Credit Rating A Note

The concept of credit rating originated in USA.

In India too, as in most other

countries, it has been the development of capital markets, which has established the
need for credit rating services. As the awareness of the investor grew, so did the
knowledge that higher returns could be obtained from the capital markets if investor
is willing to accept greater risk.
markets in India.

No doubt many investors made money, but along side success

stories were stories of failure.

relatively

large

This led to unprecedented boom in the capital

&

A number of investors burnt their fingers when

well-perceived

companies

failed

to

repay

their

debts.

Developments like these hastened the need for credit rating.

A lender wants to lend money to credit-worthy borrower. It is not possible for an
individual lender to study and decide credit worthiness of each and every borrower.
Credit rating of the instruments of the borrower by an independent authority helps
lender to take decision regarding making advances to a borrower, thus, it gives
protection to investors.

Credit rating also helps borrowers in raising loans.

Good

borrowers can also get funds at lower rates of interest, if their credit rating is good.
Credit rating is the current opinion of a professional agency of an issuers relative
ability to service its debt obligations as per terms of the debt.

The opinion is of

professional body, which is independent of the issuers business.

Credit rating is primarily intended to systematically measure credit risk arising from
transactions between lender and borrower.

Credit risk is the risk of financial loss

arising from the inability (known in credit parlance as default) of the borrower to
meet the financial obligations towards its creditor.
Instruments / Schemes Credit Rated
Credit rating is done for the following instruments:
1. Debentures, Bonds
2. Commercial papers
3. Debt funds
4. Fixed deposits

5. Preference shares
Credit Rating - Advantages
To Investors:
-

Credit rating provides symbols, which represent degree of risk involved.

Absence of any link between issuer and rating agency ensure fair assessment and
credibility of the issuer company.

It provides better choice among investment proposals.

To Issuer Company:
-

Rating acts as a marketing tool.

It reduces cost of borrowing.

Enhancement in companys reputation.

To Others:
-

Favorable impact on capital markets

Rating helps in identifies the strength and weakness of the instrument.

Credit Rating Methodology & Process

(a). Business Analysis

Industry risk including analysis of the structure of the industry, demand & supply
position, study of key success factors, impact of govt. policies, etc.

Market position of the company including market shares, product diversity, selling
and distribution arrangements, etc.

Operating

efficiency

technology, etc.

including

locational

advantages,

labour

relationships,

(b). Financial Analysis

-

Accounting quality, Auditorss qualifications, methods of valuation of inventory,

depreciation policy, etc.

Earnings protection,

Adequacy of cash flows, Working capital management,

Financial flexibility

(c). Management Evaluation

Quality & ability of the management, past tract record, management philosophies
& strategies, ability to overcome difficult situations.

(d). Regulatory & Competitive Environment

-

Trends in regulations and deregulation, Impact on company

(e). Fundamental Analysis

-

Capital adequacy,

Asset quality,

Liquidity management,

Profitability and financial position,

Interest and tax sensitivity.

Credit Rating Agencies

In India, it is mandatory for credit rating agencies to register themselves with
SEBI and abide by the SEBI (Credit Rating) Regulations, 1999. There are 4
registered agencies in India, namely,
1. Credit Rating Information Services of India Ltd (CRISIL)

2. Investment Information and Credit Rating Agency of India Ltd (ICRA)

3. Credit Analysis and Research (CARE)
4. Duff & Phelps

Standard & Poor (S&P), Moodys Investor service, Japan Bond Research Institute
are among the leading international rating agencies.
Credit Rating Symbols
The ranking of credit quality is usually done with the help of rating symbols. An
illustrative list is given below. For preference shares, the letter pf are prefixed
to the debenture rating symbols. The fixed deposit rating symbols commence
with f and the short-term instruments use the letter p.

High Investment grade

AAA (Highest safety)

AA (High safety)
Investment grade

A (Adequate safety)

BBB (Moderate safety)

Speculative grade

BB (Inadequate safety)

B (High risk)

C (Substantial risk)

D (Default)
Rating agencies may apply + or - signs for ratings from AA to C to reflect
comparative standing within the categories.

