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Criteria Structured Finance 9-02-09
Criteria Structured Finance 9-02-09
January 2006
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Structured Finance
January 2006
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CRITERIA - Structured Finance
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Rating methodology
for ABS transactions .......... 09
Rating methodology
for RMBS transactions .......... 19
In continuation of its pioneering role, CRISIL is pleased to present its criteria for
structured finance ratings. This publication, part of our series of publications
on our rating criteria, brings out the detailed criteria CRISIL uses for its ratings
on structured instruments, including securitisation across all asset classes.
This volume will supplement the four earlier volumes in this series, which
cover rating criteria in general, and specifically address criteria for rating
issuers in the manufacturing, financial, and infrastructure sectors.
By publishing this criteria series, CRISIL hopes to contribute further to the
growth of the debt markets, through a better understanding of its rating criteria
and process amongst issuers and investors.
This is the first time that any rating agency in India has brought out such
comprehensive rating criteria, especially in the structured finance space. This
effort would not have been possible without the support of the issuer and
investor communities. We would like to take this opportunity to thank all of
you for your support so far; we look forward to working with you in further
developing the Indian debt markets.
The CRISIL Ratings team welcomes your comments and questions regarding
the issues discussed in this publication. Please email us with any comments and
questions at CRISILratingdesk@crisil.com, or call any of the contacts listed in
this booklet.
CRITERIA - Structured Finance
Roopa Kudva
Executive Director and Chief Rating Officer
Evaluating risks for
securitisation transactions - A Primer
Investments in securitised paper have increased rapidly in recent times and
“pass through certificates” or PTCs are fast becoming part of mainstream
financial markets. The nature of such investments is however very different
from conventional corporate lending where traditional tools of business and
financial analysis could be used to gauge creditworthiness. Risk analysis in
PTCs requires a vastly different framework of analysis, and the focus of this
article is to provide investors with an “easy to understand” step-by-step
introduction to understanding risks in securitised paper. In addition, the article
also throws light on CRISIL's analytical framework in evaluating securitisation
transactions, and the steps taken by CRISIL in identifying, assessing and
mitigating risks.
UNDERSTANDING SECURITISATION
Generally speaking, a securitisation transaction involves sale of receivables by
the originator (a bank, non-banking finance company, housing finance
company, or a manufacturing/service company) to a special purpose vehicle
(SPV), typically set up in the form of a trust (see chart below). Investors are
issued rated pass through certificates (PTCs), the proceeds of which are paid as
consideration to the originator. In this manner, the originator, by selling his
loan receivables to an SPV, receives consideration from investors much before
the maturity of the underlying loans. Investors are paid from the collections of
the underlying loans from borrowers. Typically, the transaction is provided
with a limited amount of credit enhancement (as stipulated by the rated agency
for a target rating), which provides protection to investors against defaults by
the underlying borrowers. (For a more detailed understanding of the
securitisation process, refer CRISIL's Securitisation Handbook)
Trust and
Retention
Borrowers
Account
Scheduled
CRITERIA - Structured Finance
Monthly
Servicing agent Payouts
Sale/Assignment
of pool receivables
Originator/seller
PTCs
SPV Trust Investors
Consideration
Trustee Consideration
3
CRITERIA - Structured Finance
4
EVALUATING RISKS FOR SECURITISATION TRANSACTIONS - A PRIMER
lR
ed
Originator
is
Cr
True Sale
k
Asset
Credit Risk, or the risk of underlying assets
Bankruptcy defaulting
Portfolio remoteness
Pool Counterparty Risks on account of the
dependence on several counterparties in the
Macro economic Servicer transaction
Prepayment Commingling Legal Risks as the transaction is centred around a
Swap
k
counterparty
originator to the SPV
rty
Miscellaneous
Ma
pa
er
t
et
Ri
sk un PTCs given changing debt and capital market
Co
conditions
The four quadrants represent the fundamental Legal Risks as the transaction is centred around a
uncertainties in any securitisation transaction sale and transfer of receivables from the
and include originator to the SPV
Credit Risk, or the risk of underlying assets Market Risks which could impact the value of the
defaulting PTCs given changing debt and capital market
Counterparty Risks on account of the conditions
dependence on several counterparties in the 1. Credit Risk
transaction Credit risk forms a crucial element in the
analysis of securitisation transaction. Typically,
sizing credit enhancements adequately to cover
defaults, even under stress scenarios, covers
this risk. In the sizing of the enhancements, the
key factors evaluated include:
Asset Risk Continuum
Mortgage HCV Earth Cons. Dealer Loans against ICDs IPO Financing
Finance Moving durable financing shares
5
CRITERIA - Structured Finance
6
EVALUATING RISKS FOR SECURITISATION TRANSACTIONS - A PRIMER
mingle with other funds of the servicer. In such could result in a complete loss of the entire cash
an event, if the servicer goes bankrupt, the flows generated by the pool.
investor is unlikely to recover the collected cash
CRISIL conducts a detailed study of the legal
flows for that month.
documents to ensure that the investors' interest
CRISIL's commingling criteria takes into is not compromised and relevant protection
account the relevant short-term credit rating of and safeguards are built into the transaction.
the servicer for a given target rating on the PTC. An independent opinion from eminent external
If the rating is below requisite level, the legal counsels is also obtained on each
quantum of credit enhancement is adjusted so individual transaction to ensure a high level of
as to adequately cover the risk. due diligence on legal issues. Typically, the
2.3 Miscellaneous other counterparty risks legal opinion covers the following issues:
Swap counterparties (who provide floating or + Assignment of receivables to the trust is valid.
fixed rate cash flows depending on the terms of + Transfer of receivables to the trust constitutes
the swap) as well as banks where the cash a true sale.
collateral is deposited represent other + Cash collateral is bankruptcy remote from
miscellaneous parties whose credit quality originator.
becomes important in the overall evaluation of
the securitisation transaction. A downward + Documentation has been executed in
revision in the rating of the counterparty below accordance with stamp duty and registration
the threshold becomes a trigger for a change in laws.
the counterparty to restore the transaction to + Transaction specific issues, if any.
stability.
4. Market risks
3. Legal risks Market risks represent risks not directly related
In several developed securitisation markets, to the transaction, but other market related
there is securitisation specific legislation, factors, which could have an impact on
besides a long track record of judicial decisions transaction performance, or the value of the
on securitisation transactions. Both of these investments to the investors. A change in the
bring a high degree of predictability to the legal interest rates impacts the value of the
position on such transactions, and facilitate the instruments besides impacting prepayments
creation of transparent and well-established rates for assets. Similarly changing real estate
legal criteria for securitisation transactions. In prices could impact the performance of
the Indian context, there is a lack of judicial securitisation transactions backed by home
precedence on the subject, besides a short track loans.
record of securitisation transactions. This gives
rise to a dependence on external legal opinions.
4.1 Macro-economic risks
The key legal issue under consideration is that The performance of underlying loan contracts
in any securitisation transaction, it is essential depends on macro-economic factors like
that the transfer of receivables be a 'true sale', industry downturns or adverse price
indicating that the originator cannot retain movements of underlying assets. For instance,
control over receivables or any claim over increase in fuel prices may trigger a truckers'
receivables that could override the claims of the strike, which may in turn impact the
investors. A true sale makes the assets repayments on commercial vehicle loans.
securitised 'bankruptcy remote', i.e. the Similarly, a steep fall in the prices of underlying
bankruptcy of the originator will not impact the assets will increase chances of default. The
investors' claim on the pool's cash flows. In the borrower may prefer selling the low-value
absence of a judicial precedence on 'true sale' in asset, rather than retaining it and repaying
India, any dispute over the legal ownership of instalments on the same. Typically, CRISIL
the assets is likely to diminish the return on factors in such risks into the initial sizing of
investments, with the entire loss being borne by credit enhancements for the transaction.
the investor. Further, an unfavourable ruling
7
CRITERIA - Structured Finance
8
Rating methodology
for ABS transactions
Asset backed securitisation (ABS) refers to the securitisation of non-mortgage
retail loans. Till the late 1990s, asset classes securitised under ABS in India
included only car loans and commercial vehicle loans. Thereafter, construction
equipment loans, two-wheeler loans, utility vehicle loans, and personal loan
pools, have also been securitised. This paper describes CRISIL's approach to
the rating of ABS instruments.
1. Portfolio analysis
Portfolio analysis involves a detailed analysis of historical asset
performance. The analysis can take two forms:
A. Static pool analysis
B. Dynamic portfolio analysis
CRISIL believes that cash flow projections based on static pool analysis are
more appropriate for rating purposes than dynamic portfolio analysis,
CRITERIA - Structured Finance
because rated pools are also static in nature. Static pool analysis serves as a
very good reference point to project the performance of the pool to be
securitised. CRISIL will use a dynamic portfolio-based approach only if
adequate static pool data is not available, or if the characteristics of the pool
to be rated are quite different from those of available static pools. CRISIL
will nevertheless study portfolio data in all cases, since this data can provide
insights into recent performance and trends in the originator's portfolio;
these insights may not always be available in static pool data.
