Category: University of Mumbai BMS Notes

An important aspect of venture capital investing is the exit strategies. Venture capital funds primarily invest with an exit in mind after a few years. After successfully funding at seed, pre-production, production and expansion stages, a venture capitalist will start assessing exit strategies. The exit in the form of disinvestment or liquidation is the last and final stage of the venture capital funding.

The key types of liquidation/disinvestments are trade sales, sale of quoted equity post initial public offering (IPO), and write-offs. Let’s look at each of these in detail:

• Trade Sales: In this type of strategy the private company is sold or merged with an acquirer for stocks, cash, or a combination of both.
• IPO: If the company has done well, the venture capital investors will take the IPO route, by issuing shares registered for public offering. The venture capital investors and other private investors will get their portion of shares who can put them in the open marketplace for trading after an initial lock-in period.
• Write-offs: These are voluntary liquidations that may or may not result in any proceeds.
• Buy-back: In this method the entrepreneur buys-back the investment share from the venture capitalists and takes it back to being a privately held company. Investors who invest in a venture capital fund get distributions of public stock or cash from realized venture capital investments. Sometimes the fund may require further investments from limited partners. At other times, they may make cash or share distributions at random times during the lifetime of the fund. Investors can sell their interests to another buyer if they find one.

Venture Capital Investment process

Deal origination

Origination of a deal is the primary step in venture capital financing. It is not possible to make an investment without a deal therefore a stream of deal is necessary however the source of origination of such deals may be various. One of the most common sources of such origination is referral system. In referral system deals are referred to the venture capitalist by their business partners, parent organisations, friends etc.

Screening

Screening is the process by which the venture capitalist scrutinises all the projects in which he could invest. The projects are categorised under certain criterion such as market scope, technology or product, size of investment, geographical location, stage of financing etc. For the process of screening the entrepreneurs are asked to either provide a brief profile of their venture or invited for face-to-face discussion for seeking certain clarifications.

Evaluation

The proposal is evaluated after the screening and a detailed study is done. Some of the documents which are studied in details are projected profile, track record of the entrepreneur, future turnover, etc. The process of evaluation is a thorough process which not only evaluates the project capacity but also the capacity of the entrepreneurs to meet such claims. Certain qualities in the entrepreneur such as entrepreneurial skills, technical competence, manufacturing and marketing abilities and experience are put into consideration during evaluation. After putting into consideration all the factors, thorough risk management is done which is then followed by deal negotiation.

Deal Negotiation

After the venture capitalist finds the project beneficial he gets into deal negotiation. Deal negotiation is a process by which the terms and conditions of the deal are so formulated so as to make it mutually beneficial. The both the parties put forward their demands and a way in between are sought to settle the demands. Some of the factors which are negotiated are amount of investment, percentage of profit held by both the parties, rights of the venture capitalist and entrepreneur etc.

Post investment activity

Once the deal is finalised, the venture capitalist becomes a part of the venture and takes up certain rights and duties. The capitalist however does not take part in the day-to-day procedures of the firm; it only becomes involved during the situation of financial risk. The venture capitalists participate in the enterprise by a representation in the Board of Directors and ensure that the enterprise is acting as per the plan.

Exit plan

The last stage of venture capital investment is to make the exit plan based on the nature of investment, extent and type of financial stake etc. The exit plan is made to make minimal losses and maximum profits. The venture capitalist may exit through IPOs, acquisition by another company, purchase of the venture capitalists share by the promoter or an outsider.

Venture Capital in India

• Low level financing for proving and fructifying a new idea.
• Start-up financing where the new firms need funds for expense relating marketing and product development.
• First round financing which includes manufacturing and early sales funding
• Second round financing, which includes operational capital given for early stage companies which are selling products but not returning a profit
• Third round financing, which is also called a Mezzanine financing and includes the money needed to expand a newly beneficial company
• Fourth round financing also called Bridge financing and includes the financing the going public process.

Urban Land Ceiling and Regulation Act (ULCRA) of 1976 has been wrongly implemented and is the main culprit of the spiralling real estate prices. Land is not available to housing due to restrictions placed on conversion of agricultural land to non-agricultural land. The land prices in Bombay, Calcutta and Delhi are very high as compared to cities in the west like London and Washington. A boost to housing can rejuvenate the economy since has the maximum propensity to generate income and demand for materials, equipment and services. Moreover, funds allocated to shelter, return in the shape of income and demand to other sectors. To boost growth in the housing sector, there is an imperative need to have greater access to credit for housing in a regulated fashion. This necessitates a good housing finance system. Housing finance companies need to be recognized as being part of the total financial system, and should be given a level playing field.

Amidst liberalization, certain provisions of the Companies Act 1956, such as restrictions on inter-corporate loans and deposits continue to discriminate housing finance companies against other NBFC’s. Also certain tax laws such as deduction of tax at source, and restrictions acceptance of cash as deposits are disadvantages to housing finance companies. RBI has put housing finance on priority as core sector lending. In the developed countries, the flow of housing finance forms a substantial share of the total finance system. In fact, the savings for housing is among the single largest source of funds in their entire financial system.

Thus, it is imperative that India priorities the housing sector in order to enable a varied advantage to the economy in the form of employment, non-inflationary growth and reduced pressure on the balance of payments. The housing sector in India has been put under a lot of strain since Independence. Builders and developers too face varied problems.

Growth Factors

The Pradhan Mantri Awas Yojana (PMAY) aims to build over 2 crore affordable homes across 305 rural and urban centres.

Under this scheme, which is a part of the Housing for All vision, people can avail interest subsidy of 4% on loans up to Rs 9 lakh and 3% for loans up to Rs 12 lakh. There is also a 3% interest subsidy on a Rs 2 lakh loan for a new home in the rural areas.

The subsidies, which have made home loans affordable for the low-income group, have greatly helped people working in the unorganised sector, according to Arvind Hali, chairman of ART Affordable Housing Finance.

The government help has also resulted in housing finance companies disbursing more loans. To lend perspective, loans up to Rs 2 lakh witnessed the maximum year-over-year (Y-O-Y) growth of 10.4% in FY 2016-17.

New Dynamics:

An important development in the housing finance business has been the entry of new players. The relatively low risk in a housing portfolio has spurred new entrants in the last few years. Arguably the most significant entrant has been ICICI Home Finance. Among non-banking finance companies, Sundaram Finance and Tata Finance have launched housing finance subsidiaries in the recent past, while banks shown increased interest in acquiring housing assets.

The entry of new players and the consequent increase in competition has been followed by an interesting trend. The interest rates of most housing finance companies (HFC) move in unison, thereby suggesting that interest rate is not likely to be a competitive tool. The high level of competition has made it impossible for an HFC, with branches across the country, to charge an interest rate higher than the competition. Commercial banks are an exception to the rule, in the sense that they always charge lower than the competition.

