Securitization in India

1. Securitization in India Group Members S. Venkatakrishnan – 82038 NeerajSrivastava – 82025 SharadSachan – 82042 SubhashSen – 82043 Vivek Kumar - 82045

2. Conventional bond structure Structure of a normal debt instrument Bonds Earnings Power etc Issuer Investor • A debt instrument is the obligation of the issuer • Normally, the credit profile of the issuer depends on the aggregated earnings power of its businesses in the context of its financial risk profile and management capability • It is these businesses that would need to generate the cash flows for bond redemption Cash

3. Limitations of conventional debt funding • Limited flexibility to enhance the credit quality of the borrower • Largely standardized loan products homogenizing credit quality across cross-section of asset side inflows and liability side outflows • Firms unable to package out different levels of risk to meet varying needs of investors • Consequently, cost of funds linked to average credit profile of different cash flows Are alternatives available?

4. What are the alternatives • Third party credit support • Full financial guarantee/ Bond Insurance • Letter of Credit • Partial Financial Guarantee • Escrowing of cash flows • Pledging/Assignment of future flows • Securitization • Pledging/sale of a pool of retail receivables into a SPV • Pledging/sale of liquid assets • Pledging/sale of receivables from highly rated regular customers into a SPV

5. Third party credit support Any support provided to conventional bond structure such that • The debt instrument can achieve a rating higher than that implied by the aggregate earnings power of the issuer who deploys the cash proceeds of the bonds in its businesses Earnings Power etc Bonds Issuer Credit Support Investor Cash

6. Third party credit support • Full financial guarantee, letter of credit, bond insurance • Instruments rating is equated to the credit rating of the facility provider • Full credit support yet to commence as a commercial activity in India. Instances of full credit support usually a consequence of past relationships • International full credit support suppliers • Letters of credit- Commercial Banks • Bond insurance/ financial guarantees- monoline insurers • Partial Guarantee • Bond rating lies between the rating of the guarantor and the issuer • Initially provided by multilateral entities like IFC Washington, FMO

7. Third party credit support

8. THIRD PARTY CREDIT SUPPORT… • Applications • Weak entities that are a part of a stronger business groups- guaranteed issuance, especially CP • Entities with appetite for long tenor projects, where investor comfort is restricted to short tenor lending • Entities that enjoy long-term standing relationships with banks- letter of credit backed issuance • Entities that fit into the framework of multilateral agencies like IFC can approach them for partial guarantee

9. Escrowing of cash flows • Escrow mechanism captures future sales to • Highly rated customers, or • A Pool of large numbers of customers • Applicable to corporate issuers when • Escrowed revenues are exclusively made available for debt servicing • All operating expenses can be met out of remaining revenue sources • Can achieve a rating enhancement of upto 2 notches due to prioritization achieved without impacting operations

10. Escrowing of cash flows

11. ESCROWING OF CASH FLOWS • Applied several times for entities that are unlikely to go bankrupt like municipalities, governments and statutory bodies, for eg. • Escrow of energy sales by SEBs, property or other taxed by Municipalities • In addition, BPO, rent receivables have also been escrowed Applications • Entities with a high asset turnover ratio where escrowing a small portion pf revenues could benefit a significant portion of the funding mix • Entities having a regular inflow of stable non-operating cash flows like rentals

12. ASSIGNMENT OF FUTURE FLOWS • Future sales of goods with a ready market and relative price stability are assigned to an SPV. These are usually commodities or utilities • Key risks: Price risk and generations risk • Generation Risk of the said good/service is linked to the likelihood of continuance in operations of the facility operated can be mitigated by standby operator Generated and assigned over a period. Cash paid upfront Receivables Bonds Earnings Power etc User SPE Investor Cash Cash Responsibility for operating facility to generate receivables Standby Operator

13. Assignment of future flows • Applications • Entities with take or pay contract with a highly rated customer for any good or service • Entities producing a highly marketable commodity like oil, gas etc.