9
CRITERIA - Structured Finance
1.A. Static Pool Analysis It must be noted that static pool performance
A static pool refers to a pool of contracts may be affected by changes in several micro
originated in a particular period of time, say a and macro factors such as economic
month or a quarter. There is no addition of environment, characteristics of the asset class
contracts in the static pool over time. This pool (for instance, the behaviour of the new car loan
is distinct from the portfolio, to which contracts segment has changed after the emergence of
are added every day. Static pool analysis used car market), underwriting policies, etc.
entails a study of the behaviour of a static pool These factors, along with the characteristics of
over time. the pool being securitised and the volatility of
the CCR curve, are used to determine the base
To carry out an analysis of static pools, CRISIL CCR curve.
takes data on the performance of all the
contracts originated over several years by an
originator. CRISIL then analyses contracts 1.B. Dynamic portfolio analysis
originated in a particular month or quarter as CRISIL's dynamic portfolio analysis
one static pool. CRISIL also looks at the comprises:
performance of earlier rated pools of the same
originator, since these pools are static in nature.
Days-past-due (dpd) analysis
CRISIL analyses static pool performance based
Dpd analysis provides a quick measure of
on various parameters such as type of asset (for
portfolio quality. Most lenders use this
instance commercial vehicle loans, car loans,
parameter to monitor the performance of their
etc), whether the assets are new or pre-owned,
portfolios. Under dpd analysis, principal
original tenure, loan amount, geographical
outstanding (POS) on the total portfolio is
distribution of borrowers, loan to value ratio
classified into 'buckets' based on overdue
(LTV) etc.
status. The principal outstanding on current
The collection performance of a sample retail contracts belongs to the 'current' bucket, the
static pool is shown in the graph below: principal outstanding on contracts that are 1
Collection Performance of Sample Retail Pool month overdue belongs to '30 dpd' bucket, and
CCR so on. This is then divided by the total POS, as
Current collection efficiency shown in the table below:
Arrears collection efficiency
(Rs. million)
100% dpd
As at Total
90% Current 30 60 90 120 150 180
80% POS 640.0 80.0 39.2 16.0 4.8 13.6 6.4 800
70% 31-Mar-05
Dpd 80.0% 10.0% 4.9% 2.0% 0.6% 1.7% 0.8% 100%
60%
POS 800.0 100.0 39.0 20.0 11.0 20.0 10.0 1000
50% 30-Sep-05
Dpd 80.0% 10.0% 3.9% 2.0% 1.1% 2.0% 1.0% 100%
40%
30%
20%
10% In a rapidly-growing portfolio, dpd levels may
0%
1 4 7 10 13 16 19 22 25 28 31 34
be understated due to the fact that, in most
Seasoning (months) cases, contracts perform relatively well in the
initial months. Further, recently-disbursed
CCR denotes cumulative collection ratio Collections till date / Billings till contracts cannot move to higher dpd buckets.
date. In such cases, CRISIL calculates 'lagged' dpd:
Current collection efficiency (CCE) Collections from current month's
billing / current month's billing. instead of taking the principal outstanding of
Arrears collection efficiency (ACE) Collections from month beginning the current month as the denominator, the
opening overdues / month beginning opening overdue.
principal outstanding in some previous month
is considered. In the example above lagged 180
dpd as at September 30, 2005 is 1.25 per cent1,
against an un-lagged 180 dpd of 1 per cent.
1
POS in 180 dpd (Rs. 10 millions) divided by principal outstanding as at six months prior to the current date which is March 31, 2005
(Rs. 800 millions).
10
RATING METHODOLOGY FOR ABS TRANSACTIONS
11
CRITERIA - Structured Finance
12
RATING METHODOLOGY FOR ABS TRANSACTIONS
Low risk
+ Loan amount
Medium risk
period period
High risk A large loan is generally perceived to be
period riskier than a small one, especially in the car
finance market. Typically, the loss severity
Value
Seasoning
2
Moratorium period is the initial period of the loan tenure where the installments are not payable by the borrower e.g. some borrowers may be
given loan for 36 months; however there may be only 34 installments to be collected from the borrower with first few months being moratorium
period.
13
CRITERIA - Structured Finance
for high-value vehicle contracts is large An example of pool v/s portfolio analysis
because of the rapid depreciation in vehicle - Geographical distribution
resale prices. However, the credit quality of Portfolio Pool
Region Deviation
the target customer needs to be considered Proportion 90+dpd Proportion
East 30% 1.0% 10% Negative
before arriving at any conclusion; for 20% 1.5% 25%
West Positive
instance, a large loan might reflect lending to South 25% 2.0% 30% Negative
a large and highly creditworthy fleet North 25% 3.0% 35% Negative
Total 100% 1.9% 100%
operator: large operators typically have the Negative
Weighted average pool 90+dpd 2.1%
advantage of diversification of the end use of
the vehicles, and hence have a lower
probability of default. CRISIL draws on its We can see from the above table that the pool
base of data and experience of the Indian has a negative deviation from the portfolio,
market to correctly ascertain the underlying since the pool derives a greater proportion of
credit implications of portfolio its cash flows from the worse-performing
characteristics. regions (North and South) than the portfolio
does. Likewise, CRISIL performs this analysis
for all other parameters.
+ Overdue profile
Current contracts are expected to perform
better than overdue contracts. CRISIL takes Stress Factor for securitisation transactions
into account the extent of overdue contracts backed by Retail loan receivables
along with the weighted average seasoning Securitisation transactions achieve the
of the pool. A poorly-seasoned pool with a target rating based on the credit
high proportion of overdue contracts enhancement. The credit enhancement
signifies a significant risk of losses. sizing involves comprehensive cash flow
modeling, projecting inflows and outflows.
3. Pool v/s portfolio analysis CRISIL initially projects base case cash
flows and shortfalls based on, amongst
Since, pool performance is projected based on other things-static pool performance,
past portfolio performance, CRISIL portfolio performance and pool
benchmarks pool characteristics against the characteristics. These base case cash flows
portfolio. This analysis shows whether the pool and shortfalls are subsequently stressed
is likely to perform better or worse than the appropriately for various rating categories.
portfolio; stress assumptions are accordingly The stress applied by CRISIL is expressed as
determined. Based on the comparative pool- a factor of expected base peak shortfalls.
portfolio analysis, CRISIL uses an appropriate
stress factor over the expected shortfalls in the
pool to ascertain the level of credit Typical stress factors used by CRISIL while
enhancement required to achieve the target assigning rating on asset backed
rating ( For details refer to the box “Stress securitisation (ABS) issuances (i.e. backed
Factor for securitisation transactions backed by by car loans, commercial vehicle loans,
Retail loan receivables “) For the purpose of personal loans, two wheeler loans etc.) are:
this analysis, CRISIL compares the pool and the + AAA: at least 250% of expected base
portfolio characteristics on key parameters peak shortfalls
such as geography, loan to value ratio (LTV),
+ AA Category: at least 170% of expected
original tenure, borrower profile, income to
base peak shortfalls
instalment ratio, and asset category. The
portfolio performance is benchmarked with + A Category: at least 140% of expected
dpd status such as 90+dpd and 180+ dpd. Thus, base peak shortfalls
one can ascertain whether the pool has a + BBB Category: at least 120% of expected
negative deviation, similarity, or positive base peak shortfalls
deviation, relative to the portfolio, for a
particular characteristic.
14
RATING METHODOLOGY FOR ABS TRANSACTIONS
4. Analysis of originator's operations rating on the PTCs, the longer the tenure, the
CRISIL's rating methodology involves both higher is the minimum servicer rating that
qualitative and quantitative analysis. The CRISIL requires. This ensures that long-tenure
analysis of the originator's operations is an papers need to be backed by servicers of very
important qualitative factor. This involves an high credit quality; the criteria are gradually
analysis of management quality, length of relaxed while considering transactions of
experience of the originator in the concerned lower tenure.
business, goals and strategies of the Servicer risk analysis also indicates whether
management, and the size, market position and there is a need for a back-up servicer. In case a
reach of the entity. In addition, the method of back-up servicer is required, CRISIL will carry
origination (such as directly or through out the same analysis for the back-up servicer.
agents), underwriting standards, sanctioning The following additional factors will also be
authority and process, and pre- and post- considered:
disbursement documentation, also provide
+ Familiarity of back-up servicer with
indications of the quality of the originator's
primary servicer's operations.
operations.
+ Underlying asset class of the pool.
+ Back-up servicer's track record/past
5. Counterparty risk analysis
experience in that asset segment.
This primarily includes the following:
+ Size and geographical spread of the pool
5.A. Servicer Risk vis-à-vis backup servicer's operations.
