“We were just blown away,” McKinley recalls. “We said if a $20 loan can transform somebody’s life, we ought to be making a lot of $20 loans.” Since then, the couple estimates they have contributed between $8 million and $10 million to various microfinance programs in Asia.

Capital-raising for microfinance programs took a great leap forward in sophistication last year with the first securitization of MFI loans—a transaction in which McKinley and her husband participated. Securitization, the backbone of the U.S. mortgage market, is the process of bundling loans (or other revenue producing assets) together and selling them to investors in the form of bonds—in other words, turning them into securities, hence the term. The sponsors plow most of the net proceeds from the bond offering back into new MFI loans. In this way, they tap a new source of capital to support their microfinance initiatives. McKinley and Miller believe securitization could very well help MFIs gain access to much more capital.

Strength in Numbers
Several MFI lenders teamed up in July 2004 to securitize the $40 million pool of microfinance loans. BlueOrchard, a Swiss investment consultancy, sponsored the deal along with two MFI leaders: Developing World Markets, a Connecticut-based investment group, and Grameen Foundation USA, an offshoot of Bangladesh’s Grameen, which introduced microcredit to the world in the 1970s.

BLUEORCHARD  certainly attracted an audience. It was oversubscribed, and it sold out in an hour.

McKinley notes that these securitizations must perform well as investments if they are to succeed. “I’m adamant that we make the connection between the best microlenders and the capital markets so they will grow,” she says. The former chairman of American Funds’ Income Fund of America, one of the country’s largest mutual funds, and a portfolio manager of six of American Funds’ portfolios, McKinley advised BlueOrchard on the structure of its deal, but did not take a fee.

McKinley argues that MFI loan securitizations have several properties that should make them attractive to investors. They are not correlated with other asset classes, so they increase the diversification and lower the volatility of investors’ portfolios. Also, the fact that the collateral loans are denominated in foreign currencies provides something of a hedge against the U.S. dollar.

The BlueOrchard deal is a seven-year investment backed by a wide range of loans with tenors of less than one year. Because the average MFI loan term is four to six months in Latin America and approximately one year in Asia, the mismatch in tenor between the bond and the collateral allows the MFIs to circulate the money to borrowers several times before they must return it to investors. The securitization also provides MFIs with access to capital at a much lower rate than they would be able to secure from local banks.

Microfinance specialists have mulled such a transaction for years, but myriad challenges stood in the way. Many recipient countries did not have enough loans to bundle, and dissimilar national regulatory frameworks made it difficult to create regional packages. The currency risk of these transactions is so thorny that it put off even such a philanthropically inclined risk taker as George Soros. He considered backing a securitization several years ago, but the need to ensure that small MFIs would not lose money from currency market fluctuations stymied him. That problem, and several others, remains nettlesome.

TOP VIEW For decades, microfinance institutions in developing nations have made business loans to individuals. Now these lenders are pooling their loans and selling them as bonds to investors in the developed world. With the first deal of this kind less than a year old, observers wonder if these transactions can boost the capital available to microfinance programs.

What Is Your Quest?
Securitization is the Holy Grail, according to Michael Swack, the dean of the School of Community Economic Development at Southern New Hampshire University. “It represents sophisticated financial engineering that will help microfinance institutions access capital markets,” he argues. “The question has been: How do we package our services to be attractive to outside investors?”

Turning loans for the poor into viable investments remains a challenge. Investor satisfaction with the BlueOrchard deal will be a benchmark for determining whether such philanthropy-investment crossovers will become more common. BlueOrchard certainly attracted an audience. It was oversubscribed—which means there was more demand than supply—and it sold out in an hour. The sponsors hope to raise an additional $40 million with a second issue this spring. The minimum level of investment for individuals will be $25,000.

While these transactions bear a resemblance to traditional securitizations, which capture payment streams from credit cards, car loans or mortgages, the MFI securitization is backed by cash flows from loans for looms, handcarts, cows and pigs. Because these assets are not creditworthy in the traditional sense, the BlueOrchard sponsors secured a $30 million guarantee from the Overseas Private Investment Corp. (OPIC), a U.S. government export-finance agency. OPIC’s backing made three-quarters of the instruments issued as safe as U.S. Treasuries. Institutional investors and individuals willing to take a gamble purchased the rest.

