Securitization Markets: Indian and Global Scenario
Securitization is one of the latest financial innovations in Indian markets. It is still in its nascent stages, with securitized assets as low as about 2% of all debt outstanding. In December 2002, a legal framework was provided for securitization through the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI), which became effective from 21 June, 2002. In this Act, the provisions of securitization have been clubbed with provisions of asset reconstruction and enforcement of security interest. Though these provisions are heterogeneous in nature, one thing that is common to them is that they are related to banks and financial institutions. This new law has introduced certain major changes in the legal framework for transactions in the financial market as under:
In the framework for securitization, Banks and FIs are not permitted to create special purpose vehicles (SPVs) or special purpose establishments (SPEs) for undertaking such transactions. The law contemplates establishment of a securitization company or reconstruction company and its registration with Reserve Bank of India (RBI). Such a company in turn formulates schemes, and sets up (scheme-wise) separate trusts. RBI is required to frame regulations to be complied with and observed by such companies and the trusts to be set up by them. A securitization company can also act as an asset reconstruction company, and vice versa.
The purpose of securitization is to avoid mismatch between assets and liabilities of Banks/FIs. The lending company sells its loans to the investors through the SPV. The company securitizing assets can acquire financial assets from Banks/FIs, by issuing debentures, bonds or entering into any arrangements with the lenders/issuers. Once the company takes over the financial assets, it will be treated as lender and secured creditor for all purposes. It may then devise a separate scheme for each of the financial assets taken over. Qualified institutional buyers (QIBs) will invest in such a scheme. The QIBs include FIs, banks, insurance companies, trusts, asset management companies, provident funds, gratuity funds, pension funds and foreign institutional investors (FIIs). The company will issue security receipts to QIBs, which represent undivided interest in such financial assets. The company will realize the financial assets and redeem the investment and payment of returns to QIBs under each scheme. Any disputes among banks, FIs, securitization or reconstruction companies and QIBs shall be compulsorily referred for conciliation or arbitration under the Arbitration and Conciliation Act, 1996.
RBI issued draft guidelines to securitization companies and reconstruction companies on 18 December, 2002, soliciting views of banks, FIs and others. RBI subsequently finalized the guidelines taking into account the feedback received. The guidelines and directions provide for different aspects of securitization and asset reconstruction relating to registration, owned funds, permissible business, operational structure for giving effect to the business of securitization and asset reconstruction, deployment of surplus funds, internal control systems, prudential norms, disclosure requirements etc. for the smooth formation and functioning of securitization and re-construction companies. In addition to the guidelines and directions, which are mandatory, RBI also issued guidance notes of a recommendatory nature covering aspects relating to acquisition of assets, issue of security receipts, etc. RBI is in the process of framing a set of standard guidelines in the matter of takeover of the management, sale or release of whole or part of the business of the borrower. It already issued the format of the application form for issue of Certificate of Registration in its notification dated 7 March 2003.
Some problems and ambiguities relating to securitization are discussed below:
Problems Relating to Income Tax: As per Section 60 of the Income Tax Act, where there is transfer of income without transfer of assets, the income is chargeable in the hands of the transferor. Exemption from this provision for securitization is essential. Provisions relating to tax deducted at source (TDS) need clarification, as payment by a securitization company to its investor is neither in the form of interest nor dividend.
Legal Issues: Stamp duty is one of the major hindrances to the development of securitization in India. Stamp duty is payable on any instrument which seeks to transfer any rights or receivables, whether by way of assignment or novation or by any other mode. The instrument of transfer attracts stamp duty at an ad valorem rate, which ranges from 0.1% to 8%. Therefore, the process of transfer of the receivables from originator to SPV involves an outlay on account of stamp duty. Besides this, stamp duty may also be attracted on issue of securitized instruments to investors by the SPV. This leads to levy of stamp duty twice on the same underlying receivables and may make the securitization deal uneconomical. In addition to stamp duty, the instrument must be registered under the Indian Registration Act, 1908, which imposes additional costs to the transaction.
Another important aspect that hinders the growth of securitization in India is the lack of effective foreclosure laws. The existing foreclosure laws are not lender-friendly and increase the risks of mortgage-backed securities by making it difficult to transfer property in cases of default.
