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What does the subprime market’s
devolution mean for microfinance?
From some angles, the development of the subprime market doesn’t look that different
from the development of the microfinance sector. What are the similarities, and what
should we watch for? How can we prevent a similar downfall? Cecelia Beirne, an expert
in mortgage-backed securities, and a Portfolio Manager at MicroVest, reflects on the
implosion of the subprime sector and asks pressing questions of microfinance stake-

T    he subprime market seems to have
     evolved in a relatively short period
of time – reaching a very broad market
                                                and to manage risk in the industry. Now is
                                                the time to reflect on the evolution of the
                                                subprime market and to note the warning
                                                                                                •	 1986 - Tax Reform Act prohibits the de-
                                                                                                   duction of interest on consumer loans,
                                                                                                   while permitting deduction of interest
and earning very attractive returns before      signs in its devolution.                           for a primary residence and one addi-
imploding into the disaster that we see                                                            tional home1
today. As this market evolved the ma-           Evolution of the Subprime Market                Lenders developed the subprime loan
jor players grew comfortable with more          The following is an examination of events       product in an effort to extend financial
risk each year until eventually the entire      in the subprime market that led (ever so        services to the broader market. The loans
industry spiraled out of control. Only in       slowly) to the assumption of additional         would carry higher interest rates than
retrospect do we appreciate the magnitude       risk. In each case, we look at comparable       prime loans to compensate for increased
of risk that was considered acceptable by       challenges in the microfinance industry         credit risk. But the borrowers would be-
the mid 2000s.                                  and ask questions to help to guide its          come home owners, a traditional route
   The meteoric growth of the subprime          growth.                                         into the middle class, and neighborhoods
industry resulted from early success in a                                                       would become more stable, benefiting so-
new market and the resulting infusion of        Easing of Regulation g Opening of Un-           ciety as a whole.
capital from the secondary markets. This        derserved Market                                   Initially, underwriting standards were
success led to a tendency to relax stan-        The 1980s brought deregulation of the US        comparable to those used in the prime
dards and to take shortcuts with respect        mortgage market and tax reform, making          mortgage loan market (serving only those
to due diligence.                               higher cost loans (accompanied by tax           borrowers with strong credit histories).
   There is no reason to believe that the       savings) both legal and attractive:             Banks were prudent in following proce-
microfinance industry will develop in the       •	 1980 - Depository Institutions Deregu-       dures in approving loans. But over time,
same manner as the subprime market.                lation and Monetary Control Act per-         and with generally acceptable performance
However, we have seen a massive infusion           mits lenders to charge high rates and        in the industry as a whole, banks relaxed
of capital to microfinance and the entry           fees to borrowers                            their underwriting criteria and aimed to
of new, inexperienced investors. Caution        •	 1982 - Alternative Mortgage Transaction      meet their monthly volume targets.
will have to be taken to maintain the stellar      Parity Act permits the use of variable in-
performance seen in microfinance to date,          terest rates and balloon payments

www.microfinanceinsights.com                                                               July 2008   l   microfinance insights     l
 mitigatiNg risk

