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SECURITIZATION AND ITS ROLE IN FINANCIALCRISIS

INDEX

Sr.No. CONTENTS PAGE NO.

1 INTRODUCTION 3

2 EXECUTIVE SUMMARY 4

3 OBJECTIVE OF PROJECT 7

4 TYPES OF FINANCIAL INSTRUMETNS 8

5 LIFE CYCLE OF SECURITIZATION

6 SECURITIZATION MEANING 227 SECURITIZATION CONCEPT 24

8 HISTORY OF SECURITIZATION 26

9 FEARURES OF SECURITIZATION 29

10 USES OF SECURITIZATION 33

11 SECURITIZATION AND STRUCTURED

FINANCE

35

12REASON WHY ORGANISATION GO FOR SECURITIZATION 36

13 PROCESS OF SECURITIZATION 3814 PLAYER INVOLVED IN SECURITIZATION 43

15 CREDIT ENHANCEMENT 46

16 TYPES OF SECURITIES 49

17 ADVANTAGE & DISADVANTAGES OF

SECURITIZATION

51

18 SECURITIZATION IMPACT ON BANKING 60

19 ECONOMIC IMPACT OF SECURITIZATION 63

20 SPECIAL PURPOSE VEHICLE 66

21 ACCOUNTING FOR SECURITIZATION 6722 SECURITIZATION OF STANDARD ASSETS 70

23 FUTURE FLOW SECURITIZATION 74

24 NEED FOR SECURITIZATION IN INDIA 82

25 SAFERSI ACT 2002 84

26 SECURITIZATION GUIDELINESS OF RBI 87

27 ISSUES FACING SECURITIZED MARKET 94

28 SECURTIZATION ACTIVITY IN INDIA 98

29 RECOMMENDATIONS 114

30 CONCLUSION 126

Securitization Page 1


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INTRODUCTION

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 transactionaliesed. 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 debenture holder in the company is now capable of acquisition

and termination by transactions.



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EXECUTIVE SUMMARY

The financial-services industry is in a state of flux in which the

only constant is change. The introduction of financial sector reforms in

India has led to innovation in financial markets and instruments. the

phenomena of computerization (technology), globalization,

institutionalization and privatization capture the dynamic innovations

occurring in the financial world, and suggest the isation of the industry.

One of the most prominent developments in international finance in

recent times. That is likely to assume even greater importance in the

future, is securitization. Securitization is the process of pooling and

repackaging homogenous illiquid loans and distributing them as

marketable securities. Increased pressure on operating efficiency, market

niches, competitive advantages and capital strength, all provide fuel for

rapid changes. Securitization is one of the solutions to these challenges.

In this report, I have attempted to explore the intricacies of securitization

as process of financial engineering and its applicability to the Indian

financial system.

Firstly, securitization has been defined, and its features such as

Marketablility, merchantable quality, wide distribution, homogeneity, etc

have been noted. Securitization has lead to disintermediation and has

changed the face of banking and financial institution. Along with this, the

economic impact of securitization has also been talked about. Advantages

and motivations in the form of lower cost, capital relief, improvement in

return on equity and return on assets, off balance sheet financing, asset

liability management, improved liquidity, etc. have been highlighted.



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Securitization is a costly source and is uneconomical for small

requirements these are some of its limitations.

The scope of securitization in India has been looked at and

emphasis is laid on three potential areas of securitization in India

Mortgage-backed securities, Asset-Backed Securities and the

Infrastructure Sector. True sale characteristics of securitization

transactions are required to be reflected in the books of accounts,

statements to be furnished to the concerned regulators as also to the tax

authorities. Since there are no guidelines for accounting treatment of

these transactions, the accounting procedures with appropriate guidelines

need to be framed by Institute of Chartered Accountants of India for the

sake of uniformity.

The recommendations have been categorized into short-term,

medium-term and long-term. The Reserve Bank of Indias Working

Group has suggested that securitization should be appropriately defined

to lend uniformity of approach and restrict the benefits provided by

law/regulation for genuine securitization transactions. The

recommendations also include rationalization/reduction of stamp duties,

Inclusion of securitized instruments in Securities Contract Regulation

Act. Medium-term measures would include increased flow of information

through credit bureau, standardization of documents, improvement in the

quality of assets, up gradation of computer skills and exploring the

possibilities of securitizing non-performing assets.

The need to develop some insurance/guarantee institutions to give

comfort to investors, especially in infrastructure and mortgage sectors has

been underscored as a long-term measure. According to RBIs Working

Group, there is also a need for developing a host of financial



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intermediaries with specialized skills and sophistication to provide the

building blocks for market growth. The Government of India should

consider bringing out an umbrella legislation covering all aspects of

securitization.



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OBJECTIVES OF THE PROJECT

To have an overview of securitization concept and its practices,

processes, players.

To evaluate whether securitization provide users with adequate

solution to their asset management.

To assess the types and level of risk associated with securitization

and the solutions over those risks. To determine whether securitization and enhancements to existing

concepts adequately support corporate goals.

To determine if securitization is being carried out in compliance

with an approved Government policy or practice statement.

To determine if resources needed to develop the required

securitization process adequately. To determine if companies are operating according to established

guidelines.

To evaluate the scope and adequacy of securitization in Indian

scenario.

To determine if the RBI norms are being referred to while carrying

out securitization activity.



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TYPES OF FINANCIAL INSTRUMENTS

EQUITY ROUTE

Equity funding

Stock or other security representing an ownership interest.

On the balance sheet, the amount of the funds contributed by the

owners (the stockholders) plus the retained earnings (or losses).

Also referred to as Shareholders equity.

In the context of margin trading, the value of securities in a

margin account minus what has been borrowed from the

brokerage.

In the context of real estate, the difference between the current

market value of the property and the amount the owner still owes

on the mortgage. Thus, it is the amount, if any; the owner would

receive after selling a property and paying off the mortgage

Equity is a term whose meaning depends very much on the context.

In general, you can think of equity as ownership in any asset after all

debts associated with that asset are paid off. For example, a car or house

with no outstanding debt is considered the owner's equity since he or she

can readily sell the items for cash. Stocks are equity because they

represent ownership of a company, whereas bonds are classified as debt

because they represent an obligation to pay and not ownership of assets.



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Preference sharesA preferred stock, also known as a preferred share or simply a preferred,

is a share of stock carrying additional rights above and beyond those

conferred by common stock.

Unlike common stock, preferred stock usually has several rights attached

to it:

The core right is that of preference in dividends. Before a dividendcan be declared on the common shares, any dividend obligation to

the preferred shares must be satisfied.

