Daniel Rozas, Micro Opus

Co-authored with Vinod Kothari; MicrofinanceFocus, 19 August 2010

Our earlier article on the Hidden Risks behind Microfinance Securitization raised serious concerns about the inherent and largely unrecognized risks embedded in securitizations of microcredit assets.  While we believe that this article provided a useful contribution to microfinance sector, we recognize that it is sometimes easier to be a critic than an actor.  As the issues we raised were serious enough to inspire action, in this follow-up we explore in greater detail some of the potential solutions that we believe could mitigate these risks.

But first, a brief revisit of some of the debate prompted by the article. IFMR Capital, the primary player in Indian microfinance securitizations, published a detailed response, making an impassioned and well-argued case that their approach features a number of important improvements over the practices often seen in many bilateral assignments.  We fully agree that the discipline described by IFMR is an important element for reducing the overall risk-profile of securitizations, and their well-laid out note is a good primer on how such practices might be applied in the microfinance context.

However, we were surprised that IFMR’s note did not address in any substantive way the key issue raised by us – the difficulty of continuing cashflows from a securitized microfinance portfolio in the event of the originating MFI’s collapse. The one suggestion made by IFMR in such an event is that “an independent backup servicer that monitors & supervises performance and ‘steps in’ in the worst case, is a probable future reality.”

However, IFMR does not elaborate further, leaving us with questions:  would the servicer have its own loan officers, and if so, how would they introduce themselves to borrowers and convince them to make payments to an organization that none of them have heard of?  And since these securitized loans only comprise a part of the MFI’s portfolio, how would these new LOs explain to clients that they should pay their loans, while their neighbors, whose loans had not been securitized, receive no such demands?  Might the servicer try to expand its operations to cover all loans, or at least entire geographic regions?  How would this be coordinated with other creditors, who would presumably be entitled to the proceeds from non-securitized loans?  And is this back-up servicer also going to finance the clients, in order to maintain their repayment incentive?

These and other questions have no ready answers, and yet, having the answers should play a critical role in the risk assessment and rating of any microfinance securitization.  Fact is, regardless of the types of risk mitigants used to reduce the risk of servicer default, the fundamental premise of asset-backed securities is that the portfolio of assets can survive on its own, even when detached from the originator.  Securitisations cannot rely solely on the quality of the originators.

Consider the covered bond.  This is an instrument popular in Europe and consists of a bond issued by a financial institution, but that is also backed by a specified pool of assets (“the cover pool”), which remain on the bond issuer’s books.  When the bond issuer defaults, this cover pool falls immediately under the bond investor’s control.  The composition of the cover pool is in fact critical to receiving high ratings. And high ratings are in turn the raison d’être of covered bonds – if the rating received were not significantly higher, the institution would simply issue a regular bond.  Of course, this only works if the cover pool’s assets retain their value after the originator’s default, which indeed they do.  These are after all “formal economy” loans – mortgages, auto loans, credit cards – that have fully enforceable legal recourse to the borrower and are reported to credit bureaus.   By extension, assets that cannot retain value without their originator cannot be used to mitigate that originator’s risk, and thus could not reasonably improve on the originator’s risk rating, whether in a covered bond or a pass-thru securitization.

Since microfinance assets fall into the latter category, their securitizations should not enjoy a higher rating than the originating MFI itself, regardless of the risk mitigants implemented (excepting cash collateral and similar devices).  However, this issue need not be intractable.  We propose a number of solutions that can place microfinance securitizations on a firmer footing.  The first two proposals – the Structural Solutions – rely on financial techniques to mitigate the risk of an MFI’s default, but without resolving the underlying issue of microfinance asset dependence on the soundness of the MFI.  We thus close with two additional proposals – the Fundamental Solutions – that could be used to resolve this underlying issue, and in so doing, reduce the risk posed not just to investors in microfinance securities, but also to all other MFI creditors.

Structural Solutions

Securitisation backed by credit default swaps on the originators

Our key argument is that investors in MFI securitisation transactions carry not only the risk of the MFI asset pools but also the risk of default of the originators. Each securitisation transaction has inbuilt credit enhancements to absorb the risk of the pool losses, but has not considered the default of the originator. We suggest backing microfinance securitisations with a credit default swap (CDS) that pays compensation to the SPV – the inverstors’ repository – in case of default of the originator. Our suggested methodology is different from traditional mezzanine credit support for securitizations, as the CDS is not triggered if the pool losses increase beyond expected losses.  But if the originator collapses, that is when the CDS gets triggered. In other words, the swap issuer provides contingent credit support to the transaction. The notional value, that is, the maximum compensation that the CDS issuer would provide, should be the size of the transaction less initial cash collateral.  However, the actual payment would only be to cover the balance of the senior class, after cash collateral has been exhausted.  The compensation level would thus be dynamic, declining over the life of the security.

