Indian Economy has exhibited robust growth over the past few decades thanks to a
strong well regulated financial sector. This was demonstrated when Indian Economy
withstood the ripple effects of global financial meltdown of late 2007. The culprit of
the global financial meltdown can be traced to instruments called Collateralized Debt
Obligation and various complex derivative products meant to disperse risk traded in
a poorly regulated financial market. We have to understand that the poor regulatory
environment is biggest culprit. Indian economy has also faced its share of repercussions
of the meltdown.
India has been in the path of rapid development since late 1960s following
nationalization of 14 major banks. Banks grew in size and extent, credit growing at an
average annual rate of 19% till 1980s. In order to address the concerns over asset
quality and to adopt international norms “The Committee on Financial System” more
popularly known as Narasimham Committee was setup.
Out of various recommendation of the Committee one of them dealt with creation of an
Asset Creation Fund to which public sector banks would transfer their Non-performing
assets with certain safeguards. This was the first instance of allowing securitization
in India. However the recommendation was not accepted and banks were required to
manage NPA internally.
The idea of securitization first envisaged in the United States, in 1980s, when finance
majors like Freddie Mac and Fannie Mae issued securities to investors which were
backed by mortgage loans. At that time banks were finding it increasingly difficult to
finance the growing demand for home loans from deposits and debt that they liquidated
their loan assets by transferring it to a Special Purpose Vehicle (sponsored by the
financial institution)
Legal system adopted in India
Meanwhile, in India, during 1980s asset quality started becoming a cause of concern.
The Government had resorted to various mechanisms for managing NPA like
Sick Industrial Companies (Special Provisions) Act 1985: under which Board for
Industrial and Financial Reconstruction (BIFR) was set up. However the whole process
was cumbersome and inefficient.
Recoveries of Debt due to Bank and Financial Institutions Act, 1993: under which
Debt Recovery Tribunal was set up. However the recovery process was slow and
the stringent requirement of the act rendered attachment and foreclosure of assets
ineffective.
Corporate Debt Restructuring System: A transparent system for restructuring loan
payments to meet project cash flow was provided for. This was effective, but it only
provided for deferring the cash flow, thus the loan remained in the balance sheet.
Securitization and Reconstruction of Financial Asset and Enforcement of Security
Interest Act, 2002: under which formation of Securitization Companies and Asset
Reconstruction companies have been legalized and secured creditor is empowered to
enforce security interest without intervention of court
SECURITIZATION ; An Introduction
Simply put, under this process, assets with predictable stream of cash flows are pooled
together to distribute risk and repacked into securities with predetermined returns.
In order to understand Securitization process clearly, it is imperative to know various
parties to the Securitization process. The parties involved are
(i) Originator: The entity in whose books the assets to be securitized exist
(ii) Special Purpose Vehicle (SPV): This entity buys the assets to be securitized from
the Originator and makes payment to the Originator. This may be sponsored by a
financial institution interested in securitization and reconstruction business.
(iii) Investors: Persons like Financial Institutions, Mutual Funds, Pension Funds,
Insurance Company etc… investing in the securities issued by SPV. They
receive periodic return as per the agreement
(iv) Obligor or Borrower: This is the originator’s debtor from whom the loan amount is
due.
(v) Trustee: Those who oversee the activities of the trust to look after the interests of
the investors.
Additionally there may also be a rating agency engaged to assess the credit risk of the
security, an administrator or servicer to collect the payment due from the Obligor and
pass it to the SPV and a structurer to bring together the Originator, Investors and other
parties to a securitization deal.
SECURITIZATION; the ProcessUnder this process, also called structured finance, certain securities with predetermined
return are issued by a Special Purpose Vehicle formed for the purpose. The return
and final repayment of principal depends on cash flow generating capability of the
underlying pool of assets. The SPV can be a trust, company or partnership firm. The
SPV purchases the assets from the originator (bank or financial institution). The SPV
thus becomes entitled to the cash flow generated by the assets. This cash flow will be
repackaged to issue the security in the form of bond/debenture with predetermined
return.
Any asset that generates predictable stream of cash flow can be securitized like Credit
card receivables, Vehicle Loan receivables, equipment loan receivables, home loan
receivable, education loan receivables and even premium receivable for risk undertaken.
The Securitization process employs risk management methods similar to an insurance
company. At least some of the assets purchased may have a risk of becoming non-
performing; however pooling a large number of different types of loan assets significantly
reduces the overall risk. Loan portfolios of different quality and return are mixed in
varying proportions by the securitization company to create bonds/debenture falling
under different risk levels.
Individual securities are often split into tranches, or categorized into varying degrees
of subordination. Each tranche has a different level of credit protection or risk exposure
than another: there is generally a senior (“A”) class of securities and one or more
junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A”
class. The senior classes have first claim on the cash that the SPV receives, and the
more junior classes only start receiving repayment after the more senior classes have
repaid. Because of the cascading effect between classes, this arrangement is often
referred to as a cash flow waterfall. In the event that the underlying asset pool becomes
insufficient to make payments on the securities (e.g. when loans default within a portfolio
of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-
level tranches remain unaffected until the losses exceed the entire amount of the
subordinated tranches. The senior securities are typically AAA rated, signifying a lower
risk, while the lower-credit quality subordinated classes receive a lower credit rating,
signifying a higher risk. The return offered by the security will also depend on maturity,
cash flow pattern, prepayment and interest duration of underlying loan assets.
Advantages of SecuritizationSecuritization accelerates the cash inflow from loan thus not only providing immediate
liquidity but also ease the strain on capital adequacy. Assets Reconstruction Companies
also enable banks to focus on areas of core competency by shifting monitoring and
management of NPAs to them
Securitization offers the flexibility in structuring and timing cash flows to each security
tranche. It provides means whereby customized securities can be created to match the
tenure of assets and liabilities. Securitization also helps the originator to diversify its
funding source, by selling it to global investors.
