Community Investments Magazine · 2014-02-13 · If you have an interesting community development program or idea, we would like to consider publish-ing an article by or about you

A P U B L I C A T I O N O F T H E C O M M U N I T Y A F F A I R S U N I T O F T H E F E D E R A L R E S E R V E B A N K O F S A N F R A N C I S C O

V O L U M E F O U R T E E N N U M B E R 1

02

SPECIAL EDITION

A GUIDE TO COMMUNITY

DEVELOPMENT INVESTMENTS

LOW INCOME HOUSING TAX CREDITS

PAGE 3

COMMUNITY DEVELOPMENT REAL

ESTATE INVESTMENT TRUSTS

PAGE 7

EQUITY EQUIVALENT INVESTMENTS

PAGE 10

SMALL BUSINESS INVESTMENT

COMPANIES

PAGE 14

COMMUNITY DEVELOPMENT

MUNICIPAL BONDS

PAGE 17

MORTGAGE BACKED SECURITIES AND

COLLATERALIZED MORTGAGE

OBLIGATIONS

PAGE 20

COMMUNITY DEVELOPMENT

VENTURE CAPITAL

PAGE 24

REGULATORY RESOURCE

PAGE 28

MARCH

A

2

NOTEBOOK

Community Investments

EDITOR-IN-CHIEF

Joy Hoffmann

MANAGING EDITOR

Lena Robinson

CONTRIBUTING EDITOR

Jack Richards

ART DIRECTOR

Cynthia B. Blake

If you have an interesting community developmentprogram or idea, we would like to consider publish-ing an article by or about you. Please contact:

MANAGING EDITOR

Community InvestmentsFederal Reserve Bank of San Francisco

101 Market Street, Mail Stop 620San Francisco, California 94105

Community Affairs Departmentwww.frbsf.org(415) 974-2978

fax: (415) 393-1920

Joy HoffmannVice President

Public Information and Community [email protected]

Jack RichardsCommunity Affairs Senior Manager

[email protected]

Bruce ItoAssociate Community Investment Specialist

[email protected]

H. Fred MendezSenior Community Investment Specialist

[email protected]

Craig NolteSenior Community Investment Specialist

(Seattle Branch)[email protected]

John OlsonCommunity Investment Specialist

[email protected]

Adria Graham ScottCommunity Investment Specialist

(Los Angeles Branch)[email protected]

Lena RobinsonCommunity Investment Specialist

[email protected]

Mary MaloneProtocol Coordinator

[email protected]

Judith VaughnStaff Assistant

[email protected]

by Fred Mendez

Community Investments March 2002

As you may know, the revised Community Reinvestment Act (CRA) regulation changedthe way financial institutions are evaluated from twelve fairly broad-based “assessmentfactors” to a more bottom-line approach. Large financial institutions (those with assetsover $250 million or a subsidiary of a holding company with combined assets over $1billion) are evaluated on lending, investing and service activities that relate tocommunity development. The four federal bank regulatory agencies have definedcommunity development to mean affordable housing for low- or moderate-incomeindividuals, community services targeted to low- or moderate-income individuals,activities that help small businesses and activities that revitalize or stabilize low- ormoderate-income geographies. Small financial institutions and wholesale/limitedpurpose financial institutions are evaluated in a streamlined manner that takes someof the same information into account but is tailored to their limitations andenvironment.

The idea behind this change was to focus on the strength of financial institutions—namely, lending in the communities they are chartered to serve. The CRA’s “lendingtest” is the most heavily weighted of the three tests mentioned above except in thosecases where an institution’s charter or environment make lending difficult. The othertwo tests, investment and service, are designed to either compliment lending activityor to set a foundation for safe and prudent lending in the future.

The investment test was designed to allow financial institutions to meet theirobligations under the CRA through methods that are “innovative, creative and flexible”– adjectives that appear several times throughout the regulation. Financial institutionsvary in size and specialty, and although they are federally insured, financial institutionsare private enterprises. Consequently, agencies cannot and will not dictate what specificproducts and services they can offer as long as they are permissible by current bankinglaws.

