Microfinance is far more than simply lending money. It's investing in people using small amounts of capital and large amounts of know-how and support to help assure their success. Muhammad Yunus, an economics professor, along with the Grameen Bank, worked to alleviate the plight of poor women in Bangladesh. In 1970, Yunus started out with just $27, out of his own pocket, and began lending to poor women to buy supplies so they could maintain and grow their business. He won the Nobel Peace Prize for his efforts. And microfinance really grew going forward, moving out of the strictly philanthropic arena to become a more mainstream investment opportunity. Microfinance institutions, MFIs, generally lend to groups of women, which are then responsible for distributing the money, collecting the money and paying the bank. These are very small loans. In places like Bangladesh, the loans are usually less than $500 and the borrowers are people who are living on about $2 a day.
Howard Finkelstein, who recently left a national firm to establish his own practice at Law Offices of Howard J. Finkelstein in Brooklyn, New York, focuses a great part of his practice on structuring capital market instruments to bring western capital to MFIs worldwide. He is one of the country's pioneers in the securitization of microfinance-related obligations. In 2004, he was the lead attorney in the $87-million securitization known as Blue Orchard Microfinance Securities I, in which he successfully structured the securitization of loans to microfinance institutions in seven countries spanning three continents. He was also the lead attorney in the $60 million securitization known as MicroFinance Securities (MFS) XXEB, in which he successfully structured the multi-currency securitization of loans to 30 microfinance institutions in 15 countries. His work has helped bring nearly $1 billion to MFIs worldwide. Finkelstein talked to Lawdragon about MFIs, the challenges of funding them, the risks and benefits of these investments, and what the future holds for the practice.
Lawdragon: What got you interested in microfinance in the first place?
Howard Finkelstein: I come from a credit and structured finance background. In my finance career, I've always been focused on odd asset classes. Before I started with microfinance, my career highlight was securitizing the music royalty stream of the British rock band, Iron Maiden. I love the intellectual challenge of structuring and documenting a deal that satisfies the legal and business issues, of charting new territory and the satisfaction of having met a client's objectives. People in the banking community seem to know me as one of the guys to go to when talking about structuring securitizations of things that have never been securitized before.
One day I was approached by a banker friend who said he wanted to bring in some people to talk about microfinance CDOs. I said, I know about CDOs but I just don't know what microfinance is. I was given a short lesson on microfinance. My eyes lit up and I said, "Wow, this is really unbelievable." This was in December 2002. It took two years to close the deal, and it was probably the hardest deal of my life, and the most personally rewarding. Since then there have been a lot of other deals, very interesting and very successful deals in microfinance, and I guess it's become a passion for me, a very important part of my life and an important part of my career as well. It's a wonderful thing to be involved on a daily basis in something you really believe in.
LD: You worked on a number of huge deals, including one involving 30 institutions and 15 countries - what are some of the challenges of handing such a complex deal?
HF: There are a lot of challenges. A lot of it is that you have to deal with people and institutions that have never been involved in international capital markets transactions. A big challenge six years ago was educating microfinance professionals on the nature of international capital markets transactions and educating the capital markets professionals about microfinance. You have to educate them about the opinion they are signing, about the need for complex loan agreements, and about the terms among other things. You deal with that and you deal with credit and related problems, which are always at the forefront when you're lending. Sometimes your lenders want to be paid in one currency and your investees want to pay in another currency. Those are always interesting issues. But really, a lot of the hard work is educating people involved in capital markets transactions about what microfinance is all about and educating the people who are the backbone of microfinance about what it takes to do capital markets transactions.
LD: What types of business and legal issues relating to microfinance do you see in your practice?
HF: As I mentioned, currency is a really big issue. There are disclosure issues, obviously, for investors. There are tax issues. There's diligence as well, which is extremely important. And in every deal you want to have local counsel for each country you're in. It's important to communicate clearly to make sure the terms you discuss with local counsel are consistent with the expectations of sophisticated investors. It's like speaking two different languages, because you're usually dealing with lawyers without a lot of experience addressing concerns of developed-world investor. And people have to have a lot of patience before they can get into a venture, before lending and investing. There's just a lot of work to be done. One of the things I try to do is sort of have a database or checklist of what you need to know before you invest in a country. But again, when you're doing deals that are unprecedented, the most important service you provide for a client is to be able to develop a legal structure that satisfies its business concerns.
