Volume 9; No. 2; Spring 1997
The Emerging Secondary Market for Community Development Loans
By Kathleen Kenny, Community Investment Consultant and
Frank Altman, President and CEO, Community Reinvestment Fund
Over the past decade, a handful of pioneering organizations have gradually
built a small secondary market for community development loans. Although
the potential for growth in this market is tremendous, serious impediments
must be overcome before significant growth can occur. In the context of
today's shrinking supply of public funds for community and economic development,
the need for recycling scarce capital is greater than ever.
What is a Community Development Loan?
Community development loans differ from more traditional loans, in that,
in addition to seeking financial returns, they also seek social returns.
Most community development loans are used for multi-family affordable
housing, economic development or other public purposes that fall outside
the scope of the mainstream financing system served by Fannie Mae and
Recent amendments of Community Reinvestment Act (CRA) regulations clearly
state that in order to be considered a community development
loan, a loan must have as its primary purpose "the revitalization or
stabilization of low-or moderate income areas." The regulation also
provides examples of qualified community development loans that would receive
credit under the CRA. These examples include (but are not limited to) loans
to: nonprofits serving low- and moderate- income housing or other community
needs; loans to financial intermediaries including CDFIs and CDCs that serve
low- and moderate- income communities; loans to local, state, and tribal
governments for community development activities; and loans to finance environmental
clean-up as part of an effort to revitalize the low- or moderate- income
community in which a property is located.
Community development loans are originated by a wide range of lenders
including financial institutions, nonprofit development organizations,
city and state revolving loan funds, public and quasi-public development
agencies, community development financial institutions, lending consortia,
and special programs sponsored by the private sector.
Public funding comes from many sources--Community Development Block
Grants (CDBG), the HOME Program, rural development grants through the
U.S. Department of Agriculture, Economic Development Administration (EDA)
grants, local tax increment financing, special purpose or municipal bond
issues, and other state or local funds reserved for housing and economic
development projects. Foundation grants and private capital also serve
as important sources of development finance.
Unfortunately, drastic cutbacks in federal and state budgets combined
with the scarcity of new capital severely threaten the longevity of many
of these programs. To survive, community development lenders must look
to an emerging secondary market to replenish their capital. Without this
source of "recycled capital," some lenders may find it difficult
to continue fulfilling their community development missions into the future.
The Importance of a Secondary Market for Community Development Loans
The credit system for single family mortgages demonstrates the tremendous
possibilities offered by an organized secondary market. Today, more than
two-thirds of new single-family mortgages originated in the United States
are sold on the secondary market. By mid-1996, the outstanding balance
of residential mortgages pledged to instruments such as mortgage-backed
securities (MBS) was $1.6 trillion, or 43 percent of total residential
mortgage debt outstanding.
By now, these securities are widely understood and accepted by individual
and institutional investors alike. The maturation of this financing system
over the past two decades has meant that borrowers can readily find mortgage
loan funds at a reasonable cost, lenders can replenish and recycle their
funds, and investors can enjoy healthy returns with relatively low risk.
Likewise, the development of an efficient financing system for community
development loans would serve the needs of community-based borrowers,
lenders, investors, and the public by:
- Providing a renewable, ongoing source of capital for community-based
- Supporting the efforts of federal, state and local government and
the philanthropic community to sustain affordable housing and economic
development programs by leveraging existing assets over time.
The Pioneering Organizations
Over the past decade, a few national nonprofit organizations have helped
pave the way for an emerging secondary market by serving as a bridge between
community development lenders and institutional investors. What distinguishes
these nonprofits as a group is their flexibility and ability to adapt
to the needs of their constituents in order to fill gaps in the marketplace.
Unlike the traditional secondary market intermediaries such as Fannie
Mae and Freddie Mac who deal in large volumes and standardized products,
these nonprofit pioneers are serving the needs of community-based borrowers
and lenders whose products are anything but conventional.
An example of a pioneering nonprofit is the Community Reinvestment
Fund (CRF), an organization based in Minnesota and incorporated in
1988 to create a secondary market for community development loans
particularly loans to small businesses that create jobs and build wealth
in rural and urban communities across the country. With ongoing support
from foundations and corporations, CRF has developed a flexible yet disciplined
approach by throwing out the "cookie cutter" mentality and responding
to the unique needs of its market. That approach has enabled the Fund
to purchase more than 700 economic development and housing loans from
47 organizations as diverse as the City of Red Lake Falls (MN), the California
Integrated Waste Management Board and Homes for South Florida. To date,
CRF has privately placed ten series of its Community Reinvestment Bonds
totaling $34 million to 31 investors, including a host of banks, life
insurance companies and pension funds.
