annie donovan is director of the U.S. Treasury Department’s Community Development Financial Institutions Fund. kim saunders is president and CEO of the Eads Group, a North Carolina-based financial consulting firm. The views expressed are those of the authors and do not necessarily reflect the policies or views of the U.S. Treasury Department.
Published October 29, 2018
Drill deep into the 1,100-page Tax Cuts and Jobs Act of 2017 and you'll find some little-discussed provisions – including one likely to appeal to almost everyone. The law includes the establishment of "Opportunity Zones," low-income communities that could benefit from new tax incentives to encourage investment and create jobs.
While the nuts and bolts seem complex, the core concept is pretty simple: bring equity to capital-scarce, economically distressed areas by allowing tax deferral on invested capital gains — and potentially full tax forgiveness on new gains generated through Qualified Opportunity Funds (QOFs).
Even a casual online search suggests the financial services industry is already working to create QOFs. The success of these QOFs should be gauged not only in terms of risk-adjusted returns to private investors, but also in terms of their impact on low-income communities. We think the secret to maximizing both the private and social returns could lie in the synergies between the QOFs and a more established concept, community development financial institutions (CDFIs).
CDFIs, which are certified by the U.S. Treasury, have been around for decades. They have a proven record of investing in a variety of enterprises that contribute to communities’ economic health, even as they generate solid financial returns. Indeed, CDFIs have the benefit of hard-earned expertise that can help them make the most of Opportunity Zones. Furthermore, because the new tax incentives are specifically designed to attract equity capital, the credit products provided by CDFIs could leverage both the social impact and private return of Opportunity Zone funding.
CDFIs are community-oriented financial organizations that take a market-based approach to supporting economically disadvantaged communities. They come in a host of forms, from regulated banks and credit unions to unregulated for-profit and non-profit loan funds, venture capital funds and microfinance funds. CDFIs do not have just one origin story but have sprung from many approaches to generating economic opportunity in underserved communities.
CDFI roots trace back as far as the 1880s, when the first minority-owned banks were created in African-American communities to provide desperately needed financial services after emancipation. Credit unions emerged from the Great Depression in the 1930s and 1940s, while non-profit loan funds grew out of the community development movement of the 1960s and 1970s. CDFI formation continues today using diverse business models, including some that identify as “fintech” firms.
CDFIs are a fulcrum for collaboration, bringing together private and public sector investors in ways that make it practical for profit-driven investors to engage in underserved markets where specialized knowledge is key.
Regardless of their form, these institutions share the objective of providing access to credit for individuals and communities on the economic margins. CDFIs help families finance their first homes, support community residents starting businesses, and invest in local health centers, schools and community centers.
CDFIs do not succeed on their own. They are a fulcrum for collaboration, bringing together private and public investors in ways that reduce investment origination inefficiency and make it practical for profit-driven investors to engage in underserved markets where specialized knowledge is key. CDFIs may do this by providing financial engineering geared to the setting and by taking financial positions that allow commercial investors to realize competitive risk-adjusted rates of return.
Because of their ongoing success in funneling capital to projects with high social returns, Congress established the Community Development Financial Institutions Fund in 1994 to support the growth of CDFIs and designed its programs to ensure that CDFIs would leverage private capital alongside public resources. The CDFI Fund (directed by one of the authors of this article) operates within the U.S. Treasury Department.
The CDFI Fund invests in CDFIs, making them better partners able to innovate and to discover what works. Unlike many federal programs, the CDFI Fund provides funding at the enterprise level rather than the project level. Through a competitive process that rewards the most compelling plans for deployment of its resources, the CDFI Fund evaluates the strength of business plans and management teams and delivers flexible funding that must be matched on a dollar-for-dollar basis from private sources.
The CDFI Fund certifies CDFIs based on a set of criteria that includes their service to distressed communities that lack access to capital, their provision of development assistance alongside financial products and services, and their accountability to the communities served. CDFIs cannot be government entities — all are private organizations. From humble beginnings, CDFIs now form a robust subsector within financial services. At the end of 1997, there were 196 Treasury-certified CDFIs with total assets of $4 billion. Today, there are over 1,100 with assets of approximately $150 billion — and that figure does not include the off-balance-sheet assets managed by CDFIs, which amount to many billions more. You don’t have to look far to find one: there are CDFIs in all 50 states and D.C., as well as in most U.S. territories.
