Securitisation Transactions | Infomerics Ratings

RATING METHODOLOGY - SECURITISATION TRANSACTIONS

This note describes the rating methodology followed by Infomerics for rating securitisation instruments i.e., Direct Assignments (DA) and Pass-through certificates (PTCs) for various asset classes like., (Asset backed Securities) ABS, (Mortgage-backed Securities) MBS transactions, etc.,

What is Securitisation?

Securitisation is a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for an immediate cash payment. The cash flow from the underlying pool of assets is used to service the securities issued by the SPV. Securitisation thus follows a two stage process. In the first stage there is sale of assets to a 'bankruptcy remote' SPV in return for an immediate cash payment, which is typically known as Direct Assignment (DA) transaction and, in the second stage, repackaging and selling the security interests representing claims on incoming cash flows from the assets to third party investors by issuance of debt securities typically known as Pass Through Certificates (PTCs).

A typical transaction structure is presented below-

The underlying assets are typically secured loans (like housing loans, auto loans, commercial vehicle loans, construction equipment loans, gold loans, etc.) or unsecured loans (like personal loans, consumer durable loans, microfinance loans, etc.). The SPV is generally in the form of trust, settled and managed by a trustee. The trust purchases the pool either at par or premium. The investors subscribes to PTCs issued by the trust. The PTCs are backed by the underlying loan receivables and the beneficial interest lies with investors. The Servicer (which is typically the originator itself) is appointed by the trust to service the loans. Servicer collects monies from the underlying borrowers and deposits the same into the trust account which is used by the trustee to make investor payouts as per the scheduled waterfall mechanism. Credit Enhancement is also provided to the SPV to cover any shortfall, if arises, in the pool of assets.

Credit Enhancement may be divided into First Loss facility and Second Loss facility. First loss facility represents the first level of financial support to a SPV as part of the process in bringing the securities issued by the SPV to investment grade. Any shortfall is first covered by utilizing the First loss facility. Second loss facility represents a credit enhancement providing a second (or subsequent) tier of protection to an SPV against potential losses. Once the First loss is fully utilized, any shortfall is then covered by utilizing the Second loss facility. In some transactions a ‘liquidity facility’ (usually in the form of fixed deposit) is also provided to help smoothen the timing differences faced by the SPV between the receipt of cash flows from the underlying assets and the payments to be made to investors.

Risk analysis

Infomerics considers the following factors in the risk analysis for ABS/MBS transactions-

1. Credit Risk pertaining to loan receivables

It pertains to the risk of non-payment by the borrowers in the underlying pool. This is due to the ability and/or willingness of the borrowers. Further the risk perception of the asset class the pool belongs also has an impact on the credit risk analysis.

Infomerics studies the following aspects to analyse the credit risk-

A. Portfolio Analysis

This involves the analysis of dynamic portfolio as well as static pools.

Dynamic portfolio analysis

In the dynamic portfolio analysis, Infomerics mainly studies the portfolio ageing (dpd movement), Non-Performing Assets (NPAs) analysis and the collection efficiency data.

Portfolio Ageing (days-past-due [dpd] movement)

This analysis looks at the breakup of the portfolio based on the ageing of the past dues. Thus the portfolio is divided into various buckets - current, 0-30 dpd, 31-60 dpd, 61-90 dpd and so on & so forth. This provides a quick measure of portfolio quality. If high proportion of the portfolio is current and in early buckets, it shows healthy performance and vice versa. Some of the key measures tracked by the market participants are 90+ dpd and 180+ dpd which are used as performance benchmarks. If a portfolio grows very rapidly, the lagged delinquency levels may also be calculated to negate the denominator effect.

Collection efficiency

The monthly collection efficiencies based on total collections, collections from current billings and collections from overdues, provide an indication about the performance of the portfolio; though dpd movement analysis is more accurate and detailed measure.

Given the current environment, which is very dynamic and vulnerable to external events, it is also pertinent to study the NPA movements to understand the portfolio quality. NPA for last 2-3 years will be analysed to understand the company’s credit policies, borrower’s credit discipline and portfolio performance in such turbulent times. NPA movements reflects the quality of portfolio, its resilience and the company’s credit underwriting policies/ processes.

