The microfinance sector has long enjoyed the benefits of good asset quality and stable credit performance, which have contributed to its rapid growth.

More importantly these loans have also paved the way for the economic development of low-income populations globally, making microcredit a sound social and fiscal opportunity for investors.

However, harsh economic conditions continue to pummel the credit space as well as the once-promising securitization market for these loans, placing many deals on hold. Sector participants remain optimistic, however, citing continued interest from investors despite the slowdown.

Microfinance loans are traditionally used to finance small-scale operations and household needs among some of the poorest global populations, as well as to fund their savings, insurance and remittance programs. These loans are usually small in value and include short maturities, frequent interest payments and relatively high margins. The structures appear to be working, as the repayment rate is 98% globally, according to Mary Ellen Iskenderian, president and chief executive officer of Women's World Banking (WWB).

In 2006, there was more than $2 billion of commercial capital, including debt and equity, coming into the sector and there was 1.5 times that amount in 2007, Iskenderian said. She noted that most of this volume was debt, a lot of which was being issued through CLO structures.

The market also saw more and more unregulated not-for-profit institutions, or non-governmental organizations (NGOs), make the decision to become regulated institutions. With the influx of commercial capital into the microfinance space, particularly into those institutions that were still structured as NGOs, these companies were seeing leverage on their balance sheets rising up to five or seven times the original amount. And, lenders were feeling less and less comfortable with that kind of leverage in this unregulated, not-for-profit structure, Iskenderian said.

In a study conducted by WWB, which tracked the motivations of 27 former NGO microfinance companies that decided to become commercial entities, the No.1 reason these companies gave was the desire to access broader sources of funding in greater quantity and for greater tenures. The conversion typically requires an injection of equity or a change in capital structure, which is one of the main reasons behind the rise in equity flowing into the sector.

Attempting to take advantage of this liquidity, WWB in 2007 drew together a CDO for 14 of its microfinance members. The deal included $50 million in loans the WWB put together for its own members (a third of which was going to be in local currency) $40 million from another microfinance organization for other borrowers and another $10 to $12 million that underwriter Morgan Stanley had arranged with separate microfinance institutions. Altogether, the deal was slated to be approximately $100 million.

But when the fund was ready to launch last November, the market was not ready to take on CDO risk, despite what the assets were, Iskenderian said.

For just over a year now, the subprime market has made CDOs a virtually illiquid asset class. However, WWB was able to place most of that $50 million in whole loans through Morgan Stanley's emerging markets desk, demonstrating that there is still interest in the sector.

More and more commercial banks and some of the large multinational banks that had made commitments to microfinance, like Citibank and Standard Chartered Bank, are willing to stay in the sector despite the current credit crunch.

"What [these banks] are doing is taking a loan portfolio as security, which is a good thing because institutions are recognizing the securitizable aspect of the business," Iskenderian said.

However, there have been some cases where institutions are over-generous on what they think they need to collateralize their loan, she said, which has added a bit of negotiation to the process.

The hopes for CDOs are not completely gone from the market. There are potential CDOs of microfinance assets in the works, and there is more market activity than there was four or five months ago, said Howard Finkelstein, attorney at Akerman Senterfitt. These deals do not necessarily have to be in CDO form; they can be other types of structured investment opportunities or unstructured investments for that matter, he said. "The assumption always was that investors would rather have a diversified cross-collateralized pool of loans as opposed to investing in individual loans to MFIs in individual countries."

Another source said that he expects to see several structured deals come to fruition in the next six to eight months and is working on several of his own.

Despite being a small-scale transaction, in March the Micro Finance Bank of Azerbaijan issued $13.6 million in four-and-a-half-year bonds to international investors through a Luxembourg securitization vehicle: MFBA Bond I. Developing World Markets arranged the transaction, and the proceeds were used to make loans to Azeri small businesses.

Iskenderian said she has also recently been approached by banks - those that have not been hit as hard as some others in the current structured finance debacle - about a possible structured financing opportunity. "While I am not sure it is time yet, they are telling me that they are seeing demand for underlying assets that are clearly different from mortgages," she said.

Indeed, microfinance loans are different from the often-questionable lending in the subprime mortgage space. For the most part, microfinance borrowers are outside the mainstream economy and are able to bounce back quicker from economic shock that might hit the broader market.

