MBA (F&B)-Internship Report

Securitization The Indian Perspective

Submitted by:-Amit Kumar -334Gowrishankar-NUMBAJagdish Agarwal-371Pritish Chaudhary-406Priyaranjan Singh-408Puneet Singh Bhatia-409Sujeet Kumar-461Tirthankar Ghosh 467

Securitization : The Past, Present & Future in India

Abstract

In this paper we analyze and explain The Past, Present and the possible future status of securitization in India. India being a developing country is counted among worlds fastest growing emerging economies. Be it Bond market or the securitization, India is still at a nascent stage and still need to mature in order to be counted among the big players.

2007-08 recession in US was a great learning for the world. Past learning & government initiatives have helped India in this regard. We will study, analyze and explain all the aspects of securitization.

TABLE OF CONTENTS

I. Introduction - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -4II. History- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 5III. Evolution of different securities in India - - - - - - - - - - - - - - - - - - - - - - - - - 7IV. Examples of Securitization - - - - - - - - - - - - - - - - - - - - - - - - -- - - - - - - - - 10V. Regulatory Framework - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -11VI. Parties Involved in Securitization Process - - - - - - - - - - - - - - - - - - - - - - - -12VII. Securitization Cases1) Citibank Case - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -132) REB Case - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -133) L&T Case - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -144) RICO Case - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -14VIII. Recent Trends - - - - - - - - - - - - - - - - - - - - - - - - - -- - - - - - - - - - - - - - - - - -15IX. Future of Securitization in India- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -16X. Issues faced by Indian Securitization Market- - - - - - - - - - - - - - - - - - - - - - 18XI. Areas of Improvement- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -19XII. Conclusion- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 23

Introduction

Securitization is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors.

Through securitization illiquid assets are converted into tradable security in the secondary market. It is measure of replenishing the funds by recourse to the secondary market. Thus, the securitization is a process by which the originators of assets like loans, which are illiquid are able to transfer such assets to a special purpose vehicle ('SPV') which, in turn, issues tradable liquid securities to investors. In a typical securitization transaction, the company seeking to raise funds transfers certain assets to an SPV that is organized in such a way that minimizes the likelihood of bankruptcy.

History

The financial sector in India has witnessed a series of reforms and changes since 1991, that is, the period in which the government ensued upon a policy for larger economic reforms allowing foreign direct and indirect investment in India. The need for the legal framework on securitization can be traced way back from 1991 onwards where various committees recommended to have a law on securitization and enforcement, this was followed by the enactment of the Securitization and Reconstruction of Financial Assets & enforcement of Securities Interest Act, 2002. The Act encompasses the areas of: securitization of financial assets, reconstruction of financial assets, recognition to any security interest created for due repayment of a loan as security interest under the Securitization Act, irrespective of its form: banks and financial institutions have the power to enforce the security without intervention of the courts, setting up the Central Registry for registration of the transaction of securitization, reconstruction and creation of security interests.

Securitization of financial assets is a financial tool for the lenders to securitize their future cash flows from the secured assets and thus to release their funds blocked in them. The secured assets become a market commodity having financial returns on their realization. This aspect brings in the much-needed expertise in adept handling in realization of the secured assets. The Act has made an attempt to streamline the legal impediments of normal civil law procedures to foreclose the mortgaged assets by empowering the enforcement of the secured assets by flexible mechanism provided in the Act. It would be pertinent to inter alia highlight the key features of the Act. The Act makes provision for:

Incorporation of Special Purpose Vehicles Securitization of Financial Assets Funding of securitization Asset Reconstruction Enforcing security interest i.e. taking over the assets given as security for the loan. Establishment of Central Registry for regulating and registering securitization transactions. Offences & Penalties.

The growth in the Indian securitization market has been largely fuelled by the repackaging of retail assets and residential mortgages of banks and Financial Institutions. This market has been in existence since the early 1990s, though it has matured significantly only post 2000 with an established narrow band of investor community and regular issuers. According to Industry estimates, the structured issuance volumes have grown considerably in the last few years; though still small compared to international volumes.

Asset backed securitization (ABS) is the largest product class driven by the growing retail loan portfolio of banks and other FIs, investors familiarity with the underlying assets and the short maturity period of these loans. The mortgage backed securities (MBS) market has been rather slow in taking off despite a growing housing finance market due to the long maturity periods, lack of secondary market liquidity and the risk arising from prepayment/repricing of the underlying loan.