Static Pool Analysis

A static pool refers to a pool of loans originated in a particular period of time say a month or a quarter. There is no addition to this pool over its tenure. In the overall portfolio, new contracts are added every month as the disbursements happen; however, the pool to be rated is static in nature i.e., no new contracts is added to it after securitisation. Hence, the static pool analysis is one of the key aspects of ABS/MBS risk analysis. As past securitised pools are akin to static pools, they may also be analysed for this purpose. Performance measures like, total overdues, 90+ dpd, 180+ dpd, collection efficiencies, etc., may be studied for each static pool over its tenure. A long history of static pool data, the average value, volatility and the trend provides a more accurate basis for the analysis of the securitisation transaction.

B. Pool Analysis

This entails the analysis of the pool to be rated. It includes the following factors:

Pool selection criteria

The pool characteristics will be based on the criteria on which the pool is selected. The pool selection criteria normally includes features like minimum seasoning (Minimum holding period), maximum LTV, maximum overdue status, tenure, etc. A pool selection criteria stipulating higher -seasoning and lower maximum LTV is considered favourable for the pool credit quality.

Pool characteristics

Pool characteristics indicate the future performance of the pool. If the characteristics are better, the pool is likely to perform better and vice versa. Some of the key pool characteristics are as follows:

Key pool Characteristics	Remarks
Asset class and type	Different asset class like Home loans, Gold loans, Personal loans, Microfinance loans, Car loans, Commercial vehicle loans, Two wheeler loans, etc. have different risk characteristics and therefore have different expectation of collection shortfalls. Further, there may be different segments within an asset class e.g. SCV (Small Commercial vehicle), LCV (Large commercial Vehicle) and MHCV (Medium & Heavy Commercial Vehicle) which may exhibit different performance. In addition, the asset financed may be new asset or used / refinanced assets. All these factors are considered.
Geographical distribution	Geographical concentration may lead to the vulnerability of the pool performance in the particular geography that the pool is concentrated in. Thus, a concentrated pool is penalised by applying additional stress factor.
Loan To Value Ratio (LTV)	Lower the LTV ratio, higher is the borrower’s stake in the asset and hence, is considered favorably and vice versa.
Borrower profile	Pool performance may be different for different borrower profiles e.g. Self-employed category vs salaried profile, and First Time Buyers (FTB) or First Time Users (FTU) v/s large fleet operators in CV/CE loan segment.
Obligor distribution/ Granularity	Obligor diversity or the granularity of the pool ensures that the pool performance is not unduly affected by few obligors. Thus, if a pool has obligor concentration, it is penalised by applying additional stress factor.
Seasoning	Higher seasoning is considered favorably as the future performance is likely to be better for highly seasoned contracts. Further higher seasoning may also reduce the risk of frauds as the borrowers have already honored some of their obligations.
Installment to Income ratio (IIR)	This parameter highlights the borrower’s debt obligation vis-a-vis the earnings. Hence a lower IIR is considered more favorable.
Original Tenure	If the pool has high proportion of high tenor contracts, it may indicate a higher credit risk.
Overdue profile	Proportion of the pool in current bucket, one month overdue and 2 month overdue status is considered to assess the credit risk. Higher proportion of contracts in overdue buckets indicate higher risk.
Loan amount	The distribution of the pool in terms of loan amount may be studied as higher loan amount is generally considered more risky. However it has to be studied with the historical data of the particular originator.
Interest rate	Generally higher interest rates indicate higher risk. However, it is also subject to the prevailing interest rate scenario at the time of origination of the contract. Hence, this factor needs to be considered accordingly.

C. Pool v/s portfolio analysis

As the pool is carved out of the total portfolio. It is necessary to understand if the pool is likely to perform similar, better or worse than the portfolio. Accordingly, the risk multiplier is applied to the base case scenario which is based on the portfolio performance. In the pool v/s portfolio analysis we compare the pool characteristics with the portfolio characteristics and benchmark it with the performance measure like 90+dpd, 180+ dpd, etc. If the pool has higher proportion of contracts in the segment where the performance is weaker, an additional stress is applied.

Consider a sample pool v/s portfolio analysis for geographical distribution as follows-

	Pool (%)	90+dpd	Portfolio (%)
Maharashtra	18%	1.00%	25%
Rajasthan	13%	1.50%	10%
Tamil Nadu	20%	2.00%	15%
Gujarat	25%	0.50%	40%
Bengal	24%	2.50%	10%
Total	100%	1.15%	100%

In the above example, the pool is expected to perform worse than the portfolio since pool has higher proportion of contracts from Tamil Nadu and Bengal which has higher 90+ dpd in the portfolio. Similar analysis is done for other key pool characteristics like LTV, tenure, etc. and a suitable stress factor or risk multiplier is then applied.

