INTRODUCTIONSecuritization has been one of the most important developments in the financial markets in the developed countries. The historical use of financial intermediaries to gather deposits and lend them to those seeking funds was supplemented and even replaced by securitization processes that bypass traditional intermediaries and link borrowers directly to money and capital markets. Securitization began in early seventies in the United States with residential mortgages. Restrictions with regard to lending by mortgage banks across States within America created a lot of regional imbalances with some States being short of funds to meet the housing needs and some others having surplus funds without an attractive investment opportunity. Securitization corrected this imbalance by directly linking the savers with the borrowers.The experience in United States has shown that securitization aids disintermediation and unleashes product and price competition leading to lower interest costs and higher efficiency in the economy.

Traditionally, existing receivables, where the receivables are not contingent upon any performance from the originator were securitized. Apart from mortgages, such assets tended to be auto loans, credit card receivables, educational loan receivables, lease receivables and industrial loan receivables.Of late, however, future-flow securitization is gaining momentum leading to the emergence of new and esoteric asset classes in the securitization market. Future flow securitization refers to the sale of cash flows that would be earned/generated by the originator by delivering product/services in the future. Remittances from overseas, international telephone settlements, export receivables, vacation home loans, music album sales, movie receivables, income tax revenues are finding favours with the investors.SECURITIZATION AN OVERVIEWDefinition

Securitization is a pooling of homogeneous, financial, cash flow producing, and illiquid assets and issuing claims on those assets in the form of marketable securities. The higher yield associated with these securities attracts investors who are willing to bear incremental credit, prepayment and liquidity risk. The fundamental principle in securitization is specific identification of risks and allocation of the same to various parties who are best able to manage those risks.

As defined by the recent Ordinance:

Securitization means acquisition of financial assets by any securitization company or reconstruction company from any originator, whether by raising of funds by such

Securitization company or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise.

Securitization is the process by which, financial assets such as household mortgages, credit card balances, hire-purchase debtors and trade debtors, etc., are transformed into securities. In present day capital market usage, the term is implied to include securities created out of a pool of assets such as household mortgages, credit card balances, hire-purchase debtors and trade debtors, other receivables, etc., transferred, fully or partially, which are put under the legal control of the investors by the owner (the Originator) in return for an immediate cash payment and/or deferred consideration through a Special Purpose Vehicle (SPV) created for this purpose.

The Special Purpose Vehicle finances the assets transferred to it by the issue of debt securities such as loan notes or Pass Through Certificates, which are generally monitored by trustees. Pass Through Certificates are certificates acknowledging a debt where the payment of interest and/or the repayment of principal are directly or indirectly linked or related to realizations from securitized assets. Arrangements are made to protect the holders of the debt securities issued as above by the Special Purpose Vehicle from losses occurring on the securitized assets by a process termed as credit enhancement, which may take the form of a third party insurance, a third party guarantee of the Special Purpose Vehicles obligations or an issue of subordinated debt.

The Originator may continue to service the securitized assets (i.e., to collect amounts due from borrowers, etc.) and receive servicing fees for the same.

The Originator may also securitize the future receivables, i.e., the receivables that do not exist at the time of agreement but would be arising in future.

Purpose

Securitization is one way in which a company might go about financing its assets. There are generally seven reasons why companies consider securitization:

to improve their return on capital, since securitization normally requires less capital to support it than traditional on-balance sheet funding;

to raise finance when other forms of finance are unavailable (in a recession banks are often unwilling to lend - and during a boom, banks often cannot keep up with the demand for funds);

to improve return on assets - securitization can be a cheap source of funds, but the attractiveness of securitization for this reason depends primarily on the costs associated with alternative funding sources;

to diversify the sources of funding which can be accessed, so that dependence upon banking or retail sources of funds is reduced;

to reduce credit exposure to particular assets (for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitization can remove some of the assets from the balance sheet);

to match-fund certain classes of asset - mortgage assets are technically 25 year assets, a proportion of which should be funded with long term finance; securitization normally offers the ability to raise finance with a longer maturity than is available in other funding markets;

to achieve a regulatory advantage, since securitization normally removes certain risks which can cause regulators some concern, there can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitization as a means of managing the restriction on their wholesale funding abilities).

Establishing the primary rationale for the securitization activity, is a vital part of the preparation for a securitization transaction, since it influences the sorts of administrative tasks which need to be developed as well as the transaction structures themselves.

Securitization: The difference

Unlike a traditional bond issue, the repayment of funds raised through securitization is not an obligation of the originator, or the finance company issuing the securitizedinstrument. In a straight bond or debenture issue, in the event of the company going

bust, the investors would have a tough time getting their funds back, if at all. However, if one invests in a securitized instrument, investors are assured of interest payments even if the finance company goes bust, as the securitized loans are separated from the finance companys books through a SPV which holds these assets. At the same time, as securitized instruments can be traded, the investor is provided with liquidity as the securitized bond can be sold in the market.

Features of Securitization

A securitized instrument, as compared to a direct claim on the issuer, will generally have the following features:

Marketability:

The very purpose of securitization is to ensure marketability to financial claims. Hence, the instrument is structured so as to be marketable. This is one of the most important features of a securitized instrument, and the others that follow are mostly imported only to ensure this one. The concept of marketability involves two postulates: (a) the legal and systemic possibility of marketing the instrument; (b) the existence of a market for the instrument. As far as the legal possibility of marketing the instrument is concerned, traditional mercantile law took a contemporaneous view of marketable documents. In most jurisdictions of the world, laws dealing with marketable instruments (also referred to as negotiable instruments) were mostly limited in application to what were then in circulation as such. Besides, the corporate laws mostly defined and sought to regulate issuance of very usual corporate financial claims, such as shares, bonds and debentures. For any codified law, this is not unexpected, since laws do not lead commerce: most often, they follow, as the concern of the law-maker is mostly regulatory and not promotional.

Hence, in most jurisdictions of the world, well-coded laws exist to enable and regulate the issuance of traditional forms of securitized claims, such as shares, bonds, debentures and trade paper (negotiable instruments). Most countries lack in legal systems pertaining to other securitized products, of recent or exotic origin, such as securitization of receivables. On a policy plane, it is incumbent on the part of the regulator to view any securitized instrument with the same concern as in case of traditional instruments, for reasons of investor protection.

However, it needs to be noted that where a law does not exist to regulate issuance of a securitized instrument, it is naive to believe that the law does not permit such issuance. As regulation is a design by humanity itself, it would be ridiculous to presume that everything that is not regulated is not even allowed. Regulation is an exception and freedom is the rule.The second issue is one of having or creating a market for the instrument. Securitization is a fallacy unless the securitized product is marketable. The very purpose of securitization will be defeated if the instrument is loaded on to a few professional investors without any possibility of having a liquid market therein. Liquidity to a securitized instrument is afforded either by introducing it into an organized market (such as securities exchanges) or by one or more agencies acting as market makers in it, that is, agreeing to buy and sell the instrument at either pre-determined or market-determined prices. Merchantable quality:

To be market-acceptable, a securitized product has to have a merchantable quality. The concept of merchantable quality in case of physical goods is something which is acceptable to merchants in normal trade. When applied to financial products, it would mean the financial commitments embodied in the instruments are secured to the investors' satisfaction. "To the investors' satisfaction" is a relative term, and therefore, the originator of the securitized instrument secures the instrument based on the needs of the investors. The general rule is: the more broad the base of the investors, the less is the investors' ability to absorb the risk, and hence, the more the need to securitize.

