Introduction: Meaning of securitisation
According to Kenneth Cox securitisation is a process in which pools of individual loans or receivables or actionable claims are packaged, under written and distributed to investors in the form of securities. It is a process of liquidizing assets appearing in the balance sheet of a Bank or financial institution which represent long term receivables by issuing marketable securities there against. It involves conversion of cash flow from a portfolio of assets in negotiable instruments or assignable debts which are sold to investors. The name securitization is derived from the fact that the form of financial instruments used to obtain funds from the investors is securities. All assets can be securitised so long as they are associated with cash flow. Hence, the securities which are the outcome of securitisation processes are termed asset-backed securities (ABS). From this perspective, securitization could also be defined as a financial process leading to an issue of an ABS.
Securitisation often utilizes a special purpose vehicle (SPV), alternatively known as a special purpose entity (SPE) or special purpose company (SPC), in order to reduce the risk of Bankruptcy and thereby obtain lower interest rates from potential lenders. A credit derivative is also generally used to change the credit quality of the underlying portfolio so that it will be acceptable to the final investors. Securitization, in its most basic form, is a method of selling assets. Rather than selling those assets “whole”, the assets are combined into a pool, and then that pool is split into shares. Those shares are sold to investors who share the risk and reward of the performance of those assets. It can be viewed as being similar to a corporation selling, or “spinning off”, a profitable business unit into a separate entity. They trade their ownership of that unit, and all the profit and loss that might come in the future, for cash right now.
A very basic example would be as follows: X Bank loans 10 people Rs100, 000 a piece, which they will use to buy homes. X Bank has invested in the success and failure of those 10 home buyers, if the buyers make their payments and pay off the loans, X Bank makes a profit. Also if we look at it in another way, X Bank has taken the risk that some borrowers won't repay the loan. In exchange for taking that risk, the borrowers pay X Bank interest on the money they borrow. From the perspective of X Bank, those loans are 10 different assets. They have value- one, if the loan fails, X Bank takes ownership of the house. Two, if the loan succeeds, X Bank gets their money back along with the interest they charge.
X Bank can do two things with those loans. They can hold them for 20 years and, they would hope, make a profit on their investment. Or they could sell them to some other investor, and walk away. In doing this, they would make less profit than if they held onto them long term, but they would benefit in that they make some profit while also getting their original investment back. They give up some of the profit in exchange for not having face the risk. So X Bank decides they would rather have the cash now. They could sell those 10 loans to 10 investors. Each investor would be taking a risk in buying those loans, because if any loan defaults, that one investor loses.
Global Walk of Securitisation
Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank. But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well.
In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association sold securities backed by a portfolio of mortgage loans. Securitization only reached Europe in late 80's, when the first securitizations of mortgages appeared in the UK. This technology only really took off in the late 90's or early 2000, thanks to the innovative structures implemented across the asset classes. Securitisation as a financial instrument has been in practice in India since the early 1990s essentially as a device of bilateral acquisitions of portfolios of finance companies. As would be the case elsewhere too, securitisation in its initial form finds its way in loan sales. There were quasi-securitisations for quite a while where creation of any form of security was rare and the portfolios simply ended from balance sheet of one originator over to that of another. Most of these transactions were backed by extensive originator support. As there were no rules as to regulatory capital requirements, most of the so called securitization investors were actually taking exposure on the balance sheet of the originator. Having started sometime in 1996 or thereabouts, securitization volumes have been scaling new peaks every year. The party continued till about 2005. In early 2006, the RBI came out with guidelines on regulatory capital treatment for securitization – these dealt a severe blow to the securitization market and in 2006, the volumes are expected to be lower than those in 2005.
Advantages of securitisation:
1) Liquidification:
It creates liquidity in the market against assets which are generally sleeping or dormant in character.
2) Avenue for investment:
It creates opportunities for investment to people who want to invest to augment income, assured securities having opportunity for encashment as and when required.
3) Foreign funds:
Foreign funds can be generated through the creation of a depository of Indian scrip including shares and debentures. A GDR or IDR are issued to foreign investors through which foreign funds are mobilised for investment in India.