Punching Above Their Weight
Perhaps CDFIs’ most significant accomplishment to date: demonstrating that, as a group, low-income communities are surprisingly creditworthy. A 20-year study conducted by the Opportunity Finance Network found that unregulated CDFIs had an average delinquency rate of 3 percent and average net charge-offs of just 0.9 percent. A similar study of regulated CDFIs found an average delinquency rate of 5.3 percent, with average net charge-offs of just 0.65 percent. The comparable average net charge-off rate for “mainstream” financial institutions is 1.05 percent.
Two studies released by the CDFI Fund in 2015 examined the effectiveness of CDFIs through the Great Recession. One study, conducted by Gregory Fairchild of the University of Virginia and Ruo Jia of Stanford, focused on regulated CDFIs, while the second, led by Michael Swack of the University of New Hampshire, examined unregulated CDFIs.
Fairchild and Jia examined whether CDFIs are at greater risk of institutional failure or greater vulnerability to mortgage market downturns, or are less efficient than mainstream financial institutions. He concluded that CDFI banks and credit unions were no more likely to fail than their mainstream counterparts, even after controlling for the CDFIs’ degree of involvement in the mortgage market during the financial crisis. Furthermore, despite their focus on predominantly low-income markets, CDFI banks and credit unions had virtually the same return on capital as mainstream financial institutions.
Swack, for his part, examined the social impact of unregulated CDFIs over the recession. He found that between 2005 and 2012, banks reported lending decreases in low-income markets, while CDFI loan fund credit more than tripled. These CDFI loan funds served borrowers who would often not have qualified for credit from mainstream sources — and at terms that were still comparable to mainstream products. All told, then, CDFI loan funds provided a much-needed countercyclical boost to local economies during a critical period.
The CDFI Fund evaluates the strength of business plans and management teams, and delivers flexible funding that must be matched on a dollar-for-dollar basis from private sources.
CDFIs that report their lending activity to the CDFI Fund (only the 20-30 percent receiving assistance awards from the CDFI Funds are required to do so) have shown continuous growth in loan originations and assets under management. From 2011 to 2017, CDFIs reported originating $19 billion.
More than 80 percent of this lending activity was targeted to low-income families, high-poverty communities and underserved populations. Nearly 18 percent of the funds went to rural areas, and over 18 percent to persistent-poverty counties. This exceeds the proportion of low-income populations living in those areas — at 15 percent and 6 percent for rural and persistent-poverty areas, respectively.
The chart below shows the distribution by sector for the $5 billion originated by CDFIs for 2017.
Over the past several decades, investors have discovered the value of partnering with CDFIs to extend their reach into low-income communities, many of which are newly designated Opportunity Zones under the tax law. Banks have been at the forefront, in part due to requirements of the 1977 Community Reinvestment Act (CRA), which encourages banks to meet the needs of all sectors of the communities they serve, including low-income ones. Banks that do not receive at least a satisfactory CRA rating from their regulators may be prevented from merging with or acquiring other banks. CRA ratings are public, which also acts as further incentive for banks to do their bit.
Banks began engaging with CDFIs by investing directly in them for CRA credit. They continue to do so today, but they have also been deploying capital for purposes aligned with their own strategic goals with the help of CDFIs.
For example, in 2018, Bank of America launched a $20 million Veteran Entrepreneur Lending Program to provide affordable credit to military veterans. It chose to implement the program through five CDFIs that specialize in small business and could do a better job preparing the veterans to handle debt by structuring the loans more flexibly and managing loan performance more closely. All told, over the past several decades, Bank of America has invested $1.6 billion in some 260 CDFIs.
In 2014, JPMorgan Chase launched the five-year, $125 million Partnership for Raising Opportunities in Neighborhoods initiative with the goal of increasing economic opportunity for low- and moderate-income families. The bank selected CDFIs as partners, noting that “CDFIs deliver the loan capital to develop the community infrastructure residents need to thrive, such as affordable housing, child care centers, health clinics and grocery stores. CDFIs also provide financing to underserved entrepreneurs that are unable to qualify for traditional financing.”
An evaluation by Harvard’s Joint Center for Housing Studies found that, in the first year of the program, CDFIs leveraged JPMorgan Chase’s $33 million 2014 investment into $351 million in capital, which was used to finance some 1,250 loans in low-income communities. Those transactions created or preserved 1,600 units of affordable housing, created or saved nearly 4,500 jobs and financed 330 businesses.
Goldman Sachs’ “10,000 Small Businesses” initiative partners with CDFIs to expand the capital available to small enterprises and to provide them with technical assistance. Goldman Sachs’ investment in the initiative to date: $300 million.