14. Securitization - basics • Securitization is the pooling of “homogeneous”, “financial"," cash flow producing”, “illiquid” assets and issuing claims on those assets in the form of marketable / tradable securities • Typically, a lender / originator advances a loan to borrower and over a period of time, he expects to receive repayment of principal and interest. • In securitization, the lender / originator sells the right to receive the future receivables to a third party and receives the present value of the receivables at the initiation of the transaction • The higher yield associated with these securities attracts investors who are willing to bear the associated credit, prepayment and liquidity risk

15. Securitization - basics • The basic principles of direct assignment remain the same - the only difference being that the investor records the transaction as ‘loans’ in its books and doesn’t invest in a tradable security • The originator also provides an upfront credit enhancement in the transaction to cover for the shortfalls in the pool because of borrower defaults; • The primary advantage of securitization is the flexibility provided in terms of unbundling of risks and allocation of the same to various parties who are able to manage those risks

16. Securitization - basics • Securitization involves sale, transfer, pledge of specified assets to a Bankruptcy-remote Special Purpose Vehicle (SPV) • The SPV in turn issues Notes (Pass Through Certificates) to investors in order to fund the purchase of the assets • Investors (banks, insurance companies, and specialised funds) rely on the cash flows (principal, interest and sale proceeds when sold after foreclosure) generated by the underlying assets to pay interest and principal on the notes • The risk associated with the assets is stratified by looking at historical default and loss information • Generally, the Originator remains the Servicer of the pool of the assets it had sold to the SPV

17. Key Features of Securitization All the risks and rewards associated with underlying pool are transferred to the buyer The transaction structure should be such that the bankruptcy of the seller does not affect the underlying pool There is no recourse to seller once the underlying pool is sold

18. Key Features of Securitization Pass Through – Refers to securitization structure where the SPV makes payments, or rather, passes payments to the investors, on the same periods, and subject to the same fluctuations, as are there in the actual receivables viz. amount collected every month is passed through to investors, after deducting fees and expenses. Pay Through – Where the payment to the investors are routed through SPV who does not strictly pay the investors only when the receivables are collected by it, but keeps paying on the stipulated dates irrespective of the collection dates. In order to allow for smoothed payment to investors by removing the fluctuations in its collections, the SPV uses a guaranteed investment contract or credit enhancements or both. Credit enhancements – Refers to one or more initiatives taken by the originator in a securitization structure to enhance the security, credit or the rating of the securitised instrument. Loan to value ratio – In case of asset based lending, means the amount of loan as a percent of the value of the asset on which the loan is secured.

19. Securitization vs. traditional debt Securitization Traditional Debt The issuer holds the assets – provides security Claim against the issuer company Monthly interest; bullet principal payments Rating cannot be higher than the issuer debt rating • Isolation of pool – true sale • Claim only against the pool – no impact of issuer bankruptcy • Typically both principal and interest repaid monthly • Credit enhancement helps in getting a higher rating than the issuer

20. Receivables based financing Securitization vs Bilateral Assignment Securitization vide issue of tradable instruments by an SPV Loan/Advance Debenture Backed by charge & Escrow Bilateral Assignment of receivables between Originator & Purchaser Full Recourse On Balance Sheet No capital Relief No gain on Sale Bilateral or CMI Limited Recourse Off Balance Sheet Release of capital Possible gain on Sale Banks and capital market investors Limited Recourse Off Balance Sheet Release of capital Possible gain on Sale No capital market investors Securitization through issue of tradable instruments would attract a wider investor base and thereby result in lower cost of funds to the Originator

21. Lease/Loan/Other Agreements Originator Obligors Bilateral Assignment: Structure Diagram Purchase Consideration Payment towards Obligation Assignment Of Receivables Purchaser/ Investor Servicer Credit Rating Agency Credit Enhancement Credit enhancement and rating may be optional in a bilateral transaction depending on the comfort of the purchaser / investor

22. PARTIES TO A SECURITISATION Initial owner of the assets Sells its asset to the SPV Originator Contractual debtor to Originator Pays cashflows that are securitised Obligor Set up specifically for transaction Purchases assets from Originator Company/Trust/ Mutual Fund SPV Subscribe to securities issued by SPV Investors

23. PARTIES TO A SECURITISATION Servicer Collects monies from Obligors, monitors and maintains assets Receiving & Paying Agent Banker for the deal. Manages inflows& outflows, invests interim funds, accesses cash collateral Provides credit enhancement by way of swaps, hedges, guarantees, insurance etc. Credit enhancement provider As structurer for designing& executing the transaction and as arranger for the securities Merchant banker

24. Parties to a securitisation (contd.) Provides a rating for the deal based on structure, rating of parties, legal and tax opinion etc Credit Rating Agency Provide key opinions on the structure & underlying contracts Legal & Tax Counsel Appointed for conducting due diligence both initial and during tenor of deal Auditor Appointed for safe custody of the underlying documents and registration/ transfer of securities Custodian R&T Agents

