Breaking Down the Process of Securitization & Asset Reconstruction.

Breaking Down the Process of Securitization & Asset Reconstruction.

[Deepanshu Guwalani]

The author is a 5th year B.A.LLB (Hons.) student of ILS Law College, Pune.

Introduction

To facilitate the early resolution of Non-Performing Assets (NPAs) of banks and financial institutions, the government of India enacted Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 for the extensive use of Securitisation Companies (SCs) or Asset Reconstruction Companies (ARCs).

Securitization

Securitisation is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans, education loans etc. which generate receivables and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). The sellers here are called Originators. Securitisation thus follows a two stage process. In the first stage there is sale of single asset or pooling and sale of pool of assets to a ‘bankruptcy remote’ special purpose vehicle (SPV), in return for an immediate cash payment and in the second stage repackaging and selling the security interests representing claims on incoming cash flows from the asset or pool of assets to third party investors by issuance of tradeable debt securities. The SPV needs to be ‘bankruptcy remote’ which means that the bankruptcy of the Originator will not have any bearing on the financial obligations of the SPV. For example, in 1991, Citibank[1] sold its car loan portfolio comprising of 1,358 cars to a Special Purpose Vehicle (SPV).  Debentures carrying a coupon rate of 15.5 per cent per annum worth around INR 20 crores were issued by the SPV named as Peoples Financial Services Limited.  These debentures were backed by the car loan portfolio of Citibank.  Several institutional investors and mutual funds picked up these debentures. The SPV made monthly payments to debenture holders out of the inflows from the car loan portfolio.  The payments to these debenture holders included both interest and the principal component. At the end of 27 months the debentures extinguished and by then the SPV had paid out the entire principal and interest. These debentures were also tradeable on National Stock Exchange.

Process of Securitization

Step 1: The originator i.e. a bank, financial institution or an NBFC sells or assigns its assets which are in the form of receivables, housing loans, leases etc., to a SC/ARC. The sale must be a true sale as defined under RBI guidelines.[2]

Step 2: The SC/ARC, which needs to be mandatorily registered with RBI and needs to have securitisation / asset reconstruction as its objective in its Memorandum of Association respectively, buys these assets by incorporating a SPV in the form of a private trust of which it is a trustee. Different SPVs are formed for different categories of assets or under different schemes by the same SC for smoothing the process of returns. The SPVs also need to be in compliance with the RBI guidelines issued in this regard.[3]

Step 3: The SC/ARC (through the trust) raises funds, by issuing different classes of Security Receipts (SRs), to buy the aforementioned assets, only from Qualified Institutional Buyers (QIBs) i.e. insurance companies, Mutual Funds and Banks, etc. as they have the skill and expertise to assess risk in such a volatile market. The issue is through private placement only to protect naive retail investors and transfer or assignment of such SRs shall be in favour of other QIBs only. QIBs are issued SRs which are securities under Securities Contract (Regulation) Act. The trust shall hold and administer the financial assets for the benefit of the QIBs. Every SC/ARC needs to adhere to RBI guidelines[4] issued under the SARFAESI Act and also to revised guidelines (w.r.t. banks[5] and NBFCs[6]) issued by RBI regarding assets eligible for securitisation, Minimum Holding Period (MHP), Minimum Retention Requirement (MRR) etc.The SRs are usually in the form of Pass Through Certificates (PTCs) which can be compared to securities like bonds and debentures. The only difference being that they are issued against underlying securities. The interest that is paid to the issuer (SC/ARC) on these securities is directly passed to the investor (QIBs) in the form of a fixed income. It is different from Pay Through Securities wherein the SPV invests the receivables somewhere else for the benefit of the QIBs.

Step 4: Administrative functions relating to the cash flows of the underlying assets (collection of principal and interest payments on the loans in the underlying pool of assets) are carried out by Service Providers (usually banks or originators) on behalf of the SCs/ARCs. Banks also provide credit enhancements (extra securities or guarantees to protect QIBs) and can also act as underwriters for the issue of SRs by the SCs/ARCs.

Step 5: As cash flow arise on the assets, these are used by the SPV (SC/ARC) to repay funds to the QIBs.

Asset Reconstruction

In 1998, the 2nd Narasimham Committee Report highlighted that the huge backlog of NPAs was continuing to exert pressure on the banking sector and had severely impacted profitability. The report also recommended the creation of an asset recovery fund which would acquire and recover stressed assets and enable banks to focus on their core business. Pursuant to this and the enactment of the SARFAESI Act, many ARCs were formed in India, with ARCIL being the first. These ARCS were set up as private entities, mostly with the support of banks and as on November 2017, there were 24 operating ARCs.[7]

According to s. 2(1)(b), asset reconstruction means acquisition by any SC/ARC of any rights or interests of any bank or financial institution in any financial assistance for the purpose of realization of such financial assistance. Therefore, asset reconstruction is much broader term than Securitization.

Assets are classified into the following:[8]

  1. Standard Assets;
  2. NPAs;

NPAs are further classified into the following:

  1. Substandard Asset;
  2. Doubtful Asset;
  3. Loss Asset;

ARCs usually deal with the second type of assets and acquire them through securitisation post which the process of asset reconstruction is carried out. SARFAESI Act provides some measures for asset reconstruction, which can be taken up having regard to the guidelines framed by RBI[9]:

  1. proper management of the business of the borrower;
  2. sale or lease of a part or whole of the business of the borrower;
  3. rescheduling of payment of debts;
  4. settlement of dues;
  5. enforcement of security interest;
  6. taking possession of the secured assets;

It is observed that there seems to be no difference between Securitization and Reconstruction companies[10] under section 2 (v) and (za) of the SARFAESI Act. Neither is SC restricted to the transaction of securitization nor is ARC restricted to the transaction of asset reconstruction under the SARFAESI Act.

[1] Asset Securitisation, available at http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Asset_Securitisation.pdf

[2] Guidelines on Securitisation of Standard Assets, available at  https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=2723&Mode=

[3] id

[4] Notification as amended up to June 30, 2015 – The Securitisation Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003, available at https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=9901#C6

[5] Revisions to the guidelines on transfer of assets through securitisation and direct assignment of cash flows, available at  https://rbidocs.rbi.org.in/rdocs/content/pdfs/FIGUSE070512_I.pdf

[6] Guidelines on Securitisation of Standard Assets, available at https://rbidocs.rbi.org.in/rdocs/content/pdfs/RGST210812_ANX.pdf

[7] Asset Reconstruction Companies in India: The story so far, available at https://www.pwc.in/assets/pdfs/publications/2018/asset-reconstruction-companies-in-india-the-story-so-far.pdf

[8] Supra, note 4.

[9] Notification as amended up to June 30, 2015 – The Securitisation Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003, available at https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=9901#C7

[10] Securitisation in India: Critical Analysis http://www.manupatrafast.com/articles/PopOpenArticle.aspx?ID=c3361dbb-a103-424d-8450-0053470052eb&txtsearch=Subject:%20Finance/Banking#f30