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Securitisation: Insight

Structured Finance Market

The structured finance market in India has grown over the years. A brief picture of the structured finance market considering only the listed transaction is depicted through the graphs alongside¹. The graphs show a rise in structured finance market in the year 2007, however now the markets have significantly fallen down after recent turmoil in the finance industry. The investors have become reluctant in investing; specially after witnessing the market volatilities caused due to events like subprime crisis, failure of top investment banks. The loss of investor’s faith has reduced the structured finance growth not only in India but all over the world.

Nonetheless asset backed funding or securitisation cannot loose its relevance since the growth of the economy shall be always indebted to the contributions of structured finance. Definitely there may be attempts for stricter vigilance inviting a change in the accounting treatment, rating standards or so. Like, questions are already being raised on the off balance sheet treatment of securitized assets, and may be in the time to come securitized assets will be on the balance sheet of the originator. Let us have a closer look at the finer mode of raising funds: Securitisation.

Securitisation: Brief Introduction

Securitisation, as the name suggests implies creation of securities. Theoretically speaking, securitisation is conversion of assets into securities; such securities are issued to willing investors, who in-turn get a pay through (bond type structure) or pass through (equity type structure) interest in the asset. In other words securitisation is creation of security by taking the asset out in the market, hence creating a capital market window and immediate liquidity for the holder of assets. Though it seems like but securitisation is not financing; the entity securitising its assets is not borrowing money but selling a stream of cashflows that was otherwise to accrue to it.

Process of Securitisation

A more lucid picture of securitisation is below:

  1. Introduction to originator: An entity which securitizes its assets is the Originator. Usually an originator transfers the pool of assets to a special purpose vehicle which in turn issues securities. The typical originators are Mortgage financiers, Bank loans, Finance companies, Credit card companies, Hoteliers, rentiers, Public utilities etc. For the purpose of illustration let us assume a mortgage funding company ‘XY Mortgage Finance Limited’ or XY Co. with a number of receivables, which it intends to securitise.
  2. Familiarity with Special Purpose Vehicle (SPV): The originator transfers the pool of assets to a special purpose vehicle, which is a non-discretionary body in form of a company or trust. Supposedly the pool of receivables is USD 100 million; and the rate of return that SPV would now receive on the loans is 8.55% which is the weighted average of the interest accruing on the loans.
  3. Issuance of securities to investors: The SPV holds the pool and issues securities on the strength of the pool. The SPV uses the funds raised by issue of securities to pay off the originator for purchase of the pool. Hence the originator gets liquidity for the assets which may be maturing only after a considerable span of time. The investors of the securities have a direct interest in the pool of assets, and the SPV uses the cashflows from receivables to repay investors of securities. The securities issued by the SPV are structured into different classes of securities, wherein junior classes act as a cushion to absorb losses allowing higher rating for senior classes. Let us assume three classes of securities are being offered at different coupon rates, Class A being the cheapest. Let us suppose the weighted average cost of the coupons comes to 7%.
  4. Servicer Role: SPV is almost like a non-substantive shell, it cannot do the collection and servicing function itself. Generally, the originator himself retains the servicing function since he has proximity with the obligors and has necessary infrastructure and systems for doing so. The originator acts as a servicer and collects interest and installments from the obligor along with other allied services for which it receives a fee. Let us assume a fee for services of originator is 50 bps.
  5. Reinvestment: The cashflows collected month after month by the servicer are used to repay the securities, either with or without reinvestment. If the structure of bonds issued is pay-through then the cashflows from the pool of assets may be reinvested and the investors are paid only at a particular time. However if the bonds are pass-through then the cashflows from the pool of assets are only used for payment to the investors.
  6. Excess Spread: It is the excess of the income flowing from pool of assets, over and above the coupon payable to the investors and the expenses of the transaction. The residual interest may be held either by the originator itself, or may be sold to willing buyers. In the instant case the excess spread is as follows:
  7. Excess Spread= 8.55 – 7 – 0.50 = 1.05%

