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Credit Crunch: The Domino Effect


Microfinance is expanding in Latin America. Economies are growing and stabilizing and commodity exports are selling at good prices. International capital markets have opened up, and everything seems possible. Ladies and gentlemen, welcome to Wall Street, where we have discovered the most ingenious financial instruments engineered by Citigroup, Morgan Stanley, Deutsche Bank and Standard & Poor’s. Why do we have to worry about the mortgage crisis with our great partner to the North? The honest answer–—“CLO.”

The mood was one of pure celebration on June 3, 2008, at the administrative headquarters of Blue- Orchard Finance in Geneva, Switzerland. The Financial Times and the International Finance Corporation were hosting the Sustainable Banking Awards ceremony, and a venture by BlueOrchard and investment bank Morgan Stanley to loan money to the microfinance industry had just won the award for “Sustainable Deal of the Year.

The transaction known as BOLD2 (for BlueOrchard Loan for Development), made a big splash when it was launched in April 2007. The Collateralized Loan Obligation (CLO) was structured by Morgan Stanley to loan almost US$110 million to 20 microfinance institutions selected by BlueOrchard in 12 countries around the world, including Colombia, Nicaragua and Peru.

This was not the first time that a group of microfinance institutions had come together under the umbrella of a CLO to obtain financing in international capital markets. Nor was it the first CLO for microfinance, or even the fi rst BOLD transaction for Morgan Stanley and BlueOrchard. Both firms had previously joined forces to structure a similar securities-backed loan to microfinance institutions in 2006.

But this time Morgan Stanley had crafted a “currency swap” mechanism that would allow more than 60% of the obligations to be placed in local currencies, including Peruvian soles and Colombian pesos. It was also the first time that a major international rating agency—Standard & Poor’s—ranked a debt issued for microfinance. This fact alone was enough to attract top institutional investors.

And so it happened again. The BOLD2 securities were issued in less than a month, backed by 21 investors, among them banks, insurers and mutual funds—the cream of the crop of corporate finance. But in truth, that night in Geneva, just as BOLD2 was receiving the award for Sustainable Deal of the Year, its business was no longer sustainable—and had not been for several months.

The Innocent Pay for the Guilty
Ironically, the market began to dry up almost immediately after the BOLD2 notes were issued. “We are no longer investing in debt papers,” said Paul DiLeo, managing partner of Grassroots Capital Partners and CEO of the microfi nance investment fund, Gray Ghost Fund, adding that this policy had been in place at his firm for 18 months. A source close to Morgan Stanley said that BOLD2 could not be established today, nor would it have been set up in the second half of 2007.

“The market froze abruptly,” said DiLeo. Several CLOs scheduled for early 2007 never materialized, and at least one, which was launched and placed in the market, was open for several months without success.

The truth is that BOLD2, the greatest success of fi nancial engineering in microfinance, was also among the last, along with the initial public offering (IPO) of the Mexican microbank Comportamos. Both
enterprises were launched in April 2007, and 16 months later, there were still no takers.

Morgan Stanley created a microfinance unit when it realized the opportunity presented by its BOLD transactions.  More recently, however, the unit began to explore new products,  recognizing that the CLO opportunity had drawn to a close.

What happened? By and large the over-indebted mortgage crisis in the United States became evident in
the second half of 2007 and within a few months led to the resignation of the presidents of Citigroup and
Merrill Lynch and the collapse of Bear Stearns, the fi fth-largest investment bank in the United States Mortgage loans saved the U.S. financial system after the high-tech investment bubble burst in late 2000.  “The houses that saved the world,” read a headline of The Economist magazine. But the excess of money in the hands of banks and the sustained increases in the cost of housing provoked a new bubble that replaced the previous one. Banks began offering high-risk mortgages known as subprime loans because they are offered to low-income clients with high interest rates and hefty bank commissions. Clients became indebted thinking they could pay their mortgages by selling their homes at profi ts similar to what they had seen in previous years. And since mortgage debt can be sold in the form of bonds or secusecuritization of credit, a high volume of subprime obligations was transferred into investment funds and other institutional investments.

The 2007 mortgage crisis was unleashed when investors noticed the increase in delinquency and default rates. But they were slow to realize it, due to the growing automation of the securities market and an unprecedented abundance of liquid assets. It did not help that when the banks began to feel funds tighten, they turned to mechanisms such as CLOs similar to the microfinance transaction launched by Morgan Stanley and BlueOrchard, but backed by housing.

The repercussions were evident. Banks and investment funds had compromised their assets in high-risk
mortgages and caused a contraction of credit (the now famous credit crunch) and a downward spiral in investors’ confidence. By the end of 2007, Citigroup announced losses of US$6 billion and Merrill Lynch recognized that it had unrecoverable loans of almost US$8 billion. If the giants collapsed, who would invest their trust and money in unknown microfi nanciers in the emerging markets?

The Other Side of the Coin
Experts and investors agree that the contraction of microfi nance lending markets has no relation to the quality of the industry’s assets. “The truth is that microentrepreneurs and microfinanciers are not subprime clients— they’re prime clients,” stresses Tomas Miller, microfinance specialist at the Multilateral Investment Fund (MIF) of the IDB.

The underlying assets of the industry remain as strong as ever, agrees Paul DiLeo of Grassroots Capital Partners. The primary hesitation for investing in microfinance is the same across all investments because all markets are contracting, irrespective of the quality of assets in a particular industry. The relative increase in interest rates occurring today, DiLeo adds, is a product of diminished global liquidity after a number of very liquid years.

“Simply put, a perception of greater risk exists on the part of investors,” a source close to Morgan Stanley concurs. “Those who could have been content with a 12% profit margin yesterday now want a 25% margin, and microfi nance institutions are not willing to pay such high interest rates.”

CLOs and other financial instruments structured by the magicians of Wall Street helped build up the brand image of the industry, explains DiLeo. They gave visibility and legitimacy to microfinance  as a sector capable of playing on equal footing in international capital markets. They may have been useful public relations tools, yet their sudden end has not had a visible impact on the industry. Microfi nance institutions continue to have access to the capital needed to carry on their business. “Most funding comes from local sources,” explains DiLeo. A participant in BlueOrchard and Morgan Stanley’s award-winning operation shares his opinion: “MFIs had received local funds and many were already well-funded when they contracted the credit,” he says. “The CLOs can help diversify fi nancing sources and stimulate cross-border investments, but microfi nance institutions in the region have not lacked capital.”

Not all was rosy during microfi nance’s fl eeting surge in international capital markets. While some microfinance institutions offered shares on the stock market or complex financial transactions on Wall
Street structured by wealthy investment bankers, donor agencies and social investment funds urgently
began examining how they were handling their own funds. Had they become irrelevant? Would they have to reinvent themselves? Had they donated resources to institutions that were seeking profi t rather than development, while charging higher interest rates than commercial banks?

The rise and fall of microfinance’s structured debt during 2006 and 2007 “makes us refocus on the basis of the industry,” says Kate McKee, of CGAP. “Perhaps now it will be good to refocus on the underlying assets and directly buy corporate debt from microfinance institutions.”

But another CLO? “If the markets return,” sighs one participating investment banker nostalgically, “that’s my dream.”

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