D. Originator/Servicer operation analysis

Infomerics’ rating methodology involves quantitative as well as qualitative factors. The originators/servicer operation analysis is a key qualitative factor. Infomerics studies the method of sourcing (direct or DSAs), underwriting standards and credit appraisal system, sanctioning authority & process, pre & post disbursement documentation, etc. As the originator also typically acts as servicer in Indian ABS and MBS transactions, the system of collection and monitoring of loans especially in the overdue buckets is also studied. In addition, the management quality and length of experience in the asset class, business growth and strategies, market position and reach, financial strength, etc. also considered. The originator liquidity is also studied as it gives comfort while rating securitisation transactions as it gives additional cushion to the investor in case of collections shortfall.

Market Risk

It mainly comprises the following-

Macro-economic and regulatory risk

The macro-economic situation in a country may have an impact on the underlying asset, the borrower segment, the servicer, etc. Thus, it can have an impact on the pool collections and hence ability to service the investors. Further, the regulatory changes can also be critical for the performance of the pool or any related aspects.

Prepayment Risk

The prepayment may impact pool cash flows and shortfalls depending upon the transaction structure. E.g. in a premium structure, it may lead to premium loss to be drawn from credit enhancement and in a par structure, it may lead to loss of excess interest spread (EIS) though it may also reduce the credit risk. Infomerics applies appropriate stress factor due to prepayment risk depending upon the past prepayment rates observed in the portfolio as well as the asset class the pool pertains to.

Interest rate Risk

The interest rate risk arises if there is any mismatch between cash inflows and payouts in terms of fixed v/s floating interest rate or if there is a different floating rate benchmark for inflows and payouts. Infomerics applies appropriate stress factor to account for interest rate risk which is typically more significant in an MBS transaction.

Counterparty Risk

It mainly comprises the following-

Servicer/Collection Agent Risk

Servicer risk pertains to the risk of servicer being able to service the pool over the full tenure of the transaction. If the servicer goes bankrupt during the tenure of the transaction, then the pool collection may get impacted. In India, typically the originator itself is appointed as servicer by the trustee. Infomerics takes into account the Servicer’s length of experience in the particular asset class, management quality, collections process and follow-up mechanism, the quality of MIS, the credit quality of the servicer, any provision for back-up servicer, etc.

Commingling Risk

It is the risk of cash flows of the servicer getting commingled with the cash flows pertaining to the pool. Typically, there is a time lag between the collections from the underlying borrowers and deposit of the same into the designated collection account. If a servicer goes bankrupt during this interval, there may be commingling risk. Infomerics typically considers the short term rating of the servicer to address this risk. Hence, proper ring-fencing of the pool cash flows/ waterfall mechanism for payments to the investors is crucial while rating the transaction.

Trustee Risk

The role of the trustee is one of the most critical factor in a securitisation transaction as the trustee needs to ensure adherence to the structure by various counterparties involved in the transaction and duly discharge its duties and obligation as well as exercise its rights, whenever needed. There is typically a ‘waterfall mechanism’ in the securitisation transaction which defines the priority of payments to be made. Trustee needs to ensure that this waterfall mechanism is strictly followed. Infomerics considers the quality of trustee in terms of the length of experience, its track record, reputation, etc. Also, in case of PTC transactions, the trustee has to provide payout reports to the CRAs on a monthly basis and hence adherence to the same is important to assess the pool performance.

Other Counterparty Risk

There may be several counterparties in a securitisation transaction like designated collection account bank, guarantee provider, etc. If any of the counterparty fails to perform its duties as per the transaction structure, it may impact the investor payouts. Infomerics considers the credit quality of such counterparties to address this risk.

Legal Risk and Pool Information Risk

Legal risk is one of the most important aspect in a securitisation transaction as the transaction involves transfer of receivables which must qualify as ‘true sale’ as per the law. This means that the seller does not retain any claim or control over the receivables. This makes the assets ‘bankruptcy remote’ of the originator/seller i.e. even the bankruptcy of the originator does not impact the right of the investors on the pool cash flows and credit enhancement. Infomerics typically relies on an independent legal opinion confirming the above to address this risk.

Further, Infomerics relies on the data provided by the originator, and given the criticality of the pool information to the rating; Infomerics requires an audit report certifying the accuracy of the pool information from an external Auditor.