The servicer is the most crucial counterparty in
a securitisation transaction, especially in the
Indian context. In the Indian securitisation In such cases, CRISIL will appropriately factor
markets, there are hardly any independent in the cost of bringing in a back-up servicer,
third-party servicers, who would collect the including the temporary deterioration in
receivables for a fee. Consequently, even after collection performance.
securitising the pool, the originator typically
continues as the servicer of the pool. 5.B. Commingling Risk
This risk refers to the mixing of pool cash flows
The sustained performance of the servicer over with the servicer's cash flows. In Indian
the tenure of the pool is a crucial element of the securitisation transactions, the servicer
securitisation process. To assess servicer risk, typically collects money from the underlying
CRISIL analyses qualitative factors such as: borrower in the pool in a particular month, and
+ Management quality of the servicer - length deposits the money into the 'Trust and
of experience in the concerned business, Retention Account' in the next month. In the
goals and strategies of the management. interim, the collected money lies with the
servicer, and as do its own cash flows. If the
+ Size, market position and reach of the servicer were to become insolvent while
servicer. holding such amounts, these amounts may get
+ The collection process and structure of the attached with the insolvency estate. This could
servicer - collection strategies and follow-up result in partial or total loss of commingled
mechanism. amounts, or delayed recovery due to legal
+ The quality of management information proceedings. CRISIL assesses the risk of
system (MIS). This is critical for good bankruptcy of the servicer, and accordingly
monitoring of the securitised pool. sizes the risks arising from the commingled
amount in the enhancement calculation. The
credit rating of the servicer is a good proxy to
Apart from these qualitative factors, CRISIL determine the risk of the servicer's bankruptcy.
looks at the servicer's credit rating in the
context of the pool tenure. For a given target
15
CRITERIA - Structured Finance
3
For understanding a 'waterfall', please refer to the topic 'How is a typical waterfall mechanism structured?' in CRISIL's Securitisation Handbook,
Section 3, Page 26.
16
RATING METHODOLOGY FOR ABS TRANSACTIONS
17
CRITERIA - Structured Finance
and payout account, a few days before the + Adequacy of contingency plans
payout date. The amount to be put into the + Frequency of testing and audit
collection and payout account is ascertained
by the servicer through the MIS + Risk of permanent loss of information
(management information system) report, + Time taken to recover normal functioning
typically generated at the beginning of the + Any untoward incident in the past
month subsequent to collections. If the
servicer faces a system failure or breakdown,
MIS generation can get delayed. If CRISIL concludes that the disaster
Consequently, the servicer will not be able to recovery system is adequate, and that there is
ascertain the amount to be put into the sufficient time between the MIS generation
collection and payout account. Hence, date and the payout date to enable recovery
collections will not be deposited into the from any system failure, CRISIL reduces the
account on time. In such a case the payouts amount of minimum cash
can only be made through the utilisation of collateral/corporate undertaking required in
cash collateral/corporate undertaking. the transaction.
18
Rating methodology
for RMBS transactions
Mortgage-backed securitisation (MBS) refers to the securitisation of mortgage
loans. These loans can be against residential properties (residential mortgages)
or commercial properties (commercial mortgages). The securitisation of
residential mortgage loans is called residential mortgage-backed securitisation
(RMBS), and the securitisation of commercial mortgage loans is called
commercial mortgage-backed securitisation (CMBS). This paper describes
CRISIL's approach to the rating of RMBS instruments1.
Par structure
Under a par structure, investors in Pass-Through Certificates (PTCs) pay a
consideration that is equal to the pool's principal. Thus, there is a one-to-one
correspondence between the principal amounts outstanding on the PTCs and
the principal amounts outstanding on loans in the pool. Investors are paid the
principal portion of the pool's monthly cash flows, and receive a yield on the
outstanding PTC principal.
Premium structure
Under a premium structure, investors in PTCs pay a consideration equal to the
discounted value of the pool cash flows. The PTC yield is generally lower than
the pool yield; therefore the value of the cash flows, discounted at this yield,
will be higher than the pool principal. The excess of the discounted value over
the pool principal represents the premium paid by investors.
1
To understand CRISIL's approach to rating CMBS instruments, please refer to CRISIL's opinion piece
'Commercial Mortgage Backed Security A viable option for financing commercial real estate'.
2
Please refer to Section 1, 'Getting Started with Securitisation’
19
CRITERIA - Structured Finance
3
Repricing of a contract from higher interest rate to a lower interest rate is reflected either by reduction in the EMI amount for the balance tenure
of the contract, or by reduction in the number of instalments to be paid by the borrower, thus amortising the principal faster.
20
RATING METHODOLOGY FOR RMBS TRANSACTIONS
Prepayments impact par and premium scenarios. CRISIL then carries out a
structures differently. sensitivity analysis, to estimate pool inflows
Prepayment risk under a par structure and payouts under each of these scenarios.
The enhancement required is accordingly
Prepayments do not have a significant impact
calculated.
on par transactions since the principal
prepaid by the borrower (equal to the
investor's principal) will be passed on to the 2. Portfolio analysis
investor. However, if loans being prepaid are
Portfolio analysis involves a detailed analysis
at rates higher than the weighted average
of historical asset performance. The analysis
interest rate of the pool, there will be a
can take two forms:
reduction in EIS.
A. Static pool analysis
B. Dynamic portfolio analysis
Prepayment risk under a premium structure
In the case of a premium structure, the
principal outstanding against the borrower's CRISIL believes that cash flow projections
name on a particular loan is lower than the based on static pool analysis are more
corresponding PTC principal; the difference appropriate for rating purposes than dynamic
represents the premium outstanding. Thus, portfolio analysis, because rated pools are also
when a loan is prepaid by the borrower, there static in nature. Static pool analysis serves as a
is a shortfall on the corresponding PTC very good reference point to project the
liability. In such a case, the shortfall equal to performance of the pool to be securitised.
the outstanding premium on that contract CRISIL will use a dynamic portfolio-based
will need to be paid out of the available approach only if adequate static pool data is
enhancement. not available, or if the pool characteristics are
quite different from those of available static
pools. CRISIL will nevertheless study portfolio
+ How CRISIL analyses these risks data in all cases, since this data can provide
Repricing and prepayment play a critical role insights into recent performance and trends in
in an RMBS transaction. To analyse these the originator's portfolio; these insights may
risks, CRISIL considers following factors: not always be available in static pool data.
= The interest rate profile of the pool being
securitised, compared to the interest rate A. Static pool analysis
scenario at the time of securitisation. A static pool refers to a pool of contracts
= Historical movement of fixed and floating originated in a particular period of time, say a
interest rates offered by the originator, month or a quarter. There is no addition of
compared to those offered by its contracts in the static pool over time. This
competitors. pool is distinct from the portfolio, to which
= Historical movement of the originator's contracts are added every day. Static pool
RPLR compared to market benchmarks analysis entails a study of the behaviour of a
such as MIBOR and G-Sec yields. static pool over time.
= Monthly prepayments and repricing in To carry out an analysis of static pools for a
pools rated in the past, and in the housing loan portfolio, CRISIL takes data on
originator's portfolio. the performance of all the contracts
= Historical and current geographical spread originated over several years by an
of the originator's operations. originator. CRISIL then analyses contracts
originated in a particular month or quarter as
one static pool. CRISIL also looks at the
Based on the above factors, and the target performance of earlier rated pools of the
rating on the instrument, CRISIL generates same originator, since these pools are static in
various stressed interest rate and prepayment nature.
21
CRITERIA - Structured Finance
As housing loans are long-tenure loans, and Though lagging does overcome some of the
the market has grown rapidly only in the past limitations of dpd analysis, it is still marred
few years, there are a number of cases where by the fact that this analysis does not consider
detailed static pool data is simply not write-offs. Thus, all other things being equal,
available. In such instances, CRISIL has to originators adopting aggressive write-off
rely only on the results of dynamic portfolio policies will show better dpds than others.
analysis.
To factor this into its analysis, CRISIL obtains
historic write-off data, net of recoveries from
B. Dynamic portfolio analysis previously written-off contracts. The
CRISIL's dynamic portfolio analysis cumulative write-offs can then be seen at
comprises: various points of time. This cumulative
figure can be seen as a percentage of portfolio
Days-past-due (dpd) analysis principal, say, 12 months prior to the current
Dpd analysis provides a quick measure of date. This could give a proxy for net losses on
portfolio quality. Most lenders use this a static pool basis.
parameter to monitor the performance of
their portfolios. Under dpd analysis,
principal outstanding (POS) on the total Portfolio collection efficiencies
portfolio is classified into 'buckets' based on CRISIL studies monthly portfolio collection
overdue status. The principal outstanding on efficiencies in two forms - current collection
current contracts belongs to the 'current' efficiency (CCE) and arrear collection
bucket, the principal outstanding on efficiency (ACE). CCE indicates how much is
contracts that are 1 month overdue belongs to collected out of the current month's billings,
'30 dpd' bucket, and so on. This is then and ACE indicates how much is collected out
divided by the total POS, as shown in the of overdues at the beginning of the period.
table below: CRISIL considers the average levels and
standard deviations of both parameters.
(Rs. million) Based on this, CRISIL assumes base case
As at
dpd
Total initial collection efficiencies on the pool.
Current 30 60 90 120 150 180
CRISIL then factors in a gradual decline in
POS 640.0 80.0 39.2 16.0 4.8 13.6 6.4 800
31-Mar-05
Dpd 80.0% 10.0% 4.9% 2.0% 0.6% 1.7% 0.8% 100% collection efficiencies, as this pattern has
31-Sep-05
POS 800.0 100.0 39.0 20.0 11.0 20.0 10.0 1000 been observed by CRISIL in most static pools.