In the early 1990s, securitization was essentially a device of bilateral acquisitions of portfolios of finance companies. There were quasi-securitizations for sometime, where creation of any form of security was rare and the portfolios simply got transferred from the balance sheet of the originator to that of another entity. These transactions often included provisions, which offered recourse to the originator as well. In recent years, loan sales have become common through the direct assignment route, which is structured using the true sale concept. Though securitization of auto loans remained the mainstay throughout the 1990s, over time, the market has spread into several asset classes housing loans, corporate loans, commercial mortgage receivables, future flows, project receivables, toll revenues, etc that have been securitized.

Within the auto loan segment, the car loan segment has been more successful than the commercial vehicle loan segment, mainly because of factors such as perceived credit risk, higher volumes and homogenous nature of receivables. Other types of receivables for which securitization has been attempted in the past include property rental receivables, power receivables, telecom receivables, lease receivables and medical equipment loan receivables.

Revolving assets such as working capital loans, credit card receivables are not permitted to be securitized.

The Time line:

Evolution of different securities in India:

1. Mortgage Backed Securities (MBS)In 2004-05, the Mortgaged Backed Securities market grew moderately at 13% with the issuance valued at `33.4 billion. There was also an increase in the par transactions with all 15 transactions being made in 2005 having a par structure. Since the underlying home loans in MBS pool have a floating-rate, the scheduled cash flow on such pools is uncertain and liable to change, depending on actual interest rate. Moreover, options to convert from fixed to floating rate and vice-versa, coupled with negotiated re-pricing of loans, added to the uncertainty of the cash flow in the MBS pool.

With the underlying loans earning floating rates, Pass through Certificates (PTCs) inMBS issues are also being predominantly priced on a floating rate basis. In 2005, 52% of issuance was based on a floating rate. But given the significant expansion in the housing finance business, there is room for even more significant expansion in the MBS market.However, the long-term tenure of MBS and the lack of liquidity in the secondary market discourage investors from getting actively involved in the market. Also home loans in India get pre-paid or re-priced, thus exposing the structures to significant interest rate risk and leading to higher credit enhancement requirements.

2. Asset Backed Securities (ABS)In 2005, the market for Structured Finance (SF) grew by 121% in terms of value and 41% in the number of transactions, while the ABS market doubled from `80.9 billion in 2004 to Rs. 222.9 billion in 2004. ABS was the largest product class, accounting for 72% of the SF market in 2005. This was three times higher than the volume of `81 billion in 2003. The growth in ABS issuance was the result of the following factors:

Continued increase in disbursements by key retail asset financers Investors familiarity with the underlying asset class Relatively shorter tenure of issuances Stability in the performance of a growing number of past pools.

Another important aspect of recent ABS issuance is the increasing preference of floating rate yields. In 2005, 13% of the PTCs issued had a floating rate yield while the corresponding figure for 2004 was only 6%. Repackaged securities was also introduced, where in the cash flow on certain existing PTCs issued under an ABS transaction are acquired by a SPV and fresh PTCs are issued against the same.

Given that the Asset Backed Securities are still new for the investors in India market, their preference is for AAA/AA rated instruments as there is no market for the subordinated paper or Junk Bond.

In 2005, Rs. 2.8 billion worth of Corporate Debt Obligations (CDO) and Rs. 23 billion worth of individual corporate loans were securitized. The impeding factor in CDO growth is that, investment decisions in the CDO pool are influenced by base rating of the underlying corporate exposures.

Types of ABS in India:

a) Home equity loansSecurities collateralized by home equity loans are currently the largest asset class within the ABS market. Investors typically refer to home equity loans as any non agency loans that do not fit into either the jumbo or a loan categories. While early home equity loans were mostly second lien subprime mortgages, first lien loans now make up the majority of issuance. Subprime mortgage borrowers have a less than perfect credit history and are required to pay interest rates higher than what would be available to a typical agency borrower. In addition to first and second lien loans, other home equity loans can consist of high loan to value loans, re-performing loans, scratch and dent loans, or open-ended home equity lines of credit, which homeowners use as a method to consolidate debt.

Housing loan portfolios are considered to be high quality assets with diversified risk and attractive returns. They are by their nature amenable to securitization. In India however, in spite of outstanding to the tune of `12,000 crore in the organized sector, no transaction has yet achieved successful completion. This needs to be analyzed in light of the experience in the US markets, where the overwhelming majority of securitization deals have been of housing loans or MBS.