Cash flow analysis and enhancement

Based on the analysis of the various factors mentioned above, and the payout schedule based on the waterfall mechanism, Infomerics prepares a customized cash flow model for the particular transaction. The base case scenario is based on the historical performance and various other factors enumerated above. Thereafter the stress factor is applied based on the particular rating level, volatility of performance, concentration risk, etc. The stressed cash flows from the pool are compared with the payouts to assess the credit enhancement level (First loss facility and second loss facility).

Additionally, the Master directions, guidelines and notifications of RBI on securitisation (subject to amendments made by RBI) are also considered while rating the securitisation transactions to ensure that the pool qualifies for securitisation. For example,

1) Minimum Holding Period (MHP): The transferor can transfer loans only after a minimum holding period (MHP), as prescribed below, which is counted from the date of registration of the underlying security interest:

a. Three months in case of loans with tenor of up to 2 years;

b. Six months in case of loans with tenor of more than 2 - <=5 years

2) Minimum retention requirement (MRR): The MRR is primarily designed to ensure that the originators have a continuing stake in the performance of securitised assets so as to ensure that they carry out proper due diligence of loans to be securitised. The originators should adhere to the MRR as detailed below while securitising loans leading to issuance of securities other than residential mortgage backed securities:

For underlying loans with original maturity of 24 months or less, the MRR shall be 5% of the book value of the loans being securitised.
For underlying loans with original maturity of more than 24 months as well as loans with bullet repayments of only either principal or interest, including the loans mentioned in clause 7, the MRR shall be 10% of the book value of the loans being securitised.
In the case of residential mortgage-backed securities, the MRR for the originator shall be 5% of the book value of the loans being securitised.

Surveillance process: The below note provides the surveillance process followed for securitisations transactions rated by Infomerics.

1) In case of Direct Assignment (DA) transactions, surveillance process does not follows, since it a one-time rating exercise of providing loss estimation

2) In case of PTCs, the rating assigned is subject to monthly monitoring, quarterly reporting and annual surveillance

A) Monthly monitoring: For all PTC transactions, a monthly payout report is provided by the trustee to all the stakeholders which consists of information on debt servicing such as, monthly collections, payouts, prepayments (if any), utilisation of credit enhancement, outstanding loans and overdues details. Infomerics ensures that these reports are received on time and the performance of the pool is discussed internally and a suitable rating action will be taken in case of shortfall/utilisation of credit enhancement

B) Quarterly reporting: As per regulatory requirement, quarterly performance report of all securitisation transactions rated by Infomerics has to be disclosed on its website. The report typically consists of the details of the transactions rated, provisional ratings assigned, conversion of provisional rating to final rating, ratings withdrawn, rating transition, rating outstanding and originator wise performance of all pools (based on payout report provided by the trustee) rated by Infomerics. Infomerics ensures that the quarterly reports are published/disclosed on time as per regulatory requirement.

C) Annual surveillance: The rating assigned to PTC transaction is valid for 12 months from the date of assignment and hence has to be mandatorily reviewed before expiry of the rating like all other market instruments. Hence, Infomerics ensures that the review is carried out in a timely manner based on the pool performance through payout report made available by the trustee.

Archive

This note describes the rating methodology followed by Infomerics for rating instruments (PTCs- Pass through certificates) and facilities under (Asset backed Securities) ABS and (Mortgage backed Securities) MBS transactions.

WHAT IS SECURITISATION?

Securitisation is a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for an immediate cash payment. The cash flow from the underlying pool of assets is used to service the securities issued by the SPV. Securitisation thus follows a two stage process. In the first stage there is sale of assets to a 'bankruptcy remote' SPV in return for an immediate cash payment and, in the second stage, repackaging and selling the security interests representing claims on incoming cash flows from the assets to third party investors by issuance of debt securities typically known as Pass Through Certificates (PTCs).

A typical transaction structure is presented below-

The underlying assets are typically secured loans (like housing loans, auto loans, commercial vehicle loans, construction equipment loans, etc.) or unsecured loans (like personal loans, consumer durable loans, etc.). The SPV is generally in the form of trust, settled and managed by a trustee. The trust purchases the pool either at par or premium. The investors subscribes to PTCs issued by the trust. The PTCs are backed by the underlying loan receivables and the beneficial interest lies with investors. The Servicer (which is typically the originator itself) is appointed by the trust to service the loans. Servicer collects monies from the underlying borrowers and deposits the same into the trust account which is used by the trustee to make investor payouts as per the scheduled waterfall mechanism. Credit Enhancement is also providedto the SPV to cover any shortfall, if arises, in the pool of assets.

