Securitization is an extremely important term factor when it comes to investing and you should know about it.
Let’s start off!
17 Terms to Know About Securitized Debt Instruments
Here are the 17 terms that every investor must know about securitized debt instruments.
Let’s say Amit has given a loan of Rs 10000 to Harsh. Harsh promises to pay Amit after 12 months with an agreed interest rate of 12%.
Now, after two months, Amit needs the money, but Harsh can pay as per decided term, .i.e., after ten more months. Yash, Amit’s friend, decides to help Amit out. Yash has some extra cash and is looking to invest. So Amit and Yash make a deal.
Yash pays Amit and Amit agrees that when Harsh pays back, Yash will get the repayment. So, Yash bought/refinanced the loan given to Harsh. This step of refinancing is called securitization. On a broad scheme of things, Amit is NBFCs/banks, and Harsh is the borrower and Yash is an investor.
Securitization involves a pool of many loans that are given out by banks/NBFCs, and on the investor side, there can be more than one investor.
2. Securitization Trust
When a securitization transaction happens, all the investors who want to buy the pool of loans come together and create an entity that owns the pool.
This entity is called securitization trust. It is the special purpose entity that holds the securitized loan pool as an asset. The investors invest through this trust.
3. Pass-Through entity ( another name for Securitization Trust)
In the securitization transaction, the trust is earning interest income. But the interest income does not come under the income tax. Investors receive the income who then pay taxes on it as per their slab/ tax structure.
Thus, trust only acts as a channel for investors to invest in the pool of loans. It creates the” “Pass-through” for the investors. Therefore it is called a Pass-Through Entity.
4. PTC( Pass-Through Certificate)
Each investor owns a part of securitization trust.
The Pass-Through Certificate is a certificate of the ownership in that trust. PTCs are in Demat format.
5. Bankruptcy Remote
When you invest in PTCs, you are investing in the pool of loans, not in the NBFC. As you are not extending the debt to NBFC, even in the case of NBFC going bankrupt, your investment is not affected.
The risk profile of the investment in PTCs is dependent on the underlying loans, and it is separate from NBFC bankruptcy. It is the beauty of the securitization transaction.
The NBFC which disbursed the loans is called the originator. These loans are then pooled together and securitized. A single pool of loans can have loans that are disbursed by different NBFCs. In that case, the transaction is considered a multi-originator transaction.
The servicer is the entity which services the loans and collects the EMIs. The servicer is generally the originator. In India, there are usually no third-party servicers, while in the US, there are such precedents.
Any investor generally would not want to look into operations of the transaction. The Trustee handles this function and distributes the interest coming to the securitization trust.
SEBI has approved few agencies who can act as Trustees. Unless approved by SEBI, any agency cannot operate as Trustee.
The arranger is an investment bank that manages the deal from start to finish. Its function involves:
- Understanding the credit risk and choosing the loans for securitization.
- Working with rating agencies to get an appropriate rating.
- Helping Trustees with relevant documents to execute the transaction and list it on the exchange.
Here are some other terms that help you understand the credit risk:
10. Borrower IRR(Internal Rate of Return)
It is the rate of interest that is charged to the borrower. E.g. for gold loans, the borrowers are charged an interest rate of 18–20% per annum.
Borrower IRR on its own is not a right indicator to signify the credit risk. However, it does throw valuable insights when coupled with other factors.
E.g. If Borrower IRR is similar for two pools, but one pool has gold as collateral while the separate pool has no collateral( unsecured). In that case, gold loans pool is much safer.
11. Interest Spread
The NBFCs has some cost of capital. E.g. if NBFC got debt from the bank/investors at 12% then the cost of capital is 12%.
The difference between borrower IRR and the cost of capital is interest spread.
12. LTV(Loan to Value Ratio)
It is a ratio that indicates how much percentage of the collateral value is given as a loan. E.g. generally in home loans, banks fund 70% of the market value of the home.
Here the LTV is 70%. In the case of gold loans, maximum LTV is 75%( Giving out loan beyond 75% LTV on gold is not allowed as per RBI rules).
Capping of LTV at 75 % for gold loans ensures that variation in market rates of gold does not affect the risk profile of the loan. LTV only applies to loan in which is there is underlying collateral.
13. Underlying Collateral
Underlying collateral is the asset that is mortgaged by the borrower to avail the loan. If the borrower fails to pay the loans with interest, the NBFC/ servicer sells off the underlying collateral to recover loan dues.
Common underlying collaterals are gold jewellery, house or any other real estate property, vehicles, investments in marketable securities such as equities, debts, and mutual funds.
14. Gross NPA
If the borrower doesn’t pay the EMI for 90 days after the due date, the loan is considered NPA.
Gross NPA indicates how much percentage of the portfolio is NPA. If 2% of the portfolio is unpaid for 90 days, then gross NPA is regarded as 2%. In such cases, the NBFC liquidates the underlying collateral and recovers the loan.
15. Net NPA
If the borrower fails to repay the EMI, the NBFCs liquidates the underlying collateral and recovers the dues.
However, in particular assets ( e.g. Vehicles), the market value of the collateral is less than the outstanding dues, then the NBFCs makes a loss.
This loss after the sale of assets is considered Net NPA. If gross NPA is 2%, and after selling of collaterals of NPA borrowers, the NBFC recovers 1%, then Net NPA is 1%.
16. FLDG/ Additional Collateral
When investors invest in debt assets, the most critical concern for the investor is capital protection.
If there is going to be some Net NPA, then the investor would be very suspicious of the investing in securitization.
To cover for this risk, the originator NBFC gives additional collateral in the form of either FD or other loans as collateral. E.g. if the investors fund a loan pool of 10,000 loans, the NBFC gives the investor rights over repayments of 11,000 loans.
Here the 1,000 loans act as additional collateral, making sure that investors don’t take a loss. In a case where a borrower of the main pool of 10,000 loans does not repay the loan, the investors get paid from repayments from additional 1,000 loans.
17. Residual Maturity
Residual maturity indicates remaining tenures of the pool of loans. It helps the investors to understand the investment horizon and understand risk accordingly.
In a pool of two loans of the same principal, if one loan has a tenure of 1 month and the other one has a tenure of 5 months, the average residual maturity is three months, and maximum residual maturity is five months.