Securitization Primer

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Securitisation - a
primer
B Vinod Kothari
[For another comprehensive write-up on securitisation b Tom Nicolle, visit
our Articles page - click the left hand link].
These are etracts from Vinod Kothari's book titled Securitisation:
The Financial Instrument of the Ne Millennium. To kno more
about the book or order a cop, click here.
CHAPER 1

Just as the electronics industr was
formed when the vacuum tubes were
replaced b transistors, and transistors
were then replaced b integrated
circuits, the financial services industr is
being transformed now that securitised
credit is beginning to replace traditional
lending. Like other technological
transformations, this one will take place
over the ears, not overnight. We
estimate it will take 10 to 15 ears for
structured securitised credit to replace
to displace completel the classical
lending sstem -not a long time,
considering that the fundamentals of
banking have remained essentiall
unchanged since the Middle Ages.
Lowell L Bran

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Techgica adacee hae chaged he face f he d f fiace.
I i da e a d f aaci ha a d f eai. M
eai hae bee aaciaied.

Taaci ea cig gehe f eiie ih a c e,
heea eai ea eeig gehe f hee eiie. F eae,
he a ba ide a a f a f e a e, he aaci
ead a eaihi: ha f a ede ad a be. Hee, he
eaihi i eiaed he he e a i ceed i a debee.
The eaihi f beig a debeehde i he ca i caabe
f aciii ad eiai b aaci.
1. Basic meaning of securitisation:

"Seciiai" i i ide ee iie ee ch ce hich ce
a fiacia eai i a aaci.

Hi f ei f fiace, ad cae a, he ae beig ie
f he fe, i eee ih iace hee eai hae bee ceed
i aaci. I fac, hi a he eaie, ad b fa eaed,
cibi f cae a he d f fiace, i., he dia
hae, hich iie ieceea ehi f he ca. Oehi f a
ca i a eai, acaged a a aaci b he ceai f he
dia hae. Thi eaie iace f eciiai a iea i
he gh f he cae f f dig bie, ad hece,
idiaiai, ha ee aed he i a e f he geae
iei f he 19h ce -he he e beig he ea egie. Tha
efec he igificace f he dia hae, ad if he ae idea i
eeded, he e cce f eciiai: i a ia he d f
fiace a ie e i id.

Ohe iace f eciiai f eaihi ae cecia ae,
hich eciie a ade deb.
Asset securitisation:
Hee, i he ee i hich he e i ed i ee da caia ae
acii, securitisation ha acied a ica eaig f i , hich i a
times, for the sake of distinction, called ae eciiaion. It is taken to
mean a device of structured financing where an entit seeks to pool together
its interest in identifiable cash flows over time, transfer the same to investors
either with or without the support of further collaterals, and thereb achieve
the purpose of financing. Though the end-result of securitisation is financing,
but it is not "financing" as such, since the entit securitising its assets it not
borrowing mone, but selling a stream of cash flows that was otherwise to
accrue to it.

The imple a o ndeand he concep of
eciiaion i o ake an eample. Le a, I
an o on a ca o n i fo hie. I cold ake a
loan ih hich I cold b he ca. The loan i m
obligaion and he ca i m ae, and boh ae
affeced b m ohe ae and ohe
obligaion. Thi i he cae of imple financing.

On he ohe hand, if I ee o analicall
eniage he ca, m ae in he inan cae, a
claim o ale oe a peiod of ime, ha i, abili
o geneae a eie of hie enal oe a peiod
of ime, I migh ell a pa of he cah flo b a
of hie enal fo a iplaed ime and heeb
aie enogh mone o b he ca. The ineo
i happie no, becae he ha a claim fo a
cah flo hich i no affeced b m ohe
obligaion; I am happie becae I hae he cake
and ea i alo, and alo becae he obligaion
o epa he financie i aken cae of b he
cahflo fom he ca ielf.

Blend of financial engineeing and
capial make:

Thus, the present-da meaning of securitisation is a blend of two forces that
are critical in toda's world of finance: structured finance and capital
markets. Securitisation leads to structured finance as the resulting securit is
not a generic risk in entit that securitises its assets but in specific assets or
cashflows of such entit. Two, the idea of securitisation is to create a capital
market product - that is, it results into creation of a "securit" which is a
marketable product.

Thi meaning of eciiaion can be epeed in aio damaic od:

Securitisation is the process of commoditisation. The baic idea
i o ake he ocome of hi poce ino he make, he capial
make. Th, he el of ee eciiaion poce, haee
migh be he aea o hich i i applied, i o ceae ceain inmen
hich can be placed in he make.

Securitisation is the process of integration and differentiation.
The eni ha eciie i ae fi pool hem ogehe ino a
common hochpo (aming i i no one ae b eeal ae, a
i nomall he cae). Thi he poce of inegaion. Then, he pool
ielf i boken ino inmen of fied denominaion. Thi i he
poce of diffeeniaion.

Securitisation is the process of de-construction of an entit. If
one eniage an eni' ae a being compoed of claim o
aio cah flo, he poce of eciiaion old pli apa
hee cah flo ino diffeen bcke, claif hem, and ell hee
claified pa o diffeen ineo a pe hei need. Th,
eciiaion beak he eni ino aio b-e.

We ill en o hi pecific, peen-da meaning of eciiaion.
Hoee, le go back o he geneic meaning of he em - ha i,
coneing an ae o a elaionhip ino a eci, a commodi.
1. Meaning of securit:

Ve ndeandabl, fhe deelopmen in hi aea ill conine o
ake place. Moe financial elaion of oda ill in ime o come be
coneed ino and be anfeable a "eciie".

