PACRA Structured Finance Rating Methodology

Analyst Contacts
Momin Farooque momin.farooque@pacra.com
October 2024
The Pakistan Credit Rating Agency
Structured Finance Rating
Methodology
Table of Contents
Introduction....................................................2
Rating Outlook................................................3
Rating Watch..................................................4
Summary
This document describes PACRA’s approach to rating structured finance, a relatively complex form of debt, resulting from securitization transactions. PACRA’s assessment begins with the profile and background of the originator – the entity that requires financing. This is followed by studying the legal structure of the transaction to ensure isolation, or “de-linking,” of the pool of assets underlying the transaction from the credit risk of the originator. PACRA then analyzes the nature of the underlying assets along with their associated cash flows using a data-heavy approach to assess asset quality and payment risk. Herein, a key factor is incorporating the impact of entity specific, industry-wide, or economic changes likely to impact future cash flows. Upon completion of the analysis, usually, a “preliminary rating” is assigned. Subsequently, when the transaction is legally formalized, the legal documentation is reviewed to incorporate the credit and legal implications of the transaction structure to arrive at the “final rating”. Analyst Contacts:
Nusrat Abeer Hyder nusrat.abeer@pacra.com
+92 42 3586 9504
The Pakistan Credit Rating Agency:
Head Office
FB 1 Awami Complex
Usman Block, New Garden Town
Lahore
Phone: +92 42 3586 9504
Karachi Office
PNSC Building, 3rd Floor
M.T. Khan Road, Lalazar
Karachi
Phone: +92 21 3563 2601
Disclaimer: PACRA has used due care in preparation of this document. Our information has been obtained from sources we consider to be reliable but its accuracy or completeness is not guaranteed. PACRA shall owe no liability whatsoever to any loss or damage caused by or resulting from any error in such information. Contents of PACRA documents may be used, with due care and in the right context, with credit to PACRA. Our reports and ratings constitute opinions, not recommendations to buy or to sell.

Page | 2 April 2025
Structured Finance Rating Criteria
Methodology
Introduction
Structured finance instruments are a relatively complex form of debt, involving the pooling of assets and the subsequent sale to investors of structured claims, split into tranches and backed up by the cash flows sustaining the initial asset pool. Such instruments are usually issued to transfer or carve out risk and/or improve the marketability of a pool of underlying assets by separating the performance of the assets from the entity that originated them. These assets are created through a process known as “securitization”. Securitization allows the entity in need of funds to separate assets from the credit, performance, and other risks associated with the entity itself. Moreover, this process helps convert illiquid assets that cannot be easily sold to third-party investors into liquid, marketable securities. Securitization involves creating, combining, and recombining categories of assets, including loans and receivables, into new forms. Assets from a customer or a group of customers are pooled and repackaged, underwritten, and sold in the form of asset-backed debt instruments. The instruments or ‘asset-backed securities’ are collateralized or ‘backed’ by a pool of assets and are not considered general obligations of the entity that is in actual need of funds. This is achieved by the sale of an identifiable and specific pool of the originator's assets, either directly or indirectly, to a special purpose vehicle (SPV). This is a crucial step in the process. The aim here is to “de-link” the credit risk of the originator from that of the underlying pool of assets, so that neither the assets nor their proceeds will be consolidated as part of the bankruptcy estate of the originator/seller in the event of its insolvency. The investor in an asset-backed security is entitled to receive a pass-through of the timely payment of profit and principal on the pooled assets. The rating agency, therefore, evaluates the risks associated with the cash flows emanating from the purchased assets for repayment. Although all structured finance instruments are asset-backed, the nature of the assets may vary. Following are prominent types of such instruments:
TYPE OF ASSET-BACKED (STRUCTURED FINANCE) INSTRUMENTS Collateralized debt obligations:
Pools of commercial loans to corporates, small and medium￾sized enterprises, alongside pools of corporate bonds. Mortgage-backed securities:
Pools of residential/commercial mortgages that may consist of a single property or a group of properties financed by a single borrower, or a pool that combines numerous loans from different borrowers, which are secured by a diverse array of properties. Future Flow Securitization:
The future cash flows from pools of assets such as export receivables, telephone net settlements, and airline receivables, or flows from financial assets such as credit card voucher processing receivables, trade payments rights, or worker remittances. Regulatory Regime Structured finance transactions, wherein a Special Purpose Vehicle (SPV) is created, are currently governed under The Companies (Asset-backed Securitization) Rules, 1999, issued by the Securities and Exchange Commission of Pakistan and last amended in April 2022. These rules require SPVs to be registered with SECP, meet the conditions, and abide by their respective obligations.

