Securitisation

Securitisation

Securitisation is the process of conversion of existing assets or future cash flows into marketable securities. In other words, securitisation deals with the conversion of assets which are not marketable into marketable ones. For the purpose of distinction, 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 securitisation.

Some of the assets that can be securitised are loans like car loans, housing loans, et cetera and future cash flows like ticket sales, credit card payments, car rentals or any other form of future receivables.

Suppose Mr X wants to open a multiplex and is in need of funds for the same. To raise funds, Mr X can sell his future cash flows (cash flows arising from sale of movie tickets and food items in the future) in the form of securities to raise money.

This will benefit investors as they will have a claim over the future cash flows generated from the multiplex. Mr X will also benefit as loan obligations will be met from cash flows generated from the multiplex itself.

The process and participants

Basically banks and financial institutions can securitise their financial assets. In the traditional lending process, a bank makes a loan, maintaining it as an asset on its balance sheet, collecting principal and interest, and monitoring whether there is any deterioration in borrower's creditworthiness. This requires a bank to hold assets (loans given) till maturity. The funds of the bank are blocked in these loans and to meet its growing fund requirement a bank has to raise additional funds from the market. Securitisation is a way of unlocking these blocked funds.

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 (eg: auto loans) of similar maturity (eg: 20 to 24 months) will be bundled together for creating the securitized 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. 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, 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 securitized instruments, evaluation of their quality is of utmost importance. This is carried on by rating the securitized 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 securitised 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.