Securitisation is a process through which illiquid assets are transferred into a more liquid form of assets and distributed to a broad range of investors through capital markets. The lending institution's assets are removed from its balance sheet and are instead funded by investors through a negotiable financial instrument. The security is backed by the expected cash flows from the assets.

Securitisation as a technique gained popularity in the US in the 1970. Favourable tax treatment, legislative enactment, establishment of Government-backed institutions that extend guarantees, and a pragmatic regulatory environment appear to have contributed to the successful development of this market. The market for securitisation in the US which is dominated by home mortgages has diversified to credit cards, home equity loans, student loans and small business loans.

UK is the second largest market for securitisation after the US. Areas of securitisation in the UK are broadly similar to the US and include residential mortgages, credit cards, consumer loans, commercial real estate and student loan. The Bank of England has played a leading role in evolving guidelines for banking and other authorised institutions in its loan transfers and securitisation. Now, the Financial Services Authority (FSA) sets out the policy on securitisation and loan transfers. Experience of UK is of special relevance to India, and we should liberally draw on it.

Other countries in Europe have been relatively slow starters, though regulatory and legislative changes in Germany, France, Belgium and Spain have been fashioned to assist development of securitisation. In Japan, the securitisation market is not well developed since until recently, the Government had restricted securitisation to the assets of leasing, consumer loan and credit card companies. The Government has, however, amended laws to allow full-scale securitisaton as recently as in May 1997.

Assets are originated by a company, and funded on that company's balance sheet. This company is normally referred to as the " Originator".

Once a suitably large portfolio of assets has been originated, the assets are analysed 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. Administration of the assets is then sub-contracted back to the Originator by the SPV.

The SPV issues tradeable "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.

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.

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 (ie: the Originator continues to administer the portfolio, and continues to receive the economic benefits (profits) of owning the assets). As cash flows arise on the assets, these are used by the SPV to repay funds to the investors in the securities.

The process in general can be described to consist of the following stages.

• The process begins when the lender (or originator) segregates loans/lease/receivables into pools which are relatively homogenous in regard to types of credit, maturity and interest rate risk.

• The pools of assets are then transferred to a Special Purpose Vehicle (SPV) usually constituted as a trust. The originator may float the SPV as a subsidiary in the form of a limited company. Another option could be for the SPV to be floated jointly by the originator/individuals/banks/institutions who are interested in the securitisation deal.

• Based on these, the SPV issues asset backed securities in the form of debt, certificates of beneficial ownership and other instruments. The securities issued may be with or without recourse.

• Interest and principal payments on the loans, leases and receivables in the underlying pool of assets are collected by the servicer (who could also be the originator) and transmitted to the investors.

• Credit enhancement can add features to boost investor confidence. This could be in the form of a provision of recourse, a guarantee requiring the originator to cover losses, a letter of credit from a bank, or over collateralisation.

There could be three basic methods of transfer of assets, viz.,

1. novation,

2. assignment and

3. sub-participation.

Novation is the clearest way of selling a loan and effectively transferring both the rights and obligations. In novation, the existing loan between originator and borrower is cancelled and a new agreement between the investor and borrower is substituted. The buyer steps into the shoes of the original lender or seller who ceases to have any obligations to the borrower. The loan, is therefore, excluded from the balance sheet of the seller.

An assignment transfers from the seller to buyer, all rights to principal and interest. Assignments for the purpose of disposing of assets may fall into two basic legal categories. The first is statutory assignment, transferring both legal and beneficial title. A statutory assignment will pass and transfer from the seller to the buyer all the legal rights to principal and interest. In most cases, it will also pass on all the legal remedies available against the borrower to ensure discharge of debt. In other words, the buyer acquires the full legal and beneficial interest in the loan. The second is equitable assignment, transferring only beneficial title. It does not transfer legal rights. Thus, a buyer may not be able to proceed directly against a borrower. The seller must be joined in action. However, the seller is not liable for debt.

Sub-participation does not transfer any of the seller's rights, remedies or obligations against the borrower to the buyer. But, it is an entirely separate, back-to-back, non-recourse funding arrangement, under which the buyer places funds with the seller. In return, the seller passes on to the buyer, payments under the underlying loan, which the borrower makes to him. But, the loan itself is not transferred.

