De-jargonizer: Understanding key terms in Securitisation structures

– Financial Services Division (finserv@vinodkothari.com)

Introduction

The RBI’s regulatory framework for securitisation, the SSA Directions use several terms used in securitisation structures, some of which are aligned with global practices, while some not. In addition, the marketplace uses some so-very-Desi expressions. As transactions have started coming off the mould, it is important to understand some of the key terms  and structural considerations, to help bring more innovation and evolution in the structures. 

While we have in the past developed a general securitisation glossary for our readers, the said resource pertains to terms as they are used globally. However, this article aims to demystify key-securitisation related terminologies, specific to the Indian SSA Directions, shedding light on their relevance and practical applications. This pertains to concepts such as securitisation notes (PTCs), credit enhancement (CE), liquidity support, first loss facilities, subordinated tranches, and over-collateralisation are critical in structuring securitisation deals, determining the level of risk borne by different participants, and ensuring compliance with regulatory frameworks like those set forth by the Reserve Bank of India (RBI) and Basel III norms.

Key Components of Securitisation Exposure

1. Securitisation Notes (PTCs)

These are the securities issued in a securitisation transaction, representing an interest in the underlying asset pool. They are structured into different tranches based on risk and return characteristics.

2. Credit Enhancement (CE)

Credit enhancement is a mechanism designed to improve the credit profile of securitisation notes. CE can be achieved through various means, including:

• Cash collateral
• Subordination
• Excess spread
• Other forms of financial support like guarantees, overcollateralisation, etc.

3. Tranches in Securitisation (Tranched Cover)

• Senior Tranche: The highest-rated tranche with the lowest risk exposure.
• Mezzanine Tranche: An intermediate tranche, often referred to in market parlance when there are three tranches. To learn more about Mezzanine tranches, see our explainer, here. 
• Junior Tranche: The lowest-rated tranche that absorbs losses first.

Class A, Class B, Class C, Class D etc. : Used when there are more than three tranches.

In respect of computation of risk weights (the table of risk weights as provided under SSA Master Directions)  senior tranche actually means the senior most, and the rest of all tranches are said to be junior tranches. 

4. First Loss Facility

The first loss facility is the first layer of protection against losses in a securitisation transaction. It absorbs losses before any other tranche. However, seemingly it does not include excess spread, as excess spread is not provided by the originator or a third party [Reference drawn to para 5(h) of SSA Master Directions]

5. Equity Tranche

Though not explicitly defined, the Basel III Framework [para 712(ii)] describes the equity tranche as the one that absorbs first losses. However, RBI Regulations distinguish between equity tranche and first loss facility. Based on corporate finance principles, the equity tranche is the most junior tranche, with the right to sweep residual returns. As per regulatory provisions, the equity tranche appears to be one level above the first loss facility if such differentiation exists within a structure.

6. Over-Collateralisation

Over-collateralisation refers to the excess value of assets transferred over the funding raised by the originator. It can serve as credit enhancement if subordinated but is not counted as part of the first loss facility.

7. Underwriting Facility

The underwriting referred to in para 56 of the SSA Master Directions is the same as securities underwriting. In a securities underwriting arrangement, the underwriter is expected to acquire the securities and sell them in the market. The underwriter usually guarantees a certain extent of subscription, in case there is any shortfall, the underwriter takes up the shortfall itself.

Third party or the originator may act as underwriters to the issue of securitisation notes upon coming with specified conditions of this clause in addition to general conditions of clause 45. In case the conditions are not fulfilled, the underwriting facility shall be considered as credit enhancement,

8. Liquidity Facility

A liquidity facility is provided with the intention to smoothen the timing difference between the receipt of cash flows from the underlying assets and the payments to be made to the investors. Thus, the same is to support temporary liquidity mismatches/gaps.

Liquidity facility is not credit enhancement. Some notable features are:

• The facility is to meet the temporary cash flow mismatches and not meeting the expenses of the securitisation or losses;
• Funding is to be made available to the SPV and not to the investors;
• Once the liquidity facility is drawn-down, the liquidity facility provider shall have priority of claims over future cash flows and shall be super senior to the claims of the senior investors.

