not attract stamp duty, as it isn’t an instrument provided for specifically in the charging provisions. Among the regulatory costs, the stamp duty on transfers of the securitized instrument is again a major hurdle. Some states do not distinguish between conveyances of real estate and that of receivables, and levy the same rate of stamp duty on the two. Stamp duty being a concurrent subject, specifically calls for a consensual legal position between the Centre and the States. 2. Foreclosure Laws: Lack of effective foreclosure laws also prohibits the growth of securitization in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default. 3. Taxation related issues Tax treatment of MBS SPV Trusts and NPL Trusts is unclear. Currently, the investors (PTC and SR holders) pay tax on the income distributed by the SPV Trusts and on that basis the trustees make income pay outs to the PTC holders without any payment or withholding of tax. The view is based on legal opinions regarding assessment of investors instead of trustee in their representative capacity. It needs to be emphasized that the Income Tax Law has always envisaged taxation of an unincorporated SPV such as a Trust at only one level, either at the Trust SPV level, or the Investor/Beneficiary Level to avoid double taxation. Hence, any explicit tax pass thro regime if provided in the Income Tax Act does not represent conferment of any real tax concession or tax sacrifice, but merely represents a position that the Investors in the trust would be liable to tax instead of the Trust being held liable to tax on the income earned. Amendments need to be made to provide an explicit tax pass thro treatment to securitization SPVs and NPA Securitization SPVs on par with the tax pass thro treatment applied under the tax law to Venture Capital Funds registered with SEBI. To make it certain that investors as holders of Mutual Fund (MF) schemes are liable to pay tax on the income from MF and ensure that there is no tax dispute about the MBS SPV Trust or NPA Securitization Trust being treated as an AOP(Association of Persons), SEBI should consider the possibility of modifying the Mutual Fund Regulations to permit wholesale investors (investors who invests not less than Rs. 5 million in scheme) to invest and hold units of a closed-ended
passively managed mutual fund scheme. The sole objective of this scheme is to invest its funds into PTCs and SRs of the designated MBS SPV Trust and NPA Securitization Trust. Recognizing the wholesale investor and Qualified Institutional Buyers (QIB) in securitization Trusts, there should be no withholding of tax requirements on interest paid by the borrowers (whose credit exposures are securitized) to the securitization Trust. Similarly, there should be no requirement of withholding tax on distributions made by the securitization Trust to its PTC and/or SR holders. However, the securitization Trust may be required to file an annual return with the Income-tax Department, Ministry of Finance, in which all relevant particulars of the income distributions and identity of the PTC and SR holders may be included. This will safeguard against any possibility of revenue leakage. 4. Legal Issues Listing of PTCs on stock exchange: Currently, the SCRA definition of ‘securities’ does not specifically cover PTCs. While there is indeed a legal view that the current definition of securities in the SCRA includes any instrument derived from, or any interest in securities, the nature of the instrument and the background of the issuer of the instrument, not being homogenous in respect of the rights and obligations attached, across instruments issued by various SPVs, has resulted in a degree of discomfort among exchanges listing these instruments. To remove any ambiguity in this regard, the Central Government should consider notifying PTCs and other securities issued by securitization SPV Trust as ‘securities’ under the SCRA 5. Lack of Investor Appetite Investor awareness and understanding of securitization is very low. RBI, key drivers of securitization in India like ICICI and Citibank and rating agencies like CRISIL and ICRA should actively educate corporate investors about securitization. Mandatory rating of all structured obligations would also give investors much needed assurance about transactions. Once the private placement market for securitized paper gathers momentum, public retail securitization issuances would become a possibility.