In connecion ih eciiaion, he od "eci" doe no mean
ha i adiionall migh hae mean nde copoae la o
commece: a eced inmen. The od "eci" hee mean a
fiacia cai hich i geea aifeed i f f a dce, i
eeia feae beig aeabii. T ee aeabii, he
ie hae geea acceabii a a e f ae. Hece,
i i geea eihe aed b cedi aig agecie, i i eced b
chage e baia ae. Fhe, ee iidi, he
ie i geea ade i hge .
2. Need fo eciiaion:

The geeic eed f eciiai i a d a ha f gaied
fiacia ae. F he diici beee a fiacia eai ad
a fiacia aaci eaie, e dead ha a eai iaiab
eed he cig gehe ad eaiig gehe f eiie. N
ha he eiie d eceai ce gehe f hei ,
diec. The igh ie a be f fiacia ieediaie i he
ce, b eehee, a eai ie a fii e a ceai
ie. Geea, fiacia eai ae ceaed bac ahe
fiacia eai, ch a a a beig ae acie a ae, ad i
ha cae, he eeded fied eid f he eai hige he he
hich i ee bac-.

Fiacia ae deeed i ee he eed ie a age
be f ie i he ae ace. A he be f ie
ee iceaig, he aeage ie e ie ee cig
d -hi i a ie e f he aeace, becae gig ie
ea iee f a ide bae f ie. The a ie i
a feia ie: he i a ch i he bie f
iee. Hece, he eed a ie hich i eaie
dead, ad i iid. Thee eed e he age f ei
f fiacia ie hich d ce fiacia cai i
iid, ea dead ad hge dc, a ie
caig ceified ai abe (cedi-aig eci ) , hich
d be aaiabe i a deiai i ee e' e.
Th, eciiai i a geeic ee i baic he d f fiace,
ad i i a i a ha eciiai eee he eie age f
fiacia ie, ad hece, he eie age f fiacia ae.

Fig ae he ea a h he d f fiace efe a
eciied fiacia ie he deig fiacia cai i i
igia f:

1. Fiacia cai fe ie ieabe f e, cea
ide he each f he a ie. The iiia ee hi a
he deee f fiacia ieediai: a ieedia ch a a
ba d gehe he ece f he a ie ad e
he ae f he age iee eed f he e. Hee, he
cae he ecd diffic, ed be.

2. Sa ie ae ica i he bie f iee, ad
hece, iidi f iee i ciica f he. Udeig
fiacia aaci eed fii f iee e a fied ie,
agig f a fe h a be a be f ea. Thi
be cd ee be ed b fiacia ieediai,
ice if he ieedia ided a fied iee i he
eee, ad ief gh fd ih a i f iidi, i d ge
cagh i ei be f a iach. Hece, he ae a a
aeabe ie.

3. Geea, ie ae eaie ded ha fiacia
aaci. A ie i hge, a ade i a adad
f, ad geea caiig adad ie bigai. Hece, i
ca be ded geeica. Beide, a ia a f ie
ifai i he ai ad ice f he ie, ad bh ae fa
eaie i cae f ie ha i cae f deig fiacia
aaci.

I h, he eed f eciiai a a iecaabe, ad
ee da' fiacia ae d hae bee ha he ae,
e e adad hig ha ae ae cd b ad e, ha
i, fiacia eciie, ee aaiabe.

S ef i he ecic gic f eciiai ha he ed
ad eciiai ii. Caia ae ae da a
ace hee eehig i aded: f cai e eiie cai
e ae, i, ad ead.
3. Seciiaion of eceiable:

Oe f he aicai f he eciiai echie ha bee i
ceai f aeabe eciie f baed eceiabe. The
intention oI this application is to aIIord marketability to Iinancial claims
in the Iorm oI receivables. Obviously, this application has been
applied to those entities where receivables Iorm a large part oI the
total assets oI the entity. Besides, to be packaged as a security, the
ideal receivable is one which is repayable over or aIter a certain
period oI time, and there is contractual certainty as to its payment.
Hence, the application was traditionally principally directed towards
housing/ mortgage Iinance companies, car rental companies, leasing
and hire-purchase companies, credit cards companies, hotels, etc.
Soon, electricity companies, telephone companies, real estate hiring
companies, aviation companies etc. joined as users oI securitisation.
Insurance companies are the latest oI the lot to make an innovative
use oI securitisation oI risk and receivables, though the pace at which
securitisation markets are growing, the word "latest" is not without the
risk oI being stale soon.

Though the generic meaning oI securitisation is every such process
whereby Iinancial claims are transIormed into marketable securities, in
the sense in which we are concerned with this term here in this book,
securitisation is a process by which cashIlows or claims against third
parties oI an entity, either existing or Iuture, are identiIied,
consolidated, separated Irom the originating entity, and then
Iragmented into "securities" to be oIIered to investors.

Securitisation oI receivables is a unique application oI the concept oI
securitisation. For most other securitisations, a claim on the issuer
himselI is being securitised. For example, in case oI issuance oI
debenture, the claim is on the issuing company only. In case oI
receivable, what is being securitised is a claim on the third party
/parties, on whom the issuer has a claim. Hence, what the investor in
receivable-securitised product gets is a claim on the debtors oI the
originator. This may at times be Iurther include, by way oI recourse, a
claim on the originator himselI.