Credit Enhancement may be divided into First Loss facility and Second Loss facility. First loss facility represents the first level of financial support to a SPV as part of the process in bringing the securities issued by the SPV to investment grade. Any shortfall is first covered by utilising the First loss facility. Second loss facility represents a credit enhancement providing a second (or subsequent) tier of protection to an SPV against potential losses. Once the First loss is fully utilised, any shortfall is then covered by utilising the Second loss facility.In some transactions a ‘liquidity facility’ is also provided to help smoothen the timing differences faced by the SPV between the receipt of cash flows from the underlying assets and the payments to be made to investors.

RISK ANALYSIS

Infomerics considers the following factors in the risk analysis for ABS/MBS transactions-

1) Credit Risk pertaining to loan receivablesIt pertains to the risk of non-payment by the borrowers in the underlying pool. This is due to the ability and/or willingness of the borrowers. Further the risk perception of the asset class the pool belongs also has an impact on the credit risk analysis.Infomerics studies the following aspects to analyse the credit risk-

This involves the analysis of dynamic portfolio as well as static pools.

DYNAMIC PORTFOLIO ANALYSIS

In the dynamic portfolio analysis, Infomerics mainly studies the portfolio ageing (dpd movement) and the collection efficiency data.

i)Portfolio Ageing (days-past-due - dpd movement)

ii)Collection efficiency

STATIC POOL ANALYSIS

This entails the analysis of the pool to be rated. It includes the following factors:

POOL SELECTION CRITERIA

The pool characteristics will be based on the criteria on which the pool is selected. The pool selection criteria normally includes features like minimum seasoning, maximum LTV, maximum overdue status, tenure, etc.A pool selection criteria stipulating higher minimum seasoning and lower maximum LTV is considered favourable for the pool credit quality.

POOL CHARACTERISTICS

Key pool Characteristics	Remarks
Asset class and type	Different asset class like Car loan, Commercial vehicle loans, Two wheeler loans, etc. have different risk characteristics and therefore have different expectation of collection shortfalls. Further, there may be different segments within an asset class e.g. SCV, LCV and MHCV which may exhibit different performance. In addition the asset financed may be new asset or used / refinanced assets. All these factors are considered.
Geographical distribution	Geographical concentration may lend the pool vulnerable to the performance in the particular geography that the pool is concentrated in. Thus, a concentrated pool is penalised by applying additional stress factor.
Loan To Value Ratio (LTV)	Lower the LTV ratio, higher is the borrower' s stake in the asset and hence, is considered favourably and vice versa.
Borrower profile	Pool performance may be different for different borrower profiles e.g. Self employed category vs salaried profile, and First Time Buyers (FTB) or First Time Users (FTU) v/s large fleet operators in CV/CE loan segment
Obligor distribution	Obligor diversity ensures that the pool performance is not unduly affected by few obligors. Thus, if a pool has obligor concentration, it is penalised by applying additional stress factor.
Seasoning	Higher seasoning is considered favourably as the future performance is likely to be better for highly seasoned contracts. Further higher seasoning may also reduce the risk of frauds as the borrowers have already honoured some of their obligations.
Installment to Income ratio (IIR)	This parameter highlights the borrower' sdebt obligation vis-a-vis the earnings. Hence a lower IIR is considered more favourable.
Original Tenure	If the pool has high proportion of high tenor contracts, it may indicate a higher credit risk.
Overdue profile	Proportion of the pool in current bucket, one month overdue and 2 month overdue status is considered to assess the credit risk. Higher proportion of contracts in overdue buckets indicate higher risk.
Loan amount	The distribution of the pool in terms of loan amount may be studied as higher loan amount is generally considered more risky. However it has to be studied with the historical data of the particular originator.
Interest rate	Generally higher interest rates indicate higher risk. However, it is also subject to the prevailing interest rate scenario at the time of origination of the contract. Hence, this factor needs to be considered accordingly.

C. POOL V/S PORTFOLIO ANALYSIS

As the pool is carved out of the total portfolio. It is necessary to understand if the pool is likely to perform similar, better or worse than the portfolio. Accordingly the multiplier is applied to the base case scenario which is based on the portfolio performance. In the pool v/s portfolio analysis we compare the pool chacterisctis with the portolfio characteristics and benchmark it with the performance measure like 90+dpd, 180+ dpd, etc. If the pool has higher proportion of contracts in the segment where the performance is weaker, an additional stress is applied.