Page | 3 April 2025
Structured Finance Rating Criteria
Methodology
The SECP has enhanced “The Companies (Asset-backed Securitization) Rules, 1999” by issuing the Asset Backed Securitization Regulations, 2022. PACRA’s rating framework takes into account adherence to applicable regulations. These regulations aim to make the securitization framework more conducive to enabling companies to raise funds from the capital market through public offerings and private placements, with special focus on mortgage-backed securities and covered bonds. Among the key changes is enhancement of paid-up capital requirements of SPVs, removal of restriction on investing in real estate, the allowance for 100% ownership of originator in SPV, the allowance for credit enhancements to reduce credit risk, and the introduction of the role of servicer for maintenance and management of the asset pool. These regulations provide a more detailed operational framework, including enhanced information disclosures, mechanisms employed to payout the coupon or profit, risk factors associated with the offering (asset quality, asset pool, liquidity, collateral arrangements, etc.), among others. TERMS RELATED TO STRUCTURED FINANCE INSTRUMENTS AS DEFINED BY LAW Structured Finance Products Structured Finance Products are the instruments resulting from the securitization transactions [Credit Rating Companies Regulations, 2016] Investor "investor" means a person holding any asset backed securities issued by a Special Purpose Vehicle under [The Companies (Asset-backed Securitization) Rules, 1999] Originator "Originator" means an entity which transfers its assets to a special purpose vehicle in a securitization transaction [Asset Backed Securitization Regulations, 2022] Servicer “Servicer” means an entity appointed by the special purpose vehicle for the collection or management of the asset pool and for making allocations or distributions to holders of the securitized instrument in accordance with the regulations [Asset Backed Securitization Regulations, 2022] Securitization "Securitization" means a process whereby any special purpose vehicle raises funds through issuance of debt securities, or shariah compliant securities including Sukuk/TFC, and uses such funds by making payment to the originator and through such process acquires the title, property or right in assets [ Asset Backed Securitization Regulations, 2022] Special Purpose Vehicle "Special Purpose Vehicle" means a special purpose vehicle registered by the Commission for the purpose of Securitization [Asset Backed Securitization Regulations, 2022] Future receivables "Future receivables" means all such receivables, against which income may accrue or arise at a future date, meeting such securitized asset criteria as may be specified by the Commission including but not limited to rights, obligations, claims etc. of the parties involved and any other matters arising out of or connected therewith [The Companies (Asset-backed Securitization) Rules, 1999]

Page | 4 April 2025
Structured Finance Rating Criteria
Methodology
Flow of Structured Finance Transaction
Participants: A typical structured finance transaction involves the following participants:
i) Originator: the entity that requires financing ii) Issuer, which is a Special Purpose Vehicle: a bankruptcy-remote legal entity that issues debt securities iii) Investor: who is the financier of the structured finance instrument iv) Trustee/Investment agent: who plays a key role in monitoring the instrument, and ensuring all agreed terms and conditions are adhered to Rating Structured Finance Instruments Structured finance instruments have three key attributes that define the risk: i) pooling of assets (that directly or synthetically generate cash flows), ii) delinking of credit risk of the originator (no recourse), and iii) the splitting into tranches of the asset-backed securities. The risk analysis of any structured finance instrument focuses on three broad areas: i) Legal structure, ii) Asset risk, and iii) Repayment risk. Originator PACRA’s risk assessment starts with a basic understanding of the originator. PACRA reviews the policies and procedures by which the assets to be securitized are originated. Most of the time, originators would be the ones servicing the flow of funds so that normal business transactions with customers remain less disruptive. In this case, the originator should develop and adhere to transparent operational protocols to ensure that there is no conflict of interest in regards to the administration of the asset pool. Although the originator’s credit profile may be delinked from actual securitization, PACRA develops an understanding of the background of the originator and the industry in which it operates and look for the company to demonstrate at a minimum, the following: i) a clear strategy for meeting financing needs and ii) an understandable and realistic motivation for securitization.

