Securitisation An Overview

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SECURITISATION AN OVERVIEWBy : Parul Khannaon 08 September 2009

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SECURITISATION AN OVERVIEW

Introduction to Securitisation

Securitization has emerged globally as an important technique forbundling assets and segregating risks into marketable securities.Securitization can be regarded as an incentive for banks to becomemore efficient in order to offer the most competitive financial product.The basic purpose of securitisation is to reward the comparativeadvantage of a bank to originate loans, compared with its ability toservice the loans and its ability to bear the risk associated with those

loans.

n theory, a loan is a simple transaction where a borrower wants money,and a lender advances it and collects interest on it and this arrangementcontinues until the loan is repaid by the borrower. In practice, however,it is observed that every fifth borrower is a defaulter which ruins thelenders financials. While in case of secured loans the borrower offerscollateral such as real estate or machinery which serves as a security tothe lender, authorizing it to seize and sell the asset to recover itsmoney, in the event of default in repayment of loan by the borrower.However, this simple transaction collapses when the seizure of an assetbecomes impossible within a reasonable time. Our slow and tardy legalsystem with endless hearings and appeals keep things in limbo fordecades and as a result, there are bad debts across the entire financialsystem.

Securitisation Process

Securitisation is the process of pooling and repackaging of homogenousilliquid financial assets into marketable securities that can be sold toinvestors. The assets may be anything ranging from credit card

receivables, auto loans, equipment leases, hire purchase deals tohousing loans and non-performing assets (NPAs).
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Securitisation has emerged as an important means of financing in recenttimes. The process of Securitisation involves the following steps:

First, an entity with loans or other income-producing assets("Originator") identifies the assets that it wants to remove from itsbalance sheet.

Second,a special legal entity or Special Purpose Vehicle ("SPV") iscreated, which usually is established as a Trust and the Originator sellsthe assets to that SPV. This effectively separates the risk related to theoriginal entities operations from the risk associated with collection.

Third, to raise funds to purchase these assets the SPV issues asset-backed securities ("Asset-backed security is a security whose value and

income payments are derived from and collateralized (or "backed") by aspecified pool of underlying assets i.e. illiquid assets") to investors in thecapital markets in a private placement or pursuant to a public offering.The SPV uses the proceeds of the sale to pay back the Originator thatcreated, or originated, the underlying assets. The SPV is responsible for"bundling" the underlying assets into a specified pool that will fit the riskpreferences and the needs of investors. These securities are structuredto provide maximum protection from anticipated losses using creditenhancements like letters of credit or reserve accounts. The securitiesare also reviewed by the credit rating agencies that conduct extensive

analyses of bad-debts experiences, cash flow certainties and rate ofdefault.

Finally, Investors are paid through the money received in the form ofloan repayments by those borrowing loans through the Originator.Originators are in turn paid certain service charges by the SPV for theservicing of the loan. The services generally include: mailing monthlystatements, collecting payments, and remitting them to the investors,investors reporting, accounting, foreclosure proceedings and thelike.

This process leads to the financial asset being taken off the balancesheet of the Originator, thereby relieving pressures of capital adequacy,and provides immediate liquidity to the Originator.

Regulatory Framework

There is no clear regulatory framework for the securitisation market perse. However, securitisations originated by RBI regulated entities likeBanks, FIs and NBFCs are governed by guidelines issued by the RBI.Enactment of the Securitisation and Reconstruction of Financial Assets

and Enforcement of Security Interests Act, 2002 ("SARFAESI Act")enabled securitisation of the non-performing assets ("NPAs") of Banks,
http://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Asset


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which could sell off their NPAs to asset reconstruction companiesregistered with RBI. The SARFAESI Act laid the framework to theconstitution of asset reconstruction companies (ARCs) specialising insecuritising distressed assets purchased from banks.

Securitisation Act

The SARFAESI Act is a significant legislative initiative to address themalaise of mounting NPAs. The Act addresses the interests of securedcreditors. Its purpose is to promote the setting up of assetreconstruction/securitisation companies to takeover the NPAsaccumulated with the banks and public financial institutions. TheSupreme Court, in its judgment in the case ofMardia Chemicals Ltd.and Others vs. Union of India and Others upheld the constitutionalvalidity of SARFAESI Act.

