nitinpahuja
Nitin Pahuja
Credit Debt Obligations in INDIA – should they be favoured?
I must be sounding insane. Talking about an (Asset backed security) ABS at a time when the whole world is bearing the brunt of the subprime fiasco. But then you don’t stop doing things because somewhere, something went wrong. Indian bourses did not close down because of the Harshad Mehta incident happened in India, similarly considering MBS or an ABS should not be thought of as a taboo in India and should not deter the regulators from creating the right environment for a vibrant collateral debt obligation (CDO) market. India’s first attempt at introducing CDO was by ICICI bank in 2002, which failed drastically. Thereafter, there has not been much growth in this market.
The securitization market in India is itself in its nascent stages, so saying that, CDO market is not favorable would be incorrect, but then CDO could be used as a tool for improving the low penetration of derived and structured financial instruments in India.
To understand CDOs one needs to know what credit derivatives (CDs) are. One of the risks of investing a bank loan or a debt security is credit risk, the risk of default by the borrower. In response to this possibility, new financial instruments called credit derivatives have been developed in the recent years. CDs help investors insure against adverse movements in the credit quality of the borrower.
CDOs can be explained with a simple illustration. Imagine a small number of water reservoirs located on the slope of the mountain. The reservoirs are emptied then refilled at the start of each month. When each reservoir is completely filled, the water in it flows in to the one just below and in this way a single water source can refill all reservoirs simply by filling the top most pool. Now if source of water does not have sufficient water for the rest of the reservoir, then some reservoir down the mountain may partially or wholly empty.
The reservoir at the highest elevator, which are the ones to be replenished first, correspond to the investor with most senior claims on the cash flow of the portfolio- they are first in line to collect their share of water. The reservoir in lower elevation, which receive their water allotment only after the reservoir up the mountain have received their first due are analogous to investor with junior claims to the cash flows of the portfolio. The reservoir at the foot of the mountain is akin to a equity tranche investor, should the water source come short of its promised amount ,the lowest reservoir will be the first to dry up.
CDOs are basically specialized repackaged offerings that typically involve large portfolio of credit instruments. CDOs involve a horizontal splitting of investors into segments (called tranches) with the objective of categorizing them as:
• Senior class (that portion of funding, which has the lowest risk weight or the highest rated debt).
• Mezzanine class (that portion of funding, which has debt in ascending order of risk weight or in descending order of ratings).
• Equity tranche (balance funding, which has the highest risk weight or the lowest rated debt.).
These different tranches represent varying levels of risk and returns and are rated accordingly. They can, therefore be sold to different investors with different risk appetites.
CDOs can be structured finance CDOs (derived primarily from asset-backed securities and mortgage-backed securities). In 2006, 54% of CDOs were backed by structured finance and 35% were backed by leverage loans). Also there are synthetic CDOs (it pools derivatives rather than actual debt.) With adequate regulation, the advantages of using Funded Credit derivatives in project finance will outweigh the risks.
Regional Rural Banks (RRBs), Co-op banks and even MFs are not allowed to invest in CDOs except schemes floated by UTI. There is a lack of awareness about the structure of a CDO among the Indian investors. The regulations in India with regards to CDOs are not very clear and they are not strong enough to lure the investors. There were discrepancies regarding the responsibility in case of default, whether it is on the originator or the Special Purpose Vehicle (SPV). Also the rules with regards to the valuation of the investment were unclear before the RBI guidelines issued in 2006 and guidance note issued by ICAI. The RBI seems to have used the Basel II criteria. But the taxation issues are yet to be resolved.
Lack of instruments like CDO blocks banks assets and impairs growth through churning of assets. Also the banks forego attractive opportunities on existing relationships.
CDOs have given birth to a very popular idea, the zero coupon equity strip. With zero coupon equity, the investor receives no premium, but instead pays a fraction of the total notional exposure up front and collects the full value of the notional at maturity, minus losses from any defaults.
As an instrument, it is a major attraction for hedge funds. Introduction of such an arrangement would transfer credit risk. The financial system in the country would gain due to the multiplier effect that CDO brings in capital generation. There is enhanced third party participation with aligned risk and return. Basically the transmission of credit risk will allow risk to be hedged away by the risk-averse institutions and reside in players who are risk-takers.
