Saturday, January 1, 2011

Microfinance - Part 2

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( This is a continuation of the previous article "Microfinance – Part 1" which you can read at  )

The Andhra Pradesh Government has passed an ordinance which severely restricts microfinance companies from carrying out their operations. All MFI's have to ensure that each borrower has borrowed only once, have to take the government's permission to give a second loan, cannot collect loan repayments from people's doorsteps, etc. etc. They have basically been completely chained and fettered, and their further operations rendered unviable.  Collections in Andhra for existing loans have dropped to less than 20% of dues (that's right – that's an 80 percent drop). No doubt word is being passed around by the AP politicians who made this happen that repayment is not required and would not invite any consequences. 


AP accounts for more than 25% of the Indian Microfinance industry's loans.  The situation in the rest of the country is no doubt bad as well, though not to such a degree. Once borrowers get the message that they need not repay, that is the death of banking. The system is ensuring that such a message is passing.  In fact, in India such messages have always been passed when it comes to farmer loans which keep getting written off time and again. What this does to the moral fabric of society is another debate altogether.


The commercial banks have lent to the microfinance finance industry for onward lending. Their loans are now in jeopardy, and the industry is seeking a one-year moratorium on principal repayments. The total exposure of the banking sector to MFI's is Rupees 14,000 crores. Yes Bank has already written to its borrowers asking them to repay the 400 crores they owe it, which represents about 1 to 1.5% of Yes Bank's loan book; and it is certain that the borrowers are not in a position to do so, at least not right away.


The MFI's were carrying out a perfectly legal business and filling a niche in the market where there was a void for long. The poor man's access to credit was either from the moneylenders at usurious rates of interest, or from government schemes which were doled out through village babus acting under the control of politicians. There needs to be regulation, most certainly, but it should have been allowed to evolve since the industry is new, and it could have been brought about under the ambit of RBI. I think the system reacted in this way since it perceived a threat to it in the form of the growing clout of the MFI industry, which is right now in its infancy. And so the baby is being crushed. Since that is what the system set out to do, it is doing it correctly and at the right time. It is easier to kill a baby than wait till it is grown up. The reasons being given, like farmer suicides, are well orchestrated, and cannot be objected to.  But suicides due to indebtedness have always been happening, and they will continue to happen – nothing that is happening right now is going to stop that.


The Central Government is acting like a mute spectator. It cannot even claim that it is powerless in this case, since AP has a Congress government. Perhaps it is in the interest of all politicians to kill the microfinance industry at birth. It seems like it is not in anybody's interest to allow this industry to grow. Anybody in power, that is.


Looking at it from a different angle, it is not necessary that if the sector had been allowed to boom, things would have turned out for the better. They might have, or they may have led to another financial scam!  Let me explain by drawing out a hypothetical scenario. I shall be drawing parallels to the Global Financial Crisis of 2008 (to read my three part series on the Global Financial Crises – go to:     ).


The banks lend to the MFI's since it helps them to show it as part of their priority sector lending. MFI's borrow at 12 percent and lend onward at 25. Their costs are 6 percent. That gives them a margin on the money lent out of 7 percent. The trick is now to increase volumes. So MFI's go out and lend indiscriminately. They do not care if the same borrowers are borrowing more than once. They give out fresh loans which are used to repay old ones. Thus they amass millions of "customers" in their books.


On the investors' side, the promoters and the initial private equity investors turn a blind eye to what is happening. Their objective is to increase the valuations and offload some part of their stake to someone else. This some part more than recovers their initial investment and they retain control with the rest. It is in fact in their interest to actively increase the top-line at this stage without worrying too much about the possibility of bad debts.


It is also necessary to increase the velocity of money. They need to get more money to lend – where this is not possible based on the strength of the Balance Sheet, they have to go off Balance Sheet. So they securitize the loans. They package a few hundred thousand of these loans into a "tranche" and put it into a Special Purpose Vehicle (SPV). They then issue debentures against the security of the underlying pool of assets. All these assets are uninsured, and they are lent without collateral. But they have one big advantage, in that they are all assets yielding 25% per annum. The insurance part is easily rectified. The friendly insurance company covers defaults for a fee; their calculation is that any point in time not more than, say, 0.5% of the loans can default, and a 1% or 1.5% premium is good revenue. The executives at the insurance company get paid to increase their top line, and they have a good story to sell here; no one would be interested in asking "what happens if all borrowers default at the same time", since probability theory says that that cannot happen. Just like AIG which insured all the sub-prime loans on the premise that not all of them could default at the same time.