The SARFEASI Act was intended to serve several purposes: promote securitization, pool together non-performing assets (NPAs) of banks to realize them and make enforcement of security interests faster. The government somehow thought of merging these three things into one. However, this merger has made a mockery of the whole concept of a securitization company or an asset management company for realizing NPAs. The device of securitization was grossly misunderstood when the same was considered as a business instead of a mode of funding.
Sketchy legal provisions were formulated for asset reconstruction companies, for which guidelines have been finalized by RBI nearly after 11 months of the promulgation of the Act. These guidelines, inter alia, require an asset reconstruction company (ARC) to pay in cash or non-contingent bonds for purchase of a defaulted loan, which by itself would remove much of the incentive for the buying ARC. Further, the SARFAESI law cannot give any more powers to banks/FIs than the loan agreements do, regarding takeover of assets or management of a unit. In many cases, the security interests held by banks are floating charges and if the charge is unidentified or unascertainable, the applicability of the law becomes doubtful.
Stucture of SPV: The Act does not permit a pass through structure of SPV, which is bankruptcy remote, tax-exempt, and without any employees and has no other obligations or liabilities. Securitization as practiced in the US works on the concept of bankruptcy remoteness, which means that once the assets are securitized, these go out of the balance sheet of the originator. Thus, even if the originator or the securitization company goes into liquidation, it does not affect the securities held by the QIBs through securitization. Hence, the credit rating of the asset can be even higher than the credit rating of the originator. But such a structure of SPV has been misused in the US and Enron’s alleged use of off-balance sheet SPVs to conceal large amounts of debt and losses by artificially creating liabilities off-balance sheet, has reverberated across the industry. In view of such developments, caution exercised by the SARFAESI Act, by placing such entities under a limited company registered with RBI, having its own funds of at least Rs20m was a prudent decision. However, the financial regulators are having a re-look at the entire structure of the SPV.
Major chunk of the financial market is left out: The definition of financial institution includes non-banking finance companies (NBFC), provided the central government, by notification, specifies them as financial institutions for the purpose of this new Act. As many NBFCs are involved in housing finance, hire-purchase finance and car loans, a notification by central government is necessary for including the NBFCs in the definition of financial institutions for the purpose of this Act.
The Indian securitization efforts reportedly started during the year 1991. However, major efforts started only in 1998 when Citibank had structured securitization transactions for receivables of auto parts for three NBFCs – Tata Finance, Ashok Leyland and Kotak Mahindra for about Rs1bn. The assets securitized were receivables from the auto pool. ICICI had securitized assets of the order of Rs27.5bn in its books as on March 1999. Global Tele-systems raised about Rs1.3bn by securitizing its telecom receivables in March 2000. During this year, SBI Caps also structured a securitization deal for Karnataka State Electricity Board (KSEB) for Rs2.94bn. Receivables of KSEB had been sold to a SPV, which, in turn, raised funds by issuing bonds to HUDCO. NHB completed another securitization transaction of Rs920m in May 2001. ICICI had initiated securitization deals worth Rs70bn during 2001-02 (through pass through certificate and other routes), which created a great interest.
Some of the important types of securitization products in the well developed world securitization markets include asset-backed securities (ABS), asset-backed commercial paper (ABCP), mortgage-backed securities (MBS), and collateralized debt obligations (CDOs). CDOs can be collateral loan obligations (CLOs) or collateral bond obligations (CBOs). ICICI had come up with its CDO offer in the beginning of the year 2002, but failed largely due to lack of appetite for such debt in our country. Some of the major securitization transactions in India in 2002-03 include ICICI’s Rs23bn corporate loan proposal, Citibank’s personal loan deal of Rs2.84bn, HDFC’s Rs1.56bn housing loan deal, KMFL’s Rs760m commercial vehicle loan deal and Canfin Home’s Rs560m housing loan receivables deal. CRISIL is reported to have rated about Rs20bn over 150 securitized transactions between 1991 and 2002. Though CRISIL had been rating such instruments since 1991, the process of securitization had picked up only recently, as mentioned earlier. HUDCO is understood to have planned for securitization worth Rs50bn. There is no doubt that securitization will get a great boost now, as it has already attracted the attention of the investors, issuers and regulators.
