Community Dividend

With support, securitization could boost community development industry

For community economic development lenders, selling loans to a secondary market can be an effective recapitalization strategy.

Devon Pohlman | Community Affairs Senior Project Manager

Published November 1, 2004  | November 2004 issue

Many organizations that lead development and revitalization efforts in low- and moderate-income communities have a deep, ongoing need for funding. They often turn to community economic development (CED) lenders to meet that need.

Broadly speaking, a CED lender is an entity that makes loans to support initiatives that assist low- and moderate-income communities, such as housing rehabilitation, neighborhood reinvestment and small business development. CED lenders include some banks, government agencies and local development commissions, but the category is mainly made up of nonprofit organizations, financing companies and loan funds that developed in response to specific needs in their communities.

CED lenders rely on public and private grants to fund many of the loans they make. In recent years, increased competition and expenses in the public and private sectors have changed the environment, making corporate, philanthropic and government funding sources scarce. To continue making loans, CED lenders must find innovative ways to fill financing gaps.

One avenue that some CED lenders are pursuing is to securitize community development loans and sell them on the secondary market. Securitization, which radically altered the mortgage market in the 1970s and later transformed other consumer loan and lease markets in the mid- to late 1980s, offers some benefits to CED lenders. However, significant barriers remain for CED lenders interested in pursuing securitization. Some entities, such as the Minneapolis-based organization profiled below, are finding innovative ways to overcome those barriers and advance the securitization industry.

Basics and benefits

Securitization involves pooling loans with similar characteristics and selling them to investors. Or, as a 2003 report from the Government Accountability Office (GAO) 1/ explains, it is a process that "packages relatively illiquid individual financial assets, such as loans, leases or receivables with common features, and converts them to interest-bearing, asset-backed securities with characteristics marketable to capital market investors."

The primary benefit of securitizing a pool of loans is the increased liquidity provided to the originator. Lenders who sell loans to a secondary market source do not have to hold the loans on their books, and are able to increase loan activity, thereby increasing the flow of credit to community development organizations and generating more earned income. For CED lenders who have deployed much or all of their available funds, selling loans can be an effective recapitalization strategy.

In an article titled "Will the Securitization Revolution Spread?" 2/ Federal Reserve Bank of Minneapolis Vice President Ron Feldman discusses additional benefits that securitization offers to lenders, borrowers and investors.

According to Feldman, securitization benefits lenders by efficiently reallocating and reducing portfolio risk. For example, lenders who want greater diversification in their loan portfolios can use securitization—either the ability to sell or to purchase loans—as a means to achieve it. Additionally, the ability to sell loans in a securitized form reduces the potential impact of interest rate risk on the institution. Securitization benefits borrowers by increasing the amount of credit that lending institutions make available to the community. Furthermore, investor interest in the purchase of securities can lead to lower borrowing costs for the original borrower. The ability to purchase particular types of securities benefits investors in two ways. First, securities provide investors choices to better align maturity and risk-return needs. Second, securities provide an option that can help investors diversify their portfolios.

Barriers to CED securitization

To realize the benefits of CED securitization, CED lenders must first overcome certain barriers. The most formidable of these is a lack of standardization in loan performance data, documentation and underwriting procedures.

Investors interested in purchasing securities require accurate and reliable loan documentation and performance data in order to assess and project risks associated with the securities. Most CED lenders emerged to fill credit needs specific to their communities. As a result, they operate independently from one another and offer specialized products. Underwriting criteria, servicing protocol, documentation standards and the quality of loan performance data differ from lender to lender. 3/ The inconsistencies complicate the securitization process and, from the standpoint of potential investors, increase the risk.

A second major barrier to CED loan securitization is the need to develop and build an infrastructure to support these types of transactions. According to the GAO report cited earlier, "If securitization is to become a viable alternative for lenders, information sharing and securitization mechanisms are needed to provide consistent avenues for lenders to sell loans, achieve the volume of loans needed for a securitization, and achieve quality control." 4/

Another barrier is uncertainty related to borrower demand for community development loans. Low demand could lead to diminished loan volume, which could, in turn, hamper securitization. It may seem that there will always be a strong demand for CED loans, considering the enormous needs in some communities, but the GAO points out that "there are no mechanisms or standards for forecasting future borrower demand for such loans, making it difficult to determine what borrower demand might be across markets." 5/

According to the GAO, additional barriers to securitization include insufficient capacity, which limits lenders' ability to participate in securitization; the belief on the part of many lenders that below-market-rate products will not meet market requirements without substantial discounts; and external requirements that may prevent or serve as a disincentive for securitization.

