We have begun  a series of notes on the basics of Corporate Law. This post deals with Securitization by Umang Singh. 

Securitization process generally refers to pooling of homogenous financial assets which have regular cash flows attached to it and then repackaging it into securities which can be sold as a commodity to the investors.

Important terminologies related with securitization:

  • Originator- It is entity which gives loans to the borrowers e.g. banks or has receivables due/accruing to it. Thus, it is the entity which purports to securitize its loan/receivables.

  • Investors- involve persons/company who actually invest or buy the securitized loan/commodity offered.

  • Issuer/SPV- Generally, the originator transfers the assets to SPV who holds it for investors and issues its own security to the investors. The importance of SPV is that it can be difficult for banks to individually allocate assets to investors and also as the securitization process generally involves trenching of securities it helps in better management of the transaction. The SPV is a distinct independent legal entity from its creator (originator) and can have many functions apart from holding intermediary to investing/restructuring the cash flows as per the requirements of individual securitization transaction

  • Obligor- The debtor who is responsible for receivables /loan to the originator.

E.g. in a loan transaction which is later securitized the bank who gives the loan and who purports to securitize it is the originator and the person who is responsible for the payment of loan is obligor. T

  • Credit Rating Agency – The agency responsible for assessing the risk factor related with the securitized product. Eg. S&P, Moodys etc.

  • Investment Bank – Body responsible for documentation etc.

  • Credit Enhancement – As the securitization transaction depends upon the regular flow of receivables, it is important that the banks take proper measures to in case to curb default or late payment. Thus, the banks either create an escrow account to meet late payment or get the transaction insured or underwrite by insurance/underwriting agency.

How securitization transactions takes place?

One of the easiest examples to describe a securitization transaction is the case of automobiles loans.

Suppose a bank has given several auto loans to debtors. The bank has a minimum receivables secured for the term of the loan which will accrue to it monthly or whatever, the case may be. But the money/instalments of the loan paid by the debtors to the bank will only accrue on monthly basis (presuming you need to pay monthly instalments on the loan). The bank does not have all the money which it loaned at that specific point of time. But it does have right over those loans and will recover it with time. So, what should bank do if it needs instant cash?

The bank adopts the method of securitization to sell its loan to the investors and raise money. But how the bank does that and why would anyone buy it?

The bank knows that it cannot sell the assets/loans directly to the investors as it is not practical. Therefore, the banks create a Special Purpose vehicle which is an independent legal entity and which holds the assets on behalf of the investors. One should keep it in mind, that the transfer of all the assets from the bank to the special purpose vehicle is a true sale which means the bank has no further interest in such assets as it is completely transferred to the SPV. The SPV issues securities over those assets which the investors buy.  So, eventually the right over the instalments/ receivables which was originally with the bank is issued to the investors.

But it seems to be a very risky transaction why should anyone buy someone’s loan. What if the debtors default? So in such cases what the bank does it enhances the credibility of such securitized product by maintaining a separate escrow account to meet any late payment by investors. It also asks the credit agencies to rate such product thereby, eliminating the factor of risk if the product gets high AAA rating etc. The SPV further classifies the security into three categories for convenience lets name them Category A, B&C. Now, “Category A” securities are highly rated and offer the safest returns but interest rates on such transactions are low.  “Category B” is the medium rated product and carries a fair interest rate and “Category C” is the most risky product but to attract investors it carries the best interest rates. Now if there is any default category C investors are firstly exposed to it followed by Category B & A.

This is how a general securitization transaction takes place, there are different kinds of securitization for example Asset-backed securitization, Mortgage based securitization etc. Securitization transactions were vehemently criticized for triggering the financial breakdown in USA in 2008.  In India the securitization transactions are governed by SARFAESI ACT, 2002 and by circulars of RBI from time to time the latest issued on 7th May, 2012.