Tilak Mishra

Securitization: Increasing Liquidity in Base of the Pyramid Markets

How does one convert “credit” extended to low-income households into tradable “commodities”? Is there a way to use the best know-how of financial markets to transform an industry that makes small loans to low-income households? Is it possible to diversify an organization’s sources of funding lowering its cost of capital while at the same time increasing the returns of an investor’s portfolio?

Securitization, which typically involves conversion of assets that have predictable future cash-flows (like mortgages, automobile loans, student loans, home equity loans, credit card receivables, etc.) into rated, standardized and tradable securities, promises to offer an answer to all these questions.

Highlighting the recent $10.4 million transaction that involved India’s first mutual fund investment (by ICICI Prudential AMC) in the Indian microfinance industry, a recent blog entry by Dr. Nachiket Mor emphasized the importance of securitization as a financing channel for the microfinance industry. His blog triggered an interesting debate that argued how Micro Finance Institutions (MFIs), who have traditionally depended on uneven year-end inflows from banks, could diversify their sources of funding by participating in the assets-backed securities market via “rated” securitizations.

This particular transaction involved the securitization of receivables from over 55,000 micro loans originated by Equitas Micro Finance, a MFI based out of Chennai. It demonstrates that receivables securitization offers an economically attractive alternative to conventional sources of financing for MFIs. So, how does it all work? Securitization converts an illiquid asset into a tradable instrument in the debt-capital markets. In the case of a MFI, the underlying asset comprises of a pool of micro loans that are originated by the MFI and are backed by the future cash flows related to the loans (i.e. the collections from the low-income clients). A structurer, then, performs rigorous due diligence on the MFI by creating strict underwriting guidelines to ensure that only the most credit worthy MFIs are chosen to participate in the securitization process.

A portfolio of loans is then sold to a bankruptcy-remote entity, “Special Purpose Vehicle (SPV),” that is housed in a separate legal entity (usually a private Trust). A rating agency performs due diligence on the MFI and the loan portfolio; in order to acquire a high desired rating for the to-be-issued securities, it is critical for the originator of micro loans (the MFI in this case) and / or the investors, to provide adequate credit enhancement. Credit enhancements, such as subordination (first loss default guarantee by the originator, and second loss deficiency guarantee by the investors), over collateralization, etc. are vital risk-reduction techniques that aid in protecting the securities backed by a pool of collateral (for example, collections from low-income clients in our case) from potential losses arising out of defaults in the underlying assets (the micro loans in our case).

After purchasing the assets, the SPV then creates investment-grade debt securities, which are then sold to investors in the debt capital markets. The returns that the investors receive are directly affected by the performance of the underlying assets since the investors take in the interest and principal payments on the underlying assets for the duration of the security’s life. Also, since the SPV is a legal entity independent from the MFI, the rights of investors to the assets held by the SPV are protected in the event of the MFI experiences financial trouble.

So, why would an investor (in our case, banks, insurance companies, mutual funds, private wealth managers, etc.) like to participate in an asset-backed securities market comprising of micro loans to low income families as the underlying assets? It is because microfinance loans are an increasingly attractive asset class due to the following salient features of Microfinance loans: 1) lower acquisition costs given a loyal client base that results in high portfolio quality and loan repayment rates; 2) high liquidity and solvency given the short tenor of the micro-loans, typically less than a year, thus giving entities such as mutual funds to have an additional short-term investment opportunity; and, 3) high returns and portfolio diversity given microfinance loans’ low correlation to the mainstream markets.

On the other hand, securitization helps the MFI broaden its borrowing sources, reduce the cost of borrowings, impart pricing flexibility on the lending side, enhance ROA and other financial ratios, and/or lower leverage and boost financial return ratios. For example, since the securitization process results in the “true” sale of assets, there is generally a corresponding removal of the assets from the balance sheet of the MFI. The MFI can then realize meaningful improved balance sheet metrics (such as Return on Assets, Return on Equity and Return on Capital) and financial flexibility to manage higher growth with existing capital. Specifically, issuing additional debt (bank loans) may have adverse effects on the MFI’s balance sheet, as well as undesirable dilutive effects while issuing additional equity.

The term debt, additionally, usually carries covenants that restrict the MFI’s financial flexibility (specifically around the timing of the repayments). But, by raising funds through the sale of an asset (that already exists on the MFI’s balance sheet) and by receiving cash for the receivables within days of an invoice being issued, the MFI’s working capital needs are dramatically reduced. The MFI can then re-deploy these funds to originate and service a larger number of loans, optimize its existing distribution network and correspondingly reduce its operating costs passing on this benefit to the end customer in the form of a reduced interest rate. A lower interest rate for the microloan, finally, spurs demand for microloans and will empower the MFI to fulfill its social mission of reaching more unbanked households.