Securitization – CA Final SFM Study Material

Securitization – CA Final SFM Study Material is designed strictly as per the latest syllabus and exam pattern.

Securitization – CA Final SFM Study Material

Question 1.
Discuss briefly the steps involved in the Securitization mechanism. [May 2018] [4 Marks]
Answer:
The process of securitization typically involves the creation of pool of assets from the illiquid financial assets, such as receivables or loans which are marketable.

The following steps are taken in securitization mechanism:

Step 1	Creation of Pool of Assets	The process of securitization begins with creation of pool of assets by segregation of assets backed by similar type of mortgages in terms of interest rate, risk, maturity and con­centration units.
Step 2	Transfers to SPV	One assets have been pooled, they are transferred to Special Purpose Vehicle (SPV) especially created for this purpose.
Step 3	Sale of Secu­ritized Papers	SPV designs the instruments based on nature of interest, risk, tenure etc. based on pool of assets. These instruments can be Pass Through Security or Pay Through Certificates.
Step 4	Administra­tion of assets	The administration of assets in subcontracted back to origi­nator which collects principal and interest from underlying assets and transfer it to SPV, which works as a conduct.
Step 5	Recourse to Originator	Performance of securitized papers depends on the perfor­mance of underlying assets and unless specified in case of default they go back to originator from SPV.
Step 6	Repayment of funds	SPV will repay the funds in form of interest and principal that arises from the assets pooled.
Step 7	Credit Rating to Instru­ments	Sometime before the sale of securitized instruments credit rating can be done to assess the risk of the issuer.

Question 2.
Explain the benefits of Securitization from the perspective of both originator as well as the investor. [May 2018] [Nov. 2019] [4 Marks]
Answer:
The Originator is that entity which sells assets collectively to Special Purpose Vehicle and the “Investors” are the buyers of securitized papers which may be an individual or institutional investors such as mutual funds, provident funds, insurance companies, etc. The following are the benefits of securitization to these parties involved in securitization:
(A) From the angle of originator:
Originator (entity which sells assets collectively to Special Purpose Vehicle) achieves the following benefits from securitization.

• Off – Balance Sheet Financing: When loan/receivables are securitized it release a portion of capital tied up in these assets resulting in off Balance Sheet financing leading to improved liquidity position which helps expanding the business of the company.
• More specialization in main business: By transferring the assets the entity could concentrate more on core business as servicing of loan is transferred to SPV. Further, in case of non-recourse arrangement even the burden of default is shifted.
• Flelps to improve financial ratios: Especially in case of Financial Institutions and Banks, it helps to manage Capital-To-Weighted Asset Ratio effectively.
• Reduced borrowing Cost: Since securitized papers are rated due to credit enhancement even they can also be issued at reduced rate as of debts and hence the originator earns a spread, resulting in reduced cost of borrowings.

(B) From the angle of investor:
Following benefits accrues to the investors of securitized securities.

• Diversification of Risk: Purchase of securities backed by different types of assets provides the diversification of portfolio resulting in reduction of risk.
• Regulatory requirement: Acquisition of asset backed belonging to a particular industry say micro industry helps banks to meet regulatory requirement of investment of fund in industry specific.
• Protection against default: In case of recourse arrangement if there is any default by any third party then originator shall make good the least amount. Moreover, there can be insurance arrangement for compensation for any such default.

Question 3.
Explain the features of ‘Securitization’. [ICAI Mock Test Aug. 2018] [4 Marks]
Answer:
The securitization has the following features:

• Creation of Financial Instruments – The process of securities can be viewed as process of creation of additional financial product of securities in market backed by collaterals.
• Bundling and Unbundling – When all the assets are combined in one pool it is bundling and when these are broken into instruments of fixed denomination it is unbundling.
• Tool of Risk Management -In case of assets are securitized on non-recourse basis, then securitization process acts as risk management as the risk of default is shifted.
• Structured Finance – In the process of securitization, financial instruments are tailor structured to meet the risk return trade of profile of investor, and hence, these securitized instruments are considered as best examples of structured finance.
• Trenching – Portfolio of different receivable or loan or asset are split into several parts based on risk and return they carry called ‘Tranche’. Each Trench carries a different level of risk and return.
• Homogeneity – Under each trench the securities are issued of homogenous nature and even meant for small investors the who can afford to invest in small amounts.