By seeking creative investment opportunities, financial institutions can act as acatalyst for other private sector investment and can make a vested interest incommunities in which they are chartered to serve. This special edition of CommunityInvestments is designed to help financial institutions define Community ReinvestmentAct qualified investments and understand related regulatory and technical issues. Inaddition to the regulatory guidance provided, each of the seven articles is designed toaddress four areas concerning the most common CRA qualified investments:

1. What they are and how they work

2. Where and how they can be obtained, including some discussion of theiravailability relative to other investment vehicles

3. How they are booked; and

4. How they qualify under the CRA

This publication presumes that the reader has a working knowledge of the CRA and itsimplementing regulation. Information about the CRA regulation is available atwww.FFIEC.gov. Financial institution representatives should contact their regulatoryagency liaison to discuss any specific questions you may have regarding qualifiedinvestments. We hope you find this publication useful.

O

3

Over the past decade, the federal Low-

income Housing Tax Credit (LIHTC)

has emerged as an innovative and cred-

ible financial instrument that allows

banks both a profitable and safe re-

turn, and investment credit under Com-

munity Reinvestment Act (CRA) re-

quirements. This article discusses, in

part, what low income housing tax

credits are, how they work, how banks

can access them and how they qualify

under the CRA.

What is a tax credit?

The credit is a dollar for dollar reduc-

tion of the investor’s federal income

tax liability—if any investor owes $100

in federal income taxes and holds $100

in tax credits, the investor’s tax liabil-

ity for that year is zero. The program

was created as part of the Tax Reform

Act of 1986 in order to encourage the

development of rental housing for low-

income households (tenants housed in

properties generating tax credits must

earn 60% or less of median family in-

come for their county and state hous-

ing agencies may impose lower in-

come limits).

The program has been very success-

ful, creating over 100,000 units annu-

ally and spawning hundreds of millions

of dollars in investment. Typically used

in multi-family housing development,

the equity created by the sale of tax

credits allows a reduction of the

property’s mortgage, which in turn al-

Low-income HousingTax Credits

lows the property owner to lower

rents, rendering the property afford-

able to lower-income households. For

now, the credit only applies to rental

properties, although the Administra-

tion has suggested expanding it to fa-

cilitate home ownership.

Tax credits are generated when a

developer, either for-profit or non-

profit, builds an affordable housing

rental development. Most of the costs

associated with development, except

land and associated costs, cash re-

serves and certain financing costs, are

accrued into what is referred to as the

property’s “eligible basis.” The annual

credit amount is calculated by multi-

plying the eligible basis by the appli-

cable credit percentage (which

changes monthly). Credits are earned

over ten years, although the property

must remain affordable for at least fif-

teen years (state housing agencies may

impose longer affordability periods).

Example: Calculating the Credit

Project Cost: $7,500,000

Less ineligible costs: (1,500,000)

Eligible basis: $6,000,000

Credit percentage: x 8.55%

Annual credit amount: $ 513,000

The investor earns credits over tenyears, and the income compliance pe-riod is fifteen years. As a result, thedeveloper has a ten-year stream of tax

credits and a fifteen-year stream of tax

losses to sell to an investor. The inves-

tor is typically the limited partner of a

real estate operating partnership with

a general partner (who may be the

developer or a separate company) who

is responsible for operating the prop-

erty on a daily basis. The developer

sells a majority of the operating part-

nership (typically 99.99%) to the inves-

tor, who then contributes equity to the

property in exchange for the tax credits.

What is the investor buying?

The investor is buying a financial asset

in the form of a stream of tax benefits

(both credits and losses associated with

depreciation and interest) with real es-

tate supporting the asset. The investor’s

return is based on the price paid for this

benefit stream. The developer will typi-

cally require payment of the capital into

the property for development costs, and

as a result, the investor’s capital is typi-

cally paid in several installments depen-

dent on benchmarks such as construc-

tion completion. Full payment is due

by the time construction is complete, the

property is stabilized and the perma-

nent mortgage loan is closed. Returns

fluctuate according to the usual econo-

mic barometers but are currently in the

range of 7%–8% (after tax, assuming a

35% marginal rate taxpayer).