Simplistic Graphical Ramification
Concept of CBO’s/ CLO’s: a kind of securitisation merchandise
When a Bank transfers a pool of loans, the bonds that emerge are called collataralised loan obligations or CLOs. Where the Bank transfers a portfolio of bonds and securitises the same, the resulting securitised bonds could be called collateralised bond obligations or CBOs. A common name given to the two is collateralised debt obligations or CDOs, as in a number of cases, the portfolio transferred by the Bank could consist of loans as well as bonds, and at times, even Asset Backed Security.
Why is Securitization preferred?
Securitisation is one way in which a company might go about financing its assets. There are generally the following reasons why companies consider securitisation:
1. Improve capital returns:
To improve their return on capital, since securitisation normally requires less capital to support it than traditional on-balance sheet funding;
2. Raise finance:
To raise finance when other forms of finance are unavailable (in a recession Banks are often unwilling to lend - and during a boom, Banks often cannot keep up with the demand for funds);
3. Better return on assets:
Securitisation can be a cheap source of funds, but the attractiveness of securitisation for this reason depends primarily on the costs associated with alternative funding sources;
4. Diversify portfolio:
To diversify the sources of funding which can be accessed, so that dependence upon Banking or retail sources of funds is reduced;
5. To lower risk:
To reduce credit exposure to particular assets for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitisation can remove some of the assets from the balance sheet;
7. Manage Mortgage Assets:
To match-fund certain classes of asset - mortgage assets are technically 25 year assets, a proportion of which should be funded with long term finance; securitisation normally offers the ability to raise finance with a longer maturity than is available in other funding markets;
8. Benefits:
To achieve a regulatory advantage, since securitisation normally removes certain risks which can cause regulators some concern, there can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitisation as a means of managing the restriction on their wholesale funding abilities).
Types of Asset backed securities:
Home equity loans
Securities 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, reperforming loans, scratch and dent loans, or open-ended home equity lines of credit, which homeowners use as a method to consolidate debt.
Auto loans
The 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
Credit card receivables
Securities 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 nonamortising loan.
Indian scenario
Securitisation in India began in the early nineties. It has been of a recent origin. Initially it started as a device for bilateral acquisitions of portfolios of finance companies. These were forms of quasi-securitizations, with portfolios moving from the balance sheet of one originator to that of another. Originally these transactions included provisions that provided recourse to the originator as well as new loan sales through the direct assignment route, which was structured using the true sale concept. Through most of the 90s, securitisation of auto loans was the mainstay of the Indian markets. But since 2000, Residential Mortgage Backed Securities (RMBS) have fuelled the growth of the market.
The need for securitization in India exists in three major areas –
- Mortgage Backed Securities (MBS),
- The infrastructure Sector and
- Other Asset Backed Securities (ABS).
It has been observed that Financial Institutions and Banks have made considerable progress in financing of projects in the housing and infrastructure sector. It is therefore necessary that securitisation and other allied systems get developed so that Financial Institutions and Banks can offload their initial exposure and make room for financing new projects. With the introduction of financial sector reforms in the early nineties, Financial Institutions and Banks, particularly the Non-Banking Financial Companies (NBFCs), have entered into the retail business in a big way, generating large volumes of homogeneous classes of assets such as auto loans, credit cards receivables, home loans. This has led to attempts being made by a few players to get into the Asset Backed Securities market as well. However, still a number of legal, regulatory, psychological and other issues need to be sorted out to facilitate the growth of securitisation. People of India have not yet welcomed this concept.
Legal status given to securitisation
In 2002, India enacted a law that reads Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (SARFAESI).Though masked as a securitisation related law, this law does very little for securitisation transactions and has been viewed as a law relating to enforcement of security interests, as a very narrow avatar of personal property security laws of North America. In commercial practice, the SARFAESI has been very irrelevant for real life securitisations. Most securitisations 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 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.
An overview of the SARFAESI Act, 2002:
The Securitisation Act (SARFAESI 2002) contains 41 sections in 6 Chapters and a Schedule. Chapter 1 contains two sections dealing with the applicability of the Securitisation Act and definitions of various terms. Chapter 2 contains 10 sections providing for regulation of securitisation and reconstruction of financial assets of Banks and financial institutions, setting up of securitisation and reconstruction companies and matters related thereto. Chapter 3 contains 9 sections providing for the enforcement of security interest and allied and incidental matters. Chapter 4 contains 7 sections providing for the establishment of a Central Registry, registration of securitisation, reconstruction and security interest transactions and matters related thereto. Chapter 5 contains 4 sections providing for offences, penalties and punishments. Chapter 6 contains 10 sections providing for routine legal issues.
Section 5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, mandates that only Banks and financial institutions can securitise their financial assets. In the traditional lending process, a Bank makes a loan, maintaining it as an asset on its balance sheet, collecting principal and interest, and monitoring whether there is any deterioration in borrower's creditworthiness. This requires a Bank to hold assets till maturity. The funds of the Bank are blocked in these loans and to meet its growing fund requirement a Bank has to raise additional funds from the market. Securitisation is a way of unlocking these blocked funds.
SICA- Sick Industrial Companies Act, 1985.
BIFR- Board for Industrial & Financial Reconstruction, 1985.
RDDBFI Act- Recoveries of Debts due to Banks and Financial Institutions Act, 1993.
SARFAESI Act- Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
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 nationalisation 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. Some of the notable measures in this regard include:
- Sick Industrial Companies (Special Provisions) Act, 1985 or SICA: To examine and recommend remedy for high industrial sickness in the eighties, the Tiwari committee was set up by the Government. It was to suggest a comprehensive legislation to deal with the problem of industrial sickness. The committee suggested the need for special legislation for speedy revival of sick units or winding up of unviable ones and setting up of quasi-judicial body namely; Board for Industrial and Financial Reconstruction (BIFR) and The Appellate Authority for Industrial and Financial Reconstruction (AAIRFR) and their benches. Thus in 1985, the SICA came into existence and BIFR started functioning from 1987. The objective of SICA was to proactively determine or identify the sick/potentially sick companies and enforcement of preventive, remedial or other measures with respect to these companies. Measures adopted included legal, financial restructuring as well as management overhaul.
- Recoveries of Debts due to Banks and Financial Institutions (RDDBFI) Act, 1993: The procedure for recovery of debts to the Banks and financial institutions resulted in significant portions of funds getting locked. The need for a speedy recovery mechanism through which dues to the Banks and financial institutions could be realised was felt. Different committees set up to look into this, suggested formation of Special Tribunals for recovery of overdue debts of the Banks and financial institutions by following a summary procedure. For the effective and speedy recovery of bad loans, the RDDBFI Act was passed suggesting a special Debt Recovery Tribunal to be set up for the recovery of NPA. However, this act also could not speed up the recovery of bad loans, and the stringent requirements rendered the attachment and foreclosure of the assets given as security for the loan as ineffective.
- Corporate Debt Restructuring (CDR) System: Companies sometimes are found to be in financial troubles for factors beyond their control and also due to certain internal reasons. For the revival of such businesses, as well as, for the security of the funds lent by the Banks and FIs, timely support through restructuring in genuine cases was required. With this view, a CDR system was established with the objective to ensure timely and transparent restructuring of corporate debts of viable entities facing problems, which are outside the purview of BIFR, DRT and other legal proceedings. In particular, the system aimed at preserving viable corporate/businesses that are impacted by certain internal and external factors, thus minimising the losses to the creditors and other stakeholders. The system has addressed the problems due to the rise of NPAs. Although CDR has been effective, it largely takes care of the interest of Bankers and ignores (to some extent) the interests of borrower’s stakeholders. The secured lenders like Banks and FIs, through CDR merely, address the financial structure of the company by deferring the loan repayment and aligning interest rate payments to suit company’s cash flows. The Banks do not go for a one time large write-off of loans in initial stages.
- SARFAESI ACT 2002: By the late 1990s, rising level of Bank NPAs raised concerns and Committees like the Narasimham Committee II and Andhyarujina Committee which were constituted for examining Banking sector reforms considered the need for changes in the legal system to address the issue of NPAs. These committees suggested a new legislation for securitisation, and empowering Banks and FIs to take possession of the securities and sell them without the intervention of the court and without allowing borrowers to take shelter under provisions of SICA/BIFR. Acting on these suggestions, the SARFAESI Act was passed in 2002 to legalise securitisation and reconstruction of financial assets and enforcement of security interest. The act envisaged the formation of asset reconstruction companies (ARCs)/ Securitisation Companies (SCs).
Shortcomings faced by Indian securitised markets:
Regulatory issues:
1) Stamp Duty:
One of the biggest hurdles facing the development of the securitisation market is the stamp duty structure. Stamp duty is payable on any instrument which seeks to transfer rights or receivables, whether by way of assignment or novation (new clause added to the contract) or by any other mode. 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 securitisation commercially unviable in several states. If the securitised instrument is issued as evidencing indebtedness, it would be in the form of a debenture or bond subject to stamp duty. On the other hand, 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, as it is not an instrument provided for specifically in the charging provisions.
Among the regulatory costs, the stamp duty on transfers of the securitized instrument is again a major hurdle. Some states do not distinguish between conveyances of real estate
And that of receivables, and levy the same rate of stamp duty on the two. Stamp duty being a concurrent subject i.e. it is under the concurrent list in Schedule 7 of the Indian Constitution, specifically calls for a consensual legal position between the
Centre and the States.
2) 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 Mortgage Backed Securities by making it difficult to transfer property in cases of default. Transfer of property laws lacks on this aspect.
3) Taxation related issues:
Tax treatment of Mortgage Backed Securities, SPV Trusts and NPL Trusts is unclear. Currently, the investors (PTC and SR holders) pay tax on the income distributed by the SPV Trusts and on that basis the trustees make income pay outs to the PTC holders without any payment or withholding of tax. The view is based on legal opinions regarding assessment of investors instead of trustee in their representative capacity.
It needs to be emphasized that the Income Tax Law has always envisaged taxation of an
Unincorporated SPV such as a Trust at only one level, either at the Trust SPV level, or the Investor/Beneficiary Level to avoid double taxation. Hence, any explicit tax pass thro regime if provided in the Income Tax Act does not represent conferment of any real tax concession or tax sacrifice, but merely represents a position that the Investors in the trust would be liable to tax instead of the Trust being held liable to tax on the income earned. Amendments need to be made to provide an explicit tax pass thought treatment to securitization SPVs and Non Performing Assets Securitization SPVs on par with the tax pass through treatment applied under the tax law to Venture Capital Funds registered with SEBI. To make it certain that investors as holders of Mutual Fund (MF) schemes are liable to pay tax on the income from MF and ensure that there is no tax dispute about the MBS SPV Trust or NPA Securitization Trust being treated as an AOP(Association of Persons), SEBI should consider the possibility of modifying the Mutual Fund Regulations to permit wholesale investors (investors who invests not less than Rs. 5 million in scheme) to invest and hold units of a closed-ended passively managed mutual fund scheme. The sole objective of this scheme is to invest its funds into PTCs and SRs of the designated Mortgage Backed Security.
4) SPV Trust and NPA Securitization Trust:
Recognizing the wholesale investor and Qualified Institutional Buyers (QIB) in securitization trusts, there should be no withholding of tax requirements on interest paid by the borrowers (whose credit exposures are securitized) to the securitization trust. Similarly, there should be no requirement of withholding tax on distributions made by the
securitization Trust to its PTC and SR holders. However, the securitization trust may
be required to file an annual return with the Income-tax Department, Ministry of Finance,
in which all relevant particulars of the income distributions and identity of the PTC and SR holders may be included. This will safeguard against any possibility of revenue leakage.
5) Legal Issues:
Listing of PTCs on stock exchange:
Currently, the Securities Contract Regulation Act definition of ‘securities’ does not specifically cover PTCs. While there is indeed a legal view that the current definition of securities in the SCRA includes any instrument derived from, or any interest in securities, the nature of the instrument and the background of the issuer of the instrument, not being homogenous in respect of the rights and obligations attached, across instruments issued by various SPVs, has resulted in a degree of discomfort among exchanges listing these instruments. To remove any ambiguity in this regard, the Central
Government should consider notifying PTCs and other securities issued by securitization
SPV Trust as ‘securities’ under the SCRA.
Some issues under the SARFAESI Act: The ambiguity about whether or not Asset Reconstruction Companies (ARCs) and Securitization Companies (SCs) registered with the RBI can establish multiple SPV Trusts, has been resolved by a specific provision in
the form of sec.7 (2A) of the SARFAESI Act. In view of this, it is now possible to unambiguously adopt the trust SPV structure even under the SARFAESI Act for MBS, ABS or NPL securitization.
The current definition of ‘Security Receipt (SR)’ envisages SR to be the evidence of acquisition by its holder of an undivided right, title or interest in the financial asset involved in securitization. This definition is appropriate and sufficient for securitization structures where securities issued are all characterized as ‘Pass Through Securities’.
Subprime and securitisation
The boom and bust in the housing market in the US led to the subprime mortgage crisis. In a recent article by the Swaminathan Aiyar , he quoted ‘Recessions and financial crises may look like blemishes of capitalism, but are actually integral to its process of creative destruction’. Now the mortgage melt-down started in the US and it started in the so called sub-prime mortgage market. Mortgage Banks in America made a lot of loans on property to people who couldn’t afford the repayments after the initial discount period of the mortgage had worn off. That meant that the loans they had sold to investors started to turn bad. And because the loans had turned sour, that meant investors around the globe started to shy away from investing in mortgage backed securities. And this is where is gets complicated. When it comes to securitising mortgages there are two main categories prime loans which are made to people with good credit records or sub-prime loans which are made to people with not so good credit records they might have missed a credit card payment or telephone bill or may even be in arrears. Thus this was called the subprime lending which led to the situation of the Bank bailouts.
Concept of Credit Default swaps
Warren Buffett once described derivatives bought speculatively as "financial weapons of mass destruction." A Credit Default Swap is a credit derivative or agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer." The second party gives credit protection and is called the "seller". The third party, the one that might go Bankrupt or default, is known as the "reference entity. Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes. Of late many controversies swirled around CDS as firms with significant exposure to them such as US insurer American International Group Inc (AIG) needed to be bailed out by the government after this exposure exceeded their ability to honour contracts. It is contemplated that this derivative instrument is likely to find a new home, viz India. RBI has recently sent out feelers to a number of Banks to accept this product.
Conclusion
For securitisation to be great help, the institutional infrastructure in a country will be of great advantage. If the institutions are fully developed and legal system is quick to respond to changing commercial norms, this process is likely to face difficulties. It has been rightly said that “securitisation is an ignitive tool for Indian capital markets”.
About the SARFAESI Act 2002, a popular definition goes no law is perfect law there are some loopholes in the Securitisation Act. The strict capital requirement is making it difficult for the asset reconstruction companies.
One of the main advantages of the ARC is that it takes off bad loans from the balance sheets of the Banks. Also recently in the case of Mardia chemicals V. Union of India the Supreme Court upheld the constitutional validity of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 except subsection (2) of section 17 of the Act under which the Debts Recovery Tribunal shall not entertain the appeal unless the borrower deposits with Tribunal, 75% of the amount claimed in the notice issued under subsection (2) of section 13.
Legislative efforts
There has been many changes proposed Securities Contracts (Regulation) Amendment Bill, 2007 passed by Lok Sabha in month of May 2007 amended Securities Contract (Regulation) Act to include “securitized instruments” in the definition of “securities” as defined in Securities Contract (Regulation) Act. The amendment is made to allow listing of securitised debt on stock exchanges and therefore, make the market more liquid. SEBI has been empowered to write regulations for public offers and listing, and it has come up with draft regulation instead of falling in line with similar public offer rules for asset-backed securities in other countries.
Thus RBI guidelines thus provide a strong regulatory and institutional framework for the orderly development of the securitization market in the long term. At the same time the guidelines have eliminated some incentives for securitization. This will lead to temporary reduction in issuance volume. However, in the medium and long term, the securitization market is expected to witness reasonable growth. Also with the U.S housing bubble securitisation has got bad publicity. But if the financial regulators are set right, the credit crunch may not repeat.
_________________________________________________________________
VRINDA AGHI is a 5th year law student pursuing her LL.B from ILS, Pune.
|