The map below indicates the locations of loans purchased by CRF throughout
the United States over the last eight years. Though the map reflects the
Fund's largely regional emphasis during its formative years, CRF is gearing
up for expansion nationally over the next three years. In addition to
offices in Minnesota, Oregon and Colorado, CRF plans to establish a permanent
presence in the state of California.
Locations of CRF-purchased loans from 1989-1997
Another pioneering nonprofit, Local Initiatives Managed Assets Corporation
(LIMAC), focuses primarily on housing loans with an emphasis on tax
credit equity bridge loans. Based in New York, LIMAC opened its doors
in 1987 with an investment from The Ford Foundation, which also established
the Local Initiatives Support Corporation (LISC). LIMAC initially purchased
its housing loans exclusively from LISC, but now purchases from a wide
variety of originators such as the Low Income Housing Fund, Mercy Housing,
state housing finance agencies, and other community development financial
institutions. LIMAC's investors have also changed over time and are now
predominately banks and pension funds which make advance commitments to
purchase products that meet agreed-upon underwriting and term criteria.
LIMAC's volume has increased steadily in recent years, and now totals
$125 million in loans purchased or committed.
A third pioneer, Neighborhood Housing Services of America (NHSA),
purchases single family affordable housing loans in support of its network
of over 170 affiliated NeighborWorks® organizations throughout the
country. Under its two primary programs, NHSA buys rehabilitation loans
originated by local NeighborWorks® programs. It also buys home mortgage
loans originated by local lenders on behalf of nonprofits. NHSA now purchases
about $35 million in loans annually, with a cumulative total of over $200
million in loans in its 23 year history. The majority of NHSA's investors
are insurance companies and financial institutions.
More progress has been made in creating a secondary market for single-family
affordable housing than for community development loans. This is in large
part due to a more developed infrastructure of originators and investors.
However, the promise of a secondary market for community development loans
which include affordable multifamily and economic development loans remains
The need for a financing system for multifamily housing loans was the
subject of a landmark report issued by the National Task Force of Financing
Affordable Housing in 1992.
Sponsored by an impressive list of corporations, foundations and national
nonprofits, the task force proposed a series of recommendations designed
to promote a more efficient, less fragmented system. The effort resulted
in creation of the Multi-Family Housing Institute, based in Washington,
D.C., which has been charged with the task of implementing the recommendations
of the task force. The Institute, which is now affiliated with the Urban
Land Institute, is creating a national database to track the performance
of affordable and market rate multi-family properties. The database, which
tracks over 200 specific data elements, includes information on the loan
performance, management, and fiscal health of each property tracked. A
web site is planned for early 1998 which will make these data available
to the public. From there, industry benchmarks could be established for
property and loan performance, helping capital markets better assess the
risks of such multi-family financings.
None of the advances made to date have come easily. For example, the
first sale in 1992 of $14 million in loans by the California Community
Reinvestment Corporation (CCRC) to Fannie Mae was a lengthy and difficult
process. Since then, CCRC and several other consortia have sold relatively
small portions of their portfolios to private investors and in some cases
to their own member banks. Selling loans in this piecemeal fashion is
expensive without the help of a conduit mechanism for aggregating and
securitizing large pools of loans.
In spite of the challenges, intermediaries such as CRF, LIMAC and NHSA
are proving that community development loans are a good investment. Neither
CRF, LIMAC nor NHSA has ever been delinquent on a bond or other scheduled
payment, and there have been few defaults. Investment returns have been
attractive as well. In the case of CRF, for example, investors have obtained
returns ranging between 160 and 200 basis points above comparable Treasury
rates. Underwriting criteria are high by any standard, and risk is mitigated
by excess collateral, excess cash flow, credit enhancements and other
Investing in the diverse array of loans and products offered by these
intermediary organizations is an equally varied set of investors, including
- Philanthropic contributors who provide operating support
to these intermediary organizations as well as contributions/grants
to credit reserve funds.
- Socially motivated investors which include foundations, religious
organizations, banks and insurance companies. Though rate of return
varies widely, each of these investors is generally willing to take
a less-than-market rate return in exchange for other benefits, such
as fulfillment of community reinvestment goals.
- Standard institutional investors seeking market rates of
return. In the long run, these are the investors who will take community
development loans into the mainstream secondary marketplace.
The Size of the Potential Market
Nationally, the U.S. Department of Commerce and others have identified
more than $4 billion in loan assets held by cities, nonprofits, and revolving
loan funds. In California alone, the California Association for Local
Economic Development (CALED) estimates that more than $200 million in
economic development loans are held in the portfolios of its membership.
The potential market for multi-family affordable housing loans is also
estimated to be large. However, while the potential may be enormous, there
are no reliable data on the size or quality of multi-family loans held
in portfolios across the country. An informal survey conducted by the
Federal Reserve Bank of San Francisco of nine nonprofit lending organizations
identified more than $420 million in permanent multi-family loans held
in portfolio. Still, complete and accurate data would further the argument
that there is great profit potential in creating a secondary market for
community development loans.
