+91 99698 98000
info@acuite.in
Follow us
Executive Summary
In the context of modern financial markets, the burden of risk management is no longer limited to the investing/lending entity; rather it has become a joint responsibility of the issuer of the instrument and the lender. This shift in the risk management attitude is a necessary precursor of efficient capital markets which characteristically offer a greater extent of risk management via sharing of risks between market participants.
Structured obligations (also called Credit Enhancement Mechanisms and Structured Payment Mechanisms), by definition, are legal structures that enhance stability in the stream of cash flows for the holder of a financial instrument independent of the overall cash accruals in the issuer's core operations. In other words, structured obligations (SO), enable issuers to create financial instruments with relatively safer risk profiles in comparison to their standalone credit quality.
Apart from being quintessential tools for risk management, SOs enable such entities to raise funds from a larger cross section of investors and lenders including NBFCs, banks, mutual funds and individual investors.
Unlike the rating of bank facilities, SO ratings are a measure of instrument-specific risk and thus are a function of both, the fundamental credit quality of the issuer and strength of the structure itself. Against this background, there are three broad categories of credit enhancement mechanisms that an issuer can establish:
Mechanisms based on Securitisation of Assets
Securitisation of assets entails the originator transferring the loan/asset to a Special Purpose Vehicle (SPV). The SPV would raise funds from the investor by issuing Pass Through Certificates (PTC), having credit enhancements extended by the originator. The payments to the investor happen from the cash flow generated by this asset owned by the SPV. Alternatively, the investor and borrower can opt for a separate arrangement called direct assignment of method wherein the underlying assets are directly assigned to the investor, with no need of an SPV. Securitisation of assets is popular primarily for transactions in which the underlying assets comprise residential and commercial mortgages, vehicle financing, gold loans, LAP (Loan Against Property), construction equipment loan, personal loans among others. This section covers Acuité's approach to rating Asset backed Securities (ABS) and Mortgage backed Securities (MBS).
In order to understand the risks associated with a securitisation transaction, it is important to first familiarize oneself with the nature of such a transaction.
| Key Steps in Securitisation | Risk Associated/ Factors Analysed |
| From its overall portfolio, the originator demarcates a pool of assets (loans) that it wishes to securitise. | Overall Portfolio Risk |
| The originator then sells this underlying asset pool to a separate SPV (Trust managed by a Trustee). This sale is typically made while ensuring that all risks and rewards associated with the particular asset is transferred to the SPV, thus delineating the performance of the asset pool from the changes in the credit profile of the originator. | Legal Risk |
| The SPV raises funds from investors by issuing them Pass through Certificates (PTC). These funds are in turn paid to the originator as consideration for sale of assets to SPV | Transaction Structure |
| The servicer is then responsible for ensuring timely collection of receivables and depositing the same in a designated Trust and Retention Account (TRA). In several securitisation transactions, the originator can also act as a servicer. | Servicer Risk |
| This cash flow generated from the underlying asset pool is deposited in the TRA. It subsequently flows to the investor as interest and principal components of the PTC issuances. | Credit Risk |
| The originator may provide additional credit enhancements to cover any shortfall in collections from the underlying pool and ensure that payments to the investor are in full and in a timely manner. |
Acuité evaluates individual risk elements acting at each stage of the securitisation transaction and the interplay among them.
Overall Portfolio Risk
Analysing the various practices and policies followed by the originator of the asset becomes important before ascertaining the overall health of the portfolio. Acuité analyses the robustness and soundness of the policies adopted by the originator for the entire gamut of lending activities, including lead generation, underwriting and credit policies, post disbursal monitoring of assets and collection efficiency. Acuité also gives due importance to the quality of MIS maintained by the originator and its risk management systems. Further, Acuité analyses the target market in which the originator operates, its geographical focus, and risk appetite. The delinquency rates and track record of managing portfolio of assets from which the asset pool has been carved out is also important to understand the portfolio risk associated with the originator.
Acuité analyses the characteristics of the originator's portfolio to understand delinquency risk, prepayment risk and collection efficiency. While doing this analysis, Acuité evaluates the entire portfolio of the originator, where new loans keep getting added while older loans are closed. Such analysis wherein newly disbursed loans get added regularly is called dynamic portfolio analysis.
Mechanisms backed by a strict delineation of Future Cash Flow
In such mechanisms, the investors/holders of the instrument have the primary claim on a stream of cash flows from a particular project or any other asset. The funds are first required to be placed in a separate account, typically a Trust and Retention Account (TRA) and only after meeting the debt repayment obligations can the residual cash flow from the project/asset be utilised by the issuer for its firm's operations (reinvestment or declaring dividends). This mechanism is generally used in project financing (like infrastructure and real estate projects) and in cases wherein the borrower identifies specific assets - the cash flow from which shall be utilised to fulfill its debt obligations. Some examples of future cash flow securitisation are Toll collection receivables, rent receivables, receivables from sale of power to name a few.
