Joseph Merullo
CEO
Arrenda
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Startup Contributor

Recessionary Credit Risk - A Rising Tide

By Joseph Merullo | Wed, 09/21/2022 - 09:00

Over the past 30 years, Mexico has suffered at the hands of untamed inflation, being forced to modify its economic policies due to financial crises. As some may remember, the famous "tequila crisis" of 1994 prompted Mexicans to abandon a floating currency and implement a nominal anchor due to the financial uncertainty brought on by raging inflation at the time.

These inflationary crises, historically, have been accompanied by indicators that are usually present marketwide, and signaled well in advance of a crisis.Among which standout are (i) a deficient exchange rate regime (or exchange rate policy, e.g., the reserves of central banks), (ii) poor financial regulation, or outdated with respect to the needs of the market itself and the economy (e.g., the Basel treaties), (iii) an excess in spending without it being supported by a sound tax collection policy, or (iv) bad investment decisions through defense strategies (e.g., shorts in dollars without taking into account medium or long-term outcomes). Each one of these signals are indicative of a possible inflationary crisis and are, today, demonstrably present here in Mexico.

Inflation has had an immediate, direct effect on the indebtedness of populations in emerging economies. In markets where wages are uncompetitive in comparison to developed nations, the day-to-day hardships of inflation are more deeply felt. In countries such as Mexico, the average salaried worker lives paycheck to paycheck and earns well below that of those in more developed nations, such as Canada, the US and much of Europe. In such conditions, much of the population will go on to make debt payments with earnings that do not grow at the pace of inflation. In nations composed of households with little savings, this decrease in spending power drastically limits access to basic household goods and emergency services, such as medical care, gasoline and groceries; generating a drastic decrease in the quality of life for families living in these countries. 

Inflation has presented glaring concerns for both regulated banks and nonbank lenders alike. For the latter, as their balance sheets are often supported by revenues from unsecuritized, subprime credit products, increasing defaults present a deadly concern. Sadly, the nonbank lending market has been performing poorly over the past months. The default of creditor interest payments by Crédito Real, Unifin and Alpha Credit have raised negative sentiment surrounding the industry, with shares of Mexican Unifin falling more than 90 percent on the Bolsa Mexicana de Valores after news of the default reached the public. With this, there are those who fear that impositions of barriers to entry for new competitors in the marke will come in the form of additional regulation, further isolating innovation from an already rigid industry. 

Undoubtedly, I believe that we will face a continued increase in the rate of defaults within unsecuritized credit portfolios, particularly, within portfolios with exposure to large concentrations of subprime borrowers, those most deeply impacted by the rising devaluation of the Mexican peso. This will be reflected in the financial portfolios operated by the country's lending entities in the coming months and it is likely that we will continue to see valuations of such entities suffer. 

Now, what about fintech companies? I believe there are two likely outcomes. The first is  that they will follow the fate of the country's lending institutions, experience an increase in the default rate of their portfolios, and suffer a hard blow from which it will take time to recover. The second is that consumers take the time to look for alternatives to traditional banking, and that smart fintechs that can structure secure, attractive fi

nancing will use the opportunity of a liquidity crunch to accelerate their portfolio growth in the wake of greater financial turmoil. 

It is critical that at this time lenders demonstrate strong financial discipline and underwrite risk appropriately so as not to be dragged down by spiraling defaults. Disciplined underwriting and creative collateralization structures will be the differentiating factors of businesses that continue to thrive, as a wave of growing concern surrounding inflation and  anticipated defaults passes over the financial sector. Finding a margin between the competitiveness of a financial product without that product excessively affecting the consumer's bottom line will be the magic formula that helps companies in the sector to position themselves at the height of, or over, traditional banking institutions.  

Photo by:   Joseph Merullo

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