The involvement oI the debtors in receivable securitisation process
adds unique dimensions to the concept, oI which at least two deserve
immediate mention. One, the very legal possibility oI transIorming a
claim on a third party as a marketable document. It is easy to
understand that this dimension is unique to securitisation oI
receivables, since there is no legal diIIiculty where an entity creates a
claim on itselI, but the scene is totally changed where rights on other
parties are being turned into a tradeable commodity. Two, it aIIords
to the issuer the rare ability to originate an instrument which hinges on
the quality oI the underlying asset. To state it simply, as the issuer is
essentially marketing claims on others, the quality oI his own
commitment becomes irrelevant iI the claim on the debtors oI the
issuer is either market-acceptable or is duly secured. Hence, it allows
the issuer to make his own credit-rating insigniIicant or less-signiIicant,
and the intrinsic quality oI the asset more critical.
4. ick gide o Jagon:

Though there is a complete terminology appended to this Chapter, this
section will help the reader to quickly get Iamiliarised with the essential
securitisation jargon.

The entity that securitises its assets is called the oiginao: the name
signiIies the Iact that the entity was responsible Ior originating the
claims that are to be ultimately securitised. There is no distinctive
name Ior the investors who invest their money in the instrument:
thereIore, they might simply be called ineo.

The claims that the originator securitises could either be existing
claims, or existing assets (in Iorm oI claims), or expected claims over
time. In other words, the securitised assets could be either existing
receivables, or receivables to arise in Iuture. The latter, Ior the sake oI
distinction, is sometimes called fe flo eciiaion, in which
case the Iormer is a case oI ae-backed eciiaion.

In US markets, another distinction is mostly common: between
mogage-backed eciie and ae-backed eciie. This
only is to indicate the distinct application: the Iormer relates to the
market Ior securities based on mortgage receivables, which in the
USA Iorms a substantial part oI total securitisation markets, and
securitisation oI other receivables.

Since it is important Ior the entire exercise to be a case oI transIer oI
receivables by the originator, not a borrowing on the security oI the
receivables, there is a legal anfe of he eceiable to a separate
entity. In legal parlance, transIer oI receivables is called aignmen
of eceiable. It is also necessary to ensure that the transIer oI
receivables is respected by the legal system as a genuine transIer, and
not as a mere eyewash where the reality is only a mode oI borrowing.
In other words, the transIer oI receivables has to be a e ale oI the
eceiable, and no meel a financing again he eci of he
eceiable.

Since eciiaion inole a anfe of eceiable fom he
oiginao, i old be inconenien, o he een of being impoible,
o anfe ch eceiable o he ineo diecl, ince he
eceiable ae a diee a he ineo hemele. Beide, he
bae of ineo cold keep changing a he eling eci i
eeniall a makeable eci. Theefoe, i i necea o bing in
an inemedia ha old hold he eceiable on behalf of he end
ineo. Thi eni i ceaed olel fo he ppoe of he
anacion: heefoe, i i called a special purpose vehicle (SPV)
o a special purpose entit (SPE) o, if ch eni i a compan,
special purpose compan (SPC). The fncion of he SPV in a
eciiaion anacion cold ech fom being a pe condi o
inemedia ehicle, o a moe acie ole in eineing o ehaping
he cahflo aiing fom he ae anfeed o i, hich i
omehing ha old depend on he end objecie of he
eciiaion eecie.

Theefoe, he oiginao anfe he ae o he SPV, hich hold
he ae on behalf of he ineo, and ie o he ineo i
on eciie. Theefoe, he SPV i alo called the issuer.

Thee i no nifom name fo he eciie ied b he SPV a ch
eciie ake diffeen fom. Thee eciie cold eihe epeen
a diec claim of he ineo on all ha he SPV collec fom he
eceiable anfeed o i: in hi cae, he eciie ae called pass
through certificates o beneficial interest certificates a he
impl ceificae of popoional beneficial inee in he ae held
b he SPV. Alenaiel, he SPV migh be e-configing he
cahflo b eineing i, o a o pa o he ineo on fied
dae, no maching ih he dae on hich he anfeed
eceiable ae colleced b he SPV. In hi cae, he eciie held
b he ineo ae called pa through certificates. The eciie
ied b he SPV cold alo be named baed on hei ik o ohe
feae, ch a senior notes o junior notes, floating rate notes,
ec.

Anohe od commonl ed in eciiaion eecie i
bankruptc remote transfer. Wha i mean i ha he anfe of
he ae b he oiginao o he SPV i ch ha een if he
oiginao ee o go bankp, o ge ino ohe financial difficlie,
he igh of he ineo on he ae held b he SPV i no
affeced. In ohe od, he ineo old conine o hae a
paamon inee in he ae iepecie of he difficlie, die
o bankpc of he oiginao.
5. Feae of eciiaion:

A eciied inmen, a compaed o a diec claim on he ie,
ill geneall hae he folloing feae:

Marketabilit:
The e ppoe of eciiaion i o ene makeabili o
financial claim. Hence, he inmen i ced o a o be
makeable. Thi i one of he mo impoan feae of a eciied
inmen, and he ohe ha follo ae mol impoed onl o
ene hi one. The concep of makeabili inole o polae:
(a) he legal and emic poibili of makeing he inmen; (b)
he eience of a make fo he inmen.

A fa a he legal poibili of makeing he inmen i concened,
adiional mecanile la ook a conempoaneo ie of
makeable docmen. In mo jidicion of he old, la
dealing ih makeable inmen (alo efeed o a negoiable
inmen) ee mol limied in applicaion o ha ee hen in
ciclaion a ch. Beide, he copoae la mol defined and
ogh o eglae iance of e al copoae financial claim,
ch a hae, bond and debene. Fo an codified la, hi i
no nepeced, ince la do no lead commece: mo ofen, he
follo, a he concen of he la-make i mol eglao and no
pomoional.

Hence, in mo jidicion of he old, ell-coded la ei o
enable and eglae he iance of adiional fom of eciied
claim, ch a hae, bond, debene and ade pape (negoiable
inmen). Mo conie lack in legal em peaining o ohe
eciied podc, of ecen o eoic oigin, ch a eciiaion
of eceiable. On a polic plane, i i incmben on he pa of he
eglao o ie an eciied inmen ih he ame concen a
in cae of adiional inmen, fo eaon of ineo poecion.

