[Continued from yesterday’s Part 1.]
By: David A. Smith
The problem is, we have no security
Yesterday’s post, expanding on an excellent Micro-Finance Focus article by Daniel Rozas, sounded the alarums regarding microfinance, with an outbreak of not ‘strategic’ mortgage default but the far more plausible, and frightening, payment boycott. Mr. Rozas argues, quite convincingly (for more information, see his paper Throwing in the Towel: Lesson from MFI Liquidations, 2009), that since microfinance loans are personalized consumer credit, they are collectable only by a lender whom the borrower knows, and with the implicit or explicit promise of future credit being extended upon successful repayment of the current loan, leading to this conclusion:
The most obvious option is through a merger with a stronger institution, which can retain the MFI’s operational capacity and provide the needed capital to continue issuance of new loans.
[Additionally, there is an emerging and quite nasty potential political dimension to all this, on which I’ll post when I have some small idea what I might be talking about. For now, read David Roodman – Ed.]
In the banking world, stronger institutions abound, because (a) banks are regulated by government, and (b) banks are backstopped by government either indirectly (through deposit guarantees) or directly (through sovereign guarantees). In America, FDIC is the national shotgun wedding preacher, shuttering Bank A at 5:00 pm Friday and selling all its deposits and loans to Bank B before 9:00 am Monday, often with a hefty slug of equity injected to make the purchase attractive to Bank B.
Microfinance institutions have no such regulatory scaffolding; they exist as non-bank financial institutions that generally do not take deposits and hence rely on the capital markets. No government backstop, no national credit-availability infrastructure. No guaranteed countercyclical liquidity provider.
That wouldn’t matter so much if the loans were collateralized by remarketable assets like mortgaged formal homes, but as these are consumer loans, where the repayment is predicated on mutual personal expectations, collapse of the MFI could mean collapse of repayment. If so, the creditors will be compelled, however reluctantly, to keep the MFI on life support.
You’ll be up and lending again in no time!
However, if a buyer did emerge, it would find that while challenging, effecting repayments on long-overdue loans is not impossible.
One could draw useful lessons from the 2006-07 AP crisis in the Krishna district. That crisis had a similar pattern – repayments were stopped by way of government action,
Throughout the world, public-private interventions where the government has the lead face run into a curious induced-default-risk problem: people believe that government lending (or, for that matter, government landlord renting) is a social safety net, and that repayment (or rent) obligations are advisory. They are often encouraged to reach this conclusion by shoddy government collection practices, and rules that are seldom or selectively enforced and hence become worse than useless. South Africa’s Servcon, referenced yesterday, suffered for years with borrower repayment refusal aided and abetted by elected officials openly exhorting the government to forgive their constituents’ loans – a particularly insidious form of public-choice risk:
I judge myself by the highest ethical standards … and I always pass
The behaviour of public-sector bureaucrats is at the heart of public-choice theory. While they are supposed to work in the public interest, putting into practice the policies of government as efficiently and effectively as possible, this theory emphasizes the importance of the bureaucrat’s disposition to policy implementation.
At one extreme, bureaucrats are self-interested utility maximizers, motivated by patronage, power, pre-requisites of the office, public reputation, salary, and the ease of managing the bureau; at the other, they are characterized by pride in performance, loyalty to a programme, department, or government, and a wish to best serve their fellow.
I only best serve my fellows
Public officials, whether elected or appointed, find it almost impossible to refrain from intervening in large-scale market disruptions (like a payment boycott), and their interventions – whether harmful or helpful in the long run – nearly always complicate and delay matters, as in Andhra Pradesh:
but after a year-long hiatus, MFIs were able to restart collections.
Though the final results of these collections have not been made publicly available, a source familiar with the effort has estimated the ultimate recovery rate for one of the large affected MFIs at 60-65%, collected over a period of two years.
On the one hand, 65% recovery is a fantastic result given the scale of the default epidemic, the absence of collateral, and the government intervention.
For creditors seeking recoveries, a 60% recovery rate for affected microcredits is not bad at all. Though unlikely to cover everything, their losses would be mitigated the unaffected parts of the portfolio and the additional cushion of equity that could absorb some 15-20% of losses.