  8. Absorption of Losses: Each securitisation transaction has some kind of credit enhancement, to get the desired rating for the securities. Credit enhancement may be structural such as subordination, excess spread or it may be third party guarantee etc. The junior classes of securities issued by SPV act as a credit enhancer for the senior classes. Excess spread also acts as a credit enhancement, it is only when the excess spread is wiped out by losses then the junior classes are affected. The most junior class is the first one to absorb loss after the excess spread is wiped out, hence many a times junior class doesn’t find a buyer and is retained by originator.
  9. Benefits: Let us see how securitising the pool of receivables is advantageous in the instant case:
  • On day 1 the originator got funding of USD 100 million. The junior most or least rated class of securities issued by SPV, in the instant case Class C is usually retained by the originator himself so the actual funding of originator is only USD 97 million (Class C being 3%).
  • In addition, he gets the residual interest in the transaction, representing the cash left over after paying all investors. Thus the transaction helps to earn excess spread.
  • The investor got 3 different classes of securities to pick up, each carrying a different rating and a different coupon rate. Since the pool of assets is isolated from the main identity, hence the underlying assets for the securities are free from liabilities accruing to the originator.
  • The SPV was a creature designed for enabling the entire show – so, no regrets that the SPV gets nothing at all.

Regulatory Outline

India has a specific set of guidelines regulating securitisation transaction dated February 2006. However these guidelines are not mandatory, but non adherence to them may lead to disallowance of capital relief. Further master circular on Basel II issued in June 2008 also lay down norms for securitisation exposures.

Author: Neha Singhi
Contact: +91-33-40083385
neha@nehasinghi.com
Date: October 2008

¹ The graphs have been extracted from Moody’s Report on Structured finance in India: Growth Countries dated March 2008

Private Investments in Public Equity (PIPE)

Market Sentiments

Markets have fallen down drastically; there is hue and cry for liquidity all over the world. The losses are deepening with incidents happening one after another. The terrorist attack in Mumbai is again a blow on the Indian economy. In a situation where big giants are crumbling down, one cannot guess the plight of small and midsized corporate. In this era of huge financial crunch, the right approach should be to devise and promote means of easy financing to keep the ball rolling and regain investor’s faith.

Small and midsized companies face significant hurdles in their efforts to raise money, especially during these crisis times. As per the scenario now, investors are reluctant to make direct investments in Corporate, with a fear of losing their hard earned money. At the same time it is becoming difficult for companies to survive, if not grow with the liquidity crunch.

PIPE

PIPE is a mode of finance, which to some extent can ease the liquidity crunch in the industry. A quick brief on PIPE follows:

PIPE transaction involves allowing of private investment from investment firms, mutual funds and other qualified investors, usually at a discount to the current market value providing capital to the company. The investments may be in shares, stock or convertible security of the listed company. Once the deal is made, and the securities are issued, steps are initiated for listing the securities to the advantage of the investor.

Benefits of a PIPE deal

A PIPE deal saves a company from the complexity of selling shares through a fresh public issue. Instead, the company finds an investor and sells him a block of newly issued shares at an agreed price or a block of debt which can later be converted into shares (a structured PIPE).

Some of the benefits of PIPE deal over a fresh public issue of shares are as follows:

  • There is no fear of undersubscription, since it’s a certain deal between the investor and issuer.
  • Normally coming out with a fresh public issue involves a lot of compliance formalities, and engages a lot of time. However with PIPE the fund raising process is much faster;
  • Considering the cost of funding, even relatively small amounts of capital can be raised;
  • Pricing is certain once the deal has been negotiated (none of the uncertainty of a book build is associated);
  • Advantage over competitors, since the information of raising capital can be kept confidential;
  • Less equity dilution since the issue is made to private investors

Regulatory concerns

Whereas in countries like U.S., Australia, Canada, and the U.K. the regulations are accommodating for PIPE transactions, however in some countries compliance has to be made for norms exempting from rights issue before issuing shares to other than existing shareholder.

A PIPE transaction in India has to satisfy the conditions stipulated under SEBI guidelines for preferential issues. Further a revision of SEBI Insider Trading Regulations is required to incorporate strict norms for disallowing share trading by the investor or his advisor on basis of any unpublished price sensitive information discovered during the PIPE transactions.

Conclusion

PIPEs are increasingly becoming popular to finance growth, acquisitions and for working capital need of smaller firms. The PIPE transactions give access to capital at a lower cost than typical underwritten offerings, while simultaneously also increasing institutional investment in the company and improving the public float of securities.

Author: Neha Singhi
Contact: +91-33-40083385
neha@nehasinghi.com
Date: November 28 2008