Hee, i eed be ed ha hee a a de ei
egae iace f a eciied ie, i i aie beiee ha
he a de ei ch iace. A egai i a deig b
hai ief, i d be idic ee ha eehig ha i
egaed i ee aed. Regai i a ecei ad
feed i he e.

The ecd ie i e f haig ceaig a ae f he
ie. Seciiai i a faac e he eciied dc i
aeabe. The e e f eciiai i be defeaed if he
ie i aded a fe feia ie ih a
ibii f haig a iid ae heei. Liidi a eciied
ie i affded eihe b idcig i i a gaied ae
(ch a eciie echage) b e e agecie acig a
ae ae i i, ha i, ageeig b ad e he ie a
eihe e-deeied ae-deeied ice.

Merchantable qualit:

T be ae-acceabe, a eciied dc ha hae a
echaabe ai. The cce f echaabe ai i cae f
hica gd i ehig hich i acceabe echa i
a ade. Whe aied fiacia dc, i d ea he
fiacia cie ebdied i he ie ae eced he
ie' aifaci. "T he ie' aifaci" i a eaie e,
ad heefe, he igia f he eciied ie ece he
ie baed he eed f he ie. The geea e i: he
e bad he bae f he ie, he e i he ie' abii
abb he i, ad hece, he e he eed eciie.

F ide diibed eciied ie, eaai f he
ai, ad i ceificai b a ideede ee, i., raing, i
c. The aig ee f he beefi f he a ie, h i
heie eeced be i a ii aaie he degee f
i ied.

I cae f eciiai f eceiabe, he cce f ai
dege daic chage making aing i a nieal
eiemen fo eciiaion. A aead diced,
eciiai i a cae hee a cai he deb f he igia
i beig bgh b he ie. Hece, he ai f he cai f he
deb ae igificace, hich a ie eabe ie
e e he cedi-aig f deb ( a fi f deb)
ad , ae he ie a ideede f he iga'
aig.

Wide Distribution:
The baic e f eciiai i diibe he dc. The
ee f diibi hich he igia d ie achiee i
baed a caaie aai f he c ad he beefi
achieed heeb. Wide diibi ead a c-beefi i he
ee ha he ie i abe ae he dc ih e e,
ad hece, e fiacia c hief. B ide ie bae
ie c f diibi ad eicig.

I acice, eciiai ie ae i diffic f eai ie
dead. Hece, eciiai hae bee iae aced
ih feia ie. Hee, i i ie ha i ce, eai
ie cd be aaced i eciied dc.
Homogeneit:
T ee a a aeabe ie, he ie hd be
acaged a i hge . Hgeei, ie he abe
feae, i a fci f eai aeig. M eciied ie
ae be i affdabe he agia ie, ad hece, he
ii deiai bece eaie he eed f he ae
ie. Shae i caie a be be i ice a a a
R. 10 each, b debee ad bd ae iced i R. 100 each
R. 1000 each. Deiged f age ie, cecia ae
a be i deiai a high a R. 5 Lac. Ohe eciiai
aicai a a f hi gic.

The eed bea he he be eciied i eea
hge ae eciiai a eecie f iegai ad
diffeeiai: iegai f he eea ae i e , ad
he he ae' diffeeiai i if aeabe . Thi fe
iie he e feae : a ieedia achiee hi ce.
Special prpose ehicle:
I cae he eciiai ie a ae cai hich eed
be iegaed ad diffeeiaed, ha i, e i i a diec ad
eced cai he ie, he ie i eed a ieedia
agec ac a a ei f he ae cai hich i beig
eciied. Le ae he eaie eae f a eced debee, i
eece, a eced a f eea ie. Hee, eci chage
e he ie' eea ae eed be iegaed, ad heeafe
be i aeabe . F hi e, he ie i big i
a ieedia agec he baic fci i hd he eci
chage behaf f he ie, ad he ie ceificae he
ie f beeficia iee i he chage hed b he ieedia.
S, heea he chage cie be hed b he ieedia,
beeficia iee heei bece a aeabe eci.

The ae ce i ied i eciiai f eceiabe, hee
he ecia e ieedia hd he eceiabe ih ief, ad
ie beeficia iee ceificae he ie.
6. Seciiaion and financial
diinemediaion:

Seciiai i fe aid e i fiacia diieediai. Thi
cce eed be eabaed. The be a dead hi cce i
ae he cae f cae debee, a e-ded eci.

A a diced eaie, if e iagie a fiacia d ih eciie
(ad ch d i iagia), a fiacia aaci i be caied
a e--e eai. F eae, if a ca eed a a, if i
hae ee ch a f he ede, ad he ede i hae
eabih a e--e eai ih he ca. Each ede ha
dead he big ca, ad afe hi a. Thi i fe
diffic, ad hece, hee aea a fiacia ieedia, ch a a ba i
hi cae, hich fd f a f ch ie, ad e hee
ed fd ed he ca. N, e e he ca
eciie he a, ad ie debee he ie. Wi hi eiiae
he eed f he ieedia ba, ice he ie a ed he
ca diec i a a each, i f f a eci hich i ea
aaie, ad hich i iid ?

Utilities added b financial intermediaries:
A financial inemedia iniiall came in pice o aoid he difficlie in a
diec lende-booe elaion beeen he compan and he ineo. The
difficlie cold hae been one o moe of he folloing:

(a) Transactional difficult: An aeage mall ineo old hae a mall
amon of m o lend heea he compan' need old be maie. The
inemedia bank pool he fnd fom mall ineo o mee he pical
need of he compan. The inemedia ma ie i on eci, of
malle ale.

