More Than Enough: Overcollateralisation as credit enhancement in Securitisations 

Vinod Kothari, Dayita Kanodia and Archisman Bhattacharjee | finserv@vinodkothari.com

Overcollateralisation (OC) is a widely employed credit enhancement technique in securitisation transactions, serving as a layer of protection for investors. In essence, it refers to a situation where the value of the underlying asset pool exceeds the amount of the liabilities, that is, the securities issued. 

A simple illustration of OC is as follows: 

The total funding raised in a securitisation transaction (may be in one or more tranches) adds to Rs. 100 crores. The originator transfers loans having an outstanding principal equal to Rs. 107 crores. Here, Rs. 7 crores is OC, if the interest and principal collections on this piece of Rs. 7 crores are subordinated to the payments to the investors. That is to say, this is the seller’s subordinated share in the pool. The assets in the OC are not distinguished from the rest of the assets; that is, there is a non-distinct pool of Rs 107 crores serving to pay securities of Rs 100 crores. The OC amount, to the extent not used to meet defaults in the pool, will flow back to the originator. The OC assets of Rs 7 crores will, of course, return interest and principal during the term, as a part of the entire pool; whether the payments to the originator for the OC share of Rs 7 crores flow after all securities have been paid down, or these payments are wholly or partly released during the servicing period, is a part of the transaction structure, of course, subject to prioritising the payments due to the investors.

OC is intuitively the easiest form of credit support for the originator. It is just giving some extra assets, some more of the same type that the originator is being paid for. Like the potato vendor who weighs the potatoes, doesn’t mind adding that extra one piece so that the balance is tilting in favour of the buyer, the originator easily adds some extra assets, more so because he is not giving up the proprietary interest in these loans. 

There are various regulatory intricacies concerning OCs in securitisation transactions. This article discusses the treatment of OC along with some of the important questions concerning OCs.

OC vs other forms of credit enhancement

Points of Distinction	OC	Subordination	Excess spread	Cash Collateral
Part of MRR	Not a part of first loss facility. However can be taken to be a part of MRR if there is any other first loss facility	Yes	No	Yes
Part of Maximum Retention	Yes	Yes	No	Yes
Whether subordinated	Yes but may not be.	By definition, subordinated	Yes, mostly it is a Credit-enhancing IO strip.	Yes
Is it bankruptcy remote?	To the extent it is the asset of the originator, and is placed as collateral, it is a part of the bankruptcy estate of the originator; hence,not bankruptcy remote. This, however, may not affect investors	Yes. Bankruptcy remoteness relates to the transfer of the assets by the originator, whereas the subordinated tranche is merely an investment by the originator in the pool	Yes, the excess spread is an item in the waterfall. The placing of the item as the last item in the waterfall will not be altered by the originator’s insolvency	Originator’s retained interest in the transferred pool; may continue to be subjected to amortized cost accounting
Does it constitute a true sale?	In our view, it is a sale but not a true sale	Question does not arise	Question does not arise	It is collateral
How is it accounted for in the books of the originator?	Originator’s retained interest in the transferred pool; may continue to be subjected to armotised cost accounting	Originator’s investment in securitised assets; to be fair valued as per FVTPL (in case of equity tranche), and FVOCI (in case of non-equity tranches, depending on business model)	Originator’s retained interest, subject to FVTPL	Originator’s encumbered financial asset
Can it amortise over time, and the amortisation cashflows be paid over to the originator?	Yes	Yes	Not applicable	No, only subject to reset rules
Does it result in the build-up of the proportion of credit support as the pool amortises?	No, if it is amoritising over time. Yes, if it is used to turbo the payments to investors	No, if it is using a proportional paydown mode. Yes, if the structure is using a sequential paydown mode	Not applicable	Yes

Always subordinated or can represent seller’s pari passu interest ?

As discussed, OCs are a common form of credit enhancement. At the same time, over-collateralisation may simply be representing a seller’s pari passu interest, and may not be credit enhancing.

In the above example, say the Rs. 7 crores may also be the seller’s pari passu interest. This is quite common in case of revolving structures or the use of master trust structures. In that case, the seller’s interest is not subordinated, and hence, is not credit enhancing. Its intent is not to provide credit support, but simply to carve out a share from a larger pool or a larger asset, the remaining portion staying back with the originator. 

However, traditionally in India, OC is mostly structured as a credit support.  

OC as a part of MRR

In India, securitisation transactions by financial sector entities are governed by the Securitisation of Standard Assets Directions (‘SSA Directions’). The SSA Directions dictate that OCs cannot be considered as a part of the first loss facility for the purpose of Minimum Risk Retention (MRR) required to be maintained by the originator in the securitisation transactions. 

The Directions only prohibit considering ‘OC’ as a part of the ‘minimum risk’ that an originator is required to retain as per law. The MRR mandated by law, is necessarily required to be out of either the first loss facility and/or junior tranche. However, there is no bar on the originator to consider ‘OC’ as a part of the total risk retention in the securitisation, considering that actual risk retention is more than the MRR required. This is because OC, per se, is a form of risk retention. 

One possible angle for excluding OCs from the first loss facility could be that OC itself is a part of the asset pool, and is therefore, subject to the same losses that it intends to protect against. The source of the risk is the pool, of which the OC is a part, and the risk mitigant is also the OC – thereby creating a level of circularity.

Transfer of overcollateralized assets to SPV: whether a sale ?

