Securitization started in India in the early 1990s. Today, most mutual fund schemes have the mandate to invest in securitized debt, as per their Scheme Information Document, or SID. But investors get confused as to what it is. This should clear the air.
Upfront, let me explain certain terms that shall be employed.
- Securitized Debt: This is a form of structured finance where financial securities are created by securitizing retail loans. When individuals take out loans, their debt becomes an asset on the balance sheet of the lender. This enables the refinancing of that debt. It involves assets that are typically illiquid (such as household debt), which are impossible to sell directly.
- Pass Through Certificate (PTC): This is a security that passes through income and principal payments made to an underlying portfolio of mortgages.
- Special Purpose Vehicle (SPV): It is a distinct legal entity, created with a specific objective, often to isolate financial risk. If the parent company goes bust, the SPV can carry on because it is a separate legal entity from the organization that created it.
In my conversation with Rohit Gyanchandani, co-founder of Fincademy. I asked him four questions.
How does it work?
Securitizing refers to creating a debt product by pooling various types of loans under one bucket and issuing bonds/certificates against these loans.
The products that are securitized are Asset-Backed Securities (underlying assets are personal loans, student loans, credit card receivables, auto loans) and Mortgage-Backed Securities (underlying assets are mortgages - home loans, commercial property loans).
Suppose Bank XYZ has 10 home loan customers with an average ticket size of Rs 20 lakh each. This can be converted into a pool of Rs 2cr against which the certificates can be issued to investors. Investors in our case are mutual funds that invest in such instruments.
ABC Mutual Fund bought the certificates of this pool by paying Rs 2cr along with a small fee to Bank XYZ. Once these certificates are purchased, the interest and principal repayments collected by Bank XYZ are transferred to ABC Mutual Fund.
This transfer is done via a separate entity known as the SPV.
So ABC MF gives Rs 2cr to this SPV and then the SPV pays the same to Bank XYZ. Once this transaction is done, all the proceeds from underlying loans are transferred by the bank to this SPV and SPV transfers the same to ABC MF.
What is the risk that PTCs carry?
- Prepayment Risk: If the borrower makes an early payment then it could be a challenge for ABC MF to reinvest the same at similar or higher interest rates.
- Interest Rate Risk: This is most prevalent in the case of home loans. If interest rates go down, the borrower might refinance the loan at a lower rate and this could lead to lower interest income for ABC MF.
- Credit Risk: The risk of the borrower defaulting on repayment of principal and interest could lead to loss. This will result in a fall in the NAV of the scheme, ultimately leading to the loss for investors.
These risks are mitigated by ABC MF by using a feature called Credit Enhancement. It can be provided by the originator (Bank XYZ) in the following way:
- Overcollateralization: Issuing the certificates of lesser value than the value of underlying loans. Eg: Issuing PTC's worth Rs 1.5cr against the above underlying amount of Rs 2cr. This automatically gives a cushion against small defaults.
- Subordinate/Senior tranche: Issuing PTC of a different class, for example, Senior PTC's (priority certificates). This enables priority in case of repayments and the remaining junior tranches (high risk) can get payment after Senior PTC's are paid.
Who regulates it?
The issuance of securitized debt is governed by the Reserve Bank of India. Measures have been proposed to enhance the safety of such debt.
One is that the originator (Bank XYZ) has to hold such a pool of loans for at least 9 to 12 months before they can be securitized.
The other is that the originator (Bank XYZ) has to retain a certain minimum percentage of such pool of loans with itself. This could be around 5-10% of the book value of loans.
What is the purpose?
A major component of the Indian debt market is Government Securities, or G-Secs. Over a period of time, there have been new products coming into debt markets like Zero Coupon Bonds, Floating Rate Bonds, and corporate bonds. These bonds, if backed by a single issuer, become worthless if the issuer defaults.
Securitized debt offers a basket of loans in a single package. The loans forming this package are scattered across products and geographies.
So one default won’t make the entire package worthless. Hence, it is better in terms of risk.
The image above has been sourced from Google.