The dividend rights are often cumulative, such that if the dividend

is not paid it accumulates from year to year.

Preferred stock has a liquidation value associated with it. This

represents the amount of capital that was contributed to thecorporation when the shares were first issued. Par value may be the

liquidation value, or it may be a token amount such as a dollar or a

penny to minimize the issuer's tax.

Preferred stock has a claim on liquidation proceeds of a stock

corporation, equivalent to its par or liquidation value. This claim is

senior to that of common stock, which has only a residual claim. Almost all preferred shares have a fixed dividend amount. The

dividend is usually specified as a percentage of the par value or as

a fixed amount. For example Pacific Gas & Electric 6% Series A

preferred. Unlike debt securities, however, a company is not

legally required to pay preferred dividends, and omission of

preferred dividends is not an event of default for the company's

debt.



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Variable preferred dividends are rare exceptions; their changing

dividends depend on prevailing interest rates, or varying as apercentage of net income.

Some preferred shares have special voting rights to approve certain

extraordinary events (such as the issuance of new shares or the

approval of the acquisition of the company) or to elect directors,

but most preferred shares provide no voting rights associated with

them. Some preferred shares only gain voting rights when thepreferred dividends are in arrears for a substantial time.

Usually preferred shares contain protective provisions, which

prevent the issuance of new preferred shares with a senior claim.

Individual series of preferred shares may have a senior, pari-passu

or junior relationship with other series issued by the same

corporation.

The above list, although including several customary rights, is far from

comprehensive. Preferred shares, like other legal arrangements, may

specify nearly any right conceivable. Preferred shares normally carry a

call provision, enabling the issuing corporation to repurchase the share at

its (usually limited) discretion.

Some corporations contain provisions in their charters authorizing the

issuance of preferred stock whose terms and conditions may be

determined by the board of directors when issued. These "blank check"

preferred shares are often used as takeover defense. These shares may be

assigned very high liquidation value that must be redeemed in the event

of a change of control or may have enormous super voting powers.



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LOAN ROUTE

Certificate of deposit

A saving certificate entitling the bearer to receive interest. A CD bears a

maturity date, a specified fixed interest rate and can be issued in any

denomination. CDs are generally issued by commercial banks and are

insured by the FDIC. The term of a CD generally ranges from one month

to five years.

How CD work

The consumer who opens a CD may receive a passbook or paper

certificate, but it now is common for CD to consist simply of a book entry

and an item shown in the consumer's periodic bank statements; that is,

there is usually no "certificate" as such.

At most institutions, the CD purchaser can arrange to have the interest

periodically mailed as a check or transferred into a checking or savings

account. This reduces total yield because there is no compounding. Some

institutions allow the customer to select this option only at the time the

CD is opened.

Commonly, institutions mail a notice to the CD holder shortly before the

CD matures requesting directions. The notice usually offers the choice of

withdrawing the principal and accumulated interest or "rolling it over"

(depositing it into a new CD). Generally, a "window" is allowed after

maturity where the CD holder can cash in the CD without penalty. In the

absence of such directions, it is common for the institution to "roll over"

the CD automatically, once again tying up the money for a period of time

(though the CD holder may be able to specify at the time the CD is

opened to not "roll over" the CD).



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Commercial papers

An unsecured, short-term debt instrument issued by a corporation,typically for the financing of accounts receivable, inventories

and meeting short-term liabilities. Maturities on commercial paper rarely

range any longer than 270 days. The debt is usually issued at a discount,

reflecting prevailing market interest rates. Commercial paper is

not usually backed by any form of collateral, so only firms with high-

quality debt ratings will easily find buyers without having to offer a

substantial discount (higher cost) for the debt issue. A major benefit of

commercial paper is that it does not need to be registered with the

Securities and Exchange Commission (SEC) as long as it matures before

nine months (270 days), making it a very cost-effective means of

financing. The proceeds from this type of financing can only be used on

current assets (inventories) and are not allowed to be used on fixed assets,

such as a new plant, without SEC involvement.

Treasury bill

Treasury bills (or T-bills) mature in one year or less. They are like zero-

coupon bonds in that they do not pay interest prior to maturity; instead

they are sold at a discount of the par value to create a positive yield to

maturity. Treasury bills are considered by many to be the most risk free

investment for U.S. investors. Treasury Bills are commonly issued with

maturity dates of 28 days (~1 month), 91 days (~3 months), and 182 days

(~6 months). Treasury Bills are issued each Friday after weekly auctions,

which are held on Wednesday at about noon. Purchase orders at Treasury

Direct must be entered before 11:30 on the Monday of the auction.

Mature T-bills are also redeemed on each Thursday. Banks and financial



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institutions, especially primary dealers, are the largest purchasers of T-

Bills. They are quoted for purchase and sale in the secondary market on

an annualized percentage yield to maturity, or basis. With the advent of

Treasury Direct, individuals can now purchase T-Bills online and have

funds withdrawn and deposited directly to their personal bank account

and earn higher interest rates on their savings.

Treasury Bills are short term GOI Securities. They are issued for different

maturities viz. 14-day, 28 days (announced in Credit policy but yet to be

introduced), 91 days, 182 days and 364 days. 14 days T-Bills had been

discontinued recently. 182 days T-Bills were not re-introduced.

Repurchase agreement

A form of short-term borrowing for dealers in government securities. The

dealer sells the government securities to investors, usually on an

overnight basis, and buys them back the following day.

Reverse repurchase agreement

The purchase of securities with the agreement to sell them at a higher

price at a specific rate .For the party selling the security (and agreeing to

repurchase it in the future) it is a repo; for the party on the other end of

the transaction (buying the security and agreeing to sell in the future) it is

a reverse repurchase agreement.

Repos are classified as a money-market instrument. They are usually used

to raise short-term capital.



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CREDIT MARKET

The bond market, also known as the debt, credit, or fixed income market,is a financial market where participants buy and sell debt securities

usually in the form of bonds.

References to the "bond market" usually refer to the government bond

market because of its size, liquidity, lack of credit risk and therefore,

sensitivity to interest rates. Because of the inverse relationship between

bond valuation and interest rates, the bond market is often used to

indicate changes in interest rates or the shape of the yield curve.

Types of bond markets

The Bond Market Association classifies the broader bond market into five

specific bond markets:

Corporate

Government & Agency

Municipal

Mortgage Backed, Asset Backed, and Collateralized Debt

Obligation

Funding

Debentures

In finance, a debenture is a long-term debt instrument used by

governments and large companies to obtain funds. It is similar to a bond

except the securitization conditions are different. A debenture is usually

unsecured in the sense that there are no liens or pledges on specific assets.

