What is securitisation

By Vinod Kothari
Just as the electronics industry was formed when the vacuum tubes were replaced by transistors, and transistors were then replaced by integrated circuits, the financial services industry is being transformed now that securitised credit is beginning to replace traditional lending. Like other technological transformations, this one will take place over the years, not overnight. We estimate it will take 10 to 15 years for structured securitised credit to replace to displace completely the classical lending system -not a long time, considering that the fundamentals of banking have remained essentially unchanged since the Middle Ages. Lowell L Bryan Technological advancements have changed the face of the world of finance. It is today more a world of transactions than a world of relations. Most relations have been transactionalised. Transactions mean coming together of two entities with a common purpose, whereas relations mean keeping together of these two entities. For example, when a bank provides a loan of a sum of money to a user, the transaction leads to a relationship: that of a lender and a borrower. However, the relationship is terminated when the very loan is converted into a debenture. The relationship of being a debentureholder in the company is now capable of acquisition and termination by transactions.

Basic meaning of securitisation:

"Securitisation" in its widest sense implies every such process which converts a financial relation into a transaction. History of evolution of finance, and corporate law, the latter being supportive for the former, is replete with instances where relations have been converted into transactions. In fact, this was the earliest, and by far unequalled, contribution of corporate law to the world of finance, viz., the ordinary share, which implies piecemeal ownership of the company. Ownership of a company is a relation, packaged as a transaction by the creation of the ordinary share. This earliest instance of securitisation was so instrumental in the growth of the corporate form of doing business, and hence, industrialisation, that someone rated the it as one of the two greatest inventions of the 19th century -the other one being the steam engine. That truly reflects the significance of the ordinary share, and if the same idea is extended, to the very concept of securitisation: it as important to the world of finance as motive power is to industry. Other instances of securitisation of relationships are commercial paper, which securitises a trade debt.

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 end-result 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. Securitisation is essentially premised on the idea of asset-based funding. Asset-based funding, as a concept, implies an investor taking primarily an exposure on an asset. What can be a better way of an asset-based funding, then the investor acquiring the asset itself? This seems to be the central inspiration of securitisation - it seeks to transfer assets to investors. However, since assets are a source of income, transfer of such asset cannot imply transfer of all of such income to the investor, because then, the originator is left high and dry. Therefore, a befitting midway solution is: The originator originates or creates the assets which generate income over time. The asset is transferred to the investor. However the originator continues to manage/administer and service the asset in question. And he extracts his profit, that is, the income generated by the asset less the desired return of the investor, in one or more ways.

We have talked above about transfer of the asset to the investor - if we have in mind a single investor, transfer of the asset to the investor seems fairly easy. However, if you have multiple investors, then the only way of transferring the asset to these various investors is to transfer it in bits and pieces. Furthermore, if you want to devise an investment solution which allows investors to walk-in and walk-out the same way as in case of most other capital market options, then buying assets is certainly not a convenient solution. That is why, securitisation transactions involve a transformation device called Special purpose vehicles. A special purpose vehicle is a essentially a transformation device, whose main purpose is to convert an asset into a capital market security. How do they do it? The oldest form of securitised paper - that is, equity share, is re-invented to transform assets into securities. After all, what does an equity share do - it converts the assets of a corporation into securities, because a share is ultimately a claim on the assets of the corporation. Similarly, if an originator wanted to sell some specific assets, then he might transfer these specific assets to a specific corporation, which may issue its own securities to the investors. As long as we ensure that this special corporation holds only the assets transferred by the originator, and neither anything more nor anything less, we have thereby ensured that an investor buying the securities of this corporation is buying a fraction of the assets transferred by the originator. Thus, the key features of asset securitisation that distinguish it from traditional methods of funding are: Asset-based funding - the investor primarily looks at assets, as if he is paying money to