Budgetary Support:

Tax benefits, a low interest rate regime and high salary levels among certain sections are chiefly responsible for fuelling fast growth in the housing financial services sector. Tax benefits for housing finance contribute to housing development. For this purpose, RBI maintains a soft interest rate regime. The bank rate of interest is constantly being slashed so that it acts as a stimulant for housing demand.

Similarly, a sharp increase in size of pay packets has played an important role in making a house affordable. Regardless of salary levels, if the cost of a house comes down, it would pep up the demand for housing finance. There is reason to believe that we are witnessing a gradual movement towards loosening the restrictions that increase the cost of a house.

Housing Finance Institutions in India

The below-mentioned list of housing finance companies have been granted Certificate of Registration (COR) with permission to accept public deposits –

• Aadhar Housing Finance Limited (Formerly: DHFL Vysya Housing Finance Limited)
• Housing and Urban Development Corporation Limited
• Housing Development Finance Corporation Limited
• Can Fin Homes Limited
• Cent Bank Home Finance Limited
• Manipal Housing Finance Syndicate Limited
• PNB Housing Finance Limited
• Dewan Housing Finance Corporation Limited
• ICICI Home Finance Company Limited
• LIC Housing Finance Limited
• Sundaram Home Finance Limited

Listed below are the Housing Finance Companies having valid Certificate of Registration that can accept public deposits with prior permission obtained from the National Housing Bank for accepting public deposits:

• National Trust Housing Finance Limited
• Saral Home Finance Limited.
• GIC Housing Finance Limited
• Ind Bank Housing Limited
• REPCO Home Finance Limited
• L&T Housing Finance Limited

The Housing Finance Company is yet another form of non-banking financial company which is engaged in the principal business of financing of acquisition or construction of houses that includes the development of plots of lands for the construction of new houses.

The Housing Finance Company is regulated by the National Housing Bank. Any non-banking finance company can operate as a housing finance company, subject to the fulfillment of basic requirements as specified in the Companies Act, 1956.

• The company should obtain a certificate of registration (COR) from the National Housing Bank (NHB). The company conducting such business without a COR is an offense punishable under the provisions of the National Housing Bank Act, 1987, also the NHB can demand the winding up of such company.
• The company should have its primary business of providing finance for housing, whether directly or indirectly.
• The company should have minimum Net Owned Fund of Rs 10 Crore.

Once these basic requirements are fulfilled, the company should comply with the following conditions to get registered as a Housing Finance Company:

• The affairs of the housing finance company should not be detrimental to the interest of the present and future depositors.
• The company shall be in such a position that it is able to meet the full claims of its present as well as future depositors as and when these accrue.
• The management of the company should not be prejudicial towards public interest or to the interest of its depositors.
• The Company should have an adequate capital structure and better income prospects.

The certificate of registration shall not be prejudicial to the operation and growth of housing finance sector of the country.

Housing Finance Policy Aspect

India’s national housing policy insists on providing more dwelling houses to the citizens. It is only natural for the government to create institutions which can provide housing finance.

At the international level, institutions such as World Bank and Asian Development Bank provides both grants and loans, especially soft loans for removing slums and for the creation of housing colonies. In fact, in India, the World Bank has financed Sites and Service Schemes to a number of state governments, thereby, both housing and promotion of small-scale industries are simultaneously encouraged.

In 2019, ‘Infrastructure Leasing & Financial Services Limited’ (IL&FS), India’s leading infrastructure development Non-Banking Financial Company (NBFC) defaulted on its debt payments. Housing Finance Companies, including HDFC, Dewan Housing Finance Ltd (DHFL), PNB Housing Finance Ltd (PNBHFL) and LIC Housing Finance Ltd (LICHFL), had high exposure to IL&FS. As a result, the crisis triggered a liquidity crunch in the housing finance sector. The Reserve Bank of India (RBI), therefore, proposed to take over the regulation of Housing Finance Companies (HFCs) by amending the National Banking Act from the National Housing Bank (NHB). The NHB had been set up as an apex institution to regulate housing finance in 1988.

The overall mandate given to the NHB is to make retail housing finance affordable to all sections of the society. The RBI, in November 2019, issued a notification withdrawing exemption given to HFCs which allowed the NHB to regulate them. HFCs came under the purview of the RBI through Section IIIB of the RBI Act.

Sources of Funds

Commercial banks and co-operative societies are providing housing finance. Life Insurance Corporation is also in the race for housing finance.

While providing housing finance, the lender and borrower enter into an agreement under the Transfer of Property Act, whereby the house to be constructed is mortgaged along with the land to the creditors who is called mortgagee. The borrower is the mortgagor and he cannot sell the house to any third party until the loan is repaid. In other words, the financing institution has a charge on the property of the borrower until he repays the loan.

When the housing loan is repaid, the mortgage is lifted and the ownership of the house is transferred to the owner. The owner has now an absolute right to transfer or sell to any party he likes. In the case of granting housing loan to existing houses for the purpose of rebuilding or expansion, the house will be mortgaged to the financing company, till the loan is repaid.

NBFCs raise capital in the short-term (1-3 months) commercial paper (CP) market at a lower cost, as compared to the long term (5-10 years) nonconvertible debenture (NCD) market but face the risk of rolling over the CP debt at short frequencies of a few months.4 The frequent repricing exposes NBFCs to the risk of facing higher financing costs and, in the worst case, credit rationing.

Advantages of Housing Finance

• Industries such as cement, brick manufacturing, sanitary products, electrical fittings and glass industries experience more demand due to house construction.
• Among the financial services, housing finance creates employment, both directly and indirectly.
• Rural housing develops not only rural areas but prevents migration of labor to urban areas.
• Factories or industrial establishments create townships by providing more housing facilities to their employees. Housing finance thereby reduces congestion in urban areas.
• Housing finance helps in creation of more houses which results in building up more infrastructure facilities, such as roads, electricity generation, drinking water facilities, etc.
• Due to housing finance, there is a vertical expansion and re building of dilapidated houses and re modelling of the existing houses.
• Non conventional energy gets popularized due to modern housing facilities which is one of the major benefits of housing finance.
• Housing facilities not only improve, they also reflect the culture of the country. Chandigarh city is an example for modern housing which has been built by a French architect.

The Indian housing finance market witnessed a decent rise in home loan outstanding of approx. 16% during fiscals 2015 to 2020. It was primarily due to higher disposable income, robust demand, and a more significant number of competitors entering the vertical. In fiscal 2020, total housing loan outstanding remained at Rs 20.4 trillion. Housing loan outstanding growth plummeted in fiscals 2019 and 2020 due to the Housing Finance companies’ slow growth (or HFCs.) The pandemic-induced nationwide lockdown had a tremendous impact on the overall construction activity. The return of 80% construction workforce of migrant laborers to their villages further aggravated the problems. Shrinking job prospectus coupled with limited income growth negatively impacted demand from end-buyers, primarily self-employed borrowers.

