Daniel Rozas, Micro Opus

Co-authored with Vinod Kothari; MicrofinanceFocus, 6 July 2010

The Reserve Bank of India (RBI) recently promulgated proposed guidelines for securitization by non-banking finance companies that if implemented, would essentially gut the widespread Indian MFI practice of selling (assigning) and securitizing portions of their portfolios.  One of us has already described these consequences in detail.  Not surprisingly, this proposal caused alarm in the microfinance community and has generated intensive lobbying efforts with the RBI to modify the ruling.  As the RBI considers their case, it should bear in mind another distinguishing characteristic that sets microfinance securitizations apart.

Loan portfolios are sold and securitized for many reasons – high cost of borrowing, limited capital, funding diversification, and so on.  One of the significant merits of securitization transactions is that a substantial chunk of the securities issued qualify for top credit ratings – at least AA, often AAA. These ratings are based on the requirement that the transfer of the asset from its originating entity separates the asset from the default risk of the originator.  In securitization parlance, this is termed true sale, and such is the dependence of the rating on its validity that securitizations require a legal opinion to insure the requirement is actually met.  And it is here that microloans depart from their traditional finance counterparts from which the practice has been borrowed.

The nature of the microcredit “asset”

For property to be considered a transferable asset, it must retain value irrespective of its owner.  However, in rare cases, assets have value only when associated with a given entity.  Like David Beckham’s foot, such assets can generate cashflow to their owners, but they cannot be independently transferred or sold.  In accounting parlance, certain types of goodwill share this distinction – for example, the institutional knowledge of an organization can be very valuable, but it only retains its value so long as sufficient number of long-term staff is retained.  Consequently, in the course of liquidation, such assets can be converted to cash only if the entire organization or large parts of it are sold in whole.

This is the case with microloans, which constitute only one financial transaction within the broader ongoing relationship between the borrower and the MFI.   Without that relationship, the value of the single transaction becomes highly discounted by the borrower – simply put, she has no incentive to continue repayments to an institution that has ceased issuing new loans, let alone failed outright.  In the seminal book The Economics of Microfinance, Jonathan Murdoch argues that this incentive “is the reason why maintaining the appearance of stability is important for lenders.”[1]

Besides the theory, there is also significant field evidence demonstrating the strength of this effect.  For example, when rumors began to spread among borrowers of an NGO-MFI in Bolivia that it was closing, clients assumed their debts had been cancelled and stopped paying.  In reality, it was only merging with other NGOs to form Eco Futuro, and to convince borrowers to continue repayments, the staff not only had to explain that the branch & loan officers would remain in place, but also had to display signage of both the NGO and Eco Futuro for some time.[2]

If healthy, well-performing MFIs encounter such obstacles in the course of a merger, the problem is many times compounded when an MFI is failing.  In fact, a study of MFI failures by one of the authors demonstrated that, absent other factors, such as loans with physical collateral, creditors rarely succeed in recouping any of their investments by liquidating a failed MFI.

MFIs and Servicer Migration

The same dynamic that makes it difficult to collect repayments from a failed MFI’s clients, also figures in attempts to transfer portfolios of still-active MFIs.  In securitizations, it is common to distinguish between the origination, funding and servicing of a financial asset. The originator is the party that creates the asset. All subsequent interactions with the borrower – collections, information, borrower relationships, problem resolution, etc., are collectively termed “servicing.” For many financial assets, the origination and servicing can be divorced without causing a loss to the asset value. For example, in prime mortgages, it is common for loans to be originated by a community or local bank, sold off to a larger bank that aggregates thousands of such loans and then sells them off to capital markets through securitization. In such transactions, the servicing function is regularly outsourced to a third party. This can be done successfully because servicing practices are fairly standardized, and the borrowers continue to pay their periodic installments regardless of who the current owner of the loan is. There is no need for the originator to maintain a continuing affinity with the borrowers, as this loan, or at least its servicing component, is not “relationship-based.”

Even in cases where securitized loans remain with the originating lender, investors reserve the right to execute such transfers, termed servicer migrations, later in the loan’s life.  Such migrations are especially common when loans fall into distress and are transferred to servicers that specialize in delinquent loans.

However, in the case of microfinance, even if the problem of borrower incentives described above can be resolved, the operational difficulty of executing such a migration still remains. Most microfinance loans are created, nurtured, and serviced by the field officer who maintains a regular franchise with the borrower. Collection of microfinance receivables in most jurisdictions is not based on technology – it is based on manual efforts. Of course, MFI loan officers are often internally replaced due to employee turnover and other reasons.  But doing so for an entire loan portfolio at once and without any support from the previous servicer suggests an exercise that is as difficult as it is expensive.

In fact, no servicing migration has ever been successfully carried out in the microfinance world.  One notable case where it has been tried is ICICI Bank’s attempt to transfer the servicing of some of its partnership loans in response to the crisis in the Krishna district in Andhra Pradesh in 2006.[3]  The ICICI partnership program allowed MFIs to make microloans directly in the bank’s name, while retaining the servicing rights to those loans.