Consider a sample pool v/s portfolio analysis for geographical distribution as follows-

	Pool%	90+dpd	Portfolio%
Maharashtra	18%	1.00%	25%
Rajasthan	13%	1.50%	10%
TamilNadu	20%	2.00%	15%
Gujarat	25%	0.50%	40%
Bengal	24%	2.50%	10%
Total	100%	1.15%	100%

D. ORIGINATOR/SERVICER OPERATION ANALYSIS

Infomerics' rating methodology involves quantitative as well as qualitative factors. The originators/servicer operation analysis is a key qualitative factor. Infomerics studies the method of sourcing (direct or DSAs), underwriting standards and credit appraisal system, sanctioning authority & process, pre & post disbursement documentation, etc. As the originator also typically acts as servicer in Indian ABS and MBS transactions, the system of collection and monitoring of loans especially in the overdue buckets is also studied. In addition,the management quality and length of experience in the asset class, business growth and strategies, market position and reach, financial strength, etc. also considered.

(2) MARKET RISK

It mainly comprises the following-

MACRO-ECONOMIC AND REGULATORY RISK

PREPAYMENT RISK

The prepayment may impact pool cash flows and shortfalls depending upon the transaction structure. E.g. in a premium structure, it may lead to premium loss to be drawn from credit enhancement and in a par structure, it may lead to loss of excess interest spread though it may also reduce the credit risk. Infomerics applies appropriate stress factor due to prepayment risk depending upon the past prepayment rates observed in the portfolio as well as the asset class the pool pertains to.

INTEREST RATE RISK

The interest rate risk arises if there is any mismatch between cash inflows and payoutsin terms of fixed v/s floating interest rate or if there is a different floating rate benchmark for inflows and payouts. Infomerics applies appropriate stress factor to account for interest rate risk which is typically more significant in an MBS transaction.

E. COUNTERPARTY RISK

It mainly comprises the following-

SERVICER/COLLECTION AGENT RISK

COMMINGLING RISK

It is the risk of cash flows of the servicer getting commingled with the cash flows pertaining to the pool. Typically there is a time lagbetween the collections from the underlying borrowers and deposit of the same into the designated collection account. If a servicer goes bankrupt during this interval, there may be commingling risk. Infomerics typically considers the short term rating of the servicer to address this risk.

TRUSTEE RISK

OTHER COUNTERPARTY RISK

There may be several counterparties in a securitisation transaction like designated collection account bank, guarantee provider, etc. If any of the counterparty fails to perform its duties as per the transaction structure, it may impact the investor payouts. Infomerics considers thecredit quality of such counterparties to address this risk.

4) LEGAL RISK AND POOL INFORMATION RISK

5) CASH FLOW ANALYSIS AND ENHANCEMENT

Based on the analysis of the various factors mentioned above, and the payout schedule based on the waterfall mechanism, Infomerics prepares a customised cash flow model for the particular transaction. The base case scenario is based on the historical performance and various other factors enumerated above. Thereafter the stress factor is applied based on the particular rating level, volatility of performance, concentration risk, etc. The stressed cash flows from the pool are compared with the payouts to assess the credit enhancement level (First loss facility and second loss facility).

ARCHIVE

INTRODUCTION

Investors in securitisation transactions rely primarily on the underlying asset pool securing the transaction for repayment of interest and principal. The effective isolation of securitised pool from the credit risk of the assets of the originator can allow securtisation transaction to achieve a rating higher than that of the originator itself, if the securities are adequately protected from risk of loss at the originator level.

Infomerics will evaluate a securitisation transaction on a five-point criteria to assess whether the debt security (generally represented by PTC – Pass Through Certificate) will be fully repaid in accordance with the terms of the transaction: (i) legal structure, (ii) asset quality, (iii) credit enhancement by way of collateral coverage, (iv) financial structure; and the (v) quality of originator and servicer. All of these criteria are the principal elements that shape the credit profile of the transaction and, thereby, the determination of a rating opinion on the transaction.