However, of late there has been a perceptible positive orientation of Government policies towards securitization for the housing sector. The five-year Plan documents have repeatedly emphasized the need for developing a secondary mortgage market (SMM) for bridging the resource constraint confronting the housing sector. The Ninth Five-Year Plan has strongly recommended securitization as an important source of funds for the housing sector and has envisaged Rs. 2500 crore to come by way of securitization. The National Housing Policy (1992) of the Government of India also identified securitization as an essential measure for generating resources for housing. In particular, it has emphasized the development of a SMM in the country in order to channelize funds from wide range of investors and help integrate the housing finance system with overall finance system, especially the capital market. That securitization has come to represent a major policy plank of the Government, is further manifested in the recently announced National Habitat and Housing Policy (1998), which lays emphasis on the National Housing Bank (NHB) playing a lead role in mortgage securitization and development of a SMM in the country. NHB has taken up the issue of securitization with state Governments through the Ministry of Urban Development.

NHB is now proposing a pilot issue of MBS, as a prelude to the development of a SMM in the country. The pilot project involves securitizing a pool of housing loans originated by four Housing Finance Companies. The pool would include unencumbered loans given to individuals for residential houses, in the states of Maharashtra, Tamil Nadu, Gujarat and Karnataka, with maximum loan to value ratio (LTV) of 80%. NHB would act as the SPV and facilitate the transaction. The issue is proposed to be launched in FY 1999 2000 and is expected to be a path-breaking issue for MBS transactions in the country. All the major procedural, legal, and taxation issues are in the process of being resolved in this transaction, thus paving the way for classical securitisation transactions to take off in the country.

As with the rest of the world, the potential for mortgage securitization is enormous. In the case of mortgage securitization there are specific issues that stymie the process. These are the long tenure of loans, low spreads, cumbersome foreclosure procedures, and prepayment risks etc., all of which have led to its tardy progress. A major hurdle in India is simplified foreclosure norms. Once this happens, housing finance institutions (HFIs) will be able to tackle delinquencies effectively and will be willing to lend with less stringent credit evaluation. This is expected to enlarge volumes in the formal sector, helping a wider section of society (who would otherwise have approached the unorganized sector) to borrow at lower rates.

b) Auto loansThe second largest subsector in the ABS market is auto loans. Auto finance companies issue securities backed by underlying pools of auto-related loans. Auto ABS are classified into three categories: prime, nonprime, and subprime: Prime auto ABS are collaterized by loans made to borrowers with strong credit histories. Non prime auto ABS consist of loans made to lesser credit quality consumers, which may have higher cumulative losses Subprime borrowers will have lower incomes, shaded credited histories, or both.

Owner trusts are the most common structure used when issuing auto loans and allow investors to receive interest and principal on sequential basis. Deals can also be structured to pay on a pro-rata or combination of the two.

c) Credit Card ReceivablesSecurities backed by credit card receivables have been benchmark for the ABS market since they were first introduced in 1987. Credit card holders may borrow funds on a revolving basis up to an assigned credit limit. The borrowers then pay principal and interest as desired, along with the required minimum monthly payments. Because principal repayment is not scheduled, credit card debt does not have an actual maturity date and is considered a non-amortizing loan.

Examples of Securitization

Some examples of securitization in the Indian context are:

First securitization deal in India between Citibank and GIC Mutual Fund in 1991 for Rs 160 Million. L&T raised `4,090 Million through the securitization of future lease rentals to raise capital for its power plant in 1999. Indias first securitization of personal loan by Citibank in 1999 for Rs 2,841 Million Indias first mortgage backed securities issue (MBS) of `597 Million by NHB and HDFC in 2001. Securitization of aircraft receivables by Jet Airways for `16,000 Million in 2001 through offshore SPV. Indias first sales tax deferrals securitization by Government of Maharashtra in 2001 for `1,500 Million. Indias first deal in the power sector by Karnataka Electricity Board for receivables worth `1,940 Million and placed them with HUDCO. Indias first Collateralized Debt Obligation (CDO) deal by ICICI bank in 2002 Indias first floating rate securitization issuance by Citigroup of `2,810 Million in 2003. Indias first securitization of sovereign lease receivables by Indian Railway Finance Corporation (IRFC) of `1,960 Million in 2005. The receivables consist of lease amounts payable by the ministry of railways to IRFC. Largest securitization deal in India by ICICI bank of `19,299 Million in 2007. The underlying asset pool was auto loan receivables.

