Fitch Ratings has recently issued a report on Indian microfinance securitisations, which has drawn a conclusion that the rating of securitisation transactions must be linked to the rating of the servicer with a suggested cap of 7 notches on the difference between the highest rated tranche and the rating of the servicer.
Some of the arguments stated in the report are similar to arguments stated by other observers in the past, namely substantial dependence on the servicer, over-collateralization (and reliance on excess interest as a credit enhancement) which creates a higher dependence on the servicer, weak MIS, relatively short operating history of these originators etc.
While we have no comments on bilateral assignment transactions that routinely occur between microfinance institutions (MFIs) and banks, we believe that securitisation transactions structured by IFMR Capital have inbuilt safeguards, risk mitigants and operational controls that address substantially the risks that Fitch foresees. Further, some of the arguments that link servicer rating to tranche rating do not hold water and need further analysis.
Broadly, the report categorizes three key risks:
1. Reporting / MIS:
The report compares risk reporting on MFI securitisations to those of other asset classes and suggests PAR>0 as the appropriate risk indicator as against PAR>90. Please note that for all securitisations structured, arranged and invested in by IFMR Capital, originators provide collection reports at a granular level on each and every underlying loan (as opposed to aggregate reporting that rating agencies rely upon). Investors are provided fortnightly reports giving PAR>0-30, PAR>31-60, PAR>61-90, PAR>91-180 and PAR>181 days.
IFMR Capital has invested in a portfolio management system that is able to upload the granular customer repayment data provided by originators and create dynamic reports to analyze pool performance on an ongoing basis.
Further, the report suggests that inherent PAR data provided by an MFI may mask the ‘true nature of defaults’ due to the inherent high growth of the MFI. We suggest that an easy way to ‘unmask’ the data is to use a vintage curve analysis. The vintage curve analysis takes into account the performance of portfolios originated in each month over the history of the MFI’s operations. Hence, it is an excellent tool to understand how origination and collection mechanisms have evolved during each stage of the MFI’s development (please see the worksheet for the format of the vintage curve)
We believe that weekly repayments provides substantial value to investors in that they can track performance on a very granular level, as opposed to less frequent payments in other asset classes
Microfinance securitisations structured by IFMR Capital have brought in a transparency into the sector that is comparable to the best in the structured obligations space.
2. Collateral provided
Fitch has expressed concerns about forms of credit enhancements used. For transactions done by IFMR Capital so far, cash collateral has been the typical form of credit enhancement as against excess interest spread. This is typically provided in the form of a fixed deposit which is contributed by the MFI from its Tier-I or Tier –II capital.
Further, while the RBI has disallowed originators from reducing the cash collateral till the maturity of the transaction, rating agencies have typically not provided any benefit of the above to the rating of the tranches.
The report also expresses concern about overcollateralization (and excess interest spread) as method of credit enhancement as it is subject to reduction following default of assets. However, is that not exactly the very purpose of overcollateralization – to ensure the availability of sufficient collateral in the event of loss of value due to default? Again, the arguments are not clear.
3. Servicer dependence
The report opines that in the absence of factors that reduce servicer dependence, the ratings of securitisation transactions could be capped at the rating of the issuer. Firstly, to cap the short-term rating on a securitized paper (typically of tenure between three-months to one-year) to a long-term rating of the servicer seems incorrect. Secondly, we believe that microfinance securitisation transactions have several structural mitigants in-built to counter servicer risk and ensure that the incentives of the servicer are well aligned with that of the investor. We highlight below some of these factors as they pertain to transactions structured, arranged and invested in by IFMR Capital.
a. First loss provided by servicer in the form of cash collateral from the onset of the transaction: Typically this ranges from 10 to 14 percent for an asset class that has witnessed default rates of less than two percent over the long term.
b. Weekly payments to SPV: Daily sweeps for small size loans are impractical and will only cause errors/mismatches in payments and MIS. MFIs make weekly payments to the SPV in a securitisation transaction and the associated co-mingling risk is always accounted for in the credit enhancement provided upfront.
c. Stringent reporting norms: The servicer provides a client-wise detailed MIS on collections to the trustee and IFMR Capital with every payment. This gives continuous insights into performance of the underlying asset class, and into the ability of the servicer to collect.
d. Diversification across branches, geographies and originators: The granularity of the loans and the diversification possibilities reduce the risk of an external shock as well as concentration risks to a particular servicer.
e. Continuous monitoring and surveillance: IFMR Capital’s monitoring and surveillance setup is a critical early warning signal system that has been set up to counter servicer risk. Through its network and field visits, the team has a pulse of what is happening on the ground at all points of time. This continued involvement and diligence by the Arranger post transaction settlement differentiates microfinance securitisation from securitisation of other asset classes.
Finally, we believe that an MFI rating has to do with the performance of the entity from a balance sheet perspective given its ability to service its own debt. It does not have to do with the servicing ability of the MFI. In microfinance securitisation, the rating agency takes a one year call on the servicer’s ability to collect and administer the underlying micro-loans, not on its ability to service its own debt obligations in the long term. One could easily imagine an A rated originator being downgraded to BBB, with no impact on its ability to service or collect outstanding loans that underlie a AA securitized paper. Such examples are common in securitisation of other retail loans such as auto, two wheeler loans, wherein the underlying rating of the securitisation is significant higher than that of the servicer. (Please see the link to the Deal Portal at www.ifmrcapital.com)
Our pools continue to be serviced effectively. Further, A rated MFIs facing collection shortfalls in Andhra Pradesh are not facing collection issues in non-AP geographies, proving that even though they have debt repayment issues, pools in non-AP areas can be serviced. This goes to reinforce the fact that diversification across MFIs and geography proves to be a good way to mitigate default risks.
Further, to assume that there will be no collections at all in the event of a shock is a rather unrealistic view. Rating is done on an ultimate basis and takes recoveries into account. Collections were observed in the Krishna district incident, commencing 6-9 months after the incident.
The report suggests that the dependence on the servicer could be reduced by MFIs working together to form a network that could act as alternate servicers (particularly given the overlap of operations of MFIs in many geographies). In our view, what can really work in the situation is an effective field monitoring system which monitors the performance of the underlying micro-loan portfolio on the ground at frequent intervals, ensures greater transparency, provides early warning signals for future stress events and is more practical. In India, there is no back up servicer for any retail loan at the moment, and while competing retail loan originators can theoretically provide alternate servicing capabilities, this remains to be tried and tested.