Dpd 80.0% 10.0% 3.9% 2.0% 1.1% 2.0% 1.0% 100%
4
POS in 180 dpd (Rs. 10 millions) divided by principal outstanding as at six months prior to the current date which is March 31, 2005
(Rs. 800 millions).
22
RATING METHODOLOGY FOR RMBS TRANSACTIONS
61
13
37
49
73
97
109
25
85
Seasoning (months)
+ Borrower diversification
Current collection efficiency (CCE) Collections from
current month billing / current month billing + Original tenure
Arrears collection efficiency (ACE) Collections from
month beginning opening overdues / + Seasoning profile
month beginning opening overdue
+ Loan amount
Repricing and prepayment analysis + Overdue profile
This has been discussed above in detail.
3. Pool characteristics analysis + Asset class
3.A. Pool selection criteria
Asset class has been discussed in detail in
Pool selection criteria play a very important CRISIL opinion piece 'Evaluating Risks for
role in determining the quality of the pool. securitisation transactions: A primer'.
Securitised pools are typically 'cherrypicked',
i.e. the pool quality is expected to be better than
the portfolio quality. + Interest rate
If the weighted average interest rate of the
pool is higher than the general market rate,
Sample pool selection criteria could be as
the possibility of the repricing and
follows:
prepayment is high; conversely, a pool with a
+ Minimum seasoning of 'A' months: this low rate runs a much lower risk on these
ensures that loans have a minimum level of counts. The mix of floating-rate and fixed-
borrower's equity (which typically increases rate contracts in the pool, and whether the
as loans are repaid) and eliminates cases of contracts are based on monthly rest or
fraud to a large extent. annual rest, are also important factors.
+ Overdues should not be more than 'B' Higher interest rates are typically charged
months. from riskier customers. A comparison of the
+ Maximum LTV should be 'C' per cent. weighted interest rate of the pool, with the
+ No single geographical location (say a state) market interest rate scenario at the time of
should account for more than 'D' per cent of origination of the pool, can therefore be a
cash flows. reasonable indicator of the credit quality of
customers. However this needs to be seen in
= Originator should not have initiated nor
light of the geographies the originator
should it propose to initiate repossession
operates in, and the level of competition
proceedings or legal proceedings against any
prevalent in those geographies. Further,
of the borrowers in the pool.
certain asset types might be charged higher
= Contracts in the pool are free from any interest rates than others. Thus, a pool with
encumbrances/charge on the date of
selection.
23
CRITERIA - Structured Finance
5
Moratorium period is the initial period of the loan tenure where the installments are not payable by the borrower e.g. some borrowers may be
given loan for 36 months; however there may be only 34 installments to be collected from the borrower with first few months being moratorium
period.
24
RATING METHODOLOGY FOR RMBS TRANSACTIONS
+ Overdue profile We can see from the above table that the pool
Current contracts are expected to perform has a negative deviation from the portfolio,
better than overdue contracts. CRISIL takes since the pool derives a greater proportion of
into account the extent of overdue contracts its cash flows from the worse-performing
along with the weighted average seasoning regions (North and South) than the portfolio
of the pool. A poorly-seasoned pool with a does. Likewise, CRISIL performs this analysis
high proportion of overdue contracts for all other parameters.
signifies a significant risk of losses.
Stress Factor for securitisation transactions
backed by Residential mortgage loan
4. Pool v/s portfolio analysis receivables
Since, pool performance is projected based on Securitisation transactions achieve the
past portfolio performance, CRISIL target rating based on the credit
benchmarks pool characteristics against the enhancement. The credit enhancement
portfolio. This analysis shows whether the pool sizing involves comprehensive cash flow
is likely to perform better or worse than the modeling, projecting inflows and outflows.
portfolio; stress assumptions are accordingly CRISIL initially projects base case cash
determined. Based on the comparative pool- flows and shortfalls based on, amongst
portfolio analysis, CRISIL uses an appropriate other things-static pool performance,
stress factor over the expected shortfalls in the portfolio performance and pool
pool to ascertain the level of credit characteristics. These base case cash flows
enhancement required to achieve the target and shortfalls are subsequently stressed
rating ( For details refer to the box “Stress appropriately for various rating categories.
Factor for securitisation transactions backed by The stress applied by CRISIL is expressed as
Residential mortgage loan receivables “) For a factor of expected base peak shortfalls.
the purpose of this analysis, CRISIL compares
the pool and the portfolio characteristics on
key parameters such as geography, loan to Typical stress factors used by CRISIL while
value ratio (LTV), original tenure, borrower assigning rating on residential mortgage
profile, income to instalment ratio, and asset backed securitisation (RMBS) issuances are:
category. The portfolio performance is + AAA: at least 350% of expected base
benchmarked with dpd status such as 90+dpd peak shortfalls
and 180+ dpd. Thus, one can ascertain whether
+ AA Category: at least 210% of expected
the pool has a negative deviation, similarity,
base peak shortfalls
or positive deviation, relative to the
portfolio, for a particular characteristic. + A Category: at least 160% of expected
base peak shortfalls
+ BBB Category: at least 130% of expected
base peak shortfalls
25
CRITERIA - Structured Finance
26
RATING METHODOLOGY FOR RMBS TRANSACTIONS
6
For understanding a 'waterfall', please refer to the topic 'How is a typical waterfall mechanism structured?' in CRISIL's Securitisation Handbook,
Section 3, Page 26.
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CRITERIA - Structured Finance
Corporate undertaking
RBI'S DRAFT GUIDELINES ON
'SECURITISATION OF STANDARD In some cases, originators give a corporate
ASSETS’ undertaking as enhancement for a particular
amount instead of cash collateral; this
RBI issued draft guidelines on
reduces the carrying cost. A corporate
'Securitisation of Standard Assets' in April
undertaking works exactly like a cash
2005. These guidelines recommend
collateral. For meeting shortfalls, the Trustee
separation of credit and liquidity
will send a notice to the originator invoking
enhancement, and segregation of total
the undertaking, instead of withdrawing
enhancement into first and second loss
cash from the account. CRISIL allows
facilities. Though the final guidelines are
originators to provide corporate
yet to be issued, as a pro-active measure,
undertakings instead of cash collateral only if
issuers have incorporated these features in
CRISIL's rating/internal credit view on the
their securitisation transactions. Under
originator's unsecured debt is as good as or
these structures, a shortfall is classified as
better than the rating of highest-rated
credit or liquidity shortfall based on the
instrument in the transaction.
overdue status of the contract the shortfall
pertains to; the respective enhancement is In every transaction, CRISIL requires at least
accordingly drawn upon. Further, in the some part of the credit enhancement as either
absence of regulatory clarity, issuers have cash collateral or corporate undertaking.
had the first loss facility sized at minimum
investment grade rating, with second loss
Subordinate instrument / over-collateral
facility being the balance enhancement. For
the purpose of analysis, CRISIL studies A subordinate instrument, normally retained
separate credit and liquidity shortfall by the originator, represents the originator's
curves on static pools to size separate ownership interest in the underling pool cash
enhancements. flows. This means that the scheduled pool
cash flows are more than the total senior
payouts. Thus, the balance cash flows
8.B. Forms of enhancement represented by the subordinate interest
In the Indian context, credit enhancement is provides over-collateral for the senior
typically provided by the originator. The instrument. For instance, if the pool cash
various forms of credit enhancement are as flows in a month are Rs. 100 and senior
follows: payouts are Rs. 90, the subordinate strip
Cash collateral (CC) accounts for the remaining Rs. 10. The
collection from Rs. 100 will first be allocated
This is cash deposited by the originator in a
to the senior instrument; only the balance, if
designated cash collateral account. This
any, will be paid to the subordinate
account can only be operated by the Trustee.
instrument.
Any shortfall in the collection can be met by
the Trustee by drawing on the cash collateral
account. This is the best form of credit
enhancement since its availability does not
depend upon the pool performance.
28
RATING METHODOLOGY FOR RMBS TRANSACTIONS
29
Commercial Mortgage Backed Security -
A viable option for financing
commercial real estate
CRISIL believes that Commercial Mortgage Backed Security (CMBS) can
become an important financing tool to cater to the growing capital needs of the
real estate market. This is driven by the rapidly growing real estate market and
the consequent increase in funding needs of the industry. This commentary
analyses the key analytical issues with respect to CMBS and articulates
CRISIL's framework for such analysis.
INTRODUCTION
The Indian real estate market is growing rapidly driven by a buoyant economy,
and a favourable regulatory environment. As a result of this growth, the
funding requirement for commercial real estate is increasing substantially.
Though the real estate exposure of banks has grown significantly, only five
banks accounted for over half of the total banking exposure to the real estate
sector as at March 31, 2005. This highlights the fact that funding sources for
developers within the banking sector are highly concentrated.