Regulatory framework

Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI) was enacted in 2002 in India. Though masked as a securitization related law, this law does very little for securitization transactions and has been viewed as a law relating to enforcement of security interests, as a very narrow avatar of personal property security laws in North America. In commercial practice, the SARFAESI has been pretty irrelevant for real life securitizations. Most securitizations in India adopt a trust structure with the underlying assets being transferred by way of a sale to a trustee, who holds it in trust for the investors. A trust is not a legal entity in law but a trustee is entitled to hold property that is distinct from the property of the trustee or other trust properties held by him. Thus, there is isolation, both from the property of the seller, as also from the property of the trustee. The trust law has its foundations in UK trust law and is practically the same in India. Therefore, the trust is the special purpose vehicle (SPV). Most transactions till date use discrete SPVs master trusts that are still not seen. The trustee typically issues pass thru certificates (PTCs). A PTC is a certificate of proportional beneficial interest. Beneficial property and legal property is distinct in law the issuance of the PTCs does not imply transfer of property by the SPV but certification of beneficial interest.

The SARFAESI Act has been largely perceived as facilitating asset recovery and reconstruction. Since Independence, the Government has adopted several ad-hoc measures to tackle sickness among financial institutions, foremost through nationalization of Banks and relief measures. Over the course of time, the Government has put in place various mechanisms for cleaning the Banking system from the menace of NPAs and revival of a healthy financial and banking sector.

Parties involved in securitization process:

1. The initial owner of the asset (the originator or sponsor) who has a loan agreement with the borrowers (obligors).2. The issuer of debt instruments who also is the SPV. The structure keeps the SPV away from bankruptcy of the originator, technically called 'bankruptcy remote'.3. The investment bankers who assist in structuring the transaction and who underwrite or place the securities for a fee.4. The rating agencies that assess credit quality of certain types of instruments and assign a credit rating.5. The credit enhancer, possibly a bank, surety company, or insurer, who provides credit support through a letter of credit, guarantee, or other assurance.6. The servicer, usually the originator, who collects payments due on the underlying assets and, after retaining a servicing fee, pays them over to the security holders.7. The trustee, who deals with issuer, credit enhancer and servicer on behalf of the security holders.8. The legal counsel, who participates in the structuring of the transaction.9. The swap counterparty, who provides interest rate/currency swap, if needed.

Securitization Cases

1. Citibank caseCitibank assigned a cherry-picked auto loan portfolio to Peoples Financial Services Ltd. (PFSL), an SPV floated for the purpose of securitization by paying the required amount of stamp duty (0.1%) to ensure true sale. This is a limited company and can act only as SPV for asset securitization. This SPV is owned and managed by a group of distinguished legal counsels. PFSL then proceeded to issue Pass through Certificates to investors. These certificates were rated by CRISIL and listed on the wholesale debt market of the National Stock Exchange (NSE), with HG Asia and Birla Marlin as the market makers. Global Trust Bank acted as the Investors Representative. Citibank played the role of servicer. The certificates are freely transferable and each of the transfer will have a stamp cost of 0.10%.

The coupon of the security was high in spite of good quality of the underlying asset portfolio, because investors expected a premium to compensate for their unfamiliarity with the certificates. The investor base was limited mostly to MFs. FIs were hesitant because of the unsecured nature of the instrument and the absence of clarity on whether the certificates could be treated on par with other debt securities in their investment policy. Although the certificates were listed on the NSE, there was very little secondary market activity because there was absence of adequate amount of alternative security of similar risk profile.

Besides Citibank, NBFCs like Ashok Leyland Finance, 20th Century Finance etc. have securitized their auto loan portfolio, though, of course, these transactions involved assignment of receivables only and not issuance of securities. The asset portfolios were bought by one or two large institutions. TELCO has also reportedly sold over Rs 550 crore of its auto loan portfolios in multiple tranches through this route.

2. KEB case Another important asset class for the purpose of securitisation pertains to the power sector. The Government is keen to securitise the outstanding dues of various State Electricity Boards (SEBs) and the total market of such receivables is estimated at around Rs.10, 000 crore4. However, securitisation of these receivables is feasible provided they are sufficiently credit enhanced, preferably with Government guarantee.The initiative in this regard has been taken by Karnataka Electricity Board (KEB) who, in a recent transaction, are securitising around Rs 210 crore of their outstanding dues from various State owned public enterprises. The outstanding dues of KEB are being assigned to another State owned subsidiary, Karnataka Renewable Energy Development Ltd. (KREDL) which is acting as the SPV and in turn issuing securities. The securities are being credit enhanced by way of a guarantee from the Karnataka Government with a structured payment mechanism. HUDCO has agreed to be the investor and subscribe to the securities in full.