LEGAL STRUCTURE

A securitised transaction is distinguished from the corporate credit risk of the original owner, or “originator,” of those assets through isolation, or “de-linking” by way of an underlying pool of cherry-picked assets. The aim is to correlate the primary credit risk of the transaction to that of the pool quality; rather than the idiosyncratic credit risk of the originator. This is achieved in securitisation transaction, either directly or indirectly, by the sale of an identifiable and specific pool of the originator's assets, to a special purpose vehicle (SPV) which will lead to neither the assets nor their proceeds to be consolidated as part of the bankruptcy estate of the originator/seller in the event of its insolvency.

The SPV acquires cash generating assets by issuing PTC and using the proceeds of that issuance. The cash and all the benefits associated with such assets are passed through to the SPV to service the debt.

As bankruptcy of the SPV is rendered remote through various structural features, SPVs are often described as “bankruptcy remote”. SPVs do not assume debt other than rated debt or subordinated debt as they are not operating businesses unlike the originator. SPVs have a separate independent and legal structure than their parents as they are established for a specific and limited purpose, i.e. for issuing the PTCs. Thus, relative to corporate credit, the SPV provides improved outcome predictability as the risk factors associated with a securitisation transaction are ensconced primarily within the asset pool transferred to the SPV.

An organisation’s legal form will be determined and regulated by local law in the jurisdiction where the SPV is created. An SPV in a securitisation transaction is mainly in the form of a limited liability company, a trust, limited liability partnership, or other form of body corporate (depending on the local law in the place of establishment).

ASSET QUALITY

Loss expectation under a base scenario is analysed through the assets’ credit characteristics by Infomerics. This assumption is stressed further through each successive rating category, such that securities rated in the high investment-grade categories have loss expectations that are consistent with low probability, high-severity stress scenarios.

A broad spectrum of financial assets collateralises securitisation transaction. Mortgage loans secured by residential and commercial properties, consumer assets such as credit card receivables and auto loans, and corporate loans are the most common assets that are securitised. Securitisation transactions are broadly classified by Infomerics into four main categories: RMBS (Residential Mortgage Backed Securitisation), CMBS (Commercial Mortgage Backed Securitisation, ABS (Asset Backed Securitisation) and structured credit. Within these categories, there is a variety of sub-categories; for example, the ABS category encompasses consumer (e.g., auto loans, credit cards and educational loans, among others) and commercial assets (aircraft leases, franchise loans and corporate-linked future flows, among others), as well as Asset-Backed commercial Paper (ABCP) conduits.

The rated PTCs in securitisation transactions are serviced out of the underlying loan portfolio and collateral, if required. The assets' credit characteristics are analysed to derive a loss expectation under a scenario that reflects Infomerics' current macro-economic expectations. This is commonly referred to as the base case scenario. The base case scenario is a description of expected asset loss only, without the reflection of potential loss-reducing structural features of the transaction. The Independent Rating Committee provides a rating opinion on base case loss expectations based on values derived by one of the approaches listed below before assigning the final rating:

Default probability and loss severity are imputed to each individual loan based on loan-level characteristics through the output of analytical models developed by Infomerics. The underlying pool's loss rate is calculated using default models. This approach is typically used in the analysis of RMBS and CMBS multi-borrower transactions.
The asset portfolio is analysed based on the originators' historical performance for the Rating Committee to derive an expected loss. This approach is often used in the rating of consumer ABS transactions.
The aggregate portfolio loss rate is estimated through simulation. Correlated portfolios of corporate exposure sectors such as CDOs (Collateralied Debt Obligation) and CMBS are analysed through this approach. Separate adjustments or stresses are applied for individual simulation models. For example, the CMBS analysis often employs stressed values for rental income decline and capitalisation rates.

Loss expectations are generated under increasingly severe assumptions in addition to the derivation of a base case. The loss expectation is higher for each successive rating category, such that securities rated in the high investment-grade categories have loss expectations that are consistent with low probability, high-severity stress scenarios.

The higher rating categories loss expectations are often expressed as a multiple of base case loss estimate. For instance, an asset pool may be expected to experience 2% losses in a base case scenario, but in an Infomerics AAA(SO) scenario, the collateral pool may be expected to experience losses 4.0 times(x) greater than the base case, or 8% of the collateral pool's balance.

CREDIT ENHANCEMENT

The mechanism that provides PTC holders with protection from losses on the underlying pool is termed as credit enhancement. The rating for each bond is a reflection of the bond having sufficient credit enhancement to withstand default given the expected losses on the underlying collateral pool (determined by Infomerics under the rating stress scenario associated with the relevant bond rating).

