Indian Securitisation Awards, 2021

As the securitization market in India is on an upswing, it is time to recognize performance, innovation and service. Awards are not merely a sense of accomplishment – awards are to encourage players to move to better services and consistent performance. The awards will be given by the Indian Securitisation Foundation at the 9 th Securitisation Summit 2021 on November 18, 2021 at Four Seasons Hotel, Mumbai and may be handed over to the awardees during the Securitisation Summit.

Details for 9th Indian Securitisation Summit may be accessed at this Link.

FAQs on Securitisation of Standard Assets

We invite you all to join us at the Indian Securitisation Summit, 2021. You are sure to meet the who’s-who of the Indian structured finance space – the originators, investors, rating agencies, legal counsels, accounting experts, global experts, and of course, regulators. The details can be accessed here

On September 24, 2021, the RBI released Master Direction – Reserve Bank of India Securitisation of Standard Assets) Directions, 2021. The same has been released after almost 15 months of the comment period on the draft framework issued on June 08, 2020. This culminates the process that started with Dr. Harsh Vardhan committee report in 2019.

It is said that capital markets are fast changing, and regulations aim to capture a dynamic market which quite often leads the regulation than follow it. However, the just-repealed Guidelines continued to shape and support the securitisation market in the country for a good 15 years, with the 2012 supplements mainly incorporating the response to the Global Financial Crisis.

We bring you this frequently asked questions on Securitisation to assist you better understand the Directions.

The file can downloaded at this link: https://mailchi.mp/607563e4f4d0/faq-on-sec-guidelines

Securitisation-FAQ-contents

 

Loan Participations: The Rising Star of Loan Markets?

Anita Baid | anita@vinodkothari.com

Introduction 

The Reserve Bank of India (RBI) has issued the new guidelines, viz. Master Directions- Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 and Master Directions- Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021, on September 4, 2021, that replaces and supersedes the existing regulations on securitisation and direct assignment (DA) of loan exposures. The new directions have been made effective immediately which introduces several new concepts and compliance requirements.

The TLE Directionshave consolidated the guidelines with respect to the transfer of standard assets as well as stressed assets by regulated financial entities in one place. Further, the scope of TLE Directions covers any “transfer” of loan exposure by lenders either as transferer or as transferees/acquirers. In fact, the scope contains an outright bar on any sale or acquisition other than under the TLE Directions, and outside permitted transferors and transferees, apart from securitisation transactions.

Notably, the TLE Directions refer to all types of loan transfers, including sale, assignment, novation and loan participation. While the loan market in India is quite familiar[1] with assignments and novations, ‘loan participation’ to some, might appear to be an innovation by TLE Directions.  However, loan participation is not a new concept, and is quite popular in international loan markets, as we discuss below.

This article discusses the general concept of loan transfer and specifically delves into the ‘loan participation as a mode of such transfer. 

Loan Transfers: Assignment vs. Novation vs. Loan Participation

One of the important amendments under the TLE Directions has been the insertion of the definition of “transfer”, which is reproduced herein below- 

“transfer” means a transfer of economic interest in loan exposures by the transferor to the transferee(s), with or without the transfer of the underlying loan contract, in the manner permitted in these directions; 

Explanation: Consequently, the transferee(s) shall “acquire” the loan exposures following a loan transfer.  

This definition is customised to suit the objectives of the TLE Directions – that is, the TLE Directions would cover all forms of transfers where “economic interest” is transferred, but the legal ownership may or may not be transferred. This definition is specific to these Directions intended essentially to cover the transfer of economic interest, and is different from the common law definition of ‘transfer’. 

The provisions of TLE Directions are applicable to all forms of transfer of loans, irrespective of whether the loan exposures are in default or not. However, the TLE Directions limit the mode of transfer of stressed assets. Novation and assignment are the only ways of transferring stressed assets, whereas, in case of loans not in default, loan participation is also a mode of transfer. The said modes of loan transfers that have been permitted are not new and have existed even before. 

By inclusion of “loan participation” in the TLE Directions for the transfer of loans not in default means that the loans could be transferred by transferring an economic interest even without the transfer of legal title. However, in cases of loan transfers other than loan participation, legal ownership of the loan has to mandatorily be transferred. 

The graphic below summarises the various modes permissible mode of transfer of loans not in default, as per the TLE Directions:

In the case of assignments and novations, the assignee or transferee becomes the lender on record either by virtue of the assignment agreement (along with notice to the borrower) or by becoming a party to the underlying agreement itself. On the contrary, in the case of loan participation, the transfer is solely between the originator and the participant or transferee and thus creates no privity between the participant and the ultimate borrower. Under the participation arrangement, it is an understanding that the originator or lender on record passes to the participant whatever amount it receives from the borrower. Hence, by virtue of the transfer of the economic interest, there is a trust relationship created between the originator and the participant. 

The concept of Loan Participation

It is important to understand participation as a mode of transfer of economic interest under the TLE Directions. TLE Directions define loan participation as –

loan participation” means a transaction through which the transferor transfers all or part of its economic interest in a loan exposure to transferee(s) without the actual transfer of the loan contract, and the transferee(s) fund the transferor to the extent of the economic interest transferred which may be equal to the principal, interest, fees and other payments, if any, under the transfer agreement; 

Provided that the transfer of economic interest under a loan participation shall only be through a contractual transfer agreement between the transferor and transferee(s) with the transferor remaining as the lender on record

Provided further that in case of loan participation, the exposure of the transferee(s) shall be to the underlying borrower and not to the transferor. Accordingly, the transferor and transferee(s) shall maintain capital according to the exposure to the underlying borrower calculated based on the economic interest held by each post such transfer. The applicable prudential norms, including the provisioning requirements, post the transfer, shall be based on the above exposure treatment and the consequent outstanding.

Based on the aforesaid definition, it is essential to note the following-

  1. A loan exposure can be said to consist of two components- economic interest and legal title
  2. The economic interest in a loan exposure is not dependent on the legal title and can be transferred without a change in the lender on record
  3. In case of transfer of economic interest without legal title, the borrower interface shall be maintained entirely with the lender on record- hence, one of the benefits of loan participation would be that any amendments to the terms of the loan or restructuring could be done by the lender on record without involving the transferee
  4. The loan participation cannot be structured with priorities since the same may lead to credit enhancement- which is prohibited
  5. To the extent of loan participation based on the economic interest held post the transfer, income recognition, asset classification and provisioning must be done by the transferor and transferee, respectively

Note also, that para 12 of TLE Directions states that in loan participations, “by design”, the legal ownership remains with the originator (referred to as ‘grantor’ under TLE Directions), while whole or part of economic interest is passed on to the transferee (referred to as “participant” under TLE Directions). 

The following is therefore understood as regards loan participation –

  • Legal ownership is necessarily retained by the grantor, while it is only the ‘economic interest’ or a part of it, which is transferred to the participant.
  • As such, the originator remains the ‘face’ for the borrower, and is, therefore, called “lender on record”.
  • The TLE Directions do not prescribe any proportion (maximum/minimum) for which participation can happen. Though the Directions say that “all or part” of economic interest can be transferred. Also, the law seems flexible enough not to put any kind of restrictions on the categories or limits of economic interest which can be transferred. For instance, economic interest involves the right to receive repayments of principal as well as payments of interest (among others). The grantor can simply delineate these rights and grant participation for one but retain the other. 
  • The participant shall fund the grantor only to the extent of economic interest transferred in the former’s favour and nothing more. 
  • The participation has to be backed by a formal arrangement (agreement) between the parties

Post the “transfer”, the participant has no recourse on the grantor for the transferred interest. The recourse of both the grantor and the participant lies on the underlying borrower. Both these parties are required to maintain capital accordingly.

Essentially, the loan participation agreement, setting forth in detail the arrangement between the original lender and the participant, should specify the following- 

  1. that the transaction is a purchase of a specified percentage of a loan exposure by the participant, 
  2. the terms of the purchase of such participation, 
  3. the rights and duties of both parties, 
  4. the mechanism of holding and disbursing funds received from the borrower, 
  5. the extent of information to be shared with the participant, 
  6. the extent of right on collateral in the participated loan provided by the borrower, and
  7. procedures for exercising remedies and in the event of insolvency by any party, and clarification that the relationship is that of seller/purchaser as opposed to debtor/creditor

Is Loan Participation a True Sale?

The essential feature of loan participation is that the lender originating the loan remains in its role as the nominal lender and continues to manage the loan notwithstanding the fact that it may have sold off most or even all of its credit exposure. True Sale means that a sale truly achieves the objective of a sale, and being respected as such in bankruptcy or a similar situation. Securitisation and direct assignment transactions have inherently been driven by financing motives but they are structured as sale transactions. 