It is however, secured by all properties not otherwise pledged. In the caseof bankruptcy debenture holders are considered general creditors.



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Debentures are divided into different categories on the basis of:

(1) Convertibility of the instrument

(2) Security Debentures can be classified

On the basis ofconvertibility into:

Non Convertible Debentures (NCD): These instruments retain the

debt character and cannot be converted in to equity shares

o Partly Convertible Debentures (PCD): A part of these

instruments are converted into Equity shares in the future at notice

of the issuer. The issuer decides the ratio for conversion. This is

normally decided at the time of subscription.

o Fully convertible Debentures (FCD): These are fully convertible

into Equity shares at the issuer's notice. The ratio of conversion isdecided by the issuer. Upon conversion the investors enjoy the

same status as ordinary shareholders of the company.

o Optionally Convertible Debentures (OCD): The investor has the

option to either convert these debentures into shares at price

decided by the issuer/agreed upon at the time of issue.

On basis ofSecurity, debentures are classified into:

o Secured Debentures: These instruments are secured by a charge on the fixed assets of

the issuer company. So if the issuer fails on payment of either the principal or interest amount, his

assets can be sold to repay the liability to the investors

o Unsecured Debentures: These instrument are unsecured in the sense that if the issuer

defaults on payment of the interest or principal amount, the investor has to be along with other

unsecured creditors of the company.



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Mutual funds

An investment vehicle, which is comprised of a pool of funds, collectedfrom many investors for the purpose of investing in securities such as

stocks, bonds, money market securities and similar assets. Mutual funds

are operated by money managers, who invest the fund's capital and

attempt to produce capital gains and income for the fund's investors. A

mutual fund's portfolio is structured and maintained to match the

investment objectives stated in its prospectus.

One of the main advantages of a mutual fund is that it gives small

investors access to a well-diversified portfolio of equities, bonds and

other securities, which would be quite difficult (if not impossible) to

create with a small amount of capital. Each shareholder participates

proportionally in the gain or loss of the fund. Mutual fund units, or

shares, are issued and can typically be purchased or redeemed as needed

at the current net asset value per share (NAVPS).

PSU Bonds

Public Sector Undertaking Bonds (PSU Bonds): These are Medium or

long term debt instruments issued by Public Sector Undertakings (PSUs).

The term usually denotes bonds issued by the central PSUs (i.e. PSUs

funded by and under the administrative control of the Government of

India). Most of the PSU Bonds are sold on Private Placement Basis to the

targeted investors at Market Determined Interest Rates. Often investment

bankers are roped in as arrangers to this issue. Most of the PSU Bonds are

transferable and endorsement at delivery and are issued in the form of

Usance Promissory Note.



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Government Dated Securities

Like Treasury Bills, the Reserve Bank of India on behalf of the

Government of India issues G-Securities. These form a part of the

borrowing program approved by the parliament in the union budget. G-

Securities are normally issued in dematerialized form (SGL). When

issued in the physical form they are issued in the multiples of Rs.

10,000/-. Normally the dated Government Securities have a period of 1

year to 20 years. Government Securities when issued in physical form are

normally issued in the form of Stock Certificates. Such Government

Securities when are required to be traded in the physical form are

delivered by the transferor to transferee along with a special transfer form

designed under Public Debt Act 1944.The transfer does not require stamp

duty. The G-Securities cannot be subjected to lien. Hence, is not an

acceptable security for lending against it?

Some Securities issued by Reserve Bank of India like 8.5% Relief Bonds

are securities specially notified & can be accepted as Security for a loan.

Earlier, the RBI used to issue straight coupon bonds i.e. bonds with a

stated coupon payable periodically. In the last few years, new types of

instruments have been issued. These are: -

Inflation linked bonds:



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These are bonds for which the coupon payment in a particular period is linked to the inflation rate at that time -

the base coupon rate is fixed with the inflation rate (consumer price index-CPI) being added to it to arrive at

the total coupon rate.

Zero coupon bonds

Zero coupon bonds are bonds that do not pay interest during the life of

the bonds. Instead, investors buy zero coupon bonds at a deep discount

from their face value, which is the amount a bond will be worth when it

"matures" or comes due. When a zero coupon bond matures, the investor

will receive one lump sum equal to the initial investment plus interest that

has accrued. The maturity dates on zero coupon bonds are usually long-

termmany dont mature for ten, fifteen, or more years. These long-term

maturity dates allow an investor to plan for a long-range goal, such as

paying for a childs college education. With the deep discount, an

investor can put up a small amount of money that can grow over many

years. Investors can purchase different kinds of zero coupon bonds in the

secondary markets that have been issued from a variety of sources,

including the U.S. Treasury, corporations, and state and local government

entities. Because zero coupon bonds pay no interest until maturity, their

prices fluctuate more than other types of bonds in the secondary market.

In addition, although zero coupon bonds do not pay any interest until they

mature, investors may still have to pay federal, state, and local income tax

on the imputed or "phantom" interest that accrues each year. Some

investors avoid paying the imputed tax by buying municipal zero coupon

bonds (if they live in the state where the bond was issued) or purchasing

the few corporate zero coupon bonds that have tax-exempt status.

Floating rate notes



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Floating rate notes (FRNs) are bonds that have a variable coupon, equal

to a money market reference rate, like LIBOR or federal funds rate, plus a

spread. The spread is a rate that remains constant. Almost all FRNs have

quarterly coupons, i.e. they pay out interest every three months, though

counter examples do exist. At the beginning of each coupon period, the

coupon is calculated by taking the fixing of the reference rate for that day

and adding the spread. A typical coupon would look like 3 months USD

LIBOR +0.20%.

Example

Suppose a new 5-year FRN pays a coupon of 3 months LIBOR +0.20%,

and is issued at par (100.00). If the perception of the credit-worthiness of

the issuer goes down, investors will demand a higher interest rate, say

LIBOR +0.25%. Therefore, a dealer would then make a market of 27 /

25. This means, that he would buy bonds at the equivalent of LIBOR

+0.27%, and sell at the equivalent of LIBOR +0.25%. If a trade is agreed,

the price is calculated. In this example, LIBOR +0.27% would be roughly

equivalent to a price of 99.65. This can be calculated as par, minus the

difference between the coupon and the price that was agreed (0.07%),

multiplied by the maturity (5 year).

Deep discount bond

A bond that sells at a significant discount from par value. A bond that is

selling at a discount from par value and has a coupon rate significantly



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less than the prevailing rates of fixed-income securities with a similar risk

profile.

