Criteria for Rating of Securitized Transactions
15th September 2019 (Version 4)

Criteria for Rating of Securitized Transactions [assigning SO (Structured Obligation) ratings]

Primer on Securitization
Securitization of assets entails the originator transferring the loan/asset to a bankruptcy remote Special Purpose Vehicle (SPV). The SPV would raise funds from the investor by issuing Pass Through Certificates (PTCs), 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. Securitization 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), which cover the major two type of securitization structures.

In order to understand the risks associated with a securitization transaction, it is important to first familiarize oneself with the nature of such a transaction.

Key Steps in Securitization

Risk Associated/ Factors Analysed

From its overall portfolio, the originator demarcates a pool of assets (loans) that it wishes to securitize.

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 securitization 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 securitization 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.

  1. Delinquency Risk

To analyse the overdue position in a given portfolio, Acuité bifurcates each underlying loan among several buckets such as 'On Time payment', '30+ DPD', '60+ DPD', till '180+DPD'. This bifurcation of individual loans acts as a starting point of the dynamic portfolio analysis. Acuité calculates the bucket wise delinquency rate. The outstanding value of loans as on date in each bucket is divided by the total portfolio outstanding as on that date. Acuité evaluates the trend in this delinquency rate over a period of time. However, in cases of rapidly expanding portfolios, this delinquency ratio may understate the delinquency risk. Thus, it may be prudent to consider lagged delinquency rates as well. Here, a historical (lagged) value of the outstanding portfolio is taken. Typically, the historical value of 6-12 months of the outstanding portfolio is taken depending on the asset class, seasoning, and original tenure among others. While analysing the performance of a portfolio over a period of time, it is also important to make sense of the movement in the delinquency transition rates for a portfolio.

  1. Prepayment Rate

Acuité analyses the monthly historical prepayment rates for the portfolio, along with the expected interest rate and income level movements. Acuité also compares these prepayment rates with the benchmark rates for the same asset class.

  1. Legal Risk

Analysis of legal risks associated with securitisation transactions is important to ensure that interest of investors is protected at times, when credit quality of the originator deteriorates significantly. Essentially, the analysis revolves around the de-linking of the underlying asset pool and credit enhancement to the pool from the credit quality of the issuer. Thus, in case the originator files for bankruptcy, the performance of the asset pool and its respective credit enhancement will remain unaffected with investors receiving their payments in a timely manner.

For this de-linking to uphold in the court of law, it is essential that the sale of assets from originator to SPV is free of any recourse and that all risks and rewards associated with the asset is transferred from the originator to the SPV. Acuité analyses not only the specific terms and conditions of the asset transfer agreement, but also other documents including the rights and obligations of all involved. Acuité may also seek third-party independent legal opinion to learn about the legal risks involved in a securitisation transaction, if deemed necessary.

While assessing the legal risk of a given securitisation transaction, Acuité also takes into account the competence and experience of the designated trustee in performing its duties and responsibilities.

  1. Transaction structure

Acuité also analyses the transaction structure to determine the inherent protection to PTC investors. The two primary structural features built into the transaction are:

    1. PAR v/s Premium Structure

Transactions wherein investors pay the outstanding principal of the underlying asset as a consideration towards the issue of the PTC is called a PAR structure, i.e. PTCs are said to be issued at PAR. In this structure, typically the yield from the underlying asset pool is higher than the yield payable to PTC holders. Thus, there will be excess interest spread (EIS) accumulated from cash flows generated by the underlying pool. This EIS would be wholly or partly available to meet any shortfall in funds generated from the underlying assets, thus providing an internal credit enhancement. Balance, if any, in the EIS account at the end of the PTC tenure is typically transferred back to the originator.

In Premium structures, on the other hand, investors pay a premium over and above the outstanding principal of the underlying asset pool. Here, the cash flows generated by the underlying pool go to PTC investors and thus, no internal credit enhancement by way of EIS is available for investors.

2. Waterfall Mechanism (Tranching)

A well-defined, legally enforceable waterfall mechanism involves slicing the entire PTC issuances into various layers or tranches, with one typically being senior and one or more subordinated tranches. The objective here is to relatively insulate the senior tranche from the delinquency and prepayment risks in the pool. Here, the first right of cash flows generated by the pool is with senior tranche investors with residual funds flowing to subordinates.

  1. Servicer Risk

Since cash flow generation from the pool of underlying assets is primarily dependent on the performance of the servicer itself, analysing the profile of the servicer becomes important. The servicer's ability to adopt and adhere to policies and processes with highest level of efficiency and competence related to follow-up, collection, maintenance of MIS and operational risk mitigation become critical. For long tenure PTCs, the servicer's solvency risk becomes critical. Thus, Acuité also analyses the financial risk profile of the servicer, quality of its management and its track record. For servicers having relatively weaker credit profiles, stronger forms of credit enhancements may be mandated.

