What is Securitisation? – Accounting, Purpose, Process and its Working

Table of Contents:

1. What is ‘Securitisation’

1.1 RBI guidelines on securitization of standard assets

1.2 Assignment of debts/NPAs between banks inter se is permissible

2. Purpose of securitisation

2.1 Securitisation with or without recourse

2.2 Definition of ‘Securitisation’

2.3 Assets that can be securitised

2.4 Long dated assets and short dated funding sources

2.5 Mortgage securitisation or asset securitisation

3. How securitisation process works

3.1 Process of securitisation

3.2 Summary of process

3.3 Advantages of Securitisation

4. Credit rating is of assets securitised and not of the originator

5. Public issue and listing of securitised certificates or instruments

6. Accounting for securitisation

7. Legal framework for securitisation

7.1 Qualified Buyer (QB)

7.2 Forming a scheme and issue of security receipt

7.3 If assets not realised as per scheme

7.4 Registration of security receipt under Registration Act not required

Check out Taxmann's Guide to SARFAESI Act 2002 & Recovery of Debts and Bankruptcy Act 1993 which provides comprehensive materials on Securitisation & Debt Recovery Laws. It contains 'chapter-wise commentary on SARFAESI & RDB Act.

1. What is ‘Securitisation’

Securitisation as a technique gained popularity in the US in the 1970. UK is the second largest market for securitisation after the US.

In layman’s simple terms, ‘securitisation’ means sale and purchase of pooled (bundled) secured assets.

Securitisation started in the US in 1970 with the issue of residential mortgages by public housing finance corporations. The institutions found that they had to pay higher interest to attract short-term deposits, while rates earned on long-term mortgage loans was less. This created mismatch between assets and liabilities. The solution was found in securitisation.

Now, securitisation is used in more complicated financial structures also. There is a definite move towards securitisation in capital market in various assets such as insurance receivables, commercial bank loans, obligations of purchases to natural gas producers, future rights to royalty payments etc.

Major buyers of such debt instruments in USA are mutual funds, insurance companies, trusts and corporates with excess liquidity. In India, presently, only mutual funds and to a lesser extent Banks with surplus funds can be the buyers. Insurance companies may also be buyers.

Securitisation is sale and purchase of debts and receivables, normally through Asset Reconstruction Company.

Asset Reconstruction Company (ARC) means a company registered with RBI for purpose of carrying on business of asset reconstruction or securitization or both – section 2(1)(ba) of SARFAESI Act inserted w.e.f. 1-9-2016.

Even if the provisions of securitisation are contained in the Act relating to reconstruction of financial assets and enforcement of security interest, practically, the provisions are independent and in fact, assets with good credit rating can also be securitised.

1.1 RBI guidelines on securitization of standard assets

RBI had issued guidelines for securitisation of standard assets vide DBOD.NO.BP.BC.60/21.04/048/2005-06 dated 1-2-2006. Later, guidelines were issued vide DBOD.No .BP.BC.103/21.04.177/2001-12 dated 7-5-2012 to Banks.

The guidelines have been extended to NBFC also vide RBI circular DNBS.PD.No. 301/3.10.01/2012-13 dated 21-8-2012.

1.2 Assignment of debts/NPAs between banks inter se is permissible

Assignment of debts or NPA (Non-Performing Assets) between banks inter se is permissible. Scope of ‘banking business’ is not limited to core baking of accepting deposits and lending. RBI can formulate policy enabling banking companies to enlarge in such other activities and in that process it can define what constitutes ‘banking business’.

RBI guidelines dated 13-7-2005 authorising Banks to deal inter se in NPAs have statutory force and are not ultra vires the Banking Regulation Act, 1949 – ICICI Bank Ltd. v. Official Liquidator of APS Star Industries Ltd. (2010) 10 SCC 1 = 104 SCL 37 = 7 taxmann.com 72 (SC).

Assignee of debt can file petition for winding up – Assignee of debt under Securitisation Act can file petition for winding up – Horizon Flora India Ltd. v. Asset Reconstruction Co. India Ltd. (2011) 105 SCL 20 (Bom HC DB).

