The subprime crisis and microcredit
A summary of the causes and the consequences of the subprime crisis, and consequences for microcredit
By Tim Harmsen

Centuries from now, people will remember the financial crisis of the years 2007 and 2008. In this article, I would like to give you an overview of how this crisis came into being, what the consequences were and how these affected microcredit. In short the crisis occurred because mortgages weren’t covered by the collateral. Whenever you get a loan, you need to provide some collateral. In case you aren’t able to repay the loan, the collateral becomes the property of the loaner. In the case of the subprime crisis, the collateral wasn’t enough to repay the loan.
The mortgages were issued to people who weren’t supposed to be able to get a mortgage in the first place. Mortgages issued to these people boring a high risk of not being paid back (risk of default); hence the (euphemized) name; subprime. Why then, did the banks issue these mortgages? Because house prizes were booming, so the collateral became worth more and more every day, hence all of the subprime mortgages were overcollateralized, at least for some time. In case of delinquency of the mortgage, the bank was better off than when it was actually paid off.
Things started to get bad when the prices of homes in the US started to drop; the mortgages were now undercollateralized. Going a little back in time, banks pooled these mortgages in “Mortgage Backed Securities” (MBS). You can forget this term (but not the abbreviation) immediately. Due to US regulation, banks were now able to sell investors the subprime mortgages in this MBS package, allowing the investors to bear the risk associated with the subprime mortgages. The investors, on their turn sold the MBS to other investors. Why did people buy a risky product with mortgages that were bound to default? Because they got incredible ratings by independent bureaus that were respected by every investor. These bureaus were privately owned and their customers were the issuers of the MBS’s. If a bureau gave a rating the banks was dissatisfied with, they went to a bureau that delivered the rating they wanted. So there we have it all. This subprime mortgage flow was fortunate for the banks, for they got a hefty transaction sum on top of the entire worth of the mortgage as once. As a bonus, they were also rid of the risks. This positively impacted the issuing of inferior mortgages, leading to a kind of an infinite loop situation. Except that it wasn’t infinite, it ended in the catastrophe now known as the “subprime crisis”.

The consequences of the subprime crisis
Selling and buying MBS’s was such a lucrative business, that several banks and investment institutions invested large sums of money in it. Money that was mainly coming from major bank loans. As soon as the holders of these mortgages failed to meet the final payment dates (defaulting), problems started. The loans the investment institutions owed needed to be paid. Payments and interest were taken care of with the money the MBS’s generated, but when these stopped generating money and started losing money, the investment institutions started to get in trouble. That’s why Lehman Brother went bankrupt, which was one of the 3 out of 5 five biggest banks in America. Some business banks had been clever and covered their risks by insuring their MBS’s. One of America’s biggest insurers, AIG, needed to be bailed out by the American government because it didn’t have enough money in cash to pay for the defaulting MBS’s that they insured.
This shifted the spotlight to the subprime mortgages, so everyone soon started losing faith in the home financing business. Quickly, every supplier and demander in the home-owner chain felt the consequences of the crisis, when everything from contractors to concrete manufacturers saw the red figures accumulating in their balance sheets.
Individual homeowners saw their homes net worth decline, while people looking to buy a home weren’t able to find a bank willing to supply a mortgage. Then there were renters who were evicted from their homes because this was foreclosed because their landlord had defaulted. These events led to a decrease in consumer confidence, which led to decreases of consumer expenses, which now have caused the make three big US car manufacturer’s to apply for a governmental bail out.
Investors moved their money into save commodities, such as food and oil, skyrocketing the prices of food and energy.

How does the crises affect the market of microcredit?
At Oikos, we are concerned with how this crisis is impacting microcredits, that is why we follow this discomforting trend closely. Where do we start when we want to evaluate the consequences of the subprime crisis on microfinance? At the beginning, which is in this case an overview of the microcredit chain. The flow goes from the investors (in the case of Oikos: you) through subinstitutions and organizations (like Oikos, Oikocredit, BRAC, CD, Strømme Stiftelsen) to the MFI’s, that distribute the money to the people who need it. The chain is as strong as the weakest link, so we are going to look at how each links is affected. However, for some elements in the chain there are also positive effects
Starting with you; how are you affected by the financial crisis? There is only one person who can answer that best, but we can say some general things about individual private microfinance investors.
Generally, private consumers are careful with their money and might be hesitant to ‘invest’ in anything, even something like microcredit which is in no way connected or responsible for the global crisis. Some people may withdraw their money from microcredit institutions to move it to someplace where they think it is safer.
Institutional investors like charitable organizations fear donations might go down due to people cutting down on their spending. These organizations also invest money in microcredit, so this means that there could be less money available.
Due to these things, MFI’s receive less deposits, and money might even be withdrawn from MFI’s, so less microloans could be issued. This may trigger a snowball event leading to even less microloans available. Because, as soon as microborrowers see that no money is going to be available for a next microloan, why would they pay of the current loan? Because of faltering payback rates, even less loans will be issued, etc.
The same thing could happen due to increased interest rates the MFI’s have to charge because of the funding being so scarce.
There are other risks, too. The high food and energy prices mentioned earlier, could lead to inflation. This is also called “valuta risk”. Say that 100,-DKK are loaned to a woman who wants to buy seeds for her farm. That 100 krones are exchanged in, say 1000 units of local currency. Note that she owes 100 krones. Due to inflation, the exchange rate changes to 2000 units of local currency are worth 100,- DKK. Now she needs to pay back twice as much. And this example assumes no interest. Inflation of local currency could in theory be possible, but we see that in some places, the opposite has happened. The strong euro or dollar have devaluated relative to the local currency, and borrowers end up paying less then they initially borrowed.
So if there are at all negative consequences for microcredit, they are mainly caused by decreased consumer confidence. Due to this the whole microcredit chain will be affected. Consumers decide to withdraw deposits, consumers decide to not-invest after all, consumers decide to invest less. This has an impact on the amount of money Oikos receives, the amount of money MFI’s receive and eventually the amount of money available for microloans.
We don’t know to what extend this will happen –no one knows. After all, people concerned with microcredits hold different values and beliefs than the default consumer. 

I hope that I have given you a good overview of the crisis and its consequences for microfinance. You can always e-mail your questions (in English please) to tim@oikos.dk


Information from the following articles was used in this article. There are many more details in them. Language of all the articles is English.
http://www.wikipedia.org, article on the subprime crisis
http://news.bbc.co.uk/2/hi/business/7073131.stm
http://www.time.com/time/business/article/0,8599,1863443,00.html
http://www.iht.com/articles/2008/11/17/business/micro.php
http://crisistalk.worldbank.org/2008/11/microfinance-an.html
http://www.microcapital.org/microcapital-story-the-global-financial-crisis-and-microfinance/
http://www.vccircle.com/500/news/microfinance-less-impacted-by-global-crisis-says-akula
http://www.microcreditsummit.org/enews/2008-10_all.html
http://www.symbiotics.ch/en/latest_news.asp?id=b1354
http://groups.google.com/group/planetdhaka/msg/7b95888263ffe156