The currency risk of these transactions is so thorny that it put off even such a philanthropically inclined risk taker as George Soros.

The bonds paid their first interest at the end of January. The OPIC-backed bonds yielded 55 basis points over U.S. Treasury bills. The bonds without an OPIC backing fell into three groups, each with a higher level of risk, which yielded Treasuries plus 100 basis points, Treasuries plus 200 basis points and Treasuries plus 400 basis points.

MFIs boast a 95 percent loan repayment history. This represents a lower default rate, over microfinance’s 30-year history, than credit cards, student loans and even U.S. corporate bonds. MFI officials claim that microcredit recipients diligently repay their loans even in war-torn countries. McKinley claims that when Indonesia experienced its economic meltdown in the late 1990s, Bank Rakat Indonesia saw its loan business succeed in its core market of low-income borrowers, while large and midsize businesses defaulted in large numbers.

Yet without a long track record of default data verified by independent third parties such as ratings agencies, investors will remain leery. Damian von Stauffenberg, founder and CEO of MicroRate, the first rating agency for microlenders, says they are right to worry. “Whenever anybody talks to you about repayment rates, be suspicious,” he advises, noting MFIs can manipulate the figure by various means, which include simply reissuing delinquent loans. Von Stauffenberg says the figure investors should heed is how much of a portfolio’s loans are more than 30 days in arrears. Five percent or less is favorable.

For the first securitization, BlueOrchard put its best assets forward. All of the MFI loans in the transaction were audited and rated by MicroRate or another MFI rating agency, and all had sterling records, with only 2 percent of portfolio in arrears more than 30 days. “They took the cream of the crop,” von Stauffenberg explains.

Even so, microfinance loans, by their very nature, do not lend themselves to securitization. MFI managers have to transform a grab bag of tiny loans—$50 for a cow here, $100 for a loom there—into a pool of loans homogeneous enough to securitize. Supporters say there are enough loans in the microfinance market now that sponsors are able to find enough similar transactions. The size of the market has grown 30 percent per year for the last decade, according to Grameen.

Proponents admit there are hurdles to overcome, but argue that microfinance securitization is in the same early stage of development as credit card securitization was in the 1980s and mortgages more than half a century ago. They contend that microfinance will experience the same growing pains, but eventually become a well-established asset class.

Too Much, Too Soon
Swack worries about the fate of the poorest of the poor loan applicants, who might fall by the wayside as MFIs cater to more-affluent borrowers in an effort to secure more easily securitizable loans. Microfinance supporters promise this will not happen; many, they argue, will refocus their mission on reaching the most indigent, while allowing the success stories to graduate to commercial banks or MFIs with a less-needy clientele. However, only a handful of the hundreds of MFIs around the world qualify as lenders to high-quality clients.

Another concern stems from the fact that MFIs can effectively administer only a limited number of loans. Inability to put the revenues from a securitization to work right away might cause them to loosen their standards and make unwise loans. “If you flood the market, you’ll increase the amount of defaults—that’s been seen by governments—so we’re doing it in stages,” says Drew Tulchin, program officer for capital markets at Grameen Foundation USA.

Traditional financial instruments, such as normal bonds issued by the MFIs, will remain more useful than securitizations for some time, according to Maria Otero, president and CEO of Accion International, a Boston-based microfinance organization that started in 1961 and coined the term “microenterprise.” MFIs have succeeded in floating small bond offerings in the $10 million to $20 million range in local currencies. The Accion network ended 2004 with approximately $700 million in a portfolio of loans from roughly 20 countries, funded by a combination of bonds and savings from borrowers.

Otero expects that securitization will become a useful tool, but not one likely to be widely employed for at least another five years. Even by then, she believes it will reach only the countries with more developed bond markets, such as India, Brazil and Mexico.

“From my perspective,” Otero says, “it is far more important to make these institutions strong financially and enable them to access capital from their local domestic markets than it is to bring complicated financial engineering for which microfinance and the financial markets are not ready.”

Elizabeth Wine is a Brooklyn-based freelance writer who has written extensively about investing and philanthropy. elizabethwine1@yahoo.com