CA E SRINIVAS SECURITIZATION

SECURITIZATION
1. CONCEPT AND DEFINITION

The process of securitization typically involves the creation of pool of assets from the illiquid financial assets,
such as receivables or loans which are marketable. In other words, it is the process of repackaging or
rebundling of illiquid assets into marketable securities.It is a method of recycling of funds.

2. WHAT CAN BE SECURITIZED:

Practically speaking, any future cash flow can be securitized in the market. These assets can be automobile
loans, credit card receivables, residential mortgages or any other form of future receivables.
So, we may say that the prominent assets for the securitization are Physical Assets, Financial Assets,
Operational Assets or any other receivable.

3. FEATURES OF SECURITIZATION

a) Creation of Financial Instruments - The process of securities can be viewed as process of creation
of additional financial product of securities in market backed by collaterals.
b) Bundling and Unbundling - When all the assets are combined in one pool it is bundling and when
these are broken into instruments of fixed denomination it is unbundling.
c) Tool of Risk Management - In case of assets are securitized on non-recourse basis, then
securitization process acts as risk management as the risk of default is shifted.
d) Structured Finance - In the process of securitization, financial instruments are tailor structured to
meet the risk return trade of profile of investor, and hence, these securitized instruments are
considered as best examples of structured finance.
e) Trenching - Portfolio of different receivable or loan or asset are split into several parts based on risk
and return they carry called 'Trenche'. Each Trench carries a different level of risk and return.
f) Homogeneity - Under each trenche the securities are issued of homogenous nature and even meant
for small investors the who can afford to invest in small amounts.

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4. BENEFITS OF SECURITIZATION [ RTP NOV 2019 ]

The benefits of securitization can be viewed from the angle of various parties involved as follows:

FROM THE ANGLE OF ORIGINATOR

Originator (entity which sells assets collectively to Special Purpose Vehicle) achieves the following benefits
from securitization.
a) Off - Balance Sheet Financing: When loan/receivables are securitized it release a portion of capital
tied up in these assets resulting in off Balance Sheet financing leading to improved liquidity position
which helps expanding the business of the company.
b) More specialization in main business: By transferring the assets the entity could concentrate
more on core business as servicing of loan is transferred to SPV. Further, in case of nonrecourse
arrangement even the burden of default is shifted.
c) Helps to improve financial ratios: Especially in case of Financial Institutions and Banks, it helps
to manage Capital -To-Weighted Asset Ratio effectively.
d) Reduced borrowing Cost: Since securitized papers are rated due to credit enhancement ere they
can also be issued at reduced rate as of debts and hence the originator earns a sprees resulting in
reduced cost of borrowings.

FROM THE ANGLE OF INVESTOR

Following benefits accrues to the investors of securitized securities.

a) Diversification of Risk: Purchase of securities backed by different types of assets provides

diversification of portfolio resulting in reduction of risk.
b) He gets security which is backed by adequate collateral and has credit enhancement.

c) Securities are rated by credit rating agencies. It becomes easier for an investor to compare the
risk-return of asset backed securities with other investible instruments and make an informed choice.

5. PARTICIPANTS IN SECURITIZATION

Broadly, the participants in the process of securitization can be divided into two categories; one is Primary
Participant and the other is Secondary Participant.
Primary Participants

Primary Participants are main parties to this process. The primary participants in the process securitization
are as follows:

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a) Originator: It is the initiator of deal or can be termed as securitize. It is an entity which sells the assets
lying in its books and receives the funds generated through the sale of such assets. The originator transfers
both legal as well as beneficial interest to the Special Purpose Vehicle (discussed later).

b) Special Purpose Vehicle: Also, called SPV is created for the purpose of executing the deal. Since issuer
originator transfers all rights in assets to SPV, it holds the legal title of these assets. It s created especially
for the purpose of securitization only and normally could be in form of a company, a firm, a society or a
trust.
The main objective of creating SPV to remove the asset from the Balance Sheet of Originator. Since, SPV
makes an upfront payment to the originator, it holds the key position in the overall process of
securitization. Further, it also issues the securities (called Asset Based Securities or Mortgage Based
Securities) to the investors.
c) The Investors: Investors are the buyers of securitized papers which may be an individual, an institutional
investor such as mutual funds, provident funds, insurance companies, mutual funds, Financial Institutions
etc.Since, they acquire a participating in the total pool of assets/receivable, they receive their money back
in the form of interest and principal as per the terms agree.

