1st December, 2012:

Vinod Kothari

[The following is the text of an interview given by Vinod Kothari for an international journal, and is being produced here for the benefit of readers]

1)How did you become involved with the "Working Group for promoting RMBS and other alternative Capital Market Instruments – Covered Bonds"?

The Working Group was constituted by the National Housing Bank. Securitisation, particularly RMBS, has been lying on a very low key in India over several years, and NHB has most appropriately thought of exploring what are the reasons that kept is subdued, and what could be done to reinvigorate it. As regards covered bonds, since covered bonds are widely being perceived as the alternative on-balance sheet option for RMBS and are increasingly being tried outside of the European cradle, it is quite obvious for NHB to explore possibility of introducing the same to India.

Taking me as a part of the Group might have been due to my regular involvement with both the instruments – securitisation and covered bonds, primarily from an international perspective.

2)Why is India looking at introducing covered bonds now?

As an option for refinancing mortgages, it makes eminent sense for mortgage originators to have several options. The RMBS option has its own appeal. In India, substantial reason for demand for securitised instruments is the "priority sector" investment criteria for banks – that is, banks need a certain part of their banking credit towards the so-called priority sector. Securitised instruments qualify as priority sector investment, if the underlying loans are priority-sector loans. Hence, there is a good reason for demand for RMBS backed by low-ticket housing loans.

But then, RMBS has its own problems – the amortisation of principal is uncertain, and investors get prepayment volatilities. Investors tend to overprice their investment due to the risks associated with volatile payments. In addition, securitisation transactions in India are also subjected to tax issues.

If institutional investors are looking at smooth long-term investments, with no prepayment risk, and yet solid backing of a housing loan portfolio, the covered bond option seems ideal. Of course, there is no priority sector benefit here, but there are lots of institutional investors such as mutual funds and insurance companies who are not covered by these requirements. So, for a whole class of investors, covered bonds are much better than RMBS.

Covered bonds do not exist in India as of now – but given the flexibility of Indian law as a common law jurisdiction, there is no reason for covered bonds not existing in India.

So, it is so very timely that NHB thought of this idea. The Report, that comes on NHB platform, would not only open the door to NHB-intermediated covered bonds as recommended by the Report, but also self-issued covered bonds.

3)In our understanding, the group suggests the following structure: covered bonds issued by banks/HFCs, with the NHB fulfilling the role of an SPV by having a beneficial interest in the cover pool. Can you confirm that?

The Report looks at two possible structures – SPV-intermediated structures, and NHB-intermediated structure. In the first case, it is an SPV acquiring legal title over the cover pool and providing its own guarantee to the bondholders – the structure is very much the same as in case of UK transactions.

In the second option, NHB comes where we had SPV in the first case. NHB acquires legal title over the cover pool and provides assurance to investors to use the proceeds of the cover pool to pay investors in case of a default by the issuer of the bonds.

There are several merits of the second option over the first one. NHB is the regulator of the housing sector, and enjoys several statutory powers, including the power to change the management of a housing finance originator. In the event the default of an issuer happens due to managerial reasons, NHB may take corrective actions and avoid a default. Second, transfer of cover pool assets to NHB may happen under a statutory provision – avoiding the costly process of a true sale. Third, in terms of investor perception, NHB putting its name to the bonds has a great booster effect for investor interest.

In short, the NHB-intermediated model will be a unique model for other countries also to follow.

4)How did the NHB receive the set proposals put forward by the working group in October 2012?

NHB is very receptive. Indications are that the NHB will like to move the regulatory changes on a fast track. There is a minor amendment of the NHB Act involved – which requires the concurrence of the RBI and the Parliament. This may take some time, but NHB is surely keen to move it fast.

5)What is going to happen next? Does parliament need to approve the regulation? Do you see any obstacles head?

Parliament only approves the minor amendment of the NHB Act, which is helpful, but not essential. The Regulations may be announced by NHB itself. The legislative amendment has to move first. So, the only obstacle could be the time and urgency lost in the process of NHB to RBI to cabinet to Parliament.

6)When would you expect the first covered bond issuance to be and by whom?

Once again, if the passing of the legislative amendment could be expedited and put in the winter session of the Parliament, then may be we can see the first covered bond issuance in early 2013. Otherwise, it will go to May 2013 or so.

Most likely, it would be one of the better-rated issuers – say HDFC. Given its rating, HDFC does not need covered bond – but there may be a good reason for NHB to prevail upon a better-rated issuer to bring the first issuance to the market – to set the ball rolling.

7)Regarding ratings, what range of upnotching would you expect covered bonds to achieve above Indian banks/HFCs?

The 3 primary considerations for the notching up are robustness of legal structure, asset liability mismatches, and liquidity arrangements. The first one is clear – if NHB steps in. The second and the third are structure-dependent. If these are kept under control, I would expect notching up to 6 notches.

8)What kind of investors would Indian covered bonds be likely to attract (i.e. national, international)?

National – as we mentioned before – institutional investors such as mutual funds, insurance companies and employee benefit funds have a very strong reason to invest in housing-finance assets.

International – hedging costs are still quite high. All inclusive cost works out to almost the same as the cost of domestic borrowing. In addition, external commercial borrowing by financial institutions is tightly regulated. So, this option may not be open in the near term.

Reported by: Vinod Kothari