Securitization
is the process of transforming illiquid
assets into a security, i.e. an instrument
that is issued and can be traded in
a capital market. Assets that have been
transformed in this manner include residential
mortgages, auto loans, credit card receivables,
leases and utility payments. Securities
involving housing mortgages are referred
to as mortgage-backed securities (MBS).
The term asset-backed security (ABS)
is generally applied to any securitized
instrument other than MBS. Asset securitization
techniques were pioneered in the U.S.A
and are being embraced by a number of
Asian countries seeking to promote home
ownership, finance infrastructure growth,
and develop their domestic capital markets.
In
case of a typical Asset Securitization
financial claims are assigned or sold
to a Special Purpose Vehicle (SPV).
The objective is to legally separate
asset from the issuer. The SPV in turn
issues one or more debt instruments,
whose interest and principal payments
are serviced from the cash flows arising
out of the underlying assets. The figure
below depicts the process of Securitization.
 |
| Figure
1. Diagrammatic Representation of
the Securitization Process |
This paper discusses the evolution of
the global securitization market, process
of securitization, key decisions and
the constraints for securitization in
Sri Lanka.
The
central element of securitization is
the separation of “good”
assets from a company or financial institution,
and the use of these assets as backing
for high-quality securities that appeal
to investors. Such separation can make
the quality of an asset-backed security
independent of the creditworthiness
of the originator.
Most
ABS investors are not willing to take
significant credit risk. Hence, even
when the assets being securitized are
of good quality, many deals entail some
form of credit enhancement (please refer
Section 3.3 for more details). For this
reason, asset-backed securities tend
to have excellent credit ratings.
The originator of the underlying assets
will normally continue to process or
service the assets i.e. communicating
with borrowers and collecting their
payments. The originator normally values
this feature as the relationship with
the client can be maintained subsequent
to the securitization. The originator
may offer to sell the servicing rights
to a third party. This is often done
in the US mortgage-backed securities
market. In fact there are instances
where the stream of servicing fees themselves
were securitized as a separate transaction!
For
corporations, asset securitization provides
a new and potentially cheaper form of
financing. In the case of financial
institutions (such as banks and finance
companies) which have successful loan
programs but face capital constraints,
securitization is a means of removing
assets from the balance sheet and of
freeing up capital to support further
lending (please refer Section 4.0 for
Collaterized Loan Obligations). Asset
securitization enables an originator
to achieve a match between assets and
liabilities.
For
investors, the securities offer higher
yields and provide diversification into
a different form of investment. In the
case of large deals with high credit
ratings, the securities tend to be liquid
and may be actively traded in secondary
markets.
While
residential mortgage loans provide the
core of the global asset-backed securities
market, a wide range of other financial
claims can be and have been securitized.
Virtually any income-producing asset
with an adequate performance record
and some diversification of credit risk
can be securitized.
Consumer
finance receivables, in particular vehicle
leases and credit card receivables,
constitute the most important segments
of the non-mortgage ABS market. Other
assets commonly securitized globally
include student loans, utility receivables,
heavy equipment and loans.
In
Sri Lanka, securitizations are mainly
limited to lease receivables. There
are also instances of securitization
of hire purchase receivables, housing
loans and capacity charges on power
generation projects. The suitability
of assets for securitization lies not
so much in what they are, but in whether
following two criteria can be met by
them i.e.
-
Can they be subject to rigorous credit
and statistical analysis?
For example, does the originator have
acceptable statistics on the composition
of receivables, agings, defaults,
losses, and consistent trends in payments?
-
Are
the assets unencumbered and transferable?
If
the above criteria can be satisfied,
there seems to be no limit to the range
of assets and cash flows that may be
securitized: examples include revenues
from the singer David Bowie’s
performances. There are also instances
of securitization of future revenues
such as those generated from exports
and subscriptions for golf course memberships.
