BRAC Bangladesh: An Experience in Using Securitization as a Tool to Serve the Poorest of the Poor

1. BRAC Bangladesh: An Experience in Using Securitization as a Tool to Serve the Poorest of the Poor Dec 11, 2006 World’s first MCBS (Micro Credit Backed Security) Ray Rahman rrahman@mfanalytics.com

2. BRAC Swedish International Development Cooperation Agency Our Clients

3. Micro Credit Micro loans are appealing assets to investors: • High granularity • High diversification • Low default rates • Low prepayment risk • Limited impact of crisis/disaster on performance

4. Funding the Gap • Supply of funds for micro loans has not caught up with demand • Supply: $4 billion* • Demand: $300 billion* • MFIs are often subsidized through public money or charitable foundations • These sources of funds should be used as start-up capital • Need a financial structure that does not crowd out the private sector. • Private sector needs to be encouraged to participate • Public money has better leverage • Create sustainability *Meehan, Jennifer, Tapping the Financial markets, 2004

5. Client Profile: BRAC BRAC, founded in 1972, is the world’s largest NGO • Number of employees in Bangladesh: ~100,000 • Number of villages covered in all 64 districts of Bangladesh: > 65,0000 • Also has operations in Afghanistan, Sri Lanka, Uganda and Tanzania BRAC serves a population of 100 million (71% of country population) operated out of 1,381 area offices, with nearly 160,197 village offices in all 64 districts.

6. Client Profile: BRAC Disbursement Growth Data: as of June, 06

7. BRAC’s Sources of Funding

8. Transaction Objectives

9. What is Securitization? • Securitization is the transformation of an illiquid asset such as receivable into a tradable security • The payment of interest and principal on these securities (or ABS) lies solely and exclusively on the cash flow of the underlying pool (receivables that have been securitized) • Investors have no recourse on the originator • Sometimes, assets are worth more off the balance sheet than on it

10. Benefits With securitization: • MFIs achieves funding based on the credit quality of their receivables • This could be cheaper than getting bank loans • MFIs get an indirect access to capital markets • Multi period game: Market mechanisms reduces cost • MFIs can better leverage their capital • MFIs can better manage their risk • MFIs can improve their asset liability management • In this context, securitization is seen as a building block of an approach to MFI financing which is • indirect : it relies on loan origination by MFIs – and • market-based : it leads to increasing the supply of securities designed to meet the risk-return characteristics required by institutional investors

11. Basic Structure Senior ABS Certificates Sale of Pool Originator/Seller Receivables Pool SPV overseen by Trustee Mezzanine Cash proceeds Cash proceeds from Investors Junior • Process • A seller or originator originates loans or receivables • The securitization structure is added. The originator sells or assigns certain assets, such as micro receivables, to a special purpose vehicle (SPV) • SPV must be “bankruptcy remote” • The structure is legally insulated from originator management • Credit enhancement and rating agency reviews • The SPV issues debt via certificates, dividing up the benefits (and risks) among investors on a pro-rata basis through tranching

12. Legal Documentation Account Bank Accounts Agreement Pooling and Servicing Agreement Certificate Subscription Agreement Originator / Seller SPV Trustee Certificateholders GuaranteeAgreement Trust Deed Prospectus

13. Bottlenecks • Lack of information • Cost • Past experience of others • New Product • Legal, Tax and Regulatory framework • Servicing capacity • Portfolio of standardized loan receivables

14. The TransactionBRAC Micro Credit Securitization

15. The Team Global Deal Team: 7 countries in 6 time zones

16. The Collateral:Growth and Characteristics The focus of the transaction was to prioritize the bottom of the pyramid • Activity: • ~ 85% of loans were used for 10 activities. • ~ 70% of all loans were used for trading. Note: Data as of 4/06

17. Transaction Hurdles andSolutions

18. Investors’ Requirementsand Solutions

19. Investors’ Requirementsand Solutions

20. Information Technology Issues and Solutions

21. Our Approach:Single Originator

22. BRAC Securitization:Credit Enhancements • FMO guarantee (with KfW counter-guarantee) for Citibank’s USD 5 million investment as funding bank. • Remaining USD 10 million invested without guarantees. • Guarantee allowed by Bangladesh Bank only for the first two tranches. • Over-collateralization of 50% - i.e., USD 22.5 million of receivables pooled for every USD 15 million tranche. • In line with the level of collateralization in BRAC’s local syndications. • MF Analytics program constructs the pool of receivables and collateral. • Collateral replenished if the projected cash-flow from the pooled receivables < 140% of the next month’s expected SPV liability. • Replenishment to be identified by MF Analytics computer program. • DSRA account of USD 2.5 million.

23. BRAC Securitization:Major Layers of Complexity • First Layer of Complexity • The loans do not behave like typical loans. • Loan repayment dates change due to local (village level) holidays that are known ex post. • Second Layer of Complexity • Significant prepayment and delinquency risk. • Known ex post. • Third Layer of Complexity • Information delay • Debt Service Amount collected from the village borrowers in Village Offices reaches BRAC’s Central Account faster than the relevant information. • BRAC central office is ready with each borrower’s loan information for the previous month on the 25th of the next month. • October’s loan information is available on November 25th. • The structure of the transaction effectively addresses these major layers of complexity while reflecting the true nature of the pool: • Elimination of Cashflow Risk. • Elimination of Prepayment Risk. • Solid Credit Enhancements. • Makes Economic Sense to all Stakeholders.