  1. Credit Risk

The ability of the underlying asset pool to generate adequate and timely cash flows is analysed in this section. While analysing the credit risk in a securitisation transaction, Acuité evaluates the impact of several factors like characteristics of asset class, pool risk, macro-economic risk, interest risk and pre-payment risk.

    1. Asset Class:

The end use of the underlying loans/assets is analysed to understand the inherent risk in the securitisation transaction. For instance, Acuité believes that a pool consisting of residential home loans would be significantly safer than that of credit card receivables.

    1. Pool Risk:

Acuité believes that static pool analysis is crucial to forecast the estimated loss in the securitised pool. Static pool refers to a collection of loans to which no new loans are added. The underlying loans from the portfolio are clubbed together based on their time of origination to form discrete pools. Loans having originated during a certain time period are clubbed in one static pool. Similarly, several static pools are taken into consideration so as to compare their performance during multiple time periods. Acuité may also include past securitised pools in its static pool analysis. Acuité then analyses the delinquency curve for each static pool to understand delinquency trends with reference to seasoning of loans as well as to compare delinquency risks that may have originated during different time periods. Similarly, Acuité also analyses prepayment curves, recovery curves and collection efficiency for various static pools.

Additionally, Acuité also evaluates the following parameters of the pool while analysing the quality of the pool. The Pool is compared with the  Portfolio on various characteristics such as:

      • Loan to Value Ratio (LTV) - Lower LTV ratio indicates better future performance of the pool
      • Geographic Distribution
      • Seasoning of Pool - Higher the seasoning, lower the risk
      • Borrower profile and concentration levels
      • Asset class of the pool
      • Interest rate charged to the borrowers in the pool
      • Residual Maturity of the Pool

If pool risk is significantly different from the portfolio risk of the originator, it could mean cherry-picking while carving out the pool. The risk profile of the pool when compared against portfolio risk could be either better or worse. Thus, Acuité adequately factors in the same, while assessing credit risk for securitisation transaction.

    1. Macro-Economic Risk

The ability of the underlying asset pool to generate adequate, stable and timely cash flows is also influenced to a large extent by the overall economic environment prevailing in the country or the geography in which the asset class is largely concentrated. Any significant but unforeseen volatility in the macro economic scenario can influence the value of collaterals of the underlying assets, thus influencing the credit risk associated with the pool. Income levels of the underlying borrowers and interest rates to be paid are certain key variables that impact the ability of the underlying asset pool to generate stable cash flows. Acuité factors in the expected economic conditions over the tenure of the asset pool to incorporate the likely impact of the same on the credit profile of the underlying assets.

    1. Interest rate Risks and Pre-Payment risks

Interest rate risks primarily arise due to mismatch in the interest rate benchmarks for the underlying pool of assets and investors. For instance, in structures wherein loans in the pool are linked to floating rates and payouts to investors are on fixed interest rates, cash flows from the pool may be inadequate in a falling interest rate regime. While analysing the credit risk in a structure, Acuité takes into consideration the expected movement in interest rates, the cushion between cash flows being generated by the pool and payout to investors.

In cases wherein the pool is linked to floating interest rates, movement in benchmark interest rates also impact the expected prepayments in the pool. Prepayment risk arises when investors receive funds earlier than expected, thus exposing them to risk of re-investing these funds at lower yields. Typically, decreasing interest rates and increasing income levels lead to higher prepayments in pools based on retail loans. While analysing prepayment risk for a given transaction, Acuité analyses the expected movements in interest rates and income levels with historical prepayment patterns for a given asset class.

  1. Explicit/External credit enhancements

Based on the risk profile of the underlying pool and the transaction structure, the originator may employ additional credit enhancements (external) in the form of debt service reserve accounts (DSRA) and/or corporate guarantee. Acuité analyses the extent and quality of this additional support and its legal enforceability. Acuité may also analyse the legal structure to check whether cash collateral is available to investors even if the originator goes bankrupt. To be considered as an effective credit enhancement, Acuité believes that these enhancements should provide the required funds before due date so that payments too are made to investors on or before due dates.

As per recent SEBI guidelines, ratings where the credit enhancement/structure around cash flows lead to rated instrument being bankruptcy remote of the issuer/originator will carry the ‘SO’ (Structured Obligation) suffix. Acuite believes that ‘SO’ ratings shall be assigned to ratings of Securitization transactions entailing ratings assigned to PTCs (Pass Through Certificates). The following categories of structures will be eligible for SO suffix.
 

Type of Instrument / Structure

Rationale

ABS

Bankruptcy remote structure

MBS

Bankruptcy remote structure

CDO

Bankruptcy remote structure

Covered bonds, which have to be serviced primarily by the cash flows from the pool of loans housed in a trust, with secondary recourse to issuer

Bankruptcy remote structure

Capital protection oriented funds

These are very similar to CDOs involving a pool of corporate debt exposures, and hence ‘SO’ suffix ensures consistency. 

 

The ratings would be on the regular rating scale for debt instruments and not on the mutual fund rating scale.

 

 


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