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Banking And Finance Law Finance Essay

With the advent of time, and advent of new methods of banking and financing, the need to be more creative and to derive need methods of functioning of banking and financing sector arose. One of such methods is securitization, a well-established practise in global market. It is a global financing tool of the present era, which originated in the 1980s. Australia, Brazil, Canada, France, Germany, Hong Kong, Japan, Mexico, Netherlands, UK, USA have used some form of securitization. Of the several types, the securitization of, future receivables are the most popular in India. [1] The most essential feature of securitization is that the ‘non-tradable liquid assets are transformed to tradable securities’. [2] A well-known definition of securitization is,

“…simply stated.....a framework in which some illiquid assets of a corporation or a financial institution are transformed into a package of securities backed by these assets, through careful packaging, credit enhancements, liquidity enhancements and structuring.” [3] 

It is the process through which “an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors”. [4] In other words, a route by which a company packages its illiquid assets as a security. [5] The assets that can be securitized are several, wherein they range from credit card receivables to trade receivable, they can be airline tickets, residential mortgages, car loans, swaop contracts, tax lien, telephone receivables, trade and export receivables, hire purchase receivables, insurance premium, cinema tickets, parking fines and many more [6] . This showcases that any asses that is liquid and that can be en-cashed can be securitized. And it is also a series of financial transactions where in transfer takes place to ensure cash flow and reduce risk for debt originators. [7] 

When the banks issue loans to the borrowers, their capital is spent. Though the capital is utilized to issue loans, the balance sheet entry shows the capital as an asset, which will be appropriated in the future (as the borrower pays the principal and interest amount). Thus arises, the need to realize the value of these assets, which are on the balance sheet. They are residential mortgages, retail loans like credit card receivables and corporate loans. The reason why banks intent to reduce the size of these assets is explained by Anuk Teasdale [8] , as: (i) the revenues receivable are unchanged but the sizes of the assets are decreased, due to which there will be an increase in the return ratio. (ii) the capital in the balance sheet will be reduced, due to which there are cost savings or allows institutions to allocate that capital that is securitized to any other profitable, business. (iii) the cash flow is created for the originator (bank). For these reasons a ‘lower rated entity can access debt capital markets’ [9] which otherwise would be the regime of higher rated entities or institutions. [10] Securitization occurs “when assets, receivable or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment. Then, financial instruments are sold which are backed by the cash flow or value of the underlying assets” [11] .

1.1Objective:

In this project I would like to explain the concept of securitization, the process of securitization, the manner in which it has aided several actors and has changed the financing mechanism throughout the world. This eventually in the 2007 is blamed to be the reason for sub-prime crisis. Also would mainly focus on the Indian Securitization methods and the Securitization Laws in India.

1.2 Research Methodology

The method of research adopted in collecting or gathering the relevant information is the doctrinal method of research. The resources utilized are the primary sources from the NALSAR University of Law Library and secondary sources from the internet.

1.3 Research Plan:

The project has been divided into 7 parts, which deal with the objective of this piece in detail. While doing so, the main parts are further sub-divided, which also are further divided. In total the schematization of the project is on the basis of several intrinsic features that one need to consider while learning about the concept of securitization.

History:

The roots of securitization lie in the United States, back to the 1970s. This innovative step was first structured, when the U. S. Department of Housing and Urban Development through Government National Mortgage Association publicly traded in securities backed by a pool of mortgage loans. [12] Before, the concept emerged, banks mainly functioned as portfolio lenders, and they simply held loans to maturity or until they were paid off. It was either deposits, or at times debt, the ones which formed resource for lending loans. With the advent of time, especially after Second World War, there was hike in the demand for housing loans, which paved way to several financial institutions including banks to inculcate new methods that increase sources of mortgage funding. [13] Thus, “to attract investors, bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans” [14] . The concept of securitization finally innovated.

As the period of maturity were shorter as compared to that of mortgages, also the fact that cash flow was easily predictable in automobile loans. Techniques of securitization were applied to non-mortgage assets, for the first time in 1985, to the automobile loans. [15] Further, in 1986 the first credit card sale entered the market. [16] By 2008, securitization emerged as a vital funding source, wherein the outstanding of Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS) debt obligation was about $10.24 Trillion in U.S and $2.25 Trillion in Europe [17] . The reasons for speedy development of this concept is the simple legal procedures in respect of mortgage and debt securities. [18] 

Actors:

The ones who play a major role in the whole process of securitization and their technical terms are as such. Firstly, the originators, these are the parties, who create the assets to be securitized. These are mostly the liquid assets, which are turned into financial assets. They are mortgage lenders and banks. Secondly, aggregator, they purchase assets similar assets from many originators to form a pool of assets to be securitized [19] . Thirdly, depositor, this is the one who creates an SPV (Special Purpose Vehicle)/ SPE ( Special Purpose Entity) and then acquiring the pooled assets deposits in the SPV/SPE. [20] Fourthly, issuer, the one who issues the certificates, also called as security receipts to the investor. He sells, rather transfers the polled assets to the investor in exchange for certificate [21] . Technically speaking, the issuer is the SPV/SPE which holds the pooled assets acquired from the originator. Fifthly, investors, these invest on the pooled assets. They form the actual source of funding, in exchange for the certificates issued by the SPV. For which they would be paid principal and interest eventually on monthly basis. Sixthly, trustees, they oversee the SPV’s form of functioning and protect the investors interests in the whole process. They do this, by ‘calculating the cash flows from the pooled assets and by remitting the SPV’s net revenues to the Investors as returns’. [22] Lastly, servicer, they money due from the borrowers and remit it to the funds of the trustee to distribute to the investors. For this they are paid service charges.

Process of Securitization

Even before securitizing a pool of assets, there a certain questions that needs answers. According to Prof Ian Giddy [23] , those questions are: Is the company ready? Are the assets suitable for securitization? What pool of assets? What legal structure restrict to or to abide by? What credit enhancement? [24] After analysing the situation, it is to be decided whether to process further or not.

4.1 Traditional Method:

The traditional securitization process involves two steps [25] . In the first step, the originator identifies the pool of assets, called as recent portfolio. And sells the pool to an SPV, established for the same purpose, so that they can be realized and treated as off balance sheet assets for legal and accounting purposes. The SPV also acts as a issuer. The second step, is that the issuer after acquiring the pool of assets transfers them to the investors, through security certificates.

4.2 Conventional Method:

The conventional method of securitization involves a three- tier security design. [26] The recent portfolio’s even before being sold rather transferred away to the SPVs, they are divided into slices, called as tranches. These being three called junior, mezzanine, and senior tranche. All the three tranches have different level of risk associated with them and sold separately. It has been stated, by Andreas Jobst that:

“This structure concentrates expected portfolio losses in the junior, or first loss position, which is usually the smallest of the tranches but the one that bears most of the credit exposure and receives the highest return. There is little expectation of portfolio losses in senior tranches, which, because investors often finance their purchase by borrowing, are very sensitive to changes in underlying asset quality”.

Due to this factor, the originators can actually have a call on deciding and managing the process according to the existing social scenario, market forces and thus can convert the liquid assets to financial assets, in the most feasible manner. [27] 

Structure: A typical deal structure [28] of securitization would be as follows;

Cross Border Securitization:

Cross-border securitization transactions are those in which: (i) the company originating the asset is in one country. (ii) A trust or other special purpose entity in another country purchases the originator’s receivables. (iii) The payers on the receivables are outside the originator’s country. (iv) The receivables are largely denominated in the currency of the securities; (v) The trust receives payments directly from the payers and makes distributions directly to investor. [29] Each link in the chain, especially the originator and the SPV are in different countries. Offshore securitization is condemned as a means of avoiding regulation, tax rules, and currency exchange restrictions. The other view is that, it is a valuable tool for using the best combination of securitization actors and activities around the globe. [30] 

The most obvious question that arises in such a transaction are with respect to the governing law and its implementation in a cross jurisdictional scenario. Since, in such a transaction each discrete stage of securitization is to be done by a separate entity, which is located in a different country, the choice of law analysis is to be done individually for each stage. [31] Apart, from it, it is essential to see whether the target jurisdiction has effective bankruptcy laws in place. As one of the most crucial elements of a successful securitization transaction is the creation of a ‘bankruptcy proof’ and sheltered SPV which should be a legal entity distinct and independent from the originator, called originator’s bankruptcy proof [32] . Other considerations are the knowledge of taxing system (it can help predetermine the transaction’s form and structure to minimize the tax burden and avoid unexpected tax costs), [33] the debt collection and enforcement mechanism, and government regulations and restrictions.

Crisis

The subprime [34] crisis has led to look into a unpredicted aspect of securitization, which has been turned around for a long time. It emphasis that there is no flaw in the concept of securitization as such but rather with the reckless and excessively complex way in which it was applied to subprime mortgage loans. [35] The crisis brought securitization concerns to be reconsidered especially when it crosses borders. Sub-prime lending is done for sub-prime mortgages, sub-prime car loans, sub-prime credit cards etc. According to the .S. Federal Deposit Insurance Corporation (FDIC),

"Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Subprime loans are loans to borrowers displaying one or more of these characteristics at the time of origination or purchase. Such loans have a higher risk of default than loans to prime borrowers”.