buy certain assets, and not at an obligation on the part of the originator to pay. These assets are of course specific and ascertained assets of the originator, because investing in the general assets of the originator is no different from buying a security of the originator. The nature of the assets - the assets which are "securitised" or thus converted into securities are mostly financial assets, that is, claim to a certain stream of cashflows. This is obvious because investors pay upfront to buy such asset and they need a certainty as to their payback - which is ensured by the assets representing cashflows, better than any physical asset. Transfer of assets by the originator - since the investors need to invest into the specific assets of the originator, the originator needs to accomplish a legal transfer of such assets. This is done both to ensure investors' full and supreme legal control over these assets, as also a legal isolation of the assets from the originator -such that neither the originator nor any of his creditors can ever have any claim against those assets. Marketable securities - with the objective of creating a capital market instrument, the assets of the investor are transformed into capital market securities, such that the investors buying these securities are in fact buying a fractional claim on the originator's specific assets. Use of special purpose vehicles - special purpose vehicles are the transformation devices employed to convert the specific assets of the originator into securities. The securities may either be equity-type or pass-through securities, or may be debt-type securities, but in either case, since the special purpose vehicle has no more, and no less than the assets transferred by the originator, the securities of the SPV are essentially fractional, though re-arranged, interests in the assets transferred by the originator.

Quick guide to Jargon:

This section will help the reader to quickly get familiarised with the essential securitisation jargon. The entity that securitises its assets is called the originator: the name signifies the fact that the entity was responsible for originating the claims that are to be ultimately securitised. There is no distinctive name for the investors who invest their money in the instrument: therefore, they might simply be called investors . The claims that the originator securitises could either be existing claims, or existing assets (in form of claims), or expected claims over time. In other words, the securitised assets could be either existing receivables, or receivables to arise in future. The latter, for the sake of distinction, is sometimes called future flows securitisation, in which case the former is a case of asset-backed securitisation. In US markets, another distinction is mostly common: between mortgage-backed securities and asset-backed securities. This only is to indicate the distinct application: the former relates to the market for securities based on mortgage receivables, which in the USA forms a substantial part of total securitisation markets, and securitisation of other receivables.

Since it is important for the entire exercise to be a case of transfer of receivables by the originator, not a borrowing on the security of the receivables, there is a legal transfer of the receivables to a separate entity. In legal parlance, transfer of receivables is called assignment of receivables. It is also necessary to ensure that the transfer of receivables is respected by the legal system as a genuine transfer, and not as a mere eyewash where the reality is only a mode of borrowing. In other words, the transfer of receivables has to be a true sale of the receivables, and not merely a financing against the security of the receivables. Since securitisation involves a transfer of receivables from the originator, it would be inconvenient, to the extent of being impossible, to transfer such receivables to the investors directly, since the receivables are as diverse as the investors themselves. Besides, the base of investors could keep changing as the resulting security is essentially a marketable security. Therefore, it is necessary to bring in an intermediary that would hold the receivables on behalf of the end investors. This entity is created solely for the purpose of the transaction: therefore, it is called a special purpose vehicle (SPV) or a special purpose entity (SPE) or, if such entity is a company, special purpose company (SPC). The function of the SPV in a securitisation transaction could stretch from being a pure conduit or intermediary vehicle, to a more active role in reinvesting or reshaping the cashflows arising from the assets transferred to it, which is something that would depend on the end objectives of the securitisation exercise. Therefore, the originator transfers the assets to the SPV, which holds the assets on behalf of the investors, and issues to the investors its own securities. Therefore, the SPV is also called the issuer. There is no uniform name for the securities issued by the SPV as such securities take different forms. These securities could either represent a direct claim of the investors on all that the SPV collects from the receivables transferred to it: in this case, the securities are called pass through certificates or beneficial interest certificates as they imply certificates of proportional beneficial interest in the assets held by the SPV. Alternatively, the SPV might be re-configuring the cashflows by reinvesting it, so as to pay to the investors on fixed dates, not matching with the dates on which the transferred receivables are collected by the SPV. In this case, the securities held by the investors are called pay through certificates. The securities issued by the SPV could also be named based on their risk or other features, such as senior notes or junior notes, floating rate notes, etc. Another word commonly used in securitisation exercises is bankruptcy remote transfer. What it means is that the transfer of the assets by the originator to the SPV is such that even if the originator were to go bankrupt, or get into other financial difficulties, the rights of the investors on the assets held by the SPV is not affected. In other words, the investors would continue to have a paramount interest in the assets irrespective of the difficulties, distress or bankruptcy of the originator.