In securitisation transactions, the pool of receivables, along with the associated risks and rewards (excluding limited elements such as the retained EIS and mandated minimum retention requirements), are typically transferred to investors. The investors thereby acquire an economic and legal right over the underlying receivables, which have been sold to a SPV, constituting a true sale. Although OC forms a part of the receivables assigned to the SPV, it is not transferred with the intention of giving the investors an independent economic interest in such assets. The rights over cashflows arising from the OC are contingent in nature, becoming relevant only upon occurrence of a default or shortfall in the primary securitised pool, or in certain cases as explained above OC can also sometimes represent originator’s pari passu interest. This implies that:

1. The cashflows from OC do not accrue to the investors under normal circumstances;
2. The economic benefit of OC continues to reside with the originator, unless a specific event (default/cashflow mismatches) triggers recourse to OC assets;
3. The originator retains the residual interest in OC, and such assets eventually revert to the originator once the securitisation obligations are fulfilled.

Hence, the OC component fails to satisfy the fundamental or indicative principles of a true sale, particularly:

1. Transfer of risks and rewards associated with the receivables;
2. Loss of control and economic benefit from the assets;
3. Payment of fair value for what is transferred – in case of OC, no value is paid to the originator..

Given the above, OC should be treated as a security interest/credit enhancement rather than a true asset transfer. OC is structurally similar to a collateral arrangement where the originator provides additional assets (in the form of CC/FD) to improve the credit quality of the transaction. This is evident in the following aspects:

1. The intention behind OC is to enhance investor confidence and support senior tranche ratings, not to convey economic ownership;
2. The originator continues to bear the risk of underperformance of the OC assets, while investors rely on the OC only on a conditional basis;
3. In line with legal principles of security creation, the OC assets serve a protective purpose, not one of ownership transfer.

Thus, from both a legal and economic standpoint, OC is best characterised as a form of subordinated collateral, credit support rather than as a true asset sale. OC is typically included in securitisation structures to absorb losses or support short-term liquidity mismatches, thereby enhancing investor protection. Despite such variations in structural design, the fundamental intention remains the same: the OC is not transferred with the objective of assigning all risks, rewards, and cash flows of the underlying assets to the SPV. Neither is the OC paid for.

Therefore, since: 

1. The entire beneficial interest in the OC is not transferred;
2. The originator retains a residual or superior economic right in OC cashflows;
3. The SPV or investors have only conditional rights over OC, triggered by specific events; and
4. The cashflows of the OC are not intended to be fully alienated from the originator;
5. No additional consideration is received for the transfer of OC.

Thus, irrespective of whether the OC is structured as subordinated support or pari passu participation, it should not be treated as a true sale of receivables to the SPV but rather as a security interest provided for credit protection purposes.

If it is not a sale, is it still an assignment?

Assignment does not necessarily imply an assignment by way of a sale. It is quite possible to do an assignment by way of security – that is, transfer interest in the receivables for serving as collateral. Thus, there is no change in the language of the assignment documentation; the entire amount of Rs 107 crores (in our example) is transferred. But given the fact that the originator is being paid for Rs 100 crores only, the understanding is the remaining Rs 7 crores is merely collateral.  

Accounting and Capital Treatment for OCs 

As discussed, assets forming part of OC are transferred to the SPV for the purpose of creating a security cover and cannot be considered to be a sale to the SPV. Accordingly, these assets continue to be shown in the books of the originator. Thus, assets in the nature of loan receivables continue to be shown as such on the books of the originator. 

The SSA Directions mandate providing full capital for all unrated exposures. Therefore, if the originator has an OC (which is always unlikely to be ever rated) of 10%, the capital requirement shall be equal to the size of the OC, i.e., there will be a need for 100% capital on the OC.

Tax Considerations

Securitisation transactions in India carried out by financial sector entities and covered by the SSA Directions are eligible for pass through tax treatment under section 115 TCA of the Income Tax Act (‘IT Act’). 

According to section 115TCA, any income accruing to or received by the investor shall be chargeable to income-tax in the same manner as if it were the income accruing or received by such person, had the investments by the securitisation trust been made directly by him. It requires the TDS to be deducted while distributing income to the investors which can then be offset by the investor against its tax liability. 

Therefore, section 115TCA provides a much needed tax relief for securitisation transactions. However, a question may arise regarding the tax treatment for the income received from the assets which are a part of the OC and whether such pass-through treatment under section 115TCA will be applicable to them. 

We have discussed how assets forming part of the OC are not a sale to the SPV but a mere security cover for the assets sold of the SPV for the purpose of issuance of securities. Accordingly, the question of applicability of the pass-through treatment does not arise. The income thus received on the overcollateralised portion will be taxed in the same manner as they were before. 

Whether assets sold under a securitisation transaction can be subject to encumbrance by the originator

Transfer of assets forming part of OC is a sale with a right of reversion. It is therefore in the nature of a conditional sale with the assets reverting to the originator to the extent that the same is not used for meeting defaults. 

Therefore, the OC portion cannot be subject to encumbrance by the originator.

Can overcollateralised assets be re-securitised after the completion of a securitisation transaction?

The OC is offered as a form of credit support or security cover to the securitisation transaction. During the term of the securitisation transaction, the repayments from the assets representing the OC will either be accelerated (in case of no defaults) or will be used to absorb the defaults. It is only the remaining assets that flow back to the originator. 

In our view, the return of these assets to the originator does not constitute a transfer from the trust back to the originator, as there was no transfer of full economic or beneficial interest in the OC assets in the first place. Rather, such reversion should be viewed as a release of the security interest upon the full satisfaction of investor obligations under the PTCs.

Accordingly, the movement of these assets back to the originator reflects the natural unwinding of a security arrangement, and not a fresh or reverse sale or assignment. Hence, these assets can be offered for re-securitisation almost immediately post-closure of the earlier securitisation transaction.

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