Leasing
The basic concept of lease arrangement is the separation of

Ownership from

The Right to use of the assets. When we take machinery on lease, we get the
right to use assets on payment of monthly lease rentals. There are basically two
types of leases (i). Financial lease (ii). Operating lease.

Financial Lease:

In this form of lease the equipment is bought by the lesser

primarily for being transferred to leasee with tacit understanding between the
lessor and the leasee. The leasor recovers the investments and retunrs during the
currency of the lease.

Operating Lease:
two / more

In this form of lease the equipment is generally rolled over to

lesseses one after the other.

The investment and the return are

recovered over the various lessees depending upon the life of the equipment.

Advantages of leasing:
1. Documentation of leasing transaction is much easier and quicker.
2. Leasing can be used for unplanned capital expenditure.

3. Leasing is a method of off balance sheet financing and does not affect capital
gearing.
4. Lease rentals are fully tax deductible.

Securitization: A way of the future

Executive Summary

In the lexicon of previous decades, "intermediation" occurred when banks and non bank financial
institutions took in funds from depositors or other investors, and then lent the funds to businesses and
households, holding such loans on the books of the bank or non bank until the loans matured, rolled over
or went belly up. "Credit risk" was the major risk incurred by the financial institution, since interest rate
risk could be managed easily by making sure the contractual interest rate on the loan varied with the cost
of funds.

Over the past 15 years, however, traditional intermediation has changed dramatically at many of the
nation's largest banks. Also, large non banks, including investment banks, captive finance companies and
insurance companies, increasingly have become major players in the intermediation process, employing
the same technological advances as banks. Chief among the innovations at the major banks has been the
invention and use of loan securitization.

Securitization: A way of the future

Introduction
Securitization is the process of pooling and re-packaging of homogenous illiquid loans/ future cash flows
into marketable securities. Securitization is a relatively new concept in India but is gaining ground quite
rapidly. CRISIL rated the first securitization program in India in 1991 when Citibank securitized a pool
from its auto loan portfolio and placed the paper with GIC Mutual Fund.
Securitization is fundamentally a risk management tool. It enables corporations to separate commercial
and business risks from the risks associated with financing their operations.
Also, securitization of assets has begun to emerge as a clear option of fund raising by corporates and a
few transactions of well-rated companies have taken place in the country.

How is Securitization Done?

Securitization is the process of pooling and re-packaging of homogenous illiquid loans into marketable
securities. Securitization is the issuance of marketable securities backed not by the expected capacity to
repay of a private corporation or public sector entity, but by the expected cash flows from specific assets
[OECD (1995)]. The concept of securitization is best understood by considering a typical transaction. In a
securitization, the originator sells receivables to a special purpose vehicle (SPV) established to isolate the
receivables and to perform other functions (eg, restructuring of cash flows and provision of credit
enhancement and liquidity support). The SPV is usually structured as a bankruptcy-remote trust or
incorporated entity. The SPV finances th e purchase of receivables by issuing securities (usually notes,
commercial paper, bills, bonds, or preferred stock) to investors. Legal agreements delineate the rights and
obligations of all parties to the transaction, including the appointment of an administrator to manage the
receivables where necessary. One or more financial institutions are usually involved in structuring and
marketing the securities issued by the SPV. To facilitate investor demand, credit rating agencies assess the
likelihood that the SPV will default on its obligations and assign an appropriate credit rating. Credit
enhancement and liquidity support is usually obtained by the SPV to ensure a high rating for the
securities.

Obligors

Goods and Services

Originator

Receivables

Obligors
Liquidity
Support

Goods and Services Cash

Originator
Recievables
SPV
Recievables
Cash

Liquidity
Support

SPV

Receivables

Recievables

Credit
Enhancement

Related
Securities

Credit
Enhancement

Investors
Recievables
Recievables
Investors

Increased pressure on operating efficiency, on market niches, on competitive advantages, and on capital
strength, all provide fuel for rapid changes. Securitization is one of the solutions to these challenges.
Securitization is built around one central theme- a defined financial asset or group of financial assets can
be structurally isolated and thereby serve as the basis of a financing that is independent as a legal matter,
from the bankruptcy risks of the former owner of the financial asset(s). Additionally, by isolating
financial asset(s), securitization can facilitate access to the capital markets, vastly expanding the sources
of available funding.

