Microfinancing and the sub-prime factor
Picture this: A lending agency extends loans with minimal requirements to borrowers who have poor credit ratings at a higher rate than the prime interest rate, fueling a consumption binge by those said borrowers who then borrows even more to finance their artificial needs. If you think I’m describing how the sub-prime mortgage crisis originated, you are mistaken; I’m referring instead to what is now known as microfinancing, or the practice of providing credit to impoverished people who have low incomes and are shunned by most banks and financial institutions.
The Wall Street Journal today reports on the recent surge in microfinancing around the world even in the wake of the sub-prime crisis:
That has attracted private-equity funds and other foreign investors, who’ve poured billions of dollars over the past few years into microfinance world-wide.
The result: Today in India, some poor neighborhoods are being “carpet-bombed” with loans, says Rajalaxmi Kamath, a researcher at the Indian Institute of Management Bangalore who studies the issue. In India, microloans outstanding grew 72% in the year ended March 31, 2008, totaling $1.24 billion, according to Sa-Dhan, an industry association in New Delhi.
Like sub-prime loans, many of these microfinancing loans carry higher than average interest rates:
Around Ramanagaram, the silk-making city where Ms. Taj lives, the debt overload is stirring up social tension. Many borrowers complain that the loans’ effective interest rates — which can vary from 24% to 39% annually — fuel a cycle of indebtedness.
Don’t get me wrong, microfinancing may play a crucial role in aiding the poor in obtaining money to open up small time fruit stalls and other small trade to make a living when their non-existent credit record compounded with their low incomes make traditional banking loans difficult to procure. At the same time, a general lack of scrutiny of these loans make it difficult for lenders to be certain of their borrowers’ ability to pay them off. Some have apparently resorted to taking new loans to pay off existing ones:
“I took from one bank to pay the previous one. And I did it again,” says Ms. Taj, 46 years old. In four years, she took a total of four loans from two microlenders in progressively larger amounts — two for $209, another for $293, and then $356.
“I understand that it is credit, that you have to pay interest, and your debt grows,” Ms. Sharma says. “But sometimes the problems we have seem like they can only be solved by taking another loan. One problem solved, another created.”
A direct comparison with sub-prime loans in the US may be inappropriate at present. Unlike the American sub-prime crisis, however, microfinanced loans aren’t securitized into those infamous CDOs (collateralized debt obligations) and repackaged for sale to investors. This blog for example argues that securitization of these loans would be unwise in the light of the US subprime crisis, that it creates moral hazard for intermediaries such as banks or microfinancing agencies to aggressively extend more loans in the hopes of attracting more investors’ money:
Secondly, and this is a more obvious point, unlike sub-prime mortgages which whose total valuation was based on inflated housing prices in the range of about a few hundred thousand dollars, individual amounts owed at present come up to only a few hundred dollars. And microfinancing apologists point out that loans extended to needy households are predicated on the basis of small localised economies fueled largely by subsistence consumption rather than profligate spending:
Microfinance institutions (MFIs) lend relatively small sums of money to people in developing countries to start small, profitable businesses, not to buy overpriced homes. Many of those businesses serve local needs, which has more merit at a time when exports are collapsing. And microfinance’s reliance on peer pressure for repayment must be the envy of any mainstream banker struggling with rising foreclosures and “jingle mail”; delinquency rates are microscopic.
Still, given the enormity of what transpired in America it’s probably not too much of an over-reaction to start taking note of these MFIs and their loans. The extravagant interest rates currently charged to borrowers (a stark contrast with present inter-banking rates) may be harbingers of emerging problems. It’s hard to ignore this issue at present, even as the world struggles to regain its economic footing. Taking appropriate regulatory action now to limit usurious rates may help stave off having to choose between letting huge institutions fail or furthering moral hazards by bailing them out.