The
earliest securitization transaction
dates back to the early 1970s when the
Government National Mortgage Association
(Ginnie Mae) sold a pool of mortgage
loans. Around the world, asset-backed
securities markets have also been growing
rapidly. The first mortgage securitization
in Europe, an UK mortgage-backed issue,
was completed in 1987. Public or private
asset-backed issues have since been
consummated in France, Germany, Spain,
Italy, Belgium, the Netherlands and
Sweden, among other countries. A number
of other countries in Asia, including
Japan, Hong Kong, Thailand, Indonesia,
India and the Philippines have all seen
the introduction of asset-backed securities.
In addition, almost every day, significant
new asset-backed bonds are issued in
the Eurobond market. The instrument
has become a standard component of conservative,
yield-seeking international investment
portfolios.
Let us
look at some leading global markets.
The
United States of America is the largest
securitization market in the World.
In terms of depth, it may be the only
market in the world where securitizations
draws participation from both institutional
as well as individual investors. In
terms of width, the US market has far
more applications of securitization
than any other market. The securization
market in the U.S.A. has grown to a
massive U.S $ 5.5 trillion.
 |
Figure
2. Outstanding volume of Mortgage-backed
Securities (US $ trillions)
Source: The Bond Market Association
(30 September 2001) |
 |
Figure
3. Outstanding volume of Asset-backed
Securities (US $ trillions)
Source: The Bond Market Association
(30 September 2001) |
The
United Kingdom can well be regarded
as the securitization laboratory of
Europe, as securitization is increasingly
being used in the UK as a financing
mechanism. UK contributed transactions
worth about US $ 26 billion in 1999
and by the end of 2001, was the top
player in Europe - in fact, UK's contribution
was about 35% of total European securitization
in 2001.
Securitizations,
in the UK, have taken place with credit
card receivables, auto loans, equipment
leases and receivables from pubs. Sections
of the media and entertainment industry
are seeking to securitize royalty streams
from completed films and TV programming
and from music publishing and recording.
The
major securitization transactions in
Singapore have involved commercial real
estate, residential sales progress payment,
credit card receivables, bonds and loans.
One
of the notable deals in Singapore market
has been the issuance of an asset backed
short-term notes programme by DBS Bank.
In 1999, DBS Land, a property company,
raised Singapore $ 1.3 billion by securitizing
three office buildings.
The provider
of assets to be securitized. The cash
raised through the securitization will
be utilised to generate further assets.
The borrowers
are instrumental in creating assets
(for example, borrower of a housing
loan or a lessee).
Investors
are the subscribers to the securitized
debt instruments.
The
concept of Bankruptcy Remoteness applies
to the SPV created to hold the assets.
An SPV, which satisfies certain legal
criteria, can isolate assets so that
they are beyond the reach of the creditors
of the originator. Bankruptcy remoteness
is a critical feature that protects
the investors who purchase the securities
issued by the SPV in case of bankruptcy
of the originator.
A
typical securitization structure works
as follows:
1)
A lender, such as a bank, finance company
or corporation, originates loans. Typically,
the institution wishes to expand, but
finds available capital and the term
financing are insufficient to support
the planned expansion.
2)
The securitization structure is developed.
The originator will sell or assign certain
assets to the SPV. The nature of the
transfer and the legal status of the
SPV vary from issue to issue and require
careful structuring.
3)
The assets are chosen and the structure
designed to obtain a high credit quality/rating.
This can be accomplished in one or more
of the following ways:
-
Preparing the pool for securitization,
for example, by employing prudent
criteria in screening assets for inclusion.
Please refer Section 3.2 for the due
diligence exercise.
-
Credit enhancements, which are
more fully described in Section
3.3.
-
The SPV issues one or more classes
of securities paying defined interest
rates to investors, and pays the funds
it receives from investors to the
seller of the assets.
-
Over time, the payments from borrowers
to the originator are processed by
a servicer (typically the originating
institution itself). The servicer
passes the interest, principal and
fee payments from the borrowers, less
servicing fees, to the SPV. The SPV
in turn pays a pre-defined interest
rate to the investors, plus any principal
repayments, according to the terms
of the ABS.
-
When
all principal payments have been made
and the securities have accordingly
matured, the SPV is extinguished and
any remaining assets (including cash)
are returned to the originator.
Given
below are the key decisions in carrying
out a securitization.
