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What is a structured

finance A structured finance is a financial procedure to suit the

need of the borrower as per its specific requirement.

In many cases, a borrower may not get funding on a plainvanilla method .However, by properly structuring theprocess the borrower can be funded.

Similarly by securitising the loans funding can bearranged to meet the specific requirement of the issuer ofloan.

Structured finance serves several purpose starting fromincrease in fund flows in the system to risk mitigation ofthe system.

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Funding of a weak

company In the case of plain vanilla lending, a lending

institution can lend to a borrower only if it can

meet the following criteria : Profitability : 10% of net sales . Current Ratio : 1.33 Leverage Ratio : 1.75

The lender from its internal model finds that

these are the parameters required at aparticular point of time to avoid delinquency.

The main concern of the lender is to avoiddelinquency.

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Funding of a weak

company A Company has the following criteria :

Profitability : 3% of net sales . Current Ratio : 1.03 Leverage Ratio : 2.75

The lender wants to finance this Company .

The major concern for the lender is that if a companycan not meet the above criteria , there is a probabilitythat the Company would default.

The lender can address this concern by entering into astructured finance agreement with the company.

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Funding of a weak

company The lender sits with the company and analyses

the customer profile of the company .

The lender rates these customers and segregatethe best rated customers from the rests.

Now lender enters into agreement with theborrower in such a way that these customerswould pay directly to the lender.

The lender overcollateralise the installment by 2to 3 times .

This is an example of structured finance throughescrowing of receivable.

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Securitisation

It is used to mean a device of structured financingwhere an entity seeks

to pool together its interest in identifiable cashflows over time;

transfer the same to investors either with orwithout the support of further collaterals;

and thereby achieve the purpose of financing.

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Requirement of

Securitisation Securitisation is used for fulfilling the

following purpose : It reduces the capital requirement imposed

by the regulator. It gives an opportunity of investors to suit

their requirement as per their subjective risk

preferences. It also reduces the risk of the system .

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Terminology in

Securitisation 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, issometimes called future flows securitisation, in which case the former is a case ofasset-backed securitisation.

In US markets, another distinction is mostly common: between mortgage-backed

securities and asset-backed securities. This only is to indicate the distinctapplication: the former relates to the market for securities based on mortgagereceivables, which in the USA forms a substantial part of total securitisation markets,and securitisation of other receivables.

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Terminology in

Securitisation These securities could either represent a direct claim of the investors

on all that the SPV collects from the receivables transferred to it: in thiscase, the securities are called pass through certificates orbeneficial 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 cash flows by

reinvesting it, so as to pay to the investors on fixed dates, not matchingwith the dates on which the transferred receivables are collected by theSPV. In this case, the securities held by the investors are called paythrough certificates.

The securities issued by the SPV could also be named based on theirrisk or other features, such as senior notes or junior notes, floatingrate notes, etc.

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Asset Backed Securities (

ABS)Asset Backed Securities in a general sense

MortgageBacked

Securities( MBS)

ResidentialMortgage

CommercialMortgage

ABS in aNarrower

SenseCredit CardEquipment

Student LoanMusic Royalties

CDO

CLOLoan owned

ByBank

CBOBonds

Traded in theMarket

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Process of securitisation

Originator /Servicer

Loan sale

S.P.V. UnderwriterIssuer of

Debt

Securities

Investors

DistributionOfDebt Securities

Revenues fromDebtSecurities

Trustee

TransferOf Assets

ReceivesFund

Receives inflowFrom reference

Principal

And InterestMinusServicingFees

DisbursesRevenues toInvestors

CreditEnhancer

Provides CreditEnhancement

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CDO

In a Collateralised Debt Obligation ( CDO) structure, the issuerrepackages ( corporate or sovereign ) debt securities or bankloans in to a reference portfolio ( the collateral) , whose proceedsare subsequently sold to investors in the form of debt securities

with various levels of senior claim on this collateral. The issued securities are structured in so called senioritised credit

tranches, which denote a particular class of debt securitiesinvestor may acquire when they invest in a CDO transaction.

The tranching can be done by means of various structuralprovisioning governing the participations of investors in the

proceeds and losses stemming from the collateral.

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CDO

Subparticipation is one of the most convenient vehicles for attachingdifferent levels of seniority to categories of issued securities, so that lossesare allocated to the lowest subordinate tranches before the mezzanine andsenior tranches are considered.

This process of filling up the tranches with periodic losses bottom up

results in a cascading effect . Both interest and losses are allotted according to investor seniority.

This prioritisation of claims and losses from the reference portfolioguarantee that senior tranches carry a high investment grading ( AAA) ,provided sufficient junior tranches have been issued to shield more seniortranches from credit losses.

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Types of CDO

The classification of CDOs depends on possible variability in thevaluation of the collateral ex post the issuance of the securities.

In Market value CDO , the allocation of payments to various tranchesdepends on the mark to market returns on the reference portfoliounderlying the transactions.

The market value form of CDO s is generally applied in cases ofdistressed reference portfolio of bonds or loans such that the creditand trading expertise of the originator of these assets might providegrounds for arbitrage gains from the differences in prices between thedistressed assets on the bank books and their aggregate valuationwhen bundled in a reference portfolio underlying securities.

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Various form of structure

enhancement Waterfall

Portfolio

X 1000

Y 2000

Z 4000

CDO Tranches

AAA Senior Tranches

A Mezzanine Tranches

BB Subordinated Tranches

Equity Tranches

PaymentMade

C ll li d D b Obli i

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Collateralized Debt Obligations( CDO)

In the case of CDO , the SPV has investedcash in a basket of n assets.