Also, because they have no other source of funding and they are so reliant on their microfinance loan, they will do anything to maintain that credit relationship, Iskenderian said. "In several countries there is documented evidence of these borrowers going to loan sharks in order to stay current on their microfinance loans," she said.

But while the microfinance sector hasn't had any real problems, it is also a bit untested, said Greg Kabance, managing director at Fitch Ratings.

Furthermore, with the strong demand for their loans, microfinance institutions' portfolios are growing faster than their ability to invest in their back-office, risk management-type of functions.

"MFIs are growing at really high double-digit rates, which not only leads to operational risk but could also lead to credit risk if that growth is not managed correctly," said Sandra Mai Hamilton, associate director in the financial institutions group at Fitch.

There are also growing risks within the sector that could harm the 98% repayment rates. The poorest of these borrowers typically spend 80% of their income on food. Food prices have increased almost 40% since the beginning of the year, and unless these borrowers can increase their income dramatically, they are already spending more than their income per day on food, a market source said.

Another concern is prepayment risk. Whenever microfinance borrowers have a good harvest or extra income, many end up repaying their loan in advance. With almost 20% of a mature MFI's portfolio expected to be repaid in advance, this creates a problem for investors because they do not want prepayment, the source said.

A more long-term concern is currency risk. The first deals being done were only in dollars and euros, which puts a great deal of currency risk on the MFIs. Today, MFIs are much more conscientious about borrowing in their own currency. They realize that when they have to pay back these loans in three or five years, they risk having to pay a lot more money if the value of their currency drops, Finkelstein said.

To combat this problem, there are many intermediaries coming in that provide foreign-exchange options. Cygma, an offshoot of Chatham Financial, provides interest rate risk management and currency hedging services, such as swaps, as does MFX Solutions.

The 2007 BlueOrchard Loan for Development, BOLD 2, was elected "Sustainable Deal of the Year" at the Financial Times Sustainable Banking Awards Ceremony on June 3, 2008.

The deal, which Geneva-based BlueOrchard Finance S.A. and Morgan Stanley arranged, was structured as a CLO of unsecured loans totaling $110.2 million. Twenty microfinance institutions were financed by $106.7 million in 11 emerging countries, including Azerbaijan, Bosnia and Herzegovina, Cambodia, Colombia, Georgia, Kenya, Mongolia, Montenegro, Nicaragua, Peru and Russia. Finkelstein, who served as counsel to BlueOrchard on the transaction, noted that almost all of the MFI loans in the deal were fully hedged against currency risk.

Issuance remains on hold temporarily, market participants said. There were four or five funds out there, similar to the BlueOrchard portfolio, that were about to go to market, but then activity stalled, Fitch's Kabance said. "The environment for selling liabilities in the institutional market is just not open yet," he said. "While money is flowing into the sector, it is centered on equity funds. There are also debt funds, but they are not rated-CDO debt funds that are going to institutional investors like pension funds." Instead, the current buyers in the market are still the socially responsible investors or the double-bottom-line-type of investors, Kabance said, as well as multilateral or development banks.

Investors who like the double-bottom line, meaning not only the positive financial returns from an investment in the sector but the social responsibility benefits as well, are willing to give up basis points to invest in this area, Finkelstein said. Many of these MFIs receive below-market-rate funding from NGOs, charities or specialized lenders who want to be part of the growth of these institutions.

Double-bottom-line investors are also less sensitive to market investment trends because they are in there for both the profit and the social mission, Hamilton said.

In 2007, the General Board of Pension and Health Benefits of the United Methodist Church invested $125 million in a positive social purpose investment program aimed at promoting affordable housing, community development and loan opportunities in low-income communities around the world.

In microfinance deals alone, the fund has invested $50 million in loans throughout Latin America, Eastern Europe, Southeast Asia and Africa. It has done so through intermediaries including Developing World Markets, BlueOrchard Microfinance and Deutsche Bank GCMC, which have all been active in the microfinance securitization space.

Sector participants hope that the current credit crunch will shine a light on microfinance as an attractive way to add diversity to an investment portfolio, along with the "feel good" factor that this type of investment provides.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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