-
In securitization SPVs are legal entities
such as corporations, trusts, or partnerships
established for a specific and limited
purpose. A SPV essentially acts as
a depository for a specific group
of assets in a securitization, and
in turn, issues securities to the
marketplace for purchase by investors.
In Sri Lanka a trust is being used
as the SPV
-
SPVs do not have the right or ability
to engage in any activities other
than those rights granted to them
in the legal documents creating and
governing the securitization transaction
and the SPV. Once the SPV is created,
it must operate as a wholly independent
entity. This generally includes appointing
its own directors/ a trustee, paying
all of its own expenses, not paying
the expenses of the selling entity
and not commingling its assets with
those of any other entity, including
those of the originator.
-
Once assets are assigned to an SPV,
they are “legally isolated”
and consequently are no longer available
to the originator or its creditors.
The deposited assets can be used only
to make payments on the securities
issued to investors and may not be
reclaimed by the originator.
Assets
for the securitization are selected
through a detailed due diligence exercise
to ascertain the following:
::
Repayment history
::
Legal documentation
:: Ownership structure
:: Valuation of assets
:: Re-saleability of underlying
assets
An attempt would also be made to construct
a diversified portfolio of assets for
the securitization exercise. The diversification
in this instance can be achieved through
factors such as geographical dispersion,
industry-wise distribution, etc.
Sensitivity analysis (Stress Test) would
be carried out to ascertain the ability
of the portfolio (after credit enhancements)
to withstand adverse changes in the
economic environment.
The
due diligence on the originator is vital
in case it is to act as the servicer.
In this particular instance, the originator
must be capable of collecting principal
and interest, following up on delinquents,
maintaining statistics on performance,
passing on payments in a timely fashion,
and performing numerous other administrative
tasks.
Given
below is a selected list of risks associated
with a securitized instrument. Some
of these risks are also associated with
any fixed income instrument.
arises from the possibility
that the issuer of a securitization
instrument, usually a SPV, may default
on its liabilities. Since the SPV is
normally structured to have no assets
or business other than holding the securitized
assets, the principal focus is on the
cash flow from the assets themselves
and the credit enhancements. Therefore,
the major factor that would contribute
to credit risk is the possibility of
default by the borrowers.
Servicer performance risk arises from
the possibility that the servicer will
fail to carry out its tasks as expected
during structuring of the securitization.
This risk can be reduced through proper
screening and monitoring of the servicer.
The ability to choose an alternate servicer
can play an important role in mitigating
this risk.
This risk may be
mitigated through the structuring of
securities to be issued by the SPV to
carry a variety of maturities –
thus giving an investor the ability
to match needs.
Payments made in excess
of the scheduled principal payments
on a loan are called prepayments. Individuals
and businesses normally pay early either
because of a change in their circumstances
or because they can refinance on better
terms. When borrowers can refinance
at cheaper cost, it generally means
that investors must reinvest at lower
rates. That is why prepayment risk often
implies interest-rate risk. Although
prepayments are a factor in many securitizations,
they have the greatest impact on securities
backed by long-term, fixed-rate home
loans because it is here that they may
produce the largest change in the present
value of foregone cash flows, due to
reduction in interest rates. Prepayments
also take place when the borrower is
graduating to a better house. In Sri
Lanka this risk is not high due to exorbitant
prepayment damages imposed by financial
institutions.
takes many forms, but is
most evident when the underlying assets
are in one country and investors are
in another. Sovereign nations may interfere
with cross-border cash flows through
taxes, exchange controls or other measures.
Investment
Banks have come up with a structure
using an offshore SPV to mitigate this
risk. This structure would enable cash
flows from foreign sources such as telecom
receivables from the international operators
to be directly remitted to the off shore
SPV.
(the risk of devaluation)
arises when the assets underlying an
issue are denominated in a currency
that investors do not wish to hold.
Some securitizations contracts provide
for an increase in the local currency
payments to offset any decrease in the
currency’s value. Alternatively,
a currency swap can be employed to transform
the local currency cash flows into known
payments in, say, US dollars or Japanese
yen.
