--By Hemanta Bashyal 

 

Nepali banks are currently facing problems with capital inadequacy as well as liquidity crisis with high credit risk exposure. Loan securitisation can help in this. With the help of securitisation, they  can diversify their portfolio, create better balance sheet and create liquidity in the market. Securitisation is a process of recreating a security backed by any asset to create liquidity. It can be arbitrage motivated, selling security with higher price in the market or selling those assets that yield lower than that of the underlying assets. It can be balance sheet motivated as well, where the entity’s assets are sold to a Special Purpose Vehicle (SPV), thereby transferring security and generating cash and/or investment account on the balance sheet. 

 

In a securitisation structure,  bond classes issued can consist of a senior bond that is tranched so as to redistribute prepayment risk and one or more subordinate bonds. Collateral for an asset-backed security can be either amortising assets or non amortising assets.

 

SPV purchases assets and loan portfolios, from financial institutions and can create diversified portfolio of various assets. It also repackages security and issues to investors as per their needs which transfers assets and creates liquidity. Generally, securities issued in the market are listed in the security exchange. A seller, who is selling assets to SPV, receives cash that can be invested in other sectors or assets and thus add liquidity in the market. The seller (bank) itself can invest in such securities as support tranches with the same credit risk exposure with higher yield and categorise them as investment. This gets accounted in tire II capital, and it will increase capital adequacy as well as increase exposure to the market.

 

Exposure to Investor

Without securitisation, it may not be possible to increase exposure in assets like real estate, where there is higher capital requirement. Initial investors can minimise their risk with diversification, as SPVs can buy diversified asset portfolios and securitise it. Buyers of asset-backed security can have exposure to diversified portfolio. 

 

Who are the Potential Investors?

 

Banks and Financial Institutions:

Even if banks sold their loan portfolio, they can have exposure on the same assets. But they can reclassify such exposure as investment rather than loan and treat it as tire II capital. Those banks that have asset portfolios for managing medium term liquidity can invest on such security. 

 

Insurance Companies: Insurance companies are highly regulated and have lower risk exposure and moderate liquidity need. They can invest on such security as well as on fixed income security to generate regular returns as well as to comply with regulatory requirements. 

 

Mutual Fund: Mutual funds are also highly regulated and need to invest in fixed income securities to diversify their portfolio as well as liquidity needs. Especially, Balanced/Hybrid funds need to invest higher proportions in fixed income security. 

 

Other institutional investors: To maintain foreseeable liquidity need, other institutional investors need to invest on fixed income security with various maturity levels to match their liquidity need. 

 

General Investors: The general public are also potential investors in such security. 

 

Securitisation and Risk Tranching 

(Based on mortgage backed security):

Assets can be securitised by various methods based on  risk allocation. Risk cannot be eliminated through securitisation but can be allocated among investors through this process. Investors’ risk and return objective can be fulfilled with the help of securitisation  through reallocation of the risk and reward. 

 

Pass through Security

Cash flow of pass-through securities includes net interest, scheduled principal repayments and prepayment. Any amount paid in excess of the required monthly mortgage payment is a prepayment. Generally in pass-through security, cash flow is projected.

 

Risk Tranching 

(Prepayment risk and reallocation of risk)

Prepayment risks can be categorised into two types - contraction risk and extension risk. Contraction risk involves shortening of the mortgage pool due to a falling interest rate and rising prepayment rate. Because of decreasing interest rates, the mortgage loan taker prepays his due in excess of his scheduled principal payment. Mortgage-backed security (MBS) exhibits negative convexity as rates decline to the embedded call option, granting the mortgage borrower the right to prepay. Reinvestment rate risk is caused due to declining-interest-rate-stimulated-prepayments resulting in an earlier than expected receipt of principal while investors are faced with problem to reinvest at a relatively lower rate.

 

Extension risk: Risk associated with interest rate increase and prepayment rate decrease goes increasing as the bond prices fall, so that investors get lower cash flow than expected, which could be reinvested at a higher rate.

 

Investors have varying degrees of concern about exposure to prepayment risk to match their liquidity need. Some investors want to minimise contraction risk while others want to minimise extension risk. Fortunately, all of the pass-through securities issued on a pool of mortgage do not have to be the same.

 

 

Collateralised Mortgage Obligation (CMO)

CMO is such a securitisation where one can obtain and distribute cash flows generated by a mortgage pool into different risk packages. CMOs are securities for which cash flows have been reallocated to different bond classes called tranches, each having a different claim against the cash flows of the mortgage pass-through or pool of contraction and extension risk. Hence, a CMO can match the unique assets and viability needs of investors (institutional) and investment managers. It does not eliminate contraction and extension risk; it repackages these risks and apportions them to different classes of bond holders.

 

Furthermore, these risks can be reallocated creating a more complex structure where it can be repackaged on Planned Amortisation class (PAC CMO). PAC is a tranche that is amortised, based on a sinking find schedule that is established within a range of prepayment speeds (this is called an initial PAC collar). In a complex PAC CMO, we can engineer multiple PAC collars with support tranches. PAC reduces average life variability and protection is provided by a support tranche which is the key to prepayment protection for PAC tranches. 

