Pass-through Certificate (PTC) represents an undivided interest in a pool of underlying assets, like mortgages, loans, property, equity shares, etc. Its's one of the most preferred form of Fixed Income Securities where an investor choose to participate basis his cash flow desires.
Process - Flow
- Origination: NBFCs originate loans (e.g., mortgages, auto loans, MSME loans, micro loans) and hold them as separate asset class.
- Pooling: These asset classes are pooled together to form a larger portfolio of the same or different asset classes.
- Creation of SPV / Trust: The Pool is then transferred to a Special Purpose Vehicle (SPV) or Trust which in-turn issues pass-through certificates representing proportionate ownership in the underlying pool.
- Sale to Investors: The PTCs thus created are sold to investors seeking fixed-income securities to receive interest / principal repayments payments generated from the cash flows of the underlying assets.
- Servicing: A servicer (third party / original lender) is appointed by the SPV / Trust to collect payments (interest & principal) from the borrowers of the underlying pool.
- Distribution: The payments thus collected are passed through escrow mechanism by the SPV/Trust to the investors.
- Maturity: Upon maturity of the underlying pool & the principal is fully repaid the transaction achieves Maturity.
Points to consider while planning PTCs
- Risk Management: The NBFCs originating the loans manage their Risk / CRAR by transferring the credit risk of the underlying loans to the investors.
- Liquidity: NBFCs generate liquidity by selling these certificates and thus align their ALM while issuing loans more effectively and thus maintaining liquidity in different time brackets.
- Investor Perspective: Investors looking for a steady stream of income via interest payments and principal repayments PTCs comes handy.
HOW PTCs benefits NBFCs?
- Diversification of Risk
- Pooling of Assets: Pooling of large no of loans with distinct geography, size, end use, and distinct features of the borrowers into a single portfolio, PTCs spread the risk thus reducing the impact of any single borrower defaulting.
- Credit Enhancement: Risk Mitigation is of utmost importance and the Investor can secure the PTCs further, by way of techniques like overcollateralization and creation of reserve funds thus making PTCs more secure for Investors.
- Large Investor Base: PTCs with decent Pool & effective credit enhancement parameters attract a large group of investors (Retail / HNI / Family Offices, Institutions / Funds / etc) leading to a more reliable & stable source of funding.
- Asset-Liability Management (ALM)
- Liquidity Management: Securitizing loans and issuing PTCs unleash cashflow for the originator, improving liquidity and enabling further lending avoiding the future mismatches.
- Maturity Matching: By aligning the cash flows from the underlying assets with the existing shortfalls and all future payments to PTC holders & lenders the originator can better match their assets and liabilities, reducing ALM mismatches across different buckets.
- Managing Capital to Risk-weighted Assets Ratio
(CRAR)
- Capital Relief: With the transfer of AUM, Capital Relief can be achieved. By transferring the credit risk of the underlying assets to the investors the originator can reduce the quantum of Risk weighted Assets improving the CRAR.
- Efficient Capital Utilization: By offloading assets from the balance sheet, financial institutions can redesign their capital usage, ensuring regulatory capital requirements more efficiently.
Example
Consider an NBFC with a large portfolio of home loans, vehicle loans & LAP. By securitizing these loans and issuing PTCs, the institution can:
- Diversify its risk by spreading it across multiple investors.
- Improve liquidity, allowing for more lending.
- Enhance its CRAR by transferring the credit risk to the PTC investors.
Risks Involved
PTC transactions come with several risks one need to be aware of:
- Default by borrower of the underlying assets will adversely affect the cash flows of investors.
- Early Repayments by the borrowers will affect the cash flow structure of the PTCs including interest income for investors.
- Changes in Interest rates can impact the value of the underlying assets and the PTCs.
- PTCs are prone to Liquidity Risk and usually are not as liquid as other securities.
- Counterparty Risk such as the servicer or the SPV, may fail to meet their obligations, impacting cash flows to investors.
- Changes in laws and regulations can affect the structure and performance of PTC transactions.
- Operational Risk arising from inadequate or failed internal processes, systems, or external events.
- Market Risk arising out of Economic downturns, changes in market sentiment, or financial market fluctuations can impact PTC performance.
Mitigation Strategies
- Credit Enhancement Techniques improves the
credit quality of the issued securities, providing additional
protection to investors against potential losses from the
underlying asset pool. The same can be implemented by inclusion of
following pointers at the time of structuring of deal.
- Subordination: Structuring the securities into different tranches (e.g., senior, mezzanine, and junior). This hierarchy ensures that the senior tranches have a higher credit rating and are more attractive to conservative investors.
- Overcollateralization: The value of the underlying asset pool exceeds the value of the issued securities. For example, if the asset pool is worth ₹125 crore and the issued securities are worth ₹100 crore, the ₹25 crore excess provides additional security. This excess collateral acts as a buffer against losses.
- Excess Spread: The spread of Interest received from the underlying assets and paid to investors can be used to cover losses.
- Reserve Funds: Cash reserves / FDR may be stipulated to cover any shortfalls in the cash flows from the underlying assets. The same may be upfront or built up over time from excess spread.
- Due Diligence: Evaluate asset quality, borrower creditworthiness, and historical performance. Deep Dive into the portfolio with Heat maps and other parameters.
- Robust Legal Frameworks: Robust Legal structure is indispensable. While the pool transferred to the SPV / Trust one should ensure enforceability of the sale and applicability of the rights and obligations of all stake holders.
- Effective Risk Management Practices: Strong risk management practices, including regular monitoring of the asset pool and the servicer's performance.
PTCs are a powerful tool for financial institutions to manage risk, improve liquidity, and optimize capital usage. By understanding the process and benefits, both issuers and investors can make informed decisions to maximize their financial strategies.
At COINMEN, we view PTC as a crucial financial arrangement that supports a well-diversified and sustainable model for managing ALM and CRAR. Each transaction is more than just closing a deal; it's a step towards a more diligent and transparent process that benefits all stakeholders. Our goal is to build long-term relationships with all the stakeholders of the transaction with all our service lines.
Thinking about PTC? Let's connect and explore how we can harness its power together!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.