The Subprime Crisis & Implications for Microfinance (SVMN, 05/18/08)

Slide 1: B u ild in g F in a n c ia l S ys te m s fo r th e P o o r Me dita tions on th e US S ub -P rim e C ris is : Im plic a tions for Inte rna tiona l Mic rofina nc e S ilic on Va lle y Mic rofina nc e Ne twork Ma y 19, 2008 Ka te Mc Ke e

Slide 2: R e c e nt He a dline s Da n g e ro us Anim a ls in th e E u ro pe ’s C e n tra l B a n ks Inje c t B a nking Zo o More F un d s B a n ks F e a r a Ne w R ou n d o f B rita in to Na tio n a liz e North e rn Write -Do wn s Rock B a nk F e a rs a b o ut E c on o m y F itc h to re c o n s ide r C DO In c re a s e : De b t C ris is G rows ; G ra de s Top Mortg a g e F irm S o ld a t a F e d C o m e s to R e s c ue a s Wa ll B a rg a in S tre e t G ia n t S lip s Du b a i B u ys S ta ke in C iti; C h in a R e g ula tion to th e R e s c u e B u ys S ta ke in Mo rg a n S ta n le y C o n g re s s De b a te s Mo rtg a g e R ip ple s o f C ris is in US Ho us in g Aid P la n R e a c h World wid e

Slide 3: A fe w s ta tis tic s . . . 7.7 m ill. s ub -prim e loa ns outs ta nding a s o f S e p t. 2 m illion h om e -owne rs a t ris k of fore c los ure B y th e s um m e r of 2010, 600,000 pe ople e xpe c te d to los e h om e s wh e n loa ns re s e t US re s ide ntia l m ortg a g e m a rke t is va lue d a t a round $12 trillion – m a ny e xpe c t furth e r 20% de c line Ne a rly 8.8 m ill. h om e s (10.3 % of tota l) worth le s s th a n th e ir own e rs owe – “ups id e d own” E s t. s u b -prim e los s e s for b a nks up to $200-4 00 b ill.

Slide 4: Wh a t in th e wo rld d oe s s u b -p rim e h a ve to d o with m ic rofin a n c e ? S ub -prim e h om e loa ns vs . typic a l m ic ro-loa ns C o m ple te ly diffe re n t . . . - c lie nts - produc t fe a ture s - b us in e s s pra c tic e s (m a rke ting , orig ina tions , c o lle c tions , e tc .) -P la ye rs And ye t . . .

Slide 5: Ob s e rva tio n #1 – Un s u s ta ina b le p ro d u c ts a n d p ra c tic e s P roduc ts infe rior vs . prime – re s e ts , pig g yba c ks , a nd s o on (a lth oug h not a ll s ub-prime loa ns a re “pre da tory”) Too ofte n, little a tte ntion pa id to re pa yme nt a bility Comple x, c onfus ing , s ome time s de c e ptive Ta rg e ting a nd s te e ring [s ig nific a nc e of de -linking c re dit a na lys is /orig ina tion a nd ris k – more to c ome in a fe w s lide s ] Compe tition doe s not a lwa ys re s ult in more a nd be tte r produc t options . . .

Slide 6: Implic a tions for MF – Th e produc ts C urre n tly, MF produc ts m os tly s im ple , h e ld in portfo lio, little e vide nc e of wide s pre a d de linq ue n c y a nd ove r-inde b te dne s s prob le m s B ut lots of e m ph a s is a m on g tra ditiona l pla ye rs on produ c t innova tion, g rowth , m a rke t s h a re And a g g re s s ive ne w p la ye rs , produc ts , pra c tic e s (e .g ., S outh Afric a , Me xic o, E . E urop e , In dia ) In s om e m a rke ts , th e “va lu e c h a in” of fina nc e is de ve loping with ne w role s a nd pa rtne rs h ips How doe s / will in ve s tor de m a nd s h a pe our produ c ts ?

Slide 7: Implic a tions for MF – Th e produc ts (2) We ne e d to wa tc h out: G e tting c a rrie d a wa y with p roduc t innova tion a nd “fina nc ia l e ng ine e ring ” for its own s a ke C lie nt de b t le ve ls – a b ility to c olle c t vs . a b ility to pa y Im pa c ts of c ons um e r le nde rs a nd le nd ing

Slide 8: Ob s e rva tio n #2 – B u ye r b ia s , wis h ful th in kin g Not a ll s ub-prime buye rs , now in trouble , a re “s ympa th e tic ” B ut th e me lt-down h a s c a ug h t ma ny we ll-inte nde d fa milie s of mode s t me a ns , purs uing th e Ame ric a n dre a m of h ome - owne rs h ip Ne w re s e a rc h s h ows h ow s ys te ma tic a ttitude s , de c is ion- ma king pa tte rns a nd bia s e s influe nc e c re dit be h a vior Th os e de s ig ning a nd ma rke ting produc ts a re a lot more a wa re of th is re s e a rc h th a n th e buye rs ! Th e c omple xity of th e produc ts a nd th e h ome purc h a s e proc e s s c ompound th e s e informa tion a s ymme trie s

