Explain the Scope, Importance, Features, Advantages and Disadvantages of

Securitization (Special Purpose Vehicle).

Securitization is the process through which an issuer creates a financial instrument by
combining other financial assets and then marketing different tiers of the repackaged
instruments to investors, and this process can encompass any type of financial asset and
promotes liquidity in the marketplace.

Mortgage-backed securitiesis a type of asset-backed security that is secured by a collection of

mortgages, are a perfect example of securitization. By combining mortgages into one large
pool, the issuer can divide the large pool into smaller pieces based on each individual
mortgage's inherent risk of default and then sell those smaller pieces to investors.
In other way Securitization is the process of taking an illiquid asset, or group of assets, and
through financial engineering, transforming them into a security.

According to the Securitization Act only financial institutions and banks can securitize their
financial assets. Consider this example where GNB Bank gives out loans to customers known as
the obligors. This will be maintained on its balance sheet as assets, collecting principal and
interest. The bank will hold on to these assets until maturity and hence the funds of the bank
are blocked in these loans. Now in order to meet the increasing requirement of the fund bank
would have to raise more funds from the market. Securitization is the method to unlock these
blocked funds. It is done by transferring the assets from the originator which is GNB Bank in
this case to the Special purpose vehicle (SPV).Another thing which needs to be considered is
that the assets that are being transferred to the SPV need to be similar in terms of its maturity,
risk profile and underlying asset. The SPV will act as an intermediary who divides the assets of
the originator into marketable securities.
Features and Scope of Securitization

Incorporation & Registration of Special Purpose Vehicles

Securitization act intends to securitize and reconstruct the financial assets through two special
purpose vehicles (SPVs) Securitization Company and Reconstruction Company. Both of these
companies have to be incorporated under the Companies act, 1956 and also having them as
the main purpose. It is a requirement for the Securitization Company and the reconstruction

company to be registered compulsorily with the RBI before commencing their business
operations.
Enforcement of security interest

The main aim of the Securitization act is to make available the enforcement of security interest
which is to take possession of the assets that have been given as security for the loan. In the
event of default by a borrower this act authorizes the lender to issue a demand notice to both
the borrower and guarantor to pay off the dues within 60 days from the date of the notice.
Even after which the borrower fails to make the payment the lender (Bank or financial
institution) could resort to any of the following: (i) Take ownership of the security; (ii) Sale or
lease or assign the right over the security; (iii) Employ Manager to manage the security; (iv)
Ask any debtors of the borrower to pay any sum due to the borrower. In situations where
there are more than one secured creditors the provisions of this act will be valid only when
75% of them agree on the decision.
Scope -

Market Efficiency:- Through securitization process the companies holding financial

assets like loans have ready access to low cost sources of fund and can reduce their
dependence on financial intermediaries for their capital requirement. This translates
into lower interest cost the benefits of which are also passed to the end consumers.
Specialization:- The classic bank/financial institution model of Origination - Funding Credit administration of loans has led to an unbundling of roles and greater
specialization as various player can now concentrate on their core function, be it
origination, funding or credit administration.
Streamlined system and process:- Securitization demand high levels of data
transparency and requires robust system. This enhances the overall monitoring and
control of asset portfolios.

Advantages of Securitization

The Receivables are moved "off balance sheet" and replaced by a cash equivalent (less
expenses of the Securitization), thus improving the Originator's balance sheet.
Securitization can enhance managerial control over the size and structure of a firm's
balance sheet. For example, accounting de-recognition of assets (i.e., removal from the
balance sheet) can improve gearing ratios as well as other measures of economic
performance (e.g., Return on Equity). Financial institutions use securitization to achieve
capital adequacy targets, particularly where assets have become impaired.
More efficient financing for some private-sector institutions, securitization is used to
lower the firm's weighted-average cost of capital. This is possible because equity capital
is no longer required to support the assets. Furthermore, highly rated debt can be
issued into deep capital markets with investor demand driving down financing costs.
Securitization also releases capital for other investment opportunities. This may
generate economic gains if external borrowing sources are constrained, or if there are
differences between internal and external financing costs.
The originator does not have to wait until it receives payment of the receivables (or, in a
"future flow" securitization, until it even generates them) to obtain funds to continue its
business and generate new receivables. In many cases this is essential and a role
otherwise filled by more traditional methods of financing, including factoring (in some
ways securitization is a very sophisticated form of factoring). This is more significant
when the receivables are relatively long term, such as with real property mortgages,
auto loans, student loans, etc. and not as significant with short term receivables, such as
trade and credit card receivables.
The securities issued in the securitization are more highly rated by participating rating
agencies (because of the isolation of the receivables in a "bankruptcy-remote" entity),
thus reducing the cost of funds to the originator when compare to traditional forms of
financing. In instances where the receivables bear interest, there is usually a significant
spread between the interest paid on the securities and the interest earned on the
receivables. Ultimately, the originator receives the benefit of the spread. In addition, the
originator usually acts as servicer and receives a fee for its services.
Better risk management:- securitization often reduces funding risk by diversifying
funding sources. Financial institutions also use securitization to eliminate interest rate
mismatches. For example, banks can offer long-term fixed rate financing without
significant risk by passing the interest rate and other market risk to investors seeking
long-term fixed rate assets. Securitization has also been used successfully to give effect
to sales of impaired assets. Securitization also benefits investors. It enables them to