Devising a watertight
legal structure in a securitization
is a great challenge, particularly in
countries where the legal/regulatory
framework is evolving with regard to
securitizations. Sri Lanka is no exception.
The major issue is “bankruptcy-remoteness”:
the SPV must be insulated against bankruptcy
of the originator. In case the originator
experiences financial difficulties,
the SPV must still be able to retain
interest on the assets and obtain full
control over cash collections. Other
legal issues include the legal, accounting
and fiscal status of the asset transfer
and the form of the SPV.
is the difficulty in converting
a security to cash equivalent close
to its true value. This is also known
as the marketability risk. The creation
of a mechanism for an active secondary
market would reduce this risk.
A swap is
required when ever the underlying assets
pay interest on a floating rate basis
and the investors are serviced on a
fixed rate basis or vice a versa. As
described above, a swap may also be
employed to eliminate currency risk.
Swap counterparty risk is the risk faced
by a participant when entering into
a swap, that its counterparty may renege
on the future obligations to which it
has committed. This risk is highest
at the time it is most disadvantageous
to the counterparty to fulfil its obligations.
Credit
enhancements are the techniques employed
to eliminate or mitigate the above risks.
Credit
enhancements in isolation could be viewed
as contributing to higher cost of funds
to the originator. However, the selected
investors should be willing to settle
for lower return from credit enhanced
instruments vis a vis return from straight
debts instruments issued by the originator.
Considering the above two off setting
factors, credit enhancements can be
incorporated into securitization provided
that:
Marginal increase in funds
due to a credit enhancement
|
 |
Increase in acceptability of
the instrument and the resultant
marginal decrease in return
offered by the investors
|
Hence,
the sufficiency of credit enhancement
is a commercial decision between the
originator and the arranger of securitization.
Further, credit enhancements can also
be used to improve the credit rating
of the instrument.
Broadly,
there are four sources of credit enhancements.
1. Excess asset value or cash flows
from the underlying pool
2. Enhancements provided by the originator
3. Third party enhancements provided
by banks insurance companies etc.
4. Subordinated debt structure
There are two ways of viewing excess
asset value (asset in this case is the
present value of the future cash flows).
Firstly, the concept of loan-to-value
(LTV) ratio, where only a portion of
the value of the asset at the inception
is used for the securitization. The
excess portion can be considered as
an over collaterization. The originator
provides excess assets over and above
those being financed through securitization
with a view to having excess assets
to cover losses and or repayment delays.
Secondly, this excess asset value would
become a cash cover as and when the
cash flow is generated.
The
Originator may itself provide support
for the securitization. The degree of
support offered by the originator may
affect the degree to which the securitization
transaction can be considered to be
off the originator’s balance sheet.
In fact, Sri Lanka this credit enhancement
has been used to prevent lease assets
being considered to be transferred from
the balance sheet of the originator.
The reason is that, in case the lease
assets are moved out of the balance
sheet, the accelerated depreciation
allowances will be lost to the originator.
The major support provided by the originator
is the agreement to replace assets,
which have deteriorated in quality with
performing high quality assets.
Third
party enhancements would include letters
of credit or guarantees provided by
banks or insurance companies. Partial
guarantees can also be used as credit
enhancement.
The
subordinated debt structure or prioritised
distribution process is as follows:
-
Several classes of securities (these
are referred to as tranches) are issued
against a pool of assets to be securized.
As an example, let us assume an ABS
issue with four classes (tranches)
of bonds. In such a case, the first
three (eg. Classes A, B, C) would
pay interest at the stated rates,
commencing at the issue date and the
fourth class would be an accrual bond
(popularly known as a Z bond).
-
The
cash flows received from the underlying
assets are applied first to pay the
interest on the first three classes
of bonds, and then to retire these
bonds.
-
The classes of bonds are retired sequentially.
All principal payments are directed
first to the shortest-maturity class
A bonds until they are completely
retired. Then all principal payments
are directed to the next shortest-maturity
bonds (ie. the class B bonds). The
process continues until all the classes
have been paid off.