3. L&T caseThe recent case of a power plant construction being financed through the capital markets is an example of future flow securitisation. Although Larsen & Toubro bagged the Build, Lease and Operate contract for a 90-MW captive power plant for Indian Petrochemical Corporation Ltd. (IPCL), it preferred to transfer it to an SPV India Infrastructure Developers Ltd. (IIDL) which issued debentures in the private placement market. The debentures would be serviced out of the lease rentals due to IIDL from IPCL. L&Ts guarantee was also available to a limited extent. The novelty of this transaction is that instead of a plain loan with say, 3:1 debt equity ratio, the project was financed in the form of a securitisation like structure through the capital market with a much higher gearing ratio.4. RIICO caseThis was the first attempt at issue of structured debt paper backed by the cash flows arising out of future receivables of a utility. Rajasthan State Electricity Board (RSEB) proposed to raise resources to the tune of Rs.250 crore, but, on account of its weak balance sheet, was not able to access the market directly. A structure was, therefore, devised whereby a pool of receivables comprising RSEBs high value customers was selected based on their payment history. The pool was then rated and credit enhancements were built. While no SPV was set up specifically for the purpose of the transaction, an existing profit-making Government Company, viz. Rajasthan State Industrial Development and Investment Corporation Ltd. (RIICO), was selected as the borrowing entity and the future cash flows and underlying receivables were charged to RIICO. The bonds backed by cash flows were issued by RIICO to various investors by means of a privately placed issue. The investors continued to have recourse to the issuer i.e. RIICO in the event of shortfall in cash flows. The high stamp duties then prevalent, as also certain legal and market-related hurdles, delayed the introduction of full-fledged securitisation at that juncture.Since the first issuance in 1991, the ABS have been very popular with the NBFCs in India. Over Rs.2000 crore of debt has been raised through this route5. The repayment history of all the issues has been extremely satisfactory. The level of cash collateral to support 'AAA' rating has come down (from a peak of 16% to an average of 8%). While the investors enjoyed a higher yield, the cost to NBFCs was lower than the traditional sources such as bank loans and public deposits. The primary market size of commercial loans and auto loans is expected to be about Rs.11, 000 crore and grows annually by 6% - 8%.

Recent trendsThough the securitisation market in India is marked by relatively simple structures and stable ratings, concerns over asset quality have affected investor appetite for securitisation in the post-crisis scenario. Much of the securitisation activity is driven on the supply side by growth of retail loan portfolio in banks and NBFCs and the prevalent liquidity conditions. On the demand side, the key factors have been the requirements of mutual funds, particularly at the short end, ,insurance companies and r banks to meet priority sector lending targets. Most of the securities are acquired with the intention to hold to maturity. As per the data compiled by major rating agencies, the year 200910 has witnessed an overall moderation in the volumes in securitization market. Total issuance volume saw a decline of 22% in 200910 over the previous fiscal. The dip in the overall securitization volumes owed mainly to the 60% reduction in loan sell-off (LSO) issuances, which were mostly short-term in nature. In the case of retail loan-backed transactions, with the overall growth in retail loan portfolios being subdued and the liquidity position of most financiers being comfortable, the need to securitize as a funding source was limited. Nevertheless, securitization of retail loans, both ABS and RMBS reported a 61 per cent increase in volume in 200910. While the securitization market has remained concentrated with a handful of originators and limited investors, the asset classes have continued to diversify, the latest additions being gold loans, microfinance loan receivables and loan against property.

