Banking Article, Banking Finance 2021, Banking Finance April 2021

DEBT SECURITIZATION: THE PROCESS TO UNDERSTAND

Introduction:

Securitization is the process of liquidating the long term assets like loans and receivables of financial institutions by issuing marketable securities against them.

It can be further defined as “a carefully structured process whereby loans and other receivables are packaged, underwritten and sold in the form of asset backed securities”.

Securitization is basically a structured financial transaction. Securities evolved out of Securitization process is different from the Conventional Securities like bonds, debentures etc. on points like Source of repayment/Structure/Nature of securities.

Securitization is liquidating long term assets in to marketable securities like pass through certificates/preferred stock certificates/asset based commercial paper. the success of securitization depends upon asset’s quality, amount of amortization, default experience of original borrower, financial reputation and soundness etc.

The advantages associated with securitization can be narrated as under:

  • Innovative and Low Cost Source of Fund
  • Better Capital Adequacy Norms
  • Creation of More Credit
  • Increased Profitability
  • Tool for Asset-Liability Management
  • Higher Rate of Return
  • Spreading of Credit Risk
  • Better than Traditional Instrument

 

Background of Securitization:

The securitization process was first started in U.S.A, where the first structured asset securitized financing came into being in 1970. Firstly it was backed by mortgage loans, the securities issued by it were called “Mortgage pass through securities”.  In 1985, non-mortgage collaterals started getting securitized in U.S.A. Securitization then gained popularity in UK, like America the concept firstly backed by mortgage. Securitization of debt and the consequent debt instruments were then became popular in countries like Italy, Australia, Canada, Japan, France etc.

Securitization in India:

In India the concept of securitization was pioneered by Citibank. The first attempt was securitization of ICICI’s receivables by Citibank in February, 1991. The hire purchase portfolio of TELCO was securitized by Citibank & a sum of Rs. 15 crores was raised. HDFC followed the path & securitized its housing loan portfolio through Citibank. Other commercial banks entered into Securitization to remove their non-performing assets from their balance sheet. But in India it was not firmly rooted because of following points:

  • New Concept
  • Heavy Stamp Duty
  • Cumbersome Transfer Procedure
  • Difficulty in Assignment of Debt
  • Absence of Standardized loan Documentation
  • Inadequate Credit Rating System
  • Absence of Proper Accounting Systems
  • Absence of Guidelines

How the Bank or Other FIs Securitize an Asset?

There are five stages/process involved in the working of Securitization which can be explained as under:

  • Identification stage
  • Transfer stage
  • Issue stage
  • Credit Rating stage
  • Redemption stage

 

  • First, a bank or financial institution collects thousands of mortgages into a “pool.” Then, it divides those pools into small parts and sells them as securities. Buyers of these securities, get the right to the interest or mortgage payments by the home owners/borrowers. Since mortgages back these securities, they are also called “mortgage-backed securities.”
  • Sale of the loan by the lender to the Issuer/SPV who then sells securities to Investors.
  • Servicing Agent collects the payments from borrowers & distributes them to the Issuer/SPV for payment to investors.
  • After sale of assets to the Issuer/SPV, the lender has no power to restructure the loan or make other accommodations for its borrower.
  • That becomes the responsibility of Servicing Agent, if the borrower defaults, action is taken by the Servicing Agent to recover cash for payment to investors. It is done as per the conditions mentioned in securitization documents
  • Securities issued by SPV in securitization transaction are mostly Mortgage Backed (MBS), wherein the lender has the right to sell the property, if the borrower defaults. The most common example of MBS is “securities backed by mortgage/housing loans”.
  • True sale of financial assets (or a pool of such assets) in return for immediate cash payment.
  • Under the true sale mechanism, the assets move from the balance sheet of the originator to the balance sheet of a Special Purpose Vehicle (SPV) or ARC.
  • The assets are pooled, sub-divided, repackaged as tradable securities backed by such pooled assets.
  • Tradable securities are sold to investors either as Pass Through Certificates (PTCs) Or Security Receipts (SRs), which represent claims on incoming cash flows from such pooled assets.

 

Parties Involved in Securitization Process:

  • The originator/lender
  • The original borrowers
  • A Special Purpose Vehicle (SPV) or trust
  • A merchant or investment banker
  • A credit rating agency
  • A servicing agent-Receiving & Paying Agent (RPA)
  • The prospective investors i.e. the buyer of securities.

