How policy encourages the banks to fleece us

Yesterday’s El País carried what to me was an extraordinary story about repossessions of Spanish homes. The recession has seen the number of repossessions in Spain rising to 100,000 per year, but far from suffering for making dumb loans, the country’s mortgage laws allow banks to profit from their clients’ failure to pay.

Repossession policy dictates that if a propert has to be handed over to a bank because its owner cannot keep up with mortgage payments, the bank must endeavour to sell it at auction, and use the proceeds to reduce the amount owed. In the current, stagnant environment, however, nobody is buying, even at repossession auctions, and much of what is on offer goes unsold. Such an eventuality does not perturb the banks, however – indeed, they are probably delighted not to sell – for in the event that a property fails to attract a buyer at auction, the bank gets to keep it for 50% of what it is adjudged to be worth.

Let us say, therefore, that someone has taken out a €100,000 mortgage on a house which at the time the bank judged to be worth €100,000 (many banks, of course, made 100% loans during the boom), and that after paying, say, €10,000 plus interest of that loan the debtor loses his job – not uncommon in a country with 23% unemployment – and can no longer make his monthly payments. The debtor now owes €90,000. The bank tries to sell the house at auction, with a reserve of €75,000 (the Bank of Spain says official house prices have fallen 17%, and the bank knocks off a bit extra to make it look like it is keen to sell). Nobody is interested. The house goes unsold. The bank acquires the house for €41,500 (50% of the official value of €83,000), and the debtor, who is now homeless and jobless, still owes it €48,500, plus interest.

It won’t have escaped your notice that this is a remarkably good deal for the bank. First, it received €10,000 plus plenty of interest – let’s estimate a further €10,000 – from the hapless debtor before he lost his job. Second, it is still owed nearly €50,000 plus interest. And third, it has acquired a house worth perhaps €60,000 (if we ignore the overoptimistic official figures) for just over $40,000. Even if the debtor now does the sensible thing and tells the bank where it can put the rest of the debt, therefore, the bank will have lost just 20% of the loan. Most debtors, however, will not be so bold, and will attempt to pay back the rest of the loan for fear of losing their hard-won creditworthiness. In the latter cases, the bank will have made a profit on the original €100,000 loan of €20,000 plus several additional tens of thousands in interest, so unless significantly more than half of debtors tell the bank where to go it cannot lose on these deals.

Of course, the above example is theoretical and the actual figures are likely to vary somewhat – the bank might sell the house for €70,000, adding another ten grand to its haul, and there are costs of selling to account for too. But unless I have miscalculated it does not seem too far-fetched. Under the current policy, banks benefit by making bad loans. Since most people will try to pay back the loan even though they no longer own their property, banks can easily withstand a few bad debtors, and it is not surprising in an industry where profit rules that their vetting policy is less than rigorous. A couple of commentators in the El País article recommend raising the 50% of the value at which the bank acquires the property to 70% – this would seem a bare minimum to avoid the moral hazard created by the current law. The protesters in the 15-M movement rightly blame the banks for causing the housing crisis, but where policy puts them in a no-lose situation it is inevitable that many will take advantage.

Recession hits the world’s poorest

Of course, traditional banks like Ecobank look down on microfinance as a small-fry, over-risky industry. In Freetown I met SB, who heads a not-for-profit microfinance institution (MFI).

Set up in 2002 by a large American NGO but now self-sustaining, it has 20,000 members in four Sierra Leonean cities. It lends sums of between $120 and $2000 – in a country where most people live on a dollar a day, this means the loans are too large for the poorest people to access (SB says small loans are too costly to administrate).

Loans are for “income-generating activities” only. That is, not for weddings, funerals, medical bills or luxuries, for example, although SB is receptive to my argument that the first three of these can indirectly lead to improved income-generating capacity by relieving stress and strenghtening health (he also admits that some loans probably end up being spent on consumption rather than investment).

Most of the loans are repaid over 6-10 months, with repayments made weekly. They do not come cheap. The monthly interest rate is 3% – with inflation at around 11% this works out at an annual rate of 25%. And to this must be added the cost of travelling to the MFI’s office to make repayments (my medicine seller friend Musa said he gave up his membership because having to pay every week was too tough – his business is collapsing, and he asked me to fund him last week instead). Clients put up with these rates because they are poor, and cannot access cheaper loans because they lack collateral and credit ratings – SB’s MFI relies on word of mouth references, visits to inspect businesses, and guarantors.

Eighty per cent of clients are self-employed businesspeople, who borrow to buy palm oil for cooking businesses, refrigerators for storage, baskets and trays for hawking, and stock. The other twenty per cent are salaried but moonlighting. Eighty per cent of clients are women because, as SB says, men want to shoot for the big pot so they look down on small loans. Women are also much better payers.

The recession has hit the MFI’s clients hard. Remittances and investment from abroad have slumped, and the increased costs of food and fuel have hit customers. Many small enterprises, says SB, have gone to the wall. The normal default rate on loans is 3-4%, but in 2009 11% of money loaned was not repaid. As SB put it, “You might want to pay back a loan but if you have the choice of maintaining your credit rating or feeding your family, you don’t worry about not being able to borrow again in the future.”

If clients do default, the MFIs have limited options for chasing their losses. SB threatens to take bad debtors to the police but never carries it through because he knows it won’t help him recover the money. He worries that “clients talk to each other,” and come to see not-for-profit MFIs as a soft touch. Readers of Hernando de Soto will not be surprised to hear, moreover, that in many cases SB can’t even find his errant clients – some don’t have identity cards, and changes of address are frequent and go undetected by officialdom.

SB’s profits (which are all reinvested) have halved in the past year. Other MFIs have seen similar or worse slumps – in Morocco, once the poster child of African microfinance, the government has had to step in to help as several MFIs went bankrupt after defaults soared to 30%.

Because of the recession, many MFI clients have resorted to “multiple borrowing.” They join several institutions at once, borrow money from all of them, and often fail to repay. The problem is so serious that SB’s MFI has stopped taking new members until it figures out a way to stop the multiple borrowers. Such is people’s desperation, he says, that “if we opened up our membership now, we’d have 200 applicants queuing outside our office every day.”