11. Update on Indian securitization market With reference to new RBI guidelines
Guidelines on Securitization and Direct Assignment Transactions (May 2012) The RBI, in May 2012, put out the final guidelines on securitization and direct assignment of assets by banks. This is the first time the RBI has issued separate guidelines for Direct Assignment transactions. Amongst the important new prescription in the guidelines is the prohibition of credit enhancement for direct assignment transactions. The other key stipulations are a Minimum Holding Period (MHP) for Originators before off-loading the receivables and a Minimum Retention Requirement (MRR) through the tenure of the transaction. Income tax authorities’ notice for taxation of SPVs During FY2012, the income tax authorities sent notices to trustees of several securitization transactions—which the trustees in turn passed on to the investors, i.e., mutual fund houses—asking them to pay tax on income generated through pass through certificates (PTCs). Following this move, the MFs filed petitions in the Bombay HC, seeking a relief from the tax claim and attachment of their accounts—given that MFs are exempt from income tax. The Bombay High Court passed a stay order on the I-T department notice till the commissioner I-T disposes off the appeal filed by the mutual funds against its notice. Though the matter is sub-judice, the fund houses have been skeptical about investing in securitized instruments till the matter is sorted out. Securitization transactions in India basically operate on the premise that the beneficiaries of the SPV—typically a trust—will offer the income earned from the investment to tax, and thus the income should not be taxed at the level of the trust. The IT department’s stance effectively challenges this premise and thus, a resolution to this issue could be an important factor for determining the future of securitization going forward. Most market participants are of the view that the most immediate and severe obstacle to securitization is this unresolved issue of taxation of the securitization SPV. RBI has been mulling over the Securitization Guidelines for almost 2 years now. Dealing with the worldover tabooed structured finance instrument, RBI had released the first draft of the guideline in April, 2010 and the next in September, 2011. The industry has been kept on tenterhooks ever since awaiting the final version to be released soon. The draft guidelines had created uproar amongst the industry players that the regulators were trying to throttle direct assignment and RBI has taken good time to come out with the final guidelines on 7th May, 2012.
The highlights of the guidelines are as below:
1. Asset Eligibility – All asset except the following can be securitized : a. Revolving credit facilities b. Asset purchased from other entities c. Securitization exposure d. Loans with bullet repayment of both principal and interest 2. Minimum Holding Period and Minimum Risk Retention requirement - As an offspring of the originate-to-distribute model, in several countries such regulations have been imposed to ensure that the loan underwriting standards are not lax and no compromise is made on due diligence of assets generated in the books of the originators. RBI has followed the international trend requiring minimum lock-in for bank loans and requiring some ‘skin in the game’ before they can be securitized. The criteria set down for determining the minimum holding period is that the pool should have demonstrated minimum recovery performance to ensure good underwriting standards and should not pass the project implementation risk to the investors. The purpose of securitization is to diversify the risk. Risk in securitization is passed to the investors, but the criteria laid down above are ambiguous. RBI does not explain what “minimum” recovery performance it is looking at, this would leave market to have its own norms for minimum recovery performance of the pool before securitizing. Further the minimum holding period requirement has been pegged to the seasoning in terms of repayment frequency and tenor which in our view is appropriate. The minimum risk retention requirements are similar to the earlier draft with an addition that in case of bullet repayment loans/ receivables, the risk retained would be 10%. 3. Retained Exposure – In light of the Basel II requirements, the total exposure of the originator shall not exceed 20% of the total securitized instruments issued but shall not include interest rate swaps/currency swaps entered into with the SPV. 4. Booking of profits upfront - While earlier the profits were to be amortized over the life of the securities issued, the current guidelines allow the recognition of cash profits arising out of securitization profits adjusted against the marked-to-market losses suffered by the originator due the exposure in the securitization transaction. Booking of upfront profits, that is the sale consideration exceeding the carrying value of the assets, is in line with international practices and is favorable. 5. Due Diligence standards – The overseas branches of Indian banks cannot invest or assume exposure in securitization in such jurisdictions where minimum risk retention (MRR) requirement is not laid down/ prescribed. This in our view is not appropriate. Securitization exposures should be permitted to overseas branches, as long as the originators are adhering to the MRR requirement as prescribed by RBI whether or not other sovereign has prescribed such requirements. 6. Direct Assignments – The earlier guidelines did not include direct assignments and led to market moving from PTC structure to bilateral assignment, the September, 2011 draft guidelines strangulated their existence. As per the 2011 draft guidelines in case of direct assignments, banks were not allowed
to offer credit enhancements and liquidity facilities, in the wider sense even retention of excess spread was not permissible and the risk retention was pari passu with that of the transferee. However the final guidelines have provided a sort of relaxation here. The MRR requirements are not explicitly stated to be pari passu to the investors and RBI has taken a detour to allow risk retention by requiring the originator to obtain a legal opinion, wherein the opinion should confirm that the arrangement is not interfering with the risks and rewards associated with the loans to the extent transferred to the assignee. The risk retention requirement is on a percentage of the transferred asset. If by way of a legal opinion, the originator needs to confirm that the transferee’s risks are protected, it is nothing but a credit enhancement provided in the garb of MRR requirement. Where risk is protected, rewards automatically get protected. 7. True Sale criteria – RBI has very explicitly mentioned in the guidelines that securitization transactions should meet the true sale criteria and that they shall be beyond the reach of the creditors of the originator, in the event of bankruptcy as well. This is very thoughtful. However, most transactions at the time of structuring are said to have met the true sale criteria, but the substance of the transaction is exposed when such transactions face judicial review. So while it is thoughtful to ring fence assets securitized at the inception, the claw back of such assets would depend when the structures are put to test before the eyes of law. The originator carrying out the servicing function shall not affect the true sale criteria are again in line with international practices. 8. Securitization not permitted in certain cases – Securitization is not permitted in case of 1) resecuritization of assets, 2) synthetic structures and 3) revolving structures. These structures have been prohibited for the time being, but RBI has expressed intent to revisit their appropriateness in due course. While the revolving structures have been barred we still hold the view that intention of RBI is to bar the revolving structures where the borrower is under a line of credit, such as credit card receivables and cash credit facilities are barred, not microfinance pools as there is no line of credit provided there. There is a difference between reinstating structures and revolving structures. In reinstating structures, the repayment of the loan is by way of EMIs, but these loans are sold on regular basis, whereas in case of revolving structures as used in credit card receivables, repayments are within an agreed limit under a line of credit and the exposure varies. The intent of the RBI, it so seems is to put a bar on the revolving type structures and not against reinstating structures.