Slide 9: Implic a tions for MF – th e b uye r s ide P a y a tte ntion to th e ne w re s e a rc h from th e c ons ume r/ h a viora l s c ie ntis ts be Us e th e ins ig h ts to - de s ig n produc ts th a t work for c lie nts a s we ll a s provide rs – re a s ona ble a nd s us ta ina ble va lue propos ition - de ve lop a ppropria te ma rke ting me s s a g e s a nd c ommunic a tion s tra te g ie s - dis c los e pric ing , te rms a nd c onditions tra ns pa re ntly

Slide 10: Ob s e rva tio n #3 – s h a ky p ro c e s s e s , s ke we d in c e n tive s , a n d m o ra l h a z a rd Cre dit a na lys is : ove r-re lia nc e on c re dit s c ore s (vs . a fforda bility a na lys is , inc ome ve rific a tion, down pa yme nt, mortg a g e ins ura nc e , e tc .) Mortg a g e broke rs : th e ir role s (ma rke ting , not ris k a s s e s s me nt) a nd c ompe ns a tion a rra ng e me nts -- not on th e h ook for re pa yme nt Le nde rs : role of non-ba nk mortg a g e le nde rs + pre va le nc e of s e lling off loa ns (re duc e s a tte ntion to ris k) Oth e rs in th e fina nc e “va lue c h a in,” e . g ., a ppra is e rs , ra te rs – ove r-e nth us ia s m, c orne r-c utting a nd fra ud E ve ryone ’s a s s umption th a t h ous ing pric e s (a nd borrowe r’s inc ome ? ) would only ris e – re fi a s e xit

Slide 11: Im p lic a tio ns fo r MF – c re d it a n a lys is , p a rtn e rs a n d th e pla ye rs in th e c h a in S ta y vig ila nt a b out portfolio q ua lity wh ile innova ting loa n p roduc ts a nd c re dit a na lys is proc e s s e s to “b a nk th e unb a nke d ’ Us e of c re dit s c ore s a nd oth e r m o re e ffic ie nt unde rwriting te c h niq ue s is im porta nt to e xpa nding a c c e s s – b ut te s t th e m c a re fully to b e s ure th e y work Ta ke c a re with outs ourc ing a n d pa rtne rs h ips – e s pe c ia lly to c re a te inc e ntive s fo r h ig h p ortfolio q ua lity a nd c us tom e r s e rvic e MF m a na g e rs / oa rd s (a nd inve s tors ) ne e d to pa y b m ore a tte n tion to m a na g ing a wide r ra ng e of ris ks

Slide 12: Ob s e rva tio n #4 – In ve s to rs in th e “s lic e -&-d ic e ” fina n c e wo rld G loba l liquidity a nd inve s tor a ppe tite for h ig h e r-re turn produc t drove fina nc ia l innova tion (e .g ., ris k-ba s e d pric ing ) a nd c re a tion of e xotic inve s tme nt ins trume nts S o c omple x th a t no pla ye r s e e ms to h a ve re a lly unde rs tood th e ris ks – ove r-re lia nc e on ra ting s , c re dit e nh a nc e me nt – a nd ina de qua te due dilig e nc e a nd ove rs ig h t by fund ma na g e rs , boa rd, e tc . Th e borrowe rs we re n’t th e only one s re lying on wis h ful th inking ! Comple x s truc ture s a nd owne rs h ip c omplic a te “unwinding ” th e s e c uritie s now th a t th e c ris is h a s h it

Slide 13: Im p lic a tio ns fo r MF – Th e c lim a te fo r in ve s tm e n t Will inve s tors will do more c a re ful due dilig e nc e a nd h a ve a lowe r a ppe tite for c omple x ins trume nts (a t le a s t for a wh ile . . .)? Will th is limit a va ila bility of c ros s -borde r inve s tme nt for MF e xpa ns ion? Will ne w e ntra nts e xit or s c a le ba c k th e ir pla ns ? Wh a t a bout th e role of ra ting s ? And will th e a va ila bility of dome s tic c re dit for MF Is be a ffe c te d by th e g loba l c re dit c runc h ? MF boa rds a nd ma na g e rs mig h t do we ll to c ons ide r a lte rna tive s to s e c uritiz a tion, CDOs / CLOs , e tc .

Slide 14: Ob s e rva tion #5 – R e g ula tors in th e h ot seat R ole for ma rke t c onduc t re g ula tion a nd e ve n c rimina l pros e c ution – wh ic h produc ts a nd pra c tic e s s h ould be be yond th e pa le ? e .g ., unde rwriting to c urre nt inc ome , h ug e pre -pa yme nt pe na ltie s , mortg a g e broke r pric ing B ring pla ye rs unde r ne w or be tte r re g ula tion R e g ula tory ove rh a ul/ ons olida tion c Limita tions of s e lf-re g ula tion B ut is th e re a da n g e r of ove rre a c tion a nd s h ort- s ig h te d re s pons e s drive n b y th e c ris is ?

