Notes on Securitisation of Assets: Meaning, Process and Advantages | Credit Management

After reading this article you will learn about:- 1. Meaning of Securitisation 2. Process of Securitisation 3. Advantages 4. Disadvantages 5. Securitisation in Indian Market.

Meaning of Securitisation:

RBI in its circular on Securitization of Standard Assets, describes Securitization.

“as a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for an immediate cash payment”.

Securitisation can be defined as:

“Acquisition of financial assets by any securitization company or reconstruction company from any originator, whether by raising funds by such securitization company or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise.”

In such cases the cash flow from the underlying pool of assets is used to service the securities issued by the SPV.

Let us try to understand it from a layman’s view. In the normal course assets like loans and securities held by banks/financial institutions are expected to yield a quantifiable stream of future income (e.g. EMIs etc.). However, since this income is yet to be realised, it cannot be brought onto their books immediately. Through the process of Securitization Banks try to encash these future flow of as- yet-unrealised income.

We can also sum up that securitisation means the conversion of existing or future cash in-flows into tradable security which then is sold in the market. The cash inflow from financial assets such as mortgage loans, automobile loans, trade receivables credit card receivables, fare collections become the security against which borrowings are raised.

Securitization thus follows a two-stage process. In the first stage there is sale of single asset or pooling and sale of pool of assets to a ‘bankruptcy remote’ special purpose vehicle (SPV) in return for an immediate cash payment and in the second stage repackaging and selling the security interests representing claims on incoming cash flows from the asset or pool of assets to third party investors by issuance of tradable debt securities.

Process of Securitisation:

We have seen above that Securitisation is a process by which the future cash inflows of an entity (originator) are converted and sold as debt instruments. These debt instruments are popularly known as “Pay Through or Pass Through Certificates”, with a fixed rate of return to the holders of beneficial interest.

Under this process, the originator of a typical securitisation actually transfers a portfolio of financial assets to a “Special Purpose Vehicle” (SPV). (An SPV is an entity specially created for doing the securitisation deal. It invites investment from investors, uses the invested funds to acquire to receivables of the originator An SPV may be a trust, corporation, or any other legal entity.)

As a consideration for the transfer of such a portfolio, the originator gets cash up-front on the basis of a mutually agreed valuation of the receivables.

The transfer value of the receivables is arrived in such a way so as to give the lenders a reasonable rate of return. In ‘pass-through’ and ‘pay-through’ securitisations, receivables are transferred to the SPV at the inception of the securitisation, and no further transfers are made. All cash collections are paid to the holders of beneficial interests in the SPV (basically the lenders).

Thus, we can say that a securitisation deal usually passes through the following stages:

1. First of all the originator determines which assets they wants to securitise.

2. At second stage originator has to find out a SPV or new SPV is formed.

3. The SPV collects the funds from investors and in return issues securities to them.

4. The SPV acquires the receivables under an agreement at their discounted value.

5. The Servicer for the transaction is appointed, who is usually the originator.

6. The debtors are/are not notified depending on the legal requirements.

7. The Servicer collects the receivables, usually in an escrow mechanism, and pays off the collection to the SPV.

8. The SPV either passes the collection to the investors, or reinvests the same to pay off to investors at stated intervals.

9. In case of default, the servicer takes action against the debtors as the SPV’s agent.

10. When only a small amount of outstanding receivables are left to be collected, the originator may clean up the transaction by buying back the outstanding receivables.

11. At the end of the transaction, the originator’s profit, if retained and subject to any losses to the extent agreed by the originator, in the transaction is paid off.

Advantages of the Securitisation:

1. Securitization helps in raise funds for the standard assets, though the rating of the originator may not be high;

2. Securitised assets (receivables) go off the balance sheet of the originator which at times can be of great help to the originator. For example, a bank may need to reduce its exposure to credit so as to meet the capital adequacy norms.

3. Securitization also helps in generating liquidity which may; be critical at times for the bank/company.

4. Small investors are able to profit from such deals as under this scheme even they can invest small amounts through SPV and acquire beneficial interest in the securitized assets.

Disadvantages of the Securitization:

1. Securitization is an off-balance sheet item. The originator may thus be able to hide the true picture of its financial health by securitization of its good assets and keeping only sub­standard assets in its portfolio.

2. Another disadvantage of securitization is its opagueness. For example, a company may have taken huge liabilities but that may not be reflected in the balance sheet or conventional financial statements of the company. This is especially true where the securitisation is with recourse i.e. if the receivables which have been-securitised to the SPV, but later become NPA.

In such a case, the SPV will have the right to recover the dues from the originator. Thus, in such cases, it may be realized later on that the originator actually had a large amount of contingent liabilities but these were not reflected in the balance sheet.

Securitization in Indian Market:

Securitisation in India started around 1991. However, the first few transactions that took place during the period from 1991-2000 were in the nature of secured lending. However, it was from 2002 that this segment saw some renewed activity with auto loans on the forefront. Indian market was still afraid to take chances and the issues were predominantly of ‘AAA’ rated notes.

There are only few players in the Indian market, which is dominated by few private sector banks and some aggressive Mutual Funds only. Public sector banks remain mostly out of picture due to various reasons including the legal issues. These impediments have failed to develop the secondary market.

In spite of number of constraints, the securitization market in India grew significantly during the period from 2002 to 2004. In April 2005 RBI issued the draft guidelines. This resulted in slow down in the market as banks were readjusting their strategies in the light of draft guidelines.

In February 2006, the Reserve Bank of India (RBI) has issued final guidelines for the Securitisation of Standard Assets. These guidelines have consolidated a number of prevailing market practices with some stringent requirements on capital and profit recognition.

These guidelines are likely to further slow down the issuance of these assets as market will take its own time to re-adjust to the revised guidelines which are considered as stringent. However, in the long run the market is likely to grow as now legal framework is available and RBI has given its node for this segment of activity.

Indian securitisation market is still young and banks have only limited exposure in this segment. However, slowly it is maturing rapidly through innovation, increasing sophistication and new issuances.

What is Pass through Certificates?

A Pass through Certificate is an instrument which signifies transfer of interest in the receivable in favour of the holder of the Pass through Certificate.

In this case, the investors in a pass through transaction acquire the receivables, subject to all their fluctuations, prepayment etc. The material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayments, etc. are transferred to the investors.

The main features of Pass Through Certificate can be summed as follows:

(a) Investors get a proportional interest in pool of receivables.

(b) Collections made later on are divided proportionally.

(c) All investors receive proportional payments.

(d) Cash collected by the SPV is not reinvested.

What Do You Understand By Pay Through Certificates?

Under “Pay Through Certificates”, the SPV instead of transferring undivided interest on the receivables, actually issues debt securities (for example bonds, repayable on fixed dates). These debt securities in turn are backed by the mortgages transferred by the originator to the SPV.

Here the SPV can make temporary reinvestment of cash flows to the extent required for bridging the gap between the date of payments on the mortgages along with the income out of reinvestment to retire the bonds. Such bonds were called mortgage – backed bonds.