Market Share of Lenders in Housing Finance

Various players operating in the housing finance market include public sector banks (or PSBs), housing finance companies (or HFCs), new private sector banks, old private sector banks, and other lenders based on housing loan outstanding and housing loan disbursement. PSBs and HFCs accounted for 40% and 39% of the market share based on the housing loan outstanding in FY2019. Over the last few years, the share of housing finance companies has expanded, whereas the same has contracted for public sector banks in the market based on housing loans outstanding. When measured in market share based on housing loan disbursement, PSBs’ share was 37%, while for housing finance companies, the same was 41% in FY2019. For both major players, the share remained more or less the same over the past couple of years. Although PSBs lead in value terms, HFCs enjoy the highest market share in terms of volume compared with other lenders.

The home loan market is concentrated in the top 15 states, which accounted for ~93% of the loan outstanding at the end of March 2019. With an overall share of 23%, Maharashtra tops the list, followed by Karnataka (10%), Tamil Nadu (NS:TNNP) (9%), Gujarat (8%), and Telangana (6%). The top four states account for slightly more than 50% of the home loans outstanding.

Growth Drivers

Higher affordability, increased transparency, growing urbanization, and government incentives should drive the housing finance market’s growth over the next five years. You should note that the urban population’s share in the total population has consistently increased over the years. From 17% in 1951, it has risen to 35% in 2021. Demography-wise, we have one of the highest young populations globally, with a median age of 28 years. ~90% of Indians were below the age of 60 by the end of 2020, of which around 63% were between 15 and 59 years. Nuclearization means a shift from a joint family to a small family. Nuclearization in urban areas is also driving the housing demand in India and, in turn, home finance.

Changing lifestyles, the rise of individual consciousness, social attitudes, and increased labor mobility have also pushed housing demand across the country. These trends are expected to continue in the future. Income growth gives rise to a tendency to shift to bigger houses. Higher demand for separate homes, young-age housing loan borrowers, government Initiatives of affordable housing, and interest subsidies under PMAY should keep pushing housing finance demand is going ahead.

Housing Demand and Housing Finance Market Growth

We have witnessed subdued demand for high-priced homes in metros and faster growth in smaller districts in the recent past, and it resulted in a higher share of smaller districts in overall home loans over the past few years. According to the CRISIL (NS:CRSL) study, the top 50 districts in India accounted for 72% of the housing demand in fiscal 2019. The last two years (2019 and 2020) have mainly seen vivid growth in the share of smaller districts in the home loan disbursements, and this trend is anticipated to continue in the future, according to CRISIL.

During fiscal 2014 to 2019, the home loan market grew at ~18% CAGR. In that market, the contribution of high-priced housing jumped from 44% in fiscal 2015 to 54% in fiscal 2019. Higher project launches in the high-priced housing segment led to the growth in contribution. Note that the market share of the high-priced housing segment is increasing, albeit slowly, in volume terms. However, the low-priced housing segment (less than Rs 25 lacs) still holds more than 80% of the market share.

Refinancing Instruments

Banks and HFCs can refinance by using own deposits or by turning to the capital market. In addition, they can also avail the refinance facilities offered by the NHB. Since the year 2000, the NHB is authorized to carry out securitization transactions and issue mortgage-backed securities (MBS) on behalf of private financial institutions. Its role is that of a financial trustee and credit enhancer for the private MBS. Besides, together with its private sector counterparts it is working to establish a Mortgage Credit Guarantee Company which is intended to offer mortgage insurance services. Despite continued efforts, the Indian MBS market is still not fully developed with only one per cent of housing loans being securitised.

Major Issues in housing finance market

Entering into an era of rate war: Now a days the finance companies have entered into an era of rate war. Many players have started examining the possibility of reducing their interest rates in order to remain competitive in the market place and attract the customers. The ability to get long term funds at cheap rates is an important competitive advantage.

Availability of funds: It is the most important problem of the HFCs. The borrowing capacity of the people has increased due to the budget proposals whereas the lending capacity has not changed much since it requires the long term finance.

Lack of Clear Title: Another major issue conforming Indian housing is the lack of clear title to property. Around 90 percent of all the land in India does not have clear title. The ownership is unclear and hence, the land is off the market, thereby creating scarcity of land. This problem could be attributed to poor record keeping and complicated processes.

Risk of default: Since the HFCs are running short of funds, any default by the customers will have the direct impact on the lending capacity of the companies as the fund remain blocked during the period. HFCs are not in a position to absorb such shocks due to the paucity of funds. However, HFCs have historically had much lower default rates when compared to the banks and other finance companies.

High Stamp Duty: The cost of transferring land, stamp duty and registration charges payable are prohibitively high. This dissuades people from seeking housing, development and financing. Moreover, the procedure followed is also not transparent.

Leasing in India

Leasing industry in India is of recent origin. It was pioneered in 1973 when for the first time ‘Leasing Company of India’ was set up in Madras. For almost seven years in the country, this company was the sole leasing company. In 1980 another leasing company known as “20th Century Leasing” came into existence. Both these leasing companies were promoted by management qualified professionals from city bank.

Thereafter, a virtual explosion in the leasing industry was noticeable. In 1981 four organisations, viz., Shetty Investment and Finance, ‘Paybharat Credit and Investment’, ‘Motor and General Finance’ and ‘Sundaram Finance’ joined the leasing business essentially for taking tax advantage.

The leasing industry entered the third stage in the growth phase in late 1982 when numerous financial institutions and commercial banks either started leasing or announced plans to do so. ICICI embraced leasing activity in 1983 where-after the trickle soon developed into flood and leasing became the new gold mine.

This was also the time when the profit performance of the first two dozen companies had been made public which was so fascinating as to attract many more companies in leasing business. In the meantime, International Finance Corporation announced its decisions to open four leasing joint ventures in India.

To add to the leasing boom, the Finance Ministry announced strict measures for enlistment of investment companies on stock exchange, which made many investment companies to turn overnight into leasing companies. Foreign banks in India particularly Grind-lays did commendable work in marketing the leasing idea.

At present, there are about 300 leasing companies in the country. Apart from these, many companies engaged in other businesses are also leasing out mainly to employ their investible surplus in tax-benefit. Over the period 1980-88, gross leased assets of these companies expanded by Rs. 700 crores indicating the extent to which leasing companies have played significant role in asset formation. This is a basic fact that requires recognition and encouragement by the government. It is most intriguing to note that the leasing industry is being singled out for discriminatory practices.

Leasing is coming of age in India, as is evidenced by phenomenal growth of leasing industry by over 100 per cent in recent few years. Against only Rs. 3000 crore of lease deals done during 1993-94, the buzz in the leasing industry puts leasing volume in 1994-95 at close to Rs. 7000 crores.

A large part of this unprecedented growth was contributed by the Public Sector Units (PSUs). For instance, the IDBI single handedly did a Rs. 50 crores lease deal for the Shipping Corporation of India for financing the acquisition of a single ship.