25. Exchange of funds - initial Borrowers Rating Agency Rating with specified credit enhancement Loan agreement Servicing Agreement Proceeds Proceeds Finance Company Ltd. (Originator) Trust (SPV) Investors Asset-Backed Securities Sale of assets Trust Agreement Trustee

26. Exchange of funds - ongoing Borrowers Rating Agency Rating Loan repayments Monthly loan repayments Monthly investor payments Finance Company Ltd. (acting as servicer) Trust (SPV) Investors Monthly reports Collection reports Trustee Responsibilities Trustee Form of SPV and role of Trustee are critical in a securitization

27. Cash flows from securitized assets Tranching of Liabilities 6 month PTCs Originator SPV Investors 1 year PTCs 5 year PTCs Cash flows from securitized assets Senior PTCs AAA(SO) Originator SPV Investors Retained Unrated Tranche

28. Par and premium structures Par Structures Premium Structures Investor pays a consideration equal to the principal outstanding (par value) of the pool Investor pays a consideration equal to the present value of future cash flows. The investor pays a premium to receive the excess interest spread In return, investor is entitled to receive scheduled principal repayments along with a contracted yield In return, investor receives the entire cash flows generated from the pool Typically, interest generated on the pool is higher than the yield to the investor, the difference is called excess interest spread (EIS) No excess interest in the structure EIS provides credit support to the investors. the originator retains a subordinated right to receive the EIS. The rating takes care of the fact that the investor payouts are higher and credit enhancement is calculated accordingly Prepayments in the underlying pool are passed on to the investor As investor principal outstanding is higher than the pool principal, the credit enhancement is utilized to cover the prepayment shortfall

29. Benefits of securitization • Efficient use of capital • Off balance sheet treatment and hence release of a portion of capital tied up by these assets • Allows the company to continuously churn assets and expand business volumes even when capital availability is scarce • Balance sheet management • Off-balance sheet treatment and upfront profit generated has a positive impact on financial results like Return of Assets, Earnings per share, Net spread etc. • Alternate Source of Funding • Securitization is an alternative source of funding that does not use up limits set up by banks / institutions on the company and allows allocation of funds by investors over and above these limits

30. Benefits of securitization • Rating enhancement resulting in lower cost of funds • Capital markets and other investors demand yields linked to the rating of the issuers for direct debt investment • Securitization enables a company to achieve a rating several notches above its standalone rating and thereby lower its cost of funding • Converting illiquid assets to liquid assets • Preserving customer relationships • Securitization allows transfer of credit risk while preserving existing relationships with customers • Typically, the originator acts as servicer for the transaction and hence continues to be the point of interaction with the obligors.

31. Originator’s objectives • Each originator should define the objectives desired to be achieved through the proposed securitization transaction in order of priority • Access to an alternate source of funds / investor class • Optimization of regulatory capital requirement • Rating enhancement and reduction in cost of funds • Balance sheet management : liquidity, asset-liability matching, debt-equity ratio • Limited recourse financing • Risk management – Sector exposure / company exposure Structure of securitization may vary significantly based on the priority of objectives of the originator

32. What can be Securitized

33. Types of receivables RECEIVABLES FUTURE RECEIVABLES (performance risk of Originator for eg. Future Sales Receivables) CURENT RECEIVABLES (no performance risk of Originator for eg. Lease, hire purchase, loans) CORPORATE RECEIVABLES (ConcentratedObligor base) for eg. Car/ CV Financing RETAIL RECEIVABLES (Diversified Obligor base) for eg. Car/ CV Financing CONTRACT BACKED RECEIVABLES for eg. Long term supply contracts RECEIVABLES WITHOUT UNDERLYING CONTRACTS for eg. Tea Sales at Auctions SECURED RECEIVABLES for eg. Secured Corporate Loans UNSECURED RECEIVABLES for eg. Utility Charges

34. Retail Assets Securitization • ABS market dipped in 2009 • Absence of banks from this market • De-growth in retail originations • Tight liquidity • Concerns on asset quality • Largely becoming a liquidity providing instrument • Securitisation is a key resource raising avenue for NBFCs • CVs emerged as dominant asset class largely driven by Shriram, Tata Motors finance and Magma • Microfinance loans and gold loans are the emerging asset classes Source: ICRA Research & Industry

