MICROCAPITAL.ORG STORY: CGAP Consultant Deborah Burand Blogs About What Subprime Mortgage Securitizations Can Teach Microfinance Participants About The Sales Of Microfinance Loan Portfolios

Ms Deborah Burand [1], a consultant for CGAP, recently posted a comment on the CGAP Microfinance Blog [2] entitled ‘What subprime mortgage securitizations can teach us about sales of microcredit portfolios’ [3]. Ms Burand suggests that there is a lot that microfinance participants can learn from the subprime crisis in the US. In particular, she highlights the problems with the ‘originate to distribute’ model of securitization [4], [5], [12] and the role of this technique in exacerbating the subprime crisis. Under the ‘originate to distribute’ model, banks often sell the loans on their books in order to remove these assets (and the credit risks associated with these assets) from their balance sheets. Loans are seldom held to maturity under this model with the result that banks are able to generate more loan assets within a relatively shorter time frame. The lessons that can be learnt by microfinance participants from the subprime crisis were the subject of a previous Microcapital.Org White Paper which is set out in the Bibliography section below [6].

Securitization [12] is a financing technique under which a bank (known as the ‘Originator’) [12] transfers the loans on its balance sheet to a shell company or, in technical parlance, a ‘special purpose vehicle’ (SPV) [12]. The SPV then issues debt securities to investors in order to raise funds for the SPV to purchase the loans from the Originator. The debt securities are secured over the portfolio of loans and are therefore known as ‘asset backed securities’ (ABS) [12].

Securitization has proven to be an effective funding technique for Originators. It is quite often a cost effective fund-raising method and allows the Originator to spread the credit risk associated with the portfolio of loans to a wide variety of investors. The ‘originate to distribute’ model however has been misused in a sense that banks have in the past securitized loans that are of poor quality. Once these loans are removed from the balance sheets of these banks, they are able to generate new business and disburse further loans in the market. Such activities contributed to what is now commonly known as the subprime crisis in the US.

Securitization is not new to the microfinance sector. Ms Durand points out that, among other MFIs, BRAC [7], [8] has previously engaged in a securitization of its loan portfolio in Bangladesh. MFIs that are, for whatever reason, not in a position to fund or undertake a securitization can choose to sell part or all of their portfolio of loans to a willing investor, almost always another financial institution, in order to raise funds.

Ms Burand cautions that in order to avoid the problems that have emerged during the subprime crisis, MFIs and microfinance investors should adopt the following best practices. Firstly, participants in the microfinance sector should never adopt the ‘originate to distribute’ model. Originating banks should also retain at least 10 percent of the credit risk in relation to the securitized assets. This will mean that Originators will have an incentive to generate good quality loans, given that they still have some exposure to any downside on those assets. Secondly, Ms Burand reiterated the significance of consumer protection in this context and the importance of ensuring that microloans are only disbursed to ‘suitable’ customers. Before purchasing a portfolio of microloans from an MFI, investors should be encouraged to evaluate whether the MFI in question has adopted and adhered to consumer protection principles. If the originating MFI cannot demonstrate that it has ethical lending practices, investors should be careful not to engage in a purchase of the portfolio of such an MFI. Consumer protection is an important issue that has been the subject of previous Microcapital.Org stories [9], [10], [11].

By Chinq Yee Chong, Research Assistant

Bibliography

[1] Ms Deborah Burand, Profile on CGAP Microfinance Blog website: http://microfinance.cgap.org/author/Deborah-Burand/

[2] CGAP Microfinance Blog: http://microfinance.cgap.org/

[3] CGAP Microfinance Blog on ‘What subprime mortgage securitizations can teach us about sales of microcredit portfolios’: http://microfinance.cgap.org/2009/07/27/what-subprime-mortgage-securitizations-can-teach-us-about-sales-of-microcredit-portfolios/

[4] Bank for International Settlements on ‘Some reflections on the future of the originate-to-distribute model in the context of the current financial turmoil’: http://www.bis.org/speeches/sp080423.htm

[5] Financial Times Blog on ‘Lessons from the Financial Crisis Part 1′: http://blogs.ft.com/maverecon/2007/10/lessons-from-thhtml/

[6] MICROCAPITAL.ORG WHITE PAPER on ‘Subprime Lending: Lessons for the Microfinance Industry’: https://www.microcapital.org/downloads/whitepapers/Subprime.pdf

[7] PAPER WRAP-UP: BRAC Micro-Credit Securitization Series I: Lessons from the World’s First Micro-Credit Backed Security (MCBS), by Ray Rahman & Saif Shah Mohammed

[8] BRAC’s USD 180mn Microfinance Securitization wins Recognition from International Financing Review Asia and CFO magazine

[9] MICROCAPITAL STORY: Client Protection In Microfinance – Observations by ACCION and Prizma Mikro From A Hanson Wade Conference On Microfinance Investments

[10] MICROFINANCE PAPER WRAP-UP: Microfinance Sector’s Consumer Protection Initiative, By Maheen Saleem and Aban Haq

[11] MICROCAPITAL STORY: Thirty-Five Organizations Sign Client Protection Principles to Ensure Fair Treatment and Financial Protection of Low-Income Microfinance Clients

[12] Standard and Poor’s Glossary of Securitization Terms: http://www2.standardandpoors.com/spf/pdf/fixedincome/062403_glossaryenglish.pdf?vregion=eu&vlang=en