LD: What are the interest rates that borrowers pay?
HF: There are places and circumstances where borrowers from microfinance institutions, or MFIs, pay annualized interest rates as high as 80 to 100%. But the thing is that if they weren't able to make a go of it paying those rates, they wouldn't be doing the program. These are not people who have 401Ks to dig into to get the extra money. Also, if their profit margins weren't so high on the items that they sell, then they couldn't pay the interest rates. And second, microfinance companies, generally speaking, are sort of business advisors, teachers, and technical advisors to a lot of their customers. That's why they have to charge high rates. The MFIs' costs are just that much higher than those in the West originating credit and mortgage loans. MFIs are partners with their borrowers.
Obviously there is potential for gouging poor people. But you have to see the impact of MFIs. If you have an MFI that is charging very high rates and the borrowers are simply maintaining subsistence levels' and their lives are not really improving at all - then it's not an efficient program. It's not good for anything. People are not going to invest money. But if you see that the borrowers are paying the rates and are also improving their lives' sending their kids to school, able to put heat and energy into their houses' then it's working.
LD: So, would you say that it's really an entire program, including helping the people learn business skills and the other resources provide to the borrowers that enable these programs to succeed?
HF: Yes, but the main thing is the lending of the money and everything that goes along with it. The basic premise is that you can't alleviate poverty by simply giving money to people. You can only alleviate poverty by actually empowering the borrowers, particularly women, and giving them the means to make money themselves. The same goes for microfinance companies. The basic premise is that they have to be sustainable. But there are some MFIs that just can't provide services other than lending money. It just depends on their circumstances. The central thing is that they can improve people's lives by lending them money so they can maintain their businesses.
It's a combination of factors that get MFIs to succeed. I think one of the factors is the boldness of the people who operate these microfinance companies. The programs that have been bold have succeeded and the ones that haven't have not succeeded as well. Also, different areas of the world require different strategies. The other thing is getting money. That's where I come in. That and a good business plan. Most start-up MFIs work with governments, NGOs or government-related entities, foundations or church groups and things like that, which help to get MFIs off the ground.
LD: How did microfinance move out of philanthropy and the public sector to become a more mainstream investment opportunity?
HF: It was a gradual movement. There were people out there who said there are a lot of poor people in the world and they could be helped by this. If we build a business model that's profitable, we will attract capital. Also, 2005 was the U.N.'s Year of Microfinance. The U.N. put a lot of work into publicizing the cause of microfinance and how it works over the course of the year. When Muhammad Yunus won the Nobel Peace Prize the next year for his work in microfinance, well, that was really the tipping point. People who had worked hard for 20, 30 years with little or no recognition were now being sought after by investors and governments.
LD: What do you expect for the future?
HF: Well, it depends. One factor is what is going to happen to the world economy. This breaks down to what is going to happen on two important levels. Number one, what's going to happen with the borrowers? Is the world economy going to impact on these people wherever they are? There's been a lot talk over the last five years about how microfinance is a non-correlated asset class. In other words, it will not react with changes in the world economy. It is unlikely that people in Bolivia selling fish will be affected by the economy because people need fish they need to eat. So that is not likely to be changed by the world economy. On the other hand, there is a lot of concern that food inflation and general recession may affect them. We don't know. The evidence isn't in yet. We'll see in about a year.
The second level relates to the microfinance companies themselves. With interest rate fluctuations and other difficulties in the economy, are they going to be affected at the ground level in terms of being able to hire the right people to develop programs and reach out to more people to borrow? And the third thing that impacts all of this is the continued availability of a greater supply of capital from the western world into microfinance. The fact is that investors who put their money into microfinance over the last few years have done better than those who put their money into subprime, blue chips, major financial institutions and many hedge funds. If the microfinance sector can get that message out to the investment world, we will see continued growth.
LD: What types of risks and rewards are there for investors? Obviously, money's a reward.