What all can be securitized? 4 Only performing assets: Transfers of non-performing assets are covered by separate guidelines Homogenous pool: The oft-repeated references to homogenous pool in the Guidelines cannot be Stretched beyond a point ? ? ? Every homogenous pool is heterogeneous ? it contains assets which are diversified The meaning of homogenous is only same type of collateral : For example car loans, home loans, corporate loans. Homogenous meaning loans sharing similar risk characteristics from viewpoint of Internal classification by the bank Assets that cannot be securitized: Single loans Revolving credit facilities: Note there is no bar on revolving structure of securitization Purchased assets ABS/ MBS Loans with bullet payment of principal and interest
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What is eligible and what is not ? ? ? ? ? ? ? ? ? ? ? ? ? Ineligible assets are the same as in case of securitization Revolving credits Purchased loans Bullet repayment loans Guidelines do not apply to the following: Transfers that happen with the request of the borrower This would mean novation transactions will also be excluded Inter-bank participants Arguably, also the transferable participation rights envisaged by Nair committee Trading in bonds: Guidelines will promote issue of bonds as a replacement of loans, particularly in case of corporate lending Bonds become an easy route to escape the entire Guidelines Sale of entire portfolio upon exit decision Entire portfolio Once again, should mean a portfolio sharing risk features
Indian Securitization Market (2012)
ABS continues to form a major part of transactions in FY2012 During FY2012, the securitization market in India grew by 15% over the previous year, in value terms. The number of transactions was also 32% higher in FY2012 than in the previous fiscal. The number and volume of retail loan securitization (both ABS and RMBS together), was the highest in FY2012 compared to previous fiscals, while the LSO issuance was the lowest ever.
Source: ICRA’s estimates
Source: ICRA’s estimates
As can be seen from table 1, given the increase in both the ABS and RMBS products coupled with a reduction in LSO issuance, the overall share of retail loan securitization increased during FY2012. The average deal size was lower in FY2012 compared to the previous two fiscals, mainly due to the greater share of microfinance loan1 pools. LSO3 issuance has been witnessing a sharp decline since H2 of FY2011. LSO transactions were largely short-term in nature and the Originator would typically disburse the loan with the specific intention of securitizing it soon after the disbursement. RBI’s draft guidelines issued in the first quarter of FY2011, specially the requirement of Minimum Holding Period (MHP) of 9 to 12 months, created a potential interest rate risk for the Originator and adversely affected the LSO issuance volume 2. Moreover, the lackluster demand from mutual funds (MFs)—the key investor segment in LSOs3 in the past—owing to low secondary market liquidity for PTCs, and the prohibition on investment by liquid funds in debt with tenure longer than 91 days further impacted LSO issuance volume.
1. Nevertheless the guidelines are at a draft stage and some issuances did happen 2. Loans smaller than Rs. 30,000, typically given to women below poverty line for income generating purpose 3. Securitization of individual corporate loans or loan sell-off (LSO)
Asset-Backed Securitization
ABS remains major asset class; number of transactions rise significantly in FY2012 The number of ABS issues increased significantly by 58% in FY2012 to 178 transactions. However, in value terms, the increase was only 19% over FY2011. The average deal size was lower at Rs. 146 crore in FY2012 compared to Rs. 193 crore in FY2011. This was on account of higher number of Microfinance transactions executed in FY2012 at 65 that was about twice the issuance in FY2011 at 34.
