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Economic reforms in India have led to considerable growth in financial institutions and structures, ushering in a large range of financial instruments in the market. However, the development of securitisation -- process of converting loans and receivables into negotiable instruments -- remains in the nascent stage and suffers from constraints like lack of depth in the debt market, inadequate foreclosure laws for mortgage-backed securities and high stamp duties levied by the state governments on transfer of assets, according to a recent report by the Duff and Phelps credit rating agency.

Securitisation involves cherry-picking assets from the seller's books, building in adequate credit enhancements to ensure a high credit rating and then selling them off to a special purpose vehicle or trust. The SPV then issues debt on the basis of the strength of the underlying assets.

The most commonly used modus operandi is: a corporate (called the originator) sells a part of the asset portfolio to a trust, thereby realising today the stream of cash inflows which the asset would have fetched in the future. The trust simultaneously raises debt on the strength of cashflows of the underlying asset, using the proceeds to pay off the corporate.

The transaction is inevitably rated by a credit agency and the incorporation of adequate credit enhancements usually implies a high or highest credit quality rating.

The sellers may also be banks, financial institutions, non-banking financial companies and housing finance companies. The buyers usually are mutual funds, insurance companies, pension funds and corporates. Trusts, rating agencies and servicers act as intermediaries.

The assets that can be securitised include auto loan receivables, housing loans, credit card receivables and other loan receivables. The credit rating agency lays down the normal criteria for pool selection depending on the asset quality, disbursal systems and recovery mechanisms within the company. Credit enhancements are built in.

For a transaction to obtain a high rating one has to be careful so as to minimise the chances of default, and rigorous stress tests are applied before determining the level of credit enhancements.

Various structures for securitisation have evolved over the years which may be classified as ''pass through'', ''pay through'' or a combination of both.

''Pass through'' structure involves cashflows being directly passed to investors in securitised paper through the originator (wherever there is an SPV). Surpluses generated revert back to the originator after all claims of investors and management fees of third parties are taken care of. Payment to investors usually closely matches cashflows from underlying assets.

''Pay through'' is more in the nature of an equity investment with investors holding interest in the SPV. Cashflows from assets are collected and reinvested.

Complex combinations of both also exist. In India, all transactions follow the ''pass through'' mechanism, with some not being construed as a true sale as 100 per cent recourse to the originator may not be involved.

Two mortgage transactions aggregating Rs 196.30 million have been completed. Citibank NA provided credit and liquidity support in both cases and also acted as the successor trustee and successor receiving and payee agent. The transactions originated from companies engaged in buying land and developing property.

The National Housing Bank had initiated a pilot mortgage-backed securitisation programme about three years back. The NHB would purchase mortgage loans and issue secondary market securities from pools of these loans. Five of the largest housing finance companies have been identified as originators of the mortgage-backed loans. The pilot project is expected to raise Rs 1 billion which may be divided proportionately.

A large number of vehicle hire purchase deals and a couple of short-term trade/ bills receivable transactions have been concluded in the Indian market, with nearly all of them originating from non-banking financial companies.

The prime investors in securitisation, insurance companies and trusts, are at present, not allowed to invest in securitised paper, though it is expected it will be added to the list of approved investments for insurance companies when regulation for private sector insurance companies are announced.

The Securities and Exchange Board of India's Mutual Funds 2000 report permits mutual funds to buy securitised paper but on the condition that not more than 10 per cent of the corpus be invested in paper from the same issuer.

Securitised paper suffers from lack of investor interest on account of limited trading in the debt market. Also, inadequate closure laws in India increase the risk of MBS by making it difficult to transfer property in case of default.

Excessive stamp duties prevailing in most states in India are a major obstacle to the development of securitisation. Stamp duties vary from 3 per cent to 13 per cent in most states, resulting in securitised deals being structured in the form of transfer of beneficial interest. Maharashtra is an exception as the state government had in 1995 cut the stamp duty rates to 0.10 per cent at the time of sale and 0.01 per cent for each transaction thereafter. Karnataka and Tamil Nadu have also reduced their stamp duty rates.

For the progress of securitisation in the country it is vital that the finance ministry, in line with international practice, should allow insurance companies and banks to invest a percentage of their investable funds in securitised paper rated ''AA'' or higher by at least two independent rating agencies. This will encourage the creation of an active secondary market.

The Reserve Bank of India needs to clear the status of securitised paper as far as investment in banks is concerned and add it to the class of corporates. This will facilitate banks to invest in this paper.

SEBI -- along with the finance ministry -- will have to address the issue of allowing investment in securitised paper by foreign debt funds being set up in India. This will widen the market as most managers of these foreign funds have exposure to such paper abroad and are comfortable with the risk profile.