SBI capital markets syndicated a Rs. 240 crore lease deal for Mangalore Refinery and Petrochemical Ltd. Similarly, Infrastructural Leasing and Financial Services Ltd. syndicated a Rs. 200 crore lease deal for Maharashtra State Electricity Board (MSEB).

KDTK Mahindra Finance Ltd. has structured Rs. 300 crore transmission and distribution equipment’s lease deal for MSEB.

IDBI Sanctioned Lease finance to the tune of Rs. 1007 crore in 1997-98 which was more than what was provided during 1994-95. The institution is looking at financing leasing of small aircraft for spraying pesticides and ferrying executives and large allocation for shipping. Telecom and the power sector.

The SBI group is forming a consortium for lease financing.

A syndicate of leasing companies provided Rs. 250 crore lease finance to the Rajasthan State Electricity Board.

Banks and bank-subsidiaries:

Till 1991, there were some ten bank subsidiaries active in leasing, and over-active in stock-investing. The latter variety was ravaged in the aftermath of the 1992 securities scam.

In Feb., 1994, the RBI allowed banks to directly enter leasing. So long, only bank subsidiaries were allowed to engage in leasing operations, which was regarded by the RBI as a non-banking activity. However, the 1994 Notification saw an essential thread of similarity between financial leasing and traditional lending.

Though State Bank of India, Canara Bank etc have set up leasing activity, it is not currently at a scale to make any difference on the leasing scenario. This is different from the rest of the World, where banks are front-runners in leasing markets.

Legal Aspects of Leasing

“The delivery of goods by one person to another, for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed of according to the directions of the person delivering them. The person delivering the goods is called the ‘bailor’ and the person to whom they are delivered is called the ‘bailee’.

Financial leasing represents a “Distinctive triangular relationship” requiring three discrete parties:

(1) A lessor who advances funds for the purchase of the equipment which constitutes the subject of the leasing transaction.

(2) A lessee who selects the equipment and pays a rental fee for the right to use it.

(3) A supplier who sells the equipment to the lessor. Financial leasing also links two separates, albeit interrelated, contracts: a leasing agreement between the lessor and lessee, and a supply agreement between the supplier and lessor.

International Financial Leasing means at least there are one or more international elements in a transaction. Basically, in a finance lease transaction, if the supplier, lessor and lessee are all have their places of businesses in different countries; or regardless of the place of business of the supplier, the lessee and the lessor have their places of business in different countries, the contract of the financial leasing can be thought as an international financial leasing contract.

Since an equipment lease transaction is regarded as a contract of bailment, the obligations of the lessor and the lessee are similar to those of the bailor and the bailee (other than those expressly specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian Contract Act. Essentially these provisions have the following implications for the lessor and the lessee.

The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement.

The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor’s title, to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period.

Contents of a lease agreement:

The lease agreement specifies the legal rights and obligations of the lessor and the lessee. It typically contains terms relating to the following:

• Description of the lessor, the lessee, and the equipment.
• Amount, time and place of lease rentals payments.
• Time and place of equipment delivery.
• Lessee’s responsibility for taking delivery and possession of the leased equipment.
• Lessee’s responsibility for maintenance, repairs, registration, etc. and the lessor’s right in case of default by the lessee.
• Lessee’s right to enjoy the benefits of the warranties provided by the equipment manufacturer/supplier.
• Insurance to be taken by the lessee on behalf of the lessor.
• Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives.
• Options of lease renewal for the lessee.
• Return of equipment on expiry of the lease period.
• Arbitration procedure in the event of dispute.

Derivatives are essentially contracts that derive their value from an underlying asset. The underlying asset can be stocks, commodities, currencies, indices, exchange rates, or even interest rates. Derivative trading involves both buying and selling of these financial contracts in the stock market. With derivatives, you can make profits by predicting the future price movement of the underlying asset.

Derivative contracts can be classified into two types; Futures and Options. A future is basically a contract between a buyer and a seller, who agree to buy and sell a specific underlying asset at a future date. Similar to futures, option contracts give the buyer and the seller the right to buy and sell the underlying asset at a specific price at a future point in time. An option, on the other hand, is again sub-classified into two types; call option and put option.

However, there’s a key difference between these two futures and options. In the case of options, the buyer or the seller can either choose to exercise their right to buy or sell, or they could allow that right to lapse upon the expiry of the contract. With futures, both the buyer and the seller are obligated to honor the contract upon expiry.

Derivative contracts are short-term financial instruments that come with a fixed expiry date, which is generally the last thursday of every month. At any point in time, both futures and options contracts trade with three different expiry dates spanning over three months.

Types:

Futures: A futures contract is a legal agreement between two parties to buy or sell the underlying asset at a predetermined future date and price. The contract is executed directly through a regulated and organised exchange.

Forwards: Forward contracts are similar to futures except the deal is not made through an organised or regulated exchange. Since these are Over-The-Counter (OTC) contracts, they carry more counterparty risk for both parties involved.

Options: An options contract gives a trader the right but not an obligation to buy or sell an underlying asset at a predetermined future date and price.

Swaps: A swap is a contractual agreement between two parties to exchange cash flows at a future date based on a pre-planned formula. Similar to forwards, they are OTC contracts and consequently not traded on exchanges.

Participants:

Traders and speculators: They predict future changes in the price of an underlying asset. Based on these predictions, they take a certain position (long or short) in a derivative contract.

Hedgers: These participants invest in the derivatives market to eliminate the risks associated with future price changes.

Arbitrageurs: Arbitrage is a practice often adopted by traders to exploit the price differences in two or more markets. For example, a trader purchases stock in one market and simultaneously sells it off at a higher price in another. It is a common practice in financial markets.

Margin traders: In derivative trading, a margin is an initial amount an investor has to pay to the stockbroker. It is only a percentage of the total value of the investor’s position. Margin traders use this distinct payment feature to buy more stocks than they can afford.

Uses:

Earn money on shares that are lying idle

So you don’t want to sell the shares that you bought for long term, but want to take advantage of price fluctuations in the short term. You can use derivative instruments to do so. Derivatives market allows you to conduct transactions without actually selling your shares also called as physical settlement.

Protect your securities against

Fluctuations in prices the derivative market offers products that allow you to hedge yourself against a fall in the price of shares that you possess. It also offers products that protect you from a rise in the price of shares that you plan to purchase. This is called hedging.

Benefit from arbitrage

When you buy low in one market and sell high in the other market, it called arbitrage trading. Simply put, you are taking advantage of differences in prices in the two markets.

Transfer of risk

By far, the most important use of these derivatives is the transfer of market risk from risk-averse investors to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety, while risk-loving investors like speculators conduct risky, contrarian trades to improve profits. This way, the risk is transferred. There are a wide variety of products available and strategies that can be constructed, which allow you to pass on your risk.