Source: ICRA’s estimate The total number of issuers in the ABS space increased from 23 to 33 as some microfinance entities entered the securitization (or assignment) market. Shriram Transport Finance Company, SREI
Equipment Finance, Indiabulls Financial Services Ltd., Sundaram Finance and Shriram City Union Finance were the largest Originators in FY2012, altogether contributing to over 60% of the total number of ABS issuances. Banks continued to be absent from the securitization market as Originators (although they continue to be a key investor segment).
Residential Mortgage-Backed Securitization
RMBS issuance grows in FY2012 The number of RMBS issuances increased to 22 in FY2012 along with an increase of 53% in value terms. However, the average deal size marginally reduced to Rs. 349 crore in FY2012 from Rs. 359 crore in FY2011. RMBS segment continued to be highly concentrated with HDFC and Dewan Housing Finance, which together contributed to about 85% of all issuances.
Figure 4: Issuance Volumes in Indian RMBS Market
Source: ICRA’s estimates 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. Accordingly, banks were typically the investors in these transactions.
12.Summary
Though retail loan securitization improved in FY2012, the issuance volume in India continues to remain subdued and concentrated among few Originators. Around 75% of the market in FY2012 was essentially bilateral loan pool trading, driven by the economics of priority sector lending targets. It follows that the investor segment is largely banks—mainly private sector and foreign banks. Mutual Funds have mostly been absent from the securitization market for a variety of reasons, the latest being the unresolved issue of income tax authorities’ claim on taxing the income from securitized instruments.
13.Outlook on new RBI guidelines
Via these guidelines, the RBI aims to reduce systemic risk through the requirement of a minimum holding period and a minimum retention amount for originators. The RBI has also made an attempt at doing away with the arbitrage opportunity between “assignments” – i.e. a direct sale of assets from one financial institution to another – and securitizations, and in this attempt has created new arbitrage opportunities, this time favoring securitizations. A tantalizing comment that new guideline for amortization of credit enhancement is forthcoming will create hope amongst originators who have long been stifled by the high capital charge imposed by the earlier regulations. We expect the new regulations to be largely positive for the creation of a true securitization market in India. Several long awaited safeguards will enhance the quality of pass through certificates issued in a securitization, with the minimum holding period having the maximum impact on the rating of the securities. Originators have the flexibility of retaining interest at different levels of the capital structure; however their overall interest is capped at 20%, thus enhancing the nature of the ‘true sale’. It is also likely that assignments will now take a back-seat, with the RBI disallowing first loss credit enhancements. Minimum holding period (MHP) RBI has amended the minimum holding period requirements significantly, in line with feedback from market participants, by differentiating the MHP as per tenor and frequency of installment of the underlying asset being securitized. It has imposed a minimum holding period that varies from 3 months to 12 months across loans of different tenors and repayment frequencies. Even within one tenor, the guidelines reward loans with more frequent payouts with a lower minimum holding requirement. The MHP guidelines appear to be largely in line with market practice, with some conservatism built in. The immediate effect of the MHP guidelines will be a sharp reduction in the volume of transactions, as originators will need time to build up portfolios that qualify for a securitization. Further, the residual average life of transactions will reduce, thus increasing the component of fixed costs that are usually applicable for a securitization (e.g. legal fees, trustee charges etc.).
It remains to be seen if rating agencies will improve ratings of securities on account of higher seasoning – which may reduce transaction pricing. At the same time, the MHP guidelines appear to be much better than the drafts released earlier. Microfinance institutions, for one, can heave a collective sigh of relief – these institutions have depended on the securitization market for raising 30-60% of their fund requirements in FY 20121. Some populism has surfaced in the regulations with long term, bullet repayment agricultural loans exempted from the requirement of minimum holding. This may adversely result in an increase in the risk of priority sector portfolios currently held by banks. Minimum retention requirement (MRR) While the RBI has required originators to retain 5-10% of exposure (based on tenor), crucially the RBI has also permitted originators / investors / rating agencies to choose the portion of the capital structure where the originator may retain exposure. This will provide flexibility to originators as their rating improves (or as capital market history of the asset class builds up) to move their exposure from the first loss to a more senior position, i.e. sell down more risk in the market. Significantly, while the RBI has brought assignments under the guidelines, the RBI has also mandated that originators may not provide a first loss in assignment transactions but rather hold pari-passu exposure. For most investors, the assignment route would have limited value from a risk perspective. The assignment route had been earlier actively used by banks to meet priority sector requirements towards the end of the financial year – in many cases these deals are unrated and non-transparent / off-market terms. We believe that this is an excellent development and will assist in the development of a transparent, rated securitization market. Maximum exposure for the originator A further significant change in the guidelines is the cap of exposure of the originator, which now stands at 20% and includes all forms of exposure (excluding excess interest). This has far reaching implications for various asset classes, where the credit enhancement levels required for meeting rating thresholds exceeds 20%. In such cases, the role of a second loss credit enhancer is much more relevant to provide the requisite support for seeing a transaction through. Profit booking and accounting aspects In the 2006 guidelines, the RBI had mandated that originators recognize profit on sale from securitizations on an accrual basis, while requiring originators to recognize costs upfront. This skewed treatment has been partially relaxed with originators permitted to recognize a higher quantum of profits. However, the extent of higher profits permitted to be recognized is not meaningful. The key addition is the treatment of profits from excess interest, which was a grey area and has now been clarified.