Typically, a deep-discount bond will have a market price of 20% or more

below its face value. These bonds are perceived to be riskier than similar

bonds and are thus priced accordingly. These low-coupon bonds are

typically long term and issued with call provisions. Investors are attracted

to these discounted bonds because of their high return or minimal chance

of being called before maturity.

External Commercial Borrowing

External Commercial Borrowings (ECB) is defined to include:

1) Commercial bank loans,

2) Buyers credit,3) Suppliers credit,

4) Securitized instruments such as floating rate notes, fixed rate bonds

etc.,

5) Credit from official export credit agencies,

6) Commercial borrowings from the private sector window of

multilateral financial institutions such as IFC, ADB, AFIC, CDC

etc. and

7) Investment by Foreign Institutional Investors (FIIs) in dedicated

debt funds.

Applicants will be free to raise ECB from any internationally

recognized source like banks, export credit agencies, suppliers of

equipment, foreign collaborations, foreign equity - holders,



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international capital markets etc. Offers from unrecognized sources

will not be entertained.

BASIC MEANING OF SECURITIZATION

Securitization" in its widest sense implies every such process which



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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.,

and 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

securitization was so instrumental in the growth of the corporate form of

doing business, and hence, industrialization, that someone rated 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 securitization: it

as important to the world of finance as motive power is to industry.

LIFE CYCLE OF SECURITIZATION



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CONCEPT


Quasi-financial deals

Early-stage securitization

Advanced-stage securitization

Synthetics stage

Operating Risk transfers/Index risk transfers

? (Possibly, reinvention stage)


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Securitization is the process of conversion of existing assets or future

cash flows into marketable securities. In other words, securitization

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 securitization and the

conversion of future cash flows into marketable securities is known as

future-flows securitization.

Some of the assets that can be securitized 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.

Securitization can also be defined as a device of structured financing

where an entity seeks to pool together its interest in identifiable future

cash flows over time and transfer the same to investors either with or

without support of further collaterals and thereby achieve the purpose of

financing.

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.



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This meaning of securitization can be expressed in various dramatic

words:

Securitization is the process of commoditization: The basic idea

is to take the outcome of this process into the market, the capital

market. Thus, the result of every securitization process, whatever

might be the area to which it is applied, is to create certain

instruments which can be placed in the market.

Securitization is the process of integration and differentiation:

The entity that securitizes its assets first pools them together into a

common hotchpot (assuming it is not one asset but several assets,

as is normally the case). This is the process of integration. Then,

the pool itself is broken into instruments of fixed denomination.

This is the process of differentiation.

Securitization is the process of de-construction of an entity: If

one envisages an entity's assets as being composed of claims to

various cash flows, the process of securitization would split apart

these cash flows into different buckets, classify them, and sell these

classified parts to different investors as per their needs. Thus,

securitization breaks the entity into various sub-sets.

HISTORY



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Securitization as a tool of structured finance developed in the U.S. real

estate financing market. However, in Europe a form to mortgage funding

has existed for many years that have remarkable similarities to the present

form of securitization, although the two are not the same. This

instrument has existed in Denmark for more than 200 years. It remains

interesting that securitization in Denmark has a history of 200 years,

much longer than the U.S. mortgage market.

The first efforts towards securitizing financial assets were made in the

U.S., originating in the mortgage financing markets of the country. The

instrument was developed with a need to create a secondary market in

mortgage financing. In the process the catalysts were government

agencies formed for buying and selling federally insured mortgages.

The history of U.S. government efforts to introduce a secondary market

in mortgages goes back to the 1930s. Originally, mortgages in the U.S.

were originated by savings and loan associations that financed their

operations through retail deposits. During the Depression, deposit

markets collapsed. To allow originators to fund mortgages, the Congress

enacted the National Housing Act to create a secondary market in

mortgages. Subsequently, it created the Federal Housing Administration

(FHA). The FHA insured housing loans made by private lenders and thus

absorbed the inherent risks in housing finance. In 1938, the Federal

National Mortgage Association was created to buy and sell federally-

insured mortgages. In 1968, the erstwhile Federal National Mortgage

Association (FNMA) was split into two parts-a new FNMA and the

Government National Mortgage Association (GNMA)



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It was these agencies, FNMA (colloquially called Fannie Mae) and

GNMA (colloquially called Ginnie Mae, which was responsible for the

present-day development of securitization markets.

Ginnie Maes first securitization initiative

In 1970, GNMA did its first securitization transaction on a pass-

through structure. GNMAs pass-through were securities backed by

mortgages insured by FHA. These pass-through had the full credit and the

backing of the U.S. government, as GNMA guaranteed both the

repayment of principal and timely payment of interest.

The 1970 (GNMA-I) is still in operation. In 1983, GNMA

launched another pass-through program called GNMA-II. GNMA II had

a range of interest rates and sellers, while GNMA-I was designed for a

single seller and a single rate of interest. These programs are further

classified based on the type of mortgages pooled therein, such as single

family (SF) loans and multifamily (MF) loans.

Fannie Maes securitization deals

Though the FNMA was the oldest of all the U.S. government agencies, it

was the last to enter the securitization market. In 1968, the original

FNMA was split into a new FNMA and GNMA, with FNMA privately

owned and its shares quoted on the New York Stock Exchange. However,

due to implicit support from and historical affiliation with, the U.S.

government, the credit standing of FNMA is seen as better than private

corporation, although slightly inferior to government agencies like

GNMA.



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The first FNMA mortgage-backed security (MBS) was issued in

1981. The agency played a crucial role in promoting securitization of

adjustable rate-rate mortgages (ARMs) and variable rate mortgages

(VRMs).

Spreads over to non-mortgage assets

Securitization spread to non-mortgage assets in 1985. The first non-

mortgage securitization deal was in March 1985, when Sperry

Corporation issued $192.5million in securities backed by computer lease

receivables.

FEATURES OF SECURITIZATION



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A securitized instrument, as compared to a direct claim on the issuer,

Will generally have the following features:

Marketability: The very purpose of securitization is to ensure

marketability to financial claims. Hence, the instrument is

structured to be marketable. Marketability involves two postulates:

(a) The legal and systemic possibility of marketing the instrument

(b) The existence of a market for the instrument.

In most jurisdictions of the world, well-coded laws exist to enable and

regulate the issuance of traditional forms of securitized claims, such as

shares, bonds, debentures (negotiable instruments). Most countries do not

have legal systems pertaining to securitized products, of recent or exotic

origin, like securitization of receivables.

It is imperative on part of the regulator to view any securitized instrument

with the same concern as in case of traditional instruments, for investor

protection. However, where a law does not exist to regulate such

issuance, it is nave to believe that it is not permitted.