It has then repackaged and allocated theassets into several tranches.

In a CDO, a default in any ass in the basket

leads to a loss of coupon and notionalamount for investors of junior tranche .

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CDO

SPV

Sr.Tranche

Mznine.Tranche

JuniorTranche

Cash

Asset 1

Asset 2

Asset 3

Cash

Coupon Coupon

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Collateralized Debt Obligations

( CDO) Junior tranches incur the highest risk and receive the highest

coupon, which can be as high as 30%.

The criterion of success of a CDO is generally related to the

success of selling the junior tranche.Consequently the SPV mayhave to keep the junior tranches in its own portfolio or their parentinstitutions acquire it.

Mezzanine tranches, which incur losses if the losses of juniortranches are complete , usually have credit rating from B to AA.

Senior tranches , which is usually the largest are commonly ratedAA to AAA.

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Synthetic CDOs

The difference between cash CDO and synthetic CDO lies in the factthat the SPV in the synthetic CDO does not acquire the original assets

in a standard cash transaction., but gains long credit exposure to the assets via selling credit

protection I.e. default swap.

The SPV uses the cash from the sale of the tranches and the defaultswap premium to purchase risk free bond .

The increase in popularity of synthetic CDO is primarily due to nontransfer of ownership legally to the SPV.

SPV has no operational risk with respect to the original asset.

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Synthetic CDO

SPV

SrTranche

MzTranche

JrTranche

Cash

Risk

FreeAssetSeller

Cash

Ast 1

Ast 2

Ast 3

DS

premium

+ DsPremium

Coupon

Coupon

PaymentIn the event

Of default

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Motivation of CDO

For the SPV it is income motivated. The SPV gets fees for

placing,structuring and managing the CDO. The fees can be quite substantial . They can go up to 10% of the

notional amount.

The SPV can resort to CDO for removing the asset from itsbalance sheet and thus reducing the regulatory capital.This is

called balance sheet CDO. The motivation of the owners of the asset is to transfer the credit

risk without informing the borrower.

The motivation for the tranches in primarily the yieldenhancement.

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Over collateralisation : Volume of assetsis more than volume of issued notes.

Excess Spread: Difference betweeninterest payment from assets and CDOcoupons are collected in an account.

Guarantee by the originator.

Insurance by the third party.

Various form of structure

enhancement

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Credit Enhancement Process

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Requirement of Credit

Enhancement

Issuers standalone rating is not as per the

requirement

Lower rating would increase the cost of borrowing

Improved credit rating with the help of credit

enhancement

Rating can be enhanced to a targeted rating withthe help of credit enhancement

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Types of credit enhancement

Identification of dedicated revenue stream andescrowing the same with a standard escrow agreement

Full guarantee from another entity with superior creditprofile

Partial guarantee by way of : Partial cash flow pledging

Graded guarantee Partial interest guarantee Pool financing

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Pool Financing

SPV

INVESTORS

ULB 1

ULB 10Legend

Structured Bonds

Issue Proceeds

Bonds

Subscriptions

Subsequent Repayments

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Importance of pool financing

Smaller cash flows can be pooled together

These cash flows can be structured to meet the

payment requirement of different SPV depending

on their cash flow requirement

Besides government guarantee can be arranged

over this cash flows This would meet the requirement of the local

bodies

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Credit Enhancement

The credit enhancement in the process of direct

funding is better option than guarantee mechanism

The funding can be structured to incentivise the

efficient functioning of the issuer

The penalty provisions should also be there

Milestone based subsidy credit is better options

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Non Fund Based Facility

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Non Fund Based Facility

NFB

LC BG DPG

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LC

LC

Purchase onCredit

ReplacingCreditor with

Bank Borrowing

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Letter of Credit

Issuing Bank/

Opening Bank

Applicant/

Buyer/

Drawee

Beneficiary/

Seller/

Drawer

Advising Bank/

Confirming

Bank

Sends Invoice

Appliestobank

Bank

Opens

LC

Advises

LC

Negotiating

Bank

Ships Goods

SubmitsDocum

ents

ForNegotiation

PaymentMade

Sends Documents

S

endsdocuments

forAcceptance

Acceptsdocuments

Sends Confirmation

PaymentsMadetoBank

Payment Transmitted

Goods Receipt

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Bill Discounting

Bill Discounting

Drawer BillDiscounting

Drawee BillDiscounting

With LC Without LC

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Bill Discounting

Bill Discounting

Drawer BillDiscounting

Drawee BillDiscounting

Receivable

Financing

Replacing ReceivableFinancing with

Bill

Replacing creditor in OCLwith

Other bank

D Bill Di i

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Drawee Bill Discounting

Buyer Approaches

Selller

Buyer/

DraweeSeller/

DrawerSeller AsksBuyer to

Open LC

LC

Issuing

BankApproachesforLC

Open

ing

Advising

Bank

LC

opened

Advises

Sends Bills of Exchange

And other Documents

Acceptsdocumentsanddeposits

NegotiatingBank

Sends documents

SellergetsPayment

Goods dispatched

Paysonduedate

Pays on due date

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Bank Guarantee

Bank Guarantee

Bid BondMobilisation

Advance

Performance

Guarantee

No Asset Asset No Asset

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Domestic

Limit

BorrowerSupplier

Domestic

NFBLimit

Foreign

Limit

SLC and Trade Credit