Securitization in India: Mechanism of Debt Securitization

Introduction to Securitization:

Even if the Indian securitization industry has made considerable progress, it is still appropriate to describe it as a developing market. Its development could be summed up as "two steps forward, one step back" like that of other market segments.

What is Securitization:

The process of transforming recent or upcoming cash inflows into tradable securities is known as securitization. The market may then be used to sell such securities. Several financial assets, including auto loans, home loans, trade receivables, and credit card receivables, create cash inflows. These inflows could be used as security for loans. Such securitization aids in giving illiquid assets liquidity. Debt or asset securitization are other names for this technique. It allows originators to dispose their assets quickly and affordably while obtaining a better financing profile and better funding circumstances. Securitization involves "pooling of assets and selling these to investors through a specialized intermediary created for this purpose," according to the definition.

Parties Involved in Securitization:

Following are the main parties involved in the process of securitization:

a)    Originator - The seller to whom the portfolio belongs is referred to as the originator. The originator, the entity that owns the assets, compiles information on the loans or other income-producing assets that it no longer wants to service (these might be home loans, personal loans, or something else). They are then collected into a reference portfolio and deleted from the company's balance sheets.

 

b)    Special Purpose Vehicle (SPV) – Selling the assets in the reference portfolio to a company such as special-purpose vehicle (SPV) converts them into securities that the general public can purchase. Each security represents a stake in an amount of the portfolio's assets.

 

c)     Investors - In exchange for a certain rate of return, investors purchase the newly minted securities.  The originator often continues servicing the loans from the reference portfolio, collecting payments from the borrowers and then transferring them, less a fee, to the SPV or trustee. The investor is then given the resulting cash flows.

 

d)    Other Parties –

                                                         I.            Obligor - The originator's debtor is the obligor. 

                                                       II.            Servicer – All administrative duties connected to the securitization process are under the responsibility of the servicer.

                                                     III.            Trustee – To safeguard the interests of different investors, the trustee or investor representative must behave in a guardian-like manner.

                                                    IV.            Credit Rating Agency – The responsibility of giving a neutral assessment of the credit risk associated with the transaction falls to the credit rating agency. Credit ratings are used to do this.

                                                      V.            Regulators - The authorities advise vigilance over a number of issues, including liquidity, credit quality, capital sufficiency, and accounting.

                                                    VI.            Service Providers – The group of service providers also includes those who provide liquidity and credit enhancement.

                                                   VII.            Specialist Functionaries – Professionals who provide specialised services include accountants, tax advisors, lawyers, and other professionals.

 

Mechanism of Debt Securitization/Process of Securitization:

The formation of a Special Purpose Vehicle (SPV) for mediating between the primary market and the secondary market is the primary component of debt securitization. The underlying security must be traded on the primary market, but the newly created asset-backed security must be traded on the secondary market.

Following steps are taken for the purpose of debt securitization: 

The originator or lending institution must determine which assets are eligible for securitization. An ideal combination of securities with uniform features, such as maturity time, should be present.

These unique securities are "passed through" to Special Purpose Vehicles, which are other legal companies. These are typically established as trusts and given the responsibility of issuing securities to investors. Such securities are no longer held in the originator's portfolio once they have been issued.

Such securities are divided up into multiple pools by the Special Purpose Vehicle, which subsequently sells the pools to investors. Pass through certificates or pay through certificates are the names for these securities. The inventor of such securities has no remedy. However, the investor may hold Special Purpose Vehicle accountable for any failure to make principle or interest payments on time.

The Special Purpose Vehicle may also use credit ratings to improve the instrument's marketability. It assists in providing liquidity. Owning the impartiality of the third-party boosts investors' confidence. For confirming the security, pass through certificates can be traded on secondary markets. The investor has two options: either hold the investment until it matures or sell it to another party. The security's end investor who is still holding it at maturity is entitled to the redemption value.

Conclusion:

In short, the securitization enables individual investors to buy shares in assets that they otherwise wouldn't be able to which generates liquidity.