Essentially, the TLE Directions are entirely based on this crucial definition of ‘transfer’ which is stressing on the transfer of an economic interest in a loan exposure. Accordingly, even without transferring the legal title, the loan exposure could be transferred. Hence, the age-old concept of ensuring true sale in case of direct assignment transaction seems to have been done away with. 

However, the question that arises is whether in the case of secured loans, loan participation arrangements would transfer the right to collateral with the original lender or is it merely creating a contractual right against the originator towards proceeds of the collateral. This issue of the characterization of loan participation and when participations are true sales of loan interests has been discussed by the Iowa Supreme Courtin the case of Central  Bank and Real Estate Owned, L.L.C. v. Timothy C. Hogan, as Trustee of the Liberty and Liquidating Trust et. al., 891 N.W.2d 197 (Iowa 2017)

In this case, Liberty Bank extended loans between 2008 and 2009 to Iowa Great Lakes Holding, L.L.C. secured by the real estate and related personal property of a resort hotel and conference center. Liberty entered into participation agreements with five banks covering an aggregate of 41% (approximately) of its interest in these loans. The participation agreements were identical in terms; each provided that Liberty sold and the participant purchased a “participation interest” in the loans. It was held that Liberty had transferred an undivided interest in the underlying property, including the mortgage created on the property, pursuant to the participation agreements. The court ruled against Liberty Bank, reasoning that the participation agreements transferred “all legal and equitable title in Liberty’s share of the loan and collateral” to the participating banks. The participants were given undivided interests in the loan documents. In addition, the court noted that the default provisions emphasized that the participants shared in any of the collateral for the loan. 

Based on the discussion, the court suggested that participants should use the language of ownership, undivided fractional interest and trust, as well as avoid risk dilution devices to ensure that their interest is treated as an ownership and not a mere loan.

Loan Participation in US and UK

In the international financial market, loan participation has been a predominant component for a long time. The reason for favouring loan participation is that it allows participants to limit its exposure upto a particular credit and enable diversification of a portfolio without being involved in the servicing of loans.

The English law (prevalent in the UK) has widely adopted the Loan Market Association (LMA) recommendation that states- the lender of record (or grantor of the participation) must undertake to pay to the participant a percentage of amounts received from the borrower. This explicitly provides that the relationship between the grantor and the participant is that of debtor and creditor, provided the right of the participant to receive monies would be restricted to the extent of the assigned portion of any money received from any obligor. Hence, in case the grantor becomes insolvent, the participant would not enjoy any preferred status as a creditor of the grantor with respect to funds received from the borrower than any other unsecured creditor of the grantor. There are methods to structure transactions that enable participants to mitigate the risk of insolvency of the guarantor, as provided in the LMA’s paper ‘Funded Participations – Mitigation of Grantor Credit Risk’, however, these methods add complexity to what many regard as routine trades and are not generally adopted. 

In US banking parlance, these instruments are known simply as “participations”. The Loan Syndications and Trading Association (LSTA) had proposed that the relationship between grantor and participant shall be that of seller and buyer. Neither is a trustee or agent for the other, nor does either have any fiduciary obligations to the other. This Agreement shall not be construed to create a partnership or joint venture between the Parties. In no event shall the Participation be construed as a loan from participant to grantor. There have also been cases to draw a distinction between ‘true participation’ and ‘financing’. In a true participation, the participant acquires a beneficial ownership interest in the underlying loan. This means that the participant is entitled to its share of payments from the borrower notwithstanding the insolvency of the grantor (so the participant does not have to share those payments with the grantor’s other creditors) even though the beneficial ownership does not create privity between the participant and the borrower. On the other hand, a participation that is characterised as financing would have the same consequences as discussed above, which is to be considered at par with any other unsecured creditor of the grantor.

The following four factors typically indicate that a transaction is a financing rather than true participation: 

  1. the grantor guarantees repayment to the participant; failure by a participant to take the full risk of ownership of the underlying loan is a crucial indication of financing rather than a true participation
  2. the participation lasts for a shorter or longer-term than the underlying loan that is the subject of the participation; 
  3. there are different payment arrangements between the borrower and the grantor, on the one hand, and the grantor and the participant, on the other hand; and 
  4. there is a discrepancy between the interest rate due on the underlying loan and the interest rate specified in the participation. 

Apart from the similarity in the basic structure and business impetus for participation, the legal characterisation of these arrangements and some of their structural elements are different under UK and US law.

Conclusion

The recognition of this concept of loan participation would expand the scope for direct assignment arrangements and hence, there seems a likely increase in the numbers as well. However, it must be ensured that such arrangements are structured with care and keeping in mind the learnings from precedents in the markets outside India, to avoid any discrepancies and disputes in the future between the originator and the participant.

________________________________________________________________________________________________________________________________

[1] In India, during Q1 2020-21, DA transactions were around Rs.5250 crore, which was 70% of the total securitisation and DA volumes. With a growth of 2.3 times in the total volume of securitisation and DA transactions (due to the pandemic the number may be an outlier), in Q1 2021-22, the DA transactions aggregated to Rs.9116 crores, with a reduced share of 53% [Source: ICRA Research]

We invite you all to join us at the Indian Securitisation Summit, 2021. You are sure to meet the who’s-who of the Indian structured finance space – the originators, investors, rating agencies, legal counsels, accounting experts, global experts, and of course, regulators. The details can be accessed here

 

One stop RBI norms on transfer of loan exposures

– Financial Services Division (finserv@vinodkothari.com)

[This version dated 24th September, 2021. We are continuing to develop the write-up further – please do come back]

We invite you all to join us at the Indian Securitisation Summit, 2021. The details can be accessed here

The RBI has consolidated the guidelines with respect to transfer of standard assets as well as stressed assets by regulated financial entities under a common regulation named Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 (“Directions”).

The Directions divided into five operative chapters- the first one specifying the scope and definitions, the second one laying down general conditions applicable on all loan transfers, the third one specifying the requirements in case of transfer of loans which are not in default, that is standard assets, the fourth one provides the additional requirement for transfer of stressed assets and the fifth chapter is on disclosure and reporting requirements.

Under the said Directions, the following entities are permitted as transferor and transferee to transfer loans-

Permitted Transferors Permitted Transferees
Scheduled Commercial Banks; Scheduled Commercial Banks;
All India Financial Institutions Th(NABARD, NHB, EXIM Bank, and SIDBI); All India Financial Institutions (NABARD, NHB, EXIM Bank, and SIDBI);
Small Finance Banks; Small Finance Banks;
All Non Banking Finance Companies (NBFCs) including Housing Finance Companies (HFCs); All Non Banking Finance Companies (NBFCs) including Housing Finance Companies (HFCs)
Regional Rural Banks; 

(only for stressed loans under Chapter IV)

Asset Reconstruction Companies registered with the Reserve Bank of India under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; 

(only for stressed loans under para 58)

Primary (Urban) Co-operative Banks/State Co-operative Banks/District Central Co-operative Banks; 

(only for stressed loans under Chapter IV)

A company, as defined in sub-section (20) of Section 2 of the Companies Act, 2013 other than a financial service provider as defined in sub-section (17) of Section 3 of the Insolvency and Bankruptcy Code, 2016. Acquisition of loan exposures by such companies shall be subject to the relevant provisions of the Companies Act, 2013 

(only for stressed loans under para 58)

An entity incorporated in India or registered with a financial sector regulator in India and complying with the other conditions under clause 58 

(only for stressed loans under para 58)

Coverage

The Directions state that no lender shall undertake any loan transfers or acquisitions other than those permitted and prescribed under the Directions and the provisions of Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021. Therefore,  loans originated by the Transferor (mentioned above) cannot be transferred outside the purview of the aforesaid guidelines. Accordingly, the loans cannot be transferred to anyone, other than the transferee mentioned above, hence, this would now prohibit any loan transfers that happened outside the purview of the Directions. This in turn would also restrict covered bonds transactions wherein the loan pool was assigned to an SPV- unless the same is specifically permitted by the RBI. However, if the transfer does not result in transfer of economic interest, the same shall not be considered as a ‘transfer’ per se. Hence, covered bonds transactions that are structured in a way that the legal title is transferred, however, the economic interest is retained by the originator, the same shall be considered as ‘loan transfer’. 

At the time of occurence of default, the actual loan transfer happens and the same shall be

Further, the Directions shall be applicable even in case of sale of loans through novation or assignment, and loan participation.

In cases of loan transfers other than loan participation, legal ownership of the loan shall be mandatorily transferred to the transferee(s) to the extent of economic interest transferred.

Meaning of the word ‘Transfer’

The term transfer has been defined to mean a transfer of economic interest in loan exposures by the transferor to the transferee(s), with or without the transfer of the underlying loan contract, in the manner permitted in the Directions.

It is to be noted that loan participation transaction have also been recognised under the Directions (for transfer of standard loans) wherein the transferor transfers all or part of its economic interest in a loan exposure to transferee(s) without the actual transfer of the loan contract, and the transferee(s) fund the transferor to the extent of the economic interest transferred which may be equal to the principal, interest, fees and other payments, if any, under the transfer agreement.

