Microfinance Example: Microfinance vs. US Subprime Market

Is the microfinance industry facing the same dangers as the subprime market?  Many factors played a part in the collapse of the economy in 2009, but none so much as the collapse of the housing market.  The importance of the housing market to the overall state of the economy can be cited in the Fed’s efforts (1) to strengthen the housing market through the latest round of quantitative easing.  Now that we see the importance of this sector of assets, we must also look to the cause of it initial demise in order to ensure that history does not repeat itself.  Loose lending is that root cause (2) and for years individuals and businesses were allowed to borrow beyond their means until such time that the bloated and unrealized growth of the housing market turned south with every failed loan that came to be realized.  The exponential rise of microfinance in the emerging markets of the world closely resembles the early stages of US housing market trend(3,4) and the world is beginning to see that just as many Americans were left worse off by ill-begotten subprime loans, so too are those individuals at the bottom of the pyramid (5).  Some say that the programs of microfinance meant for social and economic improvement have simply introduced a new burden to the already downtrodden.  The major differences between the subprime US loans and microfinance EM loans are the default rates and the interest rates and these differences may be microfinance’s saving grace.  If we examine the average subprime rate pre-financial crisis we see as high as 17% (6) on amounts typically greater than $100,000 which are tied to real assets and defaulted at rates higher than 15% (7).  In contrast, microfinance loans range as high as 65% (8) on small amounts with small terms that are tied to any number of tangible or intangible assets and are defaulting at rates as high as only 3%.

From a high level, the rise of microfinance could be viewed as a microcosm of the financial crisis, however, if we examine the differentiating factors, we will see that microfinance has more factors keeping it afloat than the subprime market did.  Even though predatory lenders and lax regulation may lead to individuals entering into borrowing positions that are unsuitable, the culture of many EMs find the idea of default reprehensible and the communities of the troubled individual will often do what they can in order to support a delinquent borrower.  Contrarily, the US borrower rarely has such a close knit relationship to the community and US laws and regulations make bankruptcy and foreclosure filing a viable alternative to paying.  Microfinance institutions also have a well diversified lending pool from everything from unsecured to any number of different real assets such as animals, appliances, machinery, and real estate.  A downturn in one asset class will not affect the others thereby alleviating the risk of collapse.  On the other hand, the subprime market downturn affected all real estate throughout the entire country which in turn accounted for an extreme decline of all financial institutions’ equity holdings.  As a result of downturn, government and institutional regulations were established to ensure that borrowers fit the parameters of the lender thereby lowering risk of default.  Default and delinquency were drivers of the economic crisis, and, while the risk of dramatic economic collapse may not exist at the same level in the EMs due to the diversified underlying assets and the percentage microfinance loans in overall bank loan portfolios, enhanced regulation should still benefit the EM consumer especially in a time when, like America, EM delinquency rates are on the rise (9).

  1. http://moneymorning.com/2012/10/15/qe3-will-give-rebounding-homebuilder-stocks-an-extra-push/
  2. http://www.newgeography.com/content/00369-root-causes-financial-crisis-a-primer
  3. http://www.economist.com/node/16702063
  4. http://dailyreckoning.com/when-realtors-become-waiters/
  5. New York Times.  “15 Years In, Microcredit Has Suffered a Black Eye.” [Class Reading]
  6. http://www.mindfully.org/Reform/2007/Subprime-Lending-JEC25oct07.htm
  7. http://www.calculatedriskblog.com/2009/11/mba-forecasts-foreclosures-to-peak-in.html
  8. The Economist. “The Hidden Wealth of the Poor:  A Survey of Micro Finance.” [Class Reading]
  9. http://blogs.cgdev.org/open_book/2010/02/grameen-bank-which-pioneered-loans-for-the-poor-has-hit-a-repayment-snag.php

One thought on “Microfinance Example: Microfinance vs. US Subprime Market

  1. tlhill2012 November 23, 2012 at 11:56 AM Reply

    Kip – interesting comparison! You capture many of the causes of the subprime mortgage collapse well, although there is probably more about lack of due diligence and transparency during securitization and the power of the (mis)incentives that drove firms forward in a mad scramble for more opportunities in an increasingly competitive and frenzied space. Keynes explained bubbles as, in part, due to “animal spirits” that fuel mob think, greed, etc. That is, bubbles arise, in part, from a failure of the key assumption that markets are rational (or made up of individuals rationally calculated costs and benefits). But a Marxist might also argue that they arise from the fundamental logic of capitalism that stresses accumulation and profit at all costs. Arguably, some of these behaviors are, in fact, driving the attention to microfinance – both firms looking for “good” returns in lean times and NGOs turning less critically to the logic of capitalism as a driver of “development.” At the same time, as you point out, there are checks and balances such as the commitment to no defaults, social pressure to avoid defaults (in models that use social pressure – not all do), and due diligence/transparency (in general but especially in models that rely on this). The question is whether these often local checks are strong enough balance the capitalism and financial system incentives to cut corners and create bubbles, especially as microfinance ties into global financial flows.

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