On the other hand, a twelve-month hiatus in what was intended to be a six-month loan ruins the IRR – but as any capital provider knows, when default becomes severe, IRR goes out the window in favor of capital protection.
There go our returns
It’s worth noting that a similar recovery rate from the current crisis could be catastrophic for the MFIs most exposed to AP, even if collections happened over a shorter time period.
So absent acquisition by a well-capitalized entity, do creditors have another option for recovering on these loans?
Well, do they?
The scale of the crisis this time around is far broader, affecting the entire state (and potentially more), as opposed to a few districts. Moreover, the current political climate and lack of liquidity from banks suggests that MFIs will probably not have the option of relying on rapid growth to escape the overhang from so many bad loans.
If you’re taking in new capital hand over fast, and expanding even faster, you may not realize you’re running a Ponzi scheme.
I knew I was running a con scheme …
You may honestly believe that your profit rockets will ignite if only you can keep multiplying the users, customers, and capital sources. Only when “the market turns against you,” as a corporate banker I knew forty years ago would put it, ashen-faced, is your unconscious flimflam revealed.
I did fine until the recession
Then comes time for the fiscal cleanup – a slow and painful process.
Before effective recoveries could begin, a receiver would have to be appointed to manage the recoveries and wind down the institution.
I’ve previously written about receivership for my US for-profit, Recap Advisors. It’s equivalent to going into administration, with this exception – it’s a stopgap. The entity is kept as a going concern, and the receiver is always intended as an interim figure with the expectation of handing responsibility back to current management or their creditor-appointed successors.
This should be done as soon as the MFI falls into insolvency or defaults, while core staff is still in place. Ideally, the MFI would be taken into receivership by way of early regulatory action under pre-existing statutory authority (see, for example, the US FDIC).
There is the point – receivership or administration requires an instrumentality of the sovereign government that can provide countercyclical creditworthiness.
However, it’s unclear that such authority could be established in the present political environment, and moreover, it would take some time to set up.
These entities tend to be needed instantly but, catastrophe being a precondition to fundamental financial reform, to emerge only after the crisis (the Federal Reserve, for instance, came into being only after the Panic of 1907).
Shoulda installed those safety breaks, shouldn’t we?
The FDIC as a guarantor of deposits arrived only after the Great Depression’s run on the banks.
The UK didn’t guarantee deposits until after the run on Northern Rock
Nevertheless, the absence of a statutory authority to take an MFI into receivership does not prevent creditors from appointing a receiver through court action. The difficulty in such a circumstance is two-fold:
1. The selected receiver must be experienced in microfinance and understand the complications that arise when attempting to liquidate MFI portfolios, and
2. The legal process must avoid creating roadblocks that undermine the receiver’s ability to effectively discharge its duties.
True enough, but in this space, there are two enormous unknown risks:
- Widespread borrower boycott
- Government-sanctioned payment waiver
Once a receiver takes over the MFI, its task requires following two parallel tracks: (a) to seek out MFIs that would be interested in one or another portion of the portfolio, while (b) maintaining collections with the clients.
Doesn’t this sound more and more like the US subprime debacle writ microfinance? If so, the crisis will become national, structural, and consuming.
Obviously for the latter it cannot use any pressure tactics, as these would in any case undermine the very efforts to collect.
Don’t pressure us
How does one collect without ‘pressure tactics’? In the absence of an or-else, what is the borrower’s motivation to pay anything?
The tie-up with other MFIs is particularly critical, for that is the means by which a winding-down MFI can maintain its borrowers’ repayment incentive. Generally speaking, there are several ways of accomplishing this. Once could sell the full portfolio at deep discount, and let other MFIs attempt to collect. This is probably the least effective approach.
Effectiveness depends on your value function – if you value speed and market clearance, then a deep discount is the fastest and best. The RTC used structured auction, which combined speed and certainty with an upside share reverting to the government.
