Securitisation of Assets – An overview
RUCHI MALHOTRA

Off-late, there has been a trend of getting a higher credit rating and cheaper borrowings through the use of securitisation instruments. One has been hearing a lot of securitisation of rent, fare collections and other receipts. This article aims to present an over-view of securitisation, what it means, what are its implications and how securitisation can be used for better profitability.

Simply put, securitisation means the conversion of existing or future cash in-flows of any person into tradable security which then may be sold in the market. The cash inflow from financial assets such as mortgage loans, automobile loans, trade receivables, credit card receivables, fare collections become the security against which borrowings are raised. In fact, even individuals can take the help of securitisation instruments for better economic efficiency. Eg, an individual having regular inflows by way of rent from property can raise a loan by offering his rent receivables as security i.e. the rent receipts will first be used to pay the loan and then for other purposes. Since the lender is assured of regular cash inflows, there is an enhanced element of creditworthiness and therefore, he may offer the loan at a lower rate of interest. Of course, corporate securitisation deals involving crores of rupees are much more complicated. The importance of securitisation lies in the fact that it helps convert illiquid assets or future receivables into current cash inflows and that too at a low cost. The company may sell the receivables in the market and raise loans.

Securitisation therefore, is a process by which the future cash inflows of an entity ( originator ) are converted and sold as debt instruments called pay through or pass through certificates with a fixed rate of return to the holders of beneficial interest. The originator of a typical securitisation transfers a portfolio of financial assets to a Special Purpose Vehicle ( SPV ), commonly a trust. The SPV is basically funded by investors. In return for the transfer, the originator gets cash up-front on the basis of a mutually agreed valuation of the receivables. The transfer value of the receivables is done in such a manner so as to give the lenders a reasonable rate of return. In ‘pass-through’ and ‘pay-through’ securitisations, receivables are transferred to the SPV at the inception of the securitisation, and no further transfers are made. All cash collections are paid to the holders of beneficial interests in the SPV ( basically the lenders ).

What is an Special Purpose Vehicle ( SPV )?

An SPV is an entity specially created for doing the securitisation deal. It invites investment from investors, uses the invested funds to acquire to receivables of the originator and then uses the realizations from the receivables transferred to it to pay the investors, thereby giving them a reasonable return. An SPV may be a trust, corporation, or any other legal entity. Its activities are :- 

Holding title to transferred financial assets

Issuing beneficial interest (if the beneficial interests are in the form of debt securities or equity securities, the transfer of assets is a securitisation )

Collecting cash proceeds from assets held, reinvesting proceeds in financial instruments pending distribution to the holders of beneficial interests and otherwise servicing the assets held.

Distributing proceeds to the holders of the beneficial interests. 

Beneficial interests in the qualifying SPV are sold to investors and the proceeds are used to pay the transferor for the assets transferred. Those beneficial interests may comprise either a single class having equity characteristics or multiple classes of interests, some having debt characteristics and others having equity characteristics. The cash collected from the portfolio is distributed to the investors and others as specified by the legal documents that establishes the SPV. Normally, transfer to the SPV of receivables involves stamp duty payments. However, these costs may be offset by benefits such as the PTCs being fairly tradable and liquid, higher credit rating, etc. In India, the stamp duty on secondary market transactions is waived, if the PTCs are issued in dematerialized form.

What are Pass Through Certificates?

A Pass Through Certificate is an instrument which signifies transfer of interest in the receivable in favour of the holder of the Pass Through Certificate. The investors in a pass through transaction acquire the receivables subject to all their fluctuations, prepayment etc. The material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayments, etc. are transferred to the investors. The features of Pass Through Certificate :-

Investors get a proportional interest in pool of receivables Collections month after month are divided proportionally.

All investors receive proportional payments – no slower or faster repayment, though in some cases, some investors may be senior over others. No reinvestment of cash collected by the SPV 

What are Pay Through Certificates?

In case of Pay Through Certificates, the SPV instead of transferring undivided interest on the receivables issues debt securities such as bonds, repayable on fixed dates, but such debt securities in turn would be backed by the mortgages transferred by the originator to the SPV. The SPV may make temporary reinvestment of cash flows to the extent required for bridging the gap between the date of payments on the mortgages along with the income out of reinvestment to retire the bonds. Such bonds were called mortgage – backed bonds.

What are the advantages of securitisation for the Originator ?

The greatest advantage of securitisation is that it can help raise funds at a rating higher than what is the actual rating of the originator. The added advantage of a securitisation deal is that the securitised assets ( receivables ) go off the balance sheet of the originator. This is especially helpful in the banking industry which has to adhere to capital adequacy norms. Besides, the asset portfolio ( receivables ) is liquidated releasing cash which in turn reduces the need for demand and time liabilities that are subject to statutory reserves in case of banks. Another advantage is that small investors can profit from such deals since they can invest small sums in the SPV and acquire beneficial interest. In fact there may be issues whereby the SPV is funded mainly by small investors. Securitisation keeps the other traditional lines of credit undisturbed. Hence, it increases the total financial resources available to the firm.