The equity the investor pays is cal-

culated this way, using our previous

example above:

by Catherine Such, Vice President of Originations and Community Development, Columbia Housing


4

Annual credit amount: $513,000

Over ten years: $5,130,000

Multiplied by price: .75

(varies significantly by transaction)

Multiplied by investor’s

share: 0.9999

TOTAL EQUITY: $3,847,115

Because it is a dollar-for-dollar reduc-

tion of federal tax liability, the investor’s

annual credit amount has a positive

impact on earnings per share because

it reduces tax liability without diluting

earnings. In addition to the credit, the

investor will earn tax losses as well;

these losses do lower tax liability by

lowering overall corporate earnings but

typically the losses associated with

depreciation and interest are much less

significant to the overall investment

than the credit.

What are the investor’s rights and

responsibilities?

As a limited partner, the investor is

primarily responsible for oversight and

the general partner is responsible for

day-to-day operations. The relationship

between the limited partner and the

general partner is governed by an op-

erating partnership agreement which

is typically a complex document ne-

gotiated with the help of experienced

tax counsel.

How do LIHTCs qualify under the

Community Reinvestment Act?

An investment in Low-income Hous-

ing Tax Credits qualifies under the in-

vestment test of the Community Rein-

vestment Act. Typically, CRA credit is

given in the year the investment is

made although the benefits from the

investment last for the length of the

operating partnership.

How do you access the credit?

This is a long-term and sophisticated

financial investment. There is an ac-

tive secondary market for credits, but

many investors choose to keep their

investment over the life of the part-

nership rather than trade it. The Inter-

nal Revenue Service has a number of

requirements in Section 42 of the tax

code including highly specific and

ongoing income compliance require-

ments. The investor is typically a lim-

ited partner without daily operational

responsibility. For all these reasons, it

is important to choose your partners

carefully.

Most banks invest in tax credits ei-

ther directly or through investing with

a tax credit syndicator. Banks that

choose to invest directly typically

make a significant investment in their

own infrastructure, hiring relationship

managers, underwriters and asset man-

agers to watch over the investment. This

may be daunting for smaller banks,

particularly those not already involved

in financing affordable housing through

construction or permanent lending.

Banks interested in investing in tax

credits, but uninterested in creating a

department to do so, often choose to

work with a syndicator. Syndicators

are financial intermediaries that can

find tax credit properties, underwrite

the underlying real estate, work with

the developer, general partner and

development team (including the

property management firm) and then

manage the asset for its life. A syndi-

cator performs these services in ex-

change for a load, or a percentage,

applied to the investment. Loads vary

widely depending on the syndicator,

services performed and whether the

investor wants cash reserves. Loads

typically vary between 9% and 12%.

There has been consolidation in the

syndicator industry over the past 18

months and as a result most syndicators

who emerged from that shake-out are

relatively sophisticated and in many

cases have the financial backing of a sig-

nificant corporate parent such as a bank.

There are two vehicles for investing

with a syndicator: proprietary funds

and multi-investor funds. In either sce-

nario, the syndicator will find poten-

tial properties, perform underwriting

and present the transaction to inves-

tors. The investor typically has consent

rights to the transaction.

Proprietary funds are best for banks

wanting a significant amount of con-

trol over the investment. Typically, a

proprietary investor will exercise much

more due diligence over individual

transactions because they are the sole

or majority investor and their risk is

not mitigated by the presence of other

investors. For banks that are interested

primarily in maximizing their CRA

credit, a proprietary fund may be the

best option as the bank will have ulti-

mate control over the geography, ac-

quisition guidelines and pricing of the

investment.

The advantage of a multi-investor

fund is primarily risk diversification; for

example, in a $50M multi-investment

fund, there may be between two and

five investors, all of whom share risk.

Usually a multi-investor fund will be fully

specified, with financial and underwrit-

ing details about all the properties in

the fund, prior to the fund’s offering.


5

ABOUT THE AUTHORIn syndicated transactions, the syn-

dicator is typically responsible for pri-

mary contact with the general partner

of the operating partnership. This al-

lows the bank investor