Secondary Participants RTP MAY 2021

a) Obligors: Actually they are the main source of the whole securitization process. They are the parties
who owe money to the firm and are assets in the Balance Sheet of Originator. The amount due from
the obligor is transferred to SPV and hence they form the basis of securitization process and their credit
standing is of paramount importance in the whole process.

b) Rating Agency: Since the securitization is based on the pools of assets rather than the originators,
the assets have to be assessed in terms of its credit quality and credit support available. Rating agency
assesses the - Strength of the Cash flow,Mechanism to ensure timely payment of interest and principle
repayment,Credit quality of securities, Liquidity support, Strength of legal framework.Although rating
agency is secondary to the process of securitization but it plays a vital role.
c) Receiving and Paying agent (RPA): Also, called Servicer or Administrator, it collects the payment
due from obligor(s) and passes it to SPV. It also follow up with defaulting

borrower and if required initiate appropriate legal action against them. Generally, an originator or its
affiliates acts as servicer.
d) Agent or Trustee: Trustees are appointed to oversee that all parties to the deal perform in the true
spirit of terms of agreement. Normally, it takes care of interest of investors who acquires the securities.

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e) Credit Enhancer: Since investors in securitized instruments are directly exposed to performance of the
underlying securities and they seek additional comfort in the form of credit enhancement. In other words,
they require credit rating of issued securities which also empowers marketability of the securities.

Originator itself or a third party say a bank may provide this additional context in form of letter of credit
or surety bonds is called Credit Enhancer.
f) Structurer: It brings together the originator, investors, credit enhancers and other parties to the deal of
securitization. Normally, these are investment bankers also called arranger of the deal. It ensures that
deal meets all legal, regulatory, accounting and tax laws requirements.

6. MECHANISM OF SECURITIZATION [ RTP MAY 2020 ]

a) Creation of Pool of Assets

The process of securitization begins with creation of pool of assets by segregation of assets backed
similar type of mortgages in terms of interest rate, risk, maturity and concentration units.
b) Transfer to SPV

One assets have been pooled, they are transferred to Special Purpose Vehicle (SPV) especially created
for this purpose.
c) Sale of Securitized Papers

SPV designs the instruments based on nature of interest, risk, tenure etc. based on pool of assets.
These instruments can be Pass through Security or Pay Through Certificates, (discussed later).
d) Administration of assets

The administration of assets in subcontracted back to originator which collects principal and interest
from underlying assets and transfer it to SPV, which works as a conduct.
e) Recourse to Originator

Performance of securitized papers depends on the performance of underlying assets and unless specified
in case of default they go back to originator from SPV.
f) Repayment of funds

SPV will repay the funds in form of interest and principal that arises from the assets pooled.
g) Credit Rating to Instruments

Before the sale of securitized instruments credit rating can be done to assess the risk of the issuer.

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7. PROBLEMS IN SECURITIZATION: [ RTP NOV 2020]

Following are main problems faced in growth of Securitization of instruments especially in Indian context:

1. STAMP DUTY: Stamp Duty is one of the obstacle in India. Under Transfer of Property Act, 1882, a
mortgage debt stamp duty which even goes up to 12% in some states of India and this impeded the
growth of securitization in India. It should be noted that since pass through certificate does not evidence
any debt only able to receivable, they are exempted from stamp duty.

2. TAXATION: Taxation is another area of concern in India. In the absence of any specific provision relating
to securitized instruments in Income Tax Act experts' opinion differ a lot. Some are of opinion that in SPV
as a trustee is liable to be taxed in a representative capacity then other are of view that instead of SPV,
investors will be taxed on their share of income. Clarity is also required on the issues of capital gain
implications on passing payments to the investors.

