Capital: Using Secondary Capital to Expand Community Development
Credit Union Capacity
Antonia Bullard, Assistant Director, Vermont Development Credit Union
Secondary capital is uninsured, subordinated, convertible debt that counts
toward the net worth of a community development credit union (CDCU).
In this article, Vermont Development Credit Union, the largest user
of secondary capital, describes the benefits secondary capital offers
CDCUs and community development investors, identifies problem areas,
and offers recommendations to transform secondary capital into a real
solution for the CDCU growth challenge.
Community Development Credit Unions
As banking becomes more sophisticated and computerized, Americans of low
wealth increasingly find themselves squeezed out of the mainstream financial
system. They cannot maintain the minimum account balances required to
avoid high transaction fees. Their credit scores disqualify them for
prime credit. Interest and fee structures exploit the financial setbacks
to which their fragile circumstances make them vulnerable. They are increasingly
driven into the arms of the burgeoning predatory lending industry. The
lack of a level financial playing field, which former US Treasury Secretary
Lawrence Summers termed a major civil rights issue, keeps millions of
families from becoming homeowners, expanding small businesses, obtaining
reliable rural transportation, financing higher education, and building
assets. CDCUs have a grassroots community development mission to bring
fair and affordable financial services to this underserved population.
They may be the least well-known and understood of Community Development
Financial Institutions (CDFIs). [see box 1.]
|Box 1: The Alphabet Soup of CDCUs
|Perhaps one reason CDCUs are
poorly understood is that they define themselves in at least three
different ways. The National Federation
of Community Development Credit Unions (NFCDCU)
counts 215 member credit unions with a community development mission.
The federal regulatory and insurance body for credit unions, the National
Union Administration (NCUA) has designated
nearly 1,000 credit unions as Low Income Credit Unions (LICUs), based
on their having
a majority low-income membership (at or below 80% of national median
income, regionally adjusted[NCUA Rules and Regulations §701.34]).
Federal law allows LICUs to accept non-member deposits and secondary
capital. One hundred thirty-two credit unions are certified as CDFIs by
the US Treasury CDFI Fund. There is considerable overlap between
these groups. The great majority of CDCUs have LICU
designation, though the reverse is not true - most credit unions with
low-income designation are not CDCUs. All CDCUs are eligible to apply
for CDFI certification. Vermont Development Credit Union, along with
many others, is a CDCU, an LICU, and a CDFI. This article uses “CDCU” to
mean credit unions with a community development mission and a majority
According to the CDFI Data Project, 239 CDCUs in
43 states held a total of $3.1 billion in assets and closed 248,000 loans
worth $1.2 billion in
2002. Their commitment to underserved populations is demonstrated by an
average loan size of $5,000 and a 60 percent minority membership. The power
of CDCUs lies in their capacity to leverage private capital for community
development and their direct services to low-wealth people and communities.
Like the nearly 10,000 mainstream credit unions
in the United States,3 CDCUs are regulated depository
institutions operating under federal or
state charters whose depositors are insured by the National Credit Union
Share Insurance Fund. Reflecting their origins in low-income settings and
their mission to serve the underserved, CDCUs are often smaller and faster
growing than mainstream credit unions and have lower operating margins.
A study of 20 CDCUs receiving awards from the US Treasury’s CDFI
Fund found they averaged 20 percent annual growth, twice
the average annual growth rate for all federal credit unions between 1998
Capital and Growth
A key ratio of the financial strength of a depository financial institution
is its net worth ratio (NWR), the ratio between equity capital and total
assets. This ratio measures a credit union’s ability to absorb
losses relative to its size. NCUA regulations classify credit unions
with a NWR of at least 7 percent as well-capitalized. As of March 31,
2004, the average net worth ratio of all federal credit unions averaged
As cooperatives whose member depositors each hold
one share, credit unions cannot raise equity by selling stock as banks
can. Instead, their principal
source of growth capital is their earnings. Internally funded growth is
based on a strict arithmetic: the rate at which total assets can grow without
eroding NWR depends on the return on average assets (ROA). The 0.93% average
ROA of all federal credit unions in the first quarter of 2004 supports
an annual asset growth rate of 7.7%. To fund 10 percent annual growth a
credit union must average 1.19% ROA. To fund 20 percent growth requires
a ROA over two percent.