Another approach is to agree with the purchasing MFI on a threshold of re-performance after which the loan would be purchased. For example, once a borrower makes 5 payments, the MFI would buy the rest of the loan at some pre-agreed price. To achieve this, the two entities would have to effectively communicate the plan to the borrowers, ideally by making joint presentations of the new plan to the borrower groups.
Or the new entity could buy the whole pool of loans quickly, in bulk, at a formula price, with a post-purchase right of rescission (which, as we saw in a previous blog post, works well in low-volume times but is swamped by a high default volume).
A similar approach would be to have the borrower fully repay the loan, and then become eligible for the next cycle loan from the transferee MFI.
Growth of microfinance institutions, borrowers (log scale)
This would be the lender’s ideal situation – repay your loan in full and we will restore your credit and then lend to you again. Like all the preceding solutions, it presumes that the buying entity have ample liquidity of it own, because all these strategies require patience.
Importantly, the failing MFI should not expect to necessarily receive additional payment for such a transfer, and in some cases it should even be prepared to share some of the repayment proceeds with the transferee MFI. The ultimate outcome depends on the level of trust and the transferee MFI’s interest, but it is critical that the receiver and creditors realize that the primary objective of the transfer is to maintain the borrower’s repayment incentive.
Correct. Mr. Rozas is proving that in recapitalizing a defunct lending entity, you must mark the book to market, at large discounts, so that the buyer can restructure and work out as required.
This is not a theoretical point – a very similar situation during the liquidation of FOCCAS in Uganda in 2006 resulted in creditors rejecting exactly such an arrangement out of concern that they were “giving away” their clients for free, but which ultimately cost them far higher losses when clients stopped paying altogether.
Payment is a habit. Non-payment is a habit. When the habit of payment is replaced by the habit of non-payment, the consequences are seismic.
Bette change your habits
Throughout the collection period, it is imperative that extensive consideration be made of staff incentives. Staff would normally have little motivation to help transfer a client to a new MFI, thus helping themselves out of a job.
We saw exactly that in the US with the House of Representatives’ incredibly short-sighted attempt to penalize AIG’s bomb-defusers.
Thus, provisions should be made either for transferring staff to the new MFI, or providing bonuses or other incentives for collections.
That’s a lesson with which Kenneth Feinberg might now, reluctantly, agree.
Failure is a normal part of the business landscape. It helps weed out weaker players, provides object lessons for others, and is a necessary counterpoint to the evolutionary process of creative destruction. But there are different kinds of failures. The impact of some might be so minimal that they are only felt by management and shareholders, with clients and creditors experiencing no direct impact. Other cases can result in massive losses not only to investors, but also creditors, clients, suppliers, and the rest of the economic ecosystem that was dependent on the failed enterprise.
The Andhra Pradesh structural defaults arising from payment boycott will prove a watershed in Indian microfinance, and hence in global microfinance. They are too large to dissipate like dew in the morning sun – the sector will need to recapitalize and its regulatory and operating frameworks will be different after the recapitalization. But just how that recapitalization occurs is, in fact, critical.
Failures resulting from the current crisis could go either way. If badly handled, they could well cause banks and investors to shun MFIs for years to come, bringing the sector to a standstill (cf page 61 ff).
Not just traffic would be stopped dead
South Africa‘s Servcon experience, mentioned yesterday, set inclusionary banking/ lending back half a decade, if not longer.
A well-handled failure could actually strengthen the sector. If a failure of an MFI can demonstrate that resulting losses to creditors are manageable, it could also serve as an important demonstration that a savings-based MFI would also not present an undue risk, perhaps leading RBI to allow deposit gathering by MFIs.
For any financial institution, deposit-gathering is the end stage – it’s the retail source of capital, the cheapest source of capital, and the one that most clearly is predicated on the public interest – which in turn means strong governmental regulation. Deposit-gathering will come after, not before, the sector’s recapitalization and the emergence of a new post-consolidation regulatory, liquidation, and takeover infrastructure.
In the end, a chastened, more experienced microfinance sector could ultimately provide better quality services to the poor than has been the case during the go-go years of the past half-decade.
Vinod Khosla’s timing is looking better and better.
Part of wealth is good timing