The following article presents multiple aspects of securitization in a simplified

manner. We will be looking at numerous complex steps involved in detail; starting

from the basic question:

Ø What is Securitization?

Securitization in simple terms can be defined as a process of bundling of loans

receivables (called as a pool) together from the originator and selling it to the SPV;
which in turn issues securities which are backed by loans and later can be sold to the
investors. The whole process though looks simple but has multiple counterparties
involved at different stages. Another important point to keep in mind is that not all
the asset can be securitized. There are rules and regulations imposed by RBI where
only the qualifying and standard assets can be securitized.

Below are some of the examples where we can’t securitize the underlying assets:

 Assets purchased from the other entities

 NPA (Non-performing assets, defined as the borrower who has defaulted on 3
consecutive instalments (90 days)
 Revolving credit facilities (Examples include credit card receivables)
 Loans that have bullet payment for both principal and interest- except for
loans extended to farmers

Ø Why do we need to securitize the assets at all?

 We know that the banks, FIs need to borrow on a regular basis to grow their
balance sheet. But the problem is they won’t have the required borrowings all
the time; as their capital is blocked in disbursements and will trickle back to
them gradually with repayments from end borrowers. To overcome this
problem, they have an option of getting more loans either through other FIs
or through debt instrument like CP, Bond, CD, etc. There exists another option
also where they can sell the loans (given to the obligor) to the investor either
through PTC or DA (discussed later) and use the money to grow further.
 Another advantage of these transactions is that the assets which are sold
down will be taken off from seller’s balance sheet; thereby the name “off-
balance-sheet transaction”
 Other thing is that it can enhance the lender’s liquidity and can transfer the
riskiness associated with those assets away from the seller’s balance sheet.
 It helps in reducing the asset-liability mismatch as the product repayments are
linked to repayments for underlying loan receivables which are being sold
down (assets)
 It also helps in enhancing CRAR (Capital reserve adequacy ratio or Capital to
Risk (Weighted) asset ratio – defined as the FIs available capital in the ratio of
risk weighted asset) by transferring the risk-weighted asset making it off-
balance sheet.
 Banks need to fulfil the PSL (Priority sector lending) requirement, for which
they need to lend a fixed percentage of their volume in sectors like
agriculture, SMEs, Education, Housing, etc. Investment in these products and
taking indirect exposure to end borrowers which are in form of pooled loan
receivables makes it easier for the banks to take exposure on these originators
and thus will help the banks to meet their PSL requirements.

Ø Key players in securitization?

There are many counterparties involved in the process of Securitization. Some of

these counterparties are listed below in the diagram. In additional; there are external
law firms and auditors as well which help us in carrying out the entire process for
these transactions.
Ø Types of securitization structure

There are generally 2 types of securitization structure:

1. PTC (Pass-Through Certificates) structure

2. DA (Direct Assignments) structure

1. PTC Structure:

The major difference between PTC and DA lies in the fact that PTC transactions have
Credit Enhancement (A type of security cover/protection provided to investors in
order to absorb losses on account of non-performance of underlying borrowers)
while DA transactions don’t have any provision of credit enhancement by regulation.

Also, there is a concept of trancing in PTC transactions. So, in PTC, the investor can
invest in either senior (A1) or junior (A2) or subsequent tranches (formed based on
the risk/return appetite) depending on their risk profiles. So, investors in A1 tranche
will be less exposed to the risk (as they will have more credit enhancement) and will
have less pricing(return). Credit enhancement (CE) includes four components namely
Let’s discuss each component in more details:

a. Cash Collateral – Cash collateral is generally kept in form of fixed deposit in a

bank and can be dipped into in case of any losses in the transaction. This is generally
considered as first loss credit enhancement i.e. if the pool doesn’t perform well; then
there is a provision where originator can use the cash collateral and pay the
obligations.

b. Over-collateral – This is the extra amount which is provided by the originator

which acts as a credit enhancement for the pool. If the pool performs well, this goes
back to the originator. So, even if some of the obligors’ default on their payment
obligations, the payment to the investors can be still done from the excess collateral.

c. Excess Interest Spread (EIS) – This is defined as the residual interest amount
which is left over after paying interest to the investor i.e., pool interest – interest paid
to the investor. This arises in the pool because the interest paid by underlying loan
receivables have higher interest yield than the interest yield promised to investors;
thereby creating residual interest.

