Written by Brad Swanson, a Managing Partner at Developing World Markets, published in Microfinance Insights, a quarterly print magazine produced by Intellecap, June 2007, 2 pages, available at: http://www.dwmarkets.com/Resources.htm.
In this paper, Swanson explains the difference between collateralized debt obligations (CDOs) and the securitization of microcredit loans. He continues by explaining the benefits and challenges of each form of financial transaction as well as providing recent examples of each type of microfinance security.
In the beginning of this paper, Swanson briefly explains the benefits of securitization for microfinance institutions (MFIs) and investors. He defines securitization as “a financing process in which a company moves assets into an ostensibly bankruptcy-remote vehicle to obtain lower interest rates from potential lenders” (pg 1). Securitization allows for a simpler analysis of credit risk than analyzing company debt because the repayment of loans incorporates less variables than the functioning of an entire business. It also allows companies to raise money without selling equity, which can be costly and dilutes future returns, and allows easier diversification of asset allocation.
Swanson explains that “CDOs are securitizations in which corporate loans or corporate bonds comprise the asset pool” (pg 1). So far, at least seven microfinance CDO transactions, totaling approximately USD 300m, have occurred in international capital markets. The first major transaction of this nature was BlueOrchard Microfinance Securities I (BOMSI) co-sponsored by Developing World Markets (DWM) and BlueOrchard. Importantly, BOMSI did not ask investors to lower their expected financial returns do to the positive social nature of microfinance. To learn more about this transaction and the role of CDOs in microfinance, please read this previous MicroCapital paper wrap-up of “The Role of International Capital Markets in Microfinance,” by Brad Swanson.
Microloan securitization, the other major form of capital market transaction discussed in the paper, is similar to the CDO process except that the asset pool is comprised of individual microloans and not the corporate debt of MFIs. According to Swanson, a great deal of excitement surrounds this type of financial transaction, but only two true microloan securitizations, totaling USD 75m, have taken place so far.
Swanson explains several challenges facing the securitization of microfinance loans (pg 2). First, he cites the short maturity of microloans. Securitizations of other assets, like mortgages, are usually not repaid for a period of many years, even decades. Since most microloans are repaid within one year, several generations of loans must be incorporated into each securitization. Unfortunately, this involves a great deal more effort and complexity because work must constantly be done to continue deciding which loans should be repaid to the asset pool. This extra work leads to increased costs, meaning that investors must accept a smaller financial return.
The short maturity of microcredit loans also leads to increased “origination risk,” the possibility that the MFI won’t be able to find enough loans to keep paying the asset pool in full. The return to investors is also dependant on the effectiveness of the MFI in ensuring that loans are repaid and proper candidates selected, a problem that is exacerbated by the high level of involvement between MFIs and their borrowers.
Another challenge is the lack of a standardized rating system (although progress made since Swanson’s article). While rating agencies do exist for MFIs, credit ratings for specific investment products, like microloan securitizations, are rare. SKS has undertaken a rigorous analysis of its outstanding loan products, implying that some MFIs can handle these investment ratings.
Swanson cites the microloan securitization by BRAC, a NGO MFI in Bangladesh, as the prime example of this type of transaction. In this deal, BRAC had to go to great efforts to minimize the risk of default, including adding large amounts of extra loans to the asset pool to substitute for any defaults, a process known as over-collateralization. It is unlikely that for-profit organizations would find this to be an attractive proposition, but Swanson contends that the benefits of receiving high credit ratings and international exposure enticed BRAC to undergo the deal. It is possible that some for-profit institutions may want to realize the same benefits. To learn more about this deal, please read the MicroCapital paper wrap-up of “BRAC Micro-Credit Securitization Series I: Lessons from the World’s First Micro-Credit Backed Security (MCBS),” by Ray Rahman and Saif Shah Mohammed.
Swanson concludes by explaining some factors that both increase and decrease the likelihood of securitization emerging as a prominent source of capital for MFIs in India. He believes that MFIs have been able to raise enough funds from equity in the past, although it is the most expensive form of raising capital, but that burgeoning loans portfolios will force MFIs to look elsewhere for funds. The ten times debt to equity cap set by the Reserve Bank of Inda (RBI) also increases the likelihood of securitization because MFIs need to raise capital without taking on more debt.
Conversely, the Priority Sector Lending rules (PSLS), which force banks to devote a certain amount of resources to microfinance loans, cause over competition and force banks to drop their rates significantly in order to attract borrowers. These lower rates make it harder to attract investors because the money repaid into asset pools will be smaller then they would be otherwise. Swanson remains hopeful that the worldwide attention on this matter will lead to success stories with replicable models.
By Greg Casey, Research Assistant
Additional Resources:
Microcapital article, March 21, 2008: PAPER WRAP-UP: BRAC Micro-Credit Securitization Series I: Lessons from the World’s First Micro-Credit Backed Security (MCBS), by Ray Rahman & Saif Shah Mohammed.
MicroCapital article, January, 16, 2008: PAPER WRAP-UP: The Role of International Capital Markets in Microfinance, By Brad Swanson.
Microcapital article, July 25, 2008: “ICICI Foundation, IFMR Trust and CRISIL to Develop Rating Standards for Microfinance Institutions (MFIs) in India”
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