Advantages

Used in risk management: The value of a derivative contract has a direct relation with the price of its underlying asset. Hence, derivatives are used to hedge the risks associated with changing price levels of the underlying asset. For example, Mr A buys a derivative contract, the value of which moves in the opposite direction to the price of the asset he possesses. He’ll be able to use the profits in the derivatives to offset losses in the underlying asset.

Low transaction costs: Derivative contracts play a part in reducing market transaction costs since they work as risk management tools. Thus, the cost of transaction in derivative stock trading is lower as compared to other securities like debentures and shares.

Market efficiency: Derivative trading involves the practice of arbitrage which plays a vital role in ensuring that the market reaches equilibrium and the prices of the underlying assets are correct.

Determines the price of an underlying asset: Derivative contracts are often used to ascertain the price of an underlying asset.

Risk is transferable: Derivatives allow investors, businesses and others to transfer the risk to other parties.

Disadvantages

Counterparty risk: Derivative contracts like futures that are traded on the exchanges like BSE and NSE are organised and regulated. But, OTC derivative contracts like forwards, are not standardised. Hence, there’s always a risk of counterparty default.

Involves high risk: Derivative contracts are highly volatile as the value of underlying assets like shares keeps fluctuating rapidly. Thus, traders are exposed to the risk of incurring huge losses.

Speculative in nature: Derivative contracts are commonly used as tools for speculation. Due to the high risk associated with them and their unpredictable fluctuations in value, baseless speculations often lead to huge losses.

A merchant bank is a company that deals mostly in international finance, business loans for companies and underwriting. These banks are experts in international trade, which makes them specialists in dealing with multinational corporations. A merchant bank may perform some of the same services as an investment bank, but it does not provide regular banking services to the general public. One role of a merchant bank is to provide financing to large corporations that do business overseas. Assume, for example, that ABC Company is based in the United States and decides to purchase a supplier that is based in Germany. Merchant banker is any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager -consultant, advisor or rendering corporate advisory services in relation to such issue management in merchant banking.

Issue management refers to managing issues of corporate securities like equity shares, preference shares and debentures or bonds. It involves marketing of capital issues, of existing companies including rights issues and dilution of shares by letter of offer. Management of issue also involves other issues. The decisions concerning size and timing of the public issue in the light of the market conditions are advised by the merchant bankers. In addition to these, the merchant bankers also assist the corporate units on the designing of a sound capital structure acceptable to the financial institutions and determining the quantum and terms of the public issues of different forms of securities. Further, they also advise the issuing company whether to go for a fresh issue, additional issue, bonus issue, right issue or combination of these. In brief, managing public issue is a complicated and technical job. It involves various strategic decisions and coordination of various agencies.

The public issues are managed by the involvement of various agencies i.e., under writers, brokers, bankers, advertising agencies, printers, auditors, legal advisers, registrar to the issue and merchant bankers providing specialized services to make the issue a success. However, merchant bank is the agency at the apex level, who plans, coordinates and controls the entire issue activity and directs different agencies to contribute to the successful marketing of securities.

Issue Managers are required to be registered with SEBI to carry on their Issue Management activities, since setting up of SEBI. SEBI has formulated Rules and

Regulations for merchant bankers which bring out the requirements for Registration of issue managers apart from prescribing the conduct rules for them. In terms of these regulations, issue managers are required to mainly comply with the following requirements for registration:

• Issue manager should be a corporate body, not being a Non Banking Financial Company (as per RBI).
• He should have necessary infrastructure like adequate office space, equipment’s and manpower to effectively discharge his activities.
• He should have minimum two persons who have the experience to conduct the business of Merchant Banking.
• He should fulfil capital adequacy requirements i.e. should have a minimum net worth of Rs.5 crores.
• He should have professional qualification from an institute recognized by government in Law, Finance or Business Management.

Issue managers play vital role in fund raising through public issue of securities. Whether through book building (discussed later) or otherwise, their role is catalytic for the making of the issue a success. They are involved from cradle to grave in the issue. Hence companies coming with new issue of capital decide about Issue managers after due diligence and carefully analysing the competence and capabilities of the merchant banker to handle the issue. They provide valuable service in preparation and drafting the prospectus, pricing the issue, marketing and underwriting the issue, coordinating the activities or different agencies/institutions involved in this context to carry out legalities involved in the process, deciding the basis of allotment, making the allotment, despatch of share certificates/refund orders as the case may be, and finally, in listing of shares on stock exchanges and sometimes as market maker as well. SEBI has issued compendium of circulars to merchant bankers from time to time and broadly has divided these activities into two groups i.e., Pre-issue activities and Post-issue activities.

Pre activities:

1) Issue of shares

2) Marketing, Coordination and underwriting of the issue.

3) Pricing of issues

Post activities:

1) Collection of application forms and amount received

2) Scrutinising application

3) Deciding allotment procedure

4) Mailing of share certificates/refund or allotment orders.

Securitization is a carefully structured process by which a pool of loans and other receivables are packaged and sold in the form of asset-backed securities to the investors to raise the required funds from them. Through this process relatively illiquid assets are converted into securities. Securitization falls under the broad category termed as structured finance transactions.

Structured finance refers to securities where the promise to repay the investors is backed by the value of the underlying financial asset or the credit support of a third party to the transaction or some combination of the two. Thus, securitization is nothing but liquefying assets comprising loans and receivables of an institution through systematic issuance of financial instruments.

Structured financing instruments are derivatives of traditionally secured debt instruments where the credit standing of the instrument is supported by a lien on specific assets or by some other form of credit enhancement such as a guarantee. With a conventional secured bond, the primary source of repayment of the bond is still the earning power and cash flow of the issuer.

In a securitized transaction, the burden of repayment on the bond shifts away from the issuer to a pool of assets or to a third party. The cash flows from the pools of assets which have been securitized provide the funds for repayment to the bond.

Securitized transaction is termed as structured transaction because through specific choices relating to the type and amount of assets in the pool and particular features of the transaction, these securities may be structured to achieve a desired level of risk and a desired level of rating.

Securitization is said to have taken place when a company’s assets are removed in one way or the other form from its balance sheet and are funded instead by investors. The investors receive tradable financial instruments evidencing the investment without recourse to lending institution. The entire transaction, from the accounting point of view, is carried out on the asset side of the balance sheet, that is, one asset gets converted into another.

Mechanism of Securitization:

(i) The process of securitization starts with identification by the company (the originator) the loans or bills receivable in its portfolio, to prepare a basket or pool of assets to be securitized. The package usually forms an optimum mix so as to ensure fair marketability of the instrument to be issued.

Further, the maturities are also so chosen that the package represents one homogeneous lot. The pool of receivables is backed by the underlying securities held by the originator (in the form of mortgage, pledge, charge, etc.).

(ii) The pool of assets so identified is then sold to a specific purpose vehicle (SPV) or trust. Usually an investment banker performs the task of an SPV, which is also called an issuer, as it ultimately issues the securities to investors.