Slide 15: Implic a tions for MF – R e g ula tion Th e politic a l, polic y re g ula tory re s pons e s in th e US a nd E urope a re like ly to influe nc e th oug h t a nd pra c tic e in de ve lopin g c ountrie s G re a te r a wa re n e s s of c onc e pts s uc h a s s ub - prim e prod uc ts , re c kle s s le nding , pre da tory pra c tic e s . . . a nd la is s e z -fa ire a ppro a c h e s le s s like ly wh e n m a rke t e xc e s s e s a ppe a r? S om e da ng e r th a t ina ppropria te b a la nc e s will b e s truc k b e twe e n a c c e s s , prote c tion a nd s ta b ility g oa ls

Slide 16: S outh Afric a Na tiona l Cre dit Ac t F e a ture s of 2005 Ac t inc lude : Cre a tion of c ros s -indus try ma rke t c onduc t re g ula tion (ba nks , c ons ume r le nde rs , re ta ile rs ) a nd re g ula tor R e c kle s s le nding re quire me nt – if le nde r is de e me d re c kle s s (c a nnot prove a de qua te proc e s s of a fforda bility a s s e s s me nt), ma y not be a ble to c olle c t in c ourt Ce rta in produc t fe a ture s & pra c tic e s proh ibite d (e .g ., pre - pa yme nt pe na ltie s , ma rke ting & c olle c tions pra c tic e s ) S ta nda rd c ontra c ts a nd ma nda tory pla in la ng ua g e dis c los ure s Ca ps on inte re s t, initia tion fe e s , a nd s e rvic ing fe e s (a lbe it a t ve ry h ig h le ve ls ) R e g ula tion of c re dit bure a us a nd de bt c ouns e lors by NCR

Slide 17: S outh Afric a Na tiona l Cre dit Ac t -- impa c t Hug e c re dit s urg e jus t be fore NCA c a me into e ffe c t, followe d by (s h ort-te rm? ) le nding fa ll-off B roa d a g re e me nt th a t th e NCA h a s : Ma de le nde rs improve a fforda bility a s s e s s me nt a nd loa n/ linque nc y ma na g e me nt de B roug h t down mos t pric ing , a t le a s t to th e c a p a nd s ome e vide nc e of pric e c ompe tition R e duc e d s ome e s pe c ia lly ba d pra c tic e s in th e ma rke t, inc luding c re dit ins ura nc e a bus e s (but limite d e nforc e me nt c a pa c ity of re g ula tor) Le d to c ons olida tion a mong le nde rs – drove s ome pla ye rs to th e g round (a nd unde rg round? )

Slide 18: Will th e Ac t h a ve uninte nde d c ons e q ue nc e s ? How will c ons ume rs c ope with re s tric te d c re dit a c c e s s in th e fa c e of infla tion a nd a s pira tions ? Will th e y g o ba c k to th e “ma s h onis ta s ” (mone y le nde rs ) a nd e nd up more vulne ra ble ra th e r th a n le s s ? Mig h t s e lf-e mploye d h ous e h olds a nd informa l bus ine s s e s s uffe r from re duc e d a c c e s s ? Will unc e rta inty s urrounding c ourts ’ re c kle s s le nding ruling s h a ve a c h illing e ffe c t on le nding , e s pe c ia lly a mong le nde rs c onc e rne d a bout re puta tion ris k? Ha s c ons ume r unde rs ta nding of c re dit c os ts / rms re a lly te improve d? Is th e re e vide nc e of more / tte r c ompa ris on be s h opping ? Or a re th e y jus t c onfus e d in ne w wa ys ? Compe tition, c ons olida tion or both ? E ntry ba rrie rs up Do e s the Act strike the right balance ?

Slide 19: S ome c los ing th oug h ts R e c e nt de ve lopme nts in th e MF indus try a re e xc iting – but we ne e d to put g rowth , innova tion, a nd c a pita l ma rke t a c c e s s in pe rs pe c tive a nd ma na g e th e ir ris ks a ppropria te ly F oc us on c lie nts – don’t we h a ve a re s pons ibility to ta ke re a s ona ble s te ps to do no h a rm? Clie nts h a ve re s pons ibility too, to ma ke informe d c h oic e s – role of fina nc ia l e duc a tion, tra ns pa re nt pla in-la ng ua g e dis c los ure s , a nd furth e r work on c lie nt bia s e s S h ort-s ig h te d to re s is t we ll-de s ig ne d “lig h t-touc h ” re g ula tion In th e long run, a ll le g itima te pla ye rs be ne fit from re s pons ible fina nc e .

Slide 20: Wh o b e ne fits ? Wh o pa ys ?

Slide 21: Th a nks ! Ka te Mc Ke e , kmc ke e @worldba nk.org S e nior P olic y Advis or CG AP Wa s h ing ton DC

Slide 22: Building Financ ial S ys te ms fo r the Po o r Thank yo u!