Before we go into the nooks and crannies of securitization, let’s take a step back and understand how businesses raise money for growth.
Broadly speaking, there are two alternatives: 1. Revenue-driven: Deliver value →earn revenue → make a profit → use the profit for growth. 2. Future cashflow- driven: business project how much money they would make in future and make an offer to the investor which details if investors’ invest money today in the business, how much money they would make in future. Now the terms of investment can vary. It could be an equity investment wherein investors has higher upside but also downside if things don’t work out as expected. It can be a debt investment wherein investors get fixed return- so they don’t share any upside in profits or any downside in losses.
Securitization broadly fits into the debt bucket. Let’s look at how securitization works for Banks or Non-banking Financial Companies( NBFCs like Bajaj Finance, Mahindra Finance, Tata Capital etc. ). Let’s say NBFC named Robinhood Loans gives 10,000 loans to those in need of money. Since Robinhood Loans has deployed all of its capital, it doesn’t have any more money to offer loans, but it knows many more people who need loans. It has everything but capital, to give more loans. This is where Investment Bankers comes in. Bankers identifies a portfolio of the safest 2,000 loans out of existing 10,000 loans. From these 2,000 loans, Robinhood Loans will get ₹ 110 Cr after one year. Bankers understands the risk and concludes this is a safe portfolio and believes a 10% return is great for one year term. So it pays Robinhood Loans a sum of 100 Cr and buys the portfolio. By buying the portfolio, Bankers gets ownership on repayments. So when the borrowers repay 110 Cr after one year, it goes to the bankers. The step of buying the portfolio or the pool is called securitization. NBFC Robinhood Loans has money again and happily proceeds to give more loans. :)
As I was trying to explain this, I was sent down the memory lane of watching the movie The Big Short. ( I highly recommend the movie if you want to understand the 2008 crisis. Also “Too big to fail” is also good- probably not as excellent as The big short but still very good :D). Rather than getting into technicalities, let’s look at why it happened.
In the USA, banks were accessing the risk and then giving out housing loans. Eventually, the banks would sell the loans by pooling them. The problem was the banks were disbursing the loans on Friday and selling them in some pool by Monday, i.e. a turnaround time of one business day. The short turnaround time is a big problem. If the loan pool doesn’t perform well, viz-a-viz the borrowers don’t pay as expected, the investors lose their money, but the banks are not affected — so no downside for the banks. However, the same banks would earn millions of dollars by giving out such loans and selling them through securitization pools. Imagine if you were to buy lottery tickets. If you win the lottery, you earn the price, but if you lose, someone else pays for the lottery ticket cost. Obviously, you would buy as many tickets as you can. What those lottery tickets are to you, the housing loans were to banks. Banks had no skin the game, so sooner or later the whole thing had to go for a toss, and it did! And in a very very bad way!
So RBI learned a lesson and brought regulations for securitization in India. It basically made sure the Banks and NBFCs selling loan pools have skin in the game. It did in two ways: 1. MHP 2. MRR
Let us understand the MHP. Minimum Holding Period. Basically, Banks or NBFCs can’t immediately sell the loans through securitization. Once the bank disburses the loan, it has to hold the loans/ wait for some repayment cycles before the loan can be securitized. For housing loans, this period is 1 year. For smaller loans with total tenure less than 2 years, the bank has to wait for 3 months. Now, this is great for the investor who is buying a loan portfolio because s/he gets to see who all are repaying on time and who aren’t. S/he would then only invest in pools that are regularly repaying. Now the bank also knows it can’t offload bad loans to investors. Therefore, it remains prudent.
The second is the MRR. Minimum Retention Requirement. Imagine you are applying for a home loan. The house costs 1 Cr. The bank won’t give you a loan of 1 Cr. It would generally ask you to put your own 30 Lacs first and then give you a loan of 70 lacs. Right? The minimum retention requirement works similarly. Basically, when NBFC sells a pool of say 100 Loans, it has to give additional 10 loans as security. So if at all there is default or principal loss on any loans from the 100 loans that are securitized, the repayments from the additional 10 loans are paid to investors. Basically, the first loss is borne by the NBFC. Now when we securitize portfolio, we know historical trends, underlying assets ( e.g. Gold/ House/ Two wheeler, etc.) and we make sure there is a more than sufficient additional loan pool for any NPAs in the original pool.
I think RBI has built fantastic framework here and made sure on a structural level, investors are protected :)
These guidelines came in 2012, and the market started picking up. In 2016, the taxation on securitization asset was simplified, and it solved a big problem of investors. In last year(FY 2018–2019), India had transactions of ₹ 1.9 Lac Crore. Yes, that big! In dollar terms, it is approx 27 billion dollars, and we are just starting. Just to give you a sense, around the same time, In the USA, the volume was 520 Billion dollars, China had around 300 Billion Dollars. Japan had about 58 billion Dollars.
Author : Growfix Team (Now Wint Wealth). https://www.wintwealth.com/
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