(iii) Once the assets are acquired by SPV, the same are split into individual shares/securities which are reimbursed by selling them to investors. These securities are called ‘Pay or Pass Through Certificates’ (PTC) which are so structured as to synchronize for redemption with the maturity of the securitized loans or bills.

A PTC thus represents a sale of an undivided interest to the extent of the face value of the PTC in the aggregate pool of assets acquired by the SPV from the originator.

(iv) Repayments under the securitized loans or bills keep on being received by the originator and passed on to the SPV. To this end, the contractual relationship between the originator an d the borrowers/obligates is allowed to subsist in terms of the pass through transaction; alternatively a separate agency arrangement is made between the SPV (Principal) and the originator (agent).

(v) Although a PTC could be with recourse to its originator, the usual practice has been to make it without recourse. Accordingly, a PTC holder takes recourse to the SPV and not the originator for payment to the principal and interest on the PTCs held by him. However, a part of the credit risk, as perceived (and not interest risk), can be absorbed by the originator, by transferring the assets at a discount, enabling the SPV to issue the PTCs at a discount to face value.

(vi) The debt to be securitized and the PTC issues are got rated by rating agencies on the eve of the securitization. The issues by the SPV could also be guaranteed by external guarantor-institutions to enhance creditability of the issues. The PTCs, before maturity, are tradable in a secondary market to ensure liquidity for the investors.

From the above, it is evident that the primary participants involved in the issuance of securitization transaction are the originator, obligors, the SPV, the servicer and the credit enhancer. The originator has the assets which are sold or used as collateral for the assets backed securities. Originators are generally manufacturing companies, financial institutions, banks and non-banking finance companies.

The term obligors’ refers to borrowers who have taken loans from the originators resulting in the creation of the underlying asset. The SPV or trust raises funds to buy assets from the originator by selling securities to investors. It uses the cash flow generated by the financial assets in the pool to pay interest and principal to investors and covers its own costs. The servicer/receiving and paying agent is responsible for collecting principal and interest payments on assets when due and for pursuing the collection from delinquent accounts.

The service is usually the originator or an associate of the originator. The credit enhancer provides the required amount of credit support to reduce the overall credit risk of a security issue. Credit enhancement is provided by the originator in the form of senior- subordinate structure over collaterisation or through a cash collateral. Third party credit enhancement generally takes the form of a letter of credit or a surety bond.

Utility of Securitization:

Securitization as a financial instrument is becoming extremely popular the world over with more and more issuers resorting to raising funds through this route. This is for this fact that it confers lot of benefits on the parties to the process.

Securitization serves as handmade to organization in raising additional funds to finance their growth programme. Companies with poor credit standing and therefore finding it difficult to procure resources from the market can obtain funds by issuing asset back securities at lower interest cost due to higher credit rating on such securities. Even if the issuer is not an AAA rated company, it can issue an AAA rated securitized asset.

This can be done by carefully selecting the portfolio on the basis of criteria stipulated by the rating agency. What is more useful is that relatively illiquid assets are converted into marketable securities providing liquidity and alternate funding sources. Another advantage to the company is economy in the use of funds and greater recycling of resources leads to higher business turnover and profitability.

Further, cost of raising funds by way of securitization is cheaper than that involved in funding by way of conventional fund-raising instruments like shares, bonds, debentures, and commercial papers. Through its novel mechanism of diversifying the risk factors, enhancing the credit and removing uncertainties for investors, structured securitization facilitates the originator to access the securities market at debt ratings higher than its overall corporate rating. As a result, the company can secure funds at lower cost.

The cost of raising funds against securitized assets depends essentially on quality of assets to be securitized and image of the issuer in the minds of investors. Obviously, the price at which an asset-based securities is sold or the discount which the buyer gets differs from deal to deal. Further, bargaining powers of the negotiations bear upon the cost of acquiring funds through securitization.

Securitization also facilitates strengthening of capital adequacy of the originating company by isolating the loan-assets from the originator’s balance sheet and by removing or replacing them. Securitization is equally useful to investors. It offers multiple new investment instruments for mutual funds, insurance companies, pension funds and general investors to cater to their needs and preferences. Besides widening the choice and availability, it also provides for higher return and liquidity for the instrument.

The unique benefit which investors derive from securitization is that they can look past the issuing entity to the collateral pool that the issue represents. This transparency reduces uncertainly for the investor as to the risk element. Being a structured asset backed security, the instrument provides higher protection against rating down-grades of the originator, as compared to traditional debt securities.

It also provides opportunity for matching cash flows and managing ALM since securitized instrument carries regular monthly cash flows and has varying maturities. The prevalence of secondary markets would offer liquidity.

As a product of raising funds against receivables, securitization is far superior to bills discounting or factoring. Bill discounting has emerged as a working capital product employed to raise funds out of short-term trade receivables. In contrast, securitization is a medium to long-term source.

Even in a mature bill market, the sheer quantum of paper work in raising money against bills of long maturities would be a deterrent. Although factoring appears to be similar to securitization as the factor buys the receivables of a company at a discount, there has traditionally been no intention to rate the portfolio or create a secondary market for the receivables.

Further, factoring has emerged as a trade financing tool rather than for medium or long-term financing. However, the securitization process, if not carried out prudentially, can leave risks with the originating bank without allocating capital to back them. While all banking activity entails operational and legal risks, these may be greater under more complex activity.

It is felt that the main risk a bank may face in a securitization scheme arises if a true sale has not been achieved and the selling institution is forced to recognize some or all of the losses if the assets subsequently cease to perform. Also, funding risks and constraints on liquidity may arise if assets designed to be securitized have been originated, but because of disturbances in the market, the securities cannot be placed.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.

The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances (but also includes businesses established specifically to generate marketable debt (consumer or otherwise) for the purpose of subsequent securitization). Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates.

Purpose of Securitisation

Normally, a lender (financier) finances loans to borrowers and gets repayment with interest over a period. The lender would collect the periodic instalments and use them to finance new loans. This limits his capacity to give fresh loans, as he has to wait till, he recovers the instalments along with interest. Instead of waiting for a long time, he can pool the loans together and sell his right to receive future payments from the borrowers of these loans.

This is termed as securitisation of loans. The original lender will receive consideration for the same upfront, i.e. immediately, by securitising his loan portfolio. Of course, he will get the amount at a discounted value. He can then use the proceeds to further develop his business, which is of giving loans.

Securitisation is a form of financing involving pooling of financial assets and the issuance of securities that are repaid from the cash flows generated by the assets. This is generally accomplished by actual sale of the assets to a bankruptcy remove vehicle, i.e. a special purpose vehicle (like Asset Reconstruction Company), which finances the purchase through issue of bonds.

These bonds are backed by future cash flow of the asset pool. The most common assets for securitisation are mortgages, credit cards, auto and consumer loans, student loans, corporate debt, export receivables, off shore remittances etc.

