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January 8, 2024

What Would It Take to Create a More Robust Secondary Market for CDFI Loans?

A more robust secondary market for loans originated by Community Development Financial Institutions (CDFIs), which specialize in lending to low- and moderate-income communities, would give CDFIs greater access to capital, thus allowing them to make more loans. This is why the Community Development team at the New York Fed is researching the secondary market for loans originated by CDFIs and how that market could be expanded.

There were nearly 1,500 certified CDFIs in the U.S. as of May 2023. These mission-driven financial institutions designed to promote economic revitalization and community development are a distinct category in the financial industry. Credit unions, banks, loan funds, and venture capital funds must meet a set of requirements to earn CDFI certification. That certification is granted by the CDFI Fund, a sub-agency of the U.S. Department of the Treasury. The CDFI Fund is also authorized to provide certified CDFIs with access to sources of capital that aren’t available to other financial institutions, including technical assistance grants and long-term capital at below-market rates.

But those sources of capital are limited. Aside from deposits, the top three sources of capital for CDFIs, according to a Federal Reserve Bank of Richmond survey, are income they earn from fees and interest on loans; government funding; and banks, which loan money to CDFIs to help meet the banks’ Community Reinvestment Act obligations. Those limited sources of capital are one reason why the CDFI industry is small in relation to the rest of the financial world, with roughly $450 billion in assets, a fraction of the nearly $23 trillion held by all non-CDFI U.S. banks.

Expanding CDFIs’ access to capital through the secondary market for their loan originations would allow them to increase financing for low- and moderate-income communities in rural and urban areas. Secondary market sales include selling whole loans, selling loans on a participation basis, or securitizing loans, which is when similar loans are pooled into a portfolio and then sold as tradable, interest-bearing securities. To learn what it would take to expand the secondary market for loans originated by CDFIs, we have been talking to CDFIs, institutional investors, and regulators.

We have found that some CDFI loans are already sold on the secondary market on an individual or pooled basis. Our preliminary research shows billions of dollars in single-family home loans originated by CDFIs are sold each year. These loans, including loans backed by government programs, typically meet standards set by institutional investors and government sponsored enterprises, such as Fannie Mae and Freddie Mac. Among those criteria: the loans are granted on standardized terms and have a robust dataset on underwriting and loan performance. The loans are also created at a large enough volume to be attractive to investors.

If CDFIs want to expand the volume of their loans sold on the secondary market, the industry may benefit from moving toward more standardization, data collection, and volume.  

Standardization: To increase the probability of more sales of CDFI-originated loans in the secondary market, loans should meet institutional investors’ standards. That means loans should have similar underwriting terms, guidelines, and documentation. As noted above, we find this is already happening with residential mortgages and loans backed by government programs. If CDFIs want to sell additional types of loans, such as bridge loans for multifamily properties, then standardizing key elements and documentation for those loans would make evaluating the loans simpler for both investors and rating agencies.

Robust data collection: Our conversations with institutional investors indicate that before buying pooled loans originated by CDFIs, investors and lenders would need more data on historical performance, including delinquencies, for similar loans. Investors want to be able to assess how assets have performed during varying economic circumstances—for instance, periods of low interest rates versus periods of high interest rates. Investors would need more data on metrics like interest rates on the loans, spreads, loan-to-value ratios, debt-to-income or debt-service-coverage ratio calculations, and interest-only periods.

For example, we reviewed the data financial institutions collect on loans sold into commercial mortgage-backed securities transactions and compared this to the data some CDFIs collect when they originate commercial real estate loans. We found that CDFIs gather considerably less data than other originators. CDFIs interested in participating in a secondary market for their loans could review the data points other lenders collect on commercial real estate transactions and mirror that both at origination and throughout the life of the loan.  

Data would also be important for rating agencies working to evaluate the creditworthiness of loans originated by CDFIs. While rating agencies have become more active in evaluating bond offerings from CDFI borrowers as well as loans securitized by CDFI originators, a more robust secondary market for CDFI-originated loans would require expanded ratings of the debt CDFIs hope to securitize.

Volume: There’s already a substantial volume of loans originated by CDFIs. By creating a larger stream of loans that meet institutional investors’ standards, there might be enough volume to bring in more institutional investors and further expand the secondary market.

We’re not the first to see the potential in a more robust secondary market for loans originated by CDFIs. Our goal is to move the idea forward.

To that end, we’ve done preliminary research to size the CDFI market.  In the coming months, our team will build on this work by looking at the origination and sale of CDFI loans. We aim to understand the current size of this market, with a breakdown by collateral type and loan volumes as well as current and previous efforts at securitizing or otherwise selling loans originated by CDFIs. Current policy initiatives may impact CDFIs and their lending activity, so this research may help policymakers understand how the market could evolve.

Jacob Scott is a community development analyst at the New York Fed. He focuses on issues related to climate, health, and household financial well-being.

Maria Carmelita Recto is a community development outreach associate at the New York Fed. She focuses on issues related to household financial well-being.

Jonathan Kivell is the Director of Community Investments at the New York Fed. He focuses on issues related to community development finance and household financial well-being.

The views expressed in this article are those of the contributing authors and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.


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