Page | 5 April 2025
Structured Finance Rating Criteria
Methodology
Legal Structure
PACRA then assesses the transaction’s legal structure and documentation to assess the credit and legal implications. As part of this review, issues considered include transferability of assets, bankruptcy remoteness of SPV, taxation issues including transfer tax, stamp duty, and withholding tax, and regulatory concerns. The legal structure of a securitization transaction is expected to assure that the pool of assets underlying the transaction cannot, under any circumstances, be recovered by the originator or become a part of the originator’s assets in the event of bankruptcy. PACRA has found that the legal ability to transfer assets and attached security to a third party can often be constrained to securitization. Most securitizations rely on a “true sale” of assets to an SPV where ownership cannot be challenged in the event of the originator’s bankruptcy. Meanwhile, there are several legal restrictions and requirements applicable to the activities of SPVs, given that they fall under the regulatory purview of the SECP. Note that compliance with these regulations is an important consideration. When rating a securitization transaction, particularly in an industry with no previous securitization transactions or examples in the proposed asset class, an understanding of the legal environment is vital. Asset Risk The second step is understanding the nature of the underlying assets or pool of assets for each structured finance instrument. These are unique, and so are the cash flows. PACRA believes a securitization is impacted by the performance of the asset portfolio more directly than a company would be when the assets remain on its balance sheet. The quality of past cash flows is assessed to ascertain expected cash flows. Likely changes in cash flow patterns in response to entity-specific, industry-wide, or economic changes are given key importance and incorporated in cash flow analysis. This is a data-heavy analytical approach since it requires analysis of past trends and future projections of cash flows. PACRA looks for a set of data that provides an understanding of the underlying pool of assets. The dataset varies depending on the asset class to be securitized, but generally provides information on characteristics of the asset pool. PACRA solicits data to better understand an asset pool and its historical performance. Among other things, PACRA’s asset risk assessment takes into account the asset class, tenure, borrowers’ profile, and level of diversification at the borrower level. For many types of assets, the most easily securitized portfolio consists of a homogeneous pool, ideally with a diversified customer base that generates a stable and predictable cash flow, while concentrated asset pools are deemed higher risk. When looking at the historical performance of an asset pool, delinquencies, defaults, recoveries, and prepayments are among the more important considerations, all of which may hinder a scheduled payout to the investor. Future Flow
Securitization Assessment of asset risk in a future flow securitization differs from other types of securitization structures. This is because instruments issued under such structures are backed by assets (receivables) that do not currently exist. The receivables are usually generated over the years, through the normal course of the originator’s operations. Thus, repayments depend upon the ability of the originator to deliver certain goods/services, allowing for the creation of receivables which are then securitized. Thus, in this particular form of securitization, it is not entirely possible to de￾link the risk of the transaction from that of the originator, and the originator’s credit profile and business continuity become a central consideration when rating the instrument. PACRA analyzes the risk associated with the originator’s

Page | 6 April 2025
Structured Finance Rating Criteria
