Column : Dont give up yet on securitisation

Written by K Vaidya Nathan | K Vaidya Nathan | Updated: Aug 26 2009, 22:01pm hrs
In the first quarter of this year, SKS Microfinance securitised Rs 2 billion of loans it had lent to the weaker sections of the society. These loans, whose average loan size was about Rs 9,500, were extended to more than 2 lakh families none of which had any access to formal source of finance. Securitisation, in this example, aided the process of financial inclusion. Likewise, it can facilitate significant objectives. However, as with any potent weapon, it needs to be employed judiciously to reap its enormous benefits.

Through the process of securitisation, SKS was able to raise upfront cash equal to the net present value (NPV) of the cash flows from the loan. It also transferred the risk of the loans to the investor of these securities. Using the cash received upfront, SKS could provide more loans to other needy borrowers without having to wait till it collected the cash proceeds from the loan, which would have taken considerable time. Moreover, SKS was able to transfer the risk of these microfinance loans to investors who were comfortable bearing that risk.

Securitisation is typically done for financial assets that generate predictable and periodic cash-flows. Loans are a good example of such an asset. However, securitisation could also be undertaken for any asset that provides steady foreseeable cash flows. Typical candidates for securitisation include leases, accounts receivables, highway tolls, and even music royalties. The first securitisation transaction dates back to 1985 and was originated in the United States. Sperry Corporation, now Unisys, created securities backed by the cash streams that it would have received from leasing computer equipment. Leases, similar to loans, involve predictable and periodic cash flows.

Though securitisation enables financial institutions to raise new financing, it can be hazardous if used without proper discretion. For instance, if the originator remains certain that it would be able to securitise the loans and thereby transfer the risk, it may become lax while issuing loans. For instance, the originator may not screen the borrowers adequately. The investor himself would not be able to glean through the details of a large number of individual loans. It would have to trust the diligence of the originator and probably a third party like a rating agency, which might rate the securities. If the rating agency is getting paid by the originator during the securitisation process, such an arrangement generates a conflict of interest. In any case, all losses would be borne by the investor. At worst, the rating agency could lose some credibility. As has been evidenced during the subprime crisis, if the disintermediation process does not appropriate risks and rewards suitably, such an arrangement could be disastrous for the financial system as a whole. To harness the benefits of securitisation, the distribution of gains and losses, both monetary and non-monetary, should be such that all the players do their part well so that all get the desired benefit; no more and no less.

In the current process of securitisation, there is very little skin in the game for the originator and much less for the rating agency. The risk is almost entirely borne by the investor. If the originators and rating agencies face some monetary risk apart from the potential loss in credibility and reputation, they would have greater incentives to get the origination and risk rating right. To align their incentives, a good portion of the fees that rating agencies charge could be tied to whether they get the rating right or not. For example, the rating agencies could also be paid a bonus if they get the rating correct but be charged a penalty if they get it wrong. Currently, the pay-offs of rating agencies are similar to that of a government agency, i.e., more or less constant irrespective of how good a job they do.

This is not to suggest that the rating agencies dont add much value currently; just that that they dont have as much at stake as they should so that their incentives are better aligned. The rating agency adds value by providing its expertise in risk analysis and by objectively assessing the risk of the financial product. This benefits both the originator and investor. The investor brings the advantage of having access to substantial funds, which the originator may lack. The originators core competence, in this case, was in being able to provide credit in a commercially viable and sustainable manner. The process of securitisation pools the best competence and resource of each of the parties to the transaction, which the parties may not possess individually. If the gains and risk transfer is done more appropriately, the benefits from the disintermediation process can be significant. Securitisation neednt necessarily be a dreadful word in the post-subprime era.

The author, formerly with JPMorganChases Global Capital Markets, trains finance professionals on derivatives and risk management. His book on credit derivatives is due

to be published