In the Krishna case, the branches of the MFIs that had participated in the program had been forcibly closed by local authorities, leaving no one to collect on the loans.  In response, ICICI attempted to transfer servicing to the local Village Organizations that had been a part of the government-run Velugu microfinance program, but the results proved disappointing, with only negligible amounts collected.  When the crisis abated, ICICI transferred servicing back to the original MFIs, where it was able to recover some portion of the loans.  In fairness, using Velugu – whose collectors didn’t have much incentive to service ICICI’s loans – was probably not the bank’s first choice, but rather the result of bargains made with local authorities.  Yet such is the way of microfinance – whether Krisnha in AP, Kolar in Karnataka, or No Pago in Nicaragua, one deals with the crises one has, not those one hopes to have.

The AAA that isn’t

If the servicing of microcredit assets either owned directly or via a microcredit-backed security is not transferrable, this raises serious questions about the nature of the underlying risk assumed by the investor.  In the microfinance portfolio, some defaults, even in the low delinquency world of Indian NBFC MFIs, will happen.  For this reason, most portfolio assignment and securitization transactions have some level of protection, whether by having the MFI cover the first several percent of losses, provide additional loans as collateral that can be swapped for non-performing loans, or even set-aside cash as a guarantee.

These risk mitigation techniques ensure that investors will not suffer losses in most cases of loan deterioration.  And the rating of microcredit pools and securities is based largely on the analysis of repayment history and the level of risk coverage provided via these techniques.  But what happens when the MFI itself collapses?

The fact is that following the collapse of an MFI, expected losses to investors holding its loans, even if they had been well-performing up until then, would still be very high, quite possibly 100%.  And if that’s the case, how can the rating of such pools be any different than the rating of the MFI itself?  After all, investors’ effective risk exposure is not to the portfolio, but to the MFI.  One rating agency has already recognized this point:  in its methodology of rating microfinance securitizations in Bolivia, Fitch explicitly states that any rating would be normally limited to between one and five notches above the rating of the MFI whose portfolio is being securitized.[4]  And Bolivia, following a crisis in the late 90s, has seen substantial expansion of credit bureau coverage of microfinance clients,[5] which can serve to maintain borrowers’ repayment incentive even following an MFI’s collapse.  Though even that is just a theory – the situation has never been tested in a microfinance context.

And yet, we see that in India, where no microfinance credit bureau exists, CRISIL is issuing AAA ratings to microfinance securities where the MFI is rated as low as BBB- (one level above junk).  Unfortunately, this would not be the first time that a rating agency assigns a AAA to assets it apparently doesn’t understand.  For all the comparisons made between microfinance and subprime, this may be the one that actually fits.

True sale or mere tale?

If true sale is the precondition for asset-backed ratings, there are yet other glaring lapses that are conveniently ignored in Indian microfinance securitization. In most transactions, there is really speaking no segregation of the cashflows of securitized pools from the rest of the originator’s assets – the assets and cashflows freely commingle. In many cases, MFIs make payment of cashflows due to investors on fixed dates and in fixed amounts, regardless of the actual collection from the underlying receivables. Since transactions are quite often bilateral (courtesy of RBI Guidelines that discipline “securitization” and leave bilateral transfers completely without controls), there are even cases where the so-called investor takes post-dated checks of a definitive amount from the MFI, implying full recourse. The MFIs service the pools either with no servicing fee, or purely a token fee. The residual surplus, that is, the excess of rate of returns from the pool over the amount payable to investors, continues to flow back to the MFI without any underlying legal basis. In other words, if there was a list of 10 DON’Ts that defy a true sale, virtually all of them would be present in a typical MFI securitization in India. And yet, convenience overrides all rituals – the banks need MFI portfolios to satisfy their priority sector lending requirements, and the pressure on time in the month of March when they wake up to this need is too high to pay regard to rules of discipline.

Where does it lead to?

We strongly feel that the present form of securitization of microfinance in India needs substantial reform. It is necessary to rectify and discipline present practices in securitization, but even when that is accomplished, the strong tie between an MFI and its portfolio remains a serious conundrum for securitizations, which after all depend on breaking that very tie through true sale.   Ultimately, this may prove impossible – microfinance may be too driven by the close, ongoing relationship between an MFI and its clients to successfully adapt securitization practices that were after all developed for very different assets.   However, if a sustainable solution were to exist, it would have to resolve the obstacles that prevent investors from servicing their portfolios even after the collapse of the originating MFI.

Some approaches may hold promise, such as setting up an independent entity with fully-empowered receivership authority to take over a failing MF. This would allow the entity to continue operations until it can successfully sell the organization or transfer its non-delinquent customers to another MFI.  Critically, such a takeover would have to happen quickly, while the borrower-MFI relationship is still warm, so a drawn-out legal process would be out of the question.  Besides helping portfolio investors, such an entity could also benefit MFI creditors who have an equal interest in insuring that portfolios doesn’t melt away following MFI defaults.   It’s a complex endeavor requiring significant regulatory support, but it could prove a useful tool for stabilizing the microfinance sector in times of crisis.

Other solutions may also be possible, but first, the problem needs to be recognized.   Otherwise, the hidden risks may show themselves in a way that benefits no one.