These ‘Securitised loans’ will be purchased by mutual funds, provident funds and insurance companies, which have funds but do not have mechanism to assess, grant and recover loans. Thus, corporate bodies like finance companies having expertise in assessing, granting and recovering loans get the funds from corporate bodies like mutual funds, provident funds, insurance companies etc. which have funds but do not have expertise in loan assessment and disbursal, through process of securitisation. Thus, securitisation helps both.

Securitisation is done through Special Purpose Vehicles (SPVs). These are termed as Asset Reconstruction Companies in the present SARFAESI Act.

Thus, securitisation is a process through which illiquid assets are transferred into a more liquid form of assets and distributed to a broad range of investors through capital markets. The lending institution’s assets are removed from its balance sheet and are instead funded by investors through a negotiable financial instrument. The security is backed by the expected cash flows from the assets.

Securitisation is a process under which a pool of individual homogeneous loans is packaged and distributed to various investors having liquid funds in the form of coupons/pass through or pay through certificates; through SPVs (Special Purpose Vehicles), with the provision that the inflow of cash in the shape of recoveries will be distributed pro-rata to coupon holders.

In securitisation, the lending institution’s assets are removed from balance sheet of that lending institution and are instead, funded by investors. These investors purchase a negotiable financial instrument evidencing this indebtedness.

Basically, all assets which generate cash flow can be securitised e.g. mortgage loans, housing loans, automobile loans, credit card receivables, trade receivables, consumer loans, lease finance etc. A perfectly healthy and normal financial asset is normally securitised. It is not necessary that it should be non-performing asset.

Securitisation and factoring – distinction– Difference between factoring and securitisation is that in case of factoring, the assets are debts which have crystallized but are not due.

Securitization v/s Factoring

• Under factoring there are two parties that is the bank and the company while under securitization there are many investors involved who invest in the securitized asset.
• While factoring is arrangement between the banks and a company in which financial institution purchases the book debts of a company and pays the money to the company against receivables whereas Securitization is the process of converting illiquid assets into liquid assets by converting longer duration cash flows into shorter duration cash flows.
• While factoring is done for short term account receivables ranging from 1 month to 6 months whereas securitization is done for long term receivables of the company.
• Since factoring involves only bank and the company there is no need for any credit rating while securitization involves many investors and therefore it is necessary to take credit rating before going for securitization of receivables.
• While factoring is of many types and can be with or without recourse while securitization is done without recourse.

Securitization

• It is something with loans.
• It is related with loans.
• Medium or long term.
• Agencies will look after collections.
• Originator will take portion of credit risk.

Factoring

• It is something with bills receivables.
• Short term.
• It is related with book debts.
• Factor will look after collections.
• Factor will take 100% credit risk.

Features of Securitization

Commoditization:

Securitization is the process of commoditization, where the basic idea is to take the outcome of this process into the capital market. Thus, the result of every securitization process, whatever might be the area to which it is applied, is to create certain instruments which can be placed in the market.

Merchantable Quality:

To be market acceptable a securitized product should be of saleable quality. This concept, in case of physical goods, is something which is acceptable to merchants in normal trade. When applied to financial products, it would mean that 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.

For widely distributed securitized instruments, evaluation of the quality, and its certification by an independent expert, viz., rating is common. The rating is for the benefit of the lay investor, who 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 a drastic change, making rating a universal requirement for securitization. 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 debtors’ claim assumes significance, which at times enables investors to reply purely on the credit rating of debtors (or a portfolio of debtors) and so, make the instrument totally independent of the originators’ own rating.

Marketability:

The very purpose of securitization is to ensure marketability to financial claims. Hence, the instrument is structured in such a way 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 feature. Marketability involves two concepts:

(1) The legal and systematic possibility of marketing the instrument.

(2) 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 in the world, laws dealing with marketable instruments (also referred to as negotiable instruments) were mostly limited in relation to what was then in circulation.

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. Liquidity is afforded to a securitized instruments either by introducing it in to an organized market (such as securities exchanges) or by one or more agencies acting as, market makers i.e. agreeing to buy and sell the instrument at either pre-determined or market-determined prices.

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 that can be achieved Wider distribution leads to a cost benefit, in that the issuer is able to market the product with lower return, and hence, lower financial cost to him. But a wide investor base involves the high cost of distribution and servicing.

Pass Through Certificates

A pass-through certificates is an instrument that evidences the ownership of two or more equipment trust certificates. In other words, equipment trust certificates may be bundled into a pass-through structure as a means of diversifying the asset pool and/or increasing the size of the offering. The principal and interest payments on the equipment trust certificates are “passed through” to certificate holders. A pass-through certificate is an instrument which signifies transfer of interest in receivables in favour of the holder of the Pass-Through Certificate. The investor in a pass-through transaction acquire the receivables subject to all their fluctuation, prepayments etc. the material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayment etc., transferred to the investor.

Investors who purchase a pass-through certificate may think that this investment is more secure or less risky than others. The problem is that mortgages in the securitized instrument may not actually be entirely risk free, however. For example, when a mortgage goes into default, the holder of the securitized instrument loses money. This can result in the holder such as a major government-sponsored entity not being able to cover its payments or costs associated with business. This creates a downward cycle of money in the process of buying and selling a pass-through certificate.

Special Purpose Vehicle

A special purpose vehicle, also called a special purpose entity (SPE), is a subsidiary created by a parent company to isolate financial risk. Its legal status as a separate company makes its obligations secure even if the parent company goes bankrupt. For this reason, a special purpose vehicle is sometimes called a bankruptcy-remote entity.

Uses of Special Purpose Vehicles

1. Securitization

Securitization of loans is a common reason to create an SPV. For example, when issuing mortgage-backed securities from a pool of mortgages, a bank can separate the loans from its other obligations by creating an SPV. The SPV allows investors in the mortgage-backed securities to receive payments for these loans before other creditors of the bank.

2. Risk sharing

A corporation’s project may entail significant risks. Creating an SPV enables the corporation to legally isolate the risks of the project and then share this risk with other investors.

3. Asset transfer

Certain types of assets can be hard to transfer. Thus, a company may create an SPV to own these assets. When they want to transfer the assets, they can simply sell the SPV as part of a merger and acquisition (M&A) process.

4. Property sale

If the taxes on property sales are higher than the capital gain realized from the sale, a company may create an SPV that will own the properties for sale. It can then sell the SPV instead of the properties and pay tax on the capital gain from the sale instead of having to pay the property sales tax.