3. ACCOUNTING: Accounting and reporting of securitized assets in the books of originator is another area
of concern. Although securitization is slated to an off-balance sheet instrument but in true sense
receivables are removed from originator's balance sheet. Problem arises especially when assets are
transferred without recourse.
4. LACK OF STANDARDIZATION: Every originator follows own format for documentation. Lack of
standardization is another obstacle in growth of securitization.

5. INADEQUATE DEBT MARKET: Lack of existence of a well-developed debt market in India is another
obstacle that hinders the growth of secondary market of securitized or asset backed securities.

6. INEFFECTIVE FORECLOSURE LAWS: For last many years there are efforts are going on for effective
foreclosure but still foreclosure laws are not supportive to lending institutions and this makes securitized
instruments especially mortgaged backed securities less attractive as lenders face difficulty in transfer of
property in event of default by the borrower.

8. SECURITIZATION INSTRUMENTS

On the basis of different characteristics, the securitized instruments can be divided into following three
categories:
1) Pass Through Certificates (PTCs)

As the title suggests originator (seller of eh assets) transfers the entire receipt of cash in form of interest or
principal repayment from the assets sold. Thus, these securities represent direct claim of the investors on all
the assets that has been securitized through SPV.

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Since all cash flows are transferred the investors carry proportional beneficial interest in the asset held in the
trust by SPV. It should be noted that since it is a direct route any prepayment of principal is also
proportionately distributed among the securities holders. Further, due to these characteristics on completion
of securitization by the final payment of assets, all the securities are terminated simultaneously.
Skewness of cash flows occurs in early stage if principals are repaid before the scheduled time.

2) Pay Through Security (PTS)

As mentioned earlier, since, in PTCs all cash flows are passed to the performance of the securitized assets.
To overcome this limitation and limitation to single mature there is another structure i.e. PTS.
In contrast to PTC in PTS, SPV debt securities backed by the assets and hence it can restructure different
tranches from varying maturities of receivables.
While in Pass Through, all cash flows are passed on immediate basis, in PTS in case of early retirement of
receivables the surplus cash can be used for short term yield. This structure also provides the freedom to
issue several debt trances with varying maturities.

3) Stripped Securities

Stripped Securities are created by dividing the cash flows associated with underlying securities into two or
more new securities. Those two securities are as follows:
i. Interest Only (IO) Securities

ii. Principle Only (PO) Securities

As each investor receives a combination of principal and interest, it can be stripped into two portion of
Interest and Principle. Accordingly, the holder of IO securities receives only interest while PO security holder
receives only principal. Being highly volatile in nature these securities are less preferred by investors.

In case yield to maturity in market rises, PO price tends to fall as borrower prefers to postpone the payment
on cheaper loans. Whereas if interest rate in market falls, the borrower tends to repay the loans as they
prefer to borrow fresh at lower rate of interest.

In contrast, value of IO’s securities increases when interest rate goes up in the market as more interest is
calculated on borrowings.

Thus, from the above, it is clear that it is mainly perception of investors that determines the prices of IOs
and POs

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9. TYPES OF SECURITIZATIONS
A. Securitization with recourse
With recourse" is a legal term and relates to the credit risk retention by the originator. It essentially means
that the assets are sold to the investors through SPV with the clause that if any party in the portfolio of
assets defaults, it would be protected by the originator i.e. the originator would make the default good.
B. Securitization without Recourse
1. In case of securitization without recourse, whole risk in the asset portfolio is transferred to the investors
through the SPV i.e. originator is in no way concerned with the assets once that is sold to the SPV. This
is the true form of securitisation.
2. In this case, simply the asset would get converted into cash for the originator with no future obligation.
So, this transaction is performing two functions, one the financing and another the credit risk transfer
to the investors from the originator.

3. The issuer is under an obligation to pay to the investors only if the cash flows are received by him from
the collateral.