Will this credit default swap be significant additional cost to the transaction? It is surely an additional cost. However, it is significantly mitigated by the fact that the CDS provider’s exposure is inversely proportional to the MFI’s default risk – it would be highest in the immediate months of the CDS issuance (when, presumably, the provider would be best positioned to identify potential weaknesses in the MFI).  As the risk of default increased over the life of the security (because new events occur after the CDS is issued), exposure would be reduced both through amortization of the pool as well as the build-up of excess interest spread, which is converted to cash collateral over the course of the security’s life.

Moreover, in a number of cases – perhaps the majority – the CDS issuer may be able to recoup some or all of its outlays.  The swap could be structured to pay out based on certain triggers. While the “event of default” is the bankruptcy or another specified situation pertaining to the MFI, this does not always imply that the MFI will necessarily collapse.  And because this is a physical settlement CDS, where the protection seller receives the securitized loans in return for its payment to the investors, the seller may yet see partial or even full recoveries from these loans.  One could easily contemplate scenarios where a struggling MFI that has met the conditions to trigger an “event of default,” it might still receive capital infusions, be taken over, or otherwise find a way to continue operations and thus restart its payments to the holders of the loans.

Microfinance super-securitisations

A microfinance super-securitisation is a refined combination of the collateralized debt obligation (CDO) device that became infamous during the subprime crisis, and the multi-originator securitisations that entities like IFMR already practice. The genesis of the idea is as follows: we have made an arguably convincing argument that microfinance securitisations are still subjected to the risk of the originator default. But then, every loan to an MFI is still subjected to the same risk. So, if a microfinance securitisation is viewed, for the purpose of analogy, as a loan to the MFI, several of these “loans” may be clubbed together to form a pool of “loans.” The CDO device pools together loans having a certain probability of default, and tranches may be created out of the pool such that with a certain level of enhancement, they become AAA-worthy securities. Now, even if one of the several originators were to collapse, the loss to the pool contributed by that originator could easily be covered by the credit enhancement in the super-securitisation transaction, with no impact to the senior tranche.

Such a structure can in some ways be compared to the microfinance CDOs created by Blue Orchard and others, though instead of aggregating loans to MFIs, it would be aggregating portfolios of such MFIs.  One notable difference from a risk management perspective is that aggregations of Indian MFI portfolios wouldn’t have the added benefit of multi-country diversification.  Thus, extra focus should be paid to the intra-country geographic distribution of participating MFIs.

Fundamental Solutions

The two proposals above explore options for mitigating MFI default risk in microfinance securitizations.  However, they do so without changing the fundamental issue of the linkage of microcredit assets to the originating MFI.  Below we propose two additional solutions that could address this core problem.  Note that if successful, these solutions would not only reduce the risk of microfinance securities, but also for microfinance creditors in general.

Credit Bureau

A microfinance credit bureau has well-recognized advantages, and one is already in the process of being established in India.  As it happens, it may also prove to be valuable in the event of an MFI failure – if a client knows that a default even on a defunct MFI’s loan would undermine eligibility for loans from other MFIs, she might have more incentive to make payments to a new servicer.   This is, however untested in a microfinance context, and requires several preconditions – first, clients would have to be aware that their repayment history is being reported to a credit bureau and realize the consequences of non-payment.   Second, other MFIs would also have to make the threat real by refusing loans to customers who have been reported to the credit bureau as not making payments on a defunct lender’s loans.

Even if these preconditions were to be met, one should not implicitly assume that a “formal” economy practice would automatically work in the informal economy world of microfinance.   One ought to consider that microfinance clients might view their loans as inherent agreements with a specific MFI, and may thus regard other MFIs’ refusal to make loans on the basis of a default to a defunct lender as inherently unjust.  Of course it is possible that changed circumstances might alter the clients’ perceptions.  It is however, equally possible that angered clients might act to change such practices through political means.  And given the active involvement of politics in microfinance, this second possibility should not be discounted.  In the end, any reasonably reliable solution would have to garner the clients’ implicit support.