General Conditions on all loan transfers

The Directions lays down some generic requirements on all loan transfers. Some of the crucial ones are as follows:

  1. Having a board approved policy
  2. Must result in transfer of economic interests without resulting in a change in underlying terms and conditions of the loan contract.Must result in transfer of economic interests without resulting in a change in underlying terms and conditions of the loan contract.
  3. Clearly delineated roles and responsibilities of the transferor and the transferee
  4. No credit enhancement or liquidity facilities in any form
  5. Transferor cannot reacquire, except as a part of Resolution Plan
  6. Immediate separation of the transferor from the risks and rewards associated with loans
    1. For retained exposure- the loan transfer agreement should clearly specify the distribution of the principal and interest income from the transferred loan between the transferor and the transferee(s)
  7. Transferee to get right to transfer or dispose off the loans transferred
  8. Rights of obligors not to be affected Immediate separation of the transferor from the risks and rewards associated with loans
    1. For retained exposure- the loan transfer agreement should clearly specify the distribution of the principal and interest income from the transferred loan between the transferor and the transferee(s)
  9. Transferee to get right to transfer or dispose off the loans transferred
  10. Rights of obligors not to be affected
  11. Monitor on an ongoing basis and in a timely manner performance information on the loans acquired, including through conducting periodic stress tests and sensitivity analyses, and take appropriate action required, if any.

The aforesaid clauses are applicable on all loan transfers under the Directions- this should not include the ones exempted from the purview of the Directions. The transactions that are specified under the exclusion list should be exempted from the applicability of the entire guidelines. However, the language is suggesting that the aforesaid general conditions including the requirement of not having any form of credit enhancement is applicable, even if the transaction is exempt from purview of Chapter III regulations on Transfer of Standard Assets.

Transferor as a service provider

As allowed under the existing guidelines as well, the transferor may act as servicing facility provider for the loans transferred. While appointing a servicing facility provider, following conditions must be fulfilled:

  • Execution of written agreement outlining:
    • nature and purpose and extent of services, 
    • standards of performance
    • duration (limited to amortisation of loans, payment of all claims of transferee or termination by parties) 
    • Right of transferee to appoint other facility provider
    • No obligation on facility provider, being transferor, to transfer funds until they are received;
    • Facility provider, being transferor, must hold cashflows in trust for transferee and avoid commingling
  • Facility to be on arm’s length basis;
  • Fee must not be subject to deferral, waiver or non-payment clauses; Also, no recourse to servicing facility provider beyond contractual obligations;

Transfer of Standard Loans

Transfer of all standard loans, except the following, shall be covered under the Directions:

Exclusion List:

●      transfer of loan accounts of borrowers by a lender to other lenders, at the request/instance of borrower;

●      inter-bank participations covered by the circular DBOD.No.BP.BC.57/62-88 dated December 31, 1988 as amended from time to time;

●      sale of entire portfolio of loans consequent upon a decision to exit the line of business completely;

●      sale of stressed loans; and

●      any other arrangement/transactions, specifically exempted by the RBI

Minimum Risk Retention

The Directions specifically require that the due diligence in respect of the loans cannot be outsourced by the transferee(s) and should be carried out by its own staff, at the level of each loan, with the same rigour and as per the same policies as would have been done for originating any loan.

However, in case of loans acquired as a portfolio, in case a transferee is unable to perform due diligence at the individual loan level for the entire portfolio, the transferor has to retain at least 10% of economic interest in the transferred loans. In such a case as well, the transferee shall perform due diligence at the individual loan level for not less than one-third of the portfolio by value and number of loans in the portfolio and at the portfolio level for the remaining.

In case of multiple transferees, the MRR would still be on the entire amount of transferred loan, even if any one of the transferees is unable to perform the DD at individual level.

The following graphic summarises the position of MRR in case of transfer of loan exposures:

Minimum Holding Period

Under the erstwhile framework, there were three blocks of minimum holding periods, however under the new Directions there are two major brackets – one for loans with original maturity less than 2 years and one with more than 2 years. The table below summarises the MHP requirements for different classes of loans:

  Secured Loans

 

Unsecured Loans Project loans Acquired Loans
Loan Tenor MHP MHP MHP MHP
Upto 2 years 3 months  from the date of registration of the underlying security interest 3 months  from the date of first repayment of the loan 3 months  from the date of commencement of commercial operations of the project being financed Six months from the date on which the loan was taken into the books of the transferor
More than 2 years 6 months from the date of registration of the underlying security interest 6 months from the date of first repayment of the loan 6 months from the date of commencement of commercial operations of the project being financed
MHP requirement is not applicable to loans transferred by the arranging bank to other lenders under a syndication arrangement

 The intent of having a MHP is to ensure that the loan has been seasoned in the books of the originator for a certain specified time period. However, in case of secured loans, the MHP is being counted from the date of creation of security interest- this does not seem to be in sync with the intent of having a MHP.

Accounting of transfer of loans

If the transfer of loans result in loss or profit, which is realised, should be accounted for accordingly and reflected in the Profit & Loss account of the transferor for the accounting period during which the transfer is completed. However, unrealised profits, if any, arising out of such transfers, shall be deducted from CET 1 capital or net owned funds for meeting regulatory capital adequacy requirements till the maturity of such loans.

Borrower-wise accounts will have to be maintained for the loans transferred and retained by the transferee and the transferor, respectively.

The income recognition, asset classification, and provisioning norms will be followed by the transferor and the transferee with respect to their share of holding in the underlying account(s).

Transfer of Stressed Loans

The transfer of stressed loans can be done through assignment or novation only; loan participation is not permitted in the case of stressed loans. .In general, lenders shall transfer stressed loans, including through bilateral sales, only to permitted transferees and ARCs

Contents of the Board approved policies on Transfer and / or acquisition of Stressed Loans:

●      Norms and procedure for transfer or acquisition of such loans;

●      Manner of transfer- including e-auctions;

●      Valuation methodology to be followed to ensure that the realisable value of stressed loans, including the realisability of the underlying security interest, if available, is reasonably estimated;

●      Delegation of powers to various functionaries for taking decision on the transfer or acquisition of the loans;

●      Stated objectives for acquiring stressed assets;

●      Risk premium to be applied considering the asset classification, for discounting the cashflows to arrive at the difference between the NPV of the cashflows estimated while acquiring the loan and the consideration paid for acquiring the loan;

●      Process of identification of stressed loans beyond a specified value;

●      Price discovery and value maximization approach;

The Directions also restrict the transferor to not assume any operational, legal or any other type of risks relating to the transferred loans including additional funding or commitments to the borrower / transferee(s) with reference to the loan transferred. Any fresh exposure on the borrower can be taken only after a cooling period laid down in the respective Board approved policy, which in any case, shall not be less than 12 months from the date of such transfer.

Transfer of stressed loans undertaken by way of a resolution plan

In case of transfer of stressed loans undertaken as a resolution plan under the RBI (Prudential Framework for Resolution of Stressed Assets) Directions, 2019 resulting in an exit of all lenders from the stressed loan exposure, such transfer is permitted to the prescribed class of entities, including a corporate entity, that are permitted to take on loan exposures in terms of a statutory provision or under the regulations issued by a financial sector regulator, a

However, in case such transferee(s) are neither ARCs nor permitted transferees, the transfer shall be additionally subject to the following conditions:

  • The transferee entity should be incorporated in India or registered with a financial sector regulator in India (Securities and Exchange Board of India, Insurance Regulatory and Development Authority of India, Pension Fund Regulatory and Development Authority, and International Financial Services Centres Authority).
  • The transferee should not be classified as a non-performing account (NPA) by any lending institution at the time of such transfer;
  • The transferee(s) should not fund the loan acquisition through loans from Permitted Transferors.
  • Permitted transferors should not grant any credit facilities apart from working capital facilities (which are not in the nature of term loans) to the borrower whose loan account is transferred, for at least three years from the date of such transfer.
  • Further, for at least three years from the date of such transfer, the Permitted Transferors should not grant any credit facilities to the transferee(s) for deployment, either directly or indirectly, into the operations of the borrower.

Accounting treatment in the books of the transferee

Treatment of stressed loan in the books of the transferee for the purpose of prudential requirements such as asset classification, capital computation, income recognition shall be as follows-

Pool of stressed loans acquired on a portfolio basis shall be treated as a single asset provided that the pool consists of homogeneous personal loans.

 

Homogeneity should be assessed on the basis of common risk drivers, including similar risk factors and risk profiles.