Benefits:

• Isolated financial risk
• Direct ownership of a specific asset
• Tax savings, if the vehicle is created in a tax haven such as the Cayman Islands
• Easy to create and set up the vehicle

Risks:

• Lower access to capital at the vehicle level (since it doesn’t have the same credit as the sponsor)
• Mark to Market accounting rules could be triggered if an asset is sold, significantly impacting the sponsor’s balance sheet
• Regulatory changes could cause serious problems for companies using these vehicles
• The optics surrounding SPVs are sometimes negative

Securitisable Assets

Debt

The advantage of a securitization transaction is that it enables the holder of the underlying debt to refinance that debt. Therefore, securitization involves assets that are typically illiquid (such as household debt), which are impossible to sell directly, since each individual debt is unique and requires separate administrative processing. Securitization also involves debts of smaller amounts, such as consumer debt, which, individually, generate relatively little income (in comparison to the amount of income typically generated by institutional investors) but which can be grouped together to make up a more valuable pool. Therefore, one of the main purposes of securitization is to create a marketable asset by combining several assets that, individually, are not as readily bought or sold, or in other words, to make a market for such assets.

Few examples of assets that can be securitized:

• Residential mortgage loans; this category includesthe infamous “subprime mortgages,” which are home loans issued to individualswith a low credit rating
• Commercial mortgage loans
• Bank loans to businesses
• Commercial debt
• Student loans (mainly in the US)
• Credit-card debt: in this case, the maturity of the security issued will typically be longer than that of the underlying debt; the assets portfolio will have to be “topped up” several times in order to ensure the promised cash flows. Therefore, some of the securitized debt does not exist yet at the time when the security is created. This is referred to as “securitization of future cash flows.”
• Automobile loans

Benefits of Securitization

Securitization, also known as asset-backed securitization or structured financing, has been defined as a financing instrument whereby a company transfers rights in current or future receivables or other financial assets to an entity that serves as a “special purpose vehicle” (SPV), which in turn issues securities to capital market investors and uses the proceeds from the issue to pay for the financial assets. The source of the receivables could be any right of payment or asset that generates an income with a stable cash flow. The existing or future receivables could be the income generated, among others things by residential or commercial loans, credit card receivables, automobile loans, student loans, royalties on intellectual property, tax receivables or any other income source that is regular and predictable.

Balance Sheet Benefits

Securitization accelerates cash receipts from the receivables while removing the accounts receivables from the originator’s balance sheet. This reduces the originator’s debt/equity ratio so that it is better able to:

(i) Comply with financial covenants in respect of its on-balance sheet borrowing;

(ii) Borrow more.

(iii) Improve the return on capital

The International Financial Reporting Standards (IFRS) (which replaced the International Accounting Standards (IAS)) have made securitization structures that allow an originator to remove receivables from its balance sheet harder to achieve. Whether or not these are applied, and the effect of other accountancy practices affecting off-balance sheet treatment, depends on the jurisdiction. However, balance sheet considerations continue to be an element of financial structuring.

Cheaper Financing

By using securitization techniques to separate a pool of underlying receivables, the originator may be able to generate a lower cost of financing than it can through various forms of borrowing. This is because receivables are often a better credit quality than the originator itself. Without securitization, the originator would finance itself through borrowing based on its own creditworthiness, therefore incurring additional debt. This “swapping” of one credit for another is known as credit arbitrage.

Capital Adequacy

In most jurisdictions, financial institutions must hold a minimum capital requirement (essentially equity, reserves and various forms of subordinated debt) against “risk-weighted” assets (that is, the value of assets taking into account a risk weighting which is based on the likelihood of the asset value being realized). The requirement is expressed as a ratio that is set by the relevant regulatory authority in a specific jurisdiction. The sale of receivables for cash effectively removes risk weighted assets from the regulated institution’s balance sheet and reports additional cash instead. This balance sheet “exchange” of receivables for cash improves regulated institution’s capital structure and reduces regulatory cost.

Alternative Source of Funding

Asset securitization provides the originator with additional source of funding or liquidity because this financing technique basically converts an illiquid asset (e.g. receivable deriving from a consumer loan which itself cannot be sold) into:

(i) Cash for the originator.

(ii) A security with greater marketability for investors.

Further, the ability to sell these securities worldwide diversifies the institution’s funding base, which reduces the institution’s dependence on local economies.

New Guidelines on Securitization

The RBI has also provided certain relaxations in relation to residential mortgage backed securities (RMBS) basis the recommendations of the Committee on Development of Housing Finance Securitisation Market in India. RMBS is defined as ‘securities issued by the special purpose entity against underlying exposures that are all residential mortgages’.

Under the Draft Securitisation Framework, the minimum holding period for RMBS will be six months or six instalments, whichever is later. The MRR for RMBS has been limited to 5% of the book value of the loans being securitised. If the value of the exposures underlying an RMBS is INR 500 crore or above, it is proposed that the securities issued must be mandatorily listed.

The revisions suggested, if given effect to, will enable HFCs and NBFCs with exposure to RMBS to package such portfolios and issue securities of different credit tranches and list them. Senior tranches can be issued to investors who are risk averse, while junior tranches can be issued to institutions who subscribe to such instruments. This will certainly provide the much-needed liquidity to HFCs and over time deepen the RMBS market and ensure that these products are available to a wider spectrum of investors.

Exemptions and Prohibitions

While the Draft Securitisation Framework now permits assets purchased from other entities to be securitised, resecuritisation exposures, synthetic securitisation and securitisation with revolving credit facilities as underlying continue to be prohibited. Pooling of purchased loans along with existing portfolios will increase the rating of certain kinds of pools.

Transactions involving revolving credit facilities, loans with bullet repayments of both principal and interest and securitisation exposures continue to be exempt from the applicability of the Draft Securitisation Framework.

Capital Requirement for securitisation exposures

The Draft Securitisation Framework provides for conditions required to be met by lenders for maintenance of capital. Such conditions will come into immediate effect and will apply to existing securitisation exposures as well. Conditions required to be met for de-recognition of the transferred asset by the originator include:

• Significant credit risk associated with the underlying exposures of the securities issued by the special purpose entity (SPE) being transferred to third parties. Significant credit risk will be treated as transferred if:

(i) There are at least three tranches, risk weighted exposure amounts of the mezzanine securitisation positions held by the originator do not exceed 50% of the risk weighted exposure amounts of all mezzanine securitisation positions existing in this securitisation.

(ii) In cases where there are no mezzanine securitisation positions, the originator does not hold more than 20% of the exposure values of securitisation positions that are first loss positions.

• The transferred exposures are legally isolated from the originator and are put beyond the reach of the originator or its creditors;
• The securities issued by the SPE are not obligations of the originator;
• Securitisation does not contain clauses that require the originator to replenish or replace the underlying exposures to improve the credit quality of the pool, in the event of deterioration in the underlying credit quality.

Capital Measurement Approaches

In line with the Basel III guidelines, two capital measurement approaches have been proposed: Securitisation External Ratings Based Approach (SEC-ERBA) and Securitisation Standardised Approach (SEC-SA).

The Draft Securitisation Framework further provides that banks can adopt either of the two approaches. NBFCs (including housing finance companies) shall only apply the Securitisation External Ratings Based approach for calculation of risk weighted assets.