How to increase the breadth and depth of Indian Securitization market?

1. Introduction

Securitization is the process of converting loans into marketable securities. Under the
securitization process, an illiquid, bilateral loan arrangement between the lender (originator)
and the borrower (obligor) are converted into marketable securities. The originator transfers
his financial interest (called an assignment) to an investment vehicle (called a Special Purpose
Vehicle or SPV). The SPV, in turn, uses the future cash flows from receivables to issue securities
to investors. Under its plain-vanilla form, the securities so issued are called Pass Through
Certificates (PTCs). Under more exotic structures, the securities issued are called Collateralized
Debt Obligations (CDOs). Prior to the securitization process, the investment banker engages the
services of a Credit Rating Agency (CRA) to assess the risk points in the transaction, so that
potential investors in the PTCs or CDOs can make an assessment of risk-adjusted returns. As an
added layer of protection, credit enhancing agencies offer a guarantee to make good any
shortfall due to delinquencies or obligor failure. The underlying loans could be for mortgage
housing loans (mortgage backed securitization or MBS) or for other assets like auto loans (Asset
Backed Securitization ABS). Most of the deals in India are ABS with respect to commercial
vehicle loans. Due to conservative origination standards and simple PTC structures, the damage
caused by sub-prime mortgage loans as experienced in US and UK are not seen witnessed in the
Indian markets.

Securitization has several advantages, one of them being the diversification of bank loans to
investors via the capital markets. The initial proposition was, securitization should be
appropriately packaged and sold to diversified investors, but securitized credit intermediation
would reduce risks to the whole banking system and losses would be less likely to produce
banking system failure. Since a primary mortgage loan has a long maturity, there is a huge risk
in the portfolio due to economic, real estate market and political conditions. The secondary
market player should understand and price this risk properly. But, instead of that, they just
transferred these risks from one market to another. This resulted in the sub-prime crisis in US.
Though in the recent Global turmoil SP was blamed but we cannot deny the benefits of SP. This
means, rather than blaming, we should try to fix the problem. The basic problem was the issue
of wrong incentives, and SP was used to doctor the balance sheets. For example, one entity had
bad loans on its accounts (which were not declared “bad”); it transferred it to another entity
and did a buy back after a year, showing a profit on sale. Managers who took risks were
rewarded, credit ratings were doctored, and users followed yields blindly.

In the Indian context, securities markets are not complete without securitization products.
Incomplete markets are inefficient markets. Securitized instruments constitute a miniscule
portion of the total debt market transactions in India, valued at Rs 58,000 crore in 2008-09
(down from Rs 70,000 crore in 2007-08). Most of the securitized paper consists of Asset Backed
Securitization (ABS) rather than Mortgage Backed Securities (MBS). Indian investors are risk-
averse and only top rated papers are sold or traded. There were a few securities which were of
the ‘originate-to-distribute’ category which saw some downgrading. In FY 2008, the Indian
markets saw 434 securitization deals, as compared to 238 in FY 2007. In value, the size of the
deals was 587.1 billion, as against 369.6 (Please refer to Chart 1). However, the share of
Residential Mortgage Backed Securitization (RMBS) was hardly 1% of the total value. The
Indian securitization markets are poised for growth. There is a possibility for loan trading once
the secondary markets also pick up volumes.

Looking at events over the past one year (2007-2008), securitization has acquired a somewhat
unsavoury reputation. Despite the problems, people do realize the importance of
securitization. NISM, in association with i-peritus and CARE, has organized a one-day summit
where industry has come together to discuss the way forward, notwithstanding the problems
that occurred. The summit focussed mainly on the theme of developing the breadth and depth
of Indian Securitization market covering challenges that need to be addressed from regulatory,
legal and tax perspective and also to increase liquidity in securitized markets.

2. Regulatory Concerns
Motor vehicles were deemed dangerous when they were invented, but the usage was
controlled through better roads and traffic rules. In a similar vein, securitization, by itself, is no
evil. Thus, for the sub-prime crisis, we can’t blame on securitization. It was due to the role of
market players. In USA, risky products were offered to risky borrowers while in India they were
offered to safe borrowers. With growth-drivers like declining interest rates, high liquidity, low
lending rate etc., leading to sale of non-performing loans, which resulted in the crisis, ultimately
affecting the primary MM as well. Definitely, regulators have been lax, and Credit Rating
Agencies (CRA) had inherent conflicts of interest between business exigencies and rating
complexities. But, as opposed to this, Indian regulators have been very careful and aware of
such problems, which is why Indian MM has grown slowly but smoothly.

In India, though people are becoming aware of the problems and are talking about them, the
key concern is ‘sufficiency’ of legal infrastructure (enforceability of contracts, bankruptcy laws
etc.) which are not within the exclusive reach of regulatory body. Regulators need to recognize
then need for strengthening the buy-side due diligence. Very often, it appears that increasing
the quantity of the disclosure leads to a decrease in the quality of disclosure. Hence, there
should be a fine balance between the two, so that the most important information doesn’t get
lost. In order to effectively plan ahead to avert the next impending crisis, regulators need to
adopt a pro-active stance in order to spot opportunities for potential regulatory arbitrage.

The RH Patil Committee Report on Debt Market reforms made several recommendations for
removal of obstacles, viz. broadening the definition of securities, rationalizing stamp duty, fiscal
concessions for municipal and infrastructure bonds and also tax exemptions for special purpose
vehicles. The SEBI (Public Offer and Listing of Securitized Debt Instruments) Regulations, 2008,
represent one of the steps towards this direction. An enabling environment needs to be created
for broad-basing the investor interest in the form of pension funds, FIIs, retail investors etc.

However, actual diversification cannot be achieved if the assets find their way into the balance
sheets of other banks. This is particularly true in the case of re-securitization. The promise and
potential of securitization is also being misused by offering sub-standard loans. The regulatory
challenge is to ensure that less complex securitization takes place, and that real diversification
of ‘safer’ asset holdings is achieved. What is desirable is securitization in a simpler form,
coupled with a broader base of informed investors. Under the Basel II framework, RBI has
proposed a higher capital adequacy stipulation of 50% for all re-securitized assets. At the
summit, speakers felt the need for governing authorities to revise or introduce appropriate
regulations that would provide a conducive environment for securitization market.

Recognizing Securitization: Securitization in India received a setback owing to a decision of the

Gujarat High Court in the case of Kotak Mahindra Bank versus APS Star. The Court ruled that an
assignment of debt by a bank amounts to trading in debt. Under the section 6 of the Banking
Regulation Act, 1949, trading on debt is not a permissible activity of the bank, which is
completely against the very concept of securitization. Since this is the 60-year old Act, it has
little relevance to the current trading and business practices. Until the relevant provisions of the
Banking Regulation Act are amended, the government needs to pass an official notification to
now make securitization a permissible activity. Currently, assignment of loans is permissible
only if the assignee is registered under SARFAESI Act.

Stamp Duty: Another major legal issue is that stamp duty on securitization in the country varies
between the states and people do transactions at one place and loan at another place, which
results in complications in the documentation process. The Bombay Stamp Act is also not
conducive to or consistent with securitization. The rates of the Bombay Stamp Act are also far
higher in comparison to the Indian Stamp Act. There is a need to have a uniform and low stamp
duty in order to develop a national market. Reduced tax rates and stamp duty structures will
provide the enabling supporting environment for securitization.

Coordination between regulators: Structured financial products are sometimes built around
loopholes, regulatory grey areas, or to get away from regulation. For example, credit enhancing
institutions were exposed to risks far higher than their capital. They continued to be in business
as unregulated entities, posing as counterparty risk to other regulated entities. For this reason,
is necessary to ensure better coordination mechanisms between regulators.

Issue of PTC: Most securitization products are bilateral loan assignments between the
originator and the SPV. Regulators need to provide more clarity on bilateral loan assignments.
This would need a suitable amendment in the Banking Regulation Act to facilitate the issue of
Pass Through Certificates and onward assignment to the credit enhancing institutions.

Credit Enhancement: Credit enhancement can be through cash collateral and bank guarantee.
In practice, according to the regulations, there are differences between the bank guarantee of
two different banks in procedure and formats; dissolving these differences can really solve one
of the major challenges faced by the issuers in relation to credit enhancement. It has been
urged that credit rating agencies (CRA) to treat investment in liquid mutual funds as an
alternative to cash collateral. It is a rule that credit enhancement is done at one time and there
was a view that if it is also possible that the credit enhancement can be done in phased
manner.

Minimum lock-in period: The banking community is of the opinion that some entities like highly
rated borrowers, retail loans etc. should be exempted from minimum lock-in guideline. This is
on account of the relative safety of these underlying assets. In respect of such loans, there is
already a double layer of safety: the conservative nature of the Indian borrower and the
origination standards of the banking system.

Bringing CRA’s under regulation: Rating agencies interact more frequently these days, with
originators, issuers and investors. They are also adhering to IOSCO standards. CRAs are required
to disclose the base loss and sensitivity analysis in respect of securitized paper. As regards the
functioning of CRAs, they are recognized by SEBI and subject to inspection, but function in a
largely unfettered manner. There is a need for greater supervisory oversight on the due
diligence processes and operational aspects of CRAs.
As per IOSCO recommendations also state that there is a need to remove incentives for
overstating the value of assets and bring in more transparency into the rating process.

Leverage: Excessive levels of leverage were prevalent in USA. This included personal loans,
leverage at the corporate level and also at the fiscal deficit level.
Systemic Risk: It is necessary to identify and regulate financial institutions posing systemic risk.
This could include originators, credit enhancing institutions and investors with high exposure to
credit-based products.

In addition, the regulators need to have a framework or tools to handle liquidity and cyclicality
at the macroeconomic level; to avoid harmful irrational momentum effects and bringing
transparency and suitability in product regulation (retail as well as wholesale).

3. Tax related concerns

(Need to be added: Request Mr Vikram Vohra)

4. Concerns over Liquidity in Securitization market

The most important thing a system can do is first educating the people about ethics, through all
possible mediums. There is a strong need to aware people about pro-cons of securitization.
Like, for investors, there is a need to move away from dependence on ratings and move to
independent models. For originators, it is necessary for them to keep their skin in the game
(converse to a complete ‘originate-to-distribute’ tendency). One more suggestion during the
discussion came is, similar to securitized markets in developed countries, introducing “market
maker” in our markets will help in increasing liquidity to a greater extent.

From investor’s perspective and also on the liquidity aspect of the securitization market, the
following points arise:

 Around 80 to 90 percent of the market is controlled by merely 3 to 4 players.

 There is market for AAA rated papers but there is no market for even one denomination
down papers like AA or AA+ or AA-. This could induce originators, merchant bankers and
credit rating agencies to collude in order to rate more securities as AAA. There is a great
danger of asymmetric information if such a thing were to happen.
  Mindset of the investor base. The investors have a debt orientated approach. They want
to earn interest at regular intervals rather than wait for the securitized papers to get
mature.

 The rural market is not developed, in the sense that the receivables are contingent and
delay is almost certain, which lead to higher collateral which is against securitization.

Regarding the challenges faced by the issuers, the major issues are:

 It is strongly recommended that standardization be brought into documentation, stamp

duty, disclosures, transparency and ratings. Mutual funds being the essential player in
the securitization market with the share of other players like private banks, public sector
units, public sector banks being very minimal. Mortgage based securitization is almost 2
to 3% of the total securitization, which contrary to scenario in some of the developed
countries; which is largely due to the lack of long term securitization. There is a very
small amount of investment from corporate sector, FII and even cash rich public sector
units.

 Less developed secondary market for securitized products.

 No market maker. Securitized papers lack liquidity. There is a need for secondary listing
of PTCs.

 Originator base is too small. Originator quality is the key issue.

 Entry of Insurance companies, Pension Funds and Foreign Capital will strengthen the
investor base.

In order to promote securitization in India, we have to look at following area.

Bankruptcy: Securitization is said to be bankruptcy-remote, in case the assignment represents a

true sale. This is because the PTC holders or the credit enhancer get free and full access to the
cash flows from the obligor. In India, it is not clear whether the official liquidator will continue
to exercise a claim on the receivable accounts that are securitized. In the event of a continued
lack of clarity, securitization or even credit enhancement may not take off in India. For this
reason, the definition and mechanics of a true sale need clarity. The enabling provisions in the
regulations need to be in place.

Increasing the array of asset classes: Any asset that has a predictable cash flow structure can
be securitized. The asset class can be widened with Infrastructure projects, Lease rentals, Gold
loans, Micro-finance securitization. A structure need to be evolved to float these new classes
of securitization assets.

Building confidence: It is imperative to build confidence through accurate due diligence, as a

pre-requisite for healthy securitization market, in order to improve the transparency and
disclosure standards.

Accurate and Fair Due Diligence: So far, we do not have defaults and the market has not yet felt
the heat of lack of complete due diligence. In the near future, complete due diligence is a
crucial factor to develop confidence among traders and to grow this market. CRAs need to do
good job and provide complete documentation on securitized product. CRAs need to comply
with revised IOSCO disclosures (base loss and sensitivity analysis). Accountability of CRAs is
necessary to protect investor interests. May be bringing CRAs under regulatory control would
serve the purpose of confidence building.

Investors should have easy access to default as well as fraud data across all assets. This will
enable investors to know about a particular asset class behavior and see the trends across
products. This will help the investors to take informed decisions and position themselves
across risk profiles. As regards disclosure quality, most of the securitized products are bilateral
and little information is shared in public domain.
5. Conclusion & Recommendations

Securitization markets in India are at a nascent stage, with most of the papers in the having ABS
category. There is very little MBS. Origination standards are conservative and the instruments
are PTCs. There is also very little of CDO activity, meaning, structures are simple. These factors
reduce the risks of complexity, valuation, and risk.

Securitization is gaining traction in India. While India is fortunate to learn from the lessons of
the western world, it is necessary to create an enabling environment while exercising necessary
caution. It is necessary to remove certain impediments in regulation.

The recommendations are summarized as under:

Government Policy RBI SEBI Legal

Guide legislation by Stipulation of Oversight on Due Consistency of legal

aligning it towards Capital Adequacy Diligence Review framework with
economic objectives Standards Processes and economic objectives
Standards,
Look at stamp duty Revamp Banking Transparency and Removal of archaic
towards recovery of Regulation Act to Disclosure laws
costs, not as a align it with Standards,
source of revenue securitization Operational Uniformity of laws
structures Processes and rules across the
Inter-regulator country to have a
coordination to Facilitate laws to national market
oversee supervise credit
securitization enhancers Clarity on
assignment of loans
to facilitate
securitization

Make language and

documentation
simple and
standardized

Provide clarity on
taxation issues