What are the demerits of securitisation for the Originator ?

Since securitisation is off-balance sheet funding, the true picture of the originators’ financial position is not clear merely from the balance sheet. The best assets of the company may be transferred to the SPV and the company may be left with sub-standard assets on its books. The greatest demerit of securitisation is its opagueness. A company may have taken huge liabilities but that may not be apparent from the balance sheet or conventional financial statements of the company. This is especially true where the securitisation is with recourse i.e. if the receivables which have been securitised to the SPV become bad, the SPV will have the right to recover the dues from the originator. The originator may have a lot of contingent liabilities without anyone being aware of it. The case of the collapse of Enron is too recent in memory to forget the problems associated with off-balance sheet funding.

What is the process of securitisation of receivables ?

A securitisation deal normally has the following stages :-

The originator determines which assets he wants to securitise for raising funds.

The SPV is formed.

The SPV is funded by investors and issues securities to the investors.

The SPV acquires the receivables under an agreement at their discounted value.

The servicer for the transaction is appointed, normally the originator.

The debtors are /are not notified depending on the legal requirements.

The servicer collects the receivables, usually in an escrow mechanism, and pays off the collection to the SPV.

The SPV either passes the collection to the investors, or reinvests the same to pay off to investors at stated intervals.

In case of default, the servicer takes action against the debtors as the SPV’s agent.

When only a small amount of outstanding receivables are left to be collected, the originator may clean up the transaction by buying back the outstanding receivables.

At the end of the transaction, the originator’s profit, if retained and subject to any losses to the extent agreed by the originator, in the transaction is paid off.

How are securitisation deals to be accounted for ?

Pass through or pay through securitisation that meet the above criteria qualify for sale accounting. All financial assets obtained or retained and liabilities incurred by the originator of a securitisation that qualifies as a sale should be recognized and measured. As per FASB Statement No. 140, ( Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ), a transfer of financial assets in which the transferor surrenders control over those assets is accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor can be said to have surrendered control over transferred assets only if all the following conditions are met:- 

The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in case of bankruptcy Each transferee SPV or each holder of its beneficial interests (investors in the ABS) has the right to pledge or exchange the assets (or beneficial interests) it received.

The transferor does not maintain effective control over the transferred assets through either agreements entitling and obligating the transferor to repurchase or the ability to unilaterally cause the holder to return specific assets. (except specified exceptions) Upon completion of a transfer of assets that is accounted for as a sale as mentioned above, the transferor (seller) shall:

De-recognize all assets sold

Recognize all assets obtained and liabilities incurred in consideration as proceeds of sale, including cash.

Initially measure at fair value assets obtained or liability incurred in a sale.

Recognise in earnings any gain or loss on sale. 

The transferee shall recognize all assets obtained and any liabilities incurred and initially measure them at fair value (in aggregate, presumptively the price paid).

Accounting treatment in the books of Originator 

(i) To record the assets and liabilities created in the transaction, cash consideration received for the transfer of the assets and gain on transfer of assets

Cash A/c Dr.
Other Asset acquired A/c Dr.
To Receivables A/c Cr.
To Liabilities incurred A/c Cr.
To Gain on transfer A/c Cr.

Accounting treatment in the books of Investors

(i) At the time of investment:

Investment (PTC) A/c Dr.
To Cash A/c Cr.

(ii) Monthly pay-outs received at the end of the month:

Interest receivable A/c Dr.
To Interest income A/c Cr.

(iii) Actual receipt of the monthly pay-outs:

Cash A/c Dr.
To Interest receivable A/c Cr.
To Investment (PTC) A/c Cr.

(iii) If the investments (PTCs) are sold:

Cash A/c Dr.
To Investment (PTC) A/c Cr.
To Profit on sale of PTCs A/c Cr.

(iv) In case of pre-payment of monthly pay-outs:

Cash A/c Dr.
To Investment (PTC) A/c Cr.
To Investment (PTC) A/c Cr.
To Interest income A/c Cr.

Disclosures required to be made by the Originator

Accounting standards, generally require the following disclosures to be made in financial statements regarding securitisation deals :-

Accounting policies for measuring the retained interest and valuation of assets transferred to the SPV 

The nature of securitisation ( eg recourse or non-recourse, etc )

Cash proceeds

Gain or loss from securitisation of financial assets

Key assumptions for measuring the fair value of retained interest at the time of securitisation

Cash flows between the SPV and the transferor

Securitisation, no doubt opens up new avenues of funding for entities in need on liquidity. However, it is a double edged sword. If one does not exercise adequate caution, one may find that the contingent debt burden is too high to survive.

Ruchi malhotra
PGPMS, K.J.Somaiya inst of mgt studies
ruchi@simsr.somaiya.edu

022-33035772

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