Overcoming challenges of securitisation

This post is on behalf of Hari Nathan and Kshama Fernandes of IFMR Capital

Aparna Dalal recently wrote a blog post about IFMR Capital's securitization of microfinance loans. She raises some very insightful questions about securitization and her concerns are well noted. We would like to take the chance to reply to some of these concerns.

Concern 1: Securitization leads to a separation between originator, servicer and risk-bearing agent which can lead to a degradation lending standards.

This is a real concern as this is widely recognized as one of the principal causes for the financial crisis. We have tried to address this point within the structure in the following ways:

• Each MFI (the originators and servicers) have put up a First Loss Default Guarantee (FLDG) in the form of a cash collateral, which in this case forms about 13.8% of their total expected cash flows. Any losses due to default or prepayment are borne, first, by the originators/servicers themselves.
• IFMR Capital is acting both as the structure as well the investor in the subordinated strip. As a result, any losses above and beyond the FLDG will be borne by IFMR Capital.
• CRISIL, the rating agency in this transaction, has its reputation as a top class rating agency on the line (as it does with any other rating). Their name appears in the press-release and also appears in the press coverage from various financial news institutions. Additionally, over the last few years, they have been very conservative in their rating, requiring extremely large cash collaterals as compared to the historical default rates observed in this asset class(between 1% and 2%).

As a result, all the parties to the transaction have "skin in the game" and stand to lose either money or reputation in the event of large defaults. We believe this will act as incentive to keep lending standards high and prevent predatory lending.

Concern 2: Diversification doesn't help in the case of economy wide problems.

It is certainly true that diversification doesn't help in situations where the entire economy is affected. However, given the short tenure of these loans it would require a sudden large shock to the economy to lead to high defaults. Additionally, as far as we know, there is a very low correlation between the performance of the economy at large and the repayment rates of these low-income individuals, especially for those in rural areas (although there is relatively little data available for this sector). Finally, given the large FLDG (13.8% of total cash flows) and size of the subordinated strip (25.4% of total cash flows) it will require an enormous change in repayment rates before the IRR of the senior tranche is affected.