For widely distributed securitized instruments, evaluation of the quality, and its certification by an independent expert, viz., rating is common. The rating serves for the benefit of the lay investor, who is otherwise not expected to be in a position to appraise the degree of risk involved.In case of securitization of receivables, the concept of quality undergoes drastic change making rating is a universal requirement for securitizations. As already discussed, securitization is a case where a claim on the debtors of the originator is being bought by the investors. Hence, the quality of the claim of the debtors assumes significance, which at times enables to investors to rely purely on the credit-rating of debtors (or a portfolio of debtors) and so, make the instrument totally independent of the oringators' own rating. Wide Distribution:

The basic purpose of securitization is to distribute the product. The extent of distribution which the originator would like to achieve is based on a comparative analysis of the costs and the benefits achieved thereby. Wider distribution leads to a cost-benefit in the sense that the issuer is able to market the product with lower return, and hence, lower financial cost to himself. But wide investor base involves costs of distribution and servicing.In practice, securitization issues are still difficult for retail investors to understand. Hence, most securitizations have been privately placed with professional investors. However, it is likely that in to come, retail investors could be attracted into securitized products. Homogeneity:

To serve as a marketable instrument, the instrument should be packaged as into homogenous lots. Homogeneity, like the above features, is a function of retail marketing. Most securitized instruments are broken into lots affordable to the marginal investor, and hence, the minimum denomination becomes relative to the needs of the smallest investor. Shares in companies may be broken into slices as small as Rs. 10 each, but debentures and bonds are sliced into Rs. 100 each to Rs. 1000 each. Designed for larger investors, commercial paper may be in denominations as high as Rs. 5 Lac. Other securitization applications may also follow this logic.The need to break the whole lot to be securitized into several homogenous lots makes securitization an exercise of integration and differentiation: integration of those several assets into one lump, and then the latter's differentiation into uniform marketable lots. This often invites the next feature: an intermediary to achieve this processEconomic impact of securitization: Securitization is as necessary to the economy as any organized markets are. While this single line sums up the economic significance of securitization, the following can be seen as the economic merits in securitization: Facilitates creation of markets in financial claims:

By creating tradable securities out of financial claims, securitization helps to create markets in claims which would, in its absence, have remained bilateral deals. In the process, securitization makes financial markets more efficient, by reducing transaction costs. Disperses holding of financial assets:

The basic intent of securitization is to spread financial assets amidst as many savers as possible. With this end in view, the security is designed in minimum size marketable lots as necessary. Hence, it results into dispersion of financial assets. One should not underrate the significance of this factor just because most of the recently developed securitizations have been lapped up by institutional investors. Lay investors need a certain cooling-off period before they understand a financial innovation. Recent securitization applications, viz., mortgages, receivables, etc. are, therefore, yet to become acceptable to lay investors. But given their attractive features, there is no reason why they will not. Promotes savings:The availability of financial claims in a marketable form, with proper assurance as to quality in form of credit ratings, and with double safety-nets in form of trustees, etc., securitization makes it possible for the lay investors to invest in direct financial claims at attractive rates. This has salubrious effect on savings. Reduces costs:

As discussed above, securitization tends to eliminate fund-based intermediaries, and it leads to specialization in intermediation functions. This saves the end-user company from intermediation costs, since the specialized-intermediary costs are service-related, and generally lower. Diversifies risks:

Financial intermediation is a case of diffusion of risk because of accumulation by the intermediary of a portfolio of financial risks. Securitization further diffuses such diversified risk to a wide base of investors, with the result that the risk inherent in financial transactions gets very widely diffused. Focuses on use of resources, and not their ownership:

Once an entity securitizes its financial claims, it ceases to be the owner of such resources and becomes merely a trustee or custodian for the several investors who thereafter acquire such claim. Imagine the idea of securitization being carried further, and not only financial claims but claims in physical assets being securitized, in which case the entity needing the use of physical assets acquires such use without owning the property. The property is diffused over an investor crowd. In this sense, securitization carries Gandhi's idea of a capitalist being a trustee of resources and not the owner. Securitization in its logical extension will enable enterprises to use physical assets even without owning them, and to disperse the ownership to the real owner thereof: the society.

PARTIES INVOLVEDSecuritization normally involves a wide variety of counterparties and advisers. On one particularly complex transaction a few years ago there were 6 law firms, 3 firms of accountants, 1 insurance broker, 1 investment bank, 1 consultant and 12 principals (banks, originators, administrators, credit enhancers, underwriters and so on).

A transaction normally involves the following parties:

Originator and Administrator

Lead Underwriter who purchases the debt issued by the SPV (and sells it to Eurobond investors)

Structuring Team either involving personnel from the lead underwriter and/or other advisers

Two sets of lawyers, at least one of whom is a securitization specialist

Trustee and Trustee's lawyers representing the interests of the note holders in the event that there is (a) an enforcement event (things go wrong) or (b) any requirement to change or amend the documents or procedures after the transaction completes;

Rating Agencies required to undertake an analysis of the risks associated with the transaction and to award a credit rating to the debt issued

Originator's accountants to agree accounting treatment for the transaction, to verify the analysis and existence of the assets involved and to confirm work undertaken to show solvency

Credit Enhancement Providers and their lawyers transactions often involve a third party fronting some of the risks associated with the assets

Standby Servicer and their lawyers a third party prepared to administer the assets in the event that the existing servicer fails or is incompetent; this is now becoming a requirement for all transactions where the administrator does not already have at least an A1/P1 short term rating

Clearing Bank and its lawyers running the originator's and the Issuer's bank accounts, all of which normally require new mandates and a Bank Agreement is also set up to regulate the operation of all aspects of the accounts

Banking Facility Providers and their lawyers often there are requirements for additional banking facilities, e.g.: liquidity facilities or guaranteed deposit arrangements ("GICs")

Hedging Providers and their lawyers Paying Agents, Agent Banks, Common Depositary etc. a whole host of organizations with Euro market responsibilities

SPECIAL PUROSE VEHICLE

As opposed to a general purpose vehicle or a trading corporation, a Special purpose vehicle, as the name suggests, is formed for a special purpose: therefore its powers are

limited to what might be required to attain that purpose and its life is destined to end

when the purpose is attained.

When a corporation, call it the sponsor of the SPV, wants to achieve a particular purpose, for example, funding, by isolating an activity, asset or operation from the rest of

the sponsor's business, it hives off such asset, activity or operation into the vehicle by

forming it as a special purpose vehicle. This isolation is important for external investors

whose interest is backed by such hived-off assets, etc., but who are not affected by the

generic business risks of the entity of the originating entity. Thus SPVs are housing

devices - they house the assets etc transferred by the originating entity in a legal outfit,

which is legally distanced from the originator, and yet self-sustained as not to be treated

as the baby of the originator.

By its very nature, an SPV must be distanced from the sponsor both in terms of management and ownership, because if the SPV were to be owned or controlled by the

sponsor, there is no difference between a subsidiary and an SPV.

Being an independent, an SPV is responsible for its own funding, risk capital and management decisions. Most SPVs, for example, securitization SPVs, run on a prepunched program and do not have to take any management decision: they are almost "brain dead".

Why create an SPV?

The creation of the trust serves to separate the risks of newly created securities from the risk of the originating bank. This helps the investors in the new securities to clearly identify and assess the risk of the securities. A common reason for the failure of an issue of securities by an institution is that investors have difficulty in assessing the risk attached to the security. This is because the risk attached to the security is closely interwined with he overall risk of the issuing institution, which is complex and hard to assess.

SECURITIZATION PROCESSFollowing are the steps typically involved in a securitization process:

Identify and/or accumulate assets:

These assets could include anything from airline ticket receivables, hire-purchase rental receivables, sales cash flows of any commodity, et al.

Values are represented by future cash flows and it is essential to recognize a specific timeframe for this purpose. The market for each security will define what investor-relevant information is. This information is normally checked through credit-rating agencies that verify the credibility of the projected cash flows and the stability of their sources.

Transfer or insulate assets from transferors creditors:

Assets are isolated usually through a true sale or clean transfer by the originator to a bankruptcy-remote SPV that will issue the securitized bonds.

The issuing SPV may be either a limited purpose company, or a trust established under a restrictive deed. In both cases the SPV will be managed by an independent trustee, so that the issuer has no conflict of interest with the security.

Also acceptable is the assignor retaining legal title to the underlying asset but holding such a title subject to the equitable interest of the assignee. This effectively means that the title to the asset will be held by the borrower (assignor) subject to the first change in favour of the lender (assignee).

Issuing bonds:

The issue of debt bonds is how the anticipated cash flows from the assets are transformed into cash in hand either by an SPV offering bonds to the public or the private investor market.

The FI as an underwriter will take an initial investment position in the debt and later offload it in the market, thus making a margin. This creates a huge market for term lending and improves the performance of the FIs.

Every securitization requires the appointment of a servicer or administrator to collect and distribute obligor payments from the assets performance, manage the collection of recoveries for defaulted monitor and report on receivables.

The administrator is entitled to receive a fee for the services, paid out of the collections on the assets. This fee represents one of the methods to compensate an originator for transferring its rights to the assets.