(b) Informational difficult: An aeage mall ineo old eihe no be
aae of he booe compan o old no kno ho o appaie o
manage he loan. The inemedia fill p hi gap.

(c) Perceived risk: The ik a ineo peceie in ineing in a bank ma
be mch lee han ha of ineing diecl in he compan, hogh in
eali, he financial ik of he compan i anpoed on he bank.
Hoee, he bank i a pool of eeal ch indiidal ik, and hence, he
ineo' pefeence of a bank o he booe compan i eaonable.

Seciiaion of he loan ino bond o debene fill p all he hee
difficlie in diec echange menioned aboe, and hence, aoid he need
fo a diec inemediaion. I aoid he anacional difficl b beaking
he lmp loan ino makeable lo. I aoid infomaional difficl becae
he eciied podc i offeed geneall b a of a pblic offe, and i
eenial feae ae ell dicloed. I aoid he peceied ik difficl
oo, ince he inmen i geneall ell-eced, and i aed fo he
ineo' aifacion.
Securitisation: changes the function of intermediation:
Hence, i i e o a ha eciiaion lead o a degee of
diinemediaion. Diinemediaion i one of he impoan aim of a
peen-da copoae eae, ince b leap-fogging he inemedia, he
compan inend o edce he co of i finance. Hence, eciiaion ha
been emploed o diinemediae.

I i, hee, ia dead ha eciiai de eiiae
he eed f he ieedia: i ee edefie he ieedia' a. Le
ee he abe eae. If he ca i he abe cae i iig
debee he bic eace a ba a, i i eiiaig he
ieedia agehe ? I d ib be aidig he ba a a
ieedia i he fiacia f, b d i eed he eice f a
iee bae ccef ccde he ie f debee.

Hece, eciiai chage he baic e f fiacia ieediaie.
Tadiia, fiacia ieediaie hae eeged ae a aaci
ibe b efig a ig fci, ad hae cibed edce
he ie' eceied i b biig hei eci f ha f he
ed e. Seciiai hee eice f he ieedia i a
bacgd b aig i ibe f he ed-e ffe hee feae i
f f he eci, i hich cae, he fc hif he e eeia
fci f a fiacia ieedia: ha f diibig a fiacia dc.
F eae, i he abe cae, hee he ba beig he eaie
ieedia a eiiaed ad iead he eice f a iee bae
ee gh diibe a debee ie, he fc hifed f he
ig ii ided b he bae he diibi ii ided b
he iee bae.

Thi ha haeed hica dc a e. Wih adadiai,
acagig ad badig f hica dc, he e f ieedia
ade, aica eaie, hifed f he h acaged ae
aiie ided he ce aace a ai, he e
h baica efed he diibi fci.

Seciiai ee eiiae fd-baed fiacia ieediaie b fee-
baed diib. I he abe eae, he ba a a fd-baed
ieedia, a eei f fd, heea he iee bae a a fee-
baed ieedia, a caa, a ieie f fd. Hece, ih iceaig
ed ad eciiai, he e f fee-baed fiacia eice ha bee
bgh i he fc.

I cae f a diec a, he edig ba a efig eea
ieediai fci ed abe: i a diib i he ee ha i
aied i fiace f a age be f a ie; i a
aaiig ad aeig he cedi i i eedig he cae a, ad
haig eeded i, i a aagig he ae. Seciiai i each f
hee ieedia fci aa, each be efed b eaae
eciaied agecie. The diibi fci i be efed b he
inemen bank, appaial fncion b a cedi-aing agenc, and
managemen fncion poibl b a mal fnd ho manage he pofolio of
eci inemen b he ineo. Hence, eciiaion eplace fnd-
baed eice b eeal fee-baed eice.

Seciiaion: changing he face of banking:
Note the quotation ith hich e began this Chapter - i a
eciiaion i lol b definiel changing he face of moden banking
and b he n of he ne millennim, eciiaion old hae anfomed
banking ino a ne-look fncion.

Bank ae inceaingl facing he hea of diinemediaion. When aked
h he obbed bank, he infamo Ameican ciminal Willie Son eplied
"ha' hee he mone i." No moe o, a bank old a ! In a old of
eciied ae, bank hae diminihed ole. The diincion beeen
adiional bank lending and eciied lending claifie hi iaion.

Tadiional bank lending ha four functions: oiginaing, fnding, eicing,
and monioing. Oiginaing mean making he loan, fnding implie ha he
loan i held on he balance hee, eicing mean collecing he pamen of
inee and pincipal, and monioing efe o condcing peiodic
eillance o ene ha he booe ha mainained he financial abili o
eice he loan. Seciied lending inodce he poibili of elling ae
on a bigge cale and eliminaing he need fo fnding and monioing.

The eciied lending fncion ha onl three steps: oiginae, ell, and
eice. Thi change fom a fo-ep poce o a hee-ep fncion ha
been decibed a he fragmentation o epaaion of adiional lending.

Capial make felled eciiaion:
The fel fo he diinemediaion make ha been poided b he capial
make:

Pofeional and pblicl aailable aing of booe ha eliminaed
he infomaional adanage of financial inemediaie. Imagine a
make iho aing agencie: an one ho ha o ake an epoe
in an podc o eni ha o appaie he eni. Obiol enogh,
only those who are able to employ high-degree analytical skills will be
able to survive. However, the availability oI proIessionally and
systematically conducted ratings has enabled lay investors to rely on
the rating company's proIessional judgement and invest directly in the
products or instruments oI user entities than to go through Iinancial
intermediaries.
The development oI capital markets has re-deIined the role oI bank
regulators. A bank supervisory body is concerned about the risk
concentrations taken by a bank. More the risk undertaken, more is
the requirement oI regulatory capital. On the other hand, iI the same
assets were to be distributed through the capital market to investors,
the risk is divided, and the only task oI the regulator is that the risk
inherent in the product is properly disclosed. The market sets its own
price Ior risk - higher the risk, higher the return required.