make their investment decisions independently of the credit-standing of the originator,

and instead to focus on the degree of protection provided by the structure of the SPV
and the capacity of securitized assets to meet the promised principal and interest
payments. Securitization also creates more complete markets by introducing new
categories of financial assets that suit investors risk preferences and by increasing the
potential for investors to achieve diversification benefits. By meeting the needs of
different 'market segments', securitization transactions can generate gains for both
originators and investors.
In non-revolving structures, and those with fixed interest rate receivables, assets and
related liabilities can be matched, eliminating the need for hedges.
Because the originator usually acts as servicer and there is normally no need to give
notice to the obligors under the receivables, the transaction is transparent to the
originator's customers and other persons with whom it does business.

Disadvantages of Securitization

The synchronization of the interest generated by the pool and the interest paid to
the investors is a very arduous and tedious process.
The transfer of mortgages may be difficult for legal, regulatory or tax reasons. In the
Netherlands and in other European countries such transactions have to satisfy the
requirements of regulatory authorities.
The complexity of the transaction requires a very highly sophisticated documentation,
which covers every potential risk. The numerous participants and opinions as well as the
voluminous documentation are very time consuming and costly.

Advantages for Issuers

One of the major allures of securitization for issuers is off-balance-sheet treatment,

meaning that the assets included in the reference portfolio are wiped off the
originator's financial statements.
The benefit to financial institutions is that securitization frees up regulatory capital the
assets that banks are required to hold by their financial regulators to remain solvent.
In addition, securitization can offer issuers higher credit ratings and lower borrowing
costs.

Disadvantages for Issuers

One of the biggest drawbacks for issuers is that it's far more complicated to structure a
securitization than to structure traditional types of debt, such as a bank loan or a vanilla
corporate bond.
In addition, the transactions may not always lead to off-balance-sheet treatment,
reducing the benefit to financial institutions.

Advantages to Investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality assets:- Due to the stringent
requirements for corporations (for example) to attain high ratings, there is a dearth of highly
rated entities that exist. Securitizations, however, allow for the creation of large quantities of
AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required
to invest in only highly rated assets, have access to a larger pool of investment options.
Portfolio diversification:- Depending on the securitization, hedge funds as well as other
institutional investors tend to like investing in bonds created through securitizations because
they may be uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity:- Since the assets that are securitized are isolated
(at least in theory) from the assets of the originating entity, under securitization it may be
possible for the securitization to receive a higher credit rating than the "parent," because the
underlying risks are different. For example, a small bank may be considered more risky than
the mortgage loans it makes to its customers; were the mortgage loans to remain with the
bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank
would be paying higher interest to its creditors, and hence less profitable).
Disadvantages to Investors
Liquidity risk

Credit/default:- Default risk is generally accepted as a borrowers inability to meet interest

payment obligations on time. For ABS, default may occur when maintenance obligations on
the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator
of a particular securitys default risk is its credit rating. Different tranches within the ABS are
rated differently, with senior classes of most issues receiving the highest rating, and
subordinated classes receiving correspondingly lower credit ratings. Almost all mortgages,
including reverse mortgages, and student loans, are now insured by the government, meaning

that taxpayers are on the hook for any of these loans that go bad even if the asset is massively
over-inflated. In other words, there are no limits or curbs on over-spending, or the liabilities to
taxpayers.
However, the credit crisis of 20072008 has exposed a potential flaw in the securitization
process loan originators retain no residual risk for the loans they make, but collect
substantial fees on loan issuance and securitization, which doesn't encourage improvement of
underwriting standards.
Event risk

Prepayment/reinvestment/early amortization:- The majority of revolving ABS are subject to

some degree of early amortization risk. The risk stems from specific early amortization events
or payout events that cause the security to be paid off prematurely. Typically, payout events
include insufficient payments from the underlying borrowers, insufficient excess spread, a rise
in the default rate on the underlying loans above a specified level, a decrease in credit
enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.

Currency interest rate fluctuations:- Like all fixed income securities, the prices of fixed rate ABS
move in response to changes in interest rates. Fluctuations in interest rates affect floating rate
ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will
reflect interest rate changes in the economy. Furthermore, interest rate changes may affect
the prepayment rates on underlying loans that back some types of ABS, which can affect
yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto
loans, student loans, and credit cards are generally less sensitive to interest rates.
Contractual agreements

Moral hazard:- Investors usually rely on the deal manager to price the securitizations
underlying assets. If the manager earns fees based on performance, there may be a
temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise
with senior note holders when the manager has a claim on the deal's excess spread.

Servicer risk:- The transfer or collection of payments may be delayed or reduced if the servicer
becomes insolvent. This risk is mitigated by having a backup servicer involved in the
transaction.