Enhance and support assets and/or securities

The advantages of isolating cash flows and using them to service issued debt obligations may justify securitization. Nevertheless, ABS and MBS investors may prefer structures to contain explicit enhancements that may improve the assets performance. Others may boost the performance of the structure, or guarantee payments to investors.

SECURITIZATION STRUCTUREFigure 1 below presents a typical Securitization Structure.Figure 1: A typical Securitization Structure

Flows at the time of Securitization Periodic Cash flows post Securitization (repayment by borrowers passed on to investors)

1. Assets are originated by a company, and funded on that company's balance sheet. This company is normally referred to as the Originator".

2. Once a suitably large portfolio of assets has been originated, the assets are analyzed as a portfolio, and then sold or assigned to a third party which is normally a special purpose vehicle company (an " SPV") formed for the specific purpose of funding the assets. The SPV is sometimes owned by a trust, or even, on occasions, by the Originator.

3. Administration of the assets is then sub-contracted back to the Originator by the SPV.

4. The SPV issues tradable "securities" to fund the purchase of the assets. The performance of these securities is directly linked to the performance of the assets - and there is no recourse (other than in the event of breach of contract) back to the Originator.

5. Investors purchase the securities, because they are satisfied (normally by relying upon a rating) that the securities will be paid in full and on time from the cash flows available in the asset pool. A considerable amount of time is spent considering the different likely performances of the asset pool, and the implications of defaults by borrowers on the corresponding performance of the securities. The proceeds upon the sale of the securities are used to pay the Originator.

6. The SPV agrees to pay any surpluses which arise during its funding of the assets back to the Originator - which means that the Originator, for all practical purposes, retains its existing relationships with the borrowers and all of the economics of funding the assets (i.e.: the Originator continues to administer the portfolio, and continues to receive the economic benefits (profits) of owning the assets).

7. As cash flows arise on the assets, these are used by the SPV to repay funds to the investors in the securities.

The original concept of securitization was to create securities based on financial assets, say, receivables on mortgage loans, auto loans, credit cards, etc. However, later innovation has extended application of securitization to cover non-financial assets such as aircraft, buildings, and on the other hand, the same device has also been applied to securitize risk, such as insurance risk, weather risk, etc.

Let us consider an example:

A finance company with a portfolio of car loans can raise funds by selling these loans to another entity. But this sale can also be done by securitizing its car loans portfolio into instruments with a fixed return based on the maturity profile (the period for which the loans are given). If the company has Rs 100 crore worth of car loans and is due to earn 17 per cent income on them, it can securitize these loans into instruments with 16 % return with safeguards against defaults. These could be sold by the finance company to another if it needs funds before these loan repayments are due. The principal and interest repayment on the securitized instruments are met from the assets which are securitized, in this case, the car loans.

Selling these securities in the market has a double impact. One, it will provide the

company with cash before the loans mature. Two, the assets (car loans) will go out of the books of the finance company once they are securitized, a good thing as all risk is removed.

Forms of Securitization Structures

The financial structure of the securitized product is a function of the type of the instrument to be issued i.e. Pass Through Certificates (PTC) or Pay Through Certificates (Bonds /Debentures). In both the cases, assets are sold to SPV for further sale to investors in the form of a new instrument. However, the similarity ends here. In case of PTC, investors get a direct undivided interest in the assets of SPV. The cash flows which include principal, interest and pre-payments received from the financial asset are passed on to investors on a pro rata basis after deducting the servicing fee etc. as and when occurred without any reconfiguration. Therefore, the investor takes the reinvestment risk on the payments received. The frequency of the payment is dependent on the frequency of the payment from the financial assets. (Figure 2)

The PTC structure has a long life and unpredictable cash flows that inhibit participation by some of the fixed income investors. The pay through structure reduces the term to maturity and provides some certainty regarding timing of cash flows. It is issued as a debt security (bonds / debentures) and designed for variable maturities and yield so as to suit the needs of different investors. The debt instrument is issued in the form of a tranche and each tranche is redeemed one at a time. In this case, cash flows are to be reconfigured since they have to match the maturity profile of the debt security. The payment to investors is at different time intervals than the flows from the underlying assets. Therefore, the reinvestment risk on the cash flows till they are passed on the investors is carried by the SPV. (Figure 3)

The Act has named the securitized instrument as Security Receipt which has been added as a security in The Securities Contract (Regulation) Act, 1956 and thereby makes it available for trading through stock exchange mechanism. As per the definition of security receipt in the Act (section 2(zg)) transfer of only an undivided interest in the financial asset is allowed and thus the Act recognizes only pass-through certificates (PTC) as the possible instrument for securitization. This has eliminated the possibility of issuing pay through certificates in Indian markets which are more investor friendly and are the norm in the international markets outside USA.

Figure 2: Pass through Structure

Figure 3: Pay Through Structure

TYPES OF SECURITIZATION

To analyze the potential of securitization India, we split the securitization market into the following four broad areas: -

Asset Backed Securities (ABS)Asset backed Securities are the most general class of securitization transactions. The asset in question could vary from Auto Loan/Lease/Hire Purchase, Credit Card, Consumer Loan, student loan, healthcare receivables and ticket receivables to even future asset receivables. The split of outstanding ABS in the US is given in Figure 4

Figure 4

In the Indian context, there has been moderate amount of activity on the Auto Loan securitization front. Companies like TELCO, Ashok Leyland Finance, Kotak Mahindra and Magma Leasing have been securitizing their portfolio of auto loans to buyers like ICICI and Citibank over the past 2-3 years, with several of the recent transactions rated by rating agencies like CRISIL and ICRA. While many of the deals are bilateral portfolio buyouts, ICICI has used the SPV structure * and placed the issuance privately to corporate investors and banks.In April last year, Global Tele-Systems Ltd. raised approximately USD 32 million by securitizing the future receivables of its consumer telecom business to an SPV named Integrated Call Management Centre. Tata Finance was the sole investor in the pass through certificates issued by the SPV.One of the first publicized structured finance transactions in India was the Rs. 4.09 billion non convertible debenture program by India Infrastructure Developers Ltd (IIDL), an SPV set up for building and operating a 90 MW captive co-generation power plant for IPCL (March, 1999). IIDL raised finances on the BOLT (Build Operate Lease Transfer) model on the strength of its future cash flows from IPCL and limited support from L&T. The transaction was rated AA- (SO) by CRISIL.ICICI has done several bilateral asset backed securitization deals including securitizing DOT (Department of Telegraph) receivables from Sterlite Industries and Usha Beltron.

While the activity in the ABS market is picking up in India, the number of investors for securitized paper is very limited. In the absence of a Securitization Act, there are taxation and legal uncertainties with the securitization vehicle. In India, transfer of secured assets as required for securitization, can attract a stamp duty as high as 10% in some states precluding transaction possibilities. With favorable legislation and taxation regime, the ABS market in India can hope to see a lot of activity in future.

Future Cash Flow Receivables Asset securitization processes have been structured not only based on the collateral of existing assets but also on the collateral of future cash flow receivables. Such a structure enables asset securitization to be used as a corporate finance tool or as a tool for financing future projects. The securitization process works as follows. The trust or the SPV that is set up to carry out the securitization buys the rights to a specified stream of cash flows that is expected to be generated by the company or the planned project. The SPV will issue bonds against the collateral of the cash flow receivables. Principal and interest payments on the bonds will be met from the project receivables. Any surplus

from the receivables will be passed back to the company.

TYPES OF ASSETSAll assets that generate funds over time can be securitized. These include repayments under car loans, money due from owners of credit cards, airline ticket sales, toll collections from roads or bridges, and sales of petroleum-based products from oil refineries. In fact, artists have even raised funds by securitizing the royalty they will get out of future sales of their records.

Securitization works well if the securitized asset (say, the pool of car loans) is

homogenous (the same kind) with regard to credit risk (how sound the borrower is) and maturity. Ideally, there should be historical data on the portfolios performance and that of the issuing company with regard to credit quality and repayment speed.

Asset CharacteristicsAssets which can be securitized easily have a number of characteristics:

Cash-flow A principal part of the asset is the right to receive a cash flow from a debtor in certain amounts (or amounts defined by reference to a market or administered rate) on certain dates i.e.: the asset can be analyzed as a series of cash flows.