 

There is an inverse relationship between the prepayment risk of PAC tranches and the prepayment risk associated with support tranches. The certainty of PAC bond cash flow comes at the expense of increased risk to the support tranches. PAC bonds work in that it is packaged with a support tranche created from the original mortgage pool. If Pac tranches have higher priority claim against cash flows, principal payments to support tranches must be deferred until the PAC repayment schedule is satisfied. Thus the average life of the support tranch is extended. If actual prepayment is faster than expected, the support tranche is contracted. If prepayment is rapid than expected then support tranches will eventually be paid off and the principal will then go to the PAC holders, called busted PAC.

 

Stripped Mortgage Backed Securities:

Principal and interest component of the mortgage pool is stripped into principal only (PO) and interest only (IO) strips. POs are a class of securities that receive only the principal payment portion of each mortgage payment, and are sold at a considerable discount. PO cash flow streams start out small and increase with the passage of time as the principal component of the mortgage payment grows.

 

IOs are a class that receive only the interest component of each payment. IO strip cash flow starts out big and gets smaller over time. IOs have shorter effective lives than POs. The major risk of IOs is that the value of the cash flow that investors receive over the life of the mortgage pool may be less than initially expected and possibly  less than the amount originally invested. Both IOs and POs exhibit greater price volatility than the pass-through from which they were derived. These securities are negatively correlated, but the combined price volatility of the two strips equals the price volatility of the pass-through.

 

Credit Enhancement on securitisation of the assets backed securities:

 

The level of credit enhancement is directly proportional to the level of rating desired by the issuer. There are two types of credit enhancements: 

 

External credit enhancement

These are financial guarantees from third parties that support the performance of the bond and supplement other forms of credit enhancements. Third party guarantees impose a limit on the guarantor’s liability for losses as a specified level which includes:

 

Corporate Guarantees: sponsor agrees to guarantee a portion of the offer.

 

Letter of Credit: provides a guarantee against loss up to a certain level.

 

Bond Insurance: provides for protection against loss through the purchase of insurance against non performance.

External guarantees is the weak link adopted by rating agencies; the credit quality of an issuer cannot be higher than the credit rating of the third party guarantor. 

 

Internal Credit Enhancement: 

This includes:

1) Cash reserve funds or cash deposits that come from issuance proceeds. This excess cash provides for the establishment of a reserve account to pay for future losses. 

 

2) Excess servicing spread fund reserve funds in the form of excess spread or cash after paying for servicing and other expenses. Excess servicing spread funds can be used to fund credit losses on the collateral.

 

Overcollateralisation occurs when assets backed securities are issued with a face value less than the value of the underlying collateral.

 

Senior/subordinated structure contains at least two tranches - a senior tranche and a junior or subordinated tranche. Subordinated tranches absorb the first losses up to their limits. The level of protection for the senior tranches increases with the percentage of subordinated bonds in the structure. 

 

Regulatory Requirement and Possible Loop Holes

The regulatory of the Nepali  financial market may not be efficient for this process currently. To protect small investors, the regulators should formulate the required laws. . In this process, the issuer may buy lower quality assets during the securitisation process and may issue them to the general public so that sellers can sell their risky portfolio at a lower cost (MBS securities issued in US on 2006-2006). This may generate higher cash flow than what could be expected from selling it at fair market price. To some extent, credit rating agencies  should also be made liable on their ratings issued. Moreover, such agencies also should have some risk absorption capacity.  There must be legal provision to take specific proportions of the portfolio on support tranches, so that specific risks may absorbed by the issuer itself. The  motive is to securitise, not to sell poor assets at higher price. 

 

The mechanism of  testing the quality of assets-backed portfolio should be specific and - mentioned in the law itself. It should specify what type of securities can be securitised and what is the level of risk with those securities. Independent risk assessment mechanisms should hold before implementing such securitisation process.   To protect small investors, the regulators should circulate some rules regarding the securitisation process so that small investors can have exposure on large asset portfolios.

 

Meanwhile, there is no mechanism to hedge the credit risks of such asset portfolios. Some market participants have an exposure on such risk, and so new policies and rules should address such matters so that market participants can have exposure on specific risk and can bypass undesirable risk on their portfolio.

 

Benefit for the Nepali  Financial System

If such policies are implemented in Nepal’s financial market, most of the banks that have exposure on such loan portfolios can be protected. . Otherwise, they should liquidate those loan portfolios i.e. the borrower should pay before the loan tenure or bank may reclassify such assets in another portfolio. Reclassification is the worst scenario in the financial market, and is generally not allowed in practice. It would be wise to allow financial institutions to securitise their loan portfolio so that they can sell their portfolio to other investors who are willing to have exposure on such asset portfolios. 

 

Some financial institutions’ loan portfolio on real estate was around 40 to 45 per cent three years ago. Now, regulators  have forced these institutions to reduce this portfolio down to 25 per cent only. Due to this, the banks forced borrowers to repay loan. So  the borrowers had to fire sale their assets, which caused  huge loss. . If regulators  had allowed securitisation, those investors who have leveraged position on real estate portfolio may have been protected and banks and financial institutions could have sold their portfolio to interested investors and absorbed credit risk to some extent.