Securitization

The concept of
Funding
&
Risk sharing

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Securitization:

“Securitization is a structured finance process, which involves pooling and

repackaging of cash-flow producing financial assets into securities that are then sold to
investors. The name "securitization" is derived from the fact that the forms of financial
instruments used to obtain funds from the investors are securities.” 1

All assets can be securitized so long as they are associated with cash flow. Hence,
the securities, which are the outcome of securitization processes, are termed asset-backed
securities (ABS).

History:

"Asset securitization began with the structured financing of mortgage pools in the 1970s.
For decades before that, banks were essentially portfolio lenders; they held loans until
they matured or were paid off. These loans were funded principally by deposits, and
sometimes by debt, which was a direct obligation of the bank (rather than a claim on
specific assets). But after World War II, depository institutions simply could not keep
pace with the rising demand for housing credit. Banks, as well as other financial
intermediaries sensing a market opportunity, sought ways of increasing the sources of
mortgage funding. To attract investors, investment bankers eventually developed an
investment vehicle that isolated defined mortgage pools, segmented the credit risk, and
structured the cash flows from the underlying loans. Although it took several years to
develop efficient mortgage securitization structures, loan originators quickly realized the
process was readily transferable to other types of loans as well”2

Recent Trends:

The market of securitization is getting higher in U.S. and Asia. Credit card loans, auto
loans and home equity take an active part in securitization pools. Asian markets grew to a
size of $10 billion in the year 2000. Securitization has become so important in a countries
economy that legal revisions are being made to popularize securitization as it is a low
cost and better funding style. In Indian economy since there is a shortage of resources for

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developing large scale infrastructure which needs to grow at a rate of 25% annual rate in
the next few years to sustain a 7-8% long term growth of the Indian economy.
Securitization alone can come to the rescue for providing this long term finance.4

Major Players :

The major "players" in the securitization game, all of whom require legal representation
to some degree, are as follows (this terminology is typical, but different terms are used;
for example the "originator" is often referred to as the "issuer" or "seller".

Originator - The entity that either generates Receivables in the ordinary course of its
business, or purchases and assembles portfolios of Receivables (in that sense, not a true
originator). Its counsel works closely with counsel to the Underwriter/Placement Agent
and the Rating Agencies in structuring the transaction and preparing documents and
usually gives the most significant opinions.

Issuer - The special purpose entity, usually trusted by the owner (but can be another form
of trust or a corporation), created pursuant to a Trust Agreement between the Originator
and the Trustee, that issues securities and avoids taxation at the entity level (see
discussion below under "Foreign Securitizations").

Trustees - Usually a bank or other entity authorized to act in such capacity. The Trustee,
appointed pursuant to a Trust Agreement, holds Receivables, receives payments on the
Receivables and makes payments to the Security holders. In many structures there are
two Trustees.

Investors -The ultimate purchasers of the Securities. Usually banks, insurance companies,
and other "qualified investors." In some cases, the Securities are purchased directly from
the Issuer, but more commonly the Securities are issued to the Originator or Intermediate
SPE as payment for the Receivables and then sold to the Investors, or in the case of an
underwriting, to the Underwriters.

Custodian - An entity, usually a bank that actually holds the Receivables as agent and
bailee for the Trustee or Trustees.

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Rating Agencies - Moody's, S&P, Fitch IBCA and Duff & Phelps. In Securitizations, the
Rating Agencies frequently are active players that assist in structuring the transaction. In
many instances they require structural changes and mandate changes in servicing
procedures.

Process of Securitization:

ORIGINATOR (e.g.
BORROWER
ICICI BANK)
(e.g XYZ LTD)
BANK)
SPV

TIES Ltd.
discounte
d amount

SECURI
to ICICI

ICICI
loan through

Bank

pays
Securitizes
ICICI

SPV
(e.g. ICICI SECURITIES Ltd)

Now SPV holds the asset i.e. recovery rights from Y Ltd.