2. 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 are 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.

By securitisation, long-term illiquid assets of original lender get converted into current assets.

2.1 Securitisation with or without recourse

Securitisation can be with or without recourse to the original lender. ‘Without recourse’ means that if the borrower does not pay, the loser is Asset Reconstruction Company and/or investors, as the amount cannot be recovered from original lender. If the lending is with recourse, the Asset Reconstruction Company/investors can recover the principal and interest from original lending institution, if the borrower does not pay.

Even if securitisation is without recourse, in some cases, limited recourse may be provided, e.g. if fraud, forgery, suppression of facts, misstatements etc. by the original lender is alleged and established.

2.2 Definition of ‘Securitisation’

As per legal definition, ‘Securitisation’ means acquisition of financial asset by any Asset Reconstruction Company from any originator, whether by raising funds by such Asset Reconstruction Company from qualified buyers by issue of security receipts representing undivided interest in such interest or otherwise. [section 2(1)(z) of SARFAESI Act as amended w.e.f. 1-9-2016].

2.3 Assets that can be securitised

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.

2.4 Long dated assets and short dated funding sources

Traditionally, banks have short dated deposits. If advances are on long-term basis, these will be long dates assets, where credit risks are high. Securitisation is a way to convert the potential risks of long dated assets into viable sources of capital. Thus, mismatch between funding of assets and liabilities can be reduced.

2.5 Mortgage securitisation or asset securitisation

Securitisation can be mortgage securitisation or asset securitisation. In mortgage securitisation, pools of mortgage backed loans are converted into tradable debt securities called mortgage-backed securities. This is common in housing loans.

In Asset securitisation, assets which have an income stream are pooled and repackaged in the form of marketable securities for sale to investors. The securities are secured by the assets themselves or by income derived from them. The underlying asset generally backs the loan or security.

In case of industrial loans, the instrument may be termed as ‘collateralized loan obligations’.

3. How securitisation process works?

Briefly, securitisation is a process whereby loans, receivables and other financial assets are pooled together, with their cash flows or economic values redirected to support payments on related securities.

The originator (original lender) transfers or sells loans of a particular portfolio to SPV (Special Purpose Vehicle). The SPV breaks the loans into convenient amounts and raises money from investors by selling instruments which represent loans. These debt instruments issued by SPV will be listed on stock exchange, providing liquidity. The debt instruments must have credit rating.

The original lender utilises securitisation to finance and enhance his business activities. The lending institution’s assets are removed from its balance sheet.

Transfer to SPV– The financial assets are transferred to a new entity [referred to as ‘Special Purpose Vehicle’  (SPV)]. Theoretically, such SPV can be a company or a trust. However, in the SARFAESI Act, the assets will be transferred to an independent Asset Reconstruction Company. [Thus, formation of SPV as a trust is not envisaged].

3.1 Process of securitisation

The process of securitisation begins when the lender (or originator) segregates loans/lease/receivables into pools which are relatively homogenous in regard to types of credit, maturity and interest rate risk. The pools of assets are then transferred to a Special Purpose Vehicle (SPV) [In the present Act, an independent Asset Reconstruction Company is envisaged].

The SPV issues asset backed securities in the form of debt, certificates of beneficial ownership and other instruments.

These securities will be rated by Credit Rating Agencies.

Presently, it is envisaged that such securities will be offered to QBs (Qualified Buyers) only. Public participation is not envisaged.

The SPV acts as intermediary. It buys financial assets from seller or transferor and issues securities to the investors. Money received from investors is paid to the transferor. The investors are serviced and repaid out of the assets realised over a period of time.

Pass through certificates– In pass through certificates, a direct participation in the cash flow is sold. Receipt of asset cash flow is deposited in designated accounts. The funds are then passed on to Certificate Holders. Receivables are directly assigned to investors through SPV. Thus, the cash is collected by the original lender which is then passed on to SPV (Asset Reconstruction Company)

Pay through certificates– This involves a specific assignment/sale of asset cash flow to the SPV. The SPV then issues pay through certificates to the investors. In this case, normally, the cash is collected by the SPV from the borrower and then distributed to the certificate holders.