In order to enable healthy growth of the commercial real estate market, more
diversified sources of funding is needed. CRISIL believes that Commercial
Mortgage Backed Security (CMBS) provides a good alternative funding tool for
the developer. It is also an effective way for banks to manage their risks in the
real estate sector.
WHAT IS A CMBS?
CMBS is a financial instrument secured by receivables from commercial real
estate. CMBS is a popular fund-raising source for developers and banks
worldwide. A CMBS instrument is created by pooling together one or more
CRITERIA - Structured Finance
30
COMMERCIAL MORTGAGE BACKED SECURITY - A VIABLE OPTION FOR FINANCING COMMERCIAL REAL ESTATE
Repayment Secured
Loan Lease
Mortgage obligations
rentals
Excess
cashflows
Security trust Bank
Sale of
Price
loan
Holds security on
behalf of CMBS
investors
Trust and
SPV (trust)
retention account
Issue of
Purchase
CMBS
consideration
One time flow
Debt
Repeated flow payment
Rated CMBS holders
STEPS IN A TYPICAL CMBS + The debt servicing is met out of these net lease
TRANSACTION ARE: rentals on a periodic basis, and the balance is
apportioned towards various expenses and
+ A loan is given to the owner of the property,
reserves needed for maintenance of property.
usually the developer, by a finance entity. This
Any residual cashflows then flow back to the
loan is secured by a mortgage on the specified
borrower.
property.
+ The principal repayment on the loan is in the
+ Repayment terms of the loan are structured as
form of a balloon payment at the end of the
follows:
tenure.
+ Net lease rentals (charges such as
+ The finance entity sells this loan to an SPV. The
maintenance costs, TDS, service tax, property
SPV funds the purchase of the loan through
tax etc. are deducted from the gross rentals to
issue of one or more CMBS instruments. The
arrive at the net rentals available to service
mortgage on the property now belongs to the
debt) are paid into a designated account
SPV.
charged with the lender.
+ The developer normally acts as the servicer for
the securitisation transaction.
31
CRITERIA - Structured Finance
+ The account into which the lease rentals flow is RISK ANALYSIS FOR CMBS
converted into a trust and retention account TRANSACTIONS
(TRA) charged with the trustee.
CRISIL has developed a detailed framework for
+ The trustee draws the debt servicing amount analysing the risk in CMBS transactions. CRISIL's
pertaining to the loan, and uses it to meet the analytical framework comprises detailed analysis
payment obligation on the CMBS. of the following primary risk factors.
+ The scheduled maturity of the CMBS
instrument is the same as the maturity of the
+ Risk of reduction in the lease rentals
loan to the borrower.
As articulated earlier, the interest on the CMBS
+ Since the principal payment on the loan has to
are to be serviced out of the lease rentals from
be made either through refinancing or through
the underlying property. Thus any reduction in
sale of the property, the developer must obtain a
the lease rentals from the level assumed poses a
refinancing commitment by a specified time, in
risk factor. This reduction can arise due to any
advance of the scheduled maturity date. This is
of the following factors.
to ensure that balloon payment can be made on
the maturity date of the loan. Alternatively, the
+ Credit risk - if the existing tenant defaults on
developer may choose to make the balloon lease rental obligations.
payment from its own cashflows. + Vacancy risk - Lease tenures in India are
+ In case the developer is not able to obtain a typically very short (about three years). If the
refinancing commitment as stipulated, the CMBS tenure is longer than the lease tenure,
documents empower the SPV to do the same on then the leases have to be renewed. Vacancy
behalf of the borrower. The SPV may appoint an risk refers to a situation where such renewals
investment banker for this purpose. are not done in a timely manner.
+ If the loan is not redeemed by the maturity date,
+ Reduction in market lease rental rates at the
the SPV can enforce the security and sell the time of renewal of the lease.
property. The proceeds from the sale are used to
redeem the CMBS instrument. The excess if any + Risk of fall in property prices
will normally flow back to the borrower. This
process has to be completed by the 'legal final Property price is the second key risk element in
maturity date', which is set at a date some time a CMBS transaction. Since the principal amount
after the 'schedule maturity date'. The gap due on the CMBS is to be serviced out of
between the 'legal final maturity date' and the refinancing or sale of property, the price of the
'schedule maturity date' depends on the typical property prevalent close to the 'schedule
time it takes for taking legal possession, maturity period' assumes importance. CRISIL
completing the sale and realising the proceeds. will carry out detailed analysis of the historical
This time gap is different in different movement of property prices and then
countries/regions. prescribe coverage (called LTV) for the
transaction, depending on the target rating.
32
COMMERCIAL MORTGAGE BACKED SECURITY - A VIABLE OPTION FOR FINANCING COMMERCIAL REAL ESTATE
impact of bankruptcy of the developer (in case + Benefits of CMBS for investors
he continues to be the owner of the property), + Investors are able to participate in real estate
title disputes, risk of litigation by the developer lending in amounts that are smaller than the
etc. CRISIL will assess these risk factors principal balance of the mortgage loans in the
primarily from the point of view of the pool.
prevalent regulatory and judicial system. An
appropriately designed structure can mitigate
+ It is possible to choose contracts in such a
the above risks to a substantial extent, and reach manner that the credit and maturity
a desired rating level. preferences of investors can be met.
+ Investors can gain access to segments of the
The above risk factors represent the primary sector at low transaction and information
risk factors in a CMBS transaction. In addition, costs.
CRISIL will analyse several other risk factors
include developer specific and property specific
+ Internationally, defaults experienced on
risk before rating a CMBS transaction. CMBS are much lower than on other types of
securities.
+ Benefits for the commercial real estate sector as
BENEFITS OF CMBS a whole
CMBS has numerous benefits, from the + CMBS leads to diversification of exposure
perspectives of various players in the system: among market participants. Thus the current
+ Benefits of CMBS for issuers situation, where over half of the system-wide
+ CMBS helps in transforming relatively real estate exposure is on the books of only
illiquid real estate loans into liquid and five banks, will not arise.
tradable capital market instruments. + Capital inflows into the real estate market
+ CMBS acts as an additional source of funding become more evenly spread, as compared to
for the bank/developer. the traditional bank lending system.
+ The rating of the bank/developer can be de-
+ Monitoring of CMBS by rating agencies will
linked from the rating on CMBS, thereby enable lending to the sector become more
making it possible to achieve a desired rating risk-sensitive.
on the CMBS instrument. + CMBS can help in reducing the severity of
+ CMBS reduces the overall cost of funds and cyclicality in commercial real estate, since it
optimises the funds raised, as compared to enables the raising of funds from a diversified
bank lending, due to the possibility of having base of investors. This means that developers
rated tranches of different maturities to suit will not lack funds to undertake projects,
different investor classes. even when markets are depressed.
+ CMBS helps lenders manage risk, by
securitising selected commercial mortgages CONCLUSION
and buying or selling suitable CMBS papers. Globally, CMBS are a very popular form of
Thus, lenders can achieve their target financing real estate development. CRISIL
exposures to the overall sector, and/or believes that in India too, CMBS can be an
segments within the sector. effective way to fulfil the commercial real estate
sector's growing need for capital. The
development of the CMBS market will pave the
way for orderly growth of the commercial real
estate market.
33
CRITERIA - Structured Finance
REITs in essence operate like mutual funds. For a detailed understanding of REITs, please refer to
CRISIL's opinion piece 'Real Estate Investment Trust - An untapped investment opportunity'.
REITs are the major source of capital for the real estate industry in developed countries, especially
USA. REITs can play a huge role in the growth of the CMBS market, since they have diversified a pool
of real estate which, if offered as mortgage on borrowing by the REIT, can benefit everyone in the
transaction. Moreover the growth of the real estate sector itself can be driven by such vehicles, since
REITs allow capital to flow in from a large base of equity investors.
REIT shares can be listed on stock exchanges and traded freely, just like shares of any other company.
This develops a liquid secondary market for real estate, allowing smooth refinancing of CMBS
transactions.
34
Rating Criteria for
Collateralised Debt Obligations
WHAT IS A CDO?
Collateralised debt obligation, or CDO1, is a security that is issued by a
bankruptcy-remote entity against receivables from a specified set of debt
obligations. CDOs are typically originated by banks or wholesale financial
institutions. The pool assets in a CDO typically include corporate loans,
debentures, and bonds. A pool consisting entirely of debentures and bonds is
called a Collateralised Bond Obligation (CBO), and a pool consisting entirely of
loans is called a Collateralised Loan Obligation (CLO); these instruments are
collectively referred to as Collateralised Debt Obligations (CDOs).
A CDO issuer pools these debt instruments together, and typically issues two
or more classes of securities, with differing seniority. The cash flows collected
from the underlying receivables are paid out in the order of seniority of each
class of instrument. Thus, each class act as a credit enhancement for all classes
that ranks above it. The credit quality of any given class is therefore a function
of the credit quality of the underlying debt obligations, and of the extent and
nature of credit enhancement (in the form of either subordinate tranches or
cash collateral).