SecurityIf the security available to collateralize the cash flows is valuable, then this security can be realized by the SPV. For instance, for a mortgage loan, there is security over the property and other collateral, which will make a significant contribution towards recovering any losses which might otherwise arise. Consequently, if there is a default, an effective method of ensuring that the SPV can gain the benefit of the security will be required (otherwise securitization will be an uneconomic way of arranging funding).

Distributed risk Assets either have to have a distributed risk characteristic or be backed by a suitably-rated credit support. For instance: a single retail loan is relatively small in value in the context of the available supply of retail loans to a single transaction (normally in the region of 4,000 mortgage accounts or 100,000 personal loans or small leases); in this way, the performance of one single asset is not likely to distort the performance of the entire portfolio. Consequently, the entire portfolio can be considered as a single asset, with a predictable performance. Concentrations of risk do not have this characteristic. If individual assets were to have a significant value in relation to the whole (e.g.: suppose only 100 mortgages were to be securitized) then a different approach has to be taken, and these individual assets have to be analyzed individually and specific enhancement arranged. HomogeneityAssets have to be relatively homogeneous - this means that there are not wide variations in documentation, product type or origination methodology. Otherwise, it again becomes more difficult to consider the assets as a single portfolio.

No executory clauses The contracts to be securitized must work, even if the Originator goes bankrupt. Certain clauses are therefore difficult to include in a securitisable contract -e.g.: in a photocopier lease, the inclusion of a clause stating that the Originator will maintain the photocopier would make that lease difficult to securitize. These sorts of contract are normally referred to as "executory contracts".

CapacityIt must be possible for the necessary transactions which are needed for the securitization to take place in relation to the assets concerned - for instance, if the assets contain specific prohibitions against assignment, then they will not be securitisable in the traditional sense.

Independence from Originator The on-going performance of the assets must be independent of the existence of the Originator. This tends to be a wider restriction than the example given above about executory contracts. A number of technical matters can arise, for instance, if asset yields are quoted only by reference to the Originator (e.g.; as the Originator's rate), then this will cause a structural difficulty in the event of the Originator's insolvency (i.e.: what now is the rate that the assets yield?).

Home equity loans

Meaning of home equity loans:Home equity is basically a second loan against the mortgage of a house. The possibility of such a loan arises when the value of a house is more than the outstanding value of a mortgage - quite likely situation after the first mortgage has been partly amortized. The second lender takes a second mortgage over the house, normally secondary in priority over the rights of the first lender, and provides funding. Normally, the home equity loans do not find its application in the same house: application of the money borrowed is normally not controlled.

A home equity loan could either be a close-end loan: meaning the loan is paid off over a stated period, or it may be a line of credit, that is, one where the borrower pays regular interest but continues to enjoy the line of credit as an overdraft against the value of the house.

In the US securitization market, home equity loans forms a significant portion of non-RMBS transactions.

Data for year 2000 reveals home equity loan securitization forms approximately 25% of the total ABS market. In contrast sub prime mortgage loans form less than 10%, some estimates say only 6%, of the European mortgage-backed market. Auto loans

Auto loans securitization market:

Ever since the emergence of the ABS market, auto loans have formed an important segment. The interesting features of auto loan markets are high asset quality and ease in liquidation of delinquent receivables. The emergence of an alternative in form of asset-backed commercial paper has reduced the significance of auto loan securitizations, but the activity in this segment is still important.

Product structure

The quality of auto loans depends upon the quality of the underlying collateral, lending terms (loan to value ratio), and tenure. Recent years have seen tremendous competition in auto loan financing segment with concomitant deterioration in the quality of the loans - there is an increased proportion of used car loans versus new car loans, the loan to value ratio has worsened and the financings are for a longer period now.

Hence, increased importance is attached today to the quality of the originator.

Typical features:

The payment structure of auto loans normally ranges between 3 to 6 years which is ideal for direct pass throughs as well as collateralized bonds.

An important legal issue for auto loan securitization is whether the assignment of receivables achieves a "true sale" recognized by law. Here the understanding of the legal features of the concerned market becomes important.

Bank securitization

Collateralized Debt Obligations (CDO, CLO, CBO)There is no basic distinction between generic securitizations and the CBO/ CLO issuance at the instance of banks, except that here, the originating bank is trying to parcel out a pool of loans or bonds held by the bank. There could also be a difference of motivation: while for usual securitizations, the stronger motivation is liquidity, in case of CBO/ CLOs, the motivations could rank from capital relief, to risk transfer, to arbitraging profits, to balance sheet optimization, etc.Where the originating bank transfers a pool of loans, the bonds that emerge are called collateralized loan obligations or CLOs. Where the bank transfers a portfolio of bonds and securitizes the same, the resulting securitized bonds could be called collateralized bond obligations or CBOs. A generic name given to the two is collateralized debt obligations or CDOs, as in a number of cases, the portfolio transferred by the bank could consist of loans as well as bonds, and at times, even ABS. At a recent meeting of securitization professionals at Arizona in Feb., 2000, some participants even reported the emergence of a new bank securitization instrument: collateralized investment obligations (CIOs) where a bank securitizes its equity investments.Difference between normal securitizations and CDO structures:Though there is no basic difference in terms of the essential structure, some differences arise by the very nature of the collateral and the motives of the issuer. The important points of difference are:

The number of obligors in the collateral pool are not many: unlike mortgage portfolios or auto loans portfolios having thousands of obligors, CDO pools will have 100 -200 loans.

The loans/ bonds are mostly heterogeneous. The originator might try to bunch together loans which do not exhibit any mutual correlation, to provide benefits of a diversified portfolio.

Most CDO structures use a tranched, multi-layered structure with a substantial amount of residual interest retained by the originator.

Generally, CDO issues will use a reinvestment period and an amortization period. Some tranches might have a "soft bullet" repayment (meaning a bullet repayment that is not guaranteed by any third party).

A common practice in CDO market is arbitraging, where larger banks buy out loans from smaller ones and securitize them, making arbitrage revenues in the process. Motives in CBO/ CLO issuance:

Banks would resort to securitization essentially with 4 motives, in different combinations: sourcing cheaper funds, attaining higher regulatory capital, better asset-liability management, and reduced non-performing or under-performing assets.

There is yet another class of CDOs is called arbitrage CDOs where the originating bank buys loans/bonds from the market and securitizes the same for gaining an advantage on the rates. Since the motive of such securitizations is arbitraging, such CDOs are called arbitrage CLOs/ CBOs. To distinguish these from the ones where a bank securitizes its own receivables, the latter are called balance sheet CLOs/ CBOs.Yet another variety of CLOs is developing fast: synthetic CLOs. Here the originating bank retains the loans on its balance sheet but merely securitizes the inherent credit risk. Synthetic CLOs repackage the underlying loans into cash flows that suit the needs of the investors and are not dependant on the repayment structure of the underlying loans. Types of CDOs:As the above discussion reveals, CDOs could basically be of two types: balance sheet CDOs and arbitrage CDOs. Balance sheet CDOs are those which result into transfer of loans from the balance sheet and hence, which impact the balance sheet of the originator. Arbitrage CDOs are those where the originator is merely a repackager: buying loans or bonds or ABS from the market, pooling them together and securitizing the same. The prime objective in balance sheet CDOs is the reduction of regulatory capital, while the evident purpose in arbitrage CDOs is making arbitraging profits.

