The fallacy of unsecured lending

2013-07-24 22:11

Microfinance, or what has become more recently known as unsecured lending has been hitherto a source of finance that mainly served the disadvantaged and the unbanked.

Since the abysmal financial collapse of 2008 the apparent shift from mortgage and secured credit towards more expensive, unsecured credit has undoubtedly unmasked an opportunity among low income borrowers in terms of home improvements, but has also signaled a new market opportunity among high income borrowers through the creation of 80/20 finance (or 80% financed, 20% cash).

But, in an environment that is inconsistent with the current economic climate, where real GDP growth has averaged 2.2% and inflation 6.3% since 2008, the growth spurt in unsecured credit, the bulk consisting of credit cards and store cards, may just be a reflection of consumers' financial fragility (own calculations).

I'd like to shed some light on what I dub a misconception of these loans. Although microlenders' claimed uses of unsecured loans have not completely been dumbfounded, numbers don’t lie. The creation of so-called 80/20 mortgages may be supported by the moderate growth in mortgage agreements but subdued growth in the outstanding mortgage debtors book, indicating that mortgages are smaller than they were prior to the crisis and that unsecured loans are used to bridge high income borrowers' unmet demand for secured credit.

But, the conclusion that low income borrowers use unsecured loans for home improvements is based on the premise that many of these households do not have title deeds on their homes, making it difficult for them to access mortgage finance. Although difficult to prove, the fact that loan sizes are consistent with the level of income together with the composition of expenditure of the average low income borrower who has a monthly median income of R2800 suggests that unsecured loans are used for current consumption (Statistics South Africa, 2010). Keep in mind, ex post 2008 less than 5% of all outstanding loans of the two leading unsecured lenders (I’m not mentioning names) matures within one year, highlighting the mismatch between the consumption and repayment period.

More surprisingly, the number of consumers with impaired records in the year to March 2013 is up 480 000, up 168 000 for those who are 1-2 months in arrears but still regarded as in good standing, and up 237 000 for those who are 3 months in arrears but have impaired records. Unlike the upward, the number of civil judgments and administration orders is down 76 000 for the same period (NCR, 2013). Enough said? Although it is very difficult to prove, this, together with the emergence of fancy consolidation loan products indicating that borrowers have multiple loans may infer that long term loans are used to settle existing debt.

Without a question, the rapid growth in unsecured lending has been largely supply side driven, citing the relatively attractive profit margins, the decreasing returns on mortgages and the Basel III regulations that restrict a mismatch between long-dated loans and shorter-term deposits, as reasons, among others. If one recalls the microfinance crisis in 2002, one can rule out the possibility that the perceived attractiveness and the profit margin on unsecured loans is a reason for the rapid growth. In the years that led up to the 2002 crisis, the 1999 Exemption of the Usury Act, which permitted lenders to grant loans of R10000 or less at interest rates that exceeded 30% per annum but repayable over 36 months or less had effectively allowed for the mistreatment of financially ignorant and illiterate low income households. The industry exploded.

Today, however, the industry has exploded but it seems that things have reversed. The introduction of the NCA in 2007 has protected borrowers against exorbitant interest rates, but the fact that there is no enforced maximum loan term increases the borrower's event and default risk, especially for those liquidity constrained, low income households who stretch their affordability to meet their short term needs. A fundamental flaw of unsecured loans, well, according to me, is that its sustainability cannot be rationed solely in terms of affordability because affordability assessments are subjective and dishonest responses are unrestricted, especially for those borrowers who really need the money.

Like the rapid expansion in the microloan books of then microlender Unifer and Saambou and the subsequent rise in lenders’ provision for bad loans that led to the 2002 crisis, it’s easy to be blinded by the level of bad debts when there’s a rapid expansion in loan advances and the perceived creditworthiness of low income borrowers are overlooked by the strong interest income.

Although the South African consumer is better protected, to an extent (besides the 30% + interest rates and unrestricted loan terms) than they were in the past and lenders have taken better precaution in terms of their stringent lending criteria, I’m unassuming to remind you that history repeats itself.

Figures are rounded off.

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