Community Development Loans and The Secondary Market

Keith Turbett

New advances in the community development lending field have opened up opportunities for increasingly creative lending tools. Some are not necessarily new but are utilizing products once thought only applicable with "typical and routine" lending. One product that has been developed is packaging community development loans from entities and selling them to investors to recycle capital. This has created a unique secondary market. This market is small but could make a serious impact over the next few years as public funds begin shrinking and the need for recycling scarce capital becomes greater. Several entities are responsible for developing this market, setting it up in much the same way that a mortgage company buys home loans from lending institutions.

Examining the credit system for single-family mortgages demonstrates the tremendous possibilities offered by an organized secondary market. More than two-thirds of new single-family mortgages originated in the United States are sold on the secondary market. According to Fannie Mae, the outstanding balance of residential mortgages pledged to instruments such as mortgage-backed securities (MBS) in mid-1996 was $1.6 trillion, or 43 percent of total residential mortgage debt outstanding.

In the same way the single-family market has provided for the recycling of funds throughout the mortgage industry, the recent development of an efficient financing system for community development loans serves the needs of community-based borrowers, lenders, investors and the public. It does this by providing a renewable, ongoing source of capital for community-based lenders, and 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.

One such fund is the Community Reinvestment Fund (CRF), which is located in Minneapolis. Its core service is the creation of a secondary market for community development loans. It buys loans from development organizations, giving them cash to reinvest in their communities.

More than two-thirds of new single-family mortgages originated in the United States are sold on the secondary market.

The loans are bundled and used as collateral to issue bonds. The bonds are sold to private investors, thereby matching private investment with public funds. Since 1989, CRF has purchased or committed to purchase 864 loans, totaling more than $52 million, from 57 organizations in 13 states and Washington, D.C. In purchasing these loans, CRF has provided more than $46 million in cash to local development lenders for reinvestment in their communities. In addition, seven organizations have signed Advanced Commitment agreements to sell $6 million in future loans during the next two years. All clients agree to reinvest their loan sale proceeds into small businesses and related development projects. About 65 percent are small business loans, and the rest are for housing assistance and rehabilitation. The default rate is less than 2 percent, and the delinquency rate is 1.5 percent.

CRF works to develop a well-functioning secondary market for community development loans in three ways:

It promotes access to a steady source of funds for borrowers by purchasing loans from community-based lenders, such as local revolving loan funds, city governments, and housing and economic development authorities;
Community Reinvestment Services, CRF's loan-servicing organization, strives to ensure that borrowers repay their loans as agreed.
It issues loan-backed securities with competitive rates and a low risk-profile, factors that are attractive to investors and promote the long-term viability of the market.

Another entity in this field is the Local Initiatives Managed Assets Corporation (LIMAC), which focuses primarily on housing loans with an emphasis on tax credit equity bridge loans. Based in New York, LIMAC began in 1987 with an investment from The Ford Foundation, which also established the Local Initiatives Support Corporation (LISC). LIMAC purchases loans that were originated to:

finance the development or acquisition of low- and moderate-income housing;
help revitalize deteriorating neighborhoods and/or stabilize low-income communities;
finance the acquisition or development of property for commercial, retail and community service use benefiting low-income communities; or
create employment opportunities for low-income persons. 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, state housing finance agencies, and other community development financial institutions.

Neighborhood Housing Services of America (NHSA) also is in the market for community development loans, primarily in support of its network of more than 170 NeighborWorks organizations. 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 has purchased about $35 million in loans annually, with a cumulative total of more than $200 million in loans in its 23-year history. The majority of NHSA's investors are insurance companies and financial institutions.

Secondary market entities should be looked upon as good opportunities for investors to make an impact on their community.

Intermediaries such as CRF, LIMAC and NHSA prove that community development loans can be good investments. They have never 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 structural safeguards.

These intermediaries offer avenues for the recycling of community dollars that make an impact on the growth of the community as a whole. Whether it be for small business development, affordable housing, or economic development, these secondary market entities should be looked upon as good opportunities for investors to make an impact on their community.