Credit ratings assigned to future flow securitisation transactions are influenced by three primary factors:
Mechanisms backed by External Credit Enhancements
In the above two mechanisms, there were either a separate pool of underlying assets responsible for generating cash flows for debt servicing, or specific demarcation of future cash flows of an entity, for debt servicing. External credit enhancements were also possible, and in some cases required for these two mechanisms. However, in cases wherein separate demarcation of cash flow streams is absent for investors and debt servicing is to be done from the comingled funds of an entity, but there exists a well-defined, documented, legally enforceable, pre-default, external, credit enhancement mechanism, Acuité assigns a structured obligation (SO) rating to such instruments. In order that such a credit enhancement mechanism be considered by Acuité, the enhancement should necessarily be a pre-default event and thus should be articulated in a well-defined, enforceable structured payment mechanism (SPM)
Acuité believes that these dates should be before the upcoming due dates, (T minus x) structures, with the forthcoming due dates defined as T. The typical preferred dates for the above conditions, to ensure timely availability of funds to investors, will vary depending upon the ease with which the guarantor can make the funds available. The prime consideration here is the operational ease with which the guarantor can make the funds available for investors after invocation of the guarantee. For instance, SPM backed by a guarantee from a bank in the form of a stand by line of credit (SBLC) would typically require less time to ensure fund availability to an investor after guarantee invocation, as compared to a state government guarantee.
SPM backed by liquid collaterals:
In such structures, liquid asset collateral is created out of the funds being raised. This asset may be in the form of a Fixed Deposit or any other highly secured and liquid instrument and is typically placed in a Debt Service Reserve Account (DSRA). The balance in the DSRA is expected to be maintained till the maturity of the security. In case the issuer is unable to arrange for funds to meet its debt repayment obligations, funds in the DSRA account may be utilised to service the issuer's debt obligations on or before the due date.
SPMs Backed by DSRA
In case of a Structured Payment Mechanism (SPM) based on the creation of a DSRA, i.e. backed by liquid asset collateral like FD, or G-sec bonds, the quantum of funds in the TRA and the DSRA are to be evaluated in line with the total amount of debt to be serviced on each due date. To this end, Acuité computes the cover maintained by the DSRA and the TRA.
DSRA Cover = Amount of Funds to be placed in DSRA / Maximum Principal + Interest to be paid
Typically, a higher cover is representative of a high degree of safety. However, Acuité also understands that funds placed in the DSRA are often associated with high opportunity costs and thus adversely affect the Internal Rate of Return of the Project being financed and/or increase the effective cost of borrowing by increasing the hurdle rate for the issuer. Thus, issuers need to find the correct trade-off between the cost of credit enhancements and benefits of the same.
Although the strength of credit enhancement is proportional to the quantum of DSRA maintained, there is an implicit cap on the extent of notch-up (typically 2-3 notches) an entity can receive due to this mechanism. This is because the credit enhancement in such mechanisms continue to be critically dependent on the issuer's standalone credit risk profile, as any depletions in the DSRA account would necessarily have to be funded out of the cash flows generated by the issuer from operations itself.
Timeliness of the Cash Flow
In case of such SPMs, Acuité's objective is to ensure that there exists sufficient time for the enforcement and fulfillment of all obligations under the mechanism. SPM should clearly define the date by which the issuer needs to make adequate funds available for interest and/or principal payments to investors. Failing to do this, the SPM should also explicitly mention that the DSRA maintained by the issuer with the trustee needs to be liquidated, to ensure adequate funds are available in the TRA account well before the upcoming due date.
The DSRA should be typically maintained in the form of highly liquid and marketable instruments such as FDs with nationalised banks and G-secs. In case of any alternate forms of DSRA maintained by the issuer, for instance AAA rated corporate bonds, the SPM should ensure adequate time gap exists between the trustee commencing the proceedings to liquidate DSRA and the upcoming due date for interest and/or principal payments to bond holders.
Acuité also evaluates the legal enforceability of the SPM, by studying the trust deed and bond agreement. For SPM to be considered as credit enhancement, Acuité believes that there should be no recourse or control of the issuer over these funds, and that the trustee should exercise total control over the DSRA account, to ensure timely payment to investors.
In cases where there are no corporate guarantees/or DSRA arrangements Acuité may still examine the structure from the standpoint of the counterparty and the criticality of the arrangement to the counterparty's operations. In cases where the arrangement is deemed to be critical to the counterparty's operations, Acuité may treat the debt as if it has been contracted by the counterparty and may assign a rating equivalent to or near the counterparty's rating. The key aspects to be reckoned here would be the intent of the counterparty's management in supporting the timely servicing of the debt obligations and the criticality of the arrangement to the counterparty's operations. Such ratings will also be suffixed with (SO).
SPM BASED ON PLEDGE OF LIQUID SECURITIES
The increasing trend in offering security coverage in the form of shares/ liquid investments has prompted a need for looking at such structures differently as opposed to structures based on a security of movable/ immovable assets. Generally a rating is indicative of a probability of default and is generally unaffected by the collateral coverage. However, in cases of structures backed by liquid collateral, a right type of structure can mitigate the likelihood of default.