Balance sheet CLOs could be further classed into two: cash flow CDOs, and synthetic CDOs. Cash flow CDOs are the usual CDO tranches where the originating bank transfers a portfolio of loans into an SPV. Master trust structures are commonly employed in CDOs to enable the bank to keep transferring loans into the pool on a regular basis without having to do complex documentation everytime. Commercial loans are not regular-repaying in the sense of mortgage loans or auto loans. Hence, there is no question of regular retirement of CDOs like pass throughs in the mortgage market. Most of the cash flow CDOs repay by way of bullet repayments, and hence they need to have a reinvestment period during which the cash collected will be reinvested. Synthetic CDOs do not intend to raise cash by transferring loans, but instead merely transfer the risk inherent in the loans. In a synthetic CLO, the originating bank does not transfer the loans off its books but merely transfers the credit risk in the loans by issue of credit linked notes. The reference asset is the loans held by the bank - as the credit risk in the loans is transferred to the SPV and from there on to the investors, the originating bank achieves regulatory capital relief.The technique in a synthetic CDO consists of an SPV issuing credit linked notes to investors. The proceeds of the securities do not come to the originator, but are instead invested in AAA rated securities, to ensure that the repayment of principal to the investors is secured. The SPV in turn writes a credit default swap with the originating bank. For more on credit default swaps and other credit derivatives. The loans remain on the books of the originating bank. The bank keeps paying credit default swap premium to the SPV. Should there be any default event with the originating bank, the bank would seek a payment from the SPV, in which case the investors of the SPV would suffer losses. As long as the default event does not take place, investors get returns equal to (a) returns from the AAA-rated investments and (b) the default swap premium.Synthetic CLOs have a very substantial advantage over traditional CLOs - as there is no transfer of the loans itself, the legal issues associated with notice to obligors and perfection of legal transfer are all completely avoided.As regards regulatory capital relief on synthetic CLOs, the US FRB issued a supervisory statement no. 99 -32 dated 15th Nov., 1999. The said circular provides that for the purposes of risk-based capital, the originator may treat the cash proceeds from the sale of credit linked notes that provide protection against underlying reference assets as cash collateralizing these assets. This would permit the reference assets, if carried on the sponsoring institutions books, to be assigned to the zero percent risk category to the extent that their notional amount is fully collateralized by cash. This treatment may be applied even if the cash collateral is transferred directly into the general operating funds of the institution and is not deposited in a segregated account. The synthetic CLO would not confer any benefits to the sponsoring banking organization for purposes of calculating its Tier 1 leverage ratio because the reference assets remain on the organizations balance sheet.

In this era of bank consolidations, CDOs can help banks to proactively manage their portfolio. CDOs can also help banks in restructuring their stressed assets. ICICI made an aborted attempt to do a CBO issuance in August 2000. The CDO market in India is, however, likely to grow slowly owing to its complexities. The taxation and accounting treatment for CDOs needs to be clarified. Mortgage Backed Securities (MBS, RMBS, CMBS)Securitization of residential mortgages is the mother of all securitizations. Residential mortgage-backed securities (RMBS) are generally pass through securities or bonds based on cash flows from residential home loans, as opposed to commercial real estate loans.

Evidently enough, the residential mortgage market was one of the most appropriate applications of securitization. That is why, for good reasons, some or the other way of refinancing mortgages has been found in most parts of the world. If in USA, it was securitization, in Europe, a traditional mortgage funding instrument, Pfrandbriefe has been in vogue for almost 200 years.

There are two very strong reasons for RMBS being tuned to securitization: one, the long maturities of residential mortgages, and two, the fact that mortgage lending is backed by charge over real estate, which is a strong asset-backing enabling the investors to take an independent exposure on the receivables. The govt. support to development of secondary markets in mortgages has also been a strong reason, and the governments easily took this as one of their major welfare activities.

Typical features:

Most of the mortgage funding is for very long maturities: say, 15 years to 30 years.

If the securitization is a pass-through, the investors will get paid over such a long period, say 20 years. As that is too long a period for most investors, it is common for mortgage securitizations to adopt the bond method (collateralized mortgage obligations) which are repayable in different maturities.

RMBS could be either agency-backed or non-agency-backed. Agency-backed refers to the transactions pooled and bought by specialized securitization agencies such as FNMA (Federal National Mortgage Association) and GNMA (Government National Mortgage Association). Outside the USA also, several countries have put up their own models of FNMA as entities that buy mortgages and securitize them. Mortgages securitized by the agencies normally provide the guarantee of the agency to the investors.

If the mortgages are secured by the guarantee of the government or the securitization agency (such as GNMA or FNMA in the USA), the only risk that the investors carry is the risk of prepayment.

Depending on the level of development of securitization, mortgage securitization market can be a highly commoditized market where mortgage origination, servicing and administration can all be viewed by the market as independent commodities and be regularly traded. As we discussed above, MBS constitutes about 76% of the securitized debt market in the US. In contrast, the MBS market in India is nascent - National Housing Bank (NHB), in partnership with HDFC and LIC Housing Finance, issued Indias first MBS issuance in August 2000.In traditional mortgages, prior to securitization, home buyers obtain loans from mortgage originators. Typically, originators lend to many home buyers; thus, they end up with a loan portfolio. Such loan portfolios may either be held by the originator or sold to other investors. The demand for credit, therefore, comes from home buyers, and the mortgage originators supply the necessary credit. When the demand exceeds the supply in a region, thrifts will sell their loan portfolio (which they originated) in order to supply additional credit. When the supply exceeds the demand in a region, thrifts will buy portfolios from other regions. Often, redistribution of mortgage credit from capital-surplus to capital-deficit regions is necessary, and to accomplish this, usually the loans are sold and bought by thrifts and mortgage banks around the country. When the overall demand for credit grows at a rate that cannot be sustained by suppliers of credit, the deposit base of lenders may simply be unable to support the demand for credit. For a liquid secondary market in mortgage loans to develop, it is necessary that some of the following conditions are met:

The originators must continue to service the loans.

The loans must be standardized with respect to maturity, coupons and so on.

There must be a credible guarantee regarding the performance of home buyers in paying the loan back.

The potential of MBS in India, however, is huge. With NHB actively looking towards the development of a Secondary Mortgage Market (SMM) in the country, the MBS market in India could soon overtake the other securitization transactions in the country. An MBS market can help small HFCs with good origination capabilities and limited balance sheet strength in staying profitable and concentrate on the housing loan origination. The most important roadblocks for MBS in India are lack of mortgage foreclosure norms and the high incidence of stamp duty for assignment of mortgage necessary for securitization.CALCULATION OF MONTHLY CASH FLOWSNow we shall see how the monthly cash flows are calculated for a fixed rate mortgage (FRM). The traditional mortgage is the 30-year FRM with level monthly scheduled payments. This is an amortizing loan, wherein level monthly payments are scheduled over 360 months so that the loan is retired at the end of 360 months.

We illustrate the calculation of monthly payments, interest components and principal components for a standard 30-year FRM. Let Fo be the face value of the loan that was taken, let n be the original term of the loan in months, and let R be the annualized interest that is specified in the FRM. Then, the monthly payments x are computed as shown in equation 1 where r= R/12. x = Fo x r (1 + r)n ...(1)

[(1 + r)n 1]Then the principal payments will be simply,

Ft-1 Ft

.(2)

The interest payments for the month t are given by

(R/12) x Ft-1

.....(3)

The figure 5 shows the pattern of scheduled interest and principal payments over the life of the mortgage. Note that in the early life of the mortgage, most of the monthly payments x are applied towards repaying the interest component of the loan. It is toward the end of the life of the mortgage that the payments towards principal constitute a major part of the monthly payments. As the mortgage gets older, the outstanding principal balance declines and, as a consequence, the interest payments decline. Since the monthly scheduled payments are fixed, this means that the scheduled principal payments will increase.

PrepaymentsMortgages permit the homeowners to prepay their loans. This prepayment provision introduces timing uncertainty into the originating banks cash flows from its loan portfolio. For example, if the bank originates a pool of mortgages with a weighted average rate of 8% and six months later the mortgage rates drop significantly below 8%, say to 7%, then the loan portfolio is certain to experience significant prepayments as borrowers rush to refinance their mortgages with less costly loans. The lender has a long position in the mortgage loan that entitles him or her to monthly scheduled payments, but has also sold an option to the homeowners that gives them the right to repay the loan when the circumstances demand it. This means that the bank cannot predict the future cash flows from its loan portfolio with certainty. Clearly, the option to prepay will be priced into the loan by the bank, and the borrower will pay a higher interest rate on the loan as a consequence.

Constant Monthly Mortality: This is a measure of payment that assumes that there is a constant probability that the mortgage will be prepaid following the next months scheduled payments. For instance, consider the assumption that there is a 0.50% probability that the mortgage will be prepaid following the first month.This 0.5% probability is referred to as the single monthly mortality rate or SMM. Using the SMM, we can compute the probability that the mortgage will be retired in the next month. It depends on two factors: (a) the probability that the mortgage will survive the first month, 1-0.5% = 99.5%; and (b) the mortality rate for the month 2 (given that it survived the first month), which is 0.5%. so the probability that the mortgage will be retired in month 2 is 0.5% x 99.5% = 0.4975%. using this, we can say that the probability that the mortgage will be retired in month 3 is (1- 0.4975%) x 0.5% = 0.25125 and so on.