CDCUs face a twofold growth challenge. First, the
unmet need among their target population is so large that they typically
grow at higher than average
rates. Second, the high cost to serve a customer segment with relatively
small balances and transactions tends to squeeze ROA. To meet growing demand,
therefore, they must find sources of equity capital beyond their own earnings
such as equity grants from philanthropic sources and the CDFI Fund and/or
In response to the new community economic development policies of the 1990s
and the creation of the Community Development Financial Institutions
Fund of the US Treasury, the NCUA in 1996 added regulations allowing
Low Income Credit Unions (LICUs, see Box 1) to “offer secondary
capital accounts.” As Chairman Norman E. D’Amours explained, “Securing
this new form of capital from institutional investors will enable LICUs
to do more of what they do best: extend credit and provide quality financial
services to underserved individuals.” Like
the EQ2 pioneered
by CDFIs, secondary capital is long-term subordinated debt that can be
as equity. Unlike EQ2, secondary capital must comply with specific rules
set out in §701.34 of NCUA Rules and Regulations [see Box 2]. While
some mainstream credit unions would like to expand the availability of
secondary capital to all credit unions, it is currently a tool available
only to LICUs.
|Box 2: Secondary Capital Rules
Source: NCUA Rules
and Regulations §701.34
- Only permitted for
- Five year minimum maturity
- Not redeemable prior to maturity
- Not insured
- Subordinated to all other liabilities, including claims of National
Credit Union Share Insurance Fund
- May be used to cover operating losses to the extent these exceed
reserves and undivided earnings
- May not be pledged by the lender/investor as security for any loan
- Lender/Investor must be non-natural person (not an individual)
- Lender/investor must execute a disclosure andacknowledgment using
specific NCUA language
- Counted as debt for GAAP, but as equity for the purposes of calculating
net worth until five years before maturity.
In the last five years of its term, counted at 80%, 60%, 40%, 20% and 0% of par
Secondary capital offers distinct benefits to CDCUs and community development
investors. For CDCUs, it creates equity capacity to meet community needs
sooner than would be possible through internal growth. For investors, it
leverages limited community development resources. While a $250,000 deposit
or loan to a CDFI allows it to lend $250,000, the same amount in secondary
capital allows a CDCU with a 12.5% target net worth ratio to take in an
additional $1.75 million in deposits and expand its lending capacity by
$2 million. Under
the CRA Investment Test, a secondary capital investor can receive enhanced
consideration for making an investment with such significant
quantifiable impact. For foundation investors, secondary capital can be
a Program Related Investment (PRI), providing immediate distribution credits
that count toward payout requirements, even though the funds will eventually
By December 2003, 38 credit unions had secondary capital
accounts totaling $12.8 million. Assuming an average 10 percent NWR, this
$128 million in additional CDCU lending capacity. Total secondary capital
at individual credit unions ranged from $15,000 to $3,475,000. In 18 CDCUs,
secondary capital provided over 25 percent of net worth; in six, it provided
over 50 percent. (box 3 shows the ten largest users of secondary capital)
|Box 3: Ten
Largest Users of Secondary Capital
As currently structured and practiced, secondary capital provides only
a temporary solution to the CDCU growth challenge. Consider the following
simple model: a CDCU with $10 million in total assets that has set a
target NWR of 15% expects to grow at a 15% annual rate into a $16.7 million
institution. Most of its expansion will be fueled by deposits, which
will grow from $8.5 m t,o $14.2 m. However, its relatively low profitability
(ROA 0.5%) will yield total ear,nings of only $250,000 over the period.
If these earnings are the sole source of additional equity, NWR will
fall from 15% to 10.5%. A secondary capital investment of $750,000 will
sustain the target 15% NWR.
Immediately after receiving the secondary capital
investment, the credit union has a temporarily higher NWR, which declines
as the deposit base
expands to fill the new capital capacity. The size of this “zigzag” can
be damped by using multiple, smaller secondary capital investments at intervals.
In practice, however, the thinness of the market and the time and expense
to negotiate and document secondary capital investments inevitably create
a pattern of “lumpy” investments and temporarily higher NWRs.