Question 4.
Discuss briefly the primary participants in the process of Securitization. [Mock Test Aug. 2018] [4 Marks]
Answer:
The participants in the process of securitization are Primary Participants and Secondary Participants. The primary participants in the process of securitization are as follows:

• Originator: It is the initiator of deal or can be termed as securitizer. It is an entity which sells the assets lying in its books and receives the funds generated through the sale of such assets. The originator transfers both legal as well as beneficial interest to the Special Purpose Vehicle (SPV).
• Special Purpose Vehicle / Also, called SPV is created for the purpose of executing the deal. Since issuer originator transfers all rights in assets to SPV, it holds the legal title of these assets. It is created especially for the purpose of securitization only and normally could be in form of a company, a firm, a society or a trust. The main objective of creating SPV to remove the asset from the Balance Sheet of Originator. Since, SPV makes an upfront payment to the originator, it holds the key position in the overall process of securitization. Further, it also issues the securities (called Asset Based Securities or Mortgage Based Securities) to the inves-tors.
• The Investors: Investors are the buyers of securitized papers which may be an individual, an institutional investor such as mutual funds, provident funds, insurance companies, mutual funds, Financial Institutions etc. Since, they acquire a participating in the total pool of assets/receivable, they receive their money back in the form of interest and principal as per the terms agree.

Question 5.
Distinguish between Primary participants and secondary participants in securitization [RTP May 2018]
Answer:

Primary Participants	Secondary Participants
Primary Participants are main parties to this process. The primary participants in the process of securitization are as follows: (i)  Originator: It is the initiator of deal or can be termed as securitizer. It is an entity which sells the assets lying in its books and receives the funds generated through the sale of such assets.	Besides, the primary participants, other parties involved into the securitization process are as follows: (i) Obligors: Actually they are the main source of the whole securitization process. They are the parties who owe money to the firm and are assets in the Balance Sheet of Originator.
(ii) Special Purpose Vehicle: Also, called SPV is created for the purpose of executing the deal. Since issuer . originator transfers all rights in assets to SPV, it holds the legal title of these assets. It is created especially for the purpose of securitization only and normally could be in form of a company, a firm, a society or a trust.	(ii) Rating Agency: Since the securitization is based on the pools of assets rather than the originators, the as¬sets have to be assessed in terms of its credit quality and credit support available and that is where the credit rating agencies come.
(iii) The Investors: Investors are the buyers of securitized papers which may be an individual, an institutional investor such as mutual funds, provident funds, insurance companies, mutual funds, Financial Institutions etc.	(iii) Receiving and Paying Agent (RPA): Also, called Servicer or Administrator, it collects the payment due from obligor(s) and passes it to SPV. It also follow up with defaulting borrower and if required initiate appropriate legal action against them.
	(iv) Agent or Trustee: Trustees are ap-pointed to oversee that all parties to the deal perform in the true spirit of terms of agreement. Normally, it takes care of interest of investors who acquires the securities.
	(v) Credit Enhancer: Since investors in securitized instruments are directly exposed to performance of the underlying and sometime may have limited or no recourse to the originator, they seek additional comfort in the form of credit enhancement. In other words, they require credit rating of issued securities which also empowers marketability of the securities. Originator itself or a third party say a bank may provide an additional comfort called Credit Enhancer. While originator provides his comfort in the form of over collateralization or cash collateral, the third party provides it in form of letter of credit or surety bonds.
	(vi) Structurer: It brings together the originator, investors, credit enhancers and other parties to the deal of securitization. Normally, these are investment bankers also called arranger of the deal. It ensures that deal meets all legal, regulatory, ac-counting and tax laws requirements.

Question 6.
What are the main problems faced in securitization especially in Indian context? [Nov. 2019] [4 Marks]
Answer:
The main problems faced in growth of Securitization of instruments especially in Indian context are the following:
1. Stamp Duty : Stamp Duty is one of the obstacle in India. Under Transfer of Property Act, 1882, a mortgage debt stamp duty which even goes upto 12% in some States of India and this impeded the growth of securitization in India. It should be noted that since pass through certificate does not evidence any debt only able to receivable, they are exempted from stamp duty.
Moreover, in India, recognizing the special nature of securitized instruments in some States has reduced the stamp duty on them.

2. Taxation : Taxation is another area of concern in India. In the absence of any specific provision relating to securitized instruments in Income Tax Act experts’ opinion differ a lot. Some are of opinion that in SPV as a trustee is liable to be taxed in a representative capacity then other are of view that instead of SPV, investors will be taxed on their share of income. Clarity is also required on the issues of capital gain implications on passing payments to the investors.

3. Accounting: Accounting and reporting of securitized assets in the books of originator is another area of concern. Although securitization is slated to an off-balance sheet instrument but in true sense receivables are removed from originator’s balance sheet. Problem arises especially when assets are transferred without recourse.

4. Lack of standardization : Every originator follows own format for docu-mentation and administration have lack of standardization is another obstacle in growth of securitization.

5. Inadequate Debt Market: Lack of existence of a well-developed debt market in India is another obstacle that hinders the growth of secondary market of securitized or asset backed securities.

6. Ineffective Foreclosure laws:For last many years there are efforts are going on for effective foreclosure but still foreclosure laws are not supportive to lending institutions and this makes securitized instruments especially mortgaged backed securities less attractive as lenders face difficulty in transfer of property in event of default by the borrower.