 

Roles and Responsibilities of Parties to Securitization:

  • Lender: Lenders can be banks or non-banks.
  • Borrower: An Individual or organization which obtains loan.
  • Mortgage Broker: Facilitator between a borrower and the lender.
  • Issuer/Special Purpose Vehicle: Facilitating securitization and issuing securities to investors.
  • Servicing Agents: Collecting loan payments from borrowers and remitting to the ISSUER/SPV for distribution to the investors.
  • Trustee: A third party appointed to represent the investors’ interests & ensures that the securitization operates as per the securitization documents.
  • Underwriter: Administers the issuance of the securities to investors.
  • Credit Enhancement Provider: An independent third party who provides credit enhancement (decrease the credit risk of the structure) by providing letters of credit or guarantees.

 

Securitization Documents:

The documents create the securitization and specify how it operates.

  • Pooling and Servicing Agreement (PSA), which is a contract that defines:
    • How loans are combined in a securitization
    • The administration and servicing of the loans
    • Representations and warranties
    • Loss mitigation strategies in event of loan default
  • Underwriting: Administers the issuance of the securities to investors
  • Credit Enhancement: Designed to decrease the credit risk of the structure provided by an independent third party in the form of letters of credit or guarantees.

 

How Does Securitization Help?

Banks/FIs use securitization to raise more funds so that they can give more loans. Investors, who invest in these securities can diversify their portfolio and earn quality returns as well.  However it has no effect on the borrower, whose mortgage has been pooled. All the terms agreed between the lender and the borrower at the time of taking the loan remains intact. A possible change could be that the borrower may be asked to repay their loan installments/EMI to a different address.

 

Regulation of Securitization in India:

  • Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act) regulates securitization of stressed financial assets (NPA).
  • “RBI Guidelines” of 2006 regulate securitization of standard assets by Banks, NBFCs and other FIs.
  • Indian Stamp Act regulates stamp duty applicable to various securitization and assignment transactions. A 2016 amendment to the SARFAESI Act exempted stamp duty for securitizing or assigning non-performing assets (NPA) in favour of ARCs.
  • 2012 Revisions of RBI Guidelines, Mandating MRR & MHP Banks, NBFCs and other FIs securitizing their standard assets to retain “skin in the game” and have a continuing stake in the performance of the securitized assets, referred to as minimum retention requirement (MRR). The loan or financial asset must stay on the books of an originator for a minimum length of time, being the minimum holding period (MHP) before it can become a part of the pool to be securitized. The MRR and MHP provided for a more effective screening of loans by the Banks, NBFCs and other FIs prior to the securitization of such assets.
  • In September 2018, the Indian NBFC sector suffered a setback due to Infrastructure Leasing & Financial Services Limited (IL&FS) crises.
  • The financial sector faced another roadblock in mid-2019, when housing finance company, Dewan Housing Finance Limited (DHFL) failed to make interest payments to its bond holders, leading to its credit rating being downgraded to “D”.
  • The resulting panic in the market saw traditional sources of funding disappear for other NBFCs, and raised concerns on debt servicing. With such a sudden drop in willing lenders, NBFCs looked to securitize their standard assets to finance their funding requirements, and the Indian market witnessed a growth in the volume of securitization.
  • In the first quarter of the financial year 2019-2020, the Indian securitization market seen the highest issuance volumes as compared to the first quarter of any financial year (with 56% y-o-y growth over the same period in the previous fiscal year).
  • The RBI has constituted a special committee to review the state of mortgage-backed securitization in India. The committee released its report on dated 5 September, 2019. Specific measures were recommended to facilitate second market trading in securitized instruments. They recommended various measures to improve the securitization market in India.
  • To boost securitization market in India, RBI temporarily relaxed the MHP requirements for NBFC originators up to 31 December, 2019. RBI has further extended the relaxation of MHP till 30 June 2020. By this relaxation of MHP a larger asset pool were eligible for securitization by NBFCs. This led to a surge in securitization and assignment of auto loans/vehicle loans/finance lease receivables/microfinance/consumer durable loans & education loans.

 

Conclusion:

The success of securitization depends upon the ability of original borrower to repay their debt against which securitization has been done. It is also fully dependent upon the Scientific Credit Rating System, Standardized Loan Documentation System & Proper Accounting System. To add to its success the SPV should be separate organisation, instruments arising out of securitization should be listed in stock exchange & adequate guidelines should be given by regulators.

The securitization market will see an increased spread across asset classes and products. Securitization is likely to remain on the upward curve in the near future due to various developments on the regulatory front, continuing need for liquidity by Banks/NBFCs/FIs, growing appetite of investors, innovation of new and varied products and portfolios by NBFCs and finally the regulator’s willingness to further develop the market.

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