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Distinct features of securitization in India.
Recent years have witnessed the wide spread of Western financial innovations into developing markets. Globalisation and integration of capital markets, started in the 1990s, have made it possible for such big global players as India to adopt new financial strategies which allow increasing liquidity and accelerating development of the capital markets. One of these financial innovations is securitisation, the process of transformation of illiquid assets into a security which can be traded in the capital markets. Although the state of securitisation in India is far from that of the USA and the UK, the market for securitised assets grows at a fascinating pace. This work attempts to analyse the origination, development and current condition of securitisation in India.
Definition of securitization in India
The first widely reported securitisation deal in India occurred in 1990 when auto loans were secured by Citibank and sold to the GIC mutual fund. However, the sound legal framework for securitisation was not drafted until 2002 when the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Ordinance (Ordinance) was promulgated by the president of India (Amarchand, Mangaldas et al. 2002). According to this law, securitisation was defined as “acquisition of financial assets by any securitisation company or reconstruction company from any originator, whether by raising funds by such securitisation or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise”. The notion of financial assets for the above definition is stated as any debt or receivables. Non-surprisingly, it follows that the definition of securitisation in India is very close to that of western countries, especially taking into account that the experience of the UK is of special relevance to India.
The process and rationale
The process of Indian securitisation is also very similar to western analogues. The process starts when the lender sorts out loans/lease/receivables into pools of assets which can be organised in homogenous groups of types of credit, maturity and interest rate risk. These pools of assets are then directed to a Special Purpose Vehicle (SPV) which usually is established as a trust. The originator can manage the SPV as a subsidiary company or the SPV can be set up by a group of interested parties. The organisational structure of the SPV, therefore, determines the kind of asset-backed securities which can be represented by debt, certificates of beneficial ownership, etc. The servicer collects interests and principal amounts, leases and receivables and transmits them to investors who bought securitised papers. Three basic ways of transfer of assets exist with respect to securitisation. They include novation, assignment and sub-participation. Novation assumes writing off the loan from the balance sheet of the seller. An assignment can be implemented by means of two basic forms: the statutory assignment and the equitable assignment. The former implies transferring both legal and beneficial titles. To put it differently, the buyer gets full legal and beneficial interest in the loan. On the other hand, the equitable assignment does not transfer legal rights and may complicate legal cases against the borrower. Finally, sub-participation does not lead to any kind of transfer. Although, this general framework is operational in India, the country has a number of peculiarities. The excellent summarisation was done by the Deputy Governor of the Reserve Bank of India, Dr. Y. V. Reddy (Reddy 1999) and is listed here:
- Most securitisation deals involve the transfer of beneficial interest on the asset and not the legal title.
- The overwhelming majority of transactions are done via pass-through mechanisms.
- Many transactions involve the escrow mechanism which allows set-up of an escrow account to transfer receivables for the payment to the buyer.
- An SPV is yet to gain popularity.
- The secondary market for securitised debt is at a rudimentary stage.
At the present moment securitisation in India is focused mainly on automobile and consumer finance. The majority of deals are backed by cars, lorries, construction equipment and personal loans (Newsletter 2004). An expansion of the market is gradually following the needs of the issuers and investment bankers. There are different structural features aimed at attraction of different types of investors. The most noticeable of them include multiple tranches of pass-through certificates and prepayment protection options. According to ICRA (Investment Information and Credit Rating Agency of India) more than 90% of deals in the first half of 2004 had multiple tranches. For example, time tranching or allocating the pool cash flow from different periods of time and to different series of notes can be an effective way of structuring different tenors. This can help to address interests of investors with various time horizons. An increasing number of the asset backed securitisation issues comprise one or more tranche that can absorb prepayments made on the underlying. It, apparently, protects investors in the other tranches from prematurely receiving principal redemption when interest rates go down. The next interesting feature of the Indian securitisation process is the growing popularity of “termed” par transactions. Par structures are more convenient than premium pricing securities when prepayment protection or floating rates are used. The latter have become a distinct feature of mortgage-backed securities following increases in interest rate volatility.
The market size
There is no authentic data on securitisation in India. However, it is apparent that the market has picked up in recent years and shown a record number of transactions. Table 1 provides some important statistics on securitisation in India. According to estimates made by Moody’s and ICRA in 2001 there were 19 rated transactions for a total of $490 million. In 2002 the number of transactions reached 29 with a total almost doubling to $884 million. The year of 2003 witnessed 46 rated transactions amounting to $1.09 billion. This process was followed by concentration in the market leading to increased deal size and deal frequency per issuer, while auto loan-backed securities traditionally were the core of all securitisation deals in India. However, MBS, CDOs and partial guarantees also have hit the market.
Table 1. Securitization statistics
Players and their role
The dominant player in Indian securitisation is ICICI Bank, the second largest bank in India with more than 560 branches. This bank issues more than 60% of all securitised papers in India and arranges all its own deals. ICICI offers a full range of loans to its customers including home loans, personal loans, car loans, and construction and medical equipment loans. All of them are securitised by the bank. The bank’s portfolio of outstanding car loans amounts to £1 billion. In August 2004 ICICI completed the largest securitisation deal in India. The £220 million car loan securitisation was similar to US asset backed structures comprising three series of planned amortisation notes along with a companion bond to absorb excess prepayments, and incorporated fixed and floating rate options. The second leading player in the market is HDCF Bank. It also completed a notable deal making a transaction of £150 million backed by retail vehicle loans. The issue included four tranches with prepayment protection feature and periodically put options which could protect investors against interest rate rises. The mortgage-backed securities in India are relatively underdeveloped. The first issue was made in August 2000 by NHB (National Housing Board). Till October 2004, NHB made ten issues of mortgage-backed securities comprising 35,116 housing loans (Kothari and Gupta, 2005). However, despite the growing number of housing loans, the number of mortgage-backed securities issued remained stable on the basis of total issue. Finally, according to Fitch, estimates the investors base contains up to 15 mutual funds, 15 leading banks, insurers and other investors (Newsletter 2004).