HF: Essentially, the repayment rate of micro-loans is about 98% worldwide. It's amazing. The evidence is that this hasn't changed, but we'll have to see. In terms of the risks, in the past 20 years, no western investor has lost a penny investing in microfinance. That doesn't mean there aren't risks. It just means the risks have been averted.
In terms of rewards, the rate of return is somewhat below market rate. It's sustainable, but it's not like you reach a level of Madoff investments. The fact is we aren't just talking about individuals and families and nations, we're talking about companies, pension funds that have determined that we'll take a cut in what we normally would get because there's a double or triple bottom line. In other words, we make profit, which may not be as much, but at the same time we also get the satisfaction of helping to alleviate poverty.
LD: Do you think the economic downturn will impact which countries investors choose to invest in?
HF: I think there are always countries that are more or less attractive in terms of risks and rewards. For example, Africa, particularly sub-Saharan Africa, has been the hardest to bring money into because of the political situation there. But still there are very successful MFIs in Africa and some very smart investors have done well there. It's really a risk-benefit tradeoff.
Two things have helped this industry tremendously. First, there haven't been any bad players at a major level in terms of the funders and investors, or anybody else. There are no cases of investment fraud, disguising things, wasting money that I know of. The other thing is the investment community has been very, very careful about whom they lend to, in terms of approving business plans, and in handling difficult situations. There is no one I know of who has acted irresponsibly in terms of their investments or in how they handle those investments.
LD: What about the role of aid groups and other nongovernment organizations ("NOGs") they help or get in the way, and is managing relationships with these groups a significant part of this practice?
HF: They are extremely helpful. The groups that have been involved, from the World Bank to the USAID, to Dutch and German development agencies, have been extremely and wonderfully involved in microfinance. They've been really great. The only thing is the cost and the variables make it such that if you don't get the governments and the non-for-profits out of investors' hair, the programs aren't going to grow sufficiently. Eventually you need to abandon the noncommercial investors and get into commercial financing.
LD: I imagine that initially it would be important to get local governments and local counsel on these deals? How important is it to get them on board?
HF: It depends on the country. In some countries, the government can be more of a hindrance than a help. One of the reasons why microfinance in Bangladesh has been so successful is that the government simply leaves the MFIs alone; it does not get involved at all. There are some countries where the governments try very hard. Any businesses that you want to invest in in India faces problems created by the government. But everyone tries to adjust. In light of the credit crunch, the Indian government has made some significant adjustments to its rules on foreign investment, which really helps a lot.
LD: So would you say that one of the biggest challenges is government regulation?
HF: Yes. The fact is that if something happens, someone in government will get involved.
LD: What would you say is the up and coming place for microfinance investment and where are they currently working most effectively in India and Latin America?
HF: India provides the most opportunity because there are so many people there to be served and so many people who want to serve them, but they need an inflow of capital from the West and the government to pass regulation governing that inflow in order for them to be able to service all of those people. The most successful are probably Latin America and Bangladesh. Mongolia happens to be one of the great places to invest. The Philippines has also been very successful.
The real frontier for microfinance, the true frontier, is China. There have been a lot of efforts there. The government is trying to cooperate with western investors who want to institute microfinance primarily in rural China. There's a tremendous need there. They say there are potentially 600 million customers. That's astounding to think about that. And the Chinese people are very industrious and I think they are really ready for it. Eventually there will be lots and lots of money flowing into China as long as the government allows it. If the government in China allows poverty to continue in rural areas, their cities will be over flooded with people. They want to keep people down on the farms, but to have them have happy lives there, and that's one of the real attractions for the government of microfinance programs.
LD: It seems that governments have to be involved, at least, initially, because they are the ones that are welcoming these projects.
HF: Certainly in places like China, where it's a controlled economy even though it is sort of capitalistic. In a controlled economy you need permits to do anything. And then obviously the government has to be very involved. It depends on the country. In some, people just start them up all the time. In a lot of places there's a form of community lending.
LD: So overall would you say that it's the management of these projects that has been so important to their success?
HF: Yes. Management is important. One reason for the success of microfinance is that there really hasn't been money flowing to people who don't know how to do this. Microfinance is not like a lot of other industries where you can just step in and sort of put up your shop and invest your money and it comes out gold. You really have to understand it first and have the right skills and knowledge for it to succeed.