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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.
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Key Steps in Securitization
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Risk Associated/ Factors Analysed
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From its overall portfolio, the originator
demarcates a pool of assets (loans) that it wishes to securitize.
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Overall Portfolio Risk
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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.
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Legal Risk
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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
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Transaction Structure
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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.
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Servicer Risk
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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.
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Credit Risk
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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.
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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.
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.
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.
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.
Acuité also analyses the transaction structure to determine the inherent
protection to PTC investors. The two primary structural features built into the
transaction are:
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.
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.
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.
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.
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:
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.
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.
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.
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.
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Type of Instrument / Structure
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Rationale
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ABS
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Bankruptcy remote structure
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MBS
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Bankruptcy remote structure
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CDO
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Bankruptcy remote structure
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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
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Bankruptcy remote structure
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Capital protection oriented funds
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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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