-
During the early periods, the accrual
bonds (the class Z bonds) are paid
with no interest, but the interest
accrues as additional principal, and
the cash flow from the assets that
collateralize these bonds is used
to pay interest on and retire the
bonds in the other classes. Subsequently,
all remaining cash flows are used
to pay off accrued interest, pay any
current interest, and then to retire
the Z bonds.
The
prioritised sequential pattern means
that the A-class bonds are fairly short-term
and each subsequent class is a little
longer term until the Z-class bond,
which is a long-term bond. The Z-class
bond would also function like a zero
coupon during the initial years. The
objective is to provide credit enhancements
to A, B, and C bond at the expense of
Z bond.
This
is a product that is most appropriate
for the banking sector. As the banking
industry becomes more competitive and
focuses on capital efficiency, it has
started to evaluate alternatives to
improve returns on assets and equity.
CLOs offer capital advantages that improve
a bank’s ability to face competition.
Using CLOs banks securitize their loan
portfolios. This enables banks to use
the capital markets to efficiently finance
low yielding assets and free a significant
amount of regulatory capital. This freed
up capital can be a part of an institution’s
capital management plan to expand the
loan portfolio, pay dividends or making
strategic acquisitions. A bank can still
retain the client and the contacts,
as the portfolio is sold to a SPV and
not to a competitor bank.
The
rating agency addresses the likelihood
that an originator will repay the principal
and interest in full and on time in
accordance with the terms of the debt
instrument. A rating can offer access
to investors otherwise unavailable to
the originator, thereby enabling the
diversification of sources of financing.
There are large institutional investors
in Sri Lanka who insist on acceptable
credit rating for debt instruments.
This aspect may be more important for
originators whose name and reputation
are unknown to investors. On the other
hand rating enables investors to gauge
the risk of securities accurately and
expeditiously without tying up their
own valuable resources. As the capital
markets become more globalized, ratings
will become more important, particularly
for issuers seeking to borrow from new
markets and in new ways.
In
effect, rating becomes a checking mechanism.
The rating agency will carry out an
independent due diligence on the originator,
the portfolio and the legal structure.
Credit enhancements would also affect
the credit rating. In fact, credit enhancements
can be used to upgrade a rating to the
required levels. The rating agency would
also carry out a stress test on the
securitized instrument to ascertain
its ability to meet the terms and conditions
to investors in case of adverse variations
in the economic environment.
The
credit rating agency will maintain surveillance
on all its rated issues by monitoring
both the asset’s performance and
the parties providing support to the
transaction. Periodic monitoring of
the assets ensures a continuous and
consistent review of actual and projected
performance. Deterioration in the performance
of the underlying assets and the accompanying
credit enhancements may lead to a downgrade
of the rating. Conversely, an upgrade
of a rating may be possible if the assets
are performing exceptionally well and
all other aspects of the issue such
as supporting party ratings and other
enhancements warrant a higher rating.
As
stated earlier, the majority of securitization
in Sri Lanka has been backed by lease
receivables. However hire purchase receivables,
housing loans, operational leases and
capacity charges on power projects have
also being used for securitizations.
The constraints for structuring of such
deals can be broadly categorized into
following:
1) Legal factors
2) Taxation related factors
3) Administrative factors
There
are some Acts that preclude assignment
of receivables to a SPV (for instance,
The Finance Leasing Act of 2000). Further,
the Consumer Credit Act of 1995 permits
assignment provided prior notice is
given. As a consequence in case of most
securitizations, the future cashflows
and the underlying asset are mortgaged
to the SPV.
The
originator especially in case of lease
assets requires to benefit from the
accelerated depreciation allowances.
A sale of the underlying asset would
prevent the originator from claiming
the future tax benefits. There is no
mechanism to pass on this tax benefit
to the investors through the SPV, so
that cost of funds to the originator
can be reduced. Hence in most of the
structures in Sri Lanka, credit enhancements
such as replacement of non performing
assets in the portfolio with those which
are performing have been used to argue
out that a sale has not taken place
and therefore the tax benefits would
still accrue to the originator subsequent
to the securitization exercise.
The
borrowers in Sri Lanka are not accustomed
to selling/transferring of credit facilities.