Against this backdrop, Acuité assesses such structures in a different manner as opposed to plain vanilla borrowings. Such structures are very common in case of borrowings by investment vehicles of promoters. It has been observed that generally promoters of listed companies prefer to hold their investments in their listed companies through a clutch of privately held companies. Typically these private companies have moderate revenue streams mainly by way of dividends on the shares/ interest on investments. Such companies are structured as vehicles for promoter holding and typically do not have any other operations; their net worth and any debt requirements are for investments in promoter group companies. In the absence of any operations, these companies do not have any source of sustainable cash flow, they often must go in for refinancing of their debts/ infusion of funds by promoters. Hence refinancing ability/ financial flexibility is critical in evaluating such companies. Their financial flexibility is directly linked to the market valuation of their investment portfolio.
Acuité 's approach to evaluation of such issuers is based on the standalone credit profile of the issuer which would then be notched up for the structure. The extent of notching up will depend on two broad platforms (i) Strength of the Structure (ii) Nature and Quantum of liquid collateral
Strength of Structure
Timelines for funding the account are generally spelt out in the financing document in terms of T-n days (where T is the due date). Typically, n ranges between 3-5 days in most of the cases, since it provides adequate time to the lender/ debenture trustee to initiate the process for selling the securities and ensuring that the funds are received in the account on the due date.
Secondly tolerance for any dilution in security coverage is also a critical factor in evaluation of such structures. In case of structures backed by pledge of equity shares, if the security coverage falls below the minimum acceptable coverage stipulated in the term sheet, then an immediate top up must be arranged. Acuité believes that for such structures, any tolerance below 1.25 for two consecutive trading days will render the structure infructuous. Needless to say, monitoring the asset coverage on a daily basis and initiating action for topping up wherever necessary is crucial in such structures. Hence Acuité will examine the financing documents for these clauses.
Nature & Quantum of Liquid Collateral
As mentioned earlier, any coverage below 1.25x (in case of equity shares) shall not be reckoned for the notch up. Besides the quantum of coverage, Acuité also examines the following aspects while arriving at a notching up
1) Financial performance of the companies whose shares are being offered as collateral
2) Volatility in the share prices
3) Diversification in the security coverage
4) Diversity of Investor base - Presence of marquee investors
5) Quantum of unencumbered promoter holding vis a vis encumbered promoter holding
6) Daily Volumes on the counter - To assess the ability of the market to absorb
These ratings will be suffixed with the letters SO in brackets to distinguish them from the standalone credit ratings of the issuer.
External Credit Enhancements based on Guarantees issued by Banks /Financial Institutions
In respect of debt obligations (credit facilities availed from banks/ Capital market instruments) backed by Bank Guarantees/ Standby Letters of Credit from Banks/ Financial Institutions, the ratings will be linked to the credit quality of the Guaranteeing /SBLC issuing Bank. The ratings assigned to such credit facilities will be suffixed with the words (SO) i.e Structured Obligation, to indicate that these ratings do not reflect the standalone credit quality of the borrower/issuer and are based on certain forms of credit enhancement.
Acuité observes that Bank guarantees/SBLCs are issued by banks as per pre-defined standardized formats and are usually post default in nature i.e the lender can invoke the guarantee /SBLC only after the occurrence of default. Besides, there are no predefined timelines for invocation or payment by guaranteeing bank after invocation. Hence their utility as a 'default' mitigation mechanism is limited. Notwithstanding these limitations of a bank guarantee, it needs to be recognised that a credit facility / capital market instrument supported by a bank guarantee is considered as an exposure on the guaranteeing bank. The risk weightage assigned to such exposures is also lower than other regular exposures since the rating of the guaranteeing bank is considered for the capital adequacy. The issuance of a guarantee is a part of a normal course of business for a bank and the bank has to set aside capital to meet this off-balance sheet exposure. Any failure /inability to honour the obligations under the guarantee / commitments can potentially impact the bank's credit worthiness and impair its trust and credibility from an external standpoint. Since the implications of a default under a guarantee / SBLC are severe, a bank will ensure that its commitments under any guarantee / SBLC are met even in the most difficult circumstances.
In such cases of Bank guarantee / SBLC backed structures, Acuité may rely on external ratings assigned by other rating agencies to these banks/ financial institutions. In case of more than one rating, Acuité will generally consider the lowest of the rating. In case of overseas banks/ institutions, Acuité will map the international rating of the bank to the domestic scale and then assign a rating based on the domestic equivalent of the bank's rating. Acuité may suitably maintain a differential of 1-2 notches to the guaranteeing bank's rating /domestic equivalent rating. It is to be noted that such ratings are based on the credit quality of the guaranteeing bank and any revision in the credit rating of the said bank will result in a revision of the SO ratings assigned for the facilities/borrowings.
+91 22 49294000
+91 99698 98000
DOWNLOAD 