Benefits of Securitization
One of the principal benefits from securitization is reduction in the cost of financing. Not only is the credit rating of
the financing likely to be enhanced, but also the cost of financing in the capital markets may be less than the cost
of comparable financing from a bank. Securitization also permits tremendous flexibility.

Covenants and other terms in securitization are generally less restrictive in relation to the party benefiting from
the financing than those in private market transactions. Moreover, securitization may permit off-balance sheet
financing both the assets and the source of funding are removed from the balance sheet and thus a securitization
transaction may be a possible method of financing in some circumstances where a secured financing would be
prohibited by pre-existing restrictions in outstanding credit documents of the originator or where the originator for
other reasons does not want to undertake on-balance sheet financing.

Securitization of receivables can also accelerate the receipt of cash flows, allowing the quicker redeployment of
those assets. Securitization or other modes of structured finance can change the financier's dependence on the
originator for payment, by separating the source of payment from the originator itself.

The assets themselves are typically payment obligations, such as accounts or other amounts receivable, owing to
the originator from third parties. The purchasing entity and not the originator will issue securities to raise cash. The
securities are intended to be payable from collections on the receivables purchased by the SPV of receivables. A
potential investor in the aforesaid securities will look to the cash flow from the purchased receivables and not to
the credit of the originator.

Securitization is also useful where the originator is a regulated entity for capital adequacy purposes. In such cases,
finance can be raised which is outside the regulatory balance sheet, as the essence of the transaction is to replace
financial assets with cash, which carries zero-risk weighting for capital adequacy purposes.

At an accounting level, securitization generates immediate payments on account of financial assets and enables
the originator to survive a liquidity crunch.

Why securitize assets?

The potential benefits of securitization to the originator are:

More efficient financing

For some private-sector institutions, securitization is used to lower the firm's weighted-average cost of capital. This
is possible because equity capital is no longer required to support the assets and highly rated debt can be issued
into deep capital markets with investor demand driving down financing costs.

Improved balance sheet structure

Securitization can enhance managerial control over the size and structure of a firm's balance sheet. For example,
accounting de-recognition of assets (i.e. removal from the balance sheet) can improve gearing ratios as well as
other measures of economic performance (e.g., Return on Equity). Financial institutions use securitization to
achieve capital adequacy targets, particularly where assets have become impaired.
Securitization also releases capital for other investment opportunities. This may generate economic gains if
external borrowing sources are constrained, or if there are differences between internal and external financing
costs.

Better risk management

Securitization often reduces funding risk by diversifying funding sources. Financial institutions also use
securitization to eliminate interest rate mismatches. For example, banks can offer long-term fixed rate financing
without significant risk, by passing the interest rate and other market risk to investors seeking long-term fixed rate
assets. Securitization has also been used successfully to give effect to sales of impaired assets.

Securitization also benefits investors. It enables them to make their investment decisions independently of the
credit-standing of the originator, and instead to focus on the degree of protection provided by the structure of the
SPV and the capacity of securitized assets to meet the promised principal and interest payments.

Securitization also creates more complete markets by introducing new categories of financial assets that suit
investors risk preferences and by increasing the potential for investors to achieve diversification benefits. By
meeting the needs of different 'market segments', securitization transactions can generate gains for both
originators and investors.

Can Liabilities be Securitized?

While much of the previous discussion has focused on the securitization of assets, securitization techniques can
also be used to make implicit liabilities more explicit. For example, securitization has been used by governments as
a means of addressing expenditure arrears problems.