10. PRICING OF THE SECURITIZED INSTRUMENTS

While pricing the instruments, it is important that it should be acceptable to both originators as well as to
the investors. On the same basis pricing of securities can be divided into following two categories:
1. From Originator's Angle

From originator's point of view, the instruments can be priced at a rate at which originator has to incur an
outflow and if that outflow can be amortized over a period of time by investing the amount raised through
securitization.

2. From Investor's Angle

From an investor's angle security price can be determined by discounting best estimate of expected future
cash flows using rate of yield to maturity of a security of comparable security with respect to credit quality
and average life of the securities.

11. SECURITIZATION IN INDIA

It is the Citi Bank who pioneered the concept of securitization in India by bundling of auto loans in securitized
instruments. Thereafter many organizations securitized their receivables.In order to encourage securitization,
the Government has come out with Securitization and Reconstruction of Financial Assets and Enforcement
of Security Interest (SARFAESI) Act, 2002, to tackle menace of Non Performing Assets (NPAs) without
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approaching to Court.With growing sophistication of financial products in Indian Capital Market, securitization
has occupied an important place.
As mentioned above, though, initially started with auto loan receivables, it has become an important source
of funding for micro finance companies and NBFCs and even now a day’s commercial mortgage backed
securities are also emerging. Securitization in Indian Market is that it is dominated by a few players e.g.
ICICI Bank, HDFC Bank, NHB etc.
Securitisation may also become a key funding source for non-banks who are looking to grow their loan book
and simultaneously it can also be an attractive investment avenue for banks looking to grow their retail
assets. In order to further enhance the investor base in securitized debts, SEBI has allowed FPIs to invest in
securitized debt of unlisted companies upto a certain limit.

12. FACTORS REQUIRED FOR SUCCESS OF SECURITIZATION PROCESS

i. High quality assets with low default rate is essential

ii. Standardized loan documentation
iii. Stable interest rate structure.
iv. Well developed Capital market.
v. Investors awareness
vi. Strong Regulation

13. RISKS IN SECURITISATION

In a securitization transaction, investors are exposed to several risks at each stage of the transaction. The
various types of risks in any securitization transaction are as follows:
A. Credit risk or Counterparty risk

The prime risk wherein investors are prone to the risk of bankruptcy and non-performance of the servicer.

B. Legal risks

Since in the Indian context it is a recently developed concept there is an absence of conclusive judicial
precedent or explicit statutory provisions on securitization transactions. As a result, any dispute over the
legal ownership of the assets is likely to result in uncertainty regarding investor pay-outs from the pool
cash flow.

C. Market risks

Market risks represent risks external to the transaction and include market-related factors that impact the

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performance of the transaction. Some of these risks are as follows:

❖ Macroeconomic risks: The performance of the underlying loan contracts depends on macroeconomic
factors, such as industry downturns or adverse price movements of the underlying assets. For
example, in the transportation industry a continuous decline in industrial production may lead to a
downtrend in the use of services of the Commercial Vehicles (CVs) adversely impacting the cash flow of
CVs operators. This in turn, may impact repayments on CV loans. Similarly, a fall in the prices of the
CVs may increase chances of default as the borrower may wilfully default the loan and let the finance
company repossess and sell the underlying vehicle instead of retaining it and continuing to pay
instalments on time.

❖ Prepayment risks: A change in the market interest rate represents a difficult situation for investors
because it is a combination of prepayment risk and volatile interest rates. With a reduction in interest
rates generally prepayment of retail loans increases, resulting in reinvestment risk for investors because
investors may receive their monies ahead of schedule and may not be able to reinvest the amount at
the same yield.

❖ Interest rate risks: This risk is prominent where the loans in the pool are based on a floating rate
and investor pay-outs are based on a fixed rate or vice versa. It results in an interest rate mismatch and
can lead to a situation where the pool cash inflow, even at 100% collection efficiency, is not sufficient
to meet investor pay-outs. Interest rate swaps can be used to hedge this type of risk to some extent.