Belief is that securitization of sub-prime mortgages are at the very heart of the sub-prime crisis, of the 2007-08. [36] 

7. Securitization in India and the Laws:

7.1.1 Mode of Securitisation:

The mode of securitization adopted in India is the one of a trust structure. The transfer is treated as a sale to the trustee company (SPV), called as securitization company. The securitization companies issues securities to the investors, called as Qualified Institutional Buyers(QIBs) either in the form of Pass through certificates or in the form of Pay through certificates. [37] In case of pass through certificates, the QIBs have a right to beneficial interest in the asset itself. Whereas, in the case of pay through certificates, it is on cash flows attained from the underlying assets. [38] And the legitimate securitization process in India is the one domestic. The Indian statutory provisions do not provide for cross border securitizations, as QIBs, the investors are to be the Indian QIBs (Section 2(u), SARFAESI Act, 2002).

7.1.2 Regulatory Framework:

The financial sector of India, has a clear framework guidelines, else per se there is no clear regulatory framework for securitization in India. The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002; The Securities Interest Enforcement Rules, 2002, The Securitization companies and Reconstruction Companies (Reserve Bank) Guidelines and Direcctions, 2003; The Recovery of Debt to Banks and Financial Institutions Act, 1993 are statutory regulations that govern securitization in India. [39] 

According to SARFAESI Act 2002, only RBI regulated entities like Banks, Financial Insitutions and Non-Banking Financing Companies are the institutions which can be originators. [40] It enabled the securitization of Non-Performing Assests (NPAs) through the asset reconstruction companies registered under Reserve Bank of India. The Dr. R.H. Patil Committee recommendations on Corporate Debt and Securitization in 2005, is considered as the turning point of corporate debt and securitization. [41] The 2006, RBI guidelines for securitization of standard assets, regulate the critical aspects of securitization. 2006, guidelines define the most important aspects which were very ambiguous until then. It laid down rules as to what true sale is, capital treatment for credit enhancement is, exposure recognition is. [42] The step taken by RBI throughout in matters concerning securitization, is “anincentive-compatible prudential approach towards securitisation” - an approach defensible in the aftermath of the recent sub-prime episode in some developed countries. [43] 

Further, the amendment to the Securities Contracts (Regulation) Amendment Act, 2007 is another step towards providing a well regulated legal regime for securitization. To the definition of securities, “securitized instruments” was included through amendment. [44] 

7.1.3 Issues facing the Indian Securitisation Market:

The issues facing the Indian Securitization Market are mostly four prone [45] .

Firstly, it is the stamp duty structure existent; the existing rule of law is that stamp duty is to be paid on all instruments that seek to transfer rights or receivables. The rate of stamp duty differs in different states. In certain stated the duty is extremely high and in others they are relatively low. Therefore, securitization in the states, which have high stamp duty, poses a threat of high cost of transferring. Thus, the need is uniform and low rate of stamp duty throughout the country. The Patil Committee also recommended for the same, keeping in view the corporate debts and securitization market of India. Secondly, the existing foreclosure laws pose a threat to the Mortgage Backed Securities (MBS) as they are not lender friendly. Thus, increase the risks, as transfer in cases of default is difficult. Thirdly, the ambiguity in the taxing manner poses a threat to the securitization market. The manner of treatment od MBS, SPV trusts and NPL trusts are different. Fourthly, the Security Receipts (SR), according to SARFAESI Act can be issued, only to QIBs [46] , which excludes the NBFCs, non-NBFCs, private equity funds, etc which go un regulated and thus need for inclusion of other financing institutions which are non banking.

Conclusion:

To sum up, in its simplest form a Securitization involves:

Firstly, the originator creates a pool of receivables or purchases from entities that create them. After which, he transfers them to the SPV, either as a true sale or as a secured loan. Secondly, the SPV, acts as an issuer, by issuing certificates of transfer or security receipts in the Indian context to the investors. The certificates are issued, in exchange for the funds by the investors to the SPVs, which eventually will be passed to the originator. All of these transactions occur virtually simultaneously.

Securitization as a tool has following advantages :

Firstly, the securitization leads to an “off balance sheet” transaction, wherein cash replaces receivables. Due to which the originator’s balance sheet is improved, either resulting into gain or loss. This is the intended beneficial consequence.

Secondly, when the receivables are long term receivable, the originator need not to appropriate the funds lent, as in case of traditional method of financing. In securitization, the future receivables are turned into marketable assets, due to which, the future receivables are appropriated, without much of waiting and the newly generated funds through securitization can be used for other purposes.

Thirdly, securitization is a easy method of raising funds, than the traditional method of raising deposits.

Finally, due to securitization, a secondary liquid market is formed. “This increases the availability of credit, for the home mortgages and other financial bet instruments. Reallocates risk by shifting the credit risk associated with securitized assets to investors, rather than leaving all the risk with the financial institutions. And helps to decrease the cost of credit by lowering originator’s financing costs by offering lenders a way to raise funds in the capital market with lower interest rates.” [47] 

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