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Securitisation, which owes its origins to the mortgage markets in the USA in the 1970s, has turned out to be one of the most important innovations to have been introduced in the financial markets of developed countries in recent times.

In India, securitisation has emerged as a powerful financial management tool as well. Since its launch in the early 90s, securitisation volumes are estimated to have grown to around Rs 230 billion currently. And volumes are expected to grow significantly in future.

The growth is expected to receive an additional fillip after the passage of the ordinance on securitisation and reconstruction of financial assets providing a legislative framework for such transactions.

Although as yet, only a limited number of market participants resort to securitisation in India (unlike developed markets such as USA), there is no denying its potential as a powerful financial management tool.

With increasing awareness among originators and investors alike, it is believed that the market for such instruments would widen and deepen further in the medium term.

Securitisation refers to the conversion of cash flows into marketable securities. It is a process through which illiquid assets are packaged, converted into tradable securities and sold to third-party investors.

Such securities are referred to as Asset Backed Securities, which are typically highly rated and carry a variety of credit enhancement mechanisms.

Depending on the type of receivables securitised, the resultant instrument may be a mortgaged backed security (in the case of housing loans), a collateralised bond obligation (in case of bond receivables), and a collateralised loan obligation (in case of industrial loan receivables).

Typically, a financial intermediary advances loans to borrowers, which is supposed to be repaid along with interest over a period of time. Traditionally, the lender collects the periodic instalments and wait till maturity to recover his full principal and interest.

Securitisation allows the financial intermediary to sell his right to receive the future payments from the borrowers to a third party and receive consideration for the same upfront, the proceeds of which may be further redeployed in business. This cycle could be repeated several times leading to efficient usage of capital.

Benefits of Securitisation

Securitisation offers a wide range of benefits to both the originators and investors.

Originator's perspective: Securitisation offers an effective and relatively quick alternative funding source.

Securitisation is an off-balance sheet funding alternative. It generates cash for the originator without any addition to borrowings (without increasing the debt to equity ratio). Companies that have capital adequacy pressures can undertake securitisation to raise funds.

Securitisation helps in "upfronting" profits. In case of high-yielding portfolios like car loans and truck loans, there is a profit on sale, as the inherent yield in the portfolio is typically higher than the coupon rate on ABS. Hence, there is a boost to bottom-line and earnings per share (EPS) in the year of securitisation.

As securitised papers are highly rated, cost of borrowing is relatively lower. Even for originators rated in the AA category, there is likely to be a price advantage in securitisation as AAA has a premium price. This is all the more attractive for investors whose own credit ratings are lower.

Since securitisation helps to undertake larger business with the same capital, profitability and return on investment ratios improve post-securitisation.

After securitisation, medium-term assets are replaced by cash leading to mitigation of tenor mismatch, improving asset-liability management. Banks, financial institutions and non-banking finance companies who are fully exposed to certain industries, corporates or groups can do further business without violating exposure norms by securitising a part of the existing exposure.

After securitisation, credit and prepayment risks are eliminated as these are passed on to investors. With the advantage of a high rating, there is access to a wider base of investors.

Investor's perspective : Traditionally, investors look at safety, liquidity and yield before making any investment decision. ABS is relatively more safe as they are typically highly rated. ABS could be listed in stock exchanges like any other debt instrument, thereby enhancing their liquidity in the secondary market.

Securitised instruments also provide the flexibility to structure the instrument to suit the investor's needs, in terms of tenor or periodicity of payment. In developed markets, several classes of securities are issued from one asset pool to suit varying investor preferences. Essentially these classes of securities differ in structure, tenure, priority of payment and yield, so investors can choose the class that fits their requirements best.

Investors in ABS also get the benefit of a payment structure, which is closely monitored on a monthly basis by the rating agency and the trustees (this is not available in case of other instruments like traditional debt).

Existing assets v/s future flow

Future flow securitisation is different from traditional asset-backed securitisation, where securities issued are backed by cash flows generated from an existing pool of assets like hire purchase receivables of cars and residential mortgage receivables.

In these type of assets, the receivables have already been earned by the originator and they do not depend on the performance of the originator. In other words, such types of assets do not involve "generation risk".

On the other hand, future flow securitisation involves receivables which involve "generation risk" i.e., the receivables come into being only if the originator performs (i.e., it continues to exist, operate, deliver products or services and generate receivables) like airline ticket receivables, export receivables and remittances from abroad. In future cash flow securitisation, securities issued are backed by cash flows from assets that must be generated in future.

Forms of credit enhancement

Unlike plain vanilla instruments, in securitisation transactions, it is possible to work towards a target credit rating, which could be much higher than the originator's own credit rating. This is possible through a mechanism called "credit enhancement".

The purpose here is to ensure timely payment to investors, if the actual collection from the pool of receivables securitised for a given period fall short of the contractual payouts on the ABS. ABS are normally non-recourse instruments and therefore, the repayment on ABS would have to come from the underlying assets and the credit enhancement, with no further recourse to the originator.

In India the following forms of credit enhancements have been used:

Cash collateral: Where a specified amount of cash collateral is kept reserved with the sole purpose of meeting shortfalls in making contractual payouts to investors, if the need arises.

Guarantee by a highly rated corporate or a bank - The rating assigned to the securitised instrument cannot be higher than that of the guarantor in this form of credit enhancement.

Overcollateralisation or the issue of subordinate securities - Subordinate securities are typically unrated and invested in by the originators themselves. The payouts on these securities are subordinate to the meeting of all obligations on the senior class of securities which are rated.

This is an extract from a note on Securitisation by CRISIL

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