In all other cases, the stressed loans acquired shall be treated as separate assets

Additional requirement for Transfer of NPAs

For Transferor For Transferee
Continue to pursue the staff accountability aspects as per the existing instructions in respect of the NPAs transferred Cash flows in excess of the acquisition cost, if any, can be recognised as profit only after amortising the funded outstanding in the books, in respect of the loans
If classified as standard upon acquisition, assign 100% risk weight to the NPA

 

If classified as NPA, risk weights as applicable to NPA shall be applicable

Additional requirement for Transfer to ARCs

The following stressed loans may be transferred to ARCs:

  • loans in default for more than 60 days
  • classified as NPA
  • Including loans classified as fraud as on the date of transfer- along with proceedings related to such complaints shall also be transferred to the ARC

The Directions provide for sharing of surplus between the ARC and the transferor, in case of specific stressed loans. The Directions, however, do not specify what kinds of stressed loans these will be.

Further, the Directions also allow repurchase of the accounts from ARCs where the resolution plan has been successfully implemented.

The Directions also allow ARCs to take over loans only for the purpose of recovery (as recovery agents), without the same being removed from the Originator’s books. In such cases, the loans shall be treated as existing in the books of the Originator only.

Swiss Challenge Method[1]

Swiss Challenge method would be mandatory in the following cases:

  1. In case of a bilateral transfer of stressed loans on a bilateral basis, if the aggregate exposure (including investment exposure) of lenders to the borrower/s whose loan is being transferred is Rs.100 crore or more
  2. In case of transfer of stressed loans undertaken as a resolution plan under the Reserve Bank of India (Prudential Framework for Resolution of Stressed Assets) Directions, 2019 with the approval of signatories to the intercreditor agreement (ICA) representing 75% by value of total outstanding credit facilities (fund based as well non-fund based) and 60% of signatories by number, for the exit of all signatories to the ICA from the stressed loan exposure, irrespective of any exposure threshold.

Disclosure and Reporting Requirement

Appropriate disclosures shall be made in the financial statements, under ‘Notes to Accounts’, relating to the following

  1. total amount of loans not in default / stressed loans transferred and acquired to / from other entities as prescribed under the Directions, on a quarterly basis starting from the quarter ending on December 31, 2021
  2. quantum of excess provisions reversed to the profit and loss account on account of sale of stressed loans
  3. distribution of the SRs held across the various categories of Recovery Ratings assigned to such SRs by the credit rating agencies

Additionally, transferors must maintain a database of loan transfer transactions with adequate MIS concerning each transaction till a trade reporting platform is notified by the RBI.

 

[1] Refer our write-up on Swiss Challenge Method- https://vinodkothari.com/wp-content/uploads/2017/03/sale_stressed_assets-1.pdf

 

Refer our write-up on revised securitisation guidelines here- https://vinodkothari.com/2021/09/rbi-master-directions-on-securitisation-of-standard-assets-and-transfer-of-loan-exposures/ 

After 15 years: New Securitisation regulatory framework takes effect

-Financial Services Division (finserv@vinodkothari.com)

[This version dated 24th September, 2021. We are continuing to develop the write-up further – please do come back]

We invite you all to join us at the Indian Securitisation Summit, 2021. The details can be accessed here

On September 24, 2021, the RBI released Master Direction – Reserve Bank of India Securitisation of Standard Assets) Directions, 2021 (‘Directions’)[1]. The same has been released after almost 15 months of the comment period on the draft framework issued on June 08, 2020[2]. This culminates the process that started with Dr. Harsh Vardhan committee report in 2019[3].

It is said that capital markets are fast changing, and regulations aim to capture a dynamic market which quite often leads the regulation than follow it. However, the just-repealed Guidelines continued to shape and support the securitisation market in the country for a good 15 years, with the 2012 supplements mainly incorporating the response to the Global Financial Crisis (GFC).

Considering the fact that securitisation, along with its regulatory alternative (direct assignment) has become a very important channel of inter-connectivity and bridging between the non-banking finance companies and the banking sector, and since the ILFS crisis, has been almost existential for NBFCs, it is very important to examine how the new regulatory framework will support securitisation market in India.

By way of highlights:

  • The bar on securitisation of purchased loans has been removed; there is a holding period requirement for acquired loans, after which the same may be securitised.
  • The risk retention requirement for residential mortgage backed transactions has been reduced to 5%.
  • Minimum holding period reduced to 6 months maximum, whereas it will be 3 months in case of loans with a tenure of upto 2 years.
  • In line with EU and other markets, there is a new framework for simple, transparent and comparable (STC) securitisations, which will qualify for lower capital requirements for investors.
  • Ratings-based risk weights introduced for securitisation transactions, adopting the ERB approach of global regulators.
  • Direct assignments continue to be subjected to the familiar criteria – no credit enhancement or liquidity facility, adherence to MHP, etc. However, risk retention criteria in case of direct assignments, called Transfer of Loan Exposures, have been removed, except where the buyer does not do a due diligence for all the loans he buys.
  • By defining who all could be permitted transferees of loans, the fledgling market for sale of loans through electronic platforms, to permit retail investors to participate in the loan market, completely nipped in its bud.

Scope of Applicability

Effective date:

The Directions are applicable with immediate effect. This should mean, any transaction done or after the date of the notification of the Directions must be in compliance therewith. Para 4 of the Directions clearly provides that any transaction of securitisation “undertaken” subsequent to the notification of the Directions will have to comply with the same. This implies that 24th September is the last date for any securitisation transaction under the erstwhile Guidelines.

The immediate implementation of the new Directions may create difficulties for transactions which are mid-way. Para 4 refers to transactions undertaken after the notification date. What is the date of “undertaking” a transaction for determining the cut-off date? Quite often, securitization transactions involve a process which may be spread over a period of time. The signing of the deed of assignment is mostly the culmination of the process. In our view, if the transaction is already mid-way, and effective term sheets have been signed with investors within the 24th September, it will be improper to disrupt that which has already been structured.

Lending entities covered:

As proposed in the Draft Directions, the Directions are applicable to banks and small finance banks (excluding RRBs), all India Term financing institutions (NABARD, NHB, EXIM Bank, and SIDBI), NBFCs and HFCs. These institutions are referred to as Lenders (or Originators) herein.

Eligible Assets

What is not eligible:

The Directions provide a negative list i.e. list of the assets that cannot be securitised. These are:

  1. Re-securitisation exposures;
  2. Structures in which short term instruments such as commercial paper, which are periodically rolled over, are issued against long term assets held by a SPE. Thus, what is globally prevalent as “asset backed commercial paper” (ABCP) has been ruled out. ABCP transactions were seen as responsible for a substantial liquidity crisis during the GFC regime, and Indian regulators seem to have shunned the same.
  3. Synthetic securitisation; and
  4. Securitisation with the following assets as underlying:
    1. revolving credit facilities
    2. Restructured loans and advances which are in the specified period; [Notably, the Directions do not seem to define what is the “specified period” during which restructured facilities will have to stay off from the transaction. It appears that the bar will stay till the facility comes out of the “substandard” tag. This becomes clear from para 8 of the Directions.
    3. Exposures to other lending institutions;
    4. Refinance exposures of AIFIs; and
    5. Loans with bullet payments of both principal and interest as underlying;

The draft guidelines did not exclude 2, 3, 4(b), (c) and (d) above. It is noteworthy that the exposure to other lending institutions has also been put in the negative list. Further, synthetic securitisation, on which several transactions are based, also seems to be disallowed.

Apart from the above, all other on-balance sheet exposures in the nature of loans and advances and classified as ‘standard’ will be eligible to be securitised under the new guidelines.

With respect to agricultural loans, there are additional requirements, as prescribed in the draft directions. Further, MHP restrictions shall not be applicable on such loans.

What is not not eligible, that is, what is eligible:

It is also important to note that the bar on securitisation of loans that have been purchased by the originator goes away. On the contrary, Explanation below para 5 (l) [definition of Originator] clearly states that that the originator need not be the original lender; loans which were acquired from other lenders may also be the part of a securitisation transaction. Further, Para 9 provides that the respective originators of the said assets transferred to the instant originator should have complied with the MHP requirements, as per the TLE Directions.

At the same time, a re-securitisation is still negative listed. That is, a pool may consist of loans which have been acquired from others (obviously, in compliance with TLE Directions), but may not consist of a securitisation exposure.

Another notable structure which is possible is securitisation of a single loan. This comes from proviso to para 5 (s). This proposal was there in the draft Directions too. While, going by the very economics of structured finance, a single loan securitisation does not make sense, and reminds one of the “loan sell off” transactions prior to the 2006 Guidelines, yet, it is interesting to find this clear provision in the Directions.

Rights of underlying obligors

Obligors are borrowers that owe payments to the originator/ lender. Securitisation transactions must ensure that rights of these obligors are not affected. Contracts must have suitable clauses safeguarding the same and all necessary consent from such obligors must be obtained.