3.2 Summary of process

The process can be summarised as follows –

• • Lender sells various types of loans to borrowers
  • Out of these loans, he packs certain loans together and sells these to Asset Reconstruction Company
  • The Asset Reconstruction Company makes payment to original lender for loans purchased
  • These loans are converted into a pool of securities by the Asset Reconstruction Company for purpose of issuing Pass Through or Pay Through Certificates (PTC).
  • These PTCs are sold to individual investors [QBs].
  • The recoveries from original borrower are obtained by original lender (in case of Pass Through Certificates) and by Asset Reconstruction Company (in case of Pay Through Certificates).
  • If collection is made by original borrower, he is under obligation to pass on the money to Asset Reconstruction Company.
  • The ARC passes on these amounts to individual investors.

3.3 Advantages of Securitisation

Securitisation is designed to offer a number of advantages to the seller, investor and debt markets. Advantages of securitisation can be summarised as follows –

• • Banks can keep loans off their balance sheet, thus reducing need for additional capital
  • Alternative form to banks and financial institutions of funding risk transfer and capital market development
  • Reduce lending concentration and improve liquidity
  • Attainment of funds at lower costs since these are isolated from potential bankruptcy risk of originator
  • Better matching of assets and liabilities and development of long-term debt market
  • Provides diversified pool of uniform assets to banks and financial institutions
  • Converting non-liquid loans or assets into liquid assets or marketable securities.
  • Transfer of funds from less efficient debt market to more efficient capital market through securitisation.

For seller or originator, securitisation mainly results in receivables being replaced by cash thereby improving the liquidity position. It removes the assets from the balance sheet of the originator, thus liberating capital for other uses, and enabling restructuring of the balance sheet by reducing large exposures or sectoral concentration. It facilitates better asset liability management by reducing market risks resulting from interest rate mismatches. The process also enables the issuer to recycle assets more frequently and thereby improve earning. Finally, transparency may be improved since securitisation results in identifiable assets in the balance sheet.

Since securitised assets go off the balance sheet of originator, asset base is pruned down, thereby reducing the regulatory capital requirements to support the assets. Moreover, asset portfolio is liquidated releasing cash, which, in turn, reduces the need for demand and time liabilities that are subject to statutory reserves.

In brief, original lender transforms his illiquid assets like mortgages, lease rentals etc. into liquidity by raising money on them. The additional funds raised can be used to increase business. Cost of raising funds will be lower as there will be wider investment base and liquidity. Further, credit risk will be diversified.

Securitisation helps in recycling and roll over of assets.

For investor, securitisation essentially provides an avenue for relatively risk-free investment. The credit enhancement provides an opportunity to investors to acquire good quality assets and to diversify their portfolios.

From the point of view of the financial system as a whole, securitisation increases the number of debt instruments in the market, and provides additional liquidity in the market. It also facilitates unbundling, better allocation and management of project risks. It could widen the market by attracting new players on account of superior quality assets being available.

4. Credit rating is of assets securitised and not of the originator

The credit rating is of the transaction of the assets securitised and not of the originator or issuer. Thus, it is possible that credit rating of the securitised assets will be quite different from the credit rating of the originator. In extreme case, even if the originator company is liquidated, the asset securitised will still be good and the investor investing in the securitised asset will be protected.

Similarly, the Asset Reconstruction Company does not own the assets and hence even if it goes into liquidation, security of investor does not get affected. This ensures ‘bankruptcy remoteness’. Thus, securitisation transaction may have higher credit rating that the credit rating of the originator/issuer himself.

5. Public issue and listing of securitised certificates or instruments

Section 17A of Securities Contracts (Regulation) Act makes provision for public issue and listing of the securitised certificates or instruments.

Security Receipt issued by Securitisation Company, as defined in section 2(1)(zg) of ‘Securitisation & Reconstruction of Financial Assets & Enforcement of Security Interest Act, 2002’ has been included in definition of ‘securities’ in section 2(h) of Securities Contracts (Regulation) Act, 1956.

SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 make provisions for public offer and listing of Securitised debt instruments.

Securitised certificate or instrument – Securitised certificate or instrument is any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity, which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be [section 2(h)(ie) of SCRA].

Listing and issue of securities – Only those securities which fulfil eligibility criteria specified by SEBI and complies with requirements specified by SEBI can be issued to public [section 17A(1) of SCRA]. Issuer of securitised certificate or instrument will make application for listing to one or more recognised stock exchanges, before issuing offer document to public [section 17A(2) of SCRA].

If permission for listing is refused by any stock exchange, the issuer shall repay all moneys to applicants with eight working days. If not so repaid, interest @ 15% is payable [section 17A(3)]. All provisions relating to listing shall apply to listing of such securities [section 17A(4) of SCRA].

Listing agreement for Securitised Debt Instruments has been prescribed vide SEBI circular No. IMD/DF/5/2011 dated 16-3-2011.

6. Accounting for securitisation

ICAI has issued guidance note on Accounting for Securitisation. – see Chartered Accountant – March 2003 also available on website of ICAI. The guidance note is similar to IAS-39 [International Accounting Standard 39]

7. Legal framework for securitisation

As per the SARFAESI Act, the financial asset will be first acquired by Asset Reconstruction Company from bank or financial institution.

‘Securitisation’ means acquisition of financial asset by any Asset Reconstruction Company from any originator, whether by raising funds by such Asset Reconstruction Company from qualified buyers (QB) by issue of security receipts representing undivided interest in such interest or otherwise. [section 2(1)(z) of SARFAESI Act as amended w.e.f. 1-9-2016].

The words ‘or otherwise’ means that the funds can also be raised by means other than issue of security receipts to QB.

Originator– ‘Originator’ means the owner of a financial asset which is acquired by Asset Reconstruction company, for the purpose of securitisation or asset reconstruction. [section 2(1)(r) of SARFAESI Act]

7.1 Qualified Buyer (QB)

Qualified Buyer (QB) means a * Financial Institution * Insurance Company * Bank * State Financial Corporation * State Industrial Development corporation * Trustee or Asset Reconstruction company making investment on behalf of mutual fund` * Any other body corporate as may be specified by SEBI * Any category of non-financial investors as may be specified by RBI under section 7(1) of SARFAESI Act * Any other body corporate as may be specified by SEBI [section 2(1)(u) of SARFAESI Act as amended on 4-11-2016.

[They were earlier termed as ‘Qualified Institutional Buyers’ (QIB) till 1-9-2016]

Systemically important Non-deposit taking NBFC with asset size of 100 crores Rupees or more and other non-deposit taking NBFC with asset size exceeding Rs 50 crores or more and CRAR of 10% are qualified buyers (QB – that time QIB) for purpose of SARFAESI Act – SEBI Notification No. 11/LC/GN/2008/21670 dated 31-3-2008.

Alternative Investment Funds (AIF) registered with SEBI have been notified as ‘qualified buyers’.If AIF has invested in ARC, it shall not invest in security receipts issued by that ARC. AIF shall not invest in security receipts backed by NPA assets of banks which hold equity oF more than 10% in that AIF – RBI Notification No. 08 /26.03.001/2020-21 dated 10-3-2021.

‘Financial Institution’ means * Public Financial Institution within meaning of section 4A of Companies Act (now section 2(72) of Companies Act, 2013) * International Finance Corporation * Any Institution notified under section 2(h)(ii) of Recovery of Debts due to Banks and Financial Institutions Act, 1993 * Debenture trustee registered with SEBI and appointed for secured debt securities * Asset Reconstruction Company whether acting as such or managing a trust for purpose of securitization or asset reconstruction * Any other institution or NBFC as defined in section 45-I(f) of RBI Act, as may be notified by Central Government [section 2(1)(m) of SARFAESI Act – words in italics inserted w.e.f. 1-9-2016].