At the end of the five-year period, the CDCU in the model has grown into
its new capital base and returned to its target 15% NWR.
This model works only if the secondary capital investment
has a term of at least ten years. This is because NCUA regulations require
CDCUs to discount
the secondary capital that they count as net worth by 20 percent each year
in the last five years before maturity as shown in Chart 2.
capital investments have a maturity of seven to ten years, creating
the danger that just when the CDCU needs net worth most,
secondary capital contributes less of it. In contrast, bank trust preferred
has a 30-year term and some EQ2 has terms of up to 20 years.
The “lumpiness” of secondary capital
investments and the NCUA discounting rules reduce the efficiency with
which CDCUs use secondary
capital. A typical seven-year secondary capital investment may not be fully
needed in the first two years and discounted in the last five.
A second problem with secondary capital is its temporary nature. In year
five of our model, the CDCU needs to keep the secondary capital it has
and obtain additional equity and/or secondary capital to continue its growth.
As secondary capital is discounted and/or matures, a CDCU has four possible
(1) Retire the secondary capital
(2) Persuade the investor to extend
the term of the investment
(3) Find a new secondary capital investor to replace the secondary
(4) Replace the secondary capital with permanent equity.
If the CDCU has grown according to plan, response (1) presents two unpalatable
choices: accept a lower NWR (with serious consequences if the ratio falls
below the 7 percent regulatory threshold), or shrink to a smaller total
asset size and an acceptable NWR.
Response (2) may happen in two ways. Some secondary
capital investors will agree to extend secondary capital terms on a case-by-case
build provisions into their original agreements that extend the investment
before it starts to be discounted provided the CDCU meets certain criteria
for financial soundness and community impact. The first is typically only
a short-term answer, and the second a one-time solution. Many investors
have limited flexibility since they are themselves intermediaries who must
repay their own investors. Others speak of the need to rotate their investments
to other CDCUs, which suggests they may not fully understand the role of
secondary capital in fueling growth.
Response (3) means recruiting new investors.
This is challenging because the program- and CRA-driven investors who
provide secondary capital find
it less appealing to sustain an organization’s current size than
fuel new growth.
Response (4) is the most desirable, but the hardest
to achieve. Investors who expect equity to replace their secondary capital
may overestimate the
ability of fast-growing CDCUs to generate permanent equity through retained
earnings. Equity grants, the other possible source, are hard to find in
A possible solution to this dilemma would be
for investors to view some secondary capital investments as “probationary
equity grants.” If
a CDCU delivers growth in lending and community impact, the investor converts
the secondary capital investment into a permanent equity grant that allows
the CDCU to sustain its expanded capacity. If a CDCU does not achieve growth,
it can repay the secondary capital investment while maintaining an acceptable
As currently practiced, secondary capital seems
primarily designed to rescue poorly performing institutions. CDCUs that
achieve losses beyond
their equity base can “keep” secondary capital by converting
it to equity. CDCUs that survive a rocky period but do not grow substantially
can afford to repay it. For high-performing CDCUs, however, it provides
only a temporary solution to a chronic capital shortage that will resurface
when the secondary capital must be discounted and repaid.
Secondary Capital at VDCU
Since our founding in 1989, Vermont Development Credit Union (VDCU) has
provided $120 million in loans and served 12,000 Vermonters in every
county of the state.
As one of the nation’s fastest-growing CDCUs, with
annual average growth of 31 percent in assets and 35 percent in loan portfolio
last decade, VDCU embraced the concept of secondary capital as a tool for
meeting the growing demand from our target population while maintaining
our target 12-15 percent NWR. Our first investment of $175,000 came in
1998 from an NFCDCU program funded by the Ford Foundation. We now have
the largest total secondary capital investment of any CDCU—$3,475,000,
of which $1,500,000 is in matching investments by the CDFI Fund. Interest
rates vary from 3.5% to 5.0% and terms from five to eleven years.
To meet a narrow time window for matching funds
and disbursements set by the CDFI Fund, VDCU expanded secondary capital
2001 and 2003. As a result, we could be said to have had “excess” secondary
capital in 2003, when our NWR exceeded 20 percent. Chart 3 shows VDCU’s
total historical and projected secondary capital, assuming neither new
investment nor extensions of our existing investments. The dotted line
shows the secondary capital that counts toward net worth.