                                                                                                Very High Expenses g High Interest
                                                                                                Subprime lending primarily served bor-
                                                                                                rowers with less-than-perfect credit his-
                                                                                                tories. As such, subprime loans required
                                                                                                a higher-than-average interest rate as a
                                                                                                risk premium. That is, investors expected
                                                                                                higher delinquency rates and higher losses
                                                                                                in the subprime sector. A “cushion” against
                                                                                                these losses came from the excess interest
                                                                                                collected on the performing loans.
                                                                                                   Throughout the 1990s and early 2000s
                                                                                                subprime mortgage pools performed well
                                                                                                within expectations. But competition
                                                                                                within the industry was growing. As a
                                                                                                result, lenders pushed the envelope by ex-
                                                                                                tending loans to borrowers with weaker
                                                                                                and weaker credit histories. They could
                                  The challenge for microfinance is to avoid the unraveling     maintain high borrower interest rates by
                                                     experienced in the subprime market.
                                                                                                back-loading cash flows (adjustable-rate
                                                                                                loans carried low, initial “teaser” interest
Challenges for microfinance                     added to the chain insulating the lenders
                                                                                                rates which escalated, usually dramatically,
Microfinance has opened a huge, previ-          from the borrowers. The quicker a loan
                                                                                                over the first few years).
ously underserved market to lenders. Are        could be processed, including final ap-
all lenders carefully analyzing the oppor-      proval, the better for all parties.
                                                                                                Challenges for microfinance
tunities and challenges of the enormous
                                                                                                Microfinance is associated with naturally
and unique new market?                          Challenges for microfinance
                                                                                                high administrative expenses. As such,
   To date the sector has built a record of     The opportunities within the microfi-
                                                                                                microfinance loans require higher-than-
extremely low default rates despite rapid       nance sector have attracted a surplus of
                                                                                                average interest rates. Many expect that
growth. All participants in the industry        well intentioned but overly-zealous inves-
                                                                                                competition will result in added efficien-
– investors, lenders and regulators – will      tors fueling the growth, typically, of very
                                                                                                cies and in a decrease in interest rates. But
need to operate with caution to preserve        young institutions. Will increasing capital
                                                                                                competition abounded in the subprime
this record going forward.                      flows spur the new microfinance market
                                                                                                market and brought few real benefits to
                                                to grow too quickly? Will microfinance
                                                                                                borrowers. Will microfinance institutions
Oversupply of Capital g Entry of New            investors stick to their prudent standards
                                                                                                be enticed to deploy available capital by
Players                                         even if competitors sprint ahead of them
                                                                                                relaxing their credit standards, relying
The subprime residential mortgage market        in growth? Will they take the long-term
                                                                                                on what have historically been extremely
was a success, offering home ownership          investment view rather than striving to
                                                                                                low default rates and high margins? Could
to renters previously excluded from the         satisfy the short-term demands of inves-
                                                                                                there be a perverse incentive to drive cli-
American dream. By the late 1980s, Wall         tors?
                                                                                                ents to become over-indebted?
Street saw the opportunities to benefit            To date, lenders to the sector generally
                                                                                                   Managers and investors in the sector
from the spreads between the high inter-        have been prudent with the majority of
                                                                                                will need to address these issues head-on.
est rates paid on subprime loans and the        capital flowing to the top-tier or middle-
                                                                                                They will need to depend increasingly on
returns expected in the fixed-income mar-       tier institutions—to those institutions with
                                                                                                credit agencies to monitor client indebted-
kets. Investment banks earned substantial       strong, documented track records. The best
                                                                                                ness and on thorough due diligence.
fees from their clients for structuring deals   microfinance investment vehicles have em-
secured by mega-pools of subprime loans.        ployed thorough underwriting standards,
                                                                                                Market Competition g Innovative New
With very attractive yields, the secondary      including on-site due diligence; they also
market flourished.                              negotiate effective loan agreements con-
                                                                                                As competition in the subprime market
   The massive inflow of capital from the       taining the necessary covenants to protect
                                                                                                increased, lenders designed new products
secondary market fed the vast appetite of       all parties. All participants, especially new
                                                                                                to attract additional residential mortgage
borrowers for loans. New lenders appeared       entrants, will need to maintain the high
                                                                                                clients. Entrepreneurs with irregular in-
on the scene, often lacking the experience      standards of due diligence set by the suc-
                                                                                                come flows but good credit history and as-
of prudent lending and traditional under-       cessful early commercial investors.
                                                                                                sets now qualified for low- or no- income-
writing standards. Mortgage brokers were

46   l   microfinance insights      l   July 2008
                                                                                                                                          mitigatiNg risk