35. TOP ABS ORIGINATORS • Banks have largely been non-existent in ABS market for last one year as the retail asset growth has been minimal / negative • ABS continues to be a viable resource raising avenue for NBFCs focusing on asset finance • Top originators for 2009-10 till date are Reliance Capital, Tata Motors Finance and Shriram Transport Finance Limited Source: CRISIL report

36. Capital relief Managing Asset liability mismatch Off-balance sheet funding Reducing concentration risk Direct access to capital markets Improved RoA / RoE WHAT AN ORIGINATOR LOOKS FOR Advantages of securitization over traditional funding

37. Securitization’s ancillary benefits • Securitization creates incentives for originator for • Developing transparent credit approval process • Efficient collection procedures, and for strong mechanisms to control this process • Clear and efficient processes invariably lead to lower credit enhancement • Public availability of information about pool performance adds to confidence in securitized paper But, originators prefer to retain customer relationship and servicing

38. Benefits to investors • Premium over equivalent rated plain securities • Focused risks associated with securities • Portfolio diversification • Tailored cash flow structures • Flexible range of maturities • Experienced risk assessment

39. BENEFITS TO THE FINANCIAL SECTOR • New forms of securities – market completion • Assists development of capital markets • Attracts conservative buyers • Draws international capital • Facilitates efficient allocation of risks

40. Capital Relief • Secured Assets (100% risk weight and 9% capital), Unsecured Asset (125% risk weight and 9% capital) Bank • 12%, 10% in case of Asset Finance Companies NBFC Provisioning Relief • Standard Provisioning – Secured Assets (0.4%), Unsecured Assets (2%). NPA are provided as per the RBI norms Bank • No standard provisioning requirement. Relaxed provisioning norms compared to Banks. Hence longer collection cycles, higher delinquencies compared to Banks NBFC Originators – Incentive, Impacts

41. Originators – Incentive, Impacts • As per Basel – Rated piece (typically BBB) as per rating (typically 100% risk weight & 9% capital). Unrated to be fully deducted. No reset. Capital knock off for Collateral Bank • To be fully deducted out of capital. No reset allowed. Basel applicability?? NBFC Profit • Profit (IRR from pool – Sell down rate – expected collection cost – Expected credit losses) to be amortised by the seller Bank • Profit (IRR from pool – Sell down rate – expected collection cost – Expected credit losses) to be amortised by the seller NBFC

42. Originators – Incentive, Impacts • Proceeds from securitisation have no CRR/SLR requirement • Reduces priority sector requirement Cost of funds Bank • Reduces cost of funds. More important in case of Non Asset Finance NBFCs where provisioning requirement by Banks is leading to higher costs NBFC

43. BANKRUPTCY REMOTENESS • True sale of assets from the seller to the trustee • Legal separation of assets from the seller is achieved – investor is not exposed to credit worthiness of seller • Credit enhancement and liquidity facility – bankruptcy remoteness achieved through rating triggers • An independent legal opinion is taken post the transaction to cover all such legal issues

44. Performance of Securitisations in India • Unlike US, the rise in delinquencies has not led to widespread downgrades or defaults in securitised papers • Rating agencies largely pre-empted the deterioration in asset quality and have increased the credit enhancement requirement suitably • Safety cover for investors has remained robust • Till date, approximately 700 pools have been rated in India • 38 pools have been downgraded so far • Only 3 of which have been downgraded to speculative grade • Some of these 38 pools have been upgraded back to AAA because of stable performance at later stages

45. Key Risks • Credit Risk • It is the risk of non-payment of underlying obligors, which is dependent on underlying obligor’s ability and willingness to pay. • The underlying obligor’s ability to pay is primarily driven by adequacy and stability of income • Loan to value ratio and income generating capability of the underlying asset will indicate the obligor’s willingness to pay. • Market Risk • Macro Economic Risk – affects underlying asset valuation, income generating capacity, borrower’s income, market interest rates, change in regulations etc. • Asset Risk - general risk perception of the asset; historic performance • Prepayment Risk – prevailing and expected market interest rates and expected income levels will influence the prepayment rates • Interest Rate Risk – mismatch may arise in case where the collections from underlying borrowers are based on fixed rate and the payouts to investors are based on floating rate and vice versa.

46. Key Risks • Counterparty Risk • Servicer Risk – the ability of the servicer to service the pool over the tenure of the transaction • Commingling Risk – The time lag between the collections from the underlying obligors and deposit into collection account give rise to commingling risk. • Other Counterparty Risk – The presence of other counterparties like collection account bank, credit collateral provider etc. give rise to performance risk. • Legal Risk