Chart 4 projects total assets and NWR assuming
a modest 12 percent annual growth rate and 0.5% ROA. On this assumption,
total assets would increase
over the next decade from $27 million to $86 million. With no change in
secondary capital agreements, the contribution of secondary capital toward
net worth declines due to discounting and maturity. On these assumptions,
VDCU’s NWR will fall below our 12-15 percent target after 2005. To
avoid this, we must achieve some combination of (a) extending, renewing,
and replacing existing secondary capital investments, (b) converting secondary
capital investments to equity, and (c) obtaining new permanent equity.
Conclusions and Recommendations
VDCU’s experience with secondary capital leads us to the following
conclusions and recommendations:
- Secondary capital is a valuable tool by which investors can achieve
a leveraged community development impact in CDCUs while retaining their
capital and earning a financial return.
- In part because of the rigidity of NCUA requirements,
the pool of secondary capital investors seems unlikely to expand beyond
universe of CDFI intermediaries, foundations with PRI programs,
CRA-motivated financial institutions, and the CDFI Fund.
- CDCUs that successfully grow into the new asset size made possible
by secondary capital investments will need those investments to be
constantly extended, renewed, or replaced by equity.
- The NCUA discounting formula, whereby secondary capital is disqualified
from counting as equity for up to 60 months, limits the value of secondary
capital to the recipient without reducing the risk to the investor.
NCUA and CDCUs should explore less costly ways to plan for orderly repayment
of maturing secondary capital investments.
- CDCUs and secondary capital investors should
consider developing a standardized form of “evergreen secondary
extends its term on a rolling basis provided recipient CDCUs meet financial
community impact measures.
- The CDFI Fund and other investors should consider converting secondary
capital investments to equity grants if CDCUs achieve growth and impact
- CDCUs, regulators, and the philanthropic community should research
whether less capital-intensive tools, such as standby arrangements
and guarantees, can be structured to achieve the same results as secondary
Remarks to CDFI Awardees in January
2001, reported by Caryl Stewart
The data in this paragraph is taken
Capital, Building Communities, Creating Impact.” CDFI Data Project.
At December 31, 2003, NCUA collected
data from 9,488 credit unions www.ncua.gov
Raynor, Jared: “Credit Union
CDFI Core Awardee Impact Analysis.” NFCDCU, August 2001.
Federal Credit Unions www.afcu.org
calculations by the author
“NCUA Allows Community Development
Credit Unions to Raise Secondary Capital.” NCUA. 1996.
EQ2 is short
for equity equivalent. See www.communitycapital.org
Excluding allowances for liquidity
and loan losses
The Grantsmanship Center http://www.tgci.com/magazine/97fall/faq.asp
Data in this paragraph based on call
report data at www.ncua.gov and author’s analysis
NFCDCU currently offers terms of 6-7 years . The CDFI Fund
matches the original interest rate and term of non-federal secondary capital
investments, like those of NFCDCU.
E.g. National Community Capital Association,
which allows its 7-year agreement with VDCU to be extended up to 11 years.
“[VDCU] consistently outperformed
in all areas of growth.” Raynor op. cit.
While not strictly required
as equity, this “excess” has not been
idle. VDCU has been fully loaned-out throughout the period.
We reached this conclusion after several
would-be investors from other segments found themselves unable to comply
with rigid NCUA requirements. Some CDCUs, however, believe that if mainstream
credit unions are allowed to use secondary capital the market will expand
to the benefit of CDCUs.
Bullard is associate director
of Vermont Development Initiatives, the development affiliate of Vermont
Development Credit Union (VDCU). VDI and VDCU share a mission to build
wealth, community, and opportunity by providing affordable capital and
financial services to underserved Vermonters. VDCU has served 12,500 Vermonters
in 210 towns and invested $125 million in lending to lower-income Vermonters.
Ms. Bullard’s prior career includes
experience as an entrepreneur and corporate manager. She studied economics
and philosophy at Oxford University
and the Massachusetts Institute of Technology. Ms. Bullard can be reached
by at 802/865 3404 X104 or via email.