Case 050Structured finance and securitisationCore

Anvayana Home Loans wants to sell Rs 500 crore of home loans. Compare a direct assignment at the pool yield with a pass-through structure needing 10% credit enhancement: what does each do to its income, and how much risk does it really shed?

The situation

Anvayana Home Loans, a housing finance company, wants to free up funding by selling Rs 500 crore of home loans yielding 9.5%. It will keep servicing the loans. Expected losses on the pool are about 0.5% a year.

Route one is a direct assignment: a bank buys a Rs 450 crore pro rata share of the pool at the pool yield, paying Anvayana a 0.25% servicing fee, and Anvayana keeps a 10% pro rata share. Route two is a pass-through securitisation: a trust buys the pool and sells Rs 450 crore of senior certificates to investors at 8%, and Anvayana provides 10% credit enhancement, Rs 50 crore that absorbs losses first, while keeping the excess spread after trust costs of 0.1%. Assume the retention rules require Anvayana to keep 10% either way; RBI sets minimum retention and the treatment of each route, so confirm the current rules.

Your task

Work out Anvayana's annual income and expected loss under each route, test a stress, and say which route actually sheds credit risk.

Quick check

If the pool loses Rs 30 crore, how much does Anvayana bear under the pass-through?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The pass-through earns more, about Rs 8.50 crore a year after expected losses against Rs 5.62 crore for direct assignment, but it sheds far less risk. Under direct assignment Anvayana keeps a 10% slice and bears 10% of every loss. Under the pass-through its Rs 50 crore sits first in line, so it bears all losses up to 10% of the pool: a Rs 30 crore loss costs it Rs 30 crore, not Rs 3 crore. The structure, not the percentage kept, decides the risk shed.

Step 1What is the difference between the two routes?

Two friends sell nine tenths of a mango orchard. One keeps a tenth of every tree; the other keeps a promise to make good the first tenth of any crop failure. Both have kept 10%, but only the first has really sold nine tenths of the risk. Direct assignment keeps a pro rata slice; a pass-through with credit enhancementProtection that absorbs losses before investors do, here a Rs 50 crore first loss piece provided by the seller. keeps the first loss, and that ordering decides everything. In both, Rs 450 crore of funding is raised.

Same pool, same Rs 50 crore kept: which Rs 50 crore decides the riskDirect assignmentsold 45050kept 50: a slice of every loanKept:a 10% slice of every loanIncome a year:Rs 5.88 crExpected loss borne:Rs 0.25 crNet:Rs 5.62 crLoss borne if 30 lost:Rs 3 crPass-through certificatessenior 450 at 8%first loss 50kept 50: the bottom layerKept:the bottom 10%, first lossIncome a year:Rs 11.00 crExpected loss borne:Rs 2.50 crNet:Rs 8.50 crLoss borne if 30 lost:Rs 30 cr
Both routes raise Rs 450 crore and keep Rs 50 crore, but direct assignment keeps a pro rata slice, earning about Rs 5.62 crore a year net and bearing Rs 3 crore of a Rs 30 crore loss, while the pass-through keeps the first loss, earning about Rs 8.50 crore and bearing all Rs 30 crore.
Step 2What does each route earn?

Under direct assignment Anvayana earns 9.5% on its Rs 50 crore slice, Rs 4.75 crore, plus 0.25% servicing on Rs 450 crore, Rs 1.13 crore: Rs 5.88 crore. It bears 10% of the Rs 2.5 crore expected loss, so nets Rs 5.62 crore. Under the pass-through the pool earns Rs 47.5 crore; investors take Rs 36 crore and the trust Rs 0.5 crore, leaving Rs 11.0 crore of excess spreadInterest the pool earns above what the investors are paid and the costs of the structure, which flows back to the seller. for Anvayana, but it bears the whole expected loss, netting Rs 8.50 crore.

Step 3How much risk has Anvayana actually shed?

Run a stress. Losses of Rs 10 crore cost Anvayana Rs 1 crore under direct assignment and Rs 10 crore under the pass-through; Rs 30 crore costs Rs 3 crore against Rs 30 crore. In any loss short of 10% of the pool, the pass-through leaves Anvayana with all of it: it has sold funding, not credit risk. Only beyond Rs 50 crore do investors lose. Capital follows the same logic: a first loss piece typically attracts capital close to its full amount, while a pro rata slice attracts far less, so confirm the current risk weights before comparing returns on capital.

Losses Anvayana keeps, by route and by size of pool loss, Rs crore110Pool loses 102% of pool330Pool loses 306% of pool650Pool loses 6012% of pooldirect assignmentpass-through
When the pool loses Rs 10 crore, Rs 30 crore or Rs 60 crore, Anvayana bears Rs 1, 3 and 6 crore under direct assignment but Rs 10, 30 and 50 crore under the pass-through, where its first loss piece absorbs everything up to Rs 50 crore.

The view: if Anvayana's aim is to shed credit risk and capital, direct assignment does it; if the aim is funding at the lowest cost while keeping the economics, the pass-through does that, at the price of keeping nearly all the risk. The pass-through's extra Rs 2.9 crore a year is mostly payment for holding the first loss.

Where candidates lose it

The usual slip is treating 10% kept as 10% of the risk kept in both cases. Retention percentages are equal; the position in the loss order is not, and the first loss piece keeps almost all realistic losses.

The second is comparing incomes without the expected loss. The pass-through's higher income includes excess spread that must first absorb every loss in the pool.

What the interviewer asks next

  • At what annual loss rate does the pass-through stop earning more than direct assignment?
  • Why might a bank buyer prefer direct assignment to buying the senior certificates?
  • How would a rating agency size the 10% enhancement for this pool?
  • What happens to Anvayana's excess spread if borrowers prepay heavily?

Company names and figures are illustrative.