Subprime Crisis & Microfinancing in India

The sub prime crisis is definitely a credit market problem, first and foremost and thus it's advised that people remain long in equities. The root cause of sub prime crises is conjuring trick of structured finance mismanagement, which basically makes bad credit look like good credits. Credit risk is now being repriced throughout the system, impacting greatly the borrowing cost for ordinary consumers and companies in those countries, where the sub prime structured finance crisis has hit. However, the downside is incidentally greater on credits for people who own credit instruments and equities.

The problem with sub-prime crisis was not structured finance instruments per se, but the way these securities were not tracked, not properly rated, not properly analyzed etc. in short, were mismanaged. In sub-prime lending the institutions that granted these loans promptly sold them on the securitization process to other institutions, which sold them on to others, and so on again and again. Those who suffered losses were the ultimate holders. There were so many of them, all over the world, that no one knows where the losses were being borne.

The recent sub-prime crisis is good example of mess created by mismanaging the structured finance instruments and one can draw a few lessons from this crisis so as to exercise caution as far as the microfinance industry in India is concerned.

Looking at the demand, broad basing the reach of financial services to the people falling in the low income category, help them invest in and benefit from their skill sets is a need of the hour. The intentions might sound quite philanthropic however microfinance is turning out to be a profitable market for commercial banks which is quite evident from their presence in this area.

As commercial banks entering this market do not have the infrastructure to ensure the last mile connectivity and have to rely heavily of microfinance institutions (MFI). The MFIs who were grant based organizations have begun to graduate from it to capital based organizations. Equity and Securitization came forth as good methods of sourcing capital for these microfinance initiatives.

MFIs have incentive of freeing up more capital and expanding their reach by selling of the portfolio and transferring the risk to the investor. Although defaults clauses exist in the securitization deal, but as the securities change multiple hands the situation would not be much different compared to the current sub-prime crisis.

The securitization of loans in India is covered by a number of rigorous guidelines. The fact that the sub-prime bust originated in securitized loans should not induce further restrictions on this. It is a useful innovation and the RBI rules should take care not to scare it away totally.

Securitization is a good tool to be carefully used. Let not the RBI make the rules too strict. It is more important to ensure that the originator of the loan practices the appropriate procedures of lending, having adequate security and monitoring of repayments in time.

Microfinance requires new and innovative products to ensure greater reach to further encourage more sophisticated financial instruments to participate in the microfinance market. Taking the stock of current and future developments, regulation of microfinance becomes important. Rating of MFIs, structured securities, regulating secondary market for structured securities would be good precautionary steps.

Structured Finance Explained

Let's assume a farm equipment manufacturing corporation has some of its sales for cash, but the bulk of its sales are from installment sales contract. Effectively, an installment sale contract is a loan to the buyer of the farm equipment. The loan specifies an interest rate that buyer pays. The credit department of Farm Equipment Corporation makes decision as to whether or not to extend credit to a customer. That is, the credit department will receive a credit application from a customer and, based on criteria establish by the firm, will decide on whether to extend loan and the amount. The criteria for extending credit or a loan are referred to as underwriting standards.

As Farm Equipment Corporation is extending the loan, it is referred to as the originator the loan. Moreover, Farm Equipment Corporation has one more department that is responsible for servicing the loan. Servicing involve collecting payment from borrowers, notifying borrowers who may be delinquents and, when necessary recovering and disposing of the collateral (i.e. farm equipment in our illustration) if borrower do not make loan repayments by the specified time. While the servicer of the loans need not be the originator of the loan, in our illustration, Farm Equipment Corporation is both originator and servicer.

Now suppose Farm Equipment Corporation has more than Rs. 200 Million of installment sales contract shown on its balance sheet as an asset. Now, when Farm Equipment Corporation wants to raise Rs 200 Million it can raise the fund with structured financing rather than issuing corporate bonds for Rs 200 Million.

To do so, the Farm Equipment Corporation will set up a legal entity known as SPV. Farm Equipment Corporation will then sell the Rs 200 Million loan to the SPV for cash. But where does SPV will get Rs. 200 Million to pay to Farm Equipment Corporation? It obtains the funds by selling the securities that are backed up by these Rs 200 Million loans. These securities are called asset backed securities or bond classes that are issued in a structured finance transaction.

Looking at the credit risk, role of the rating agency or a risk consulting firm will be to focus on:

Credit Quality of Collateral as determined by the asset type, borrowers' ability to pay the loan and the borrower's equity in the asset. Currently micro finance in India is mainly without adequate collaterals. Credit rating will also need to see experience of the originator of the underlying loans and to see if the loans have the same characteristic in which the originator has experience in. Rating agency will assess the nature of underwriting standards vis-à-vis historical default rate. It will also monitor default rates over time to determine whether there is improvement or deterioration in the underwriting standards.

The quality of loan servicing: The agency will look at recovery rates along with default rates which determine the ultimate loss rate. This is a high reputation risk area for many banks as recovery is being done using a goon's protection money asking approach.

Cash flow stress and payment structure: Credit rating agency will also look for stress on cash flows for both the originator and the borrower and rationalization of payment structure to gauge the credit risk. Lot of scope exists for innovation in this area which is possible through various public and private extension services.