TO CAPITAL MARKETS FOR COMMUNITY DEVELOPMENT LENDERS
UNBLOCKING OBSTACLESTO CAPITAL MARKETSFOR COMMUNITYDEVELOPMENT LENDERSImproving access to thecapital markets occursby enhancing the collaborative vision ofpractitioners,Wall Streeters andphilanthropistsWhere access is a direct function of adoptingmarket standards, increasing scale, through poolingand converting operations from portfolio to a capitalmarkets asset management model.“The breadth and attitude of our vision for today’s potentialor tomorrow’s dream will profoundly influence what we seeat this moment. ” —(Author unknown)byGregory M. StantonDirector, Capital Markets Access Programand the Wall Street Without Walls InitiativeJune 2003APPLIED RESEARCH CENTERIN COMMUNITY ECONOMIC DEVELOPMENTSCHOOL OF COMMUNITY ECONOMIC DEVELOPMENT SOUTHERN NEW HAMPSHIRE UNIVERSITY
School of Community Economic DevelopmentBoard of Overseers 2002Rob BassCleveland, Waters & BassConcord, NHRobert J. BergInternational ConsultantJohn BlackfordConcord, NHEllen LazarNeighborhood ReinvestmentCorporationWashington, DCGus NewportIndependent ConsultantOakland, CAWilliam NinacsThe Canadian CED NetworkVictoriaville QuebecCharles E. CollinsJamaica Plain, MAJoyce DickensRocky Mount, NCDenise FairchildLos Angeles Trade-Technical CollegeLos Angeles, CARichard A. Gustafson, Ex-officioSouthern New Hampshire UniversityManchester, NHSamuel KaymenLyndeborough, NHRoy PriestNational Congress of CEDWashington, DCJohn RauhIndependent ConsultantNew Castle, NHClifford N. RosenthalNational Federation of CDCUsNew York, NYPaul Schneiderman, Ex-officioSchool of Business-SNHUManchester, NHGregory M. StantonCapital Market Access ProgramNew York, NYMichael SwackSchool of CED-SNHUManchester, NHPeter UvinThe Fletcher School of Lawand DiplomacyTufts UniversityMedford, MADenise VieraHartford, CTRobert ZevinRobert Brooke Zevin Associates, Inc.Boston, MA 2003 Gregory M. Stanton and the School of Community Economic Development, SNHUPublished by Community Economic Development PressSchool of Community Economic DevelopmentSouthern New Hampshire University2500 North River RoadManchester, NH 03106ISBN: 0-9743372-0-XFor reprints contact:603/668-2211arc@snhu.edu
Executive SummaryThis paper examines the persistent obstacles, gapsand barriers to the capital markets, that preventa freer flow of capital to needy communities.The supply of capital from the community developmentfinance industry is currently provided by a host of mission-driven financial intermediaries. These includeCommunity Loan Funds, Community DevelopmentCorporations (CDCs), Revolving Loan Funds (RLFs),Community Development Credit Unions (CDCUs) andMicro-lending Financial Intermediaries (MFIs).1 Collectively we will refer to them as Community DevelopmentFinancial Institutions (CDFIs).These CDFIs finance various community assets suchas single and multifamily affordable housing, small business loans, consumer loans and community facilities.Yet, the increasing demand for capital cannot be met bythe current supply of traditional philanthropic, government, concessionary rate, and other sources of capital.While there have been a few CDFIs successful inachieving limited access to financing from institutionalinvestors, according to Kevin Smith, Vice President ofthe Fannie Mae Foundation, “.there is an inadequateflow of capital into the Community DevelopmentFinance System to fulfill the supply needs for affordablehousing and build healthy, vibrant communities nationwide.”2 This is the major challenge to practitioners facing current and potential future declines in grant andconcessionary-rate capital from philanthropy and government.Our examination of major obstacles, such as the scaleof lending or documentation of loans, joins other important current research and pilot projects, that are dedicated to finding solutions to the capital shortage affecting most depressed communities, minority businessesand aging community economic development infrastructure. The premise of this paper is that sustainedcapital markets access is a function of increased scale,standardization of practices, documents and processesand improved management skills.1 Community Development Financial Institutions include all ofthe following: Community Development Financial Institutions; Revolving Loan Funds; Community DevelopmentCorporations, called CDCs; and Community DevelopmentCredit Unions.2 Fannie Mae Foundation “Expand Capital to Communities.”A presentation by Kevin Smith, Washington, D.C., September26, 2002.CAPITAL MARKETS ACCESS PROGRAM 2003This paper is divided into three sections:Section I. Problem Areas and Obstacles to theCapital Markets. This section reviews some of theproblem areas and systemic blockages to the capitalmarkets that may be caused both by inadequate infrastructure within CDFIs, such as data collection andinformation systems, and the fact that many CDFIshave not adopted certain market standards, such asstandard underwriting processes.Section II. The Capital Access Landscape. Thissection highlights the current capital markets businessmodel for small business loan