Building Financial Systems for the Poor

Meditations on the US Sub-Prime Crisis:Implications for International Microfinance

Silicon Valley Microfinance NetworkMay 19, 2008

Kate McKee

Building Financial Systems for the Poor

Meditations on the US Sub-Prime Crisis:Implications for International Microfinance

Silicon Valley Microfinance NetworkMay 19, 2008

Kate McKee

Recent HeadlinesRecent Headlines

Dangerous Animals in the Banking ZooBanks Fear a New Round of Write-Downs Fears about Economy Increase: Debt Crisis Grows; Top Mortgage Firm Sold at a BargainDubai Buys Stake in Citi; China Buys Stake in Morgan StanleyRipples of Crisis in US Housing Reach Worldwide

Europe’s Central Banks Inject More FundsBritain to Nationalize Northern Rock BankFitch to reconsider CDO GradesFed Comes to Rescue as Wall Street Giant SlipsRegulation to the RescueCongress Debates Mortgage Aid Plan

A few statistics . . . A few statistics . . .

7.7 mill. sub-prime loans outstanding as of Sept.2 million home-owners at risk of foreclosureBy the summer of 2010, 600,000 people expected to lose homes when loans resetUS residential mortgage market is valued at around $12 trillion – many expect further 20% decline Nearly 8.8 mill. homes (10.3% of total) worth less than their owners owe – “upside down”Est. sub-prime losses for banks up to $200-400 bill.

What in the world does sub-prime have to do with microfinance?What in the world does sub-prime have to do with microfinance?

Sub-prime home loans vs. typical micro-loans

Completely different . . .- clients- product features- business practices (marketing, originations, collections, etc.)-Players

And yet . . .

Observation #1 – Unsustainable products and practicesObservation #1 – Unsustainable products and practices

Products inferior vs. prime – resets, piggybacks, and so on (although not all sub-prime loans are “predatory”)Too often, little attention paid to repayment abilityComplex, confusing, sometimes deceptiveTargeting and steering[significance of de-linking credit analysis/origination and risk – more to come in a few slides]

Competition does not always result in more and better product options . . .

Implications for MF – The products Implications for MF – The products

Currently, MF products mostly simple, held in portfolio, little evidence of widespread delinquency and over-indebtedness problemsBut lots of emphasis among traditional players on product innovation, growth, market shareAnd aggressive new players, products, practices (e.g., South Africa, Mexico, E. Europe, India)In some markets, the “value chain” of finance is developing with new roles and partnershipsHow does/will investor demand shape our products?

Implications for MF – The products (2)Implications for MF – The products (2)

We need to watch out:

Getting carried away with product innovation and “financial engineering” for its own sakeClient debt levels – ability to collect vs. ability to payImpacts of consumer lenders and lending

Observation #2 – Buyer bias, wishful thinkingObservation #2 – Buyer bias, wishful thinking

Not all sub-prime buyers, now in trouble, are “sympathetic”But the melt-down has caught many well-intended families of modest means, pursuing the American dream of home-ownershipNew research shows how systematic attitudes, decision-making patterns and biases influence credit behaviorThose designing and marketing products are a lot more aware of this research than the buyers!The complexity of the products and the home purchase process compound these information asymmetries

Implications for MF – the buyer sideImplications for MF – the buyer side

Pay attention to the new research from the consumer/behavioral scientistsUse the insights to - design products that work for clients as well as providers – reasonable and sustainable value proposition - develop appropriate marketing messages and communication strategies- disclose pricing, terms and conditions transparently

Observation #3 – shaky processes, skewed incentives, and moral hazardObservation #3 – shaky processes, skewed incentives, and moral hazard

Credit analysis: over-reliance on credit scores (vs. affordability analysis, income verification, down payment, mortgage insurance, etc.) Mortgage brokers: their roles (marketing, not risk assessment) and compensation arrangements -- not on the hook for repayment Lenders: role of non-bank mortgage lenders + prevalence of selling off loans (reduces attention to risk)Others in the finance “value chain,” e. g., appraisers, raters – over-enthusiasm, corner-cutting and fraudEveryone’s assumption that housing prices (and borrower’s income?) would only rise – refi as exit

Implications for MF – credit analysis, partners and the players in the chainImplications for MF – credit analysis, partners and the players in the chain

