The New York Fed’s Community Development team has been studying how the secondary market for loans originated by Community Development Financial Institutions (CDFIs) could be expanded. A more robust secondary market for loans made by CDFIs, which specialize in lending to low- and moderate-income communities, would give CDFIs greater access to capital. That, in turn, could increase the capital available to borrowers in the rural communities, suburbs, and urban neighborhoods CDFIs serve.
Building on our earlier work, we interviewed industry participants and hosted a discussion in October in partnership with the San Francisco Fed. That discussion focused on lending originated by CDFI loan funds for affordable apartment buildings. CDFI loan funds aggregate capital from banks and other investors at below-market rates and lend that money to other organizations, including nonprofit housing developers and small businesses in lower-income communities. Our goal in these conversations is to find opportunities for increased access to the secondary market for CDFI apartment building loans and learn how those opportunities might apply to other segments of the CDFI industry.
Understanding CDFI Loan Funds
CDFI loan fund leaders say there is robust demand from borrowers for more loans. Asset managers say they see buy-side demand for securitized CDFI loans, as well as CDFI corporate bonds.
Industry stakeholders stress six issues that have hindered the expansion of a secondary market for CDFI loans: The need for greater standardization of underwriting and terms, data collection, and volume of CDFI loans—as we discussed in an earlier article—as well as issues about the types of loans CDFI loan funds make, how they service those loans, and risk management.
Loan types: In the affordable apartment space, CDFI loan funds typically originate loans to finance predevelopment, acquisition, and construction. These loans usually have less than $2 million in original principal balance and shorter terms, making them different than the commercial real estate loans that are pooled, securitized, and purchased by investors.
Some CDFI loan funds do originate larger, longer-term, and standardized loans, such as permanent debt on Low Income Housing Tax Credit properties. However, many loan funds do not originate these loans, or originate a limited number of them, because of challenges with funding them. Expanding this portion of the loan funds’ portfolios would require access to longer-term sources of funding.
The CDFI Fund’s Bond Guarantee Program is one potential source, since it facilitates loans with terms of up to 30 years. However, industry participants generally felt that additional sources, such as the secondary market, would be necessary to scale up longer-term lending.
Underwriting: To be responsive to the credit needs of the communities they serve, CDFI loan funds originate loans that often include more flexible underwriting and documentation than conventional loans. This may include CDFIs taking a second mortgage on a property, accepting alternative types of borrower documentation, and providing technical assistance to borrowers.
Such unique characteristics and terms of these loans may make them challenging for capital market investors, so finding mission-driven investors may be key if these loans were to be sold.
Servicing: When they hold loans in their portfolios, CDFIs have full control over servicing throughout the life of the loans. CDFI loan fund leaders say their ability to offer more flexibility around ongoing financial reporting and loan extensions, often in close coordination with their borrowers, enables them to originate loans that borrowers might not receive otherwise.
For example, CDFI loan funds can offer extensions to borrowers past the fully extended maturity date. They can do this because they own the loan and are comfortable with the underlying borrower’s ability to repay.
In contrast, capital markets typically have standard servicing policies with consistent treatment for both performing and non-performing loans. These loans are usually managed by loan and asset servicing firms, with practices that include strict payment due dates, loan performance reporting requirements, and guidelines for how a loan can be extended or modified.
If CDFIs were to sell a loan and service it on behalf of a buyer, they would need to agree to certain servicing conditions and might lose the flexibility to extend the loan past the maturity date agreed to in the loan documents.
Volume: There’s already a substantial volume of loans originated by CDFIs, but a relatively limited portion of CDFI loan funds’ portfolios are the types of standardized loans likely to be pooled and securitized, such as loans collateralized by Low Income Housing Tax Credit properties. 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. To do so, it would be necessary to aggregate loans from multiple originators. But CDFI loan fund leaders stressed that they see themselves as originators and see the work of aggregation as a separate line of business they may not have the capacity to undertake.
One solution might be for a third party to step in to aggregate the loans. A possible step in that direction is a program managed by Freddie Mac that aims to expand the pool of originators whose loans can be sold into a Freddie securitization.
Data: Our earlier work noted the gap between the data CDFIs collect and the robust data investors need for due diligence.
Some in the CDFI industry say they would need a strong incentive to streamline, collect, and report data. Doing so could provide benefits, like unlocking private capital, scaling up lending activities, and easing administrative and reporting burdens to donors, the CDFI Fund, and lenders.
Others in the industry say the loan-level data and reporting gap may not be as wide or insurmountable as it seems. For example, CDFIs that are members of the Federal Home Loan Bank system already report a considerable amount of data. Many of the fields that CDFIs would need to collect may only have to be updated quarterly or annually rather than monthly, and data collection may be easier for loans collateralized by Low Income Housing Tax Credit properties, which tend to have sophisticated borrowers.
Conversations with CDFI loan funds suggest that they collect some data points for underwriting and approval but don’t include them in loan onboarding and servicing systems. These include debt service coverage ratio, net operating income, and property valuation.
For the CDFI loan funds that can’t meet increased data reporting requirements, using wraps or guarantees from philanthropic capital could facilitate secondary market sales.
Risk: When loans are securitized and sold, an open question is how much of the junior tranches, which are bonds that have a lower priority of payment, would stay with CDFIs. Another question is around managing interest rate risk for CDFI originators before loans are sold. Both would need to be addressed in the mechanics of a secondary market.
The final challenge may be in how CDFI loan funds think about their business. They typically see themselves as balance-sheet lenders where the ability to underwrite and service nonstandard loans for the communities they serve is core to their mission and strategy. However, accessing new forms of institutional capital, including the secondary market, means buyers of the loans will expect a degree of standardization in loan terms and servicing, as mentioned earlier. This expectation creates a natural tension between CDFI loan funds’ strategy and investors’ asset management practices.
One possibility is that a more robust secondary market for CDFI loans could mean CDFI loan funds keep most of their more unique loans on their books while using the secondary market for more standardized loans that they wouldn’t be able to make without the additional funding.
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.