securitization, Rule144A private placement activity3, and secondary market activity as applied to the community developmentfinance industry’s efforts to improve its access to thecapital markets.Section III. Vision and Innovation: Steps to Improve Capital Markets Access. This section examines the possible improvements, new ideas andinnovations that may be helpful in improving capitalmarkets access for the community developmentfinance industry. Community development lendersand Wall Street professionals need to work together tosolve the capital access problem. In so doing, they willidentify and build strong pathways into the flows ofinstitutional capital for community development projects. Success in closing the “capital gap” will be basedon the success of CDFIs accessing mainstream markets through achieving scale and piggybacking withother CDFIs (as issuers) and using the market’s customary structures. These collaborative efforts mustmeet and pass institutional investor’s due diligencetests and appetite for various security types. Successfully accessing capital markets will require thatCDFIs: 1) Quantify liquidity needs and market size; 2)Accurately document asset performance; 3) Designinnovations necessary to isolate perceived and actualrisks related to Community Economic Development(CED) investments; and 4) Utilize incentives such asthe New Markets Tax Credit to appeal to institutionalinvestors.3 Definition of Rule 144A for Private Placements. Excerpt fromthe CPA Online Journal 2001. “The principal objective of Rule144A is to increase the efficiency and liquidity of the U.S. market for equity and debt securities issued in private placementsby allowing large institutional investors to trade restricted securities more freely without subjecting the companies to the SECregistration and disclosure process.”3
4UNBLOCKING OBSTACLES TO CAPITAL MARKETS FOR COMMUNITY DEVELOPMENT LENDERSThe innovations that we discuss here include: Creating community development financial guarantees and financial wraps custom-tailored for CEDproducts, but shaped by generic investment gradeinstitutional investor demand. This may include theuse of “dead” or underused government assets, such asthe assets of Housing and Urban Development(HUD) auctions to provide additional collateral toraise CED transaction credit quality and reduce thefinancial guarantee and transaction costs. Employing relevant financial engineering to developfinancial products that use the New Markets TaxCredit. Modernizing the CDFI’s approach to financing andasset management—from the Portfolio Method ofFinancing (PMF) to a Capital Markets Financing(CMF) method of asset management. The CMFmethod originates, packages and sells assets to increasecapital and liquidity, rather than just originating assetsand managing them through maturity. We realize thatmany community development lenders will want tomaintain a portion of their loans in portfolio. Thismay make sense for certain types of loans or a certainpercentage of the overall portfolio. We also realize thatmany lenders are reluctant, for good reason, to selltheir loans at a discount. We are cognizant of theseissues, and our innovations will take these concernsinto account.This paper invites bold action from practitioners andfinance professionals in finding common ground andmethods to efficiently finance pools of non-conformingassets. Bold action calls for substantively improving systems of tracking and servicing assets, finding more costeffective means of credit enhancement, and adoptingstandards that are accepted by capital markets. Boldaction requires debate and analysis on how to gain capital access by communities. Bold action must address anincreasing capital gap and make it a priority on thenational agenda.How we view obstacles to capital access and what wedo to overcome them—now—profoundly influencessociety. We must investigate how to integrate the loansoriginated by community development lenders intocapital markets instruments. There are many ideas andinnovations being discussed in the field. The CapitalMarkets Access Program (CMA)4 has organized and ispart of a team of institutions and individuals that isworking to promote innovation in the field.Credit InsuranceAssignment ofGovernmentCollateralCapital MarketsAsset ManagementFour innovations currently being pursued include:1. Establishing a Financial Guarantee Corporation orcapability to provide a financial guarantee by creditenhancing or wrapping CED transactions to investment grade credit quality.2. Establishing a CED financial Product Task Force forhigh net worth individuals and institutional investors.3. Developing a peer-to-peer lending capacity forCDFIs in the form of a mini-Federal ReserveSystem.4. Establishing a Capital Markets intensive trainingprogram alongside the Federal Reserve Bank’s Community Affairs Programs.4 The author, G.M. Stanton is Director of the Capital MarketsAccess Program, a foundation-funded program to improveaccess by nonprofit organizations to the capital markets.Started in 1998.Not to be copied in whole or in part without authorization.CAPITAL MARKETS ACCESS PROGRAM 2003