On occasions, governments have unilaterally borrowed from taxpayers, superannuitants, public servants, welfare
beneficiaries, and the suppliers of goods and services by running into payment arrears. When governments have
expenditure arrears, agents end up with implicit claims on the government for which they have no title and which
will be honoured, at best, at some unspecified future date and for an uncertain amount. Having no title to their
claim seriously limits creditors' financial management capacity, since they cannot trade or enforce their claims.

In the past securitization has been used as a means of formalising these implicit debt obligations providing a
degree of certainty to creditors and enhancing fiscal credibility (e.g., Argentina's issuance of bearer consolidation
bonds (BOCONs) to creditors in 1991). Securitization of implicit debts also enables marketability, which can
improve creditors' welfare by allowing them to reallocate their resources in an equitable, transparent, and efficient
manner.

Status in India

The major players in the asset securitization market in India are expected to be commercial FIs, PSUs, Corporates,
Government bodies, Mutual Funds, Pension Funds, etc. Securitization generally pre-supposes that the Originator
has a bulk of its assets in the form of self-amortising financial assets, either with or without underlying security. It
is also imperative that these assets should have a clearly established repayment schedule. Moreover, since capital
market instruments have a minimum marketable tenure, the receivables underlying the securities should
themselves have a sufficiently long tenure, so as not to frustrate the securitization exercise.

While securitization started off in the housing loan sector, the development of the securitization market as a
standard funding option across most industries has been the result of a constantly expanding universe of
securitizable non-mortgage asset types.

Securitization is a relatively new concept in India but is gaining ground quite rapidly. CRISIL rated the first
securitization program in India in 1991 when Citibank securitized a pool from its auto loan portfolio and placed the
paper with GIC Mutual. Since then, securitization of assets has begun to emerge as a clear option of fund raising by
corporates and a few transactions of well-rated companies have taken place in the country.

While some of the securitization transactions which took place earlier involved sale of hire purchase or loan
receivables of non-banking financial companies (NBFCs), arising out of auto-finance activity, many manufacturing
companies and service industries are now increasingly looking towards securitizing their deferred receivables and
future flows also. Information on past deals is not readily available, as most of them have been bilateral one-toone and unrated transactions. In the context of rated transactions, CRISIL has rated about 50 transactions till date,
with volume aggregating to well over Rs 4,500 crore. Other rating agencies in India, viz., ICRA, DCR and CARE have
also been actively involved in the process. The majority of these being in the nature of outright sales of auto loan
portfolios without subsequent issue of securities and do not amount to securitization in the real sense. There has
till date been no instance of downgrading of the rating assigned to any of these transactions.

As per an estimate, out of the total asset securitization attempted between 1992 and 1998, as much as 35 %
relates to hire purchase receivables of truck and auto loan segment. The car loan segment of the auto loans
market has been more successful than the commercial vehicle loan segment mainly because of factors such as
perceived credit risk, higher volumes and homogeneous nature of receivables. Other types of receivables for which
securitization has been attempted include property rental receivables, power receivables, telecom receivables,
lease receivables etc.
However, while several ABS transactions may have assumed a form similar to that of securitization, the absence of
marketable securities available for distribution to several investors would imply that in substance all these
transactions partake of the essential characteristics of a structured loan deal rather than of a securitization
transaction. So far, Securitization in India was meant to imply any of the following distinct activities:

Structured obligations against receivables (whether loans or debentures/bonds)

Outright sale of financial/trade receivables without issue of securities

Securitization transactions involving assignment of receivables to an SPV and issue of securities backed by
these receivables

In the first type, there is no legal true sale of receivables. The lenders/investors rely on a structured payment
mechanism for timely servicing of their dues and not on the performance of the assets. Further, the receivables do
not go off the balance sheet of the Originator and the lenders/investors continue to have full recourse to the
Originator.

In the second type, while the Originator would get the benefit of off-balance sheet funding, it fails to satisfy a basic
requirement of securitization i.e. issue of securities backed by these receivables. Securitization is incomplete
unless it involves an issue of (marketable) securities whereby the risks and rewards are channeled into the capital
market (at least into the wholesale segment). Thus, only the third type of activity falls under the category of true
securitization as understood internationally.