Benefits and threats of securitization
Securitisation can bring many benefits to the participants of this process. First, originators may replace receivables by cash improving the liquidity position. This benefit may be well appreciated by ICICI which has a substantial portfolio of loans. Second, removing assets from the balance sheet of the originator can free capital for other purposes, help reduce exposure to sectoral concentration and improve transparency since assets should be clearly identified to be suitable for securitisation. The problem of transparency is important to Indian authorities and can be partially alleviated through appropriate securitisation laws. Third, investors get the advantage of relatively risk-free investment which can be further guaranteed by credit enhancement agreements. The new ways of diversification brought by securitisation lead to more stable investment portfolios for financial institutions. Finally, for the entire financial system securitisation may enhance the variety of debt instruments in the market, provide better resource allocation and improve management of project risks. It also can attract new players in the market by offering superior quality assets. It is worth noting that securitisation may bear great risks if not done properly as well. A potential conflict of interests may arise if the same bank conducts originating, selling and servicing the same issue of securities. Since securitisation in India is dominated by several large banking groups it is possible that the conflict of interests may occur. Moreover, operational and legal risks may be augmented in the securitisation process since the activity becomes more complex in comparison with regular bank services. It is also noted that securitisation may reduce the power of central banks to govern the monetary system. However, this problem is not on the agenda of the Indian government since the level of securitisation is still nascent.
Risks involved in the process
A number of risks can be pinpointed with respect to securitisation in India (Suhumar and Ramanath 2002). First of all, the contributors are directly exposed to the credit risk of the borrowing counterpart. This type of risk can be mitigated by comprehensive selection of securities to be included in the pool and by credit enhancement. The PSCE (Pool Specific Credit Enhancements) in the form of over-collateral and cash collateral are often assigned to the SPV in India. The so-called co-mingling risk means that funds collected by the trustee (for instance, ICICI Home) can be retained for some period of time before redemption to investors. However, generally trustees in India have the credit rating of AAA which substantially reduces the co-mingling risk. Risk of prepayment is very high in India because of highly volatile interest rates which are common for developing countries. However, taking into account various reserve requirements that ensure that the cut-off yield is not violated, this type of risk may be easily overcome. Risk of re-scheduling can be monitored by credit agencies. They can require contributors to purchase re-scheduled loans if credit enhancements are insufficient to cover the reduction in future receivables. Overall, securitisation in India bears similar risks as that of any other country. However, it is a way of addressing these problems, which may not be always commensurate, but may induce some anxiety amid investors.
There are a number of legal factors which may concern Indian authorities with respect to securitisation. First of them is a stamp duty. Under the statutory legislation, securitisation involves transfer of mortgaged debt. This procedure should be done by means of a special instrument which involves paying ad valorem stamp duty. This stamp duty can reach as much as 8 per cent of the value of the transaction which turns out to be a burdensome payment for participants in the securitisation market. Second, any transfer of property requires compulsory registration. This procedure makes securitisation deals even more expensive. Third, the existing foreclosure laws impede development of securitisation since they make it difficult to transfer property rights in the case of default. This situation does not encourage improvement of secondary trading in securitisation instruments. However, some great strides have been made recently in order to better securitisation legislation. The adoption of Ordinance allowed dealing with three largely unrelated aspects of securitisation: securitisation and securitisation companies; asset reconstruction and asset reconstruction companies; and enforcement of security interests. The Ordinance clarified the ambiguity which existed with regard to permissibility of assignment of future cash flows from receivables by including such receivables to the group of financial assets. The law, however, evoked a mixed reaction among market participants. For instance, addressing several issues in one Ordinance may make certain provisions not entirely applicable in the context of securitisation. Some ambiguous aspects need clarification as well.
On the whole, securitisation in India seems to be accelerating in its development. More and more institutions start participating in the market and the scope of securitised assets is steadily growing. Only in 2004 the average securitisation deal doubled, amounting to £50 million. The financial structure of agreements is getting more complicated in order to suit new types of investors. However, problems still remain. One of the most important of them is legislation which lags behind the hovering securitisation market. Authorities respond to new demands with great delay and not always properly. Nonetheless, the perspectives of the Indian securitisation market are fascinating. With the second largest population in the world mortgage-backed securities and auto loans are doomed to play a great role in India.
Amarchand, Mangaldas, et al. (2002). "India." International Financial Law Review: 33-35.
Kothari, V. and A. Gupta (2005). Development of RMBS market in India: Issues and Concerns: 1-53.
Newsletter (2004). ABS market firing on all cylinders. Structured Finance International. London. Nov/Dec: 1.
Reddy, Y. V. (1999). Securitization in India: Next Steps. Seminar on Government Securities Market. Chennai.
Suhumar, V. and R. Ramanath (2002). Securitization in India - A Study, Indian Institute of Management Bangalore: 12.