Wednesday, June 27, 2012

Securitization Process !

Bank - Asset & Liability:
A typical bank balance sheet consists of 'Assets' and 'Liabilities'. 

Any bank's primary duty is to adjust these assets and liabilities to acquire profit. So, there are cash inflows from these assets, with which they pay partly towards clearing off their liabilities and retain the rest as profits. Therefore, performance(i.e. cash inflows) of the assets are critical for any bank to survive in the market. 


Bank Asset(loan) structure:
Typical bank loan structure is shown below. Loan repayment amount has principle and interest component, which is packaged together as Equated Monthly Installments(EMI) by the bank and is paid by the customer pays every month.


[Note: Interest component is more(in the EMI amount) towards the beginning of loan tenure.]

An asset becomes non-performing when it ceases to generate income for the bank. In India, a Non-Performing Asset (NPA) is defined as one with interest or principal repayment instalment unpaid for more than 90 days ( 3 months time).

NPAs causes several problems to the bank:
> It drain bank's profitability

> It also impacts banks capital adequacy. In India, under RBI guidelines, banks have to maintain certain ratio between the capital they have and the risks they are exposed to. NPAs affect this ratio. 

> NPAs also effects credit growth of the country as the bank’s prime focus now becomes zero percent risk and as a result becomes risk averse to fresh credit or increases its cost of funds which may affect genuine borrowers.


NPA Management History in India: 

The problem of NPAs in Indian Credit market is not a new phenomenon. Figure below shows the various steps taken by Indian govt. over a period of time to manage the rising NPAs of banks. 




I will briefly touch upon them here.

1. Pre-1980s : Socialist Indian govt. best bet was to nationalize everything and try and write of NPAs from banks balance sheet. This obviously wasn't going to help them for long. 

2. 1980-1990 : Realising the growing industrial/instutional sickness in Indian market, where more and more enterprises were going bust or deep red in losses, that's when Indian govt. seem to have woken up from sleep and enacted the first such act to contain NPAs. 

This was the SICA(see full form in picture) Act 1985. This act constituted BIFR(see full form in picture) body, which was to negotiate with the sick enterprise and the bank and help resolve a common ground through legal, managerial or financial reconstruction mechanisms.

Over a period of time, Banks realised that this was not working as, an average BIFR negotiations took them 5-6 yrs for resolution. 

3. 1990s - With the growing clamour among banks, Indian govt. enacted the RDDBFI Actwhich enabled set of Debt Recovery Tribunals(DRTs). This obviously was a good news initially but over a period of time with rising NPA appeals to DRTs, we were back to square one with regards to delays. 

4. 2000s - In 2002 Indian govt. setup SARFAESI Act 2002 which was a benchmark reform in the Indian banking sector. The progress under this Act had been significant, as there was an overall reduction of NPAs within banks. This Act empowered banks to skip going to the courts and settle the NPAs on its own. 


SARFAESI Act,2002: 

The SARFAESI Act empowers Banks / Financial Institutions to recover their NPAs without the intervention of the Court. The Act provides three alternative methods for recovery of non-performing assets:

Securitisation - we will talk about this in detail below 

Asset Reconstruction - you reconstruct the structure of the loan by changing the loan tenure, monthly installments etc.

Enforcement of Security without intervention of the court - Banks can take over the property which they have loaned into their possession by promulgating this Act and then auction/sell it to recover their costs.

(Note: Non-Banking Financial Institutions like Ge Money, Reliance mOney, Fullerton, Future Money etc are not covered in this Act).

At present 3 legal options are available to banks for resolution of NPAs - the SARFAESI ActDebt Recovery Tribunals and Lok Adalats. The SARFAESI Act has been the most important means for recovery of NPAs. 




Securitisation:

In a usual loan process, banks have to hold the assests for the whole duration of the loan tenure to realise full profit from that assests. As a result the funds of the bank(which it had loaned) are blocked and to meet its growing fund requirement a bank has to raise additional funds from the market. 