Hence, individuals/borrowers would resist
participating in the process of securitization
in such ways as signing of the letter
of consent, or other transfer documents
related to the Registrar of Motor Vehicles
(RMV). In fact RMV procedures are presently
very cumbersome for a securitization.
The
above constraints should change for
securitization to become a major source
of financing in Sri Lanka.
Given
below is a typical securitization structure
in Sri Lanka
 |
| Figure
4. A diagrammatic representation
of the steps involved in the issuing
of the Trust Certificates |
 |
| Figure
5. The diagram depicts the flow
of funds in servicing the Trust
Certificates. |
The
securitization structures were first
invented in U.S.A. in 1970s. Today it
is a major source of financing in a
number of countries.
In
a typical securitization the future
cashflow is assigned or sold to a Special
Purpose Vehicle (SPV). The SPV in turn
issues one or more debt instruments,
whose interest and principal payments
are serviced from the cashflows arising
from the underlying assets. Any cashflow
with a predictable future stream can
be used for securitizations
Bankruptcy
remoteness is an important concept in
a securitization. The legal structure
of a securitization should enable the
assets of the SPV to be isolated from
the creditors of the originator.
Credit
enhancements are incorporated in the
structure to enhance the acceptability
of the securitized debt instruments
to the investors and thereby reduce
cost of funds to the originator. Credit
enhancements would also enable the improvement
of the credit rating of the instruments.
The
first securitization deal in Sri Lanka
was carried out in 1995. However securitization
have become a popular source of financing
since 1999. It is gradually developing
into an alternative source of financing
for the leasing and hire purchase sectors
in the country. There are a number of
legal taxation and administrative impediments
in Sri Lanka that presently hinder the
potential growth in securitization market
REFERENCES
Audino,
D., “Securitization: The Rating
Agency Approach to Credit Risks”
Euromoney/DC Gardner workbook, Euromoney
Publications plc., 1996.
Fabozzi
F.J., “The bond market Analysis
and Strategies” Special Edition
for CFA.
Fabozzi,
F. J., editor; Fabozzi, T. D., editor,
“The Handbook of Fixed Income
Securities”, 4th ed., The McGraw-Hill
Companies, Inc.
Gangwani,
S., “Speaking of Securitization:
Securitization 101”, Deloitte
& Touche, Special Edition, Vol.
3 Issue 4-1, 20th July 1998.
Linsay,
J., Thomson, C., “Securitization:
Tax and Accounting Issues” Euromoney/DC
Gardner workbook, Euromoney Publications
plc., 1996.
Shaw,
Z., “Securitization: Credit Enhancement
and Cash Flow Analysis” Euromoney/DC
Gardner workbook, Euromoney Publications
plc., 1996.
 |
Mr. Kulatilaka is the Chief
Executive Officer, Citi National
Investment Bank, Colombo,
a joint venture between National
Development Bank and Citi
group.
He graduated from University
of Moratuwa in Civil Engineeringwith
first class honors. He obtained
his Masters Degree (M.Eng)
from Asian Institute of Technology
in Bangkok inIndustrial Engineering
and Management. Mr Kulatilaka
is also a fellow of the Chartered
Institute of Management Accountants
(FCMA) a Chartered Financial
Analyst (CFA).
He
held several Executive positions
including Chief Executive
Officer, CKN Fund Management
Private Ltd., Project Management
Specialist, Financial Markets
Project, United States Agency
for International Development
(USAID), Officer-in-Charge,
Small and Medium Enterprises
Unit (SME) Sampath Bank Ltd
and Project Officer, National
Development Bank of Sri Lanka.
He has several publications
and research papers to his
credit. He is a Visiting Lecturer
in financial management at
University of Moratuwa, member
of the panel of lecturers/examiners
in the open University of
Sri Lanka and Sri Jayawardenapura
University. He was the President
of the Unit Trust Association
of Sri Lanka and one of the
four member committee to design
the Code of Ethics Standard
of Practice to be implemented
by the Sri Lanka Association
for Securities and Investment
Analyst (SLASIA) and member
of the Management of Professional
Development Committee of CIMA.
|
|