Usually, an annual prepayment known as the conditional prepayments rate (CPR) is used to measure the speed of the prepayments. Given an annual CPR, we can estimate the SMM. Remember that the probability the mortgage will survive a month is (1-SMM). For a period of one year, the probability of survival is (1-SMM)12. this is set equal to (1 CPR). So we get:

(1-SMM)12 = 1 CPR

or,

CPR = 1 (1-SMM)12 If SMM is 1%, it implies that 1% of the outstanding principal is paid down each month.The Public Securities Association (PSA) assumes that 0.2% of the principal is paid in the first month and will increase by 0.2% in each of the following months., finally leveling out at 6% until maturity. This convention is referred to as the 100% PSA. The PSA benchmark is not a model of prepayments but used as a benchmark in the industry. Mathematically, the PSA benchmark can be expressed as follows:

Months 1 to 30: CPR = 6% x t/30,

Where t is the number of months since the origination of the loan, or

Months > 30: CPR = 6%

Mortgage cash flows with prepayments:We can construct future cash flows from a single loan with a face value of Rs. 100,000 and a rate of 9%. The mortgage loan has a life of 30 years. Prepayments are assumed to occur at a rate of 100% PSA. We detail the calculations next:

First, using the prepayment rate assumption, we can compute the SMM for month t = 1 as follows:

CPR = 6% x 1/30 = 0.06/30 = 0.002SMM = 1 (1 CPR)1/12 = 1 (1- 0.002)1/12 = 0.00167

As noted earlier, the method of calculating SMM is the same until t = 30. After t = 30, CPR = 6% until the loan is retired. Note that SMM = 0.005143 after t = 30 until end. Second, total mortgage payments at t = 1 are obtained by applying equation (1) with Fo = 100,000, n = 360 and r = 0.09/12. we get the payment x at t = 1 to be 804.62. we calculate the interest payment by multiplying the outstanding balance with the monthly interest rate. For t = 1, we get 100,000x 0.09/12 = 750.

The scheduled principal payment at t = 1 is obtained by subtracting the interest payments from the total mortgage payments: 804.62 750 = 54.62.

Finally prepayments at t=1 are computed by applying SMM to the remaining principal:

= 0.000167 x [100,000 54.62]= 16.67

Total principal outstanding at t = 2 is obtained by subtracting the total principal payments at t = 1 from 100,000 to get:

100,000 [54.62 + 16.67] = 99,928.70 We then apply the procedure each time to get the projected future cash flows of the mortgage loan.

RISKS INVOLVED IN SECURITIZATIONThe inherent nature of the securitized instrument makes it less risky. The cash flow from the securitized instrument is backed by tangible identified financial assets earmarked exclusively for an instrument and is independent of the originator. Dependability of these cash flows is further strengthened as signified by the ageing of the portfolio. This means, an asset having a cash flow for three years would be monitored for the first 8 to 10 months to determine its historic loss profile. Earmarking a specific pool of aged assets is the core feature contributing to lowering the risk associated with securitized product. Further, the pool of borrowers creates a natural diversification in terms of capacity to pay, geography, type of the loan etc and thereby lowers the variability of cash flows in comparison to cash flows from a single loan. So, lower the variability, lower is the risk associated with the resulting securitized instrument.

With such multiple options for risk reduction and natural diversification inherent in the

product, can a securitized instrument be presumed to be risk free? No. Primary risks

associated with securitized product are pre-payment risk and credit risk. The pre-payment means refinancing at lower rate of interest or early repayment of the loan amount in part or in full. This risk is associated with mortgaged backed products using the pass through structure (PTC). Generally, loan agreements allow the borrower to make an early payment of the principal amount. The risk originates from the possibility of obligor making such early payment of principal amount and thereby disturbing the yield and the investment horizon of the investors. For premium securities, accelerated pre-payment reduces the average life and yield since the principal is received at par which is less than the initial price. Opposite is the case of securities purchased at a discount. Consequently, investors have to predict the average life of such securities and may have to look for alternate investment opportunities in a changed interest rate scenario.

The Act provides for PTC as the securitized instrument and so the pre-payment risk will

exist in Indian market. Factors affecting pre-payment and corresponding pre-payment

models to evaluate this risk will have to be developed in order to make investment decisions.

Credit risk reflects the risk that the obligor may not be able to make timely payments on the loans or may even default on the loans. In case of defaults, internal and external risk

enhancement measures will come into play. Finally, the mortgaged backed securitized product in the foreign markets are backed by a guarantor who guarantee to the investors the timely payment of interest and principal. As of now, such guarantees do not exist in Indian market. However, National Housing Board (NHB) is working in this direction to guarantee securitization of housing loan mortgages.

CREDIT RISK

Rating Agencies really only deal with credit risk as a commercial matter (i.e.: they will make an assessment of credit risk). All other risks have to be structured out, dealt with beyond doubt or shown to be sufficiently remote. Sufficiently remote normally means inconceivable. Any residual concerns which are not specifically analyzable as credit risks will involve serious costs for the structure (e.g.: corporation tax and VAT risks).

SOLVENCY

Both rating agencies need to feel comfortable that the seller of the assets is solvent and is expected to remain solvent for a period of two years from the date of the transaction. Proving solvency to this standard is not a straightforward exercise. The legal definition of solvency is a 20 page paper, and the tests which are necessary to show that a company is solvent can be tortuous. A true solvency analysis will also take into account contingent assets and liabilities (including deferred tax) which are not normally shown on the face of a balance sheet, and will require a comprehensive and detailed analysis of the balance sheet and projected cash flows.

TAX RISKS

The rating agencies require tax, accounting and actual cash surpluses to be in step (or to the extent out of step, so that it does not matter) throughout the transaction and in a variety of tax, interest rate and credit environments. CORPORATION TAX Since the Inland Revenue does not give advance rulings on the likely tax treatment of different structures, the rating agencies normally require the structures to be analyzed across all potential tax treatments. On the Anglo transaction, for instance, it was determined that there were 9 different potential tax treatments for the transaction. Each had to be analyzed, and the 3 principal tax treatments had to be modeled in detail. STAMP DUTY If stampable transfers are involved, then it would be normal for the transfers to be completed offshore. However, the rating agencies normally consider that the assets could be repatriated (if the trustee was required to enforce the security) and therefore provision has to be made to pay any stamp duty which COULD then become payable. If more than one transfer has been made, then double, or even triple stamp duty provision can be needed. This is a real capital cost to the transaction, but careful management and structuring can enable the capital so required to be used efficiently. SPECIFIC LEGAL RISKS

This is an area which the lawyers specializing in securitization will be able to advise on more fully. These are normally dealt with by either investigation or by the production of an opinion. However, a thumbnail sketch follows: Title

Nothing must be capable of upsetting the title to the assets which the Issuer is acquiring. Dealing with these concerns is often not straightforward. No charges (actual or implied) must be capable of operating so as to restrict the originator's ability to sell the assets, in particular in existing banking facilities. This means a thorough review of any likely source of implied right to the assets is required. Consequently, if the assets have passed through a number of hands prior to the securitization, then each transfer has to be considered. Portfolios purchased from other companies raise particular problems.

The question as to the solvency or insolvency of any company involved at any stage with the receivables has to be addressed. Contractual

All of the agreements must be binding upon all of the parties. The Issuer must be properly constituted etc.... Statutory

CCA regulated agreements in particular cause problems of their own. A full CCA review of the documents is normal practice. Similarly, product liability issues need to be analyzed out or shown to be the minimum. SPECIAL RISKS

Each structure has to address different problems. Sometimes the answer to these problems is empirical (i.e.: the risk is included in the analysis of the transaction and quantified). However, some points can only be dealt with by legal analysis and an opinion. The extent to which the law firm involved is prepared (on occasions) to be slightly "sporting" can be critical. Set off and related risks

Set off can occur in a variety of ways for instance: lessees could have deposited money with an originator of the assets (who then becomes insolvent), or lessees could have paid for maintenance of equipment (which is then not carried out). Even if there is no legal justification for the set off (i.e.: the lessor is wrong), it may still have to be taken into account in the structure. Similar risks relate to the position of the Issuer in the event that there is a liquidation of the administrator. A critical aspect of the structure will be the consideration of the liquidator's rights in this circumstance can the collection of the Issuer's receivables (and their payment to the Issuer) be interrupted or stopped?

