Understanding the concept
Securitisation is a process wherein lenders (originators), generally banks, pool their income-generating assets (mortgages, credit card receivables, etc./reference portfolio) and sell them to an issuer such as a special purpose vehicle ("SPV") created specially by a financial entity to purchase the assets.
The SPV in order to buy the assets, raises money by issuing debt securities to the investors in the market. The investors receive fixed or floating payments serviced through the periodic payments made by the borrowers on the mortgages and other loans. In some cases, the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on after charging a servicing fee directly to the SPV.
Furthermore, the reference portfolio is divided into tranches viz. senior tranches, mezzanine tranches, and junior tranches, based on their risks and seniority.
Synthetic Securitisation: In synthetic securitisation, the reference portfolio is not sold to any issuer, rather only the credit risk is sold to the investors through a lying credit derivative such a credit default swap. Basically, the lender sells the exposure of the reference portfolio to the investor who in lieu of premiums paid by the bank, agrees to pay the bank/lender a pre-agreed amount in case the reference portfolio goes bust. Just like securitisation, synthetic securitisation generally involves three tranches that are sold to investors. However, unlike securitisation, the reference portfolio is not sold; rather, tranches are sold to investors in synthetic securitisation.
Role of Tranches
The reference portfolio is tailored into tranches in both securitisation and synthetic securitisation to suit different types of investors based on their risk appetite. Generally, the portfolio is divided into three tranches:
- junior tranches (first loss or equity tranche)
- mezzanine tranche (second loss tranche)
- senior tranche
As the names suggest, the junior tranche covers the first 10% losses. In contrast, mezzanine tranches cover 10%-20% of losses, and the senior tranche covers the last 70%-80% of the losses in case of default in the reference portfolio. The premium payable to investors is directly linked with the risk attached to the tranches. The higher the risk on the tranche, the higher the premium is payable to the investors and vice versa. The tranches must also be rated by the rating agencies for them to be issued to the investors. The safest tranche gets the highest ratings. A safe tranche means the probability of the tranche (containing loans, receivables, etc.) defaulting is extremely low.
Why securitisation and synthetic securitisation?
Banks engage in the securitisation process in case they do not want certain assets on their balance sheet for regulatory reasons or for other reasons like excessive risk etc. and are able to find buyers for such assets.
Synthetic securitisation is a hedging tool used by banks to manage risk exposure for assets which are difficult to sell. Instead, they just sell the risk through credit derivates such as credit default swaps to investors who are willing to pay the bank in case of default in lieu of periodic premiums.
Regulatory framework in India
Securitisation in India is majorly governed by Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 ("Master Directions") issued by the RBI. It is pertinent to note that synthetic securitisation has been prohibited by the RBI vide the Master Directions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.