This 4-page paper discusses the subprime credit market collapse and the comparable forces that could apply to microfinance. Written by Cecelia Beirne, a portfolio manager at global microfinance intermediary MicroVest Capital Management, the paper concludes with recommendations for the microfinance industry. One can find the full version here.
Providing a background on the subprime loan market, the paper showed how these new products allowed customers with less-than-perfect credit to become homeowners and thus follow a traditional route into the middle class. By bundling loans into pools for sale on the secondary market, the subprime mortgage market grew from USD 65 billion in 1995 to USD 332 billion in 2003.
The author emphasizes that subprime lending is not synonymous with predatory lending. However, ample supply of funding from the secondary market and high demand for home ownership led to rapid and unsustainable growth. Lenders grew despite inadequate staff training and infrastructure development. Also, technology increased the distance between lenders and clients, often creating cultures which tolerated or even provoked abusive policies toward borrowers.
In 2006 and 2007, the market began to see increasing loan defaults, as many loans were underwritten without income verification. Today, borrowers face home foreclosures, lenders are acquiring properties worth a fraction owed to them, loan servicers cannot handle the volume of defaults and investors have seen their portfolios depreciate.
According to the paper, commercial microfinance is not equal to subprime lending as microfinance loans do not rely on the value of underlying collateral. However, microfinance is a nascent, high-growth industry with several similarities to the early stages of the subprime lending industry. These commonalities are:
- Expansion of financial services to the underserved
- Influx of available funding to the markets
- Prevalence of high interest rates to offset increased risk
- Appearance of innovative new products, facilitating market penetration
- Increased reliance on technology to facilitate growth
The author concludes by recommending proper due diligence by investors and caution against careless deployment of available funding by microfinance institutions (MFIs). With microfinance breaking into the capital markets, the author believes those in the field need to learn from the mistakes of the subprime market. Finally, investors can protect against predatory lending by monitoring the following:
- Compare average yields to net income. In other words, are the interests of borrowers and investors in balance?
- Examine a sample of delinquent loans across loan products.
- Review new loan products, ensuring each is suitable for the MFI.
- Request a schedule of fees charged at underwriting and collection. Are these fees reasonable, and do borrowers clearly understand the loan terms?
- Evaluate the MFI’s character; effective lenders respect their staff and clients.
by Jennifer Lee
Additional Resources:
MicroVest White Paper: “Subprime Lending: Lessons for the Microfinance Industry”, by Cecelia Beirne, April 2008.
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