SPV issues bonds on this asset to investors to raise money,

which is generally coordinated by Merchant or Investment
banker

GENERAL INVESTORS
1 2 3 4 5

SPV receives money on bond issue. Later SPV recovers loan from Y Ltd.
and repays bonds and interests to investors.

Diagram based on the discussion with Mr. Sunil Pullyakot on August 06, 2008

In simple words, the concept of securitization works in the following stages :-

Stage 1: The bank is the loan originator and servicer (ICICI BANK). The bank lends loan
to the borrowers e.g. Y Ltd. Loan principal plus interest payments from the bank balance
sheet are removed over to next stage.

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Stage 2 : In this stage, a Special Purpose Vehicle (SPV) will be the loan purchaser.The
SPV buys the loans from the bank and issues the securities.The loan principal plus
interest payments are further passed through to the third stage.
Stage 3 : In this stage, the loan package will be an investment banker who underwrites
and packages the securities for sale and collects fees for the service.
Stage 4 : The party in this stage is the individual investor (individuals or banks) who buys
the securities for cash flow claims.

Advantages:

The Securitization structure is intended to provide significant advantages to Originators,

such as:
1. The Receivables are moved "off balance sheet" and replaced by a cash equivalent (less
expenses of the Securitization), thus improving the Originator's balance sheet and
resulting in gain or loss, which itself is usually an intended, beneficial consequence.
2. The Originator does not have to wait until it receives payment of the receivables to
obtain funds to continue its business and generate new Receivables. In many cases this is
essential, and a role otherwise filled by more traditional methods of financing, including
factoring. This is more significant when the Receivables are relatively long term, such as
with real property mortgages, auto loans, student loans, etc., and not as significant with
short term Receivables, such as trade and credit card Receivables.
3. The Securities issued in the Securitization are more highly rated by participating rating
agencies, thus reducing the cost of funds to the Originator when compare to traditional
forms of financing.
4. In non-revolving structures, and those with fixed interest rate Receivables, assets and
related liabilities can be matched, eliminating the need for hedges.

Disadvantages:

May reduce portfolio quality: If the AAA risks for example are being securitized out, this
would leave a materially worse quality of residual risk.
Costs: Securitizations are expensive due to management and system costs, legal fees,
underwriting fees, rating fees and ongoing administration. An allowance for unforeseen
costs is usually essential in securitizations, especially if it is an atypical securitization.

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Size limitations: Securitizations often require large scale structuring, and thus may not be
cost-efficient for small and medium transactions.
Market Factors: “Sanz warns: A strong potential supply of securitized bonds needs to be
met by the demand of dedicated emerging market or structured finance investors, and at
this point there is no sign of investors returning to this market." 3 In the time of recession
in the economy it happens that there are no investors willing or able to buy securities
leading to a downfall of the securitization market

Bibliography:
1. Securitization. Retrieved August 2, 2008 from Wikipedia website:
http://en.wikipedia.org/wiki/Securitization

2. Securitization. Retrieved August 2, 2008 from Wikipedia website:

http://en.wikipedia.org/wiki/Securitization#History

3. Structured Finance.
Section: EEMEA
Euromoney, Feb2008, Vol. 39 Issue 466, p62, 2/3p, 1c.
Item Number: 31328753
Retrieved August 02, 2008, from EBSCO HOST Research Databases.

4. Subrahmanyam Ganti (Sept. 2002). Securitize Indian Banks’ Future. The ICFAI
Journal of Applied Finance, Vol. 8, No. 5, 62-63.

Other web resources you may refer to:

http://en.wikipedia.org/wiki/Securitization

http://www.securitization.net/

http://www.investopedia.com/ask/answers/07/securitization.asp

http://www.investorwords.com/4445/securitization.html

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http://www2.standardandpoors.com/spf/csv/equity/JP%20Securitization%20Structures.pdf

http://www.tmac.ca/conference/2004/presentations/c_kilgour.pps

http://www.membersocieties.org/srilanka/linked%20files/Securitisation.pdf