Rating of underlying risk has been a major issue in international securitization market as also for the Indian markets. Because as CDO uses portfolio of credits, rating such credit risk is very important to determine the risk involved in such structure. Also from the point of view of investors, a creditable rating would help them to make correct investment decisions. This would help increase the prospects of CDO in India.
Lack of secondary market liquidity, longer duration of the structure, stamp duty issue is a still a cause for concern; a heavy duty is levied on the transfer of the portfolio which increases the cost of the SPV. There is also prepayment risk, interest rate risk it also lacks transparency in volume, price, parties to the transaction and also there is lack of awareness about the structure and its working.
In India, CDOs can play a very important role for those banks which face a credit crunch. Especially the co-op banks, rural banks and the micro finance institutions. If these bodies can effectively use the benefits of CDO they will be equipped with large base of capital to allot credit to the much needed section of the society.
These entities can pool their credit portfolio together with the other banks with higher rated pool of assets and form a portfolio by creating a SPV, which can come out with bonds having tranches with varying credit risk and returns. This would help them to reissue the limited capital at their disposal. These institutions poses a large potential with CDOs because of high credit rating of their disbursed credit these institution enjoy 99% recovery rate. There is a huge potential for securitization for future receivables in infrastructure sector in India. Enabling risk diversification should be the foremost objective of the regulator if the enormous funding needs of infrastructure (one estimate puts it at Rs 2,00,000 crore over the next three years) in India are to be met.
The Bond market in India is not fully developed as other developed countries. Developing Bond market would therefore help a great deal in creating a customer base for the CDOs. Secondary market needs to be improved to provide liquidity to the instrument which is the most important factor for the success of CDOs. The very reason for the success of equity market in India is that they are extremely liquid. Thus it has a huge customer liking.
As the scope of MFs is growing at a very rapid pace in India, it is no means difficult to get Indian investor involved in a financial instrument like CDO. The mindset against unsecured securities has to undergo a significant change to accept financial claims in the case of securitization of future flows as collateral. What is needed is a strong regulatory body which can address the issues related to valuation, accounting, taxing, rating agencies, originator responsibilities.
Pulkit Bubna - student
Welingkar Institute of Management, Mumbai
I must be sounding insane. Talking about an (Asset backed security) ABS at a time when the whole world is bearing the brunt of the subprime fiasco. But then you don’t stop doing things because somewhere, something went wrong. Indian bourses did not close down because of the Harshad Mehta incident happened in India, similarly considering MBS or an ABS should not be thought of as a taboo in India and should not deter the regulators from creating the right environment for a vibrant collateral debt obligation (CDO) market. India’s first attempt at introducing CDO was by ICICI bank in 2002, which failed drastically. Thereafter, there has not been much growth in this market.
The securitization market in India is itself in its nascent stages, so saying that, CDO market is not favorable would be incorrect, but then CDO could be used as a tool for improving the low penetration of derived and structured financial instruments in India.
To understand CDOs one needs to know what credit derivatives (CDs) are. One of the risks of investing a bank loan or a debt security is credit risk, the risk of default by the borrower. In response to this possibility, new financial instruments called credit derivatives have been developed in the recent years. CDs help investors insure against adverse movements in the credit quality of the borrower.
CDOs can be explained with a simple illustration. Imagine a small number of water reservoirs located on the slope of the mountain. The reservoirs are emptied then refilled at the start of each month. When each reservoir is completely filled, the water in it flows in to the one just below and in this way a single water source can refill all reservoirs simply by filling the top most pool. Now if source of water does not have sufficient water for the rest of the reservoir, then some reservoir down the mountain may partially or wholly empty.
The reservoir at the highest elevator, which are the ones to be replenished first, correspond to the investor with most senior claims on the cash flow of the portfolio- they are first in line to collect their share of water. The reservoir in lower elevation, which receive their water allotment only after the reservoir up the mountain have received their first due are analogous to investor with junior claims to the cash flows of the portfolio. The reservoir at the foot of the mountain is akin to a equity tranche investor, should the water source come short of its promised amount ,the lowest reservoir will be the first to dry up.
CDOs are basically specialized repackaged offerings that typically involve large portfolio of credit instruments. CDOs involve a horizontal splitting of investors into segments (called tranches) with the objective of categorizing them as:
• Senior class (that portion of funding, which has the lowest risk weight or the highest rated debt).