The first two types are already witnessing some activity from certain lending institutions. Other players in the
reckoning are multinationals like GE Capital and Citibank who have been acquiring asset portfolios generated by
local NBFCs like Ashok Leyland Finance, 20th Century Finance and other companies like TELCO.

The third type of activity, which would involve issue of tradable securities either in the form of PTCs or structured
debentures, is the one that is expected to see larger volumes in the long run. This segment would comprise within
it, both corporates willing to raise funds against their assets as also FIs wanting to securitize their loan portfolios. In
fact, organisations like HUDCO and Rural Electrification Corporation have already evinced interest in creating a
securitization structure for their future investments in the infrastructure area.

Some of the pioneering transactions that have either been concluded or are being structured in this regard are
housing loans, auto loans, State electricity boards receivables and future flows in terms of remittances from
overseas workers, international telephone settlements, export receivables, future sale of oil and gas and other
commodities, project cash flows and toll receivables are finding favour with investors.

Future Prospects
In brief, securitization will grow in future for two significant reasons:
a) Securitized paper is rated more creditworthy than the FI itself
b) Strict capital requirements are imposed on the FIs
Future trends in securitization of assets will not only be influenced by those FIs who are knowledgeable about this
process, and therefore, aware of its potential but will also be affected by the level of knowledge in the financial
community as a whole as well as the perception of the regulators.

The debt market has deepened and widened in recent years in India after the introduction of financial sector
reforms. The recent recommendation of the committee on financial sector reforms (Narasimhan Committee Phase
II) stipulates that the minimum shareholding by Government /Reserve Bank of India in the equity of the
nationalized banks should be brought down to 33%. The same report also emphasizes financial restructuring with
the objective of, interalia, hiving off non-performing-asset portfolio from the books of the FIs through
securitization.

The guidelines of RBI restricting the quantum of the public deposits that can be raised by an NBFC have given them
further incentive to look for alternative sources of funds. The opening of the insurance sector for privatization can
create demand for the securitized paper.

The Indian financial system is sound and very well developed. A number of new financial products have arrived and
been tested in the market during the brief period since the reforms began. The past few years have also witnessed
a healthy trend towards computerisation of transaction and information management systems. The availability of
computer technology would thus permit the capture and manipulation of large databases, which are a basic
requisite in structuring, securitized products.

The debt market is poised for substantial growth with the development of the sovereign yield curve across
different maturities and the active participation of primary dealers. The Indian market has existing well-developed
institutions, specialized regulators in Banking, Capital Markets, Rating Agencies and also a well-developed regime
of controls and supervision.

The existence of specialized financing institutions like Housing Finance Companies, Urban / Infrastructure
development Bodies like Housing and Urban Development Corporation (HUDCO), Rural Electrification Corporation
(REC) etc. who not only have existing securitizable portfolios but also have the capacity to keep creating such
assets with a view to securitizing them. Since most such institutions are facing resource constraints, securitization
will enable them to focus on their core competency of supporting infrastructure products through the gestation
stage and securitizing them later, rather than funding them till maturity.
The domestic financial institutions are fast reaching their prudential limits in various sectors. Further lending by
them to these sectors is thus dependent upon their being able to securitize their existing portfolios.

The investors with long term funds have traditionally favoured equity and Government securities
portfolio and have stayed out of debt. Also the present illiquidity of the loan portfolios does not
allow FIs to actively manage or manipulate the related sector, interest rate or maturity risks. This

places a restriction on further asset expansion, as assets once taken on the books necessarily need
to be carried till maturity. Securitization will provide solution for their requirements.

The market is thus at a stage where debt is increasingly going to be offered in a tradable form, whether or not
secondary market trades take place in individual cases. Securitization, by converting debt into tradable financial
instruments, provides an opportunity for more efficient reallocation of sector specific risks among a more
diversified set of players. By offering an exit option, it channelises surpluses that have so far remained untapped,
to capitaldeficient sectors of the economy.