The second issue is of having a market for the instrument. Securitization

is a fallacy unless the securitized product is marketable. The purpose will

be defeated if the instrument is loaded on to a few professional investors

without any possibility of having a liquid market therein. Liquidity is

afforded either by introducing it into an organized market (securities

exchanges) or by one or more agencies acting as market makers, i.e.,

agreeing to buy and sell the instrument at pre-determined or market-

determined prices.



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Merchantable Quality: To be market-acceptable, a securitizedproduct has to have merchantable quality. Merchantable quality in

case of financial products, means the financial commitments

embodied in the instruments are secured to the investors'

satisfaction. To the investors satisfaction is a relative term, and

therefore, the originator of the securitised instrument secures the

instrument based on the needs of the investors. The general rule is:

the more broad the base of the investors, the less is the investors

ability to absorb the risk, and hence, the more the need to

securitise. For widely distributed securitised instruments, quality

evaluation, and its certification by an independent expert, viz.,

rating is common. The rating is for the benefit of the lay investor,

who is otherwise not expected to be able to appraise the degree of

risk involved. Securitization is a case where a claim on the debtors

of the originator is being bought by the investors. Hence, the

quality of the claim of the debtors assumes significance, which at

times enables investors to rely purely on the credit-rating of

debtors and so, makes the instrument totally independent of the

originators own rating.

Wide Distribution: The basic purpose of securitization is to

distribute the product. The extent of distribution, which the

originator would like to achieve, is based on a comparative analysis

of the costs and the benefits achieved thereby. Wider distribution

leads to a cost-benefit, as the issuer is able to market the product

with lower financial cost. But a wide investor-base involves costs

of distribution and servicing. In practice, securitization issues are



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still difficult for retail investors to understand. Hence, most

securitizations have been privately placed with professional

investors. However, in time to come, retail investors could be

attracted to securitized products.

Homogeneity: To serve as a marketable instrument, the instrument

should be packaged into homogenous lots. Most securitized

instruments are broken into lots, affordable to the marginal

investor, and hence, the minimum denomination becomes relative

to the needs of the smallest investor. Shares in companies may be

broken into slices as small as Rs.10 each, debentures and bonds are

sliced into Rs.100 to Rs.1000 each. Designed for larger investors, a

commercial paper may be in denominations as high as Rs. 5Lac.

Other securitization applications may also follow this logic.

The integration of several assets into one lump, and then

their differentiation into uniform marketable lots often invites the

next feature: an intermediary for this process.

Special Purpose Vehicle (SPV): In case, the securitization

transaction involves any asset or claim which needs to be integrated

and differentiated, unless it is a direct and unsecured claim on the

issuer, the issuer will need an intermediary agency to act as a

repository of the asset or claim being securitized. Thus, the issuer will

bring in an intermediary agency to hold the security charge on behalf

of the investors, and then issue certificates to the investors of

beneficial interest in the charge held by the intermediary. So, the

charge continues to be held by the intermediary, but the beneficial

interest becomes a marketable security.



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USES OF SECURITIZATION

Securitization leads to Financial Disintermediation

If one imagines a financial world without securities, all financial

transactions will be carried only as one-to-one relations. If a company

needs a loan, it will have to seek such loan from the lenders, who will

have to establish a one-to-one relation with the company. Each lender has

to understand the borrowing company, and look after his loan. This isoften difficult, and hence, a financial intermediary, such as a bank, pools

funds from many such investors, and uses these pooled funds to lend to

the company. If the company securitizes the loan, and issues debentures

to the investors, will this eliminate the need for the intermediary bank,

since the investors may now lend to the company directly in small

amounts each, in form of a security which is easy to appraise, and which

is liquid?

Securitization: Changing The Function Of Intermediaries

Disintermediation is an important aim of a present-day corporate

treasurer, since by leap-frogging the intermediary; the company reduces

the cost of its finances. Hence, securitization has been employed to

disintermediate.

However, it does not eliminate the need for the intermediary: it

merely redefines the intermediary's role. E.g.: if a company is issuing

debentures to the public to replace a bank loan, it may be avoiding the

bank as an intermediary, but would still need the services of an

investment banker to successfully conclude the issue of debentures.

Traditionally, financial intermediaries made a transaction possible by



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performing a pooling function, and contributed to reduce the investors'

perceived risk by substituting their own security for that of the end user.

Securitization puts these services of the intermediary in the background.

E.g.: where the bank being the earlier intermediary was eliminated and

instead the services of an investment banker were sought to distribute a

debenture issue, the focus shifted from the pooling utility provided by the

banker to the distribution utility provided by the investment banker.

Securitization seeks to eliminate funds-based intermediaries by fee based

distributors. In the above example, the bank was a fund-based

intermediary, a reservoir of funds, but the investment banker was a fee

based intermediary, a catalyst, and a pipeline of funds.

In case of a direct loan, the lending bank was performing several

intermediation functions noted above: it was a distributor as it raised its

own finances from a large number of small investors; it was appraising

and assessing the credit risks in extending the corporate loan, and having

extended it, it was managing the same. Securitization splits each of these

intermediary functions, each to be performed by separate specialized

agencies. Distribution will be performed by the investment bank,

appraisal by a credit-rating agency, and management possibly by a

mutual fund that manages the portfolio of security investments of

investors. Hence, a securitization replaces fund-based services by several

fee-based Services.



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Securitization and Structured Finance

Securitization is a "structured financial instrument". "Structured finance"

has become a buzzword in today's financial market. It means that a

financial instrument is structured or tailored to the risk-return and

maturity needs of investors, rather than a simple claim against an entity

or asset. On the investors side, securitization seeks to structure an

investment option to suit the needs of investors. It classifies thereceivables or cash flows not only into different maturities but also into

senior, mezzanine and junior notes. Therefore, it also aligns the returns to

the risk requirements of the investor.

Securitization as a Tool of Risk Management

Securitization is more than just a financial tool. It is an important tool of

risk management for banks. It primarily works through risk removal but

also permits banks to acquire securitized assets with potential

diversification benefits. When assets are removed from a bank's balance

sheet, without recourse, all the risks associated with the asset are

eliminated. Credit risk is a key uncertainty that concern domestic lenders.

By passing on this risk to investors, or to third parties when credit

enhancements are involved, financial firms are better able to manage their

risk exposures.



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REASON WHY ORGANISATION GO FOR SECURITISATION.

Securitization is one way in which a company might go about financing

its assets.