Methodology ability to continue to generate receivables, and hence, cash flows. This analysis is inclusive of the volatility of future receivables and concentration of exposure to one or a limited number of parties/clients, geographies, sectors, suppliers, products, etc. Repayment Risk Once the quality of cash flows has been ascertained, the adequacy of cash flows is analyzed. This is also data-heavy. It focuses on actual coverages against the redemption schedule of structured finance instruments. PACRA assesses the timing of cash flows vis-à-vis repayment terms. PACRA develops a base-case portfolio performance expectation, which represents the anticipated performance of a portfolio under a non-stressed economic scenario. This base case is run through stress scenarios at each desired rating category. The stressed scenarios would represent the minimum cushion available. To assess the cushion appropriately, PACRA should be able to accurately project what percentage of cash flows from a pool of assets may not be available due to extended nonpayment to meet repayment obligations to investors. Some securitization transactions are impacted by the potential that customers make prepayments, repaying their obligations ahead of schedule. The analysis incorporates an understanding of which customers are most likely to prepay and for what reasons. In case of a financial institution, repayments received on a loan portfolio are generally used to cover floating, short-term liquidity needs, funding additional loans, or paying short-term liabilities. Liquidity managers typically have access to a range of cash inflows and are therefore able to cover liquidity needs even if expected loan payments are not received. In contrast, when this same loan pool is securitized, the cash flows from the loans are the only monies available to meet fixed repayment obligations. Delinquencies and defaults increase the cost of securitization to originators, as credit enhancement and liquidity facilities are put into place to cover potential cash shortfalls when expected payments from the assets are not received. For this reason, clearly understood trends in delinquencies and loss exposures are important to managing the securitization. The level of rating would be dependent on quantum (asset risk) and sustainability of coverages (repayment risk) against the commitments during the life of the instrument. Preliminary and Final Rating Most of the time, the originators will approach PACRA with a proposed structure of the transaction. PACRA assesses all the draft documents and proposed structure and assigns a “preliminary rating”. Once the transaction is legally formalized, the rating team is obligated to review the legal documentation. In case of material variation from the original proposed structure, the Rating Committee may decide on a lower or higher “final” rating. For rating of structured finance instruments, the Credit Rating Companies Regulations (2016) require the following
disclosures:
“…information about the originator like its name, its principal business, its brief financial and operating position for the last five years, nature of defaults and delay, if any, in repayment of any financial obligation during the last five years, nature and value of assets backing the instrument, detail of guarantee, if any, or any other additional security arrangement, transaction structure, collection mechanism etc.” Challenges Faced While Rating Structured Finance Instruments Availability of reliable and standardized data in the rating process of structured finance instruments is of paramount importance. The availability of data is typically the major impediment in the rating process. This is because the data required for the ongoing management of an asset pool is frequently different from that evaluated in the standard

Page | 7 April 2025
Structured Finance Rating Criteria
Methodology entity/instrument rating process. Securitization may call for data in formats not previously captured by a company’s systems. Recreating historical data for existing assets using new parameters is time-consuming and can be a major cause of delay. However, companies that bring their information systems in line with the data requirements of such transactions find that the process can be completed efficiently. Surveillance Once an instrument is issued, PACRA undertakes a formal review once every six months. Surveillance frequency may be higher depending on repayment terms, frequency of repayments, and other unique characteristics of a particular instrument. PACRA also establishes a relationship with the trustee/investment agent of the instrument to remain updated on all instrument-related information. Rating Scale To differentiate between the rating scale of plain vanilla debt instruments and structured finance instruments, the letters “sf” (Structured Finance) is being added as a suffix to PACRA’s standard rating scale.