Infomerics’ ratings for each bond is a reflection of whether the bonds have sufficient credit enhancement available to withstand default given losses on the underlying collateral pool that is expected under the rating stress scenario associated with the relevant bond rating. Credit enhancement can be sourced internally through various forms as subordination, excess interest or over-collateralisation (OC) or cash collateral or externally by a third-party provider in the form of a provision of reserve fund account, external equity, financial guarantee or a combination of the above. Credit-linked securitisation transaction typically do not have additional credit enhancement; rather, the rating is dependent on the underlying entity or guarantee provider.

In a simple two-class senior-subordinated (senior/sub) structure, all losses on the asset pool are allocated first to the subordinate class until its balance is reduced to zero (assuming that the proceeds of the subordinated note were applied to purchase performing receivables). Thus, the subordinate class provides credit enhancement to the senior class. Generally, whatever cash is remaining is paid to the subordinated tranche post repayment of interest and principal due to the senior tranche. A subordinated bond can be written down each month by an amount equal to realised losses on the underlying collateral or incur shortfalls if collections are insufficient to repay the full due amount. In case, the size of the credit enhancement is consistent with Infomerics’ loss expectation derived under its AAA(SO) stress scenario and if the bond is able to make timely interest payments, then the senior bonds can achieve an AAA(SO) rating from Infomerics.

Many a time, securitisation transactions are “tranched” into multiple senior/sub classes with ratings ranging from AAA(SO) through B(SO). Losses are generally allocated in reverse sequential order commencing with the most junior and lowest rated tranche. The junior tranche’s protection is generally provided either by excess interest, OC, an unrated class that is allocated losses first until it is reduced to zero, or a cash reserve fund fully funded at closing (or with monthly excess interest) that will be utilised first to cover losses. The adequacy of the total credit enhancement or other forms of protection given the loss scenarios for the rating category concerned is reflected in the rating of the junior tranche. Generally, the credit enhancement available to the junior tranche coupled with the subordination of the junior tranche reflects the protection available for the most senior tranches.

FINANCIAL STRUCTURE

Infomerics will analyse any counterparty dependencies, such as provision of derivatives, bank accounts, or financial guarantees, as these represent credit exposures beyond the securitised asset pool. In the absence of any structural mitigants, securitisation transactions which are dependent on the credit quality of an underlying entity or guarantee provider are credit-linked to those entities.

The senior classes have priority in payment of interest and repayment of principal over the subordinated class in senior/sub SF transactions. However, AAA(SO) rated tranche, which is typically the most senior class, is often split into multiple PTCs with varying maturities or payment schedules. The manner in which principal collected on the asset pool is distributed among PTCs varies; though the amount of loss protection for a rated tranche provided by subordination, excess interest, or OC is generally unaffected by the financial structure.

The specific structure of the transaction concerned in assessing the adequacy of credit enhancement at each rating level is covered by cash flow modelling. A number of stress assumptions that are applied at different rating levels is included in the cash flow criteria. Stresses may include, but are not limited to:

High and low prepayment stresses;
Asset coupon compression to stress revenue levels;
Front- or back-loaded (or other) timings for when defaults and losses occur;
Interest rate stresses to assess the materiality of unhedged exposures, as well as carrying costs associated with defaulted assets;
Basis risk stresses to assess unhedged exposures regarding different interest rate bases for assets and liabilities;
Foreign exchange stresses to assess exposures to unhedged currency risks.

The asset class and type involved and the financial structure of the transaction concerned will influence the extent and nature of cash flow stresses.

Originator and Servicer Quality

The securitisation transaction and performance of the underlying assets can be affected by the originator, servicer, and CDO asset manager. The operational processes for each originator, servicer, or asset manager participating in a securitisation transaction rated by Infomerics is reviewed by Infomerics’ operational risk team or asset-specific rating analysts

The assessment indicated by an internal score, opinion or public rating may lead to adjustments to a transaction's base case expected loss and credit enhancement levels, application of a rating cap or cause Infomerics to decline to rate a transaction.

SURVEILLANCE:

After assignment of rating, Infomerics monitors the performance of the portfolio in accordance with its prescribed surveillance process, until the PTCs are paid in full or the rating is withdrawn. Out of the five key rating factors as discussed above, asset quality, credit enhancement and the quality of originator & servicer often evolve over the term of a transaction. In contrast, legal structure and financial structure are usually stable and affected only by specific events.