The basic principle of CDO is that, in a pool of diversified assets, the chances of
all of them defaulting simultaneously is significantly lower than the chances of
any one or few defaulting. Hence, from a given pool of assets, different classes
of cash flows can be segregated, based on the certainty of these cash flows, and
assigned corresponding rating. Thus, a target rating of AAA can be achieved
with a pool of lower rated (say A or BBB) assets, by appropriately structuring
the cash flows.
CRITERIA - Structured Finance
1
Please refer to CRISIL's opinion piece 'The ABCs of CDOs', available on www.crisil.com, for a brief overview of
the international and Indian CDO markets, different types of CDOs, and the advantages of CDOs.
35
CRITERIA - Structured Finance
2 3
Transfer/sells Issues PTCs
assets SPV
Seller/ (managed by a
Originator Trustee) Investors
5 4
Consideration Consideration
Servicing Payment to
1 Agent Trust and Retention investors
Loans 8
Account (maintained and
given by operated by the Trustee)
seller Receivables collected
and deposited by
servicing agent
6 7
36
RATING CRITERIA FOR COLLATERALISED DEBT OBLIGATIONS
The rating process entails a detailed analysis The third step in legal due diligence is to
of the legal structure adopted and the taxation determine whether there could be an
issues arising in the transaction. As in all incidence of income tax or other taxes or
securitisation transactions, it is of primary levies on the SPV, impacting the cash flows
importance to ensure that from the assets. In addition, in transactions
where post-default recoveries on assets are
- the assets are transferable
given credit in the rating analysis, the
- the transfer of assets constitutes a 'true sale' security relating to the underlying debt
and instruments is also examined, to determine
- the incidence of tax and its implications on whether the security has been perfected, and
the transaction structure have been examined whether it remains valid even after the
transfer of the assets. CRISIL also examines
whether the necessary stamp duties and
The first step in legal analysis is to determine other dues have been paid.
whether or not the selected assets are capable
of being transferred. Some loan documents
could prevent a lender from assigning the 2. Credit analysis of underlying pool of assets
right to receive loan repayments. Therefore, The ability of any asset in the CDO pool to
the pool assets' underlying documentation generate cash flows depends on the
needs to be examined for clauses that might underlying obligors' capacity to repay. This is
restrict such an assignment. represented by the obligor's credit rating,
Once transferability is established, the next which is assessed in the normal course
step is to establish the 'true sale'. In a CDO through an analysis of its business and
transaction (as in all other securitisation financial profile, management quality, and
transactions), the originator transfers the other relevant parameters in the rating
assets to an SPV. This SPV is created, and process.
exists, solely for the purpose of the To determine the rating of each asset in the
transaction. The SPV is also prevented from CDO pool, CRISIL uses one or a combination
carrying out any other business.
37
CRITERIA - Structured Finance
2
CRISIL has developed 'Quick Rating Model' (QRM), a model that estimates an obligor's ratings based on its financials. This model is based on a
statistical study of financials over 500 manufacturing companies and the corresponding CRISIL ratings.
3
For understanding a 'waterfall', please refer to the topic 'How is a typical waterfall mechanism structured?' in CRISIL's Securitisation Handbook,
Section 3, Page 26
38
RATING CRITERIA FOR COLLATERALISED DEBT OBLIGATIONS
39
CRITERIA - Structured Finance
probabilities, asset cash flows, asset the portfolio based on the industry / sector of
correlations, and recovery rate assumptions, each asset. To simulate portfolio losses with
to simulate portfolio default and loss this correlation behaviour, the set of numbers
distribution statistics. The use of this tool to randomly generated is multiplied by the
analyse portfolio quality is the most 'Cholesky decomposition' of the asset
important step in the CDO rating process. correlation matrix. This results in a default
distribution with the intended correlation
behaviour.
Monte Carlo Simulation
Under the Monte Carlo simulation, a number
of independent trials are simulated. Each trial Inputs for CRISIL's CDO model
randomly generates a set of numbers, each The key inputs for CRISIL's CDO model are:
number having a one-to-one correspondence (a) Asset ratings and associated default
with an identified cash flow (a specific probabilities (computed from CRISIL's
interest/principal repayment from a specific default statistics).
obligor). For example, if the pool consists of 30
loans of five-year tenure with annual (b) Asset cash flows.
interest/principal payments, 150 numbers (c) Asset correlation assumptions (based on
will be generated in each simulation. The first CRISIL's in-house database of asset
five numbers correspond to the five annual behaviour in the rated and non-rated
cash flows of Asset 1, the next five correspond universe).
to those of Asset 2, and so on. (d) Assumptions on the level and timing of
In a particular trial, each asset is determined to recoveries expected within the tenure of the
have either paid on time or defaulted, in a CDO (based on the servicer's past experience
manner calibrated to be consistent with the with various asset classes).
probability of default associated with that
particular asset's credit rating. For instance, if (a) Asset ratings and associated default
the probability of default on a given asset is 10 probabilities
per cent (derived based on its credit rating),
The methodology employed in determining
the simulation engine will ensure that, on
asset ratings has been discussed above
average, that particular asset defaults 10 times
(section 2, 'Credit analysis of underlying pool
in every 100 trials. The accumulation of the
of assets'). Based on the asset rating and asset
behaviour of each of the assets in the portfolio
tenure, CRISIL assigns a default probability
in a trial gives the total portfolio default for
to each cash flow of each obligor.
that particular trial. The portfolio default
behaviour for the entire set of trials gives the CRISIL has comprehensive rating statistics
portfolio loss distribution. The portfolio loss by virtue of its extensive coverage of the
distribution represents an estimate of various Indian debt market, of almost two decades.
possible loss levels, and the corresponding CRISIL has developed a default matrix based
probabilities of occurrence. Based on the on the performance of its ratings. This matrix
nature of each asset, CRISIL could also provides the default probability of each
assume some post-default recovery, but only rating across different tenures.
if it expects recovery to take place within the
CRISIL has published its default statistics5.
maturity of the PTCs issued.
These default statistics have shown an
CRISIL's CDO model also incorporates asset unambiguous link between CRISIL's ratings
correlation assumptions while simulating and default probabilities. The study also
portfolio behaviour. This involves the highlights the high 'Gini coefficient' of
generation of an asset correlation matrix for CRISIL's ratings, indicating that CRISIL
ratings have performed well as predictors of
default.
4
A statistical package: information available at www.sas.com
40
RATING CRITERIA FOR COLLATERALISED DEBT OBLIGATIONS
(b) Asset cash flows deviation and the extremes (very low and
CRISIL analyses details of the cash flows on very high loss levels) increase significantly as
the underlying assets, the availability of a result of greater correlation (see chart
prepayment options, and interest rate below).
revision options. Loss distribution with different correlation levels
Correlation of 0
(c) Asset correlation assumptions Correlation of 0.5
Probability
among corporates are not readily available. 30%
Therefore, CRISIL uses equity return 20%
correlation studies as proxy for asset 10%
correlation in the CDO rating process. These 0%
studies are continuous in nature and are 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
5
“India's first default study validates CRISIL's ratings”, March 2005
41
CRITERIA - Structured Finance
Based on the above factors, the Monte Carlo mechanism, credit enhancement levels are
simulation exercise is carried out. This derived for each tranche to achieve the
simulates the pool collections and shortfalls desired target rating. These credit
(loss levels) under each trial. With a enhancements are stipulated in a manner
sufficiently large number of such trials, the such that the credit characteristics of the
portfolio loss distribution is generated. various CDO tranches reflect the credit
Taking into account this loss distribution, the characteristics of similar rated plain vanilla
instrument structure, and the waterfall instruments.
42
Rating Criteria for Instruments with
Partial Guarantee
Debt instruments fully guaranteed by third-party guarantors have been in
vogue for a long time in the Indian debt markets. Given the limited demand in
the Indian market for corporate debt with ratings below 'high safety' (AA
rating), the use of a partial guarantee to improve an instrument's rating, and
thereby its marketability, has the potential to become a handy tool for
corporates, financial institutions and investors.
In a partial guarantee structure, a guarantor rated higher than the issuer,
provides guarantees for payment of some part of the cash flows payable on a
debt instrument, while leaving the rest to the credit risk of the issuer. CRISIL
has developed an approach to assess the credit risk of debt instruments that are
partially guaranteed. This approach analyses the individual probability of
defaults of the two entities - the borrower and the guarantor - as represented by
their credit ratings. It then assesses other critical parameters of the partial
guarantee mechanism such as the extent of guarantee coverage, and the nature
of the guarantee. These analyses form the base of CRISIL's credit opinion on the
instrument.
The rating assigned to a partially guaranteed instrument will be a 'structured
obligation' ('so') rating. This rating can range anywhere between the borrower's
and the guarantor's ratings, based on the extent of guarantee coverage. CRISIL's
approach allows issuers to achieve a significant rating enhancement with a
guarantee whose coverage is less than the issue's total debt-servicing obligation
till maturity.
Prior to the development of CRISIL's methodology, the approach for partial
guarantees used by rating agencies all over the world was the 'weak link
approach', where no credit was given for any coverage less than the full debt-
servicing obligation on the instrument. Hence, an instrument with, say, a 90 per
cent guarantee from a higher-rated credit (i.e. 90 per cent of interest and
principal payments guaranteed) would be rated identically to the same
instrument without a guarantee. Under this approach, the partial guarantee
yielded no benefit from the point of view of the instrument's rating.