The Act provides three alternative methods for recovery of NPAs,namely: (i) Securitisation; (ii) Asset Reconstruction; and (iii)Enforcement of Security without the intervention of the Court. The mainobjective behind this Act is to strengthen creditor rights throughforeclosure and enforcement of securities by banks and financialinstitutions. By conferring on lenders the right to seize and sell assetsheld as collateral in respect of overdue loans, it allows banks andfinancial institutions to recover their dues promptly without goingthrough a costly and time-consuming legal process.

Salient features of the Act

Incorporation & Registration of Special Purpose Vehicles - The SARFAESIAct proposes to securitise and reconstruct the financial assets throughtwo SPVs viz. Securitisation Company and Reconstruction Company.Securitisation Company and Reconstruction Company ought to be acompany incorporated under the Companies Act, 1956 havingsecuritisation and asset reconstruction respectively as main object.

The SARFAESI Act requires compulsory registration of Securitisation

Company and Reconstruction Company with the RBI under theSARFAESI Act before commencing its business. Further a minimumfinancial stability requirement is also provided by requiring SecuritisationCompany and Reconstruction Company to possess owned fund of notless than Rs.2 crore or up to 15% of the total financial assets acquiredor to be acquired.

Securitisation companies who are registered with RBI cannot makesubstantial change in the management or location without prior approvalof RBI. The expression substantial change in management means the

change in the management by way of transfer of shares oramalgamation or transfer of the business of the company.


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Funding of securitisation - The Securitisation Company or ReconstructionCompany may raise the necessary funds, for the acquisition of financialassets, from the QIBs by issuing a security receipt. Security receipt isexempted from compulsory registration under the Registration Act.Security receipts issued by any Securitisation Company orReconstruction Company are the "securities" within the meaning ofSection 2(h)(ic) of the Securities Contracts (Regulation) Act, 1956.A Scheme of acquisition has to be formulated for every acquisitiondetailing therein the description of financial assets under acquisition, thequantum of investment, rate of return assured etc. Further separate anddistinct accounts have to be maintained in respect of each scheme ofacquisition. Realizations made from the financial assets have to be heldand applied towards the redemption of investments and payment ofassured returns. In the event of non-realization of financial assets, theQIB holding not less than 75% of the total value of the security receiptsissued, are entitled to call a meeting of all QIB and pass resolution andevery such resolution is binding on the Securitisation Company orReconstruction Company, as the case may be.

Enforcement of security interest - As discussed already the mainobjective of the Securitisation Act is to provide for the enforcement ofsecurity interest i.e. taking possession of the assets given as security forthe loan. The Act empowers the lender, in the event of default by a

borrower, to issue demand notice to the defaulting borrower andguarantor, calling upon them to discharge their dues in full within 60days from the date of the notice. If the borrower fails to comply with thenotice, the bank or the financial institution may take recourse to one ormore of the following measures:

Take possession of the security;Sale or lease or assign the right over the security;Appoint Manager to manage the security;

Ask any debtors of the borrower to pay any sum due to the borrower.

If there are more than one secured creditors, the decision to makeprovisions of this Act will be made applicable only when 75% of themare agreeable.

Transaction to which the Act is not applicable - The provision of this Actshall not apply to:

A lien on any goods;

A pledge on movable property;

Creation of any security in an Aircraft;


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Creation of any security interest in any vessel;

Any conditional sale, hire purchase or lease or any other contractin which no security interest is created;

Any right of unpaid seller under Section 47 of the sale of GoodsAct. Any property not liable to attachment;

Any security interest for repayment of any financial asset notexceeding one lakh rupees;

Any case in which the amount due is less than 20% of theprincipal amount and interest thereon.

Any security interest created on agricultural land.

Offences & Penalties - Following are the offences prescribed under theSecuritisation Act:

Default in filing particulars of transactions relating to assetsecuritisation, asset reconstruction and creation of securityinterest.

Default in filing particulars of modification.

Default in giving intimation of particulars satisfaction.

Non-compliance of RBI directives by Securitisation Company and

Reconstruction Company.

Contravention, including attempt to contravene and abetting incontravention, of any

Documents

Securitisation An Overview