Impediments to Creating a Secondary Market for Community Development
Significant barriers must be overcome before the market for community
development loans is able to achieve its full potential as a fully-functioning,
high-volume secondary market. Lack of shared practices and policies among
originators will likely continue to be obstacles in this diverse marketplace.
Consistent loan documentation, common approaches to underwriting, and
risk-weighting systems to standardize credit quality could all help in
reducing these obstacles.
Another major constraint is the lack of a financial infrastructure for
community and economic development loans. A successful secondary market
requires a "string" of relationships along the financing pipeline
from loan originators to investors. These relationships are well developed
in the single-family mortgage market, but are incomplete or nonexistent
for multi-family affordable housing and community and economic development
loans. Until the market catches up, organizations such as CRF and LIMAC
will continue to play multiple roles, such as providing credit enhancement
for their own portfolios or warehousing loans.
Originators of community development loans often price their loans substantially
below market rates. Yet, at the same time, some potential loan sellers
are reluctant to "mark their loans to market" (discount the
face value of the asset). In addition, sellers accustomed to a continuing
stream of capital sometimes hesitate to use the secondary market, especially
if there is a discount involved, when new funds are freely available.
CRF and others stress the need for an educational process with potential
sellers to help them understand how to value these assets in a mainstream
Even if underwriting, documentation, and pricing issues are resolved,
community development loans may always require some form of credit enhancement
to attract large numbers of investors. Since many community development
loans are subordinated to other creditors with respect to either collateral
or cash flow, credit enhancements reduce investor credit risk. Moreover,
because there is currently incomplete information on the overall performance
of community development loans, credit enhancements compensate for the
risks, real or perceived, that accompany incomplete information. In time,
when a track record is established, it is hoped that even credit enhancements
can be priced and sold to investors seeking higher returns for higher
Other impediments exist since these investments are not liquid, not
rated (though this may change over time), and not publicly traded. Each
of these factors limits the field to institutional investors alone--at
least for the time-being.
Promising Signs and A Hopeful Future
The experience of these pioneering organizations over the past decade
has demonstrated that properly structured financial instruments make it
possible for private institutions to invest in the community development
financing system while decreasing reliance on public sector incentives,
guarantees or tax dollars.
But in order for these programs to be meaningful, they must achieve
greater scale. The costs of organizing a budding national market are enormous.
The philanthropic community, including the Ford Foundation, has played
a critical role in providing venture capital for some of these early efforts.
Other key stakeholders--foundations, corporations, and the public sector,
are beginning to recognize the enormous untapped resources that a viable
secondary market for community development loans could unleash.
Most industry leaders would agree that there has been progress on all
fronts. Piece by piece, a secondary market is taking shape. All of the
organizations described above share a common vision--that of a fully-functioning,
private capital market for community development loans in the not-too-distant
future. And, with the trend toward reduced public support, the sooner
Community Reinvestment Fund
2400 Foshay Tower
821 Marquette Avenue, Minneapolis, MN 44412
Ph: (612) 338-3050, website: www.crfusa.com,
Local Initiatives Managed Asset Corporation
733 Third Avenue, New York, NY 10017
Ph: (212) 455-9882, E-mail: email@example.com
Neighborhood Housing Services of America
1970 Broadway, Suite 470, Oakland, CA 94612
Ph: (510) 832-5542
Multi-Family Housing Institute
1025 Thomas Jefferson Street, NW, Suite 500
Washington, DC 20007
Ph : (202) 624-7165
|| Kathleen Kenny is an independent consultant, based in San Francisco,
who specializes in programs that promote community investment. Her
clients include banks, foundations, nonprofit community development
organizations, cities, and the Federal Reserve Bank of San Francisco.
She is the former Deputy Director of the Development Fund in San Francisco,
where she helped establish eight bank lending consortia for affordable
housing in seven states. She can be contacted at KathKenn@aol.com.
| Frank Altman is President and Chief Executive Officer of the
Community Reinvestment Fund. Prior to co-founding CRF, he held senior
positions in several state agencies in Minnesota, including the Minnesota
Housing Finance Agency. In addition to his responsibilities at CRF,
he serves on numerous national boards and commissions. In 1993, he
was named Financial Services Advocate of the Year for Minnesota and
Region V by the U.S. Small Business Administration.
1 For further detail
on the regulatory definition of a community development loan, please refer
to Regulation BB, "definitions."
2 Vandall, Kerry D.
Improving Secondary Markets in Rural America, paper prepared for the Federal
Reserve Bank of Kansas City, December, 1996.
3 From the Neighborhoods
to the Capital Markets, The National Housing Task Force on Financing Affordable