14. TOKENIZATION

Before we discuss the concept of Tokenization it is necessary to understand the concept of Blockchain.
Blockchain, sometimes referred to as Distributed Ledger Technology (DLT) is a shared, peer-to- peer, and
decentralized open ledger of transactions system with no trusted third parties in between. This ledger
database has every entry as permanent as it is an append-only database which cannot be changed or altered.
All transactions are fully irreversible with any change in the transaction being recorded as a new
transaction. The decentralized network refers to the network which is not controlled by any bank,
corporation, or government. A block chain generally uses a chain of blocks, with each block representing the
digital information stored in public database (“the chain”).
A simple analogy for understanding blockchain technology is a Google Doc. When we create a
document and share it with a group of people, the document is distributed instead of copied or transferred.
This creates a decentralized distribution chain that gives everyone access to the document at the same time.
No one is locked out awaiting changes from another party, while all modifications to the document are being
recorded in real-time, making changes completely transparent.

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Following figure represents the working of any Blockchain transaction.

APPLICATIONS OF BLOCKCHAIN

Some initiatives that are already existing in various fields like financial services, healthcare, government,
travel industry, economic forecasts etc. are discussed below:

(a) Financial Services: Blockchain can be used to provide an automated trade lifecycle in terms of the
transaction log of any transaction of asset or property - whether physical or digital such as laptops,
smartphones, automobiles, real estate, etc. from one person to another.

(b) Healthcare: Blockchain provides secure sharing of data in healthcare industry by increasing the
privacy, security, and interoperability of the data by eliminating the interference of third party and avoiding
the overhead costs.
(c) Government: At the government front, there are instances where the technical decentralization is
necessary but politically should be governed by governments like land registration, vehicle registration and
management, e-voting etc. Blockchain improves the transparency and provides a better way to monitor
and audit the transactions in these systems.
(d) Travel Industry: Blockchain can be applied in money transactions and in storing important
documents like passports/other identification cards, reservations and managing travel insurance, loyalty,
and rewards thus, changing the working of travel and hospitality industry.
(e) Economic Forecasts: Blockchain makes possible the financial and economic forecasts based on
decentralized prediction markets, decentralized voting, and stock trading, thus enabling the organizations
to plan and shape their businesses.

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RISKS ASSOCIATED WITH BLOCKCHAIN

Some of the risk associated with the use blockchain technology are as follows:

a) There may be questions about who is responsible for managing risks if no one party is in-charge, and
how proper accountability is to be achieved in a blockchain.

b) The reliability of financial transactions is dependent on the underlying technology and if this
underlying consensus mechanism has been tampered with, it could render the financial information
stored in the ledger to be inaccurate and unreliable.

c) In the absence of any central authority to administer and enforce protocol amendments, there could
be a challenge in the development and maintenance of process control activities and users of public
blockchains find difficult to obtain an understanding of IT controls implemented and the effectiveness of
these controls.

d) As blockchain involves humongous data getting updated frequently, risk related to information overload
could potentially challenge the level of monitoring required. Furthermore, to find competent people
to design and perform effective monitoring controls may again prove to be difficult.

MEANING OF TOKENIZATION

Tokenization is a process of converting tangible and intangible assets into blockchain tokens. Digitally
representing anything has recently acquired a lot of traction. It can be effective in conventional industries
like real estate, artwork etc.

TOKENIZATION AND SECURITIZATION

Since tokenization of illiquid assets attempts to convert illiquid assets into a product that is liquid and tradable
and hence to some extent it resembles the process of Securitization. Hence, following are some similarities
between Tokenization and Securitization:
a) Liquidity: - First and foremost both Securitization and Tokenization inject liquidity in the market for
the assets which are otherwise illiquid assets.
b) Diversification: - Both help investors to diversify their portfolio thus managing risk and optimizing
returns.
c) Trading: - Both are tradable hence helps to generate wealth.
d) New Opportunities: - Both provide opportunities for financial institutions and related agencies to
earn income through collection of fees.

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