Executory contracts

Contracts which impose obligations upon the lessor are not generally securitisable. An example of an obligation would be procuring that maintenance is carried out, or agreeing to collect funds on behalf of a third party. The concern arises from a view that, were these obligations to be carried out poorly, then the lessor would be in default, which could then permit the lessee to avoid his obligations. A lessee may also have the right to reject the replacement of the lessor with a third party. Essentially the problem is that the contract becomes personal to the particular lessor and not generic. However, there are certain techniques and credit enhancement structures which could be used in these circumstances.

Unsecured creditors

The rating agencies are also concerned to ensure that either the Inland Revenue or HM Customs do not become unsecured creditors to any part of the transaction structure in other words, that there are known liabilities to either body which might not be met at any future point. This is considered to give an excuse to "go after" the Issuer or the structure as a whole to try to recover assets which have been sold to the Issuer and unravel the deal. A detailed investigation of the deferred tax positions of the originator and any group companies is therefore required. Plans have to be made to show how any resulting liabilities are proposed to be paid, given certain assumptions about origination levels and credit losses.

Contractual failure

Even if a party has committed in contract to do XYZ, will they actually do it? On the Anglo transaction, officers of both the trustee and the clearing bank were required to confirm separately to Moodys that if their respective organizations agreed in contract to do something, then they would actually do it. CREDIT RATING MECHANISMThe rating agencies will wish to visit the originator/administrator to assess the quality of the management, the way that the company is set up and to review the administrative procedures. Prior to the visit, it is normal practice to prepare a file on the company including financial information, procedures, company history, senior staff biographies and example contracts. Collating and preparing this information normally takes several weeks. Asset analysis

This is the one risk which the rating agencies are prepared to take a commercial view on. This view is based upon an analysis of the asset pool proposed to be securitized, and a review of the historical performance of the originator's assets based upon certain assumptions. Generally the golden rules are: present your data appropriately (detailed advice is required on this point, since the exact approach should be closely linked to the way that the transaction is to be structured), and

generate as much data as possible irrelevant data can be discarded, but data which is missing is impossible to replace; rating agencies, in the absence of data, make conservative guesses (e.g.: 100% default rates, no recoveries etc..).

Once they have reviewed this information, the rating agencies will make an assessment of their worst case expectations as to the performance of the portfolio (normally absolutely dismal, of course). The structure then has to be designed to ensure that, should these losses appear, the rated debt is paid in full and on time. Transaction analysis This involves the production of detailed computer models of the transaction, which are then used to determine the way in which the structure will behave in different stress environments. Typical variables are: credit loss levels, delinquency levels, interest rates, corporation tax rates, VAT rates etc. Each rating level normally has associated with it a certain combination of stress assumptions, becoming more stressful for higher ratings.

Models are used differently by the two rating agencies: S&P require that the model demonstrates that note holders will receive all amounts due on time using the appropriate stress assumptions for that rating. The model normally has to be audited, and S&P require a copy of it which they review in detail. Moody's will not normally rely on models produced by third parties, and would seek to write their own. However, lease transactions are too complex to permit them to take this approach. On the Anglo transaction, for instance, they used our model, but treated its results with some circumspection. Their view seemed to be not that the structure had to meet certain minimum levels of stress (as S&P) but that the structure should be set up to deal with a variety of combinations of assumption, and that in certain circumstances, these assumptions could show a default. S&P's approach means that, once the structure and the model is agreed, it is possible to be reasonably certain as to the required levels of credit enhancement for each rating level. Moody's approach is less empirical, and this means that there can be no certainty that the credit enhancement levels are appropriate. Legal and tax

It is now normal for the rating agencies to require detailed opinions on the transaction addressing both legal and tax risks. These opinions are extremely difficult documents for lawyers to write, since the levels of comfort required are higher than those which would be necessary from a commercial perspective. This is one of the expensive elements of a transaction. For the ALPS transaction (aircraft leases), for instance, a separate legal opinion had to be procured for each jurisdiction in which an aircraft could land result: 118 legal opinions. From a rating perspective, the intrinsic value of the aircraft was a key part of the credit analysis and therefore the aircraft have to be demonstrated to be recoverable if there is a default on the lease. On the Anglo transaction, the tax analysis was so complex that the only way that sufficient comfort could be given was to offer nine alternative tax treatments for the transaction. The relevant partner of Clifford Chance was fairly happy (at a commercial level) as to the likely tax treatment of the transaction but at a rating level (100% certainty), he could only be certain that it would be one of the nine. This meant that the tax opinion ended up the wrong side of 80 pages. The rating process is complicated, but not too mysterious. Managing the rating process is a key element in the control of the transaction. Our advice is always that it is the originator who should control this process. As a result, the selection of the originator's advisers is a crucial element in ensuring a successful and controlled transaction - since it is through the assistance of these persons that the rating agency relationship is maintained. Several transactions which we have worked upon have changed radically as a result of the mismanagement of the rating process by third parties over whom the originator had no control.

CREDIT ENHANCEMENT TECHNIQUESUnlike in plain vanilla instruments, in securitization transactions it is possible to work towards a target credit rating, which could be much higher than the originators own credit rating. This is possible through a mechanism called Credit Enhancement. The purpose of credit enhancement is to ensure timely payment to the investors, if the actual collections from the pool of receivables securitized for a given period are short of the contractual payouts on Asset Backed Securitization (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.

Understanding of risk enhancement measures, which at times are used in combination, is also necessary to analyze the risk profile of securitized product. Normally, these risksenhancement measures are provided to cover the historic risk profile (first level risk) of the financial assets and some percentage of losses which may be higher than the historic risk profile (second level risk). Internal risk enhancement measures like over-collateralization, liquidity reserve, corporate undertaking, senior / sub-ordinate structure, spread account etc. cover the first level risk. External risk enhancement measures like insurance, guarantee, letter of credit are used to cover the second level risk.

i)Overcollateralisation splitting the Issuer liabilities into different classes: senior, mezzanine and junior (for instance), and arranging to pay them in that order, so that the senior liabilities are effectively protected by the existence of the subordinated liabilities

ii)Insuranceinsuring the credit performance of the assets (so that, from the Issuer's perspective, losses do not occur)

iii)Financial Guaranteearranging for the Issuer's obligations under the rated notes to be guaranteed (so that if the Issuer is unable to make a payment, then someone else will make it for him)

iv)Letter of Creditarranging for a bank facility which the SPV can draw down in the event that it suffers significant credit losses.

When asset-backed securities are purchased by investors, the investment risk they undertake directly relates to the credit quality of the original borrowers whose loan contracts are offered as collateral for the securities. In order to offer the purchasers a further enhancement to the credit quality, the issuer of the securities may wish to provide further payment guarantees obtained from a third party insurer or through a process of what is termed as over-collateralization.Over-collateralization works when there are several classes of securities being issued. In an over-collateralization, a subordinated class of securities absorbs the losses due to payment defaults of the original loan borrowers first. The senior class of securities, is therefore, shielded from default risk. The senior class of securities is now over-collateralized and will attract an enhanced credit rating. Over-collateralization means for servicing an instrument of Rs. 100/- cash flow from underlying asset valuing Rs. 110/- are earmarked. Similarly, cash worth Rs. 5/- called Liquidity Reserve may be separately earmarked for servicing an instrument of Rs. 100/-. These features cover investors against the likely default in cash flow from the borrower to the extent of Over-collateralization / Liquidity Reserve. In case of Senior / sub-ordinate debt, cash flows from two groups of borrowers are

independently used to bundle two set of securities. These two trenches of securities are issued with a pre-determined priority in their servicing. This means the senior trench has

prior claim on the cash flows from the underlying assets so that all losses will accrue first to the junior securities up to a pre-determined level. Thereby, the losses of the senior debt are borne by the holders of the sub-ordinate debt, normally the originator.

The difference between yield on the assets and yield to investors is the spread which is the gain to the originator. A portion of the amount earned out of this spread is kept aside in a spread account to service investors. This amount is taken back by the originator only after the payment of principal and interest to investors.

In a third party insurance scheme, an independent insurer would guarantee payment of interest and principal of the securities in the event of default by the original borrowers. Such credit enhancement will raise the credit quality of the securities above that of the underlying loans offered as collateral and increase the marketability of the securities.Other third party credit enhancement measures such as insurance, guarantee and letter of credit are also used by originator to get a better credit rating for the instruments.

