There is an irony in the fact that so much of the conversation at the recent Social Capital Markets conference was about moving philanthropy towards a financial markets approach that seems to be in the process of breaking down in the for-profit financial markets. However, we should not confuse financial innovation with excessive risk taking.
I just read the great book When Markets Collide. Published this year, the book comments on events that were occurring in the financial market as recently as the spring of this year. Author Mohamed El-Erian is the former head of the Harvard endowment and current co-CEO of PIMCO, one of the largest investment management companies in the world (he also spent 15 years at the International Monetary Fund). In the book, El-Erian says that when asked what career he would suggest a young women go into he replies “structured finance” without hesitation. His point is that while we are in a cyclical move away from structured finance due to excessive risk taking, the structured finance movement will continue to dominate financial markets over the long term.
All of this brings me to a great session I attended at the SoCap conference in which my friend George Overholser of NFF Capital Partners described how grantmakers can inject capital into a nonprofit debt financing deal to make it more attractive to for-profit lenders. The idea is that if a profit seeking lender will only lend to a nonprofit at a 10% interest rate, they may be willing to lend at a lower rate if a philanthropist puts up capital that will act as a “first loss” cushion. Let’s say that for example the loan is for $5 million. The philanthropist might put up $500,000 that the lender could lay claim to if the nonprofit was unable to fully repay the loan. This reduces the risk to the lender and therefore lowers the interest they are willing to accept to complete the loan. The philanthropist is willing to put up the money because the injection of a relatively small cash cushion can unleash much larger new cash flows into the nonprofit system. While the provider of the “first loss” cushion can achieve a maximum financial return of 0% (just getting all their money back if the nonprofit doesn’t default on the loan) and a maximum loss of 100%, this actually compares favorably to the guaranteed 100% “loss” that occurs when you make a grant. While a first loss capital cushion is not superior to making a grant, it is another tool to be considered by high-impact grantmakers.
This brings me to a recent announcement by Schwab Charitable (the national donor advised fund) of its pioneering program to allow their donor advised funds to put up capital to guarantee microfinance loans. The program is being run in collaboration with the Grameen Foundation. According to the press release:
“‘We are excited to be partnering with Schwab Charitable to expand the reach of microfinance loan programs around the world,’ said Alex Counts, President of Grameen Foundation. ‘Historically, guarantee programs have only been open to large foundations or to the very wealthy. This program opens up participation to a much broader range of donors, democratizing access and building a solid base of ongoing support.’
…Donors who agree to participate will recommend that up to 10 percent of their Charitable Gift Accounts be set aside for a period of 24-36 months to help guarantee microfinance loans. Any funds used to guarantee microloans will stay in their accounts, will continue to be invested for the entire period and will be applied to the guarantee only if the microfinance program has losses in excess of reserves. In addition, Schwab Charitable will report back to participating donors on the social and economic impact that these microfinance loans provide to their various recipients.”
Like all tools, structured finance can be used in inappropriate ways. As El-Erian points out in his book, the “securitization” of home loans (pooling them and reselling the loans to investors) was a positive development. However, misaligned incentives encouraged excessive risk taking that is now coming back to haunt the mortgage markets. Structured finance is a powerful tool and powerful tools can be dangerous, but I think the development of social capital markets towards more sophisticated forms of structured finance is inevitable. Let’s work on getting it right.
Sean Stannard-Stockton is a principal and director of Tactical Philanthropy at Ensemble Capital Management. Ensemble Capital provides families both traditional investment management and philanthropic planning. He is the author of the blog Tactical Philanthropy and writes the column On Philanthropy for the Financial Times.