Public Financial Institution – “Public financial institution” means— (i) the Life Insurance Corporation of India, established under section 3 of the Life Insurance Corporation Act, 1956 (ii) the Infrastructure Development Finance Company Limited, referred to in of section 4A(1)(vi) of the 1956 Act (which is repealed under section 461 of the 2013 Act) (iii) specified company referred to in the Unit Trust of India (Transfer of Undertaking and Repeal) Act, 2002 (iv) institutions notified by the Central Government under section 4A(2) of the 1956 Act (which is now repealed under section 465 of the 2013 Act) (v) such other institution as may be notified by the Central Government in consultation with the Reserve Bank of India [section 2(72) of Companies Act, 2013].

Broadly, ‘Public Financial Institution’ [PFI] means IDBI, ICICI, IFCI, LIC, UTI IRBI, GICI, SCICI, SIDBI, State Financial Corporations, NABARD, NCDC etc.

Asian Development Bank has been notified as ‘Financial Institution’ vide notification No. SO 1275(E) dated 30-10-2003.

Category I Alternative Investment Funds (AIFs) set up as trust and registered with SEBI are specified as ‘qualified buyers’, subject to the conditions specified in Notification DoR. FIN. No. 08/26.03.001/2020-2021 dated March 10, 2021 issued by RBI.

7.2 Forming a scheme and issue of security receipt

The Asset Reconstruction Company will devise a separate scheme for each of the financial asset taken over. QB (Qualified Buyers) will invest in such ‘scheme’.

The Asset Reconstruction Company will issue ‘security receipts’ to QB or such other category of investors including non-institutional investors as specified by RBI from time to time – section 7(1) of SARFAESI Act. Words in italics inserted vide 2016 Amendment Act.

The Asset Reconstruction Company will realise the assets and redeem the investment and payment of returns to QB under each scheme. Account of each scheme of every financial asset will be kept separately by Asset Reconstruction Company and funds realised from that asset will be utilised only for redemption of investments and payment of returns under that scheme. [section 7(2) of SARFAESI Act].

The scheme may be in nature of trust for QB to be managed by Asset Reconstruction Company. Provisions of Indian Trust Act will apply to the extent they are not inconsistent with provisions of SARFAESI Act. [section 7(2A) of SARFAESI Act].

‘Scheme’ means a scheme inviting subscription to security receipts proposed to be issued by Asset Reconstruction Company under that scheme. [section 2(1)(y) of SARFAESI Act].

‘Security receipt’ means a receipt or other security, issued by Asset Reconstruction Company to any QB, pursuant to a scheme, evidencing the purchase or acquisition by the holder thereof, of an undivided interest in such financial assets. [section 2(1)(zg) of SARFAESI Act].

The security receipt represents undivided interest in financial asset. It does not create, declare, assign, limit or extinguish any right, title or interest to or in immovable property except to the extent of undivided interest afforded by the security receipt. It does not require registration under Registration Act, 1908. [section 8(a) of SARFAESI Act].

The ‘security receipt’ will be a ‘security’ under section 2(h)(ic) of Securities Contracts (Regulation) Act, 1956.

Provisions of Other Acts should be followed – The security receipts are required to be issued without prejudice to provisions in Companies Act, SEBI Act and SCRA. [section 7(1) of SARFAESI Act].

Thus, provisions of those Acts in respect of issue, listing, trading etc. will have to be followed.

7.3 If assets not realised as per scheme

If financial assets are not realised by securitisation or reconstruction company as per the scheme, the Qualified Buyers (QBs), representing at least 75% of total value of security receipts issued under that scheme will be entitled to call a meeting of all QBs. Resolutions passed at the meeting will be binding on reconstruction company. [section 7(3) of SARFAESI Act].

QBs will follow procedure at the meeting similar to meeting of Board of Directors of the company. [section 7(4) of SARFAESI Act].

7.4 Registration of security receipt under Registration Act not required

Registration of the security receipt representing undivided divided interest in the financial asset is not required under Registration Act, 1908, even if the financial asset is an immovable property. Similarly, transfer of such security receipt will not require registration under Registration Act, 1908. [section 8 of SARFAESI Act].