Ind-Ra: Recent Performance of Microfinance Securitisation Calls for A Tighter Structure to Handle Extreme Events

India Ratings and Research (Ind-Ra) believes that the higher volatility of default in microfinance (MFI) loans warrants higher rating level stresses and structural mechanisms to ensure rating stability. Ind-Ra believes that if the default rate (PAR>0 as % of original principal of the pool) in an MFI transaction remains 20% higher than the budgeted stress levels for the first nine months, then the senior class, which is typically rated in the 'A' rating category, may be downgraded by three notches. Also, a 10% higher-than-budgeted stress for the first nine months could lead to a four-notch downgrade of a 'BB+' rated junior tranche.

In the recently published report 'PSBs Relying on Inorganic Route to Grow Retail Book', Ind-Ra has highlighted that the past performance of MFI loans is a poor proxy of future defaults because of the higher default volatility of this asset class than of other retail loan asset classes. Ind-Ra believes structural mitigants and an appropriate default assumption lend stability to these transactions. The pass through certificates (PTCs) issued by MFI securitisation trusts are typically promised a timely payment of interest and ultimate payment of principal (TIUP) structure. Ind-Ra believes that such structure lends more stability to the rating of senior class tranche than a timely interest and timely principal structure. Many MFI securitisation transactions closed during 4QFY17 had a default based trigger which allows EIS to be trapped in the EIS account. The trapped EIS has to be used to amortise PTCs. Quicker amortisation of PTCs has allowed the transactions to withstand slightly more stress, leading to better rating stability.

Maharashtra, Karnataka, Madhya Pradesh, Gujarat and Uttar Pradesh together contribute 90% to the total defaults in four moderately stressed Ind-Ra rated transactions which are seasoned by less than nine months. Several districts in these five states have witnessed a higher level of defaults. The reasons behind the high delinquencies in these districts vary from state to state and are largely a manifestation of local political interference, drought and event risks such as demonetisation coupled with borrower overleverage.

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