reflections on securitization and netting…
An article in the Business Standard today says ICICI Bank plans to securitize Rs. 20 crore worth of microcredit. Right now there’s no secondary market for microcredit securities, but ICICI is tying up with CRISIL to rate these securities (they are hoping for AAA) and also trying to rope in Grameen Bank to back up the securities in case of defaults.
Surprising as it may seem, the % of defaults in microcredit is incredibly low, just 0.5% (which is why the AAA rating seems reasonable). ICICI is providing credit to micro finance institutions at a 8% rate of interest per year. Earlier it was 14%.
This is all very good. ICICI is probably securitizing to take microcredit loan off its balance sheet, and to avoid the hassles of keeping a close tab on collections. So I doubt its motives are altruistic, but in this case that’s ok.
I think fundamentally this is what has changed about banks. Once banks were the risk takers, if they lent money to an entrepreneur all the risk of non payment was borne by them. Collaterals were about the only protection agains this risk.
Securitization makes it easy for them to transfer the risk to the secondary market. The good thing about that is that makes the availablity of credit easier. And cheaper. In some cases like micro credit, its even a blessed thing. On the other hand by providing an easy exit route to banks from iffy loans, securitization makes banks put more of their resources into places where they can make a faster bang for the bank – and the best place for that is by trading on their own account in the capital markets. This leads to higher inflows into the capital markets and since the number of companies receiving these inflows are not going to change, the only logical result is to push up their valuation beyond any logical explanation. This is only aggravated by the indiscriminate use of derivatives which enable you to leverage beyond any reasonable limits. (For instance, LTCM at the time of its collapse for instance had an effective leverage of 1:550+, crudely put that means that if LTCM owned Rs.1, it posted that Rs.1 as collateral to buy Rs. 550. Does that sound weird or what?)
Securitization has its benefits, but I think one has to be very careful about its applicability. For instance I think securitizing credit card payments, and maybe even home loan mortgages is the sort of thing that encourages profligate spending, and makes banks less than discriminating in handing out loans. Defaults there are likely to be higher as well, so it consequently results in analysts trying to fudge reality resulting in artificially inflated valuations of such securities. Worse still I think is the newer trend of securitizing account receivables, which is treading on even thinner ice.
Right now, India has not gotten as far as the US in relaxing Securitization regulations, but we have to be very careful. Microcredit securitization is mostly good, it does encourage entrepreneurship and provides easier credit to people who need them most, however securitization of credit card payments I believe should be a no no.
Besides securitization, the other thing that I am realizing is that complicated netting agreements have become the norm in the West. Netting, crudely put, means that suppose you and I had entered into 10 transactions with each other, in some of which I am the borrower and in some I am the lender, then in case you default on a particular transaction, I am allowed to net it off against a different transaction in which I owe you. It seems like a reasonable thing, but its implementation is awfully complicated because the “you” and “I” are not individuals but multi billion dollars companies operating out of different countries under different assumed entitites.
Disputes in the future could well center around the exact terminology of the netting agreements put in place by sly lawyers. And these netting agreements will keep getting ever more devious.