Future of Securitization in India

According to a report by RBI, Securitization in India will grow in future for two significant reasons:a) Securitized paper is rated more creditworthy than the Financial Institution itselfb) Strict capital requirements are imposed on the Financial Institutions.Future trends in securitization of assets will not only be influenced by those FIs who are knowledgeable about this process, and therefore, aware of its potential but will also be affected by the level of knowledge in the financial community as a whole as well as the perception of the regulators. While the benefits that securitization brings are well documented, it may however, be worthwhile to examine whether the domestic financial markets are sufficiently developed to accept the product and utilize it efficiently.The debt market has deepened and widened in recent years in India after the introduction of financial sector reforms. The recent recommendation of the committee on financial sector reforms (Narasimhan Committee Phase II) stipulates that the minimum shareholding by Government /Reserve Bank of India in the equity of the nationalized banks should be brought down to 33%. The same report also emphasizes financial restructuring with the objective of, inter alia, hiving off non-performing-asset portfolio from the books of the FIs through securitization. According to an estimate, Indian banks may be able to raise funds at 200 basis points above US Treasury rate for an issue of US$ 150 million with a maturity of five years, giving them a gain of 200 to 400 basis points over the domestic rates after taking care of related expenses. The securitized paper can be raised in a period of 16 weeks after signing the mandate with advisors/lead manager. The costs involved are advisors fee to the tune of 1.5% of issue size, rating agency fee US $ 300,000, legal expenses US$ 500,000 and road shows US$ 100,000. The guidelines of RBI restricting the quantum of the public deposits that can be raised by an NBFC have given them further incentive to look for alternative sources of funds. The opening of the insurance sector for privatization can create demand for the securitized paper. The Indian financial system is sound and very well developed. A number of new financial products have arrived and been tested in the market during the brief period since the reforms began. The past few years have also witnessed a healthy trend towards computerization of transaction and information management systems. The availability of computer technology would thus permit the capture and manipulation of large databases, which are a basic requisite in structuring, securitized products. The debt market is poised for substantial growth with the development of the sovereign yield curve across different maturities and the active participation of primary dealers. The Indian market has existing well-developed institutions, specialized regulators in Banking, Capital Markets, Rating Agencies and also a well-developed regime of controls and supervision. The infrastructure sector has already started witnessing contracting of debt in a tradable form by most lending institutions. This has been concurrent with the advent of Structured Debt Obligations which has in turn familiarized Rating Agencies to 'SO' ratings.

The existence of specialized financing institutions like Housing Finance Companies, Urban /Infrastructure development Bodies like Housing and Urban Development Corporation (HUDCO), Rural Electrification Corporation (REC) etc. who not only have existing securitisable portfolios but also have the capacity to keep creating such assets with a view to securitizing them. Since most such institutions are facing resource constraints, securitization will enable them to focus on their core competency of supporting infrastructure products through the gestation stage and securitizing them later, rather than funding them till maturity. The domestic financial institutions are fast reaching their prudential limits in various sectors. Further lending by them to these sectors is thus dependent upon their being able to securities their existing portfolios.The investors with long term funds have traditionally favored equity and Government securities portfolio and have stayed out of debt. Also the present illiquidity of the loan portfolios does not allow FIs to actively manage or manipulate the related sector, interest rate or maturity risks. This places a restriction on further asset expansion, as assets once taken on the books necessarily need to be carried till maturity. Securitisation will provide solution for their requirements.The market is thus at a stage where debt is increasingly going to be offered in a tradable form, whether or not secondary market trades take place in individual cases. Securitization, by converting debt into tradable financial instruments, provides an opportunity for more efficient reallocation of sector specific risks among a more diversified set of players. By offering an exit option, it channelizes surpluses that have so far remained untapped, to capitaldeficient sectors of the economy.

Asset Class-wise distribution of ABS Pools:

Issues facing the Indian Securitisation Market

1. Stamp Duty: One of the major hurdles facing the development of the securitisation market is the stamp duty structure. In India, stamp duty is payable on any instrument which seeks to transfer rights or receivables. Therefore, the process of transfer of the receivables from the originator to the SPV involves an outlay on account of stamp duty, which can make securitization commercially unviable in states that still have a high stamp duty. Few states have reduced their stamp duty rates, though quite a few still maintain very high rates ranging from 5-12 per cent. To the investor, if the securitized instrument is issued as evidencing indebtedness, it would be in the form of a debenture or bond subject to stamp duty, and if the instrument is structured as a Pass Through Certificate (PTC) that merely evidences title to the receivables, then such an instrument would not attract stamp duty.

SEBI has suggested to the government on the need for rationalization of stamp duty with a view to developing the corporate debt and securitization markets in the country, which may going forward be made uniform across states as also recommended by the Patil Committee.

Foreclosure Laws: Lack of effective foreclosure laws also prohibits the growth of securitization in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default.