Capital markets tend to align risks to risk takers. Free oI constraints
imposed by regulators and risk-averse depositors and bank shareholders,
capital markets eIIiciently align risk preIerences and tolerances with issuers
(borrowers) by giving providers oI Iunds (capital market investors) only the
necessary and preIerred inIormation. Any remaining inIormational advantage
oI banks is Irequently oIIset by other Ieatures oI the capital markets: variety
oI oIIering methods, Ilexibility oI timing and other structural options. For
borrowers able to access capital markets directly, the cost oI capital will be
reduced according to the conIidence that the investor has in the relevance
and accuracy oI the provided inIormation.

As capital markets become more complete, Iinancial intermediaries become
less important as cotact points between borrowers and savers. They become
more important, however, as specialists that (1) complete markets by
providing new products and services, (2) transIer and distribute various risks
via structured deals, and (3) use their reputational capital as delegated
monitors to distinguish between high- and low-quality borrowers by
providing *third-party certiIications oI creditworthiness. These changes
represent a shiIt away Irom the administrative structures oI traditional lending
to market-oriented structures Ior allocating money and capital.

In this sense, securitisation is not really-speaking synonymous to
disintermediation, but distribution oI intermediary Iunctions amongst specialist
agencies.
1. Seciiaion and ced finance:

Securitisation is a "structured Iinancial instrument". "Structured
Iinance" has become a buzzword in today's Iinancial market. What it
means is a Iinancial instrument structured or tailored to the risk-return
and maturity needs oI the investor, rather than a simple claim against
an entity or asset.

Does that mean any tailored Iinancial product is a structured Iinancial
product? In a broad sense, yes. But the popular use oI the term
structured Iinance in today's Iinancial world is to reIer to such
Iinancing instruments where the Iinancier does not look at the entity as
a risk: but tries to align the Iinancing to speciIic cash accruals oI the
borrower.

On the investors side, securitisation seeks to structure an investment
option to suit the needs oI investors. It classiIies the receivables/cash
Ilows not only into diIIerent maturities but also into senior, mezzanine
and junior notes. ThereIore, it also aligns the returns to the risk
requirements oI the investor.
2. Seciiaion a a ool of ik
managemen:

Securitization is more than just a Iinancial tool. It is an important tool
oI risk management Ior banks that primarily works through risk
removal but also permits banks to acquire securitized assets with
potential diversiIication beneIits. When assets are removed Irom a
bank's balance sheet, without recourse, all the risks associated with
the asset are eliminated, save the risks retained by the bank. Credit
risk and interest-rate risk are the key uncertainties that concern
domestic lenders. By passing on these risks to investors, or to third
parties when credit enhancements are involved, Iinancial Iirms are
better able to manage their risk exposures.

In today's banking, securitisation is increasingly being resorted to by
banks, along with other innovations such as cedi deiaie to
manage credit risks.
Seciiaion and cedi deiaie:

Cedi deiaie ae onl a logical eenion of he concep of
eciiaion. A cedi deiaie i a non-fnd baed conac hen
one peon ageed o ndeake, fo a fee, he ik inheen in a cedi
iho acing aking oe he cedi. The ik cold be ndeaken
eihe b gaaneeing again a defal, o b gaaneeing he oal
epeced en fom he cedi anacion. While he fome cold be
j anohe fom of adiional gaanee, he lae i he e
concep of cedi deiaie. Th, if B bank ha a concenaion in
a Ion and Seel egmen hile A bank ha concenaion in
Teile, he o can dieif hei ik, iho acall aking
financial epoe, b engaging in cedi deiaie. A can agee o
gaanee he en of B fom a pa of i Ion and Seel epoe,
and B can gaanee he en of A fom Teile (deiaie do no
neceail hae o be ecipocal). Th, A i no eaning boh fom
i on epoe in Ion and Seel, a alo fom he fee-baed
epoe i ha aken in Teile.

Cedi deiaie ee logicall he ne ep in deelopmen of
eciiaion. Seciiaion deelopmen a pemied on cedi
being coneed ino a commodi. In he poce, he ik inheen in
cedi a being pofeionall meaed and aed. In he econd
ep, one old age ha if he ik can be meaed and aded a a
commodi ih he ndeling financing inoled, h can' he
financing and he cedi be ipped a o diffeen podc?