Where Opportunity Zones Fit In
Earlier this year, governors of all 50 states and territories and the mayor of D.C. nominated 8,700 low-income census tracts, designated in June by the U.S. Treasury Department, as Opportunity Zones under the Tax Cuts and Jobs Act. CDFIs reporting to the Treasury’s CDFI Fund have invested $7.4 billion in over 75,000 transactions since 2003 in places now designated as Opportunity Zones. What’s more, there are 318 CDFIs whose headquarters are located in Opportunity Zones. As Qualified Opportunity Funds seek to deploy their equity capital, CDFIs will be uniquely positioned to provide both local market intelligence to a new class of investors as well as complementary debt funding.
The Liberty CDFI Story
The African-American-owned Liberty Bank and Trust Company is both an FDIC-designated minority depository institution and certified CDFI. Headquartered in New Orleans, Liberty was founded in 1972 by Alden McDonald, who is still at the helm. McDonald said he is optimistic that Opportunity Zones can raise the capital that will spread the growth being experienced in other parts of the city to impoverished neighborhoods.
Liberty largely serves minorities in the communities collectively known as New Orleans East. With a full range of products such as affordable small-business loans, small-dollar consumer loans and mortgages, it finances everything from grocery stores to start-ups of all kinds. It makes restaurant loans, too: but for Liberty, the acclaimed Dooky Chase’s Restaurant in Tremé would not have received the credit it needed to expand back in 1982 and transform itself into New Orleans’s premier dining spot for authentic Creole cuisine.
But for Liberty, the acclaimed Dooky Chase’s Restaurant in Tremé would not have received the credit it needed to expand back in 1982 and transform itself into New Orleans’s premier dining spot for authentic creole cuisine.
Liberty’s customers often do not meet conventional underwriting standards. But Liberty designs its products and services in ways that set up its customers for success, yet still operates under the same regulatory regime as any other bank.
Liberty has thrived despite a series of catastrophes ranging from an oil price collapse to Hurricane Katrina to the Great Recession, all of which disproportionately affected its low-income markets and customers. The key to success for many CDFIs is understanding the unique risks of low-income communities and borrowers and managing them in ways conventional investors often are not equipped to do.
When it comes to risk mitigation in underserved markets, it’s not always about money, and data don’t always tell the full story. CDFIs take the time to dig deeper, offering a host of services to loan customers that enhance their creditworthiness. In particular, they coordinate resources from a variety of partners to provide the hand-holding that can make the difference between success and failure.
For example, in post-Katrina New Orleans, many of Liberty’s loan applicants were in a bind because the cost of repairing their homes exceeded market value. Liberty decided to extend credit anyway. But it went to exceptional lengths to make the loans work, intervening to prevent cost overruns once renovations began, as well as requiring homeowners to use insured contractors and to get multiple bids. It also had its own inspectors verify the quality of the work.
Liberty has expanded its footprint over the past decade to include 16 branches serving primarily low-income African-Americans in seven states. In 2009, near the nadir of the housing crisis, Liberty acquired Home Federal Savings Bank, a minority-owned depository institution in Detroit. At the time, the residential real estate market was upside down in many places, but it was truly dead in Detroit. Virtually no mortgages were being written.
Despite the lack of sales comparables to establish market values, Liberty began to lend to customers in Detroit. To reduce the odds of failure, the bank deployed some of the same tactics developed for the New Orleans East market after Katrina.
Liberty was subsequently contacted by JPMorgan Chase, which was planning to commit a substantial sum to the revitalization of Detroit. JPMC wanted to form a partnership to increase mortgage lending to Liberty’s target market at a more rapid clip. JPMC funded a loan loss reserve, which Liberty leveraged five-fold from its own balance sheet. The partnership proceeded to originate substantial loan volume, all of which had loan-to-value ratios over 100 percent and some as high as 150 percent. To put it simply, JPMC has discovered the value of partnering with CDFIs to extend its reach into low-income markets.
The history of public-private partnerships designed to advance social ends and fueled by tax incentives is not one of unalloyed success. But CDFIs do have a record of proving the skeptics wrong. They know the communities they have been a part of for decades, know where the good investment opportunities are and understand how to finance commercially viable ventures in low-resource settings. And if the new Opportunity Funds created to invest in Opportunity Zones make full use of CDFIs dedication and hard-won expertise, there’s every chance this one will be a winner.