The Community Reinvestment Fund model

One major player in the securitization of CED loans is Community Reinvestment Fund (CRF), a Minneapolis-based nonprofit organization. Since it began operations in 1988, CRF has purchased 1,500 CED loans totaling $350 million. The organization has purchased loans from more than 110 CED lenders across the country, ranging from small towns like Black Duck, Minn., to large, statewide entities like the Wisconsin Housing and Economic Development Authority.

CRF is developing innovative ways to overcome some of the major barriers to CED securitization. Since its beginnings, the organization has pioneered an effort to purchase and package CED loans. CRF purchases CED loans in one of two ways: they are bought from an existing portfolio, or CRF works with CED lenders on an advance-commitment basis. The latter approach allows CRF to dictate underwriting and documentation standards in advance. By keeping the standards consistent from seller to seller, CRF can avoid the standardization problems that are a major issue for potential investors.

To increase investor confidence and make securitized CED loans more marketable, CRF began delivering rated securities earlier this year. In July, a CRF affiliate called Affordable Housing No. 2 LLC, working through Wells Fargo Brokerage, offered $84.7 million in certificates backed by first mortgages on affordable rental properties. Standard & Poor's issued an "AAA" rating on $63.5 million of the offering. Certificate buyers included banks, mutual funds, insurance companies and pension funds.

Simultaneously, CRF worked with Wall Street Without Walls, a finance-oriented technical assistance organization that helps CED lenders access capital markets, and Piper Jaffray to deliver its first rated debt offering backed by small business loans. This offering, which CRF brought to the market in October, is backed by a $50 million loan pool that contains more than 130 loans originated by 43 CED lenders in 20 states. Standard & Poor's rated more than $46.5 million of the debt offering "AAA."

"Rated securities have allowed us to attract more institutional investors who want to participate in community economic development with the assurance that their investment has been carefully evaluated by a third party," says CRF President and CEO Frank Altman. "It's an important step for both CRF and the industry."

To help develop an infrastructure for CED securitization and enhance the capacity of loan originators, CRF has offered training to CED lenders. As Altman explains, "Selling financial assets is not something that has been done extensively in the community development field. A lot of groups simply did not understand the process."

CED lenders' knowledge of and comfort level with securitization has grown. For example, Altman notes that many of the lenders his organization works with are now using the secondary market as part of their capitalization strategy. When CRF first began operating, many lenders only sold loans on an as-needed basis. Increasingly, CED lenders are selling loans before they run out of loan capital.

"That has led many groups to be repeat sellers," says Altman. "They've developed a schedule."

A strong foundation

By providing standards and supports for the unique, independent organizations that make up the CED lending industry, CRF is overcoming some of the major barriers that have limited CED loan securitization. The organization's issuance of debt certificates and notes with investment-grade ratings is an additional development that could form a strong foundation for growth in the industry.

It is likely that developments and advances will continue if more CED lenders, intermediaries and investors recognize that, in Altman's words, "the mechanism works." Industry leaders are hopeful that there will be collaboration among major CED lenders that will encourage more widespread use of the secondary market as a recapitalization tool. If those hopes are realized, it could mean more resources and a brighter future for low- and moderate-income communities.

Devon Pohlman is a housing program professional with the Minnesota Housing Finance Agency.

1/ Community and Economic Development Loans: Securitization Faces Significant Barriers. General Accounting Office, GAO-04-21, October 2003, p. 6. The name "General Accounting Office" was in place at the time of the report's publication, but the agency changed its name to "Government Accountability Office" on July 7, 2004.

2/ The Region, Federal Reserve Bank of Minneapolis, September 1995.

3/ GAO, p. 41.

4/ Ibid., p. 42.

5/ Ibid., p. 35.