The Reserve Bank of India (RBI) is planning to enable securitisation of non-performing assets (NPAs) through the special purpose entity (SPE) route, on the lines of securitisation of standard assets, as an alternative investment route in stressed assets.

The central bank, on Wednesday, released a discussion paper on Securitisation of Stressed Assets Framework (SSAF) and invited stakeholder comments by February 28.

Securitisation of Stressed Assets is a financial structure whereby an originator of NPAs sells these to a SPE that funds such an acquisition by issuing securitisation notes, per the paper.

The SPE, in turn, appoints a servicing entity to manage the stressed assets, typically with a fee structure that incentivises them to maximise recoveries on the underlying loans.

Investors are paid based on the recovery from underlying assets, as per the waterfall mechanism depending upon the seniority of the tranches.

“This could be the beginning of junk bond market in India. It could also provide an opportunity for asset reconstruction companies to earn other income,” Hari Hara Mishra, Director, UV ARC.

Asset selection

The paper underscored that the question that needs to be addressed in respect of SSAF is whether the framework should be restricted only to NPAs, or expanded to include standard assets too, up to a ceiling.

Securitisation involving only NPAs may have uncertain cash flows, mainly dependent on recoveries from underlying assets and issuance of securitisation notes on those underlying assets may not have regular servicing, which may be a limiting factor for the universe of investors.

Internationally, a limited window is permitted for inclusion of non-NPA (standard) assets for structuring purposes. However, such transactions having combination of standard and NPA assets may lead to issues of regulatory arbitrage, complexity in valuation, etc.

During preliminary interactions with a focused set of market participants, RBI said the views broadly mirrored the global experience in terms of asset selection — retail stressed assets — mortgages, unsecured personal loans and loans taken by MSMEs.

In these categories of loans, where the borrower base is diversified, the cash flows are relatively predictable even where the assets are stressed, and borrowers often continue to make regular payments. With relatively predictable cash flows, the complexities involved in structuring such transaction are reduced.

The paper said an additional option is to permit stressed large corporate accounts. However, the downside is that these accounts may exhibit highly uncertain cash flows; delays in decision making by the Inter Creditor Agreement/Committee of Creditors leading to deterioration in value of underlying; and, representation by the resolution manager of only a part of the entire set of creditors.

On the other hand, these assets have significant enterprise value backed by tangible security and potentially may attract wider investor base. Moreover, since these accounts form major part of NPAs of financial sector, excluding them from SSAF will limit the universe of underlying pools.

Further, in order to have a portfolio approach towards recovery from varied pool of stressed assets, a floor on the value of underlying or number of loans in underlying assets can be considered.

Resolution Manager

The paper said the Resolution Manager’s (RM) economic interests ought to be closely aligned with interests of investors. It suggested that RMs, who are usually employed on fee-based mechanism for recovery, should be incentivised for early resolution and higher recovery, rather than acting as cost centre through yearly fees and negligible output.

To align the incentives for RMs, prudentially, it may be justifiable to stipulate that RMs retain a share of the risk by investing in securitisation notes, per the paper.

The key issue, then, would be to determine as to who should bear the incidence of minimum risk retention (MRR)– the originator or the RM, and in what manner. One option is to leave it to market to decide through the contractual terms of the structure.

Another option is to distribute MRR between originator and RM through regulatory guidelines. A third option can be to specify recovery-based fee structure for RM and MRR with originator.

Interim finance

Under SSAF, resolution/recovery of stressed assets is envisaged to be carried out by an independent RM. The paper noted that resolution effort may require additional/interim finance to meet administrative, operational, and other expenses required to kick-off the resolution/recovery plans.

RMs can either finance the same through funding raised from investors, borrowings from lending institutions, or a combination of the two.

In case of financing by lending institutions to RM, there is a possible risk of over valuation of underlying assets at the time of transfer by originator to SPE where the originator could end up extending finance to RM in exchange of over valuation of stressed assets, cautioned the paper.

Prudentially, it may be necessary to discourage such practice of artificially levering up books by originator without any real value addition.

The paper said credit enhancement arrangements assist in structuring and broadening the pool of investors with potential inclusion of even those investors with slightly lower risk appetite and would break the ground for initial take-off of SSAF.