An Overview

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, lease receivables, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are assetbacked securities (ABS). The process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace.

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors. The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages

Issuance volume in the Indian structured finance (SF) market shrunk further by 22% in FY2010 over the previous fiscal to Rs. 426 billion Single corporate loan securitizations [also known as Single Loan Collateralised Loan Obligations (CLOs) or Loan Sell-Offs (LSOs)], the largest product class in FY2009, witnessed a slowdown in FY2010mainly a fallout of fresh regulatory guidelinesand accounted for only 34% of the total volume. The recommendation of the Reserve Bank of India (RBI) in its Mid-term Review of the Annual Policy Statement for FY2010 in October 2009, regarding the minimum lock-in period and minimum retention requirement, affected corporate loan sell-down transactions, which were mostly shortterm in nature. Nevertheless, as observed by ICRA in its report in April , regulatory factors like priority sector lending (PSL) targets for banksand the resultant acquisition of such loan pools from non-banking finance companies (NBFCs)continued to be the key motivator for transactions.

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Residential mortgaged backed securities: A type of security whose cash flows come from residential debt such as mortgages, home-equity loans and subprime mortgages. This is a type of mortgage-backed securities that focuses on residential instead of commercial debt. Asset backed securities: A type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution Collateralized debt obligations: An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. Similar in structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk. Commercial mortgaged backed securities : A type of mortgage-backed security that is secured by the loan on a commercial property. A CMBS can provide liquidity to real estate investors and to commercial lenders. As with other types of MBS, the increased use of CMBS can be attributable to the rapid rise in real estate prices over the years.

Future flow securitization: A future receivable securitization, as the term implies, raises funds based on expected future cash flows that have not, at the close of the transaction, been generated. These types of transactions can be split into two distinct areas: long term contract receivables and future cash flows

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Stamp Duty: One of the major hurdles facing the development of the securitization market is the stamp duty structure. In India, stamp duty is payable on any instrument which seeks to transfer rights or receivables. 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 states that still have a high stamp duty. Few states have reduced their stamp duty rates, though quite a few still maintain very high rates ranging from 5-12 per cent. 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. Taxation related issues: There is ambiguity in the tax treatment of mortgage-based securities, SPV trusts, and NPL trusts. Presently, the investors or the buyers (PTC and SR holders) pay tax on the earnings from the SPV trust. As a result the trustee makes income payouts to the investors without any payment of tax. The Income Tax law envisages the taxation of an unincorporated SPV either at the trust SPV level or the investor level in order to avoid double taxation.

Issues under the SARFAESI Act: A security receipt (SR) gives its holder a right of title or interest in the financial assets included in securitization. This definition holds good for securitization structures where the securities issued are referred to as pass through certificates. However, the rationale fails in the case of pay through certificates with different classes of primary and secondary rights to the cash flow. Legal Issues: Investments in PTCs are typically held-to-maturity. As there is no trading activity in these instruments, the yield on PTCs and the demand for longer tenures especially from mutual funds is dampened. Till recently, Pass through Certificates (PTC) were not explicitly covered under the Securities Contracts (Regulation) Act, definition of securities. This was however ammended with the Securities Contracts (Regulation) Amendment Act, 2007 passed with a view to providing a legal framework for enabling listing and trading of securitised debt instruments.

Economic benefits: Securitization benefits the economy as a whole by bringing financial markets and capital markets together. Financial assets are created in the financial markets, e.g., banks or mortgage financing companies. These assets are traditionally refinanced on on-balance sheet means of funding of the respective banks. Funding alternative: Being distinct and different from the originator's own obligations, a well structured ABS stands on its own credit rating and thus generates genuine incremental funding. This is so as the originator's existing creditors may invest in the ABS in addition to providing lines of credit to the originator. Balance sheet management : Fundamental benefit of a true sale, i.e., freeing up the capital of the originator would apply in the case of all securitization transactions. In response, the balance sheet gets compressed and becomes more robust. Its ratios improve. Alternately, reduction in leverage post-securitised sale can be restored by adding on new assets to the balance sheet Re-allocation of risks :Securitization transfers much of the credit risk in the portfolio to the ABS investors and helps to quantify the residual credit risk that the originator is exposed to. This is very useful, as the originator can then take larger exposure to individual obligors as well as provide a higher degree of comfort to his creditors.

Operating process efficiency :The extent of portfolio analysis and information demanded by securitization programs often lead to serious re-examination and consequent reengineering of operating processes within the originator organisation.

Benefits to investors

Low event risk : The pool of assets representing the obligations of a number of entities is usually more resilient to event risks than the obligations of a single borrower i.e. the risk that the credit rating of the security will deteriorate due to circumstances usually beyond the obligor's control is much higher in the latter case. Higher yields for lower/similar risk :ABS usually offer higher yields over securities of comparable credit and maturities. The yield spread typically represents the premium paid to compensate for prepayment risk, amortizing cashflows and the uniqueness of the instrument. Structured issuances :Through appropriate structuring, an ABS can be tailored to meet investor standards on credit quality, yield and maturity.

The tax laws have no specific provision dealing with securitization. Hence, the market practice is entirely based on generic tax principles, and since these were never crafted for securitizations, experts opinions differ. The generic tax rule is that a trustee is liable to tax in a representative capacity on behalf of the beneficiaries therefore, there is a prima facie taxation of the SPV as a representative of all end investors. However, the representative tax is not applicable in case of nondiscretionary trusts where the share of the beneficiaries is ascertainable. The share of the beneficiaries is ascertainable in all securitizations through the amount of PTCs held by the investors. Though the PTCs might be multi-class, and a large part might be residual income certificates in effect, the market believes, though with no reliable precedent, that there will be no tax at the SPV level and the investors will be taxed on their share of income.

. Making Asset securitization attractive to issuers. . Developing the market by i. Attracting more asset classes and issuers ii. Broader investor category iii.Secondary market for trading ABS paper Improving rating and information on ABS deals.