Moody's: Indian structured finance deals pose greater liquidity risk than other markets

Moody's Investors Service says that most Indian structured finance transactions pose greater levels of liquidity risk than typical deals in other countries, a phenomena which was highlighted during demonetization, but various structural features act as mitigants.

"This higher liquidity risk occurs because most Indian transactions pay both interest and principal to investors on a predetermined periodic basis -- known as timely payment -- whereas in other countries, principal payments are typically only passed through to investors once they are received from the underlying borrowers," says Siddharth Lal, a Moody's Analyst.

"Furthermore, the characteristics of the underlying borrowers in certain Indian transactions - such as auto asset-backed securities (ABS) - accentuate the liquidity risk posed by such deals," says Lal.

Moody's conclusions are contained in its just-released report, "Structured Finance -- India: Timely principal payment increases liquidity risk".

"The earnings of the underlying borrowers in auto ABS -- and therefore their ability to make loan repayments - tends to be volatile and, as a result, the level of cash collections from borrowers can vary greatly from month to month," says Lal.

By requiring timely payment of principal, Indian transactions pose an elevated level of liquidity risk because of the risk that short-term disruptions in loan repayments from borrowers will result in temporary cash flow shortages for a deal and potentially disrupt payments to investors.

In any scenario where cash flows to a transaction are temporarily disrupted, cash reserves supporting the rated notes would have to be utilized at an accelerated pace to fund the payment of principal to investors, even when principal is not received from the underlying borrowers.

However, as indicated, various structural features mitigate this liquidity risk, including the presence of cash reserve facilities supporting the rated notes, and which are fully funded at closing and do not amortize over the lives of transactions.

Typically, such reserves cover up to three months of principal and interest payments at closing, and the coverage builds up as the notes amortize.

In addition, liquidity support for transactions is available in the form of excess spread, which is the amount of interest collected from the portfolio that is in excess of the aggregate amount of interest due on the notes and other fees and expenses payable in each month.

The excess spread in Indian auto ABS transactions provides the first level of effective buffer to meet principal payments due on the notes in scenarios when shortfalls occur in principal collections on the asset-side.

As indicated, the liquidity risk posed by Indian transactions as a result of the timely payment of principal was highlighted in the aftermath of the government's demonetization policy.

In November 2016, the government withdrew all INR500 and INR1,000 currency notes from circulation, or approximately 86% of all currency notes at the time. As a result, collections for the Indian auto ABS Moody's rated at the time dropped by an average of around 1.3%.

Because of the need to make timely principal payments, these transactions had to rely on cash reserves to make interest and principal payouts to investors in the month immediately following demonetization.

The average utilization of cash reserves was less than 1%, while the maximum was 1.4%. However, if the drop in collections had been more severe and prolonged, it could have led to a significantly higher utilization.