Available data indicates that ICICI had securitised assets to the tune of Rs.2,750 crore in its books as at end March 1999. Assets to the tune of Rs.1,200 crore was in the process of being bought over up to end of FY-1998'99.. CRISIL is reported to have rated about Rs. 1,200 crore of securitised transactions up to 1998. In addition, there have been several unrated transactions.

The first widely reported securitisation deal in India dates back to 1990 when Citibank securitised auto loans and placed a paper with GIC mutual fund. Since then, a variety of deals have been undertaken. Asset classes chosen have concentrated mostly on auto and hire purchase receivables of NBFCs. According to some estimates, 35 per cent of all securitisation deals between 1992 and 1998 related to hire purchase receivables of trucks and the rest towards other auto/transport segment receivables.

Apart from these, some innovative deals have also been struck. Earlier, in 1994-95, SBI Cap structured an innovative deal where a pool of future cash flows of high value customers of Rajasthan State Industrial and Development Corporation was securitised. An oil monetisation deal has been structured where the future flows of oil receivables accruing to a company was securitised. Real estate developers have securitised receivables arising out of installment sales. The recent securitisation deal of Larsen & Toubro has opened a new vista for financing power projects. The deal was a securitisation of lease receivables even before the plant was completed. Thus, this securitisation deal financed even the asset creation.

National Housing Bank (NHB) has made efforts to structure the pilot issue of mortgage backed securities (MBS) within the existing legal, fiscal and regulatory framework. Under the proposed transaction, mortgage debt shall be transferred/assigned/sold to NHB by Housing Finance Companies (HFC) (originator) pursuant to an agreement/contract in the 'debt simplicitor form'. NHB will act as an issuer of pass through certificates (PTCs) and as a trustee on behalf of the investors. There is a view that there will be a conflict of interest if NHB, a regulator also acts as a trustee. However, as stated in the RBI discussion paper on universal banking, the ownership, regulatory and supervisory framework of the development financial institutions are under review.

On the basis of the Indian experience, the following features of securitisation appear noteworthy.

1. Most deals have involved the transfer of beneficial interest on the asset and not the legal title.

2. Most transactions have followed the pass-through mechanism.

3. In fact, many transactions have followed the escrow mechanism where receivables are transferred to an escrow account for payment to the buyer.

4. According to Duff & Phelps India, a rating agency, past deals have mostly been direct purchases of receivables by institutions and bigger NBFCs.

5. Routing the transaction through a Special Purpose Vehicle is yet to gain popularity.

6. There appears to be no secondary market for securitised debt.

7. The market is unregulated and lacks transparency in terms of volume, price, parties to the transaction, etc.

8. The settlement procedures are not clear.

9. There are no standard accounting and valuation norms.

Securitisation is designed to offer a number of advantages to the seller, investor and debt markets.

1. For seller or originator, securitisation mainly results in receivables being replaced by cash thereby improving the liquidity position. It removes the assets from the balance sheet of the originator, thus liberating capital for other uses, and enabling restructuring of the balance sheet by reducing large exposures or sectoral concentration. It facilitates better asset liability management by reducing market risks resulting from interest rate mismatches. The process also enables the issuer to recycle assets more frequently and thereby improve earning. Finally, transparency may be improved since securitisation results in identifiable assets in the balance sheet.

2. For investor, securitisation essentially provides an avenue for relatively risk-free investment. The credit enhancement provides an opportunity to investors to acquire good quality assets and to diversify their portfolios.

3. It also provides opportunity for matching cash flows and managing ALM since a securitised instrument carries regular monthly cash flows and has varying maturities. The prevalence of secondary markets would offer liquidity.

4. From the point of view of the financial system as a whole, securitisation increases the number of debt instruments in the market, and provides additional liquidity in the market. It also facilitates unbundling, better allocation and management of project risks. It could widen the market by attracting new players on account of superior quality assets being available.

If not carried out prudentially, Securitisation can leave risks with the originating bank without allocating capital to back them. While all banking activity entails operational and legal risks, these may be greater, the more complex the activity. It is felt that the main risk a bank may face in a securitisation scheme arises if a true sale has not been achieved and the selling bank is forced to recognise some or all of the losses if the assets subsequently cease to perform. Also, funding risks and constraints on liquidity may arise if assets designed to be securitised have been originated, but because of disturbances in the market, the securities cannot be placed. There is also a view that there is at least a potential conflict of interest if a bank originates, sells, services and underwrites the same issue of securities.

More Information about SPV & the Process of "Stripping" of Assets is given in the next article