The U.S. Subprime Crisis: Five lessons for microfinance

July 15, 2008    

Less than two years ago, nagging delinquency problems started to crop up in one tiny corner of the U.S. home finance market – so-called subprime mortgages (that is, higher cost home loans to borrowers unable to qualify for traditional financing). They made the dream of first-time home ownership possible for many. Yet today, an estimated two million subprime loans appear likely to default. And the crisis has set off worldwide concerns about how the resulting credit crunch and a looming U.S. recession will affect growth in countries rich and poor.

What does this mean for microfinance?

Observation #1 – Unsustainable products and practices

Subprime lenders often target lower income people and places with higher priced and poorer quality products that were often complex, confusing, and even deceptive. Many loans had unsustainable characteristics – like artificially low teaser rates and steep prepayment penalties. Frequently, credit scores alone substituted for careful analysis of repayment ability, and the practice of reselling subprime loans to investors shortly after they were originated meant that lenders did not have to live with the consequences if the loans went bad.

Implications: For now, typical microfinance products are still fairly simple, and there is little evidence of widespread delinquency or overindebtedness. Resale of loans to investors is in its infancy and faces many practical challenges.

Some markets are developing incredibly quickly, however. The entry of consumer lenders in markets such as Mexico, India, and Eastern Europe is extending credit far down the income pyramid and introducing new and more aggressive products and underwriting practices at a rapid clip.

Microfinance providers would be well advised to keep an eagle eye on clients’ debt levels and portfolio performance as well as market share. Not all innovation is good. There is value in simplicity and ensuring that clients understand their rights and obligations, as well as product features.

Observation # 2 – Buyer psychology

The great majority of subprime borrowers genuinely intended to repay. However the problem was not just poorly designed loans -- biases and wishful thinking also contributed to soaring delinquency and default rates. Many borrowers assumed, for example, that both their incomes and home values would rise, so they could handle more debt.

Implications: Consumer psychologists and behavioral economists have just started to explore decision making and cognitive biases of typical microfinance clients. Our market research, product design, delivery techniques, and client interface should use these insights to make credit work for the borrower and lender alike.

Observation #3 – Shaky credit processes in the lending value chain

Over-reliance on credit scores, outsourcing of loan marketing and origination to brokers (subject to little oversight), and the dominance of nonbank lenders with looser underwriting standards all contributed to the subprime melt-down. Reckless lending was widespread, and the players in the chain had weak incentives to ensure repayment ability.

Implications: Careful underwriting, risk management techniques, and a strong focus on portfolio quality are critical to the impressive repayment performance of microfinance internationally.

The subprime experience reminds us that innovations like credit scoring, outsourcing, and partnership models require care in their implementation. Scandals with loan brokers in South Africa and outsourced collections agents in India offer cautionary tales. And creating the right incentives for staff, managers and partners – to balance volume with quality – is essential and especially challenging when providers are expanding at double-digit rates and facing stepped-up competition.

Observation #4 -- Investors and slice-and-dice finance

Global liquidity and investors’ appetite for higher return product drove financial innovation, including in the subprime market. The attractive returns led investors to shortcuts like over-reliance on ratings instead of analysis and due diligence on the underlying risks of these exotic securities.

Implications: Will the credit crunch and collapse of complex investment vehicles dampen investor appetite just as mainstream investors begin to discover microfinance? We should expect more careful due diligence and perhaps simpler instruments. Microfinance expansion plans assuming access to almost unlimited cross-border capital should perhaps be tempered. Greater attention to alternatives – like domestic deposits and borrowing – is also in order.

Observation #5 – Regulators in the hot seat

Having been slow to act when things started going wrong, U.S. policy makers are now busy with a raft of legislative and regulatory fixes, including loan restructuring and risk-sharing and consumer protection and education measures. The challenge is to strike the right balance in favor of continued innovation while reining in the worst abuses and dealing with predatory players. Re-establishing long-term market vibrancy is critical.

Implications: The final shape of policy and regulatory responses in the United States will likely influence the rules of the game in developing and emerging markets as well. We need to promote “light-touch” policy and regulatory solutions that strike a careful balance between promoting access and protecting consumers.

The spiraling subprime crisis offers a chance to reflect on how to build a solid foundation and ensure the long-term health of our sector – and the opportunity to define principles and practices of responsible finance that ensure client benefit and shareholder value.

This article was originally published as a highlight on the Microfinance Gateway.