Subprime Time: Microfinance Debt Hits the Stock Exchange

Tell me more about this microfinance.

Right now, the hot topic in microfinance is the initial public offering (IPO) of SKS Microfinance, one of the largest microfinance institutions in India with a portfolio size of over US$1 billion.  This isn’t the first time a major microfinance institution has gone public, but it is more interesting because the CEO is a disciple of Muhammad Yunus, who believes what organizations like SKS are doing undermines the social mission of microfinance.  But there is other interesting financial news in the microfinance world that is flying under the radar.  This, for example:

NYSE Euronext and Microfis plan to set up the first organised market for listing and trading of bonds based on debt from international microfinance institutions and solidarity businesses as defined by the Economic Modernisation Act (LME).

The new NYSE Euronext market segment will offer investors a range of products in an environment that is secure and transparent.  Microfis will handle origination, analysis and tracking of high-quality assets, as well as their transformation into tradable securities and their syndication.  Scheduled for launch in the last quarter of 2010, the market segment is dedicated to responsible finance.

In other words, Microfis, an organization with the noble mission of “foster[ing] the emergence of new, financially responsible asset classes,” will assemble and securitize microfinance debt to be sold on the NYSE Euronext stock exchange.  This is more interesting to me than SKS and a handful of other organizations deciding to go public.  It could be a good development in the sense that it will open up more capital sources for microfinance institutions and still allow them to maintain independent governance and focus on the social mission of poverty alleviation.  Unfortunately, it could also be the first step toward a subprime crisis for the microfinance sector.  As demand for microfinance securities increases, the temptation will be to relax the standards for evaluating MFI debt.  This is what Countrywide Mortgage, the  investment banks, and the ratings agencies did during the subprime crisis, collectively churning out junk that, as the millions of newly unemployed already know, practically brought down the U.S. economy.

The number of microfinance investment vehicles from 2000-2008 (source: CGAP)

So, more money will be chasing fewer good assets, people will continue to assume that they are getting top quality MFIs with a strong history of repayment, when, in reality, the debt is likely to be much riskier.   The graph below shows the growth in microfinance investment vehicles (MIVs), which finance microfinance institutions.  The growth has been strong, but these investors have been focusing on a select group of credit-worthy organizations.  As the curve becomes steeper and demand for investment opportunities grows, the supply of microfinance debt or equity will need to grow as well.  As in any situation, quantity, unfortunately, will come at the expense of quality.

Growth of microfinance investment vehicles, which invest in MFIs, over the last ten years.

Right now there are only a couple hundred MFIs worldwide that have the capability and internal controls necessary for dealing with the capital markets.  Securitizing microfinance debt involves bundling a number of loans together from the MFI’s portfolio and selling them off in tranches to investors.  The problem with microfinance debt is that an uptick in defaults can be catastrophic for the MFI.  Just like in It’s a Wonderful Life, perception is everything in microfinance.  The incentive for clients to repay their loans is the promise of another loan.  If a number of clients are not repaying their loans and the rest of the clients think that there is a chance the MFI won’t survive until their next loan cycle, they will stop paying as well, since their incentive is gone.  For this reason, a securitized microfinance portfolio can quickly become infected with bad debt, particularly when the microfinance institution is poorly managed and does not have experience with the rigorous demands of money from the capital markets.

A bubble occurs when too much money is chasing too few good assets.  Assets become overvalued as the cheap money flows and people’s judgment becomes clouded as they try to get a piece of the action.  This is what happened with the subprime crisis, when everyone thought that housing prices could never go down.  And, with a string of IPOs beginning with Compartamos in 2007, talk of microfinance as a potential asset bubble is nothing new:

This rapid rise and fall of new asset classes is a constant in financial markets: oil in the 1970s, technology stocks in the late 1990s, real estate in the early 2000s, and now the subprime lending market. All of these boom and bust cycles are characterized by too much capital chasing too few assets (or too few assets of quality), and a severe misunderstanding of the risk involved.

Could the next generation of microfinance institutions fall victim, like so many subprime lenders, to the flood of Wall Street capital? If most of the capital invested in microfinance is already chasing a small percentage of “top tier” microfinance institutions, then new capital from Wall Street will be directed at less mature organizations that are not prepared for large scale commercial investments. These organizations will crumble under the pressure to be profitable. To avoid a microfinance meltdown Wall Street must proceed with more due diligence and caution than it did when diving into subprime mortgage lending. If not, microfinance will end up on the front page of the Wall Street Journal, but this time not due to a Nobel Prize.

This guy doesn’t mince words.  Fortunately, this article was written in 2007 and his dire predictions haven’t necessarily been borne out.  Compartamos is doing fine, even in the face of the economic crisis, and most microfinance bubbles are confined to a few particularly hot markets, like India.  According to CGAP, however, the volume of assets under management by microfinance investment vehicles increased 72% in 2007 and 31% in 2008. More private equity firms are beginning to get in the game, looking for equity investments (this means they are looking to either buy MFIs or own a sizable part of them). Hedge funds and banks are creating microfinance portfolios because they see money to be made and it looks good from an investor relations standpoint (forget about our BP holdings – we support microfinance!).

In closing, as long as the quality of the MFI debt remains high, creating a formal asset class that can be be traded on international stock exchanges seems like a positive step toward expanding financing opportunities for the microfinance sector.  But with microfinance credit bubbles already appearing in parts of the world, unstable regulatory environments in developing countries, and increased attention from Wall Street, the potential for trouble is there.  Not every microfinance institution is an SKS or Compartamos.  In fact, very few are as good as these two.  It will be critical for investors – and the organizations that are securitizing the debt – to understand this before they put their dollars to work.

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