From investor’s point of view, they have variety of securities to choose from tailored
according to their risk profile. Securitised products offer avenue for diversification of
portfolio. The risk of securitized product is insulated from the credit risk of the Originator.
Asset Reconstruction
Asset Reconstruction is another means of managing Non-performing assets. This
process helps extract maximum recovery value from asset at minimum cost. An Asset
Reconstruction Company has been given powers by SARFESI Act to
(i) Restructure the loan to suit cash flow of the borrowing entity
(ii) Sell or lease part/whole of the assets of the business to a third party
(iii) Change the management structure by appointing own directors(this was kept
in abeyance till recently, however in 2010, RBI has come out with guidelines
requiring Reconstruction companies to conduct proper due diligence through an
independent council before the final takeover)
(iv) Restructure the business operation – like expansion, diversification and closure
(v) Enforcement of security interest in accordance with provisions of the Act
(vi) Take possession of the secured asset in accordance with the provisions of the
Act
The Asset Reconstruction process is similar to Securitization. Firstly an SPV is formed
to acquire the Non–performing asset. The banks and financial institution selling the
Non– performing asset receives debentures or cash as consideration. The SPV issues
securities to investors and utilizes the finance raised to pay cash, or redeem debenture
issued, as the case may be to Banks and Financial institutions.
Determination of value of the distressed asset is an important process in the
Reconstruction process. Reconstruction companies have to arrive at fair value of the
asset acquired to derive maximum value from operations.
Similar to Securitization, reconstruction also relieves the bank of the burden of NPA and
allows them to allocate resources for core activities. It improves the liquidity position of
banks/FI
Requirements under SARFESI
The Securitization Act requires compulsory registration of Securitization and
Reconstruction companies under the SARFESI Act before commencing its business.
Further a minimum capital requirement is provided by requiring the company to possess
owned fund of Rs 2 crore or upto 15% of the total financial assets acquired or to be
acquired. The Reserve Bank of India has the power to specify the rate of owned fund
from time to time.
The act empowers the secured creditor to enforce security interest without the
intervention of court of tribunal not withstanding anything contained in section 69 or
section 69(A) of the Transfer of property act, 1882.
Under section 69 of the Transfer of Property Act, 1882 a mortgagee can take possession
of mortgaged property and sell the same without intervention of the court only in case
of English Mortgage. Thus we can see that the Securitization Act has removed the
restrictions previous imposed upon the creditor to approach court.
The Apex court in Mardia Chemical vs. Union of India examined various issues of the
Act which are discussed below
One contention of the petitioner was that section 13, dealing with enforcement of
security interest, empowered the secured creditor with unchecked arbitrary power since
there was no forum or mechanism to resolve any dispute which may arise in respect of
alleged default or overdue.
The Honourable Supreme Court pointed out that any law which did not give the other
party an opportunity to represent his case would be struck down by article 14 of the
Constitution. The court observed that a forum of internal mechanism must be evolved to
consider any objection raised by the borrower in reply to notice issued under section 13.
Another provision that can under scrutiny of the Apex court was section 17(2) which
required that 75% of the money due to be pre-deposited with Debts recovery tribunal to
prefer an appeal against the action taken by secured creditor or authorized officer under
the Act.
The supreme court held the condition of pre-deposit in the present case is bad
rendering the remedy illusory on the grounds that (i) it is imposed while approaching the
adjudicating authority of the first instance, not in appeal, (ii)there is no determination
of the amount due as yet (iii) the secured assets or its management with transferable
interest is already taken over and under control of the secured creditor (iv) no special
reason for double security in respect of an amount yet to be determined and settled (v)
75% of the amount claimed by no means would be a meager amount (vi) it will leave the
borrower in a position where it would not be possible for him to raise any funds to make
deposit of 75% of the undetermined demand. Such conditions are not alone onerous
and oppressive but also unreasonable and arbitrary. Therefore, in our view, sub-section
(2) of Section 17 of the Act is unreasonable, arbitrary and volatile Article 14 of the
Constitution.
Subsequently by an amendment in 2004 following changes were made in sub-section
(3), the following sub-section shall be inserted, namely:--
"(3A) If, on receipt of the notice under sub-section (2), the borrower makes any
representation or raises any objection, the secured creditor shall consider such
representation or objection and if the secured creditor comes to the conclusion that such
representation or objection is not acceptable or tenable, he shall communicate within
one week of receipt of such representation or objection the reasons for non-acceptance
of the representation or objection to the borrower:
Provided that the reasons so communicated or the likely action of the secured creditor
at the stage of communication of reasons shall not confer any right upon the borrower
to prefer an application to the Debts Recovery Tribunal under section 17 or the Court of
District Judge under section 17A";
The RBI had issued guidelines for securitization of standard assets by banks, financial
institutions and NBFCs in February 2006. The guidelines broadly dealt with ensuring
arms-length relationship between originator and the SPV, Capital treatment for credit
enhancement, amortization of profit/premium arising on account of sale, disclosure
by the originator and treatment of liquidity facility. RBI has treaded cautiously in the
aftermath of recent sub-prime crisis. SEBI has taken steps for public issue and trading of
securitized instruments in secondary market. In 2007, Securities Contracts (Regulation)
Amendment Act 2007 was amended to include “securitized instruments” in the definition
of securities, thus creating a legal framework for public issue and secondary market
trading of such instruments. Finally SEBI also released “Public Offer and Listing of
Securitized Debt Instruments Regulations 2008” in this regard.