Stay vigilant about portfolio quality while innovating loan products and credit analysis processes to “bank the unbanked’Use of credit scores and other more efficient underwriting techniques is important to expanding access – but test them carefully to be sure they workTake care with outsourcing and partnerships – especially to create incentives for high portfolio quality and customer serviceMF managers/boards (and investors) need to pay more attention to managing a wider range of risks

Observation #4 – Investors in the “slice-&-dice” finance worldObservation #4 – Investors in the “slice-&-dice” finance world

Global liquidity and investor appetite for higher-return product drove financial innovation (e.g., risk-based pricing) and creation of exotic investment instrumentsSo complex that no player seems to have really understood the risks – over-reliance on ratings, credit enhancement – and inadequate due diligence and oversight by fund managers, board, etc.The borrowers weren’t the only ones relying on wishful thinking!Complex structures and ownership complicate “unwinding” the securities now that the crisis has hit

Implications for MF – The climate for investment Implications for MF – The climate for investment

Will investors will do more careful due diligence and have a lower appetite for complex instruments (at least for a while . . .)?Will this limit availability of cross-border investment for MF expansion? Will new entrants exit or scale back their plans? What about the role of ratings?And will the availability of domestic credit for MFIs be affected by the global credit crunch?MF boards and managers might do well to consider alternatives to securitization, CDOs/CLOs, etc.

Observation #5 – Regulators in the hot seatObservation #5 – Regulators in the hot seat

Role for market conduct regulation and even criminal prosecution – which products and practices should be beyond the pale? e.g., underwriting to current income, huge pre-payment penalties, mortgage broker pricingBring players under new or better regulationRegulatory overhaul/consolidation Limitations of self-regulation

But is there a danger of overreaction and short-sighted responses driven by the crisis?

Implications for MF – Regulation Implications for MF – Regulation

The political, policy regulatory responses in the US and Europe are likely to influence thought and practice in developing countriesGreater awareness of concepts such as sub-prime products, reckless lending, predatory practices . . . and laissez-faire approaches less likely when market excesses appear?Some danger that inappropriate balances will be struck between access, protection and stability goals

South Africa National Credit Act South Africa National Credit Act

Features of 2005 Act include:Creation of cross-industry market conduct regulation (banks, consumer lenders, retailers) and regulatorReckless lending requirement – if lender is deemed reckless (cannot prove adequate process of affordability assessment), may not be able to collect in courtCertain product features & practices prohibited (e.g., pre-payment penalties, marketing & collections practices)Standard contracts and mandatory plain language disclosuresCaps on interest, initiation fees, and servicing fees (albeit at very high levels)Regulation of credit bureaus and debt counselors by NCR

South Africa National Credit Act -- impactSouth Africa National Credit Act -- impact

Huge credit surge just before NCA came into effect, followed by (short-term?) lending fall-offBroad agreement that the NCA has:Made lenders improve affordability assessment and loan/delinquency managementBrought down most pricing, at least to the cap and some evidence of price competition Reduced some especially bad practices in the market, including credit insurance abuses (but limited enforcement capacity of regulator)Led to consolidation among lenders – drove some players to the ground (and underground?)

Will the Act have unintended consequences?Will the Act have unintended consequences?How will consumers cope with restricted credit access in the face of inflation and aspirations? Will they go back to the “mashonistas” (money lenders) and end up more vulnerable rather than less?Might self-employed households and informal businesses suffer from reduced access?Will uncertainty surrounding courts’ reckless lending rulings have a chilling effect on lending, especially among lenders concerned about reputation risk?Has consumer understanding of credit costs/terms really improved? Is there evidence of more/better comparison shopping? Or are they just confused in new ways?Competition, consolidation or both? Entry barriers up

Does the Act strike the right balance?

Some closing thoughts Some closing thoughts

Recent developments in the MF industry are exciting – but we need to put growth, innovation, and capital market access in perspective and manage their risks appropriatelyFocus on clients – don’t we have a responsibility to take reasonable steps to do no harm?Clients have responsibility too, to make informed choices – role of financial education, transparent plain-language disclosures, and further work on client biasesShort-sighted to resist well-designed “light-touch” regulation

In the long run, all legitimate players benefit from responsible finance.

Who benefits? Who pays?Who benefits? Who pays?

Thanks!Thanks!

Kate McKee, kmckee@worldbank.orgSenior Policy AdvisorCGAPWashington DC

Building Financial Systems for the Poor

Thank you!