The deelopmen of cedi deiaie ha no edced he ole fo
eciiaion: i ha onl inceaed he poenial fo eciiaion.
Cedi deiaie i onl a ool fo ik managemen: eciiaion i
boh a ool fo ik managemen a alo ea managemen. Eniie
ha an o go fo eciiaion can eail e cedi deiaie a a
cedi enhancemen deice, ha i, ece oal en fom he
pofolio b bing a deiaie, and hen eciie he pofolio.
3. Economic impac of eciiaion:
Seciiaion i a necea o he econom a an oganied
make ae. While hi ingle line m p he economic ignificance
of eciiaion, he folloing can be een a he economic mei in
eciiaion:
-1 Faciliae ceaion of make in
financial claim:
B ceaing adeable eciie o of financial claim, eciiaion
helps to create markets in claims which would, in its absence, have
remained bilateral deals. In the process, securitisation makes financial
markets more efficient, b edcing anacion co.
-2 Dipee holding of financial
ae:
The basic intent of securitisation is to spread financial assets amidst as
man savers as possible. With this end in view, the securit is
designed in minimum sie marketable lots as necessar. Hence, it
results into dispersion of financial assets.One should not underrate the
significance of this factor just because most of the recentl developed
securitisations have been lapped up b institutional investors. La
investors need a certain cooling-off period before the understand a
financial innovation. Recent securitisation applications, vi., mortgages,
receivables, etc. are, therefore, et to become acceptable to la
investors. But given their attractive features, there is no reason wh
the will not.
-3 Pomoe aing:
The availabilit of financial claims in a marketable form, with proper
assurance as to qualit in form of credit ratings, and with double
safet-nets in form of trustees, etc., securitisation makes it possible for
the la investors to invest in direct financial claims at attractive rates.
This has salubrious effect on savings.
-4 Redce co:
As discussed above, securitisation tends to eliminate fund-based
intermediaries, and it leads to specialisation in intermediation functions.
This saves the end-user compan from intermediation costs, since the
specialised-intermediar costs are service-related, and generall
lower.
-5 Dieifie ik:
Financial intermediation is a case of diffusion of risk because of
accumulation b the intermediar of a portfolio of financial risks.
Securitisation further diffuses such diversified risk to a wide base of
investors, with the result that the risk inherent in financial transactions
gets ver widel diffused.
-6 Foce on e of eoce, and
not their onership:
Oce a ei eciie i fiacia cai, i ceae be he e
f ch ece ad bece ee a ee cdia f he
eea ie h heeafe acie ch cai. Iagie he idea
f eciiai beig caied fhe, ad fiacia cai b
cai i hica ae beig eciied, i hich cae he ei
eedig he e f hica ae acie ch e ih ig
he e. The e i diffed e a ie cd.I hi
ee, eciiaion caie Gandhi' idea of a capiali being a
ee of eoce and no he one. Seciiaion in i
logical eenion ill enable enepie o e phical ae
een iho oning hem, and o dipee he onehip o he
eal one heeof: he ocie.
4. The alchem of eciiaion: i he m
of pa moe han he hole?

A eeia ecic ei fe aied i: de eciiai ead
a ea cia beefi? Afe a, a ha eciiai de i bea a
ca, a e f ai ae, i ai be f caified ae,
ad ffe he ie. Iagie a d ih eciiai: each
ie d be aig a i i he caified, cie ca a a
he. S, h de i ee a ecic e, if he ca i "de-
ced" ad d diffee ie?

A Ne Zeaad-baed cha ae he fig eae iae he
ache f eciiai:

T aeciae he deig ecic diig a eciiai,
cide a hheica hdig ca XYZ Ld, hich ha
i baace hee hig he ha hee h-ed
bidiaie, X, Y & Z. (The ce f eciiai ca be
hgh f a eaig diigihabe f ae a if he
ee he h-ed bidiaie, X, Y ad Z.)

Ae X i 100% deb fiaced (5 ea debee ied a
9%) ih i ae a ige 5 ea a a AAA-aed
be aig 10%.

Assume Y is a new soItware company with no earnings or
perIormance history, but with projections Ior extremely
attractive, albeit volatile, Iuture earnings.

Assume Z is a well-known manuIacturing company with
predictable but unspectacular earnings.
II XYZ went to the debt markets seeking additional senior
unsecured Iunding, potential investors would Iace the diIIicult
task oI evaluating its assets and assessing its debt repaying
abilities. The assessed cost oI marginal XYZ borrowing might
consist oI an "average" oI the conservatively calculated returns
on the assets oI the segments that comprise XYZ. Note that
this average would necessarily reIlect known and unknown
synergies, and costs and associative risks arising Irom the
collective ownership oI the constituent parts (i.e., the group's
imputed contribution Ior credit support, insolvency risk and
liability recourse) and would likely include an "uncertainty"
discount.

Now consider the probable outcomes iI XYZ were to legally
sell or "spin-oII" the ownership oI one or more oI its "parts." In
exchange Ior the exclusive rights to the cash Ilows Irom X,
investors would return to XYZ maximum equivalent value in the
Iorm oI cash.
Such an oIIering:
appeals to a wide range oI investors, including those with a
preIerence Ior, and superior inIormation regarding, the risk
represented by X's obligors and those new investors who have
had an aversion Ior the risk presented by the associated costs
and risks represented by Y and Z
returns to XYZ the Iull value the market attaches to the
certainty oI the inIormation concerning X, now Iree oI any
discount imposed by the uncertainty oI the inIormation
regarding Y and Z.

Admittedly, the value oI the resulting XYZ shares depends in
part on the disposition oI the cash received Irom the spin-oII. II
XYZ retains the cash, there may be a discount or revaluation
resulting Irom the market's assessment oI XYZ's ability to
achieve a return equal or better than it would have earned Irom
keeping the asset.

There is always one clear collateral beneIit to the resulting XYZ
that derives Irom any divestment. The perceived value oI the
remaining components is relieved oI any previously imposed
discount Ior the disposed component's credit support and
insolvency risk.

Holding aside separate considerations oI corporate strategy
and intentional and coincidental internal synergies, to the extent
that the consideration received Irom the divestment improves
(in the perception oI the market) the capital structure oI the
resulting XYZ and/or improves the marginal Iunding cost Ior the
resulting XYZ, the decision to divest or securitise is simpliIied.
II the inIormation held by XYZ concerning any oI its segments
is not or cannot be Iully disclosed, or when disclosed will not
be Iully or accurately valued, the correct decision is to retain
the asset.

Without securitisation, XYZ's bank or Iactor Iaces signiIicant and largely
irreducible costs oI evaluating the marginal impact on XYZ's borrowing cost
Irom XYZ's pledging oI assets (receivables) and oI evaluating similar
inIormation Ior each other borrower that the lender or Iactor Iinances. II the
imposed cost oI borrowing is to be judged solely on the assets (which is, as
we've shown, the most eIIicient way to assess the true cost oI asset based
borrowing), evaluating each pool oI assets and assessing the likelihood that
the cash Ilows Irom them will be uninterrupted must be repeated Ior each
borrowing.