MRR Requirements

Underlying Loans MRR Manner of maintaining MRR
Original maturity of 24 months or less 5% Upto 5%-

●      First loss facility, if available;

●      If first loss facility not available/ retention of the entire first loss facility is less than 5%- balance through equity tranche;

●      Retention of entire first loss facility + equity tranche  < 5%- balance pari passu in remaining tranches sold to investors

 

Above 5%

●      First loss facility, or

●      equity tranche or

●      any other tranche sold to investors

●      combination thereof

In essence, the MRR may be a horizontal tranche, vertical tranche and a combination of the two (L tranche]. If the first loss tranche is within 5%, the first loss tranche has to be originator-retained, and cannot be sold to external investors. However, if the first loss tranche is more than 5%, it is only 5% that needs to be regulatorily retained by the originator.

 

 

Original maturity of more than 24 months

 

10%
Loans with bullet repayments
RMBS (irrespective of maturity) 5%

Para 14, laying down the MRR requirements, uses two terms – equity tranche and “first loss facility”. While the word “first loss facility” is defined, equity tranche is not. Para 5(h) defines “first loss facility” to include first level of financial support provided by the originator or a third party to improve the creditworthiness of the securitisation notes issued by the SPE such that the provider of the facility bears the part or all of the risks associated with the assets held by the SPE .

However, Explanation below para 14 may be the source of a substantial confusion as it says OC shall not be counted as a part of the first loss facility for this purpose.

What might be the possible interpretation of this (euphemistically termed as) Explanation? OC is  certainly a form of originator support to the transaction, and economically, is a part of the first loss support. However, first loss support may come in different ways, such as originator guarantee, guarantee from a third party, cash collateral, etc. Equity tranche, deriving from the meaning of the word “tranche” which includes both the notes as also other forms of enhancement. Therefore, what the Explanation is possibly trying to convey is that in capturing the equity or first loss tranche, which, upto 5%, has to be  originator-retained, the OC shall not be included.

This, however, does not mean that the OC will not qualify for MRR purposes. OC is very much a part of the originator’s risk retention; however, in constructuring the horizontal, vertical and L tranche of transactions, the OC shall not be considered.

To give examples:

  • A transaction has 15% OC, and then a AAA rated tranche: In this case, the original has the 15% OC which meets the MRR requirement. He does not need to have any share of the senior tranches. This point, looking at the language of the Explanation, may be unclear and may, therefore, reduce the popularity of OC as a form of credit enhancement.
  • A transaction as 5% OC, 5% junior tranche, and remaining 95% as senior tranche. The originator needs to hold the entire 5% junior tranche (assuming original maturity > 24 months).
  • A transaction has 5% OC, 2% junior tranche, and 98% senior tranche. The originator needs to hold the entire 2% junior tranche, and 3% of the 98% senior tranche.

Para 16 first clarifies what is though clear from the 2006 Guidelines as well – that the requirement of retention of MRR through the life of the transaction does not bar amoritisation of the MRR. However, if MRR comes in forms such as cash collateral, it cannot be reduced over the tenure, except by way of absorption of losses or by way of reset of credit enhancements as per the Directions.

Listing Requirements

The Directions specify a minimum ticket size of Rs. 1 crore for issuance of securitisation notes. This would mean an investor has to put in a minimum of Rs 1 crore in the transaction. Further, the Directions also state that in case securitisation notes are offered to 50 or more persons, the issuance shall mandatorily be listed on stock exchange.

Interestingly, the limit of 50 persons seems to be coming from the pre-2013 rules on private placements; the number, now, is 200. It is typically unlikely that securitisation transactions have 50 or more investors to begin with. However, recently, there are several portals which try to rope in non-traditional investors for investing in securitisation transactions. These portals may still do a resale to more than 50; it is just that the number of investors at the inception of the transaction cannot be more than 49. Also, if there are multiple issuances, the number applies to each issuance. The number, of course, has to be added for multiple tranches.

The Draft Directions stated a issuance size based listing requirement in case of RMBS, as against the investor group size based requirement prescribed in the Directions.

SPE requirements

SPE requirements are largely routine. There is one point in para 30 (d) which may cause some confusion – about the minimum number of directors on the board of the SPE. This is applicable only where the originator has the right of nominating a board member. If the originator has no such right, there is no minimum requirement as to the board of directors of the SPE. In any case, it is hard to think of SPEs incorporated in corporate form in India.

Accounting provisions

The Directions give primacy to accounting standards, as far as NBFCs adopting IndAs are concerned. In such cases, upfront recognition of profit, as per “gain on sale” method, is explicitly permitted now. As for other lenders too, if the gain on sale is realised, it may be booked upfront.

Unrealised gains, if any, should be accounted for in the following manner:

  1. The unrealised gains should not be recognised in Profit and Loss account; instead the lenders shall hold the unrealised profit under an accounting head styled as “Unrealised Gain on Loan Transfer Transactions”.
  2. The profit may be recognised in Profit and Loss Account only when such unrealised gains associated with expected future margin income is redeemed in cash. However, if the unrealised gains associated with expected future margin income is credit enhancing (for example, in the form of credit enhancing interest-only strip), the balance in this account may be treated as a provision against potential losses incurred.
  3. In the case of amortising credit-enhancing interest-only strip, a lender would periodically receive in cash, only the amount which is left after absorbing losses, if any, supported by the credit-enhancing interest-only strip. On receipt, this amount may be credited to Profit and Loss account and the amount equivalent to the amortisation due may be written-off against the “Unrealised Gain on Loan Transfer Transactions” account bringing down the book value of the credit-enhancing interest-only strip in the lender’s books.
  4. In the case of a non-amortising credit-enhancing interest-only strip, as and when the lender receives intimation of charging-off of losses by the SPE against the credit-enhancing interest-only strip, it may write-off equivalent amount against “Unrealised Gain on Loan Transfer Transactions” account and bring down the book value of the credit-enhancing interest-only strip in the lender’s books. The amount received in the final redemption value of the credit-enhancing interest-only strip received in cash may be taken to the Profit and Loss account.

STC securitisations

Having a simple, transparent and comparable (STC) label for a securitisation transaction is a very important factor, particularly for investors’ acceptability of the transaction. Securitisation transactions are structured finance transactions –the structure may be fairly complicated. The transaction may be bespoke – created with a particular investor in mind; hence, the transaction may not be standard. Also, the transaction terms may not have requisite transparency.[4]

Simple transparent and comparable securitisations qualify for relaxed capital requirements. STC structures are currently prevalent and recognised for lower capital requirements in several European countries. The transactions are required to comply with specific guidelines in order to obtain a STC label. The Basel III guidelines set the STC criteria for the purpose of alternative capital treatment.

The STC criteria inter-alia provides for conditions based on asset homogeneity, past performance of the asset, consistency of underwriting etc.The Para 37 of the Directions provides that securitisations that additionally satisfy all the criteria laid out in Annex 1 of the Directions can be subject to the alternative capital treatment. The criteria mentioned in the Directions are at par with requirements of Basel III regulations.

Investors to the STC compliant securitisation are allowed relaxed risk-weights on the investment made by them.

The Directions further require, originator to disclose to investors all necessary information at the transaction level to allow investors to determine whether the securitisation is STC compliant.

STC criteria need to be met at all times. Checking the compliance with some of the criteria might only be necessary at origination. .In cases where the criteria refer to underlying, and the pool is dynamic, the compliance with the criteria will be subject to dynamic checks every time that assets are added to the pool.

Facilities supporting securitisation structures

A securitisation transaction may have multiple elements – like credit enhancement, liquidity support, underwriting support, servicing support. These are either provided by the originator itself or by third parties. The Directions aim to regulate all such support providers (“Facility Providers”).  The Directions require the Facility Providers to be regulated by at least one financial sector regulator. For this purpose, in our view, RBI, IRDAI, NHB, SEBI etc. may be considered as financial sector regulators.

Common conditions for all Facilities

For provision of any of the aforesaid facilities, the facility provider must fulfill the following conditions:

  • Proper documentation of the nature, purpose, extent of the facility, duration, amount and standards of performance
  • Facilities to be clearly demarcated from each other
  • On arm’s length basis
  • The fee of the Facility Provider should not be subject to subordination/waiver
  • No recourse to Facility Provider beyond the obligations fixed in the contract
  • Facility Provider to obtain legal opinion that the contract does not expose it to any liability to the investors

Credit Enhancement Facilities

In addition to the above mentioned conditions, following conditions must be fulfilled by the Facility Provider:

  • To be provided only at initiation of transaction
  • Must be available to SPV at all times
  • Draw downs to eb immediately written-off

Liquidity facilities

The provisions about liquidity facilities are substantially similar to what they have been in the 2006 Guidelines. However, the provisions of 2006 Guidelines and the Draft Directions requiring co-provision of liquidity facility to the extent of 25% by an independent party have been omitted. This would mean, the originator itself may now be able to provide for the liquidity facility if an independent party could not be identified or in any other case.