Figure 6:Profile of credit enhancement in retail securitization transaction in India

(Source: The Chartered Accountant May 2002)

RBI REGULATIONS AND GUIDELINES(1) Acquisition of Financial Assets

The Asset Acquisition Policy shall provide that the transactions take place in a transparent manner and at a true price in a well informed market, and the transactions are executed at arms length in exercise of due diligence;ii. The Policy so framed should provide for checks in the matter of acquiring assets

from a single Bank/FI, own sponsors and any single entity upto a desirable level of ceiling so that possible departures from desirable practices are avoided;iii. The percentage of financial assets to be acquired should be appropriately and objectively worked out keeping in view the fact that the percentage of ownership stake has a bearing on the speed with which security interest rights can be enforced in accordance with the provisions of the Ordinance;iv. For easy and faster realisability, financial assets due from a single debtor to various banks / FIs may be considered for acquisition. Similarly, financial assets having linkages to the same collateral may be considered for acquisition to ensure relatively faster and easy realization;v. Both fund and non-fund based financial assets may be included in the list of assets for acquisition. Standard Assets likely to face distress prospectively may also be acquired;vi. Acquisition of funded assets should not include takeover of outstanding commitments, if any, of bank / FI to lend further. Terms of acquisition of security interest in non-fund transactions, should provide for the relative commitments to continue with bank/FI, till demand for funding arises;vii. Loans not backed by proper documentation should be avoided;

viii. The valuation process should be uniform for assets of same profile and a standard valuation method should be adopted to ensure that the valuation of the financial assets is done in scientific and objective manner. Valuation may be done internally and or by engaging an independent agency, depending upon the value of the assets. Ideally, valuation may be entrusted to an asset acquisition committee, which shall carry out the task in line with an Asset Acquisition Policy laid down by the Board in this regard;ix. A record indicating therein the details of deviations made from the prescriptions of the Board in the matter of asset acquisition, pricing, etc. should be maintained;

x. To ensure functioning of Securitization Companies/ Reconstruction Companies on healthy lines, the operations and activities of such companies may be subjected to periodic audit and checks by internal / external agencies. (2) Engagement of Outside Agency

Securitization Companies/ Reconstruction Companies may engage the services of reputed specialized external agencies to handle the task of taking possession of secured assets in pursuance of its right to enforce security interest.(3) Sale Committee

It is desirable that the Sale Committee authorizes in case of joint / consortium financing, the secured creditor with the highest outstanding, or more preferably, the Securitization Company/ Reconstruction Company as the designated secured creditor to arrange for the sale of secured assets.(4) Issue of security receipts

(i)The parties in question may finalize the price at which security receipt will be issued as per the mutually agreed terms and on assessment of the risks involved;(ii) In cases where security receipts are issued involving transfer of risks to the full extent and rewards to a limited extent, there could be a possibility of sharing of surplus between the issuer and the investors;(iii) The issuer may consider obtaining credit rating from any of the recognized credit rating agencies. The matters relating to charging of management fee by the Securitization Company/ Reconstruction Company, for managing schemes floated by it, may be as per the mutually agreed terms. As per Amendment ( 29.03.2004)

Every Securitization company or Reconstruction company seeking the Banks registration under Section 3, or carrying on business on commencement of the Securitization Companies and Reconstruction Companies (Reserve Bank) (Amendment) Guidelines and Directions, 2204, hall have a minimum Owned fund not less than fifteen percent of the total financial assets acquired or to be acquired by the securitization Company or Reconstruction Company on an aggregate basis or Rs. 100 crore, whichever is less; irrespective of whether the assets are transferred to a trust set up for the purpose of securitization or not.

Further the Securitization Company or Reconstruction Company should continue to hold this owned fund level until the realization of the assets and redemption of security receipts issued against such assets.

The Securitization Company or Reconstruction Company can utilize this amount towards the Security Receipts issued by the trust under each scheme. This will ensure the stake of the Securitization Company or Reconstruction Company in the assets acquired.

No subsidiaries of the Bank: Some of the ARCs are currently being promoted by Ban and FIs. The shareholding of such ARCs are dispersed in such a manner that they do not become subsidiaries of any of the promoting institutions.

NPA to be taken over at proper price: Care has to be taken in constituting the management structure and operations of the ARC such that even if the promoting Bank or FIs transfer their NPA portfolio, then it will treated as transfer to an independent or non-subsidiary ARC. Valuation of the NPA portfolio will have to be negotiated at arms length and upsides on recovery can be even shared with ARC.

NPA acquisition based on properly framed policies: Every ARC is required to have a financial asset acquisition policy which interalia must lay down policies and guidelines for the valuation of NPAs acquired by the ARC (having realizable value and capable of being reasonably estimated and independently valued).

True sale and not adjustment: The acquisition of financial assets by an ARC must conform to the principles of a true sale.

SECURITIZATION IN ASIA

Hong KongHong Kongs English law based legal system is probably the most securitization-friendly in Asia and makes it quite straight-forward to structure true sale transactions from a legal, regulatory and accounting perspective. Bankruptcy law is well developed and the regulatory environment, with guidelines for regulatory off-balance-sheet treatment, which largely follow the Bank of England model, is sophisticated. There is no withholding tax on interest payments to a non-resident, simplifying the securitization offshore of interest-bearing receivables. Rating agencies, monocline insurers and investors have now become increasingly comfortable with Hong Kong.

In addition to consumer-related assets such as mortgages, more innovative structures, such as those used in the Queens Funding and Pacific Palisades residential property transactions and the Wharf commercial property transaction, have also been used in Hong Kong. We have also seen the development of the Hong Kong Mortgage Corp., which has now acquired its first pools of residential mortgages and will likely look to securitization as one of its funding strategies.ThailandPutting a transaction together under the Thai civil law system has historically been legally more complex than in Hong Kong. Thai law does not generally recognize the concept of a trust, which causes the SPV to run commingling risk if the debtors continue to pay into the originators normal collection account. As a result, if notice has not been given to debtors, on the bankruptcy of the originator, the SPV will not be entitled to claim the payments belonging to it, but instead will have a claim as an unsecured creditor. In addition, although the auto lease and hire purchase receivables in the Thai cars type structure were assignable as a matter of Thai law, a true sale could not be achieved economically due to the imposition of tax on the purchase price of the receivables. VAT was also imposed on any servicing fee. In addition, withholding tax was payable on payments of interest offshore.

In 1997, the Thai government passed a new securitization law which helped to alleviate some of the concerns by:

Setting up a structure for onshore SPVs. Clarifying that the SPV does not require a license as it not a finance or a credit foncier business. Allowing the SPV to charge interest in excess of 15% p.a. Removing the originator bankruptcy risk if the transfer of the receivables to the SPV satisfied certain conditions.KoreaHistorically, the transfer of receivables by a Korean resident to a non-resident required the consent of the Ministry of Finance and Economy (MoFE), which had not been forthcoming until 1997. the original transactions dominating the Korean market in 1997 involved Korean merchant banks as sellers of US dollar denominated equipment lease receivables owned by Korean corporations. None of these transactions closed.

Receivables can be assigned although notice to the debtor (which must be notarized with a fixed date) has to be given, which may lead to customer confidentiality issues for banks.

The issue of withholding tax payable on interest payments to a non-resident remains a problem, but this can be mitigated by using the double tax treaty with Ireland which reduces the withholding tax rate to zero.

Korea has also passed a Securitization law which will require some amendments before the full benefit for foreign investors can be realized.The PhilippinesThe Philippine legal environment is friendly towards securitization although only a few securitization transactions have closed. Receivables can be assigned and a true sale can be achieved to remove the bankruptcy risk of the seller.

Although securitization was contemplated some time ago it has had little use as a financing tool. There has been frequent talk about the securitization of overseas workers remittances, although no transaction appears to have closed. In addition to a lack of regulatory and accounting off-balance-sheet guidelines as well as the typical tax problems, banks wishing to sell assets require Central banks approval.China The size of China and its economy make it an obvious candidate for securitization. However, attempts to securitize PRC cash flows have, in general, so far failed. The issue is complicate further the lack of certainty in the bankruptcy and security laws, which are still developing and the requirement that the consent of debtors is needed to achieve a true sale of assets, such as loan or trade receivables. This may prove logically