Securitization The conversion of existing or future cash in-flows of any person into tradable security which then may be sold in the market. The cash inflow from financial assets such as mortgage loans, automobile loans, trade receivables, credit card receivables, fare collections become the security against which borrowings are raised.

 Securitization therefore, is a process by which the future cash inflows of an entity ( originator ) are converted and sold as debt instruments called pay through or pass through certificates with a fixed rate of return to the holders of beneficial interest. The originator of a typical securitization transfers a portfolio of financial assets to a Special Purpose Vehicle ( SPV ), commonly a trust.  The SPV is basically funded by investors. In return for the transfer, the originator gets cash up-front on the basis of a mutually agreed valuation of the receivables. The transfer value of the receivables is done in such a manner so as to give the lenders a reasonable rate of return

 MARKETABILITY  HOMOGENITY  INTEGRATION AND DIFFERENTIATION  MERCHANTABLE QUALITY  COMMODITIZATION

All assets that generate funds over time can be securitised. These include  repayments under car loans,  money due from owners of credit cards,  airline ticket sales,  toll collections from roads or bridges, and  sales of petroleum-based products from oil refineries. In fact, artists have even raised funds by securitizing the royalty they will get out of future sales of their records.

 In a straight bond or debenture issue, in the event of the company going bust, the investors would have a tough time getting their funds back, if at all.  However, if one invests in a securitized instrument, investors are assured of interest payments even if the finance company goes bust, as the securitized loans are separated from the finance company’s books through a SPV which holds these assets.  At the same time, as securitized instruments can be traded, the investor is provided with liquidity as the securitized bond can be sold in the market.

1. Originator: An entity making loans to borrowers or having receivables from customers 2. Special Purpose Vehicle: The entity which buys assets from Originator and packages them into security for further sale 3. Investment Bank : A body that is responsible for conducting the documentation work. 4. Credit Rating Agency: since investor takes risk credit rating agency play imp role. 5. Obligors: borrower of original loan 6. Investor: The party to whom securities are sold.

What is a Special Purpose Vehicle ( SPV )? An SPV is an entity specially created for doing the securitization deal. It invites investment from investors, uses the invested funds to acquire to receivables of the originator and then uses the realizations from the receivables transferred to it to pay the investors, thereby giving them a reasonable return. An SPV may be a trust, corporation, or any other legal entity. Its activities are :-  Holding title to transferred financial assets  Issuing beneficial interest  Collecting cash proceeds from assets held, reinvesting proceeds in financial instruments pending distribution to the holders of beneficial interests and otherwise servicing the assets held.  Distributing proceeds to the holders of the beneficial interests.

What are Pass Through Certificates? A Pass Through Certificate is an instrument which signifies transfer of interest in the receivable in favor of the holder of the Pass Through Certificate. The investors in a pass through transaction acquire the receivables subject to all their fluctuations, prepayment etc. The material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayments, etc. are transferred to the investors.

What are Pay Through Certificates? In case of Pay Through Certificates, the SPV instead of transferring undivided interest on the receivables issues debt securities such as bonds, repayable on fixed dates, but such debt securities in turn would be backed by the mortgages transferred by the originator to the SPV. The SPV may make temporary reinvestment of cash flows to the extent required for bridging the gap between the date of payments on the mortgages along with the income out of reinvestment to retire the bonds. Such bonds were called mortgage – backed bonds.

 Mortgage backed securities  Asset backed securities

 Assets backed securities :Those securities whose income is derived from pool of underlying assets that are unable to sold individually Example: payments from car loan, credit card.  Mortgage backed securities: securities backed by mortgage loans(loan secured by real estate property) are called MBS.

 Off-balance sheet financing – remove illiquid assets.  Improves capital structure  Extends credit pool  Reduces credit concentration  Risk management by risk transfers  Avoids interest rate risk  Improves accounting profits

What are the demerits of securitization for the Originator ?  Since securitization is off-balance sheet funding, the true picture of the originators’ financial position is not clear merely from the balance sheet.  The best assets of the company may be transferred to the SPV and the company may be left with sub-standard assets on its books.  The greatest demerit of securitization is its opaqueness. A company may have taken huge liabilities but that may not be apparent from the balance sheet or conventional financial statements of the company. This is especially true where the securitization is with recourse i.e. if the receivables which have been securitized to the SPV become bad, the SPV will have the right to recover the dues from the originator.  The originator may have a lot of contingent liabilities without anyone being aware of it. The case of the collapse of Enron is too recent in memory to forget the problems associated with off-balance sheet funding.

Process of Securitization of Receivables 1) The originator determines which assets he wants to securities for raising funds. 2) The SPV is formed. 3) The SPV is funded by investors and issues securities to the investors. 4) The SPV acquires the receivables under an agreement at their discounted value. 5) after acquisition of asset SPV splits the pool into individual shares and reimburses itself by selling them.these securities are known as pay or pass through certificates and normally wothout recourse. 6) SPV enters into credit enhancement procedures 7) these securitiesare then rated by credit rating agencies

8)The SPV either passes the collection to the investors, or reinvests the same to pay off to investors at stated intervals. 9)In case of default, the servicer takes action against the debtors as the SPV’s agent. 10)When only a small amount of outstanding receivables are left to be collected, the originator may clean up the transaction by buying back the outstanding receivables.

5/2/ Typical Securitization Structure

Securitization of assets has been immensely successful in developed capital markets. In India, however, very few transactions of small value have taken place so far. Several obstacles are hindering the growth of securitization in India: · Stamp duty on transfer of assets by originator to the SPV, as high as up to 13%. · If PTC issued in form of a receipt, it is not transferable by endorsement & delivery; if PTC is issued in form of a promissory note it will attract stamp duty. · Ambiguity on whether PTCs can be regarded as negotiable promissory notes. · Unresolved tax issues – who will be taxed? · Weak foreclosure laws failing to provide adequate comfort to investors in ABSs.