Underwriting facilities

Underwriting is hardly common in case of securitisations, as most issuances are done on bespoke, OTC basis. Again, most of the provisions in the Directions relating to underwriting are similar to the 2006 Guidelines with one difference. The 2006 Guidelines required Originators (providing underwriting facilities) to reduce Tier 1 and Tier 2 capital by the amount of holdings (if it is in excess of 10% of the issue size) in 50-50 proportion.

The Directions are silent on the same.

Servicing facilities

Third party service providers have started emerging in India, particularly by way of  necessity (forced by events of default  of certain originators) rather than commercial expediency.

The provisions of the Directions in para 59-60 are applicable even to proprietary servicing, that is, the originator acting as a servicer, as well as a third party servicer.

It is important to note that arms’ length precondition [Para 45 (b) ] is applicable to originator servicing too. Hence, if the servicing fees are on non-arms’ length terms, this may certainly amount to a breach of the Directions. The other requirement of para 45 (e) seems also critical – the payment of servicing fee should not be subordinated. There should not be any bar on structuring a servicing fee in two components – a fixed and senior component, and an additional subordinated component. This is common in case of third party servicers as well.

Lenders who are investors

The meaning of “lenders” who are investors, in Chapter V, should relate to the entities covered by the Directions, that is, banks, NBFCs, HFCs and term lending institutions, who are investing money into securitisation notes. Obviously, the RBI is not meant to regulate other investors who are outside RBI’s regulatory ambit. The part relating to stress testing was there in the earlier Guidelines too – this finds place in the Directions.

It is also made clear that the investors’ exposure is not on the SPE, but on the underlying pools. Hence, the see-through treatment as given in Large Exposures Framework applies in this case.

Capital requirements

Capital has to be maintained in all securitisation exposures, irrespective of the nature of the exposure an entity is exposed to. If the securitisation transaction leads to any realised or unrealised gain, the same must be excluded from the Common Equity Tier 1 or Net owned Funds, and the same must be deferred till the maturity of the assets.

Further, if an entity has overlapping exposures, and if one exposure precludes the other one by fulfilment of obligations of the former, then the entity need not maintain capital on the latter. For example, if an entity holds a junior tranche which provides full credit support to a senior tranche, and also holds a part of the senior tranche, then its exposure in the junior tranche precludes any loss from the senior tranche. In such a situation, the entity does not have to assign risk-weights to the senior tranche.

Liquidity facilities

For the liquidity facilities extended in accordance with Chapter IV of the Directions, capital can be maintained as per the External Rating Based Approach (which has been discussed later on). For liquidity facilities not extended in accordance with Chapter IV of the Directions, capital charge on the actual amount after applying a 100% CCF will have to be considered.

Derecognition of transferred assets for the purpose of Capital Adequacy

 The Directions has laid down clear guidelines on derecognition of transferred assets for capital adequacy, and has no correlation with accounting derecognition under Ind AS 109. Therefore, irrespective of whether a transaction achieves accounting derecognition or not, the originator will still be able to enjoy regulatory capital relief so long as the Directions are complied with.

There is a long list of conditions which have to be satisfied in order achieve derecognition, which includes:

  1. There should complete surrender of control over the transferred exposures. The originator shall be deemed to have retained effective control over the exposures if:
    • It is able to repurchase the exposures from the SPE in order to realise the benefits, or
    • It is obligated to retain the risk of the transferred exposures.
  2. The originator should not be able to repurchase the exposure, except for clean-up calls.
  3. The transferred exposures are legally taken isolated such that they are put beyond the reach of the creditors in case of bankruptcy or otherwise.
  4. The securitisation notes issued by SPE are not obligations of the originator.
  5. The holders of the securitisation notes issued by the SPE against the transferred exposures have the right to pledge or trade them without any restriction, unless the restriction is imposed by a statutory or regulatory risk retention requirement
  6. Clean-up call
    • The threshold at which clean-up calls become exercisable shall not be more than 10% of the original value of the underlying exposures or securitisation notes.
    • Exercise of clean-up calls should not be mandatory.
    • The clean-up call options, if any, should not be structured to avoid allocating losses to credit enhancements or positions held by investors or otherwise structured to provide credit enhancements
  7. The originators must not be obligated to replace loans in the pool in case of deterioration of the underlying exposures to improve the credit quality
  8. The originator should not be allowed to increase the credit enhancement provided at the inception of the transaction, after its commencement.
  9. The securitisation does not contain clauses that increase the yield payable to parties other than the originator such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the underlying pool
  10. There must be no termination options or triggers to the securitisation exposures except eligible clean-up call options or termination provisions for specific changes in tax and regulation

Further, a legal opinion has to be obtained confirming the fulfilment of the aforesaid conditions.

The draft directions issued some quantitative conditions as well, which have been dropped from the final Directions.

Securitisation External Ratings Based Approach

 The Directions require the lenders to maintain capital as per the ERBA methodology. Where the exposures are unrated, capital charge has to be maintained in the actual exposure.

Para 85 signifies that the maximum capital computed as per the ERBA methodology will still be subject to a cap of the capital against the loan pool, had the pool not been securitised.

The maximum risk weight prescribed in the ERBA approach is 1250%, which holds good for banks, as they are required to maintain a capital of 8%. For NBFCs, the capital required is 15%, so the maximum risk weight should not have been more that 667%. However, para 85 should take care of this anomaly which limits the capital charge to the capital against the loan pool, had the pool not been securitised.

Investor disclosures

Disclosures, both at the time of the issuance, and subsequent thereto, form an important part of the Directions. A complete Chapter (Chapter VII) is dedicated to the same. The disclosures as laid in Annexure 2 are to be made at least on half yearly basis throughout the tenure of the transaction.

This includes substantial pool- level data- such as a matrix of % of the pool composition and corresponding maturities, weighted average, minimum and maximum MHP, MRR and its composition broken down into types of retention, credit quality of the pool (covering overdue, security related details, rating, distribution matrix of LTVs, Debt-to-Income ratios, prepayments etc.), distribution of underlying loan assets based on industry, geography etc.

 

[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/85MDSTANDARDASSETSBE149B86CD3A4B368A5D24471DAD2300.PDF

[2] https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/STANDARDASSETS1600647F054448CB8CCEC47F8888FC78.PDF

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=48106

[4] Our write-up on STC criteria can be viewed here; https://vinodkothari.com/2020/01/basel-iii-requirements-for-simple-transparent-and-comparable-stc-securitisation/

 

Refer our write-up on guidelines for transfer of loan exposures here- https://vinodkothari.com/2021/09/rbi-norms-on-transfer-of-loan-exposures/

Global securitization enroute to pre-Covid heights

– Abhirup Ghosh (abhirup@vinodkothari.com)

The pandemic disrupted life economies across the globe, and so did it to securitization transactions. However, increase in vaccinations across the globe has had a positive impact on the most of the structured finance markets world-wide, but potential new variants continue to be a threat.

This write-up reviews the performance of securitization across the major jurisdictions.

Read more

Global Securitisation Markets in 2020: A Year of Highs in the midst of Turmoil

-Vinod Kothari (vinod@vinodkothari.com)

[Revised March 2021]

Even as the pandemic disrupted life and economies across the globe, securitisation activity in different countries scaled new highs, at least in certain asset classes.

Securitisation in USA

Agency and non-agency RMBS

Agency RMBS was the star performer, at least in terms of new issuance volumes. Data available till Nov 2020 suggests that the new issuance volumes for 2020 will be about double of what it was in 2019, and the highest ever achieved in history. There are two reasons primarily responsible, of which the first one is quite obvious – historically low mortgage rates, particularly for refinancing activity. Second reason is that during the pandemic, there was extensive use of technology in mortgage origination and documentation, which led to far faster and simpler turnarounds for the borrowers.

Non-agency RMBS, however, is expected to end about 40% lower than 2019 volumes. Origination levels were halted because of shut-downs and the prevailing economic situation. Lenders put caution on the forefront as 30-day delinquencies continued to soar up.

Figure 1: US RMBS Issuance [By author, based on SIFMA data]

As may be clear, the issuance of agency MBS in 2020 was almost double of last year, whereas as non-agency securities were 45% lower or almost half of the number in 2019.

Asset-backed securities

The issuance volumes across all other classes of asset backed securities were down – from about 6% in case of auto-ABS to about 90% in case of credit cards ABS.

Figure 2: ABS issuance in USA

The CLO market was among the asset classes very badly affected, with the 2020 issuance less than 40% of the number in 2019. The decline in origination volumes of asset classes like credit cards is attributed to tighter lending standards by banks, and of course, lesser spending by individuals on travel or amusement, due to lock down.

Securitisation in Europe

Euro area will end with a GDP contraction estimated at 7.7% in 2020[1].

As per data prepared by AFME, new issuance in 2020 in Europe was down by about 11.9% compared to 2019[2].