• Mezzanine class (that portion of funding, which has debt in ascending order of risk weight or in descending order of ratings).
• Equity tranche (balance funding, which has the highest risk weight or the lowest rated debt.).
These different tranches represent varying levels of risk and returns and are rated accordingly. They can, therefore be sold to different investors with different risk appetites.
CDOs can be structured finance CDOs (derived primarily from asset-backed securities and mortgage-backed securities). In 2006, 54% of CDOs were backed by structured finance and 35% were backed by leverage loans). Also there are synthetic CDOs (it pools derivatives rather than actual debt.) With adequate regulation, the advantages of using Funded Credit derivatives in project finance will outweigh the risks.
Regional Rural Banks (RRBs), Co-op banks and even MFs are not allowed to invest in CDOs except schemes floated by UTI. There is a lack of awareness about the structure of a CDO among the Indian investors. The regulations in India with regards to CDOs are not very clear and they are not strong enough to lure the investors. There were discrepancies regarding the responsibility in case of default, whether it is on the originator or the Special Purpose Vehicle (SPV). Also the rules with regards to the valuation of the investment were unclear before the RBI guidelines issued in 2006 and guidance note issued by ICAI. The RBI seems to have used the Basel II criteria. But the taxation issues are yet to be resolved.
Lack of instruments like CDO blocks banks assets and impairs growth through churning of assets. Also the banks forego attractive opportunities on existing relationships.
CDOs have given birth to a very popular idea, the zero coupon equity strip. With zero coupon equity, the investor receives no premium, but instead pays a fraction of the total notional exposure up front and collects the full value of the notional at maturity, minus losses from any defaults.
As an instrument, it is a major attraction for hedge funds. Introduction of such an arrangement would transfer credit risk. The financial system in the country would gain due to the multiplier effect that CDO brings in capital generation. There is enhanced third party participation with aligned risk and return. Basically the transmission of credit risk will allow risk to be hedged away by the risk-averse institutions and reside in players who are risk-takers.
Rating of underlying risk has been a major issue in international securitization market as also for the Indian markets. Because as CDO uses portfolio of credits, rating such credit risk is very important to determine the risk involved in such structure. Also from the point of view of investors, a creditable rating would help them to make correct investment decisions. This would help increase the prospects of CDO in India.
Lack of secondary market liquidity, longer duration of the structure, stamp duty issue is a still a cause for concern; a heavy duty is levied on the transfer of the portfolio which increases the cost of the SPV. There is also prepayment risk, interest rate risk it also lacks transparency in volume, price, parties to the transaction and also there is lack of awareness about the structure and its working.
In India, CDOs can play a very important role for those banks which face a credit crunch. Especially the co-op banks, rural banks and the micro finance institutions. If these bodies can effectively use the benefits of CDO they will be equipped with large base of capital to allot credit to the much needed section of the society.
These entities can pool their credit portfolio together with the other banks with higher rated pool of assets and form a portfolio by creating a SPV, which can come out with bonds having tranches with varying credit risk and returns. This would help them to reissue the limited capital at their disposal. These institutions poses a large potential with CDOs because of high credit rating of their disbursed credit these institution enjoy 99% recovery rate. There is a huge potential for securitization for future receivables in infrastructure sector in India. Enabling risk diversification should be the foremost objective of the regulator if the enormous funding needs of infrastructure (one estimate puts it at Rs 2,00,000 crore over the next three years) in India are to be met.
The Bond market in India is not fully developed as other developed countries. Developing Bond market would therefore help a great deal in creating a customer base for the CDOs. Secondary market needs to be improved to provide liquidity to the instrument which is the most important factor for the success of CDOs. The very reason for the success of equity market in India is that they are extremely liquid. Thus it has a huge customer liking.
As the scope of MFs is growing at a very rapid pace in India, it is no means difficult to get Indian investor involved in a financial instrument like CDO. The mindset against unsecured securities has to undergo a significant change to accept financial claims in the case of securitization of future flows as collateral. What is needed is a strong regulatory body which can address the issues related to valuation, accounting, taxing, rating agencies, originator responsibilities.
Pulkit Bubna - student
Welingkar Institute of Management, Mumbai