MFI Liquidation Facility

Recognizing the importance of an MFI-client relationship, we suggest that an emergency liquidation facility be established to take over as receiver of a failing MFI.  Its objective would be to stabilize operations, then sell the entity in whole or in part to other MFIs or investors, with proceeds going to repay security holders and other creditors.  Parts of this process are patterned on the Federal Deposit Insurance Corporation’s (FDIC) process for closing failed banks in the US:

1. The appropriate legal framework would have to allow the MFI to be taken over while it is still in operation, ideally before client repayments begin to falter.  We suggest this authority be vested in RBI, at least for the NBFC MFIs that it oversees.   Upon finding an MFI insolvent, RBI would appoint a receiver, which would take custody of the institution, its premises, loans and accounts.  For the process to function appropriately, RBI’s decisions should be final with no basis for court review or other procedures that might interfere with the efficient execution of receivership.  Subsequent court challenges may be allowed, but the legislation guiding this process should spell out sufficiently clear authorities, so that court challenges are limited only to extraordinary situations, such as abuse of power.
2. RBI would appoint a receiver that has the specialization and capacity to run an MFI and safeguard its assets.  An additional difficulty would be that no organization could realistically maintain staff just only for such eventuality, given that MFI failures are expected to be highly infrequent events.  One option would be to set up a function under the auspices of MFIN, the self-regulatory organization overseeing most NBFC MFIs, which would presumably already have specialized staff on-hand to carry out its MFI monitoring responsibilities.  Note that the receiver would have the option to retain or replace top management, but would in both situations rely on the MFI’s own staff to carry out operations.  Because MFIN, being an association of NBFC MFIs, represents potentially interested parties (as competitors and potential purchasers of liquidated assets), it is important that receivership operations remain separate from day-to-day work, with RBI providing oversight.
3. Maintaining ongoing operations requires both collection of existing payments, and equally importantly, issuing new loans to clients, in order to maintain the credibility of the institution and avoid drop-off in repayments.  For a cash-strapped MFI, this would almost certainly require suspension of repayments to creditors, including repayments to investors in the MFI’s microloan-backed securities.  Ideally, suspension of repayments would preserve sufficient cash-flow to fund operations, and if not, these may be supplemented by the Liquidation Fund (see below).
4. The aim of the receiver would be to stabilize portfolio performance, commission an audit and set the MFI up for sale.  The simplest case would be if the institution is purchased in whole by an MFI or other investor.  However, if loan pools are purchased separately, the transfer would have to be clearly communicated to the affected clients, ideally with the participation of the purchasing MFI’s staff.  In such situations, the defunct MFI’s loan officers would also have to be promised appropriate incentives to insure their cooperation with the transfer.   A similar approach would be to transfer clients to new MFIs after they have repaid their loans to the defunct MFI, while maintaining their place in the loan cycle, i.e. the new MFI would agree to provide transferred clients with same or higher amount loans than the ones they had just completed.  Such a strategy would allow the liquidating MFI to run off its portfolio without the additional demands of having to issue new loans.
5. Creditors would receive proceeds from loan repayments and sales based on seniority, or in the case of holders of microloan-backed securities, based on returns from the underlying loans less liquidation costs.   In both cases, payments to creditors could be deferred if needed until the liquidation is completed.   Importantly, to align the liquidator’s interests with those of the creditors, most of the liquidation costs should be calculated as a share of the proceeds.
6. In order to supplement cashflow for the defunct MFI’s operations and fund the base fees of the liquidation team, a Liquidation Fund should be established by RBI, funded by a small tax on credit investments made to MFIs.

Establishing such a system would require policy-level changes, but because its benefits would accrue not only to microloan-backed security holders but also to other creditors, it could provide an important element of stability to the microfinance market.  Because it would reduce the losses borne by creditors in the event of an MFI failure, it should also result in lower interest rates charged by lenders to MFIs covered by such an authority.

From exploration to implementation

These proposals are only initial examinations of approaches that could build upon the existing risk management structures used in microfinance securitizations and microfinance funding more broadly.  We hope that they will spark further debate and exploration among industry practitioners and stakeholders, including regulators and investors.  And if and when a significant-sized MFI does fail in India, we hope that a liquidation framework will be in place that can successfully limit investor losses, provide service continuity to clients, and thus insure that investors and other stakeholders continue to maintain their confidence in the sector.