EU regulators proposed some amendments to securitisation regulations, by amending Capital Requirements Regulations. “Securitisation can play an important role in enhancing the capacity of institutions to support the economic recovery, providing for an effective tool for funding and risk diversification for institutions. It is therefore essential in the context of the economic recovery post COVID-19 pandemic to reinforce that role and help institutions to be able to channel sufficient capital to the real economy.”[3] Accordingly, three amendments are proposed to securitisation regulatory framework: more risk-sensitive treatment for STS on-balance-sheet securitisation; removal of regulatory constraints to the securitisation of non-performing exposures; and recognition of credit risk mitigation for securitisation positions.

Figure 3: European securitisation issuance

Securitisation in China

Securitisation in China is expected to be about 10-15% lower than the volumes in 2019. A report from S&P recorded first half of 2020 to be almost the same as first half of 2019, but given the concerns and tightened lending by banks, it is expected that lower RMBS issuance will keep overall issuance levels low in 2020[4].

Figure 4: Securitisation Issuance in China – from S&P report

Securitisation in India

Indian securitisation statistics are typically collated on April-March basis. For Q2, Q3 and Q4 of calendar year 2020, securitisation activity [in Indian parlance, securitisation also includes bilateral portfolio transfers, called direct assignment] was highly subdued, as shadow-banking entities which are the major originators of transactions had stopped lending due to the prevailing lock-down. In addition, there were moratoriums imposed by the RBI whereby payments under existing loans were permitted to be withheld for a period of 5 months.

However, once the lockdowns have gradually been lifted, there is a very strong resurgence of economic activity. The Govt. had provided a sovereign guarantee for an additional 20% lending on existing lending facilities, subject to limits. While the non-banking financial entities are not needing significant funding by way of securitisation, there is a strong investor appetite.

This period has also been associated with defaults or credit events by some of the originators, and sale of the ABS investments held by some mutual funds. Hence, the market has seen servicer transitions, as also tested the (il)liquidity of investments in securitisation transactions.

Rating activity

As may be expected, there have been major rating actions during the year as performance of most asset classes was disrupted due to the pandemic. Rating agency S&P reported 2551 structured finance rating actions, which included 1950 downgrades owing to the impact of the pandemic[5]. Moody’s, in a report, states that once Covid-led payment holidays abate, there will be increasing pressures on retail-focused ABS transactions. RMBS transactions, consumer ABS etc are likely to see rising delinquencies.

Moody’s also forecasts the default rates in non-investment grade corporates to increase to 9.7% (trailing average of 12 months) by March, 2021. This will be the highest default rate after 2009. This will result into substantial pressure on CLOs.[6]

 

[1] Moody’s estimate

[2] https://www.afme.eu/Publications/Data-Research/Details/AFME-Securitisation-Data-Report-Q4-2020

[3] https://oeil.secure.europarl.europa.eu/oeil/popups/printficheglobal.pdf?id=716379&l=en

[4] https://www.spglobal.com/ratings/en/research/articles/200811-china-securitization-performance-watch-2q-2020-the-worst-may-have-passed-11604587

[5] https://www.spglobal.com/ratings/en/research/articles/201218-covid-19-activity-in-global-structured-finance-as-of-dec-11-2020-11782903

[6] https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1249099

Link to related articles:

 

FAQs on restructuring of securitised loans

– Kanakprabha Jethani, Ass. Manager

(finserv@vinodkothari.com)

Background

The first half of this financial year came with lots of schemes to “apparently” support the financial sector during this time of crisis starting from moratoriums, restructuring, interest subvention and so much more. All these schemes were then adorned with an extension of their time limits, so much that at one point the borrower would altogether tend to forget he has an outstanding liability with some lender.

While the credit risk is an issue lenders cannot ignore, they also cannot ignore the fact that a huge chunk of their borrowers are not going to or will not be able to pay. Considering this, they are bound to allow moratoriums and offer restructuring benefits to them.

A lending transaction is between the lender and the borrower. Providing benefits such as moratorium, restructuring etc. is a matter of agreement between the two. However, in certain cases where there is an involvement of external parties, such as in the case of securitisation or direct assignment of a loan pool, practical dfficulties may arise.

The following FAQs intend to answer the basic questions regarding providing the restructuring benefit to borrowers of loans that have been securitised/assigned by the originator.

Stage1: While contemplating the decision to provide benefit of the schemes

1.     Can the originator provide such benefit?

The originator retains/invests in a very small portion of the portfolio. The rest of it is sold off to the assignee/SPV. The moment an originator sells off the assets, all its rights over the assets stand relinquished. However, after the sale, it assumes the role of a servicer. Legally, a servicer does not have any right to confer any relaxation of the terms to the borrowers or restructure the facility.

Therefore, if at all the originator/ servicer wishes to extend moratorium to the borrowers, it will have to first seek the consent of the investors or the trustees to the transaction, depending upon the terms of the assignment agreement.

On the other hand, in the case of the direct assignment transactions, the originators retain only 10% of the cash flows. The question here is, will the originator, with a 10% share, be able to grant moratorium? The answer again is No. With just 10% share in the cash flows, the originator cannot suo-moto grant moratorium, hence, approval of the assignee has to be obtained.

2.     Is approval of investors required?

As discussed above, when an asset is securitised/assigned, the investor becomes the ultimate owner of the asset to the extent of his/her investment in the said asset. Hence, any change in the terms of the loan impacts the rights/liabilities of such investors. Hence, the investors, being the actual owners of the asset, must agree to offer the benefit of any restructuring, moratorium etc.

As for schemes which provide an additional/separate credit facility to the existing borrower such as ECLGS scheme[1], such facilities are treated as separate facilities and are not linked with the existing loans (the one which is securitised). Hence, in such cases, the approval of the investor or trustee shall not be required. However, it is recommended that a NOC is obtained from the investor or trustee to the effect that the originator is providing the additional funding based on the existing lending exposure on the borrower.

3.     How will the approval be obtained ?

The investors may decide on the manner of providing approval. The originator, in the capacity of the investor (to the extent of retention in the transaction), may propose and initiate the process and obtain approval of other investors.

4.     Is it mandatory for the investor to approve?

The investors, like in any other investment, has the right to consider their benefits and losses and accordingly decide on whether to approve. Further, investors may also give conditional approvals, say a change in payout structure, alteration of interest rate etc., considering the increased risk and the fact that investor is, for the time being, foregoing its returns.

5.     What happens if investors do not agree?

In case the investors do not agree, no benefit of restructuring/moratorium can be provided to the borrower. But, considering the liquidity crunch in the economy, it is very likely that the borrower will fail to pay the loan instalments, thereby resulting in reduced cashflows from the borrower. However, in case the investors did not agree to grant restructuring benefits and amend the payout structure, they will have to be paid. This would call for the credit support to be utilised. Over time, when credit enhancement is utilised, the rating of the PTCs may be downgraded.

6.     What happens if investors agree?

In case the investors agree for providing the benefit to the borrower, the same shall come be put into effect by a revision in payout structure for the investors. The payout structure will be revised as per the terms of restructuring or moratorium as the case may be.

7.     What happens with the remaining investors if the majority  agrees?

The assignment agreement usually provides the nature of approval required to amend the payment terms- either majority or else 100% of the investor, either in number or in value (usually 100%). Hence, in case the majority has agreed, the rest of the investors shall have to bear the outcome of moratorium/restructuring.

Implementation stage:

8.     What will be the immediate impact on investors agreeing to provide the benefit?

When the investors agree for providing any such benefits, they simultaneously agree for an added arrangement concerning the payout structure. Hence, the immediate impact shall be on the cashflows arising out of the underlying assets.

9.     What will be the impact on the agreed payout structure?

The payouts may be reduced or deferred or structured in any other way as per the restructuring terms.

10. Can the investors in a securitisation transaction agree for moratorium/restructuring but not for reschedulement or recomputation of payout structure?

In case the investors agree for moratorium/restructuring, such approval would inherently come with reschedulement or recomputation of the payout structure. This is because, if moratorium/restructuring benefit is provided, the cashflows on the underlying asset would be impacted. This, in turn, would affect the cashflows in the securitisation transaction. Hence, when agreeing to provide the benefit to the borrower, investors must bear in mind that there would be a simultaneous change in their payout structure as well.

11. Can the credit enhancements be used to make payments to the investors in case they have agreed to provide the benefit?

Credit enhancements are utilised usually when there is a shortfall due to credit weakness of the underlying borrower(s). In case the investor have agreed for the restructuring, consequently the payout structure must have also been revised and hence, avoiding any default leading to utilisation of the credit enhancement. Irrespective of granting the restructuring benefit,  if there is still default, though credit enhancements can be utilised, however, it will reduce the extent of support, weaken the structure of the transaction and may lead to rating downgrade.

