What can you look for as an investor if you want to safeguard against borrower defaults? In this blog post, MYC4’s Credit Operations Manager, Titus Kuria, shares some of his knowledge on good credit practice and discusses the types of collateral and security most commonly used by MYC4’s Providers.
The universal best practice on credit stipulates that loans should be granted primarily based on ability to pay and character. These are the main pillars of good credit practice. Providers on the MYC4 platform, in their policies and practice uphold this maxim. Other key elements of credit include capital, collateral and conditions.
Ability to pay is easily quantifiable and measurable in that it is based on cashflow analysis. Cashflows can be ascertained or verified through audited accounts, bank statements, or borrower’s internal records (e.g. daily sales records or receipt books). The major pitfall with relying on cashflow analysis/ ability to pay is that the records relied on are mostly historical, while repayments are expected in the future. Forecasting future cashflows is the tricky part. Future cashflows can be tremendously affected by factors such as poor business strategy, diversion of loan funds to unprofitable ventures, mismanagement, and general economic downturn.
Character is more difficult to ascertain. Among means of judging a borrower’s character include referees, timely payment of bills & credit history, family stability, temperament, moral integrity and general stability (residence, place of work etc). However, despite best efforts at evaluating a person’s character, true character is only revealed in adversity. It is when a business is facing difficulty that characteristics not consistent with a good borrower emerge, such as a carefree attitude to paying the loan.
Because future cashflows are difficult to predict and true character is only revealed in adversity, collateral plays a crucial part as a safeguard. Collateral is essentially a means of last resort, or at best a secondary means of recovery. Collateral acquires varying importance based on the market. In Africa, where credit scoring is not well developed, collateral plays a crucial role in ensuring loan performance. Collateral assures that in case of default by a borrower, in a matter of time there is a fall-back position that will cover potential losses. The amount of possible recovery from collateral and the period taken to recover is dependent on the type of collateral taken.
With the risk sharing agreements in place with our providers, collateral taken assumes lesser importance to the investors as a repayment source of last resort. This is especially so where providers give guarantee to the investors that defaulted loans will be 100% repaid. The guarantees under risk share agreements are all cash – backed meaning that a portion of the outstanding loan is held in cash or cash equivalents. In the case of 100% guarantee, collateral is of higher importance to the provider (than investor) as it provides their fall-back position for recovery of monies paid out under the guarantee upon default. The converse holds true for providers offering less than 100% guarantee; the collateral plays a bigger role in secondary recovery for both investor and provider.
Herebelow is a discussion of the commonly used collaterals on MYC4:
- Developed property : This is the most preferred collateral by banks and other financial institutions in Africa. The main reason that it is preferred is that its value is seen to be perennially appreciating (except in cases of property bubble). It is also more permanent in nature than other forms of collateral. The human attachment to property or rather the intrinsic value attached to property is very high. It also has elaborate legal mechanisms for noting a financiers’ interest in it. The legal mechanism is also the downside of property as collateral, in that it takes very long to be legally able to sell.
- Undeveloped land: Most undeveloped property (non agricultural) belongs to the government and is held by individuals on leasehold of say 99 years etc. On every leasehold includes conditions for holding the land, for example, one may be required to develop the property or utilize it in some prescribed way. There is always a risk that the government may revoke the lease if the property is left idle for long periods. However, undeveloped property is still taken as good collateral for the same attractive reasons as developed property, given that the government rarely exercises its right to repossess idle land.
- Motor vehicles: Motor vehicles are highly preferred by MFIs because they are easy to dispose in case of default. The secondary market for motor vehicles is very high. They are also attractive as collateral because the legal process for noting a financiers’ interest is easy and quick. The legal process for disposing of the collateral is also quite easy and fast. The downside of the motor vehicle as collateral is that it is a depreciating asset, and easily prone to accidents (It is essential that MFIs note their insurable interest on motor vehicle collateral with the insurer). The motor vehicle is also highly mobile and a rogue borrower can easily hide it, or remove parts.
- Household and business chattels: These became popular as collateral to MFIs as a means to avail credit to entrepreneurs who did not have the traditional collaterals required by banks and other financial institutions. There is risk of someone losing their basic dignity when their household goods are to be sold for default on loan. The fear of embarrassment is at times more of a motivation to pay than the monetary value of the household collateral.
- Debentures: Debenture is a legal instrument that gives rights to a financier over the property of a limited liability company. Debenture can be general, covering all assets owned by company; or specific debenture, laying claim to a particular asset. Debentures have extensive legal procedures to register, and also has extensive legal procedures to effect against a limited liability company.
- Personal guarantees: This is an undertaking by a third party to pay on behalf of the borrower. The legal enforceability of this is a long process as proof is required by court of law that all other means of recovery have failed.
- Shares in publicly listed companies: These are attractive because they are very liquid. However they are prone to price volatility, and also are not a popular investment for the target clientele of MFIs and by extension MYC4.
You can see a small video with Titus below and read more about this topic in Ole Vestergaard’s post When times are hard – how do you repay the loan? and Tim Vang’s Does your business have the ability to repay?.