GREGORY M. STANTON5Introduction and BackgroundCommunity Development Financial Institutions(CDFIs) capitalize themselves through a mixture of public, private, and philanthropic investments and contributions. Unlike many “conventional” financial institutions, most CDFIs do not re-capitalizethemselves by packaging and selling their loan portfolioson a secondary market. It is not clear how many CDFIloans could potentially be sold on a secondary market. Itis also unclear to what extent there is a desire on the partof CDFIs to sell their loans and thus obtain additionalcapital, or to what extent CDFIs are experiencing capitalliquidity problems.The Department of Treasury’s Community Development Financial Institutions Fund suspects that the capital liquidity issues are serious enough to create a demand for a secondary CDFI market. The Fund alsohypothesizes that the current secondary market (to theextent that one exists) is inadequate to meet this demand. Yet, a definite and positive relationship betweenaccess and standardization almost certainly exists: A correlation exists between integrity of the data collectionprocess, market acceptable servicing procedures, and thelevel of institutional investment interest in CED assets.Obstacles, Barriers & Gaps.By analyzing the obstacles over which practitionersand CED professionals have some control, this articlehighlights the required changes in systems, processes,infrastructure and knowledge that positively and substantially affect the potential of CDFIs to increase theiraccess to capital.A “capital gap” occurs when organizations can nolonger finance their CED assets from their usual and customary funding sources. To bridge the gap, practitionersare challenged to identify and attract other consistentsources of capital, addressing their target area’s capitalneeds. Only through a collaboration of practitioners,philanthropists, social investors5 and capital markets financiers, all motivated to bridge a large and increasing“capital gap,” will a solution be found. The work thesegroups do together in thoughtful collaboration will resultin debt instruments that will bring large institutionalinvestors into the CED finance marketplace.What is needed is a radical shift from “the tried andtrue” in the way CDFIs obtain investment financing—atransition from the older portfolio financing model to adynamic capital markets model.Capital Markets Access for CDFIs, CDCs and RLFsas a function of scale, standardization and managementInstitutional Investor Interest(Theoretical model)6050403020100CapitalMarketsAccessScale &Standardization1234567Standardized documents, servicing practices, data collection, pooling & scaleFigure 15 Social investors are defined by their interest in both the socialand financial returns of an investment or concerned about the“double bottom line.”CAPITAL MARKETS ACCESS PROGRAM 2003
6UNBLOCKING OBSTACLES TO CAPITAL MARKETS FOR COMMUNITY DEVELOPMENT LENDERSPMF: CMFOld Model:“Portfolio”New Model “Capital Markets” Lend all available funds and manage untilmaturity Manage assets only against catastrophic loss No target number for originations and loanquality No known rate of deployment Package and sell loans to increase liquidityLow rate of idle funds/high deploymentManage for market benchmarks and returnEngineer products to meet investor demandFigure 2While the method of financing called “securitization”has been bandied about quite liberally, the reality is thatany large-scale loan securitization either in the public orprivate capital markets remain out of reach for themajority of CDFIs at present. Yet, the process of monetizing loan portfolios, or portfolios of well-documentedassets, and packaging them as investment-grade privateplacements, including 144A private placements, eitherfrom individual issuers or as a pooled group of loansfrom multi-issuers, remains a viable and strategicfinancing mechanism.Just as it has already proved to be a major source offinancing in the for-profit financial services market thatprovides small business loans to average and higher riskborrowers, this process has proved to be a sizable sourceof liquidity to some of the larger CDFIs. Examples ofsuccessful applications of the Capital Markets Fundingprocess of economic development loans in the community development sector are the Community Reinvestment Fund (CRF) of Minneapolis, Minnesota, and SelfHelp Inc. of Durham, North Carolina.6 They demonstrate that applying capital market based methods, financial engineering, loan servicing and performance tracking techniques in no way compromise an organization’smission and service to its communities.With these thoughts in mind, we need to analyze theproblem areas, review the capital market landscape andenvironment, and devise meaningful and innovative solutions to community investment problems.6 The Community Reinvestment Fund of Minneapolis, Minnesota has underwritten over 250 million in economic development loans. Self Help of Durham, North Carolina has underwritten over 1.5 billion in mortgages for low-low incomecommunities. Both organizations have been largely responsible for attracting a number of institutional investors to investin their community and economic development. These firmsinclude: Prudential Securities, Washington Mutual, WellsFargo, MetLife, Mennonite Pension Fund and Equitable Insurance. Their role, as well as many other CDFIs, have been instrumental in growing this marketplace and has been theinspiration for bringing their clients’ mission to Wall Streetand getting it financed.Not to be copied in whole or in part without authorization.CAPITAL MARKETS ACCESS PROGRAM 2003
