Types of Securitisation Instruments

‘Pass Through Securities’: Also known as participation certificates, it represents direct ownership interest in the underlying asset pool. All the periodic payments of principal and interest are collected by the servicer and passed on to the investors. In this structure there is no modification of the cash flow as it is received from the obligor(s).

Tranched Securities: In this type of security, the cash flows from the obligors are prioritised into tranches. The first tranche receives the first priority of payment followed by subsequent tranches.

Planned Amortisation (PAC) Tranches: A principal sinking fund is created that takes care of prepayments beyond a certain band. This ensures stability of cash flows and hence offers lower yields compared to similar tranches without a sinking fund.
Z-Tranches or Accretion Bonds: No interest is paid during a certain period (lock out period) during which the face value of the bond increases due to accrued interest. After the lock out period, the tranche holders start receiving interest and principal payments.

Principal Only (PO) Securities: The PO investors receive only the principal component of the underlying loans. These bonds are usually issued at a deep discount to their face value and redeemed at face value.

Interest Only (IO) Securities: The IO investors receive only the interest component of the underlying loans. These securities have no face or par value and its cash flow diminishes as the principal is repaid or prepaid.

Floater and Inverse Floater Securities: The floater and inverse floaters are instruments that pay a variable interest rate linked to an index such as LIBOR. The Floater pays an interest rate in the same direction of interest rate movements while a reverse floater pays an interest rate in the opposite direction of the interest rate movements.

Amortizing and Non-amortizing Securities: The principal repayment for instruments issued could be done either by a) repaying total amount at maturity, or b) throughout the life of the security. The latter refers to a schedule of payments called amortisation schedule and securities issued under this are called amortizing securities. Loans having this feature include car & home loans.

Let us take an example to understand the process of securitization. Consider a bank, ABC Bank. The loans given out by this bank are its assets. Thus, the bank has a pool of these assets on its balance sheet and so the funds of the bank are locked up in these loans. The bank gives loans to its customers. The customers who have taken a loan from the ABC bank are known as obligors.

To free these blocked funds the assets are transferred by the originator (the person who holds the assets, ABC Bank in this case) to a special purpose vehicle (SPV).

The SPV is a separate entity formed exclusively for the facilitation of the securitisation process and providing funds to the originator. The assets being transferred to the SPV need to be homogenous in terms of the underlying asset, maturity and risk profile.

What this means is that only one type of asset (e.g. auto loans) of similar maturity (e.g. 20 to 24 months) will be bundled together for creating the securitised instrument. The SPV will act as an intermediary which divides the assets of the originator into marketable securities.

These securities issued by the SPV to the investors and are known as pass-through-certificates (PTCs).The cash flows (which will include principal repayment, interest and prepayments received ) received from the obligors are passed onto the investors (investors who have invested in the PTCs) on a pro rata basis once the service fees has been deducted.

The difference between rate of interest payable by the obligor and return promised to the investor investing in PTCs is the servicing fee for the SPV. The way the PTCs are structured the cash flows are unpredictable as there will always be a certain percentage of obligors who won’t pay up and this cannot be known in advance. Though various steps are taken to take care of this, some amount of risk still remains.

The investors can be banks, mutual funds, other financial institutions, government etc. In India only qualified institutional buyers (QIBs) who possess the expertise and the financial muscle to invest in securities market are allowed to invest in PTCs.

Mutual funds, financial institutions (FIs), scheduled commercial banks, insurance companies, provident funds, pension funds, state industrial development corporations, et cetera fall under the definition of being a QIB. The reason for the same being that since PTCs are new to the Indian market only informed big players are capable of taking on the risk that comes with this type of investment.

In order to facilitate a wide distribution of securitised instruments, evaluation of their quality is of utmost importance. This is carried on by rating the securitised instrument which will acquaint the investor with the degree of risk involved.

The rating agency rates the securitised instruments on the basis of asset quality, and not on the basis of rating of the originator. So particular transaction of securitisation can enjoy a credit rating, which is much better than that of the originator.

High rated securitised instruments can offer low risk and higher yields to investors. The low risk of securitised instruments is attributable to their backing by financial assets and some credit enhancement measures like insurance/underwriting, guarantee, etc  used by the originator.

The administrator or the servicer is appointed to collect the payments from the obligors. The servicer follows up with the defaulters and uses legal remedies against them. In the case of ABC bank, the SPV can have a servicer to collect the loan repayment installments from the people who have taken loan from the bank. Normally the originator carries out this activity. Once assets are securitised, these assets are removed from the bank’s books and the money generated through securitisation can be used for other profitable uses, like for giving new loans.

For an originator (ABC bank in the example), securitisation is an alternative to corporate debt or equity for meeting its funding requirements. As the securitized instruments can have a better credit rating than the company, the originator can get funds from new investors and additional funds from existing investors at a lower cost than debt.

Benefits to the Originators

Lower cost of borrowing

A source of liquidity

Improved financial indicators

Asset-Liability Management

Diversified fund sources

Positive signals to the Capital Markets

An avenue for divestiture (sale of more stock holdings)

Benefits to the Investors

Investors purchase risk-adjusted securities based on its level of maturity. For instance, an auto loan or credit card receivables backed paper carries regular monthly cash flows, which can match the requirements of investors like mutual funds.

New Asset Class

Risk Diversification

Customisation

Decoupling with Originator

Securitisation in India

In India during 1990-91, the first securitisation deal was undertaken by Citibank. They securitized auto loans and placed a paper with GIC mutual fund. Later on, a variety of deals had been undertaken. Almost 35 per cent of all securitisation deals undertaken between 1992 and 1998 related to hire purchase receivables of trucks and the rest towards other auto/ transport segment receivables.

During 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. ICICI had securitised assets to the tune of ` 2,750 crore in its books as at the end of March 1999. 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 First Mortgage backed Securities in India were issued by National Housing Bank and Housing Development Finance Corporations in 2001. NHB has made efforts to structure the pilot issue of mortgage backed securities (MBS) within the existing legal, fiscal and regulatory framework.

Asset Classes

Typically, any asset that produces a predictable stream of cash flows can be securitized. The types of assets that are securitized today include:

Mortgage-backed

Residential mortgage-backed securities (RMBS)

Commercial mortgage-backed securities (CMBS)

Retail Loan Pools

Credit card receivables

Auto loan receivables

Student loan receivables

Equipment lease / loan receivables

Trade receivables

Toll receipts

Risk Transfers

Insurance risk

Weather risk

Credit risk

Mortgage Backed Securities (RMBS and CMBS) form the largest two segments of the securitization market in the world.