2. Issues under the SARFAESI Act: A security receipt (SR) gives its holder a right of title or interest in the financial assets included in securitisation. This definition holds good for securitisation structures where the securities issued are referred to as pass through certificates. However, the rationale fails in the case of pay through certificates with different classes of primary and secondary rights to the cash flow. Also, the SARFAESI Act has been structured such that SRs can be issued and held only to Qualified Institutional Buyers (QIBs). There is a need to expand the investor base by including NBFCs, non-NBFCs, private equity funds, etc.

3. Legal Issues: Investments in PTCs are typically held-to-maturity. As there is no trading activity in these instruments, the yield on PTCs and the demand for longer tenures especially from mutual funds is dampened. Till recently, Pass through Certificates (PTC) were not explicitly covered under the Securities Contracts (Regulation) Act, definition of securities. This was however amended with the Securities Contracts (Regulation) Amendment Act, 2007 passed with a view to providing a legal framework for enabling listing and trading of securitized debt instruments. This will bring about listing of PTCs which in turn will support market growth.

Areas to improve

Below are some of the few areas to improve the Indian securitization industry, ensuring quality deals, effective supervision and enhanced liquidity

Presently, SPVs are not eligible as counter-parties in an interest rate swap and derivative contract with a bank. In a transaction with significant interest rate risk, like a long tenure MBS, there is critical need to mitigate it through tools such as interest rate swap. It is recommended that RBI many consider amendments to the General Guidelines on Derivatives and Swap, allowing SPVs to be included as counter-party.

RBI should converge with SEBI to prescribe a more comprehensive standard set of disclosures, similar to the guidelines for listed PTC as recommended by SEBI. This could be benchmarked against what is required internationally, that are required to be made by the seller/originator to all the parties involved in the transaction, both at origination and post-issuance. This will go a long way in enhancing the transparency and build investors confidence. RBI may also consider establishing or helping establish an information repository which will collate the asset class performance data from various originators active in the securitization market and making the industry wide benchmarks available to various participants. This will help informed decision by the investor.

Presently, SPVs are not eligible to enter into interest rate swap. In a transaction with significant interest rate risk, like a long tenure MBS, there is critical need to mitigate it through tools such as interest rate swap. Lack of availability of such tool creates a major hindrance in the growth of the market. It is understood that that SEBI many consider SPVs to be included in eligible entities to enter into interest rate swap to mitigate interest rate risk for a securitized pool.

Long term investors are needed for the development of the securitization market. Players like Insurers, Pension Funds and Provident Funds etc are required to play a key role in the market. The Ministry of Finance should formulate a policy to allow these players to invest in long-term PTC/Securitized Assets. This would increase the size of the market and also the scope of assets being securitized. It is also recommended that the Ministry of Finance get the approval of the Ministry of Labor to authorize Pension/Provident funds to invest into securitized paper.

A lot depends on what has been put forth by the SARFAESI Act, 2002, and to discuss, or rather focus on the future of Securitization, one has to analyze the clauses of so. Therefore, an attempt has been made to forecast about one of the most essential elements with the help of following:

Explaining and Understanding the Characteristics of Real-Property-Securitized Products: In order to continuously promote effective real property securitization, the investor's understanding of the characteristics of securitized products is essential. If only the higher return is emphasized and investment is made without full understanding of the risk factors, the investment in real-property-securitized products will not be repeated by investors when risks materialize and losses are experienced. To prevent such problems, written offers to invest in real-property-securitized products and oral presentations to potential investors must be well prepared and fully explain the products' characteristics, as well as the transaction prices of the subject properties and return-related information (e.g. tenant information, and other appropriate disclosures) etc.

Establishment of Better Environment for Promotion of Securitization: Rationalizing the Rental Agreement: With regards the rental and leasing of properties, the normal rental system used for residential properties is also used in the case of office and commercial properties (under the "normal rental system" the rights of landlords are to some degree regulated in order to protect the rights of residential tenants deemed to be in a relatively weak position). When landlords advise tenants of non-renewal or cancellation of rental agreements the so-called Due Cause System limits the landlords' right to terminate them, even when such cancellation is stipulated in the agreement with three to six months notice. Landlords must show reasonable cause for refusing to renew or cancel rental agreements: for example, the landlord may require the subject property for his/her own use. Supplementary lease provisions are also common. Usually it may be agreed that the tenant can terminate the rental agreement with one to six months prior notice. Under these conditions, the termination period of the rental agreement is unpredictable, and it is pointed out that the revenue streams from securitized property, which are essential to successful real property securitization, are also unpredictable.