Disclosures from originators and diligence by investors The RBI requires originators to disclose the extent of MHP and MRR in a transaction in the disclosure memorandum, and in addition provide sufficient information for investors to conduct stress test on their exposures. Additional disclosures are welcome and will only enhance transparency. Bank investors would need to demonstrate that they have a sound understand of the inherent risk in securitization investments, an understanding of the underlying assets, extent of possible loss arrived at through stress tests, credit enhancements available etc. These requirements are quite standard and an insistence on such minimum standard may well inhibit pure ‘priority-sector purchases’ by banks. It is also good that the RBI has not mandated that banks undertake field audits of the underlying assets, implying that the investor may rely on the originator to maintain the credit risk of the portfolio as long as the originator has sufficient skin in the game. Treatment of assignments It is very welcome that the RBI has brought an unregulated assignment market into the realm of these guidelines. While it is not clear why the RBI has not permitted originators to retain first loss in assignments, the consequence of this guideline may well be the end of the bilateral assignment market. The stringent due diligence and credit monitoring requirements on investors of assignment transaction may well inhibit this market. Further, the RBI has disallowed capital benefits on the basis of rating for investors in assignment transactions, Further, this will also end the undesirable market practice of building recourse back to the originator via bilateral assignment transactions (via routes such as replacement of non-performing assets, representations taken on a continual basis, servicer liabilities etc.). The ‘true sale’ criteria for assignments are quite unequivocal and in line with the true sale requirements for securitization. Re-securitizations not permitted In line with the earlier draft regulations, the RBI has not permitted re-securitizations, synthetic securitizations and securitization of revolving loans. It is therefore clarified that there is no bar on revolving securitizations where underlying loans are amortizing in nature. Further, securitization of short term trade finance receivables (even bullet in nature) has been explicitly permitted as long as there is adequate credit history of the borrower with the originator (minimum of two cycles). This is a good and meaningful step and may help in developing the trade receivable securitization market
14.BIBLIOGRAPHY
ARTICLES:
? ? ? ? ? ? Anshu S. K. Pasricha, On Financial Sector Reform in Emerging Markets: Enhancing Creditors’ Rights and Securitizing Non-Performing Loans in the Indian Banking Sector—An Elephant’s Tale, 55 Buff. L. Rev. 325 (2007) Barbara Ridpath, Arvind Sivaramakrishnan, Securitization Must Take the Centre Stage Again, (2010) Markus K. Brunnermeier, Lasse Heje Pedersen, Market Liquidity and Funding Liquidity ,Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(6), 2201 (2009) Michael R. Scott , The Subprime Mortgage Crisis: Securities Litigation (2009) The Road to Reform, The Report of the CRMPG III, p.19, (retrieved from http://www.crmpolicygroup.org/docs/CRMPG-III.pdf (last accessed on 18.01.2011) Indian securitization summit report (2009) –Improving Indian securitization markets
BOOKS:
? ? ? Robert F. Reilly, Robert P. Schweihs, Valuing intangible assets, McGraw-Hill Professional (2008) Tamar Frankel, Securitization: Structured Financing, Financial Assets Pools, and Asset-Backed Securities, 2nd Edition, Fathom Publishers (2006) Vinod Kothari, Securitization: The Financial Instrument of the Future, John Wiley & Sons (2007)
WEB SOURCES: ? http://www.financialstabilityboard.org/publications/r_0804.pdf (last accessed on 18.06.2012) ? http://www.stanford.edu/~mckinnon/papers/zero_interes_in_bank_lending.pdf (last accessed on 14.06.2012) ? Farlex Free Dictionary, http://financial-dictionary.thefreedictionary.com/Liquidity (last accessed on 12.07.2012) ? Ghosh, T P, “Innovations in asset-backed securities”, http://www.financialexpress.com/fe/daily/19990331/fex31002.html ? Standard and Poor, “Global CBO/CLO Criteria”, http://www.standardandpoors.com/ResourceCenter/RatingsCriteria/Struc turedFinance/articles/pdf/globalcboclo99.pdf
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