Define Securitisation

The Concept

Security means a financial claim in the form of document which is marketable. Securitization is an array of conversion of non marketable as-sets into marketable securities. Non marketable assets may be in the form of existing assets or future cash flows which are translated into marketable securities. The conversion of existing assets into marketable securities is known as asset-backed securitisation and the conversion of future cash flows into marketable securities is known as future-flows securitization.

Example

Car loans, Housing loans etc. –Asset Backed Securities

Ticket sales, Credit card payments, Car rentals etc. - Future-Flows Securitization

Accordingly, securitization is a process by which financial institutions create additional liquidity on the backing of their existing assets through the sale of financial instruments.

Origin

During 1970, securitization technique was originated in the US. Initially, the market for securitisation was dominated by home mortgages only. Subsequently, credit cards, home equity loans, student loans and small business loans also came into picture.

The second largest market for securitisation is in UK and it is dominated by 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 loan transfers and securitisation. Now, the Financial Services Authority (FSA) sets out the policy on securitization and loan transfers.

The Process and Participants

Banks and financial institutions are allowed to securitize their financial assets as per section 5 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

Traditionally, Banks provide loans to borrowers based on the borrowers’ creditworthiness. The repayment of principal and interest is based on the tenure of the loan such as short term (within 1 year) or Long term (above 1 year). The loan is to be treated as an asset and the outstanding portion of the loan is shown in the balance sheet of the bank. The bank has to raise additional funds from the market to meet its requirement since huge funds are blocked in loans. Securitization is a way of unlocking these blocked funds. The following steps are involved in the process of securitization:

Step -1 – Originator

In the first step, the banker or financial institution is called originator. The originator segregates loans/lease/receivables into pools which are relatively homogenous in regard to types of credit, maturity and interest rate risk.

Step -2 – Special Purpose Vehicle

The pools of assets are transferred to a Special Purpose Vehicle (SPV) usually constituted as a trust. It may be floated either as a subsidiary in the form of a limited company or jointly by the originator / individuals banks / institutions (merchant bankers) who are interested in the securitisation deal.

Step-3 – Splitting of Securities

The SPV splits various assets and issues asset backed securities (pass through certificate or pay through certificate) in the form of debt, certificates of beneficiary ownership and other instruments with or without recourse according to their maturity date and interest rate.

Step-4- Payment for Securities

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.

Step-5- Credit Rating

A pass through certificates or pay through certificates are to be rated by credit rating agency when issued to the public. It is mandatory in some countries. This debt instruments can also be traded in the secondary market particularly for interest swap.

Participants Involved in a Securitisation Transaction

Primarily, three parties are involved in the process of securitization transaction namely originator, SPV and investor.

The Originator - This is the entity on whose books the assets to be securitised exist and is the prime mover of the deal. The entity designs the necessary structures to execute the deal. In a true sale of the assets, the Originator transfers both the legal and the beneficial interest in the assets to the SPV.

The SPV - This entity is the issuer of the bond/security paper and is typically a low-capitalised entity with narrowly defined purposes and activities. It usually has independent trustees / directors. The SPV buys the assets to be securitised from the Originator, holds the assets in its books and makes upfront payment to the Originator.

The Investors - The investors could be either individuals or institutions like financial institutions (FIs), mutual funds, pension funds, insurance companies, etc. The investors buy a participating interest in the total pool of assets and receive their payments in the form of interest and principal as per an agreed pattern.

Apart from these three primary players, others involved in a securitisation transaction include:

The Obligor(s) - The obligor is the Originator’s debtor or the borrower of the original loan. The credit standing of the Obligor is very important in a securitisation transaction, as the amount outstanding from the Obligor is the asset that is transferred to the SPV.

The Rating Agency - The rating process assesses the strength of the cash flows and the mechanism designed to ensure full and timely payment. In this regard the rating agency plays an important role as it assesses the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework.

Administrator or Servicer - Also called as the receiving and paying agent, it collects the payment due from the Obligor(s) and passes it to the SPV. It also follows up with delinquent borrowers and pursues legal remedies available against defaulting borrowers.

Agent and Trustee - It oversees that all the parties involved in the securitisation transaction perform in accordance with the securitisation trust agreement. Its principal role is to look after the interests of the investors.

External Credit Enhancements - Underwriters sometime resort to external credit enhancements to improve the credit profile of the instruments. There are various types of external credit enhancements such as surety bonds, third-party guarantees, letters of credit (LC) etc.

Structurer - Normally, an investment banker is responsible for bringing together the Originator, credit enhancer, the investors and other partners to a securitisation deal. He also helps in structuring the deals along with the Originator.

The following picture depicts the process of securitization: