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What Is Securitization: A Very Basic Example


Securitization is a mystery to many smart, reasonably well informed people, I realized as I was trying to explain it to my barber. So here's a simplified explanation. Let's start with a 10-year mortgage. (It's easier to see the chart with a 10-year mortgage than a 30-year mortgage, but it works the same way with any maturity. The mortgage consists of 12 payments a year, for 10 years. Let's group the payments together by year, so each box on the following chart constitutes 12 monthly payments.

Now let's throw four such mortgages together. They look like this:

Now let's pool those into one. Think of it this way. Each payment is represented by a coupon, like an IOU. The lender has 120 coupons for each mortgage. He throws all the coupons for four mortgages into one box. The he starts sorting the coupons according to the year that the payment will be made. He takes all of the coupons for payments in the first year, he staples them together, and calls them "Tranche A." Then he takes all the coupons for payments in the second year, staples them together, and calls them "Tranche B." In the chart below, each tranche has its own color.

When we started this explanation, before securitization, we thought the natural grouping of coupons was to put all the coupons from one borrower together. However, after securitization, all the coupons for one year are put together. The buyer of this tranche gets coupons from different home-owners, but all the coupons are to be paid in the same year. This is a highly simplified example, because we haven't talked about who gets what if the mortgage is paid off early, or what happens if one borrower does not pay. Add these rules, and you have a mortgage-backed security, consisting of 10 tranches. Each tranche can be sold individually. Why do this? Dr. Frankenstein applies himself to finance? There's a good reason. Few investors want to buy coupons for the entire life of the mortgage (10 years in this example, but 30 years in most cases).* However, there are folks who want the first year payments (money market funds). There are others who will be very interested in second and third year payments, such as property and casualty mutual funds. Other insurance companies might want fourth and fifth year payments, while university endowments, pension funds, and bond mutual funds might want the longer maturities. Investors are more interested if the specific tranche is tailored to their needs.

When the experts on TV talk about "slicing and dicing" mortgages, this is what they mean. Was this understandable? Or too basic? Please leave a comment. ----* Mrs. Businomics wants to know why few investors want to hold the entire 10 years of coupons, or 30 years of coupons. Well, some folks want a shorter-term investment. That's easy to understand; they don't want to tie their money up for too long. Your car insurance company collects your premiums when you mail them a check, but it will be a while before they have to make payments on collisions. In the meantime, they need a short-term investment, but they can't tie the money up for 10 years. What about the folks who do want to tie up their money for a long time, like a pension fund or life insurance company? They don't want to receive money back too early. They would rather keep it working, earning interest. If they get money back, they'll only have to re-invest it. When they first invested their money, they would not be sure how much they would get back, because future interest rates on the reinvested money are unknown. The earlier tranches have shorter maturity and less risk; both of these result in low interest rates. The buyers of these tranches will receive interest at a rate lower than the overall mortgage rate. The later tranches will pay progressively higher interest rates, for reasons of both risk and maturity. In addition, the later tranches need higher interest rates because the buyers expect refinancings to work against them. If interest rates fall, the homeowners will refinance and the investors suddenly have to reinvest their money at low rates. If, however, interest rates rise, then the investors are locked into their investment at just the time when they'd like to jump onto another, higher rate investment. So why be an investor in the later tranches? The return seemed to compensate for the risk. Remember that most of the deals were closed before foreclosures became a significant problem, so risk seemed low. The higher tranches also have the advantage of no cash flow early on. See my last two paragraphs of explanation for Mrs. B.

Another Example

Asset securitisation:
However, in the sense in which the term is used in present day capital market activity, securitisation has acquired a typical meaning of its own, which is at times, for the sake of distinction, called asset securitisation. It is taken to mean a device of structured financing where an entity seeks to pool together its interest in identifiable cash flows over time, transfer the same to investors either with or without the support of further collaterals, and thereby achieve the purpose of financing. Though the endresult of securitisation is financing, but it is not "financing" as such, since the entity securitising its assets it not borrowing money, but selling a stream of cash flows that was otherwise to accrue to it.

The simplest way to understand the concept of securitisation is to take an example. Let us say, I want to own a car to run it for hire. I could take a loan with which I could buy the car. The loan is my obligation and the car is my asset, and both are affected by my other assets and other obligations. This is the case of simple financing.

On the other hand, if I were to analytically envisage the car, my asset in the instant case, as claim to value over a period of time, that is, ability to generate a series of hire rentals over a period of time, I might sell a part of the cash flow by way of hire rentals for a stipulated time and thereby raise enough money to buy the car. The investor is happier now, because he has a claim for a cash flow which is not affected by my other obligations; I am happier because I have the cake and eat it also, and also because the obligation to repay the financier is taken care of by the cashflows from the car itself.

'Banks will have to unload bad loans to Asset Reconstruction Companies by FY2007' read a
leading business newspaper headline sometime back.

A bank selling its bad loans! This might sound strange, but it has been made possible by securitisation. This article explains the concept of securitisation and how it can change the banking business in India. The concept Securitisation is the process of conversion of existing assets or future cash flows into marketable securities. In other words, securitisation deals with the conversion of assets which are not marketable into marketable ones. For the purpose of distinction, the conversion of existing assets into marketable securities is known as asset-backed securitisation and the conversion of future cash flows into marketable securities is known as future-flows securitisation. Some of the assets that can be securitised are loans like car loans, housing loans, et cetera and future cash flows like ticket sales, credit card payments, car rentals or any other form of future receivables. Suppose Mr X wants to open a multiplex and is in need of funds for the same. To raise funds, Mr X can sell his future cash flows (cash flows arising from sale of movie tickets and food items in the future) in the form of securities to raise money. This will benefit investors as they will have a claim over the future cash flows generated from the multiplex. Mr X will also benefit as loan obligations will be met from cash flows generated from the multiplex itself. The process and participants 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 (loans given) 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.

Consider a bank, ABC Bank. The loans given out by this bank are its assets. Thus, the bank has a pool of these assets on its balance sheet and so the funds of the bank are locked up in these loans. The bank gives loans to its customers. The customers who have taken a loan from the ABC bank are known as obligors. To free these blocked funds the assets are transferred by the originator (the person who holds the assets, ABC Bank in this case) to a special purpose vehicle (SPV). The SPV is a separate entity formed exclusively for the facilitation of the securitisation process and providing funds to the originator. The assets being transferred to the SPV need to be homogenous in terms of the underlying asset, maturity and risk profile. What this means is that only one type of asset (eg: auto loans) of similar maturity (eg: 20 to 24 months) will be bundled together for creating the securitised instrument. The SPV will act as an intermediary which divides the assets of the originator into marketable securities. These securities issued by the SPV to the investors and are known as pass-through-certificates (PTCs).The cash flows (which will include principal repayment, interest and prepayments received ) received from the obligors are passed onto the investors (investors who have invested in the PTCs) on a pro rata basis once the service fees has been deducted. The difference between rate of interest payable by the obligor and return promised to the investor investing in PTCs is the servicing fee for the SPV. The way the PTCs are structured the cash flows are unpredictable as there will always be a certain percentage of obligors who won't pay up and this cannot be known in advance. Though various steps are taken to take care of this, some amount of risk still remains. The investors can be banks, mutual funds, other financial institutions, government etc. In India only qualified institutional buyers (QIBs) who posses the expertise and the financial muscle to invest in securities market are allowed to invest in PTCs. Mutual funds, financial institutions (FIs), scheduled commercial banks, insurance companies, provident funds, pension funds, state industrial development corporations, et cetera fall under the definition of being a QIB. The reason for the same being that since PTCs are new to the Indian market only informed big players are capable of taking on the risk that comes with this type of investment. In order to facilitate a wide distribution of securitised instruments, evaluation of their quality is of utmost importance. This is carried on by rating the securitised instrument which will acquaint the investor with the degree of risk involved.

The rating agency rates the securitised instruments on the basis of asset quality, and not on the basis of rating of the originator. So particular transaction of securitisation can enjoy a credit rating which is much better than that of the originator. High rated securitised instruments can offer low risk and higher yields to investors. The low risk of securitised instruments is attributable to their backing by financial assets and some credit enhancement measures like insurance/underwriting, guarantee, etc used by the originator. The administrator or the servicer is appointed to collect the payments from the obligors. The servicer follows up with the defaulters and uses legal remedies against them. In the case of ABC bank, the SPV can have a servicer to collect the loan repayment installments from the people who have taken loan from the bank. Normally the originator carries out this activity. Once assets are securitised, these assets are removed from the bank's books and the money generated through securitisation can be used for other profitable uses, like for giving new loans. For an originator (ABC bank in the example), securitisation is an alternative to corporate debt or equity for meeting its funding requirements. As the securitised instruments can have a better credit rating than the company, the originator can get funds from new investors and additional funds from existing investors at a lower cost than debt. Impact on banking Other than freeing up the blocked assets of banks, securitisation can transform banking in other ways as well. The growth in credit off take of banks has been the second highest in the last 55 years. But at the same time the incremental credit deposit ratio for the past one-year has been greater than one. What this means in simple terms is that for every Rs 100 worth of deposit coming into the system more than Rs 100 is being disbursed as credit. The growth of credit off take though has not been matched with a growth in deposits. So the question that arises is, with the deposit inflow being less than the credit outflow, how are the banks funding this increased credit offtake? Banks essentially have been selling their investments in government securities. By selling their investments and giving out that money as loans, the banks have been able to cater to the credit boom.

This form of funding credit growth cannot continue forever, primarily because banks have to maintain an investment to the tune of 25 per cent of the net bank deposits in statutory liquidity ratio (SLR) instruments (government and semi government securities). The fact that they have been selling government paper to fund credit off take means that their investment in government paper has been declining. Once the banks reach this level of 25 per cent, they cannot sell any more government securities to generate liquidity. And given the pace of credit off take, some banks could reach this level very fast. So banks, in order to keep giving credit, need to ensure that more deposits keep coming in. One way is obviously to increase interest rates. Another way is Securitisation. Banks can securitise the loans they have given out and use the money brought in by this to give out more credit. A K Purwar, Chairman of State Bank of India [ Get Quote ], in a recent interview to a business daily remarked that bank might securitise some of its loans to generate funds to keep supporting the high credit off take instead of raising interest rates. Not only this, securitisation also helps banks to sell off their bad loans (NPAs or non performing assets) to asset reconstruction companies (ARCs). ARCs, which are typically publicly/government owned, act as debt aggregators and are engaged in acquiring bad loans from the banks at a discounted price, thereby helping banks to focus on core activities. On acquiring bad loans ARCs restructure them and sell them to other investors as PTCs, thereby freeing the banking system to focus on normal banking activities. Asset Reconstruction Company of India Limited (ARCIL) was the first (till date remains the only ARC) to commence business in India. ICICI Bank [ Get Quote ], Karur Vyasya Bank, Karnataka Bank [ Get Quote ], Citicorp (I) Finance, SBI, IDBI, PNB, HDFC [ Get Quote ], HDFC Bank and some other banks have shareholding in ARCIL. A lot of banks have been selling off their NPAs to ARCIL. ICICI bank- the second largest bank in India, has been the largest seller of bad loans to ARCIL last year. It sold 134 cases worth Rs.8450 Crore. SBI and IDBI hold second and third positions. ARCIL is keen to see cash flush foreign funds enter the distressed debt markets to help deepen it. What is happening right now is that banks and FIs have been selling their NPAs to ARCIL and the same banks and FIs are picking up the PTCs being issued by ARCIL and thus helping ARCIL to finance the purchase. A recent report in a business daily quotes , Rajendra Kakkar, ARCIL's Chief Executive as saying, "We have got a buyer, we have got a seller, it so happens that the seller is the loan side of the same institutions and buyer is the treasury side."

So the risk from the balance sheet of banks and FIs is not being completely removed as their investments into PTCs issued by ARCIL will generate returns if and only if ARCIL is able to affect recovery from defaulters. A recent survey by the Economist magazine on International Banking, says that securitisation is the way to go for Indian banking. As per the survey, "What may be more important for the economy is to provide access for the 92% of Indian businesses that do not use bank finance. That represents an enormous potential market for both local and foreign banks, but the present structure of the banking system is not suitable for reaching these businesses. Securitising micro-loans- bundling many loans together and selling the resulting cash flow- may be the way of achieving economies of scale. One private bank, ICICI, securitised $4.3 million of micro-loans last year. But most Indian banks are more interested in competing for affluent customers". In closing Securitisation is expected to become more popular in the near future in the banking sector. Banks are expected to sell off a greater amount of NPAs to ARCIL by 2007, when they have to shift to Basel-II norms. Blocking too much capital in NPAs can reduce the capital adequacy of banks and can be a hindrance for banks to meet the Basel-II norms. Thus, banks will have two options- either to raise more capital or to free capital tied up in NPAs and other loans through securitisation.

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