There are generally seven reasons why companies consider securitization:

1. To improve their return on capital, since securitization normally

requires less capital to support it than traditional on Balance-sheet

funding

2. To raise finance when others forms of finance are unavailable ( in

recession banks are often unwilling to lend and in a boom, banks

often cannot keep up with the demand for funds)

3. To improve return on assets securitization can be a cheap source

of funds, but the attractiveness of securitization for this reason

depends primarily on the costs associated with alternative funding

sources.

4. To diversify the sources of funding which can be accessed, so that

dependence upon the banking or retail sources of fund is reduced.

5. To reduce credit exposure to particular asset ( for instance, if a

particular class of lending become large in relation to the balance

sheet as a whole, then securitization can remove some of the assets

from balance sheet)



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6. To match-fund certain classes of assets-mortgage assets are

technically 25 year assets, a proportion of which should be funded

with long term finance; securitization normally offer the ability to

raise finance with a longer maturity than is available in other

funding markets

7. To achieve a regulatory advantage , since securitization normally

removes certain risks which can cause regulators some concern,

there can be a beneficial result in terms of availability of certain

forms of finance ( for example, in UK building societies consider

securitization as a means of managing the restriction on their

wholesale funding abilities)



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PROCESS OF SECURITIZATION

Section 5 of the Securitization and Reconstruction of Financial Assets

and Enforcement of Security Interest Act, 2002, mandates that only banks

and financial institutions can securities 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'screditworthiness.

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.

Securitization is a way of unlocking these blocked funds.



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STAGE 1: ASSET IDENTIFICATION:-

The originator, first identifies the asset or a pool of assets that have to

be securitized. There must be some basic conditions that must be satisfied

by an asset, which is to be securitized. The cash flows from the reference

asset should be reliable and payments should be periodically obtained.

This means that the asset portfolio should have a documented history

showing default and delinquency experience. This record should be

credible. The assets have to be of good quality that in turn facilitates the

marketability to be quick and easy. This could be either on assets own

strength or with some sort of credit enhancement. This is to ensure that

default risks are brought down considerably. The pool of assets should

carry identical dates of interest payment and maturities. To make the

transaction meaningful, the total quantity of assets to be securitized

should be huge enough to spread over the securitization costs.

Assets that stand a chance of being sold to investors with only the

minimum layer of additional credit enhancement should ideally have the

following characteristics:

be well diversified

Have a statistical history of loss experience

be homogenous in nature

be broadly similar in repayment and final maturity structures

be to some extent liquid

STAGE 2: STRUCTURING THE SECURITIES



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The SPV is a separate entity formed exclusively for the facilitation of the

securitization 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 (egg: auto loans) of similar

maturity (egg: 20 to 24 months) will be bundled together for creating the

securitized 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.

STAGE 3: INVESTOR SERVICING

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.

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



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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 cash flows 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.

The investors can be banks, mutual funds, other financial institutions,

government etc. In India only qualified institutional buyers (QIBs) who

possess 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 securitized instruments,

evaluation of their quality is of utmost importance. This is carried on by

rating the securitized instrument which will acquaint the investor with the

degree of risk involved.



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The rating agency rates the securitized instruments on the basis of asset

quality, and not on the basis of rating of the originator. So particular

transaction of securitization can enjoy a credit rating which is much better

than that of the originator.

High rated securitized instruments can offer low risk and higher yields to

investors. The low risk of securitized 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 securitized, these assets are removed from the

bank's books and the money generated through securitization can be used

for other profitable uses, like for giving new loans.

For an originator (ABC bank in the example), securitization is an

alternative to corporate debt or equity for meeting its funding

requirements. As the securitized 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.

PLAYERS INVOLVED IN SECURITISATION



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The primary participants involve in the issuance of asset-backed

securities are the originator, servicer, issuer, credit enhancer, trustee, and

investors. The originator creates the underlying assets that are sold or

used as collateral, the merchant banker and the originator establish the

structure and the issuing vehicle, the rating agencies set the rating, credit

enhancer improve the credit quality, and the trustees create the trust and

issue certificates.

Originators

Originators create the assets that are sold or used as collateral for asset-

backed securities. Originators include finance companies, financial

institutions, commercial banks, and insurance companies, thrift

institutions and securities firms.

Servicers

Servicers who are usually the originators or affiliates of the originators

of the assets, are responsible for collecting principal and interest

payments on the assets when due and for pursuing the collection of

delinquent accounts. They also provide the trustee and the certificate

holders with monthly and annual reports about the portfolio of assets sold

or used as collateral. The reports details the sources collected and the

distributed funds, the remaining principal balance, the remaining

insurance amount, the amount of fees payable out of the trust and

information necessary for certificate holders to prepare their financial

statements and to assess their tax liability.

Issuers



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The originator does not usually sell assets to third-party investors directly

as asset- backed securities. Instead, they are sold first to either a conduit

or a bankruptcy remote finance company. Such companies, known as

limited purpose corporations, are subsidiaries or affiliates of the

originator or the merchant banker that were separately incorporated to

facilitate the sale of assets or to issue collateralized debt instruments.

Issuers become bankruptcy remote by limiting their activities to issue

asset-backed securities and using the proceeds to buy the assets that back

the securities. Conduits are issuers of asset-backed securities that do not

originate or necessarily service the assets that underlie the securities.

They buy assets from different originators or sellers, pool the assets and

then sell them to investors. Conduits are particularly useful for firms that

do not have enough assets to package as asset-backed securities

themselves.

Merchant Bankers

As asset-backed securities issue involves a merchant banker, who either

underwrites the securities for public offering or privately places them. As

an underwriter, the merchant banker purchases the securities from the

issuer for resale. In a private placement, the merchant banker does not

purchase the securities and resell them, rather the merchant banker acts as

an agent for the issuer, matching the seller with a handful of buyers. In an

asset-backed security issue the merchant banker, whether functioning as

an underwriter or privately placing the securities is instrumental in

structuring the issue. The issuer and merchant banker work together to

see that the structure of the issue meets all the legal, regulatory,



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accounting and tax objectives. The merchant banker also works with the

credit enhancers, rating agencies and trustees.

Rating agencies

Credit rating agencies assigns rating to asset-backed securities issues just

as they do for corporate bonds. Credit rating is based on three criteria: the

probability of the issuer defaulting on the obligation, the nature and

provisions of the obligation and the relative position of the obligation in

the event of bankruptcy.

Trustees

A Trustee in asset-backed security is the intermediary between the

servicer and the investors and between the credit enhancer and the

investors. A trustee is used whether the issue is a sale of assets by the

issuer or a collateralized debt obligation of the issuer. The responsibilities

of the trustee include buying the assets from the issuer on behalf of the

trust and issuing certificates to the investors. As the obligors make

principal and interest payments on the assets, the servicer deposits the

proceeds in a trust account, and the trustees passes them on the investors.

