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by Ashanka S. Jayaratne

Asset Securitization is becoming a buzzword in town. Financial institutions and corporates are increasingly looking at asset securitization as a way of structuring the balance sheet and/or as an alternative way of financing projects. The history of asset securitization goes as far as 1965 in USA, but it's a fairly new phenomenon even in Europe. The first mortgage backed securitization in UK took place in 1987 and spread to other European countries only after 90s. In recent our big neighbour India is increasingly exploring advantages of securitization.

Among the driving forces are glaobalisation, disintermediation, reliance on ratings, and most importantly investor acceptability. A proper securitization program could improve the capital requirements, shareholder wealth and return on capital for a company.

The investors are able to isolate the originator's risks from the instrument unlike in a debenture issue. Asset Securitization is defined as "the process of pooling together a group of receivables from financial assets and the issuing of debt instruments to investors based on the strength of the stream of future cash flows".

Features of Securitization Ability to derecognise the assets from the Balance Sheet In order to derecognise the sale of assets should pass the "true sale" criteria. According to FAS 140: Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities issued by Financial Accounting Standard Board (FASB) of the USA, the control is said to be surrendered if,

* The asset cannot be reassumed by the transferors, its receiver or its creditors even in the event of bankruptcy

* The transferee is free to pledge or exchange the asset

* There is no repurchase agreement between the transferor and the transferee

* The transferor does not have a freestanding call on the transferred assets, other than clean up call.

However due to the nature of the financial assets, the originator may continue to involve with the securitized asset through limited recourse (norm is 10%), servicing of the asset and/or in exercising the clean-up call that do not impair the true sale.

Ability to sell components of an asset (financial component approach) or in entirety This is applicable where securitized assets could be divided in components. For example a housing loan portfolio may be stripped into interest and capital component separately and be sold, or the cash receivables may be sold in total without distinguishing between the interest and capital. In latter approach the originator could incur a capital loss or a gain depending on the difference between the discounted rate of the cash flows and yield of the assets. For example if the housing loans have an interest yield of 16% and the originator sells the cash receivables by discounting (to calculate NPV) at 14%, the difference could result in a capital gain for the originator.

Special Purpose Vehicle (SPV)

This is an entity established for the limited purpose of purchasing the secruritized assets from the originator and issuing asset backed notes to the investors. The SPV could take the form of a limited liability company or a trust. SPV will be consolidated in the originator's books unless the SPV is a Qualifying SPV (QSPV). According to SLAS 26 subsidiary is an enterprise that is controlled by another enterprise (known as the present). However, a subsidiary should be excluded from the consolidation when:

* Control is intended to be temporary because the subsidiary is acquired and held exclusively with a view to its subsequent disposal in the near future; or

* It operates under severe long-term restrictions, which significantly impair its ability to transfer funds to the parent.

A trust may be a better vehicle as a QSPV where the investors are the beneficiaries of the trust. The trust is governed by the Trust Ordinance and most importantly as per the terms of the trust deed.

The trust may be administered by the originator if the originator is a bank, but the treatments to the securitized assets become important. As long as the receivables are held for the benefit of the investors, and the investors have the right to choose a different trustee with a special resolution, originator need only disclose the same off balance sheet. In the case of a breach of trust deed, trustee may be held liable by the investors.

Credit Enhancement

This is a mechanism built-in during the structuring process of the securitization to add value to the investors. It will address risks such as default risk, delinquency risk, and early repayment risk. Most popular credit enhancement mechanism is through trenching. That is to issue senior notes and mezzanine/subordinated notes.

Usually the originator will invest in the subordinated notes assuring his commitment and faith on the cash flow. Larger the portion of subordinated notes, higher the credit worthiness of the senior notes. However, if the originator's investment in the securitized subordinated notes is substantial, derecognition of the assets will become questionable. Usually 10-20% of the subordinated notes invested by the originator does not break the rules of 'true sale'.

Transaction between related parties

If a related party invests in the asset backed notes, a question of fairness of the sale to the existing creditors could arise. For example, a company could sell the future cash receivables at a loss to the originator passing the benefit to the buyer (related party), and thus depriving the existing creditors of their dues.

Under the bankruptcy and solvency laws of UK, if the originator becomes insolvent within two years subsequent to the secruritization, the creditors can challenge sale on the basis of sale not being a true sale or not having sold at a fair value.

The other features not discussed here but pertaining to securitization includes swaps, trigger events, co-mingling of funds, insurance, guarantees put and call options.

I believe it is high time we drew up guidelines to facilitate securitization in Sri Lanka in the local context, encouraging the companies. This will boost capital markets, create more avenues of raising money and give another lifeline to dying investment-banking sector. However, till such time where disputable areas exist in applying existing accounting rules, it is advisable to use the principle of "substance over commercial form" to transactions.

The information contained herein are opinions and facts from various reliable sources.

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