Microfinance
Securitizing Microfinance is a Bad Idea
Microfinance Insights, a magazine that often has some interesting commentary, has on its blog a curious suggestion for securitization of microfinance loans, called here the “Originate to Distribute” model. Why is this curious? Because, as the blog itself notes, securitization – or the repackaging of loans, and their sale to a third-party – is at the core of the recent financial crises.
MI would have us believe that the problem with securitization was only its implementation, and therefore, can be fixed. But there is a more fundamental problem with securitization – as applied to subprime or microfinance loans – that is not one merely of implementation, and thus cannot be fixed by regulation and transparency.
As pointed out by this World Bank paper, securitization creates a moral hazard that “adversely affects the screening incentives of lenders.” In the MFI world this means that if MFIs do not own the risk of a loan, they are less likely to screen potential creditors properly. The result is likely to be an increase in default rates.
This is not all, though. If the subprime crises was caused partly by moral hazard, the impact of that hazard was magnified by the availability of cheap and plentiful credit. Banks vastly increased credit availability to subprime creditors simply because money was cheap and easy to be had. This reduced any remaining incentive on the part of lenders to conduct proper due diligence.
Microfinance was, till recently, in a similar situation – overfunded but with few good organizations to lend through (see the 2008 MF Banana Skins report). Given the availability of cash, it is unclear why securitization – as a means of increasing capital for MFIs – is even necessary. Any good MFI should have no trouble raising cash. And any bad MFI should not get cash – even through securitization.
Finally, the idea of securitization for MFIs also ignores another article in MI that talks of the Dangers of Leverage. The author argues that many MFIs are blind to the risk of credit default.
Further analysis from the Risk Roundtable in Mumbai supplies an eerie parallel to the early stages of the downfall of banks and investment banks. The risk survey leading up to the Roundtable found that most respondents, including MFIs, investors and lenders, felt that liquidity risk is the major risk, not risk of credit losses.
Microfinance, as a sector, has done well – continuing to provide moderately positive returns even in the current environment (see graph). This has led its proponents to claim that microfinance is a separate asset class uncorrelated to bonds, equities, and even alternative assets such as real estate, commodities, and hedge funds.
Symbiotics Microfinance Index (USD)
Yet, the dynamics of risk and return can not be any different in microfinance. Given that MFIs do not consider credit risk extremely high and have amply money for lending, their incentives for proper screening are already low. Securitization would take away any remaining incentives, and seems to be a solution looking for a problem, rather than the other way around, that could prove dangerous for this still unproven sector.
Update: After some research, I’ve realized that securitization of microfinance is not so new after all. The MIT Journal Innovations discussed it in 2007 (Is Securitization Right for Microfinance). Go back even further, and BusinessWeek had a feature on it in September 2004 (Tiny Loans, High Finance). And according to this discussion at Chicago’s GSB, the idea has been around “since the mid-1990s.”
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5 comments for “Securitizing Microfinance is a Bad Idea”
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Hi Dweep,
Securitization will help in greater fund availability for MFIs. After the financial crisis, MFIs are finding it pretty difficult to raise bank debt.
Blaming securitization alone for the financial crisis is not correct. Please check this article for a good analysis on some of the aspects of the mortgage meltdown: http://www.inman.com/buyers-sellers/columnists/jackguttentag/mortgage-industry-struggles-manage-default-risk
Bhalchander
The earlier URL requires premium subscription.
Check this : http://www.pmi-us.com/media/pdf/news/guttentag.pdf
Bhalchander
Bhalchander,
I don’t challenge that securitization will allow MFIs to raise more money. But:
1) They don’t need more money – the good MFI’s are rolling in it.
2) Securitization will remove the incentives for MFIs to make good loans. In other words, the low default rates – which seem so certain right now – will likely rise.
Bottomline, securitization leads to a moral hazard, and unless there is a solution to that, it remains a bad idea.
I looked at your website, btw – very interesting concept. Is it similar to Kiva, or goes further?
Hi Dweep,
Some additional comments:
1. With the financial crisis even the bigger MFIs who were rolling in money a year back are finding it difficult to raise debt and also equity. Securitization helps with their debt needs and also reduces the need for them to raise equity. That was incidentally the original purpose for which mortgage securitization was introduced. The cost of equity is high ~ 25 %, hence securitization does add value. Eventually securitizing a part of the portfolio will reduce the cost of capital and interest rates for borrowers.
2. Indiscriminate securitization and creating exotic products can be harmful. One can reduce the moral hazard by having the MFI deposit a first loss default guarantee with the security issuer and by making statistics available and monitoring the performance of the microloan portfolio securitized. The rating should be derived on such factors over the long term.
On the last part, with United Prosperity we do guarantees. With a guarantee we facilitate local linkages between MFI and Bank. Further the impact for the social guarantor is higher as $1 in guarantee could result in $2 to @5 in loans. There is also no foreign exchange risk for the social guarantor and MFI.
Thanks
Bhalchander
[...] same twin problems – too much credit and moral hazard on the part of those doing the lending (see this post for more). Yet, despite these problems, microfinance continues to [...]