By developing a market Ior asset-speciIic expertise (not the least oI which is
represented by the expertise oI the rating agencies), and by relying on the
capital markets to determine the best price Ior the rated asset-backed
securities (such rating representing the expression oI the inIormation
provided by the developed expertise), the cost oI borrowings Ior issuers
using properly organised securitisation structures has steadily decreased and
is well below the cost oI borrowing Irom a lending institution.
Caping cale and olme efficiencie

By aggregating similarly originated assets into a suIIiciently large pool, the
consequences oI an individual receivable deIaulting, and the levels oI risk oI
defal, ae minimied. If e fhe collec and aggegae diimila pool of
ae, and ie eciie backed b he aggegaed cah flo deied
fom he ndeling ae, a a el of le of pobabili and he baic
pinciple of dieificaion, he maginal ik o he pchae (ineo) of
ch a eci i ignificanl le han he ik of holding een a pool of
indiidal eceiable. And i i fa le han he ik aociaed ih a ingle
eceiable.

If a booe can idenif, egegae and hen aifacoil decibe fo
ineo a pool of eciiable ae oheie held on i balance hee,
he eciiaion poce can gie ha booe a loe co of fnding and
impoe i balance hee managemen. The booe faced ih ch an
opponi ho chooe no o eciie n he ik of handicapping i
abili o compee.
1. ik and benefi of eciiaion:

The Bank fo Inenaional Selemen in a 1992 pblicaion iled Ae
Tanfe and Seciiaion had he folloing o a on he ik and benefi
of eciiaion:

The poible effec of eciiaion on financial em ma
ell diffe beeen conie becae of diffeence in he
ce of financial em o becae of diffeence in he
a in hich monea polic i eeced. In addiion, he
effec ill a depending pon he age of deelopmen of
eciiaion in a paicla con. The ne effec ma be
poeniall beneficial o hamfl, b a nmbe of concen ae
highlighed belo ha ma in ceain cicmance moe han
offe he benefi. Seeal of hee concen ae no pincipall
peio in nae, b he ae efeed o hee becae
he ma inflence monea ahoiie' polic on he
deelopmen of eciiaion make.

While ae anfe and eciiaion can impoe he
efficienc of he financial
em and inceae cedi aailabili b offeing booe
diec acce o end-ineo, he poce ma on he ohe
hand lead o ome diminion in he impoance of bank in he
fiacia ieediai ce. I he ee ha eciiai
cd edce he i f fiacia ae ad iabiiie
hed b ba, hi cd ede e diffic he eeci f
ea ic i cie hee cea ba eae
hgh aiabe ii eee eiee. A decie i
he iace f ba cd a eae he eaihi
beee ede ad be, aica i cie hee
ba ae edia i he ec.

Oe f he beefi f eciiai, ae he afai
f iiid a i iid eciie, a ead a iceae i
he aii f ae ae, ahgh cedi ehacee
cd ee hi effec. Mee, he aii cd be
ehaced b ee eae aiai i he cedi
adig f he be. A edeace f ae ih
eadi aceaiabe ae ae cd ee, i ceai
cicace, e a iidai a ed gig-
cce cce f aig ba.

Mee, he eciiai ce igh ead e
ee he fiabii f ba if -ba fiacia
iii ee f caia eiee ee gai a
ceiie adaage i iee i eciied ae.

Ahgh eciiai ca hae he adaage f eabig
edig ae ace bed he cai f he caia bae
f he baig e, he ce cd ead a decie i
he a caia eed i he baig e, heeb
iceaig he fiacia fagii f he fiacia e a a
he, bh aia ad ieaia. Wih a baia
caia bae, cedi e ca be abbed b he baig
e. B he ae ha caia bae i, he e he e
be haed b he. Thi cce aie, eceai
i a cie, b eecia i he cie hee ba
hae adiia bee he dia fiacia ieediaie.

The f iece be ee cae he ihee i f eciiai:

10 reasons as to wh the Titanic was actuall a
securitisation instrument:
) The downside was not immediatel apparent.
2) It went underwater rapidl despite assurances it was unsinkable.
3) Onl a few wealth people got out in time.
4) The structure appeared iron-clad.
5) Nobod reall understood the risk.
6) The disaster happened overnight London time.
7) Nobod spent an time monitoring the risk.
8) People spent a lot tring to lift it out of the water.
9) People who actuall made mone were not in original deal.
10) Despite the disaster, people still went on other ships.

The abe highigh he i ihee i eciiai. Oe f he bigge
ihee hea i eciiai dea i ha he ae aicia hae
eceai beieed eciied ie be afe, hie i eai, a
f he eee cedi i dbf eceiabe. F eae, a
gig eci f eciiai ae i b-ie a a ad he
ei a. Siia, a f he heah-cae eceiabe de a
eceiabe a eee gd cedi.

Oe iace f a faie i eciiai dea i he USA i he
eciiai f heah cae eceiabe b a ca caed Te
Fiacia. I Chaia a ae eeced 20 ea i i f fad.
I fac, he fi ba eciie cedi-cad ae--RebicBa
Deaae, i 1987--faied i 1988, ad he Fedea Dei Iace C.
aid ff ie ea.

I a aice ied On the Frontiers of Creative Finance: How Wall
Street can Securitise Anthing [Fe, Ai 28, 1997] Ki Ca
ed: " Ie d eed beae, f ce. Fiacia ae ae
i f hig iee idea i he abd. Se f hee eic
eciie i dbed cae, hich i dbed cae a
bacah."

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