The methodology pioneered by CRISIL addresses this issue and is an
improvement over this traditional approach: CRISIL's approach factors in the
benefits that the investor derives from a partial guarantee. The new approach
CRITERIA - Structured Finance
was applied to rate the debt issues of Ballarpur Industries Ltd and Bharti
Mobile Ltd, which were partially guaranteed by the Washington-based
International Finance Corporation (IFC), and were the first partial guarantee
transactions of this nature to be rated globally. This article highlights the criteria
adopted by CRISIL in rating instruments carrying partial guarantees.
43
CRITERIA - Structured Finance
THE NEW APPROACH A guarantee for a specific cash flow mitigates the
The new approach is scientifically designed to default probability of that cash flow, to the extent
simulate all the possible default scenarios of the that the guarantor's credit risk is superior to the
instrument, either due to default by the issuer or issuer's. Thus, as the extent of guarantee coverage
by the guarantor, based on historical default rates (in terms of the number of instalments covered)
observed by CRISIL in over 15 years of its rating increases, a larger number of cash flows will carry
history. This simulated default pattern on the lower default probabilities, thereby reducing the
partially guaranteed instrument is then compared instrument's overall default risk. This has been
with the default pattern of plain vanilla scientifically measured using CRISIL's
instruments at various rating levels. The eventual proprietary default statistics, which are a crucial
rating on the partially guaranteed instrument will input in arriving at the instrument's final rating.
be based on the rating of the plain vanilla
instrument demonstrating the closest similarity in Timing of Guarantee: The projected cash flows of
its default pattern to that of the partially a company often carry varying risk levels at
guaranteed instrument. different points in time due to company-specific
CRISIL adopts a strict definition of default: it reasons such as project implementation,
treats the first rupee of delayed or missed cyclicality of the industry, and anticipated capital
payment as a default. Therefore, the simulation infusions. A guarantee for debt repayment
assumes that each cash flow can exist in one of two obligations during the weakest expected period of
states: it is either paid fully on time or there is a a company's future cash flows reduces the credit
default event. Under this approach, the partial risk more than a guarantee available during a
guarantee structure works if it increases the period when the issuer is expected to have strong
probability that some instalments will be paid in cash flows and easy access to funds. For instance,
full and on time, rather than if it increases the in a toll road project, the initial construction
probability that a part (less than 100 per cent) of all period might carry the highest risk, whereas in
instalments will be paid on time. In other words, most other companies, the farthest cash flows
having a guarantor guarantee a part of all carry the highest risk of default. Thus, the timing
instalments may not result in any significant of the guarantee is also important in assigning a
rating enhancement under this approach. On the rating based on a partial guarantee.
other hand, if the same guarantor guarantees full
payment on the same proportion of instalments, Nature of Guarantee: A variant of the partial
there is likely to be a significant rating benefit. guarantee, which can effectively address the
In line with the above thinking, one can consider a timing effect, is called a 'rolling guarantee'. A
partially guaranteed instrument as two rolling guarantee is one that, if not invoked, rolls
independent instruments, carrying the credit risk over to cover the subsequent repayment
of the issuer and guarantor respectively. A obligation. For a given extent of guarantee
combination of several such instruments would coverage, a rolling guarantee is far better than a
result in a credit default behaviour that will be 'fixed payment' partial guarantee. This rolling
comparable to a plain vanilla bond in a rating guarantee will, in effect, address the weakest
category lying between the rating of the issuer and period in a company's future cash flows, and will
guarantor. The partial guarantee, therefore, provide a 'curing period' for the company to
enhances the rating on the instrument, up from the recover and commence regular payments on the
issuer's rating, and towards the guarantor's rating. instrument.
The level of enhancement would depend on
several factors, detailed below:
Legal and payment structure: Legal and payment
Guarantee Coverage: The extent of coverage is the structures assume great importance in partial
most crucial input in assessing the level of rating guarantee transactions. CRISIL scrutinises the
enhancement. A higher guarantee cover would guarantee document to assess the terms of the
take the rating closer to the guarantor's rating; guarantee. CRISIL requires a legal opinion stating
needless to say, full coverage would equate the that guarantee is unconditional and irrevocable,
instrument's rating with the guarantor's rating.
44
RATING CRITERIA FOR INSTRUMENTS WITH PARTIAL GUARANTEE
barring certain triggers in the structure. In higher for a multilateral agency than a bank.
addition, CRISIL also requires the guarantee CRISIL will also require the guarantor to confirm
document to mention: that it will adhere to the stipulated structure.
+ the quantum of the guarantor's obligation for In addition to the above, CRISIL also looks at
both principal and interest payment, other relevant parameters including cash flows
+ that the guarantor's liability should continue available to meet non-guaranteed payments,
even if the issuer makes a reference to the BIFR documentation, and the outlook on the stand-
or files for winding up or effects a change in its alone ratings of the borrower and guarantor.
management, and
+ that the guarantor's liability should be CONCLUSION
continuing regardless of a change in the trustee
CRISIL believes that the ratings assigned through
this partial guarantee methodology meets the
Further, CRISIL evaluates the nature of guarantor highest standards of rigour, and convey value to
to stipulate the guarantee invocation date, which investors. With lenders and investors in the
should be adequately distanced from the due Indian markets preferring to invest only in highly
dates for payouts to investors. This is to ensure the rated instruments, CRISIL expects this new
guarantee money is received well before the concept to be a powerful financing tool in the
relevant payout date. For instance, if the hands of corporate treasurers, while adequately
guarantor is a multilateral agency, CRISIL may addressing the concerns of the investing
stipulate a much earlier guarantee invocation community.
date, than if the guarantor is a bank, as the
response time to a guarantee invocation may be
45
Rating criteria for Future Flow
Securitisation
INTRODUCTION
Future flow securitisation transactions are transactions in which investor
payments are met out of cash flows that are to be generated in future, such as
property rental receivables, toll receivables, credit card receivables, oil and gas
sale receivables, and the like. Thus in a future flow transaction, collateral used
by the originator is not existing claims against existing obligors, but future
claims against future obligors.
CRISIL has rated several securities backed by future flow structures. CRISIL
expects that the market for future flow securitisation transactions will grow
significantly, as the Indian debt market matures and investments in
sophisticated debt instruments increase. CRISIL assigns ratings for such future
flows transactions that can be up to three notches higher than the credit quality
of the originator of the assets or cash flows. The extent of notch-up is based on
various factors, which have been discussed in detail in this article.
Designated Payment 7
customers Trust & Retention
(obligors) Account
Provide
product for
services Excess
Agreement to 2 Principal and
remit to TRA collections 8 interest
6
CRITERIA - Structured Finance
4 Proceeds
Special Purpose
Investor
Vehicle
Securitised 3
notes
Right to collect
Proceeds
1 receivables 9
5
Borrower
(Originator)
Initial Transaction
Periodic payments
over the life of the
instrument
46
RATING CRITERIA FOR FUTURE FLOW SECURITISATION
47
CRITERIA - Structured Finance
48
RATING CRITERIA FOR FUTURE FLOW SECURITISATION
+ Residual cash flows after escrowing the house working group on asset securitisation
future flows for rated debt and sufficiency of classifies future flow transactions as executory
the same to meet operating commitments. contracts. To quote:
“A transfer of property that is not in existence
operates as contract to be performed in future or in
Thus, CRISIL evaluates whether the future flow other words as an executory contract. The
structure impairs the originator's standalone implication of this provision is that in case of
performance and whether the free revenues of bankruptcy of the Originator, the contract can be
the originator are sufficient to meet essential treated by the Liquidator as being an executory
expenses (for example to perform its basic contract, which can be therefore terminated by him.
operations, or pay salaries). The monies that are paid as consideration by the
investors for the purchase of the receivables, while
recoverable would be as unsecured creditors of the
+ Structure and payment risk Originator.”
The structure and payment risk analysis CRISIL's rating on an originator's ordinary debt
involves a detailed study of the structure of the assesses the likelihood of full and timely
transaction, the mode of collection, the schedule payment on the debt and does not necessarily
of payments to investors, and the like, to assess reflect the probability of continued operations.
the strength of future cash flows. An CRISIL's rating for the future flow structure
examination of the following is carried out: captures this difference. Hence, to that extent,
+ Agreements with the obligors (such as nature the higher rating factors in the lower probability
of take-or-pay contract if any, payment of bankruptcy than of timely payment on other
terms). rated debt.
+ Historical collection pattern.
+ Assumptions made for projecting future
+ Escrow Structure
flows (including pricing agreements, interest
earned on balances). In future flow transactions, CRISIL stipulates
that the Issuer maintain an escrow account into
+ Co-mingling risk (mingling of the identified
which all amounts due on the instrument from
future cash flows with the originator's other
time to time are deposited. As the rating is
cash flows).
dependent on payments from the escrowed
+ Other factors that can result in variability in cashflows, it is essential that the cashflows be
future flows. accessible to the trustee/investors at all times.