Analyst Contacts
Momin Farooque momin.farooque@pacra.com
October 2024
Structured Finance Rating Criteria
Scale
Structured Finance Ra�ng
Structured Finance ra�ng reflects forward-looking opinion on credit worthiness of underlying instrument; more specifically it covers rela�ve ability to honor financial obliga�ons. The primary factor being captured on the ra�ng scale is rela�ve likelihood of default. Scale Long-Term Ra�ng AAA (sf) Highest credit quality. Lowest expecta�on of credit risk. Indicate excep�onally strong capacity for �mely payment of financial commitments AA+ (sf) AA (sf) AA- (sf) Very high credit quality. Very low expecta�on of credit risk. Indicate very strong capacity for �mely payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events. A+ (sf) A (sf) A- (sf) High credit quality. Low expecta�on of credit risk. The capacity for �mely payment of financial commitments is considered strong. This capacity may, nevertheless, be vulnerable to changes in circumstances or in economic condi�ons. BBB+ (sf) BBB (sf) BBB- (sf) Good credit quality. Currently a low expecta�on of credit risk. The capacity for �mely payment of financial commitments is considered adequate, but adverse changes in circumstances and in economic condi�ons are more likely to impair this capacity. BB+ (sf) BB (sf) BB- (sf) Moderate risk. Possibility of credit risk developing. There is a possibility of credit risk developing, par�cularly as a result of adverse economic or business changes over �me; however, business or financial alterna�ves may be available to allow financial commitments to be met. B+ (sf) B (sf) B- (sf) High credit risk. A limited margin of safety remains against credit risk. Financial commitments are currently being met; however, capacity for con�nued payment is con�ngent upon a sustained, favorable business and economic environment. CCC (sf) CC (sf) C (sf) Very high credit risk. Substan�al credit risk “CCC” Default is a real possibility. Capacity for mee�ng financial commitments is solely reliant upon sustained, favorable business or economic developments. “CC” Ra�ng indicates that default of some kind appears probable. “C” Ra�ngs signal imminent default. D (sf) Obliga�ons are currently in default. *Where “sf” denotes structured finance Ra�ng Modifiers | Ra�ng Ac�ons Outlook (Stable, Posi�ve, Nega�ve, Developing) Indicates the poten�al and direc�on of a ra�ng over the intermediate term in response to trends in economic and/or fundamental business / financial condi�ons. It is not necessarily a precursor to a ra�ng change. ‘Stable’ outlook means a ra�ng is not likely to change. ‘Posi�ve’ means it may be raised. ‘Nega�ve’ means it may be lowered. Where the trends have conflic�ng elements, the outlook may be described as ‘Developing’. Ra�ng Watch Alerts to the possibility of a ra�ng change subsequent to, or, in an�cipa�on of some material iden�fiable event with indeterminable ra�ng implica�ons. But it does not mean that a ra�ng change is inevitable. A watch should be resolved within foreseeable future, but may con�nue if underlying circumstances are
not setled. Ra�ng watch may accompany ra�ng outlook of the respec�ve opinion. Suspension It is not possible to update an opinion due to lack of requisite informa�on. Opinion should be resumed in foreseeable future. However, if this does not happen within six (6) months, the ra�ng should be considered withdrawn. Withdrawn A ra�ng is withdrawn on a) termina�on of ra�ng mandate, b) the debt instrument is redeemed, c) the ra�ng remains suspended for six months, d) the en�ty/issuer defaults., or/and e) PACRA finds it imprac�cal to surveil the opinion due to lack of requisite informa�on. Harmoniza�on A change in ra�ng due to revision in applicable methodology or underlying scale. Surveillance. Surveillance on a publicly disseminated ra�ng opinion is carried out on an ongoing basis �ll it is formally suspended or withdrawn. A comprehensive surveillance of ra�ng opinion is carried out at least once every six months. However, a ra�ng opinion may be reviewed in the intervening period if it is necessitated by any material happening. Ra�ng ac�ons may include "maintain", "upgrade", or "downgrade". Note: This scale is applicable to the following methodology(s): a) Broker En�ty Ra�ng b) Corporate Ra�ng c) Debt Instrument Ra�ng d) Financial Ins�tu�on Ra�ng e) Holding Company Ra�ng f) Independent Power Producer Ra�ng g) Microfinance Ins�tu�on Ra�ng h) Non-Banking Finance Company Disclaimer: PACRA has used due care in prepara�on of this document. Our informa�on has been obtained from sources we consider to be reliable but its accuracy or completeness is not guaranteed. PACRA shall owe no liability whatsoever to any loss or damage caused by or resul�ng from any error in such informa�on. Contents of PACRA documents may be used, with due care and in the right context, with credit to PACRA. Our reports and ra�ngs cons�tute opinions, not recommenda�ons to buy or to sell