Session VII B SECURITIZATION INSTRUCTOR: Prof. (Dr.) Paresh Shah,F.I.C.W.A.,Ph.D. (Finance)., F.D.P. (IIMA) 1 Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA)

Special Purpose Vehicle A special purpose vehicle (SPV) also known as special purpose entity (SPE) is a body corporate (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives, primarily to isolate financial risk, usually bankruptcy but sometimes a specific taxation or regulatory risk.

FEATURES OF SPV  Auto-pilot arrangements that restrict the decision- making capacity  Use of professional directors, trustees or partners;  Thin capitalization  Absence of an apparent profit-making motive  Domiciled in 'offshore' capital havens  Specified life;  Creator or sponsor may transfer assets SPE  Exist for financial engineering purposes

Advantages and Disadvantages of SPV Analysis of benefits Analysis of risks Residual or ownership risks Recognition and measurement

Uses of SPVs in Corporate Industry Securitization Financial engineering Risk sharing Regulatory reasons Property investing

Securitization Form of financing which involved pooling of financial assets and issuance of securities that are repaid from the cash flows generated by the assets such as auto loans, mortgages, credit cards, student loans, consumer loans, corporate debts, etc.

Is a synthetic technique of – Conversion of assets into securities – Securities into liquidity – Subsequently into assets on an ongoing basis – Increasing thereby the turnover of the business and profit – While also providing for flexibility in yield, pricing pattern, issuing risk, and marketability of instruments used to the advantage of both borrowers and lenders Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 7 CONCEPT

Suitable for securitization for the banks and financial institutions are housing loans, car and truck loans, credit card receivables, trade receivables etc. The crucial link in the securitization chain is the – Creation of ‘SPECIAL PURPOSE VEHICLE (SPV)’ – SPV intermediates between primary market for underlying assets and secondary market for the asset backed security Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 8 CONCEPT

Originator or lending institution identifies the assets out of portfolio Pool of identified assets is then ‘passed through’ to SPV SPV splits the pool into individual shares or securities and reimburses itself by selling these to investors These securities known as” Pay or pass through certificates” Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 9 SECURITIZATION PROCESS

SPV may enter into credit enhancement procedures either by obtaining an insurance policy to cover the credit losses or by arranging a credit facility from a third party lender to cover delayed payments Pass through certificates before maturity are tradeable in a secondary market to ensure liquidity for the investors In India, absence of trading facility in securitization Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 10 SECURITIZATION PROCESS

OLD WINE IN NEW BOTTLE because – The originator (the transferor of the pool of assets) is selling a stream of cash flows which is to accrue to it – Security, evidencing financial claim, is represented by the specific assets transferred by the originator or the cash flow of the originator – Give rise to a capital market instrument and hence marketable – Credit rating becomes inevitable Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 11 PERSPECTIVE OF FINANCE PERSONNEL

MBS is the pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to the investors Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 12 MORTGAGE BACKED SECURITIES

PASS THROUGH CERTIFICATES (PTC) – The cash flows are distributed to the holder of the securities on a pro rata basis – Incase of prepayments, holder of the underlying asset pays the remaining principal before the final scheduled payment, this amount is also proportionately passed on to the security holders. – PTC reflects the ownership rights in the assets backing securities Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 13 INSTRUMENTS OF SECURITIZATION

PAY THROUGH SECURITY (PTS) – SPV typically owns the receivables and simply sells the debt that is backed by the assets – Issuer of debt is free to restructure the cash flow from the receivable into payments on several debt tranches with varying maturities Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 14 INSTRUMENTS OF SECURITIZATION

STRIPPED SECURITIES – Interest only (IO) holders are paid back out of the interest income only – Principal only (PO) holders are paid out of principal repayments only. THESE securities are highly volatile in nature and least preferred IO securities values goes up when interest rates rises Prepayment of mortgages, the PO securities increase in value Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 15 INSTRUMENTS OF SECURITIZATION

DEFINITIONS 'Bankruptcy remote' means the unlikelihood of an entity being subjected to voluntary or involuntary bankruptcy proceedings, including by the originator or its creditors; 'Credit enhancement' is provided to an SPV to cover the losses associated with the pool of assets. The rating given to the securities issued by the SPV (PTCs) by a rating agency will reflect the level of enhancement; Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 16

DEFINITIONS First loss facility represents the first level of financial support to a SPV as part of the process in bringing the securities issued by the SPV to investment grade. The provider of the facility bears the bulk (or all) of the risks associated with the assets held by the SPV; Second loss facility represents a credit enhancement providing a second (or subsequent) tier of protection to an SPV against potential losses; Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 17

DEFINITIONS Liquidity facilities' enable SPVs to assure investors of timely payments. These include smoothening of timing differences between payment of interest and principal on pooled assets and payments due to investors; 'Originator' refers to a bank that transfers from its balance sheet a single asset or a pool of assets to an SPV as a part of a securitisation transaction and would include other entities of the consolidated group to which the bank belongs. Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 18

DEFINITIONS 'Securitisation' means a process by which a single performing asset or a pool of performing assets are sold to a bankruptcy remote SPV and transferred from the balance sheet of the originator to the SPV in return for an immediate cash payment; Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 19

DEFINITIONS 'Service provider' means a bank that carries out on behalf of the SPV (a) administrative functions relating to the cash flows of the underlying exposure or pool of exposures of a securitization; (b) funds management; and (c) servicing the investors; Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 20

DEFINITIONS 'SPV' means any company, trust, or other entity constituted or established for a specific purpose - (a) activities of which are limited to those for accomplishing the purpose of the company, trust or other entity as the case may be; and (b) which is structured in a manner intended to isolate the corporation, trust or entity as the case may be, from the credit risk of an originator to make it bankruptcy remote; Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 21

DEFINITIONS 'Underwriting' means the arrangement under which a bank agrees, before issue, to buy a specified quantity of securities in a new issue on a given date and at a given price if no other purchaser has come forward. Prof. (Dr.) Paresh Shah; F.I.C.W.A.,Ph.D.;F.D.P. (IIMA) 22