Typically, liquidity facility takes the form of the following:

• Servicer advance: Here the servicer itself extends out of its own pocket to make payments as per the structure and subsequently the same is reimbursed from the collections made from the portfolio. The reimbursement to the servicer in this case becomes the priority as soon as the collections are made;
• Bank facilities: Here a revolving facility is opened with a bank. Drawdowns are made as and when need arises. This is common in case of pay-through structures.
• Cash collateral: This is the most common form of liquidity enhancement, though, India, cash collateral is used as a credit enhancement. Cash collateral is hard collateral to meet periodic delinquencies. Even though having cash collateral is the ideal situation for the investors, however, for the originator cash collateral leads to a negative carry.

9. Interest rate swaps/Currency swaps

In securitization, interest rate swaps (IRS) and currency swaps (CS) play a crucial role in managing interest rate and currency risks, respectively. These financial instruments help align the cash flows of the underlying assets with investor preferences or hedge against market fluctuations.

For instance, in a securitization structure where the underlying pool of loans carries a floating interest rate, but investors prefer fixed-rate returns, an interest rate swap can be employed to convert the floating-rate payments into fixed-rate payments, ensuring alignment with investor expectations. However, it is important to note that interest rate swaps do not serve as credit enhancements, as their purpose is not to cover shortfalls in investor payments but rather to mitigate interest rate risk.

Additionally, since the Special Purpose Vehicle (SPV) legally owns the underlying loan pool, any interest rate swap arrangements must be executed by the SPV to effectively manage interest rate exposure within the securitization structure.

In respect of currency swaps these are particularly useful in cross-border securitization when the underlying asset pool is denominated in one currency, but investors require payments in another. For example: Suppose a SPV securitizes a pool of auto loans in India denominated in Indian Rupees (INR) but attracts global investors who prefer to receive payments in U.S. Dollars (USD). Since the cash inflows are in INR but the SPV needs to make payments to investors in USD, it is exposed to foreign exchange risk. To mitigate this, the SPV enters a currency swap agreement with a bank or financial institution. Under this agreement, the SPV exchanges INR denominated cash flows for USD at a predetermined exchange rate.

10. Tranched cover

For definition of tranched cover reference may be drawn to Basel: CRE 22, which defines “tranched cover” under para CRE 22.93 as: tranched cover is a mechanism of transfer of an exposure in one or more tranches to a protection seller or sellers. Further as per the definition of “tranched cover”some level of risk of the loan pool is required to be retained by the originator; and the risk transferred and the risk retained are of different seniority. Further as per the definition, tranched cover can only be provided for the senior tranches (eg second loss portion) or the junior tranche (eg first loss portion). Usually tranched covers are provided in the form of a guarantee issued by the protection seller or providing cash collateral by such a seller.

The graphic below shows the overall universe of securitisation exposure.

Figure: Summarizing the meaning of securitisation exposures

Other Resources 

We have over the years developed several other resources on securitisation. Should the reader wish to understand this area better, reference may be had to below comprehensive resources

1. Write-Ups and Reports 

• Securitisation Primer (For a primer on the basic principles underlying securitisation.) 
• Indian Securitisation Report, 2019 (For a holistic introduction to securitisation in India, the motivation for parties in a securitisation transaction, and regulatory framework for securitisation in India) 
• Vikas Path: The securitised path to Financial Inclusion (2024) (For curated resources on securitisation and co-lending, including: securitisation mechanics, accounting, tax aspects, compliance, etc.) 
• Taxation in Securitisation: A judicial overview 
• Securitisation of MSME receivables in India
• Our securitisation resource centre: For other write-ups and material in this space

2. Youtube Videos 

• What is Securitisation  
• Securitisation and Sale of Loans: The evolving regulatory regime 

3. Regulatory representations and Advocacy 

• Representation for Regulatory Amendments to Promote Securitisation in India
• Simple, Transparent and Comparable (STC) securitisation: Discrepancy in risk weights needing urgent remedy