The future of securitization in microfinance

This post is a follow-up to our original post on IFMR’s recent securitization deal.

Pulling off this securitization was no small feat.  Two of the elements of this deal that make it so important are the experience and rigor of the participants.  That experience translates into hard-thinking about the details of the contract.  For that reason, it's especially worth drawing out the key details that make the deal work.

The fact that IFMR Capital is putting their some of their own money on the line is a big deal.   It does two things.  1) It reduces risk for other investors directly by absorbing losses beyond the "first losses" absorbed by the microfinance institutions themselves. 2) It means that IFMR Capital should have an ongoing interest in trouble-shooting problems that might arise with the micro-lenders.  If I were an investor, those 2 facts would help me sleep much better at night.

Alex at India Development Blog has a really nice post in which she addresses the concern that "Diversification doesn't help in the case of economy wide problems."  She writes:

"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)."

Maybe spending years in downtown New York has skewed my intuition, but the recent US mortgage crisis looms large in my financial consciousness.  It's not crazy to imagine a correlated shock in the microfinance industry.  Let's say, for the same of argument, that repayment discipline gets out of hand at a single institution, and it collapses or nearly collapses. This first crisis could trigger re-assessments, financial jitters, and trouble re-financing at other institutions -- possibly even creating a downward dynamic in the sector that becomes a self-fulfilling prophesy.  The problem is not economy-wide shocks so much as sector-specific events that spread quickly across the market.

This kind of scenario seemed really unlikely in the US housing market, and investors felt better knowing their mortgage investments bundled pieces from different parts of the country.  Surely, all of the markets wouldn't ever go down at the same time, would they?  Well, we know what happened in 2008...  I have no particular reason or any evidence to think that the Indian microfinance market holds the seeds of a similar kind of melt-down.  But it's striking to note how similar the reasoning here seems to be to that in the US circa 2005-7.  And we got that very wrong in the US.  

Alex is right that the fact that these are short-term loans helps reduce perceived risk. Alex also makes a good point specific to this deal: holders of senior debt should be in a strong position due to the size of the guarantees here:

"Finally, given the large [First loss default guarantee] (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."

The IFMR Capital group is smart and thoughtful, and they certainly seem to know what they're doing.  This securitization is an exciting development -- and because it's so important, it deserves a close look.  Taking a cue from Alex's post, the big question looking forward is: what will happen in future attempts to securitize microfinance that can't build off such generous guarantees or the involvement of a top-notch group like IFMR?