The trustee should be willing to take over the Servicers role if the

servicer withdraws or is unable to perform.

CREDIT ENHANCEMENT



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Credit enhancements are required in every Securitization. The nature and

amount depends on the risks of the Securitization as determined by the

Rating Agencies, Underwriters/Placement Agents and Investors. They are

intended to reduce the risks to the Investors and thereby increase the

rating of the Securities and lower the costs to the Originator. Typical

forms of credit enhancement are:

1. Over-collateralization - transferring to the Issuer, Receivables in

amounts greater than required to pay the Securities if the proceeds of the

Receivables were received as anticipated). The amount of over-

collateralization (usually 5% to 10%) is determined by the Rating

Agencies and the Underwriters/Placement Agents, and this in turn will

depend upon the quality of the Receivables, other credit enhancement that

may be available, the risk of the structure (such as the possible

bankruptcy of the Originator/Servicer), the nature and condition of the

industry in which the Receivables are generated, general economic

conditions and, in the case of foreign-based Securitizations, the

"Sovereign risk". If all goes well, it is repurchased at the end of the

transaction or returned as part of the residual interest. This form of credit

enhancement is required in virtually all Securitizations.

2. Senior/subordinated structure - issuance of subordinated or

secondary classes of Securities, which are lower-rated (and bear higher

interest rates) and sold to other Investors or held by the Originator. In the

event of problems, the higher rated (senior) Securities receive payments

prior to the lower rated (subordinated) Securities. It is not uncommon for

there to be a number of classes of Securities that are each subordinated to

the more highly rated, resulting in a complex "waterfall" of payments of



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principal and interest. In the common structure described above, senior

and subordinated classes of Notes would be paid, in order of priority,

prior to classes of Certificates, and Certificates prior to any residual

interest in the Issuer. This form of credit enhancement has become

routine, but cannot be used in a grantor trust structure, which is why the

owner trust has become most common.

3. Early amortization - if certain negative events occur, all payments

from Receivables are applied to the more senior securities until paid.

4. Cash collateral account - the Originator deposits funds in account

with Trustee to be used if proceeds from Receivables are not sufficient.

Adjustable depending upon events. May be in the form of a demand

"loan" by the Originator to the account.

5.Reserve fund - subordinated Securities retained by the Originator or

Trustee and pledged for the benefit of the Trust (and, therefore, the

Investors).

6. Security bond - guarantee (or wrap) of all payments due on the

Securities. Issued by AAA-rated monoline insurance companies (if

available).

7. Liquidity provider - in effect, a guarantee by the Originator (or its

parent) or another entity of all or a portion of payments due on the

Securities.

8.Letter of credit (for portion of amounts due on Securities) - not used

much anymore because of costs. These were common in the late 1980's

when issued by Japanese banks at low rates.



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TYPES OF SECURITIES

The appropriate structure for securitization depends on a variety offactors like quality of assets securitized, default experience of original



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borrowers, amount of amortization at maturity, financial reputation and

soundness of the originator. The general principle is that the securities

must be structured in such a way that the maturity of these securities may

coincide with the maturity of the securitized loans. However, there are

three important types of securities as listed below:

a. Pass through and pay through certificates .In the case of pass

through certificates, payments to investors depend upon the cash flow

from the assets backing such certificates. In other words, as and when

cash is received from the original borrower by the SPV, it is passed on to

the holders of certificates at regular intervals and the entire principal is

returned with the retirement of the assets packed in the pool. Thus, pass

through certificates have a single maturity structure and the tenure of

these certificates is matched with the life of the securitized assets. On the

other hand pay through certificates has a multiple maturity structure

depending upon the maturity pattern of underlying assets.

b. Preferred stock certificates Preferred stocks are instruments issued

by a subsidiary company against the trade debts and consumer

receivables of its parent company. In other words, subsidiary companies

buy the trade debts and receivables of parent companies to enjoy

liquidity. Thus trade debts can also be backed through the issue of

preferred stocks. Generally these stocks are backed by guarantees given

by highly rated merchant banks and hence they are also attractive from

the investors point of view. These instruments are mostly short term in

nature.

c. Asset based commercial papers This type of structure is mostlyprevalent in mortgage backed securities. Under this type SPV purchases



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portfolio of mortgages from a single group on the basis of interest rates,

maturity dates and underlying collaterals. They are, then, transferred to a

trust which in turn issues mortgage backed certificates to the investors.

ADVANTAGES

A. Issuer's View of Securitization

Advantages

Reduces funding costs

Through Securitization, a company rated BB but with AAA Worthy cash

flow would be able to borrow at possibly AAA rates. This is the number

One reason to securitize a cash flow and can have tremendous impacts on



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borrowing costs. The difference between BB debt and AAA debt can be

multiple hundreds of basis points. For example, Moody's downgraded

Ford Motor Credit's rating in January 2002, but a Senior automobile

backed securities issued by Ford Motor Credit in January 2002 and April

2002 continue to be rated AAA, because of the strength of the underlying

collateral, And other credit enhancements

Reduces asset-liability mismatch

"Depending on the structure chosen, securitization can offer perfect

matched funding by Eliminating funding exposure in terms of both

duration and pricing basis

Lower capital requirements

Some firms, due to legal, regulatory, or other reasons, have a limit orrange that their leverage is allowed to be. By securitizing some of their

assets, which qualify as a sale for accounting purposes, these firms will

be able to lessen the equity on their balance sheets while maintaining the

"earning power of the asset.

Locking in profits

For a given block of business, the total profits have not yet emerged and

thus remain uncertain. Once the block has been securitized, the level of

profits has now been locked in for that company, thus the risk of profit

not emerging, or the benefit of super-profits, has now been passed on.

Transfer risks:



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Credit, liquidity, prepayment, reinvestment, asset concentration;

Securitization makes it Possible to transfer risks from an entity that does

not want to bear it, to one that does. Two good example of this are

Catastrophe Bonds and Entertainment Securitizations. Similarly, by

securitizing a block of business (thereby locking in a degree of profits),

the company has effectively freed up its balance to go out and write more

profitable Business.

Off-Balance Sheet

Derivatives of many types have in the past been referred to as off balance

sheet. This term implies that the use of derivatives has no balance sheet

impact. While there are differences among the various accounting

standards internationally, there is a general trend towards the

Requirement to record derivatives at fair value on the balance sheet.

