Meditations on the U.S. Sub-Prime Crisis

Kate McKee is a Senior Advisor at CGAP focusing on policy issues including consumer protection and state-owned banks. She previously led USAID’s Microenterprise development office as well as directed federal policy development and helped create pioneering secondary market mechanisms for non-conforming home loans at Self-Help. Board service included chairing the Consumer Advisory Council of the Board of Governors of the US Federal Reserve.

Less than two years ago, nagging delinquency problems started to crop up in one tiny corner of the U.S. home finance market - so-called ”sub-prime” mortgages. While many sub-prime borrowers were refinancing existing mortgages, and some were speculators, others were borrowers pursuing the dream of owning their first home. Many sub-prime loans had characteristics that we now know to be unsustainable - artificially low “teaser rates” that are now adjusting upwards to much higher rates unaffordable to many borrowers, steep pre-payment penalties, and complex features geared to the investor markets into which they were resold. 

What began as a niche problem has now spread in dramatic fashion - delinquencies and foreclosures have skyrocketed, with an estimated two million sub-prime loans likely to default, creating a precipitous decline in housing values in many markets. As the ripples move outward, the crisis is now threatening the U.S. with economic recession, and setting off worldwide concerns about how the resulting credit crunch and possible U.S. recession will affect growth in countries rich and poor.

What consequences might the sub-prime crisis have for microfinance in developing countries and what lessons can our field draw from its underlying causes?

Observation #1:  Unsustainable products and practices

A sub-prime mortgage is a mortgage loan underwritten using lower credit standards than those used in the prime lending market.

In the U.S. credit market, sub-prime lenders disproportionately targeted minority and lower-income people and places with higher-priced products offered on inferior terms. In some cases, borrowers that could have qualified for prime loans were “steered” to inferior financing. The increasingly typical practice of selling sub-prime loans shortly after they were originated meant that often, mortgage brokers and even lenders did not have to live with the consequences if the loan went bad. Many of the products and practices were at best, reckless, and too often, predatory. While the sub-prime market offered a valuable opportunity to many, too often loans were complex, confusing and downright deceptive. High levels of competition and product innovation in the aggregate failed to offer meaningful choices of products and providers to consumers.

Implications: Typical microfinance products are still fairly simple and there is little evidence of widespread delinquency problems or over-indebtedness. Resale of loans to investors is in its infancy and faces many practical challenges. However, with the entry of aggressive consumer lenders in rapidly developing markets such as Mexico, India and Eastern Europe, credit is extending far down the income pyramid with new products and underwriting practices. While the full effects of these developments cannot yet be predicted, over-indebtedness could surface and microfinance providers would be well advised to keep an eagle eye on portfolio performance as well as market share. Not all innovation is good, and competition in the overall market does not necessarily result in better choices for the consumer.

Observation #2:  Buyer bias and wishful thinking

A small but not insignificant share of sub-prime borrowers in the U.S. were either speculating on rising home values or taking advantage of the lax underwriting standards. To be sure, greed and poor judgment played a role in the crisis. But the majority of those now in trouble borrowed in good faith and genuinely intended to repay their loans. Buyers’ systematic biases and wishful thinking contributed to soaring delinquency and default rates. Cutting-edge consumer behavioral research reveals that optimism, the desire to own a home, and other psychological factors can often override careful analysis of repayment capacity. Brokers and lenders capitalized on these attitudes in their product design and marketing techniques. The buyers’ disadvantage was further compounded by the complexity of the mortgage products, low levels of financial literacy, and voluminous but ineffective disclosure requirements.

The sub-prime crisis underscores that client education and good customer service is critical.

Implications: Consumer psychologists and behavioral economists have just started teaming up to explore attitudes, decision-making and cognitive biases of typical microfinance clients in developing countries. The microfinance industry's market research, product design, delivery techniques, and client interface should bring these insights on board as soon as they are available, since common assumptions about client attitudes and behavior are probably wrong. The goal should be to design sustainable and responsive products rather than to exploit information asymmetries more cleverly! This research and the sub-prime experience suggests that as players with a long-term perspective on the market, we need to be sure we are offering our clients a reasonable and sustainable value proposition, disclosed transparently and communicated with care. 

Observation #3: Shaky credit processes in the mortgage “value chain”

We can now see that the sub-prime loan screening and underwriting processes failed too often. One contributing factor was over-reliance on credit scores relative to traditional risk management techniques such as down payment requirements, income verification, and mortgage insurance. Outsourcing of loan marketing and origination to mortgage brokers that were subject to no or negligible regulation was another weakness. A third factor was the role of non-bank mortgage lenders; banks could protect the parent brand by doing very profitable sub-prime business through an affiliate with a different brand and looser underwriting standards. Moral hazard permeated the system, since neither brokers nor lenders expected to suffer the consequences of delinquency and default when loans were resold into the investor market.

