Call for caution

Recent spate of defaults in microfinance securitisation transactions raises concern

Sandipan Chatterjee

Recent defaults in seven microfinance securitisation transactions with an initial senior-class pass through certificate (PTC) amount of INR8,493.4 million and an initial rating predominantly in the ‘A’ category have again highlighted the need for greater caution in evaluating the microfinance loan securitisation, according to India Ratings and Research (Ind-Ra). As the principal payment is promised on the final maturity date, losses were getting postponed. These losses cumulated in the range of 2.80%-3.10% for senior class and nearly 100.00% for the junior class of INR457.3 million, which was rated in the ‘BBB’/‘BB’ category.

Volatile loan performance warrants differentiated treatment: The similarity of borrowers from microfinance institutions (MFIs), in terms of their vulnerability to sociopolitical events, financial literacy and credit behaviour, renders the microfinance sector susceptible to any kind of adverse idiosyncratic event and more so in case of a system-wide event such as demonetisation. Thus, the microfinance sector has shown a volatile loan performance despite a low average historical default rate. Ind-Ra highlighted the volatility in the performance of MFI loans compared with other asset classes in its report PSBs' Reliance on Portfolio Acquisition from NBFCs.

Ind-Ra factors in the high volatility of the microfinance loan asset class in its model, reflected through the robust performance of Ind-Ra-rated microfinance transactions, which have not experienced a default and have majorly retained their initial ratings, even after demonetisation.

Protection against defaults largely dependent on performance of underlying pool itself: 
In the case of the securitisation of a microfinance pool, internal credit enhancement (CE), which is a part of cash flows from the pool, forms 70.00%-80.00% of the total CE. On the other hand, in the case of pools of other asset classes, internal CE is between 55.00% and 60.00% of the total CE. However, the 70.00%-80.00% internal CE is contingent on the robust performance of the securitised pool itself. Hence, in case of defaults in the underlying pool, it may be of little help to safeguard investors against losses.

Issuer-specific underwriting quality needs to be factored in analysis: Ind-Ra, however, believes that demonetisation alone cannot be blamed for the defaults, as these defaults are largely concentrated to specific geographies and have not affected on-balance sheet liabilities of the issuers. The sector was already facing challenges in terms of borrower overleveraging, which was highlighted in Microfinance: Borrower Overleverage Warrants Course Correction from MFIs. Moreover, demonetisation exposed the weaknesses in the underwriting standards of some issuers.

For the quarter ended September 2016, the aggregate gross loan portfolio of MFIs grew 84.00% yoy and the average loan outstanding per borrower increased 19.00% yoy. High growth in some of the MFIs’ loan book prior to demonetisation may have come at the cost of deterioration in underwriting standards. Ind-Ra places utmost importance in understanding issuer origination experience through several cycles and suitably factors any negative deviation in underwriting standards.

On-balance sheet debt vs. securitisation: High capital buffers and the ability to raise capital to mitigate the impact of demonetisation enabled MFIs to maintain their ratings and led to no losses on the balance sheet debt. On the other hand, because of the bankruptcy remoteness of a securitisation transaction, any support beyond initially provided CE is not allowed in such transactions. Hence, quite a few of them suffered losses. Additionally, balance sheet debt benefited from timely regulatory intervention by the Reserve Bank of India, which delayed the provisioning post demonetisation. Securitisation transactions typically do not have such benefits. Hence, factoring in an extreme event risk in CE sizing becomes all the more important.

Direct assignment of MFI loans is riskier affair: As on 31 December 2017, about 17.00% of the gross loan portfolio of NBFC-MFIs was classified as off-balance sheet items. About 27.00% of the off-balance sheet portfolio is in the form of direct assignment securitisation transactions. Such transactions are without any CE. Hence, chances of realised losses in such transactions are quite likely to exceed the initial expectation, as is the case with the defaults observed in the seven transactions, which resulted in a loss given default of 8.00%-9.00% of the securitised pools.

Delinquency stabilising post demonetisation: 
As mentioned in FY19 Outlook: Structured Finance, weighted average 0+dpd for MFI loan pools dropped to 6.29% in December 2017 from the peak of 12.00% in December 2016 during demonetisation. The collection efficiency for Ind-Ra-rated MFI transactions has improved since December 2016. Ind-Ra expects issuers to use this opportunity to tighten underwriting standards and investors to ask for deeper portfolio performance information and undertake greater due diligence.

The writer is a senior analyst at India Ratings and Research.