24. BRAC Securitization:Other hurdles • World’s first micro credit securitization • Bangladesh Government regulators (Central Bank and SEC) • Had no precedents for this transaction. • Securitization laws in infancy. • Information technology • BRAC’s branches were not all computerized until recently. • Still a time lag between loan collections and information availability that had to be incorporated into structure. • Learning curve • Originator has no previous experience with such transactions. • Lack of “clear documentation” on BRAC’s operations. • Investors had very little direct experience with micro credit • Regulators had to understand a complex transaction in the context of the local market. • Global and Bangladesh legal teams had no precedents, and no experience in micro credit

25. Some Key questions: Costs and Savings • Who covered the cost? • Most of our cost was paid via FMO and KfW’s technical assistance program • BRAC pays the monthly maintenance cost • BRAC paid the transaction legal cost (issuance cost) • Did BRAC save money? • BRAC saved over 200 bp compared to other funding schemes • The savings from securitization is enough to generate 1.5 new loan for every 100 loans securitized or more than 48,000 micro entrepreneurs will get additional funding (from this savings) • In other words the savings provides a marginal growth of new loans of 1.5% for BRAC

26. Summary: BRAC Microcredit Securitization • We enabled the transaction • We monitor and maintain the dynamic pool until maturity (6.5 years) • Our solutions led to the creation of the world’s first micro credit backed security (MCBS) • BRAC saved over 200 bp compared to other funding schemes • The structure mitigated all operational and financial hurdles • Received local AAA rating (the first in Bangladesh) • The transaction was over-subscribed by institutional investors • The structure is replicable

27. SMEs as a Securitizable Loan Class

28. SMEs As Economic Drivers • The SME sector provides the majority of employment and GDP in the US, Europe. • 99.7% of all firms qualify as SMEs (500 employees or less). • Provide 50% of private sector growth in the US • Yet SMEs share in only 10% in all measurable business financing.

29. SME Underwriting Overview • In the US, 56 large banks controlled 45% of the $460 Billion of outstanding SME loans in 2001. • Large banks rely on <$100,000 loans given based on credit scores and quantifiable factors. • Small banks focus on $100,000+ loans relying less on credit scores and more on relationship. • One would, therefore, assume that large bank SME loans would be more appropriate for securitization given the standardization of underwriting policies across originators and the proven analysis that credit risk based lending of SME loans is able to be modeled more effectively. • Asset-based underwriting and financial statement analysis also serve as underwriting methodologies for SMEs.

30. Reasons to Securitize SMEs • Gain access to financing directly from capital markets. • Transfer portfolio risk off of balance sheets and to capital markets. • Regulatory capital requirement relief • Unload under/non-performing assets

31. SME Securitization Characteristics • In the US, the market is comparatively non-existent for SME ABS while Europe has a developed SME market. • In Europe, SME ABS represented 5.3% of Euro-denominated ABS issuance in 2005. • Securitization is still an underutilized financial technology for SME financing. • In Europe, the European Commission found that only 1% to 2% of securitizable SMEs on banks balance sheets had been securitized.

32. Multi-originator Issues, Our Solutions

33. Multi-originator Issues, Our Solutions

34. Multi-originator Issues, Our Solutions

35. Our Approach:Multi Originator

36. The SME Synthetic Securitization • Intended to allow credit risk transfer off of originator’s balance sheet to investors • Credit Default Swap on the securitized portfolio is the product used to achieve this credit risk transfer. • Credit-Linked Notes passed to investors. • Possibility for multi-originator securitization.

37. The Synthetic Structure Moody’s Investor Services

38. Basic Structural Mechanisms • Issuing Bank enters into a CDS with the intermediary bank. The issuing bank pays a regular premium based on the outstanding principal balance. The intermediary bank pays out any losses on the portfolio • The Intermediary hedges its risk by entering: • Into a CDS with a senior investor and • Passes credit-linked interest and principal payments to the SPV in return for cash proceeds from CLN issuance. • The SPV issues CLNs to investors who are the end holders of risk

39. SACE’s Potential Role • Serve as the intermediary between selling banks and the SPV • With collateral which has exposure to risky foreign currencies: • provide guarantees to the end user SME on principal • Wrap the CLNs with Political Risk Insurance to protect investors from sovereign risks

40. In Closing • We offer innovative leadership relating to the securitization of new and exciting asset classes including microloans and SMEs • Can leverage knowledge of existing structures to create customized solutions • Evaluate the loan portfolio • Assess risk and creditworthiness • Distill portfolio trends and properties • Develop turn-key tailor-made solutions • Design innovative and relevant financial instruments • Optimize asset/liability structure • Reduce cost of funds • Diversify investor base

41. Final Thoughts: Path to Prosperity and Profitability The operational and technical methodology verified in BRAC transaction can easily be customized for other transactions in the world

42. Contacts • Ray Rahman • rrahman@mfanalytics.com