Then they invite a credit rating agency, which is eager to rate the issue, for a fee. The fee by the way is paid by the MFI – and we know that the one who pays is the one who calls the shots. The credit rating agency runs its own spreadsheets which assign a 1% probability of loss, etc., look at the insurance cover, and declare that it is Triple A. The insurance company in the meanwhile, would perhaps have agreed to the cover since it is rated Triple A!  The rating agency collects its fees, and its responsibility ceases right there. If challenged, they can always show detailed spreadsheets backed up by sound theoretical financial models working off on "probability", "net present value of future inflows", "net margins" , etc. etc.


The MFI, based on the insurance and the rating, calls its debenture issue as "Triple A highly safe, securitized lending" offering a return of, say, 12%. Fund managers who run debt funds are always looking for Triple A rated securities to add to their portfolio. Once a security is rated Triple A, it is perhaps not their job to look at the underlying assets of the pool. In any case, it is a pool, and not all can default at the same time, right? A few fund managers hold back; they are suspicious and do not invest. But a few others who do, immediately show an increase in their portfolio returns, which gets reported in the press. The fund managers who have not invested get pulled up by their AMC bosses at the next quarterly review, since the fund flows have started to go to the other funds, they are losing market share. So our skeptical fund managers have no choice but to jump into the bandwagon. In any case, they are doing their bit by ensuring that it is Triple A; the rest is not their lookout.


The MFI uses the proceeds of the debenture issue to promptly lend out again. That creates another few hundred thousand borrowers, based on which another SPV is formed, and the same cycle repeats all over again. Meanwhile, those in the MFI who have figured out what is happening cannot stop it, for several reasons. The system is on a roll, and anyone who resists will be brushed out of the way. Their bonuses depend on the amount of money they lend out; it is in their interest to lend out more and more. There are fissures building up within the system like those under the ground before an earthquake, but it is no one's interest to go around looking for fissures; those who warn of future collapse are labeled as Cassandras and ostracized for spoiling the party.


The funds which subscribe to these debentures are all acting on behalf of millions of investors spread across the country. These investors in turn could be banks or institutions who are funneling their borrowers' money into these funds. The rot spreads.


RBI in the meanwhile starts getting worried and talks of putting curbs in place. In fact, they do institute some measures like increasing the risk weightage on these assets, and declaring that MFI's who form SPV's for onward lending retain at least a part of the loans in their books; this does result in abating the frenzy somewhat; but it is too little and too late.


And then one day something like the current crisis hits. The trigger could be anything. It could be a spontaneous public uprising due to farmer suicides; it could be politicians playing dirty; it could be that a couple of MFI's got too greedy and started lending to absolute paupers without addresses; or it could just happen for no reason, but happen it will. When the fissures develop within the system, the earthquake finally happens because of a small shift in the tectonic plates.


And all hell breaks loose. People stop repaying their loans. MFI's loan books are suddenly worthless. Their SPV's are worthless. The funds who invested in these SPV's are helpless. The paper they hold is worthless. However, the people who have invested in these funds are all common folk who are not even aware of all this. If the government does not intervene, the whole banking and insurance sector in the country could collapse. The financial industry is built on trust; once a couple of banks go under, the entire system will be in danger of collapsing. It does not help that the major lenders who are facing trouble are "too big to fail". Their collapse could endanger the stability of the country. So the government steps in and bails out the ailing banks with taxpayers' money.


All this sounds familiar, of course. It is very similar to what happened during the global financial crisis.


So in a way it is good that the MFI crisis hit us now when the industry is in its infancy. The sector will still bounce back – there is too much of a need out there for that not to happen. However, the warning bells that have been rung now, will result in better regulations and oversight. The industry will self-regulate. RBI will put in rules in place for lending. The government at the center will pass laws or work with the state governments for a common framework for regulation. The industry will evolve and emerge much stronger.


Bad  things that happen also result in some good, sometimes.


Varahan said...

SHGs were there even before the MFIs came into being. In fact, the NGOs which formed the SHGs in the initial stages, saw the captive clientele available for them, to lend and make money. Since these NGOs were attached more with the concept of loan from one place and cohesiveness of groups, did not try to make a kill and were conservative. Some NGOs who had the urge to make a kill did not have the ways and means to mobilise money for onlending from the nationalised banks.

But the MFIs which were purely commercial oriented entities wanted to make a kill and increased their interest rates to such an extent that they were happy to ensure only interest repayment. This killed the golden goose (SHGs) which gave the income.

As you had stated, because of severe competition amongst the MFIs to corner maximum number of SHGs under their fold, they totally forgot what is called "selection of customer". Who ever was ready to borrow was a customer. In fact, the MFIs went to doorsteps to disburse loans !

Dinesh Gopalan said...

Bhuva, these are the problems inherent in scaling up - how do you get the advantages without falling for the traps?