Securitisation is a way of unlocking these blocked funds.

Liquidity for bank means something which can be easily converted into cash. Usually loans have a tenure of min. 4-5 yrs and hence not liquid. 

So, banks convert these illiquid assets into a liquid ones by properly pacakaging them into similar asset categories and then selling them to investors by issuing them securities. This process is called securitization. 

So everything from auto loans, credit cards, personal loans, residential and commercial mortgages etc, all can be securitized. 


Main parties involved in a securitization process are:

1. Banks - Who wants to securitize its assets

2. Credit Rating Agencies - These are companies which work along with banks and rates each asset category and defines if its a 'risky' or 'safe' asset. 

3. Securitization Company - The special purpose vehicle created for the purpose of securitization which actually purchases the assets from banks and sells it 

to investor by issuing them securities.

4. Investors - People who are interested to buy securities from Securitization Company. They buy such securities as they get higher returns on their investments. There are mix of investors - some are risk takers(hedge funds) and some who don't and buy only safe assets. Due to risky nature of the transactions only Qualified Institutional Buyers are allowed to invest. So firms like banks, mutual funds, hudge funds, insurance cos. etc.

5. The borrowers who pay their regular EMIs as usual. 

Please see the figure below which shows a typical securitization process. 



In recent past, banks have been increasingly adopting to securitization process for following reasons:

> Securitization has given banks an alternate method to garner cashand then to lend it to other entities. Getting more capital has been increasingly important because they need to fund increasing number of industries in India (power companies are major credit seekers are they are perenially in loss) and also due to the BASEL III regulations which will be in operation from Jan 2013 onwards. 

Balance sheet management - Once the bank sells its assets to the Securitization company, it is relieved of the tensions of that loan and then its the problem of the Securitization and eventually the investor(thats why investors gets higher returns as they are taking risks). 

This ensures bank's balance sheet looks good and more robust and can concentrate on more productive work rather than wondering on who hasnt paid its due. 

Appropriate allocation of risks for banks - Suppose a bank has lots of housing loan in its asset and the house price is going down. Its a matter of concern for the banks or say a certain sector of its asset portfolio is not performing good(say credit cards), then it may want to get rid of such portfolio by resorting to securitization(we will talk about this a little later). 

ICICI Bank had amassed a huge debt due to Credit Cards defaults. Thanks to the globalization and boom in multiplexes, foreign goods in markets, flashy neon lights and fancy GUCCI specs and Versace denims, floating in Indian market. Indian customers had gone crazy and so were the banks !! The banks had gone crazy selling their credit cards and Indian customers spending credit unresponsibly. 

Bank DSA Agent: "Hello Sir! Mein Idli Rasam bol rahi hoon, Aap humare lucky draw mein select huay hain aur aapko humare bank ke taraf se ek Lifetime FREE Credit Card diya jaata hai !"

Customer: "Ok! Accha hua aapne phone kiya ! Mujhe kuch bombs kharedney thay. Boliye kab bhej rahe hai aap credit card ?" 

Bank DSA Agent: - Hangs Up- 

So, due to enormous amount of NPAs ICICI Bank had accumulated over time, so when Chandra Kochar(current head of ICICI Bank), took over charge, she had literally stopped ICICI Bank to issue Credit Cards for some time till they resturctured their portfolio and allocated risks through securitization and related methods. 


Securitization in case of NPAs:
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NPAs are bad loans for banks. It doesnt provide them any returns. So, banks have resorted to securitization for such loans as well. The middle-man company in such cases are called "Asset Reconstruction Company(ARC)" (instead of securitization company). The returns on such NPA loans are higher than safe or moderate safe loans are they are risky assets. 

So, once banks sells their NPAs to ARCs, they write it off(remove them) from their balance sheet with the money they have received through sale and hence it has now being converted into a good loan. 

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