Implications:  To date, the microfinance sector has achieved impressively low default rates, by developing innovative underwriting and risk management techniques for extending credit to those previously considered unbankable. Maintaining this focus on portfolio quality is critical - and especially challenging when providers are expanding at double-digit rates and facing stepped-up competition. The incorporation of credit scoring tools into microfinance underwriting offers enormous potential; the sub-prime experience reminds us, however, that such lending innovations require care in implementation. Similarly, while outsourcing and partnership models offer potential to increase efficiency and expand access, extreme care must be given to their design and implementation to ensure adequate controls and well-balanced incentives for high-quality portfolio performance and customer service. 

Observation #4:  Investors in the world of “slice-and-dice” finance

To a large degree, liquidity in world capital markets and investors’ appetite for higher-return product has driven financial innovation, including in the sub-prime market. This niche was at the forefront of financial engineering, as loans were sold and repackaged into increasingly complex securities that offered investment opportunities for banks, investment banks, and hedge funds. The attractive returns may have led investors to rely excessively on ratings rather than careful analysis of the risk and performance of underlying portfolios. The various checks and balances - ratings, regulators, bond insurers, and most significantly, boards of directors - all seem to have failed to exercise adequate due diligence and oversight to prevent the crisis. And the complex securities and ownership arrangements definitely complicate the “unwinding” process, severely limiting the flexibility of lenders, loan servicers and policy makers to negotiate loan restructuring on delinquent and defaulting loans and portfolios.

Implications: The “irrational exuberance” that has characterized global investing is likely to be tempered by the sub-prime crisis. At a minimum, we should expect more careful due diligence and perhaps a reduced appetite for complex financial instruments. Microfinance expansion plans based on the assumption of almost unlimited access to cross-border capital, beyond the current large pool of microfinance-dedicated capital in specialized pools and funds, may need to be reduced. The specialized investors may be rebalancing their risk profiles and taking extra care to assess their portfolio companies and associated microfinance products and practices. The role of competent ratings becomes all the more important. Microfinance managers and boards should consider the potential down sides of securitization and other such financing options.

Observation #5:  Regulators in the hot seat

Leading players in the  microfinance industry  would do well to get out in front of these issues and articulate the principles and practices of sound lending and responsible behavior vis-à-vis their clients.

The sub-prime crisis has raised pointed questions about the adequacy of financial policy, regulation and supervision. Perhaps the most obvious potential response is market conduct regulation to address the most egregious abuses. One key focus is “client suitability assessment,” that is, preventing reckless lending by requiring lenders to take reasonable steps to analyze borrowers’ ability to repay. The crisis has also spotlighted problems of fragmented regulation and regulatory arbitrage. The players in the sub-prime value chain are overseen by a wide variety of federal and state regulators, and crucial parts of the system, such as mortgage brokers, receive at best very light regulation. The melt-down has also revealed the limitations of self-regulation - the banks appear to have been happy to profit through their less-regulated mortgage affiliates while protecting the core brand.

Implications:  The final shape of policy and regulatory responses in the U.S. are likely to influence the rules of the game in developing and emerging markets. Regulators and politicians will have a greater awareness of the havoc that reckless lending, predatory practices, and sub-prime players can wreak. They are also likely to recognize the strong potential downside of either inattention or laissez-faire approaches when market excesses begin to appear. Regulators and policy makers should be looking for “light-touch” solutions that strike a careful balance between promoting access and protecting consumers. 

Conclusion

In some respects, microfinance is the sub-prime market in most developing and emerging countries. Expanded financial options can offer valuable services to low-income and unbanked people, but bad practices, products and even players can enter the marketplace, harming consumers, legitimate lenders, and the broader financial system and economy. As we seek to innovate and compete with aggressive consumer lending, the microfinance industry needs to ask tough questions about the longer-term viability of our new products, practices, risk management techniques and financing strategies. We should anticipate credit cycles and periodic crises, especially in fast-moving emerging markets.  We need to focus more attention on ensuring that clients understand their rights and obligations, in general, as well as the specific produce and all its features.

We should embrace rather than resist “light-touch” market conduct regulation – by reining in the worst abuses, it protects the legitimate players.

This spiraling crisis offers a chance to reflect on how to build a solid foundation and ensure the long-term health of our sector. While appropriate market rules can set the floor and define the boundaries of acceptable practice, voluntary “self-regulation” can set the bar higher and differentiate the “high-road” providers. We must define principles and practices of “responsible” finance that ensure client benefit as well as shareholder value. And our collective self-interest is served by meaningful, practical efforts to increase financial literacy and client capacity to use finance well. Finally, we should continue to explore innovative and appropriate housing finance products for low-end markets.