Property Evaluations Based On Income Stream: In order to precisely reflect the risk/return potential of a subject property, it is important that during the process of implementing securitization due diligence is conducted with respect to the physical attributes of the property including structure, building equipment and deferred maintenance; the legal matters such as the contents of rental agreements and the rights and interests of parties with respect to the subject property; and economic factors such as the rent-paying abilities of tenants and the prospects for development in surrounding areas. Also, it is important that property evaluations are based on income factors.

Securing Prime Properties for Securitization: In order to establish and offer attractive securitized products in which a wider group of investors are likely to become interested, it is necessary that many properties which have the high returns that investors require be secured for purchase at prices reflecting their risk/return profile. In relation to securitized products currently under development, it is noted that the number of properties that satisfy conditions regarding rental incomes and occupancy ratios is limited. In order to improve returns and reduce risk factors, it is necessary to increase the supply of prime properties by positively promoting the remodeling and reconstruction of existing properties. As real property securitization takes off, new properties can be built specifically for this purpose. Problems related to the securitization of projects under development are as: Firstly, it is difficult to project the return in advance, because of fluctuating development costs and development periods; and secondly, there is a substantial time lag between the initial investment and the realization of income.So, the risk stemming from the uncertainty of the return can be reduced by combining the securitization of new developments with the securitization of existing properties; and especially in the early stages of project development, projects could make practical use of public loans and guarantees through the government policy finance.

Nair Committee report on re-examining and suggesting revision with respect to Priority Sector classification and related issues (February 2012):The M.V. Nair Committee set up by RBI, in its report submitted in February 2012, recommended that bilateral assignment of loans and securitization should continue to be allowed to be classified as priority sector provided the underlying asset is eligible for Classification under priority sector advances. Also, it talks of clear due diligence criteria for assets acquired through NBFCs, which is a positive. Moreover, increasing the priority sector targets for foreign banks from 32% to 40% would increase the funding avenues for various entities that want to avail priority sector benefits. Nevertheless, these benefits have to be seen in the light of:

I. Overall cap of 5% of adjusted net bank credit (ANBC) on priority sector bank lending through non bank financial intermediarieswhich includes portfolio buy-outs and investment in securitization instruments.

Given that several banks, particularly private sector banks have been investing in securitization or direct assignment transactions to meet their PSL targets, this move would have an adverse impact on the buying appetite of banks that were exceeding the 5% cap. This is turn could adversely affect the ability of the originating NBFCs to securitize their portfolios.

II. Proposed interest spread cap of 6% for NBFC-AFCs and 3.5% for HFCs

This recommendation is likely to have an impact on securitization of certain asset classes like Microfinance loans and SME Loans, where the interest spread has been observed to be higher than 6%. Barring a handful of transactions, most microfinance transactions have an interest spread greater than 6% and in some cases the spread has been observed to be higher than 10% also- this is primarily due to high interest rate on the underlying loans, which is typically in the range of 22%-26%.

III. Capping of off-balance sheet exposure (of NBFCs) at 35% This is likely to have an immediate bearing on the portfolio of 3-4 large NBFCs that have off balance sheet exposure exceeding 35%

IV. Also, the committees recommendation is to continue to exclude loans against gold jewelers from priority sector advances

Hence the attractiveness of this asset class for securitization is expected to remain low.

Though retail loan securitization improved in FY2012, the issuance volume in India continues to remain subdued and concentrated among few Originators. Around 75% of the market in FY2012 was essentially bilateral loan pool trading, driven by the economics of priority sector lending targets. It follows that the investor segment is largely banksmainly private sector and foreign banks. Mutual Funds have mostly been absent from the securitization market for a variety of reasons, the latest being the unresolved issue of income tax authorities claim on taxing the income from securitized instruments. The final guidelines on securitization and bilateral assignments are expected to result in a significant decline in volume of bilateral assignments given the prohibition on credit enhancements by Originators in these transactions. The other key factors that will largely shape the course of securitization of retail asset loans going forward are the extent to which the Nair committee recommendations are adopted and also the legal stance on the taxation of PTCs. In addition to regulatory prescriptions, the pace of growth in loan book size among key players would continue to be a basic determinant of level of securitization activity.

Conclusion

The dramatic growth in the use of securitization to fund corporate loan assets suggests that this is a form of financing that is here to stay. However, the process of securitizing complex and non-homogenous assets gives rise to a number of legal and structural complexities. There is a requirement to strengthen & regularize the securitization market because it is still in the blooming stage and if went awry, it could lead to catastrophic financial implications.

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