Friday, September 10, 2010

Human Capital Contracts and Microfinance

By: Matthew Denhart

A growing movement in international development is the continued development of the microfinance sector. Microfinance attempts to overcome market failure in lending to the poor, who often do not have the means to post collateral to help offset a bank's risk of lending. To manage risk, microfinance institutions insist that borrowers arrange themselves into peer groups, and that the entire group guarantee repayment of the loan. This allows people with very local knowledge of the credit worthiness of their peers to provide information on potential borrowers that would have been extremely costly for the microfinance institution to obtain for itself. Although microfinance seems to work better in some countries than others, and microfinance institutions have varying levels of success, overall this system of personalized lending appears to be a promising way to help finance the productive activities of the poor.

Earlier this week, a few of my colleagues and I had lunch with a bright young lawyer, Tonio DeSorrento. Tonio has a number of clients who are trying to develop another innovative financial product, namely human capital contracts (HCCs) to finance higher education. CCAP has discussed this equity-like concept in a number of places (see here, here, and here).

At lunch I was intrigued to learn from Tonio that a few HCC arrangements currently exist, and that they operate in a similar way as microfinance arrangements (see this article in The Economist). Perhaps the greatest challenge facing HCCs is the question of whether contracts can be enforceable. An investor agreeing to pay college costs up front for a percentage of a student's future income must know that the student will be good for the money. This can be very difficult to discern since there are a number of ways one could evade future repayment.

Two organizations, Lumni and Enzi, have largely taken the microfinance model and applied it to HCCs. Lumni seeks donations from individuals that go into a fund they manage and then use to invest in equity contracts with students. Enzi operates by connecting individual investors to individual borrowers through the internet in a fashion similar to the popular online microfinance organization, These peer-to-peer arrangements attempt to overcome the enforceability issue by personalizing the loans, similar to microfinance.

As Tonio related to me, most HCCs are currently being originated with below market-rate capital. Can the idea be translated into a successful for-profit financial product? Microfinance has had some major successes.

HCCs have other significant challenges too though. As Andy Gillen points out, probably the most significant is that readily available and cheap government loans pose very stiff competition since they offer interest rates that fall well below the market rate. This creates an adverse selection problem for HCC providers. Only those students who believe they would have a lower repayment obligation by agreeing to pay a portion of future income would prefer HCCs to subsidized loans. The students finding themselves in this predicament are those who are likely to not have high incomes upon graduation, and thus are generally a losing financial proposition for HCC providers.

However, Tonio informs us that there are several start-ups who are trying to overcome these, and other challenges. This is an encouraging sign. I will be following the development of this industry closely.

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