GREGORY M. STANTON7Section I. Problem Areas and Obstacles to the Capital MarketsOver the last twelve months, this author hasbeen listening to community economic development and capital markets finance professionals across the country talk about the major problemareas and obstacles that CDFIs encounter trying to findalternative sources of capital. Those discussions have ledto an identification of the problems involved in adoptinga capital markets model for CDFIs.Major Obstacles:1. Lack of Knowledge. There is a lack of knowledgeamong CDFIs about capital markets mechanismsand underlying requirements .2. Concern about Cost. CDFIs are rightfully concernedthat selling loans on a secondary market will requirethem to take discounts on their loans. That is, theyare concerned that they will lose money when theysell their loans. Most CDFIs cannot afford to do this.3. Lack of Market Data. For any emerging asset class togain credibility in the capital markets, it must have ahistorical and reliable performance database of fiveyears. This allows investors to analyze the assets overtime to determine trends and projected risk. A minimum of at least a three-year period is required formost rating agencies and investors to get comfortablewith average performance, worst-case scenarios, andlikely returns. With the exception of the Small Business Administration’s (SBA’s) database and severalthird-party data tracking indices on the performanceof small business loans, the CDFI industry has nobody of data that has been uniformly collected, ishighly reliable, and is accurate for capital market investors to analyze risk and performance.4. Lack of Incentives. There is a dearth of incentives toestablish loan production goals, that attempt to in-crease loan volume and improve quality based on acomprehensive system of awards for grants and Program Related Investments (PRIs).7 Today, CDFIs donot have the ability to quantify demand or their needfor liquidity.5. Continued Use of Unsophisticated Portfolio Valuation Models. Currently, CDFIs do not price adequately to earn sufficient spread income for longterm viability without additional grant funding.CDFIs may not price their loans to the risk assumed.Below-market rate loans with insufficient spread,along with the cost of technical assistance, requiremany CDFIs to raise substantial operating incomefrom grants and donations. This is a large issuewithin the field. Many CDFIs knowingly subsidizethe cost of their technical assistance services becausetheir customers cannot afford to pay the full cost ofthat assistance. The provision of assistance also helpscreate loan demand from the targeted groups andindividuals. This, in itself, is not an obstacle to accessing mainstream capital markets for CDFI loans, butmany CDFIs are unable to project growth in lendingdue to limitations in raising the operating capitalneeded to subsidize the lending.6. No Incentive to Pool. There is little or no regionalaggregation for financing assets. CDFIs are notorganized to participate as part of pool loan originators, nor are they organized as part of a cooperativenetwork of loan sellers or issuers.7. CDFIs Do Not Farm Out Specialized Services. Unlikemany traditional lenders, CDFIs do not breakdownand quantify the profitability of each part of theunderwriting process and farm out specialized functions to more cost-efficient vendors.7 Program Related Investments are a type of grant or loan provided by foundations which usually have more flexible terms,conditions and lower rates than conventional loans.CAPITAL MARKETS ACCESS PROGRAM 2003
8UNBLOCKING OBSTACLES TO CAPITAL MARKETS FOR COMMUNITY DEVELOPMENT LENDERSCurrent Efforts—Not EnoughWhile the CDFI industryparticipants and trade associNo sense ofations have recently undertaken research initiatives toreal marketgather financial data aboutloanthe credit quality of the CDFIsdemand byas financial service entities,target area.and a new research effort willlook at individual CDFIs andNo reliabletheir portfolios of assets, theforecastingcurrent and historical percapabilities.formance of their loans—none pr
4. Establishing a Capital Markets intensive training program alongside the Federal Reserve Bank’s Com-munity Affairs Programs. 4 The author, G.M. Stanton is Director of the Capital Markets Access Program, a foundation-funded program to improve access by nonprofit organizations to the capital markets. Started in 1998. Credit Insurance .
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