12. What will be the impact on the rating of the transaction?

Usually, any delays in payout, defaults etc. lead to a downgrade in the rating of the transaction. However, here it is important to consider that in a securitisation or a direct assignment, the transaction mirrors the quality of the underlying pool. Now, in case of moratorium, there will be a standstill on asset classification and in case of restructuring, the asset classification will be upgraded to standard. Hence, there is no impact on the credit quality of the underlying asset.

If the credit quality of the loans remain intact, then there is no question of the securitisation or the direct assignment transaction going bad. Therefore, we do not see any reason for rating downgrade as well.

Further, the SEBI had on March 30, 2020, issued a circular[2] directing rating agencies to not consider delays/defaults caused due to COVID disruption, as a default event for the purpose of rating.

After implementation:

13. What will be the impact in the books of the investor?

In case of securitisation, the income will be booked by the investor as per the revised payout structure. In case of direct assignment, the assignee shall take the impact of restructuring in its books. Say, in case there is a reduction in interest rate, the asset must be booked at such revised interest rate in the books.

14. What will be the impact on asset classification and provisioning for such loans?

In case of moratorium, the asset classification will be on a standstill for the period for which moratorium is granted. After the moratorium period is over, the asset classification as per IRAC norms shall be applied. Further, as per the RBI guidelines for moratorium[3], additional provisions shall be required to be maintained.

In case of restructuring, the asset classification shall be on the revised loan, as per the IRAC norms.

15. Who will be required to maintain additional provisions?

Usually, investors maintain provisions corresponding to the PTCs held by them. The asset classficiation and provisioning is done on the basis of payout from such PTCs. Similarly, any additional provision that is required to be maintained, shall be maintained by the investor corresponding to the value of PTCs held.

Further, in the case of DA,both the assignee and assignor shall maintain the provisions, in their respective share of interest in the loan.

16. Suppose, after restructuring, the borrowers still fails to pay as per the restructured terms, what will be the impact on the rating?

In case the borrower fails to repay as per the restructured terms, it is a case of default beyond the moratorium/restructuring allowed by the RBI. This would result in a downgrade in the quality of the underlying asset. Hence, it is quite probable that the rating of the transaction may downgrade.

17. In case there is a rating downgrade, can the size of classes/tranches be changed?

The prime motivation for tranching a securitisation transaction is to obtain high rating for atleast a part of the transaction. Hence, the upper class, say class A, gets the maximum amount of credit support and is sized in a manner that it is able to get superior rating.

Now, when there is a threat of rating downgrade, the size of classes/tranches cannot be changed to maintain the rating. It is crucial to consider that the rating is allotted based on the structure of the transaction and not the other way round.

Hence, if at all, the originator intends to maintain the rating to the transaction, it may introduce further credit support to the transaction, but the size of classes should not be changed.

_____________________________________________________________________________________________________________________________________

[1] Refer our write-up on http://vinodkothari.com/2020/05/guaranteed-emergency-line-of-credit-understanding-and-faqs/

[2] https://www.sebi.gov.in/legal/circulars/mar-2020/-relaxation-from-compliance-with-certain-provisions-of-the-circulars-issued-under-sebi-credit-rating-agencies-regulations-1999-due-to-the-covid-19-pandemic-and-moratorium-permitted-by-rbi-_46449.html

[3] Refer: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11872&Mode=0

Electronic Mortgages: Towards a new trend in paperless mortgage lending

– Vinod Kothari

vinod@vinodkothari.com

Paperless lending based on e-agreements and electronic documentation seems to be the future. The mortgage market is seeing the emergence of electronic mortgage note called ENotes. ENotes, which are issued as electronic negotiable instruments, have become popular in the US mortgage market. The COVID pandemic has given strong push the popularity of contactless and paperless lending format in the mortgage market too.

Like the transfer of shares and bonds world-over has been replaced by demat trades, the replacement of paper mortgages may be replaced by electronic version, sooner than one can imagine.

Electronic documentation has been given legal validity in most countries world-over. The USA passed the Uniform Electronic Transactions Act (UETA) way back in 2000, and Electronic Signatures in Global and National Commerce Act (commonly known as the ESIGN Act) in the year 2000. Most countries have similar enabling laws[1]. These laws grant legal validity to electronic mortgage documentation too. Armed with this power, US national mortgage depository MERS® introduced electronic mortgages almost 16 years ago[2].  The Mortgage Industry Standards Maintenance Organization® (MISMO) eMortgage Community of Practice was formed in 2001 to develop standards for efficient eMortgage processes, transactions, and XML data protocol. However, eNotes surged during the pandemic months. It is reported that by end of May, 2020, there were 597,139 eNotes, with the numbers for Q1 of 2020 being 300% of the corresponding quarter in the previous year.

Concept of ENotes

The typical mortgage creation process in US practice, based on a loan for purchase of a house (“purchase money loan”) involves the creation of promissory note whereby the borrower passes possession/control of property documents to the lender, for the purpose of securing a loan. If the mortgage is transferred by the original lender, the promissory note is “indorsed” to the transferee. Under the ENote format, the mortgage is electronically signed and registered with MERS. The electronic mortgage is stored in an electronic vault maintained by MERS[3]. As the mortgage changes hands by way of transfer of the mortgage, the original lender’s name is replaced by transferee – as would have happened in case of dematerialised shares.

UETA and E-Sign laws facilitated the creation of electronic negotiable instruments by the concept of “transferable records”, which was intended to be an electronic version of the mortgage promissory note[4]. The transferable record methodology involves a depository called “controller” of the note, who is responsible for recording, registering and evidencing the transfers of interest in the note.

Judicial recognition of ENotes

Rulings such as New York Community Bank v. McClendon, 29 N.Y.S.3d 507 (N.Y. App. Div. 2016), and Rivera v. Wells Fargo Bank, N.A., 189 So. 3d 323, 329 (Fla. Dist. Ct. App. 2016) have recognised the right of an assignee of an eNote in taking foreclosure action. Courts have held that the assignee needs to establish that it is either the controller of the authoritative copy of the ENote or is the beneficiary thereof, and produces the paper trail of the transfers leading up to the right of the assignee.

Market acceptability of ENotes

Fannie Mae[5] and Ginnie Mae[6] started accepting ENotes. Ginnie Mae has started accepting ENotes only recently and as part of the initial phase, issuers may apply to participate as e-Issuers and begin securitizing government-backed mortgages comprised of digital collateral with Ginnie Mae approval.

However, it is stated that the real push to ENotes came in 2018 when Quicken Loans initiated a complete process of end-to-end electronic mortgage closing, called e-closing[7]. Quicken Loans launched a digital mortgage product called Rocket Mortgage, in November, 2015, presumably one that allows closing a mortgage in less than 10 minutes. In less than 2 years, Quicken Loans became the largest mortgage lender in the USA.

Remote Notarisation – the other part of the digital mortgage eco-system

To prove that a document is authentic in all its aspects, notarization is necessary. The new system of Remote Online Notarization (“RON”) was adopted back in 2010.

RON typically allows documents to be notarized in electronic form with the signer signing with an electronic signature and appearing before a commissioned electronic notary online via audio-video technology. This allows anyone with an Internet connection to get documents signed and notarized online.

This process has several benefits in terms of security and fraud prevention. RON has had growing acceptance in the US.

It is said that before Covid-19, ENotes were growing at a modest pace as the industry collaborated on solutions to facilitate broader adoption, including acceptance of RON[8].

Other Benefits of ENotes

Apart from the benefits already discussed above, the growing acceptance of ENotes has much to do with several other benefits as well, such as, reducing the operational costs, faster turnaround times, faster signing process, improved data quality and validation, etc.

These give ENotes the push towards a completely paperless mortgage process apart from the convenience factor.

Conclusion

Considering the more than $9 trillion size of US mortgage industry, digital mortgage lending is still a long way to go. Digital mortgages are still less than 5% of the total mortgage originations, whereas digital personal loans are close to 60% of the total loan originations.

The growing acceptance of ENotes is certainly providing the push required from the traditional to a completely “e” driven mortgage process.

[1] The eIDAS Regulation (Electronic Identification and Authentication and Trust Services) is the e-sign law in the EU. The Personal Information Protection and Electronic Documents Act (PIPEDA) is a similar law in Canada. The Electronic Transactions Act 1999 is the governing law in Australia.

[2] Refer to https://www.mersinc.org/index

[3] For a white paper on the ENote methodology, see here: https://www.mersinc.org/publicdocs/eNote_White_Paper.pdf

[4] See section 15 of UETA

[5] https://www.fanniemae.com/deliveremortgage/

[6] https://www.ginniemae.gov/newsroom/Pages/PressReleaseDispPage.aspx?ParamID=203

[7] https://www.housingwire.com/articles/48774-the-fully-digital-mortgage-has-truly-arrived-as-use-of-enotes-skyrockets-by-nearly-5000/

[8] https://cib.db.com/insights-and-initiatives/flow/trust-and-agency/digital-mortgages-come-of-age.htm#2