Securitization has emerged as one of the dominant means of capital formation through out the world, and particularly in the US, Canada, Europe, Latin America and South-east Asia. Each year trillions of dollars of securitization transactions are structured by a wide range of entities like financial institutions, auto financiers, leasing companies, credit card issuers, infrastructure and insurance companies, governments and local authorities.
United States: More than 75% of global securitization volumes are accounted far by the US. Both institutional and individual investors partake in this vast market. US investors also participate in the securitization issues of other major markets such as Europe and Japan. The US markets are very liquid, innovative and sophisticated. In the US, the market for CDOs had grown phenomenally from $1bn in 1995 to $234.5bn in 2002. The US securitization market has grown beyond $5 trillion, providing necessary liquidity to US financial institutions and their customers, both individuals and businesses. SPEs are critical components of this process.
Canada: The securitization market in Canada is vibrant, fast growing and innovative. It has brought some cutting edge structures into the mechanism of securitization. The first securitization of mutual fund fees was done in Canada. Residential mortgages, credit card account receivables, and auto loans and leases make up about 60% of the outstanding asset-backed debt. The other types of assets include equipment leases and loans, commercial mortgages and trade account receivables. The Canadian securitization market has grown dramatically during the past four to five years. In this period, it increased from $12bn to $76bn including both asset-backed commercial paper and debt, mainly due to entrance of banks into securitization markets. However, much of the asset-backed debt was in the private placement market until early 1999 when public issues began to pick up.
Europe: UK, France, Spain, Italy and Germany are the major players. The total outstanding volume of European MBS/ABS is over $130bn of which nearly 50% is accounted for by MBS transactions. With the advent of the euro, cross-border transactions are no longer hindered by currency differences.
Asia: Japan’s banking system, plagued by a high percentage of non-performing loans, hopes to adopt the securitization route to partly mitigate the problem of bad loans. With a suitable regulatory framework already in place and market stimulating measures expected to be undertaken by the government, perhaps Japan could also emerge as a major player. One of the most notable issues to emerge from Asian markets in 2000 was the $367m issue maturing in 2009, by Korea Asset Funding Ltd (issuer). It was the first international securitization of non-performing loans originated by Korea Asset Management Corp (KAMCO). The other Asian countries where significant presence of securitization is felt include Hong Kong, Thailand and Malaysia.
Latin America: While the region’s securitization markets are less developed than those of North America and Europe, Argentina and many other Latin American countries have been making significant strides recently to develop the legal and financial infrastructure needed. In 2000, the total cross border issuance was $2.6bn, of which 80% comprised future flows. The issuers were from bigger Latin American countries. Mexico maintained the lead with 49% share in the total, followed by Argentina (29%) and Brazil (26%). Latin America continues to move into the secondary stage of securitizing the existing assets that are denominated in local currencies and selling these securities in their domestic capital markets, from its primary stage of cross border future flow issuance. Changes in regulatory, tax, and legal frameworks, and the privatization of pension systems have been the driving forces in this process.
Securitization has already helped banks and corporates to raise more than $7 trillion globally. It has emerged as one of the most attractive means of capital formation in the US and in Europe as well as in Asia and Latin America. Generally, income-generating assets are securitized. But even the non-performing loans can also be securitized if the risks can be mitigated by several asset diversification and credit enhancement techniques. In Japan, China, Indonesia and Malaysia, securitization of non-performing loans has picked up greatly.
In India, the SARFAESI law is an extremely important piece of legislation. Implemented in proper spirit, it can provide safe harbour to secured lenders and may enlarge investment in corporate finance. But lack of clarity on some of the issues pertaining to this law and various other issues relating to the taxation matters, high incidence of stamp duties, and lack of investor appetite and understanding of the instrument amongst investors, originators and even rating agencies appear to be some of the reasons for the tardy growth of securitization.
Though securitization in India is in a nascent stage, it holds a great promise in the MBS/ABS areas, particularly for funding resource-starved sectors like infrastructure, power, and housing. There is a lot of scope for further growth in the securitization of the other assets like credit cards, trade credits, receivables, auto loans and lease receivables. Project finance loans, both performing and non-performing, bonds, and commercial and residential mortgages have also a great future, pursuant to the legislation passed and various other measures being taken by the government to clear the ambiguity in various matters. However, the government and the regulatory authorities in India must realize that the market stimulating measures taken by them to date remain incomplete and that further action will be necessary for the Indian securitization market to achieve its true potential.