This component of CE flows back to the originator on every pay-out basis. One
important point to consider is once the EIS goes back to the originator can’t be
recalled and hence this is also known as floating credit enhancement.

d. Principal Subordination – This amount is calculated based on the tranche. So,

for senior (A1) investor, junior (A2)’s principal is subordinated i.e., A2 won’t get
principal amount (though they will be getting the interest amount on the pay-out
basis) until A1 investors are paid off fully.

PTC transactions are generally divided into the following categories:

Let’s focus on each starting with the first one

a. PAR Structure – In this type of structure, the investor pays an amount equal to
pool principal to originator (seller) upfront and the originator earns income on a
monthly basis via EIS.

b. Premium structure – In this type, the investor pays a higher amount than the
pool principal since they also pay a discounted value of all future EIS amount upfront
to the seller (originator) upfront.

c. Turbo par structure – In this type, the EIS in the structure goes back towards
amortizing principal investment of investors instead of flowing back to the originator
and thus this structure sees faster amortization compared to conventional PAR
structure.

2. DA (Direct Assignment) Structure:

In DA Structure, investors directly buy the pool from the originator and the
collections are distributed on a pari-passu basis based on a predetermined ratio, with
no need of SPV. In these structures, there is no provision of credit enhancement. So,
the question arises is why any investor will want a pool which doesn’t have support in
the pool against default. This is because of various reasons.

1). DA structures are easy to structure compared to the PTC structure

2). Basis the lesser counterparties involved; the cost to originators is relatively lesser
in DA transactions. Hence keeping in mind, the higher risk for the investor; some
compensation could be transferred to investors in the form of higher return

3). In DA structures, the assets are directly transferred to investor’s balance sheet and
hence provides them with an avenue to acquire high-quality assets

4). For institutions which are planning to delve into a new product/sector; DA
transactions will provide insights into retail loan behaviour without any hassle of
servicing these loans

Ø Conditions Required for Securitization

Now, we know that the whole process of securitization is regulated by RBI. So, RBI
has formulated some rules and regulations which every entity entering the market of
securitization should follow. Some of them include:

1. MHP (Minimum Holding Period): MHP refers to the minimum number of

instalments an obligor must pay before his loan can be securitized by the seller.
According to the policy, for monthly repayment frequency if the tenure is less than 2
years than MHP is 3 months; for tenure in between 2- 5 years MHP is 6 months and
for greater than 5 years MHP is 12 months.

2. MRR (Minimum Retention Requirement): It is defined as the minimum amount

that an originator must invest in these transactions in order to ensure there is a
moral obligation to ensure timely servicing of the underlying loans. According to the
policy, it should not be less than 5% of original pool principal for tenure less than
equal to 2 years and 10% of original pool principal for the transaction with tenor
greater than 2 years.

Ø Outlook

Securitization market by volume was at 1.9 lakh crores by the end of FY 2019
compared to the 85k crores in FY 2018. Of the total securitization volumes,
transactions comprising of microfinance, vehicle finance and mortgages loans
constitute the majority. There is a significant increase in the DA securitization in the
market compared to the PTC transactions due to their ease of execution.

As we all know, currently NBFC sector is facing a crisis of confidence on account of

multiple defaults and as mentioned in my previous article on Liquidity crisis, it all
started with the default of IL&FS and spread into other sectors creating panic among
the investors. The primary reason for the default was inefficiency in managing the
asset-liability mismatch. Here, securitization instrument can be used to manage ALM
as in securitization; where we can have future receivables paying to extinguish the
liabilities on this instrument and thereby creating equilibrium between asset and
liability repayments.

Stay tuned for further updates

Nitish Kumar Ranjan

Data Science- Vivriti Capital