There is also a Generally accepted principle that, where derivatives are

being used as a hedge against Underlying assets or liabilities, accounting

adjustments are required to ensure that the Gain/loss on the hedged

instrument is recognized in the income statement on a similar Basis as the

underlying assets and liabilities. Certain credit derivatives products,

particularly Credit Default Swaps, now have more or less universally

accepted market standard Documentation. In the case of Credit Default

Swaps, this documentation has been formulated by the International

Swaps and Derivatives Association (ISDA) who have for long time

provided documentation on how to treat such derivatives on balance

sheets.

Earnings



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This is the one benefit that is never talked about in the Asset-Backed and

Structured Finance Worlds. Securitization makes it possible to record an

earnings bounce without any real addition to the firm. When a

securitization takes place, there often is a "true sale" that takes place

between The Originator (the parent company) and the SPV. This sale has

to be for the market value of the Underlying assets for the "true sale" to

stick and thus this sale is reflected on the parent companies Balance

sheet, which will boost earnings for that quarter by the amount of the

sale. While not Illegal in any respect, this does distort the true earnings of

the parent company.

Admissibility

Future cash flows may not get full credit in a company's accounts (life

insurance companies, For example, may not always get full credit for

future surpluses in their regulatory balance sheet),And a securitization

effectively turns an admissible future surplus flow into an admissible

Immediate cash asset.

Liquidity

Future cash flows may simply be balance sheet items which currently are

not available for spending, Whereas once the book has been securitized,

the cash would be available for immediate Spending or investment.

Strategic tool

Securitization benefits the FIs in different ways by:

providing strategic choices;



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reducing funding costs;

Developing core competencies in certain areas.

For example, some institutions specialize in originating and servicing, not

financing at all. Other institutions expand business volume without

expanding their capital base in the same proportion. The process helps in

identifying cost pools of various activities in the value chain. As can be

seen from Figure, securitization is changing the horizons of traditional

banking significantly:Traditional Banking

BookingOriginationCredit

undertakingFunding

Securitization

Originate StructureCredit

enhancementPlace Trade Service

Many new lines of business grow out of securitization - insurance of

assets, clearance services, custodial services and master servicing of

securities etc. Depending upon the core competence and trade off

between costs and benefits, institutions may like to retain or divest of

some of these activities. Institutions may develop competitive advantage

through more efficient marketing, tighter credit monitoring, lower cost

servicing, higher volumes (automobiles, credit Cards etc.) And other

ways to outperform competitors



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DISADVANTAGES OF SECURITIZATION

May reduce portfolio quality: If the AAA risks, for example, are being

securitized out, this would leave a materially worse quality of residual

risk.



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Costs: Securitizations are expensive due to management and system

costs, legal fees, underwriting fees, rating fees and ongoing

administration. An allowance for unforeseen costs is usually essential in

securitizations, especially if it is an atypical securitization.

Size limitations: Securitizations often require large scale structuring, and

thus may not be cost-efficient for small and medium transactions.

Risks: Since securitization is a structured transaction, it may include par

structures as well as credit enhancements that are subject to risks of

impairment, such as prepayment, as well as credit loss, especially for

structures where there are some retained strips.

To investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality credit-

enhanced assets: Due to the stringent requirements for corporations (for

example) to attain high ratings, there is a dearth of highly rated entities

that exist. Securitizations, however, allow for the creation of large

quantities of AAA, AA or A rated bonds, and risk averse institutional

investors, or investors that are required to invest in only highly rated

assets, have access to a larger pool of investment options.

Portfolio diversification: Depending on the securitization, hedge funds

as well as other institutional investors tend to like investing in bonds

created through Securitizations because they may be uncorrelated to their

other bonds and securities.



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Isolation of credit risk from the parent entity: Since the assets that are

securitized are isolated (at least in theory) from the assets of the

originating entity, under securitization it may be possible for the

securitization to receive a higher credit rating than the "parent," because

the underlying risks are different. For example, a small bank may be

considered more risky than the mortgage loans it makes to its customers;

were the mortgage loans to remain with the bank, the borrowers may

effectively be paying higher interest (or, just as likely, the bank would be

paying higher interest to its creditors, and hence less profitable).

Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrowers

inability to meet interest payment obligations on time. For ABS, default

may occur when maintenance obligations on the underlying collateral are

not sufficiently met as detailed in its prospectus. A key indicator of a

particular securitys default risk is its credit rating. Different tranches

within the ABS are rated differently, with senior classes of most issues

receiving the highest rating, and subordinated classes receiving

correspondingly lower credit ratings.

However, the credit crisis of 2007-2008 has exposed a potential flaw in

the securitization process - loan originators retain no residual risk for the

loans they make, but collect substantial fees on loan issuance and

securitization, which doesn't encourage improvement of underwriting

standards.



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Event risk

Prepayment/reinvestment/early amortization: The majority of

revolving ABS are subject to some degree of early amortization risk. The

risk stems from specific early amortization events or payout events that

cause the security to be paid off prematurely. Typically, payout events

include insufficient payments from the underlying borrowers, insufficient

excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in

the default rate on the underlying loans above a specified level, a

decrease in credit enhancements below a specific level, and bankruptcy

on the part of the sponsor or servicer.

Currency interest rate fluctuations: Like all fixed income securities,

the prices of fixed rate ABS move in response to changes in interest rates.

Fluctuations in interest rates affect floating rate ABS prices less than

fixed rate securities, as the index against which the ABS rate adjusts will

reflect interest rate changes in the economy. Furthermore, interest rate

changes may affect the prepayment rates on underlying loans that back

some types of ABS, which can affect yields. Home equity loans tend to

be the most sensitive to changes in interest rates, while auto loans,

student loans, and credit cards are generally less sensitive to interest rates.

Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the

securitizations underlying assets. If the manager earns fees based on

performance, there may be a temptation to mark up the prices of the



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portfolio assets. Conflicts of interest can also arise with senior note

holders when the manager has a claim on the deal's excess spread.

Servicer risk: The transfer or collection of payments may be delayed or

reduced if the servicer becomes insolvent. This risk is mitigated by

having a backup servicer involved in the transaction.

IMPACT ON BANKING

Other than freeing up the blocked assets of banks, securitization 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.



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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 off take?

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 offtake 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

Securitization. Banks can securitize the loans they have given out and use

the money brought in by this to give out more credit.

Not only this, securitization also helps banks to sell off their bad loans

(NPAs or non performing assets) to asset reconstruction companies



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(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, Karur Vyasya Bank, Karnataka Bank, Citicorp (I) Finance, SBI,

IDBI, PNB, 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."



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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 securitization 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 busi

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