verification loans. Upwardly-mobile bor-                  tion technology to process loans and to                    mary investment. There was a myriad of
rowers stretching to buy a new home now                   minimize human interaction with bor-                       third parties whose fortunes were linked to
qualified for interest-only loans. While                  rowers. Too often this resulted in many                    the extraordinary success of the mortgage
these were valid products, they prolifer-                 loans moving from delinquency to fore-                     industry and of the secondary market.
ated in spite of the lack of reliable data on             closure without adequate consideration of                     Greed was endemic in the market
their effectiveness.                                      alternatives. Other loans fell through the                 and it enabled the players to tolerate
                                                          cracks racking up unreasonable late fees                   ever-increasing levels of risk while their
Challenges for microfinance                               and other charges while they languished                    competition did the same. In retrospect,
MFIs have already started designing and                   without proper attention.                                  awareness of the real estate bubble and of
delivering new products such as consumer                                                                             the escalating over-indebtedness of most
loans, housing loans and micro-insurance.                 Challenges for microfinance                                low-income Americans suggested a gath-
But do these new products perform as well                 The growth of the sector depends on the                    ering storm, perhaps the inevitability of a
as the traditional commercial loan prod-                  availability of adequate infrastructure, and               market implosion. But for the most part,
ucts? Do microfinance institutions have                   information technology may be the most                     it evolved rather gradually and therein lays
the resources to analyze the effectiveness                important component of infrastructure.                     the danger: It was easy to believe that the
of each of their loan products? Are they                  Will the promise of cell phone technology                  extraordinary success would continue.
able to segment their markets and analyze                 to serve rural markets be successfully real-                  Commercial microfinance stands at the
regional needs? Early microcredit prod-                   ized? Will the industry embrace technol-                   threshold of the capital markets. Success
ucts have very short tenors; we need to al-               ogy to provide standardized reporting and                  has accelerated in recent years with signifi-
low for frequent adjustments as the MFI                   the transparency that investors require?                   cant benefits to investors and with enor-
perfects its lending techniques.                          Does the industry exercise caution in                      mous benefits to the end clients (the en-
   Sophisticated analytical tools are nec-                balancing its need to embrace technology                   trepreneurs at the bottom of the economic
essary for sustainable growth, especially                 with its need to remain in touch with bor-                 pyramid). The buzzwords of the subprime
in times of rapidly changing markets and                  rowers?                                                    industry (predatory lending, loan defaults,
rising competition. Top-tier microfinance                    The success of the industry to date has                 complicated loan products) are unheard of
institutions already deploy these method-                 depended on the relationship between                       in the microfinance industry. There is no
ologies, which need to become industry-                   lender and client, the loyalty of those bor-               indication that microfinance will likely fol-
standard.                                                 rowers underserved by traditional bank-                    low the course of the subprime industry.
                                                          ing. Care must be taken to preserve this                      But there are potential risks in the evo-
Market Competition g Increased Reli-                      relationship.                                              lution of any fast growing industry. Now
ance on Technology                                                                                                   is the time to recognize how risks escalate,
Mortgage origination and mortgage loan                    Be cognizant of the risks ahead                            to learn from the mistakes of others and
servicing are labor-intensive operations.                 The events described above demonstrate                     to be mindful as microfinance industry
At the same time that competition was                     the gradual evolution of some of the risk                  develops. n
growing in the subprime industry, infor-                  factors that resulted in the collapse of the
mation technology was becoming more                       subprime market. There were other fac-
sophisticated and less expensive. The way                 tors including the proliferation of “liar
to cut costs and thereby to compete was to                loans” (not subject to income verification)                    The next issue of Microfinance
maximize the use of technology.                           where borrowers misstated their income                         Insights will focus on Innovations
   The challenge was to use technology                    in order to meet underwriting criteria,                        in Technology for financial inclu-
without alienating those clients who of-                  while underwriters looked the other way.                       sion. Submit your article ideas at
ten needed assistance in managing their                   There were appraisers who inflated prop-                       team@mfinsights.com.
loan payments. It was very tempting to                    erty valuations contributing to borrowers
buy impressive, state-of-the-art informa-                 draining all of the equity from their pri-

    Cecelia Beirne is the Portfolio Manager at MicroVest Capital Management, LLC. From 1993 to 2007, she man-
    aged a portfolio of mortgage-backed securities as a Vice President at Financial Security Assurance (FSA), a
    bond insurer. Cecelia can be reached at cbeirne@microvestfund.com. MicroVest Capital Management, LLC
    (MicroVest) is the first private microfinance investment fund in the United States that provides financial capital
    to growing microfinance institutions (MFIs) in emerging markets. MicroVest is based in Bethesda, Maryland
    and was founded by CARE, MEDA, and the Seed Capital Development Fund. Visit www.microvestfund.com
    to learn more.

1. Chomsisengphet, Souphala and Anthony Pennington-Cross. “The Evolution of the Subprime Mortgage Market.” Federal Reserve Bank of St. Louis Review, Jan/Feb 2006, p 38.

www.microfinanceinsights.com                                                                                  July 2008      l   microfinance insights              l

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