Brief write-up on Pass through Certificates (PTCs)

Background When certain financial asset classes (retail or corporate) are pooled together and 'undivided interest' in the pool is sold, 'pass-through securities' are created. The term 'undivided interest' means that each holder of the security has a proportionate interest in each cash flow generated by the pool. The pass-through securities assure that cash flow from the underlying asset classes would be passed through to the holders of the securities in the form of regular payments of interest and principal. The entity selling the receivables (also usually the originating entity) to the Trust is called the 'Originator' and the entity which has borrowed the funds and is responsible for repayment is the 'obligor'. What is the nature of a typical transaction? First, a special purpose vehicle (SPV) is created, to de-link the pool assets (cash flows) from the company that wants to securitise (the `originator'). The SPV is usually a 'trust' and has no borrowings of its own. The SPV then issues tradable debt instruments called `pass through certificates' and sells them to potential investors. Proceeds from the sale of PTCs are then utilized by the SPV to purchase/ buyout the asset pools from the Originator. In a typical securitization deal, assets in the pool include auto loans, Commercial vehicle (CV) and construction equipment (CE) loans, personal loans OR single corporate loans. While banks and NBFCs sell the assets as Originators, investors in the PTCs could be other banks, insurance companies, pension funds, mutual funds and possibly even individuals. Since the SPV is a set up as a 'bankruptcy remote' entity, it is not impacted by bankruptcy of the originator. Schematic Representation of a transaction Security Trustee

(Collateral provider if any)

Security Provider

Originator (Bank /NBFC)

Loan

Obligor / (Corporate /Retail)

Security

Trust (mostly a Bank / NBFC)

Designated Payment Account

PTC Investors

What are the different types of PTC transactions Practically any asset class can be packaged and sold down under the PTC route. However, the PTC market in India can be broadly segregated into two categories viz. a) Single corporate loans. Herein, a loan given by an originator (Bank/ NBFC/ FI etc.) to a single entity (obligor) is converted into pass through certificates and sold to end investors. b) Retail asset pools comprising multiple borrowers and asset classes such as Personal loans, Credit Card receivables, Construction Equipments, Commercial Vehicles, passenger cars and two wheelers. Till fiscal 2006, retail asset pools dominated the securitization market in India. FY 2007 witnessed a change with a strong growth in 'single-corporate loan' sell-downs. Corporate loans accounted for nearly one-third of the loans securitized in the fiscal year 2007. How are Retail pool PTC transactions different from Single Loan PTCs? Unlike single loan sell-downs, the retail asset pools comprise several different borrowers within multiple asset classes. A transaction may involve either a single asset class (such as CVs or CEs) or a composite pool comprising multiple asset classes. In retail pool transactions, the exposure is towards several small ticket borrowers and hence the methodology of analysis (explained later) is different from that followed for single loan PTCs, wherein the exposure is on the corporate borrower. Further, retail pool PTCs in majority of the cases are rated the highest (i.e. AAA) owing to the stipulation of a cash collateral, unlike single loan PTCs, wherein the rating is mostly the same as the stand-alone rating (in the absence of any credit enhancement) enjoyed by the issuer on other instruments such as debentures and bonds. Are PTCs rated? All PTCs are rated by one of the four accredited rating agencies in the country. The rating is based on the financial strength of the obligor, as the end-investors have no recourse to the originator of the loans. Effectively the rating on the PTCs represents the 'stand-alone credit risk' of the obligor. The rating takes into account the relative repayment ability of the obligor. Is there any maturity mismatch in PTC investments? In most cases, maturity of the underlying loan to the obligor is a day or two earlier than the maturity of the PTC, to avoid any payment mismatch to the PTC holders. For the lenders, there is no mismatch either, as most transactions are pre-marketed. Loans are hence originated with the specific intention of securitizing them, and are often sold down within a few days of the disbursement. Thus, the originator's funds are locked in for a minimal period. The difference between the origination and the securitization rate on the loan amount represents the income of the originator. Are credit risks in single loan PTCs comparable with those on conventional instruments such as Debentures? There is no difference in the credit risk on the exposure taken through a single loan PTC vis--vis a plain vanilla debenture. Internally, credit risk assessment in a PTC investment is based on the analysis of the obligor and not originator of the loan.

In effect, the methodology adopted to evaluate the credit risk in the case of a single loan PTC is identical to that followed in the case of investment in debentures / CPs or other financial instruments issued by the obligor. Why is the Single Loan PTC route preferred by Issuers? While the short term money markets have developed well in India over the years, the medium and long term corporate debt market has yet to take-off in a meaningful manner. Historically the Indian financial market has been pre-dominantly a 'loan-market' wherein borrowers enjoy strong relationships with their consortium banks. Only a small segment of the borrowers enjoy direct access to the debt capital markets. Hence borrowers continue to rely on their banks to meet their medium term borrowing needs in most cases. The PTC route offers a good alternative to address this issue as originating banks given their strong relationship with the corporate / NBFC borrowers and strong balance sheets are better placed to arrange / organize funds for the borrowers through immediate disbursement. Over time however, the banks may need to sell down a part of this exposure in order to comply with single borrower limits. Besides, the limited depth of the corporate debt market has led to longer time to close out large funding needs for borrowers. However, under the single loan PTC route, large funding needs are organized / syndicated by the banks themselves and subsequently sold down to the market. What is the profile of borrowers in the Single loan PTC segment? As per data compiled by CRISIL, the financial sector borrowers dominate this space accounting for 40 % of all single loan PTC transactions completed since 2006. This is followed by Telecom (17%) and Real Estate (17%). This is followed by Construction (3%) and Petroleum (3%). What is the mechanism of analyzing credit risk in a retail pool? A retail pool comprises several small ticket loans and thus differs from a single corporate loan, where there exists only a single borrower. Since it is difficult to conduct a credit analysis of each borrower in a retail pool, a portfolio approach is followed in analyzing the retail pools. Retail pools are evaluated by assessing features such as seasoning of the pool, the cash collateral being posted by the Originator as a credit enhancement measure, the past track-record of the originator (examining asset quality of on-balance sheet assets and those sold down), the servicing ability of the originator and the on-going performance of the relevant asset class in the current economic scenario. Since, performance of retail pool PTCs is dependent on the repayment ability of the retail borrower; cash collateral plays a very important role in enhancing the overall rating and credit profile of the transaction. What are the benefits to a lender / originator in securitizing the loan? NBFCs and Banks have undertaken to sell-down transactions of retail pools, primarily from a liquidity and liability management perspective. With capital getting costlier and successive regulation stipulating higher levels of capital adequacy, banks and NBFCs have been facing constraints in growing their balance sheets. In the absence of credit derivatives, securitizing loans in this manner is a technique to achieve transfer of risk for the originators of these loans. Such transactions also enable the originators to stay within the limit caps for exposures to individual clients / corporate groups / industry sectors.

While bilateral trading of loans between banks / institutions and risk transfer through participation certificates have been happening, these are very limited in number and mostly limited to the private sector and foreign banks operating in the country. Reference Annexure: Enclosed please find, Sample rating rationale of a Single loan securitization (eg. Suzlon Energy Ltd.) Sample rating rationale of a retail asset pool transaction originated by ICICI Bank Legend of terms used: SPV: Special Purpose Vehicle PTC: Pass through Certificates CV: Commercial Vehicles CE: Construction Equipment SL: Single Loan CP: Commercial Paper CD: Certificate of Deposit NBFC: Non Banking Finance Company FI: Financial Institution

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