Based on the strength of the cash flows, the CRISIL requires the escrow account to be a no-
structure of the instrument, and past collection lien account and the account should either be
efficiency, CRISIL specifies a level of credit charged to the trustee or the Issuer should
enhancement (in terms of cash collateral or over- declare trust over the account. Also the account
collateralisation levels) required to achieve a should at all times be under the control of the
desired rating. trustee. CRISIL will ascertain whether the
cashflows are charged in favour of any other
creditors of the Issuer. If prior encumbrances do
+ Legal Risk exist, then CRISIL will require the Issuer to
If the originator continues to generate sufficient obtain the requisite consents/pari passu letters.
receivables, the timely payment on the rated Typically, CRISIL will stipulate a payment
instrument is strongly linked to the robustness structure to be followed by the Issuer and the
of the transaction's legal framework. There are trustee. CRISIL requires that the payment
differing opinions as to how future flow structure be documented and confirmed by all
structures would be treated in the event of parties to the transaction, i.e. the Issuer, the
originator's bankruptcy. The report of RBI's in- trustee and the account bank. It is also
mandatory that the payment structure be
disclosed in the offer document.
49
CRITERIA - Structured Finance
+ Documentation
In case of a future flow transaction, CRISIL
requires the following documents to be in place:
+ A tripartite agreement between the trustee the
Issuer and the account bank, incorporating
the payment structure and establishing the
trustee's rights over the cashflows.
+ Trustee agreement.
+ Offer document which should also contain the
stipulated payment mechanism.
50
RATING CRITERIA FOR FUTURE FLOW SECURITISATION
51
Securitisation - Legal Issues and
Compliance Requirements
This article describes CRISIL's legal and compliance requirements for
securitisation transactions, future flow transactions and guaranteed ratings.
52
SECURITISATION - LEGAL ISSUES AND COMPLIANCE REQUIREMENTS
In April 2005 RBI has issued two draft guidelines: Although there are diverse case laws on the
1. 'Securitisation of Standard Assets' and subject of true sale, CRISIL is of the opinion
that in cases where the originator retains a
2. 'Purchase/sale of Non Performing Assets' high level of risk in the assets, the courts are
where securitisation companies and likely to recharacterize the securitisation as
reconstruction companies are not involved. secured borrowing by the originator.
Therefore, if transactions have unusually
Currently there is no clarity on process of high levels of risk retention by the originator,
securitisation of performing assets under the CRISIL may regard such transfers as being
SARFAESI Act. Further, the Act excludes certain inconsistent with a true sale.
assets such as receivables from hire-purchase
contracts or receivables backed by the security of + Option and obligation to repurchase assets
aircraft or ships.
CRISIL will treat an obligation on the part of
The RBI has permitted originators to carry on the originator to repurchase assets on account
securitisation transactions outside the purview of of deteriorating credit quality as being
the SARFAESI Act and all securitisation inconsistent with a true sale. Accounting
transactions are currently executed outside the guidelines issued by the Council of the
ambit of this Act. Institute of Chartered Accountants of India,
however, permit the originator to provide the
transferee with a 'put' option for the assets. If
Crisil's legal requirements
the option is structured as an arms-length
CRISIL examines every securitisation transaction transaction, distinct from the transfer of the
in light of the following issues: assets, this will not vitiate a true sale.
+ True sale
Where there is a put option, CRISIL will
'True sale' is the single most important issue in examine the option contract to determine if
any securitisation transaction. A true sale will the same can be construed as a transaction
establish that the assets transferred to the SPV that is distinct from the securitisation.
are bankruptcy remote from the originator's
estate. In most cases, the servicer retains the option
to purchase the assets when they decline to 10
Since there is no statutory definition of true sale per cent or less than the size of the original
and no judicial interpretation of the same, in pool, for administrative ease. This is not
India, when evaluating a transaction for true inconsistent with a true sale because such a
sale, CRISIL will examine the following: repurchase is not linked to the credit quality
of the assets1.
+ Extent of recourse to the originator and risk
retained by the originator in the assets + Intention of the parties
While mere recourse to the originator will not The intention of the parties to a transaction is
vitiate true sale, it is important to check the often scrutinised by the courts in order to
extent to which the transferee will have determine a true sale. Therefore, it is
recourse to the originator- this reflects the risk important that the language used in
retained in the assets by the originator. transaction documents clearly conveys the
The higher the level of risk retained by the intentions of the parties and that the nuances
originator, the greater the chances that the of a transaction do not have the potential to
assets cannot move off its balance sheet. vitiate a true sale. For example, the price at
Therefore, while the transfer of assets to the which the assets are purchased is an
SPV may be valid, the assets themselves may important consideration for establishing the
not be remote from the originator's estate in intention of the parties. An unviable
bankruptcy.
1
Accounting norms permit the servicer to have a “clean-up call option”, which may be exercised by the servicer if it becomes unviable for it to
service the assets when the value of the assets falls to 10 per cent or less of the original value.
53
CRITERIA - Structured Finance
purchase price (if the purchase price received Apart from the due diligence conducted by it,
is significantly less than the fair market value CRISIL also bases its analysis of a transaction on
of the assets sold) can have the effect of re- professional opinion. For each transaction
characterising a securitisation. CRISIL CRISIL requires the originator to obtain a legal
examines each transaction document to opinion from an independent counsel
ensure that there are no discrepancies confirming that the transfer of assets is
between the terms of the proposed consistent with a true sale.
transaction and the execution of the same.
+ Stamp duty and registration laws
+ Extent of control retained by the originator over Stamp duty can be described as a tax on
the assets transactions, and is a charge levied on all
In some transactions, the originator may documents of a commercial nature. Indian
retain control over the assets even after they states are empowered to determine their own
have been transferred. For example, the stamp duty rates and these rates vary from state
originator may have a call option on the assets to state, ranging from negligible to astronomical
or the transferee may be restricted from amounts on the same transaction. Stamp duty is
further transferring the assets. an important issue unique to securitisation
transactions executed in India.
CRISIL will acknowledge a transfer to be a
true sale only if the transferee gains For reasons mentioned below, CRISIL requires
unrestricted rights to the assets. Covenants all transaction documents to comply with the
restricting the transferee's ownership of the stamp duty and registration laws. Therefore,
assets will be viewed as inconsistent with a CRISIL examines the executed documents in
true sale. each transaction and requires representations
and warranties from the originator and a legal
opinion confirming that the documents adhere
+ Appointment of the originator as servicer
to the relevant stamp and registration laws.
While the appointment of the originator as the
servicer is the normal practice in most
securitisation transactions in India, at times + Consequences of stamp duty evasion
this could be inconsistent with a true sale. For The consequences of evading stamp duty are
example, if the servicer indemnifies the serious. In terms of the Indian Evidence Act,
transferee from payment defaults by the documents that are required to be stamped
obligors or if the originator takes on servicing and have not been duly stamped (that is
of assets without adequate consideration, this either unstamped or inadequately stamped)
could vitiate a true sale. CRISIL cannot be adduced as evidence in a court of
acknowledges that even if the documents do law. This renders the documents
not evidence an adequate servicer fee2 the unenforceable, unless the deficient stamp
servicer consideration may be reflected in the duty is paid at the time of enforcement. The
purchase price. problem is that an inadequately stamped
document attracts an enormous penalty,
It is also important that the transferee be given
sometimes up to ten times the deficiency in
the right to appoint another servicer if the
stamp duty paid.
originator fails to comply with the terms of
the servicing agreement. This will further
prove that the originator has lost control over + Bearing the cost of stamp duty
the transferred assets.
The stamp duty payment liability is usually
decided by way of contract between the
parties to any transaction. In the absence of
2
Most agreements quote a fee of Rs.100, which is obviously not the total consideration for the servicer.
54
SECURITISATION - LEGAL ISSUES AND COMPLIANCE REQUIREMENTS
55
CRITERIA - Structured Finance
3
The content of the opinion will however vary depending on the facts of a transaction.
56
SECURITISATION - LEGAL ISSUES AND COMPLIANCE REQUIREMENTS
4
CRISIL provides the option to the issuers to adhere either to CRISIL's standard guarantee format or a format of issuer's choice. A legal opinion
may not be required if the issuer / guarantor chooses to execute the guarantee document as per CRISIL's standard guarantee format.
57
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Analytical Contacts
Managing Director & Chief Rating Officer
R. Ravimohan
N. Muthuraman
Head
Tel.: + 91 (22) 5691 3118
Email: nmuthuraman@crisil.com
Ramraj Pai
Head
Tel.: + 91 (22) 5691 3036
Email: rpai@crisil.com
Business Development
Mukesh Agarwal
Director
Tel.: + 91 (22) 5691 3035
Email: magarwal@crisil.com
Kanchan Arora
Head
Tel.: + 91 (22) 5691 3075
Email: karora@crisil.com
CRITERIA - Structured Finance
Sachin Gupta
Head
Tel.: + 91 (11) 2372 1603
Email: sgupta@crisil.com
Hani Jalan
Manager
Tel.: + 91 (22) 5691 3077
Email: hjalan@crisil.com
January 2006
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