Chapter 2 – Securitisation

Securitisation – Concept

Securitization is a method through which illiquid assets are transformed into more liquid form, which are distributed to a broad range of investors through the medium of capital market. It is the process of converting illiquid financial assets into liquid marketable securities through an intermediary called special purpose vehicle. Through the securitisation process, the assets are removed from the balance sheet and the funds generated through securitisation can be ploughed back for further asset expansion. The Special Purpose Vehicle converts assets into securities called as ‘Pass Through Certificates’ and sell them to the buyers who may require that particular asset class as a requirement or investment. Since these certificates are backed by assets, they are also called asset backed securities (ABS). If assets which have underlying mortgages are secuiritised, they are called as “Mortgage Based Securitisation”. Securitisation is the process of pooling of individual long term loans which are packaged and sold to various investors in the form of Pass Through Certificates (marketable securities) through a Special Purpose Vehicle with the provision that the inflow of cash in the form of recoveries will be distributed pro rata to the buyers. The advantage of securitisation is that the receivables are removed from the books as they have been sold but the transaction does not create a liability in the balance-sheet. Thus, securitisation helps in asset-liability management and also in capital adequacy. Securitisation is a structured process and effected only for standard assets and rated by the rating agencies.

Securitisation Process

• The lender first selects the assets they want to securitise.
• The issuer (Special Purpose Vehicle) makes payment to the lender for the loans securitised.
• The assets are converted into a pool of securities by the issuer for the purpose of issuing Pass Through Certificate (PTC).
• The PTCs are sold to other investors who are willing to invest.
• The lender continues to receive the recoveries from the original borrowers and the same are passed on to the SPV
• The SPV in turn passes the recoveries to the investors.

Securitisation in Retail Banking

In Retail banking, there is a concept called Collateral Debt Obligation (CDO). In CDO, asset classes/receivables like Car Loans, Credit Card Receivables and Mortgage Loans like Home Loans, are grouped together and securitised. Multiple layers of PTCs with varying rates and coupons are issued based on the quality of assets and risk perceptions underlying in the asset.

EMI FOR REPAYMENT IN RETAIL LOANS

• In EMI model of repayment, the loan is repaid in full in uniform monthly installments spread over the repayment period.
• The EMI will consist of two components namely the principal and interest.
• In EMI, the principal component will be less during the initial months and the interest component will be more. As the repayment progresses, the principal component will increase and the interest component will reduce. This is because, as the repayment progresses, the principal component will get reduced and hence interest charges also will decrease. Hence the subsequent installment will service more of the principal.
• The formula for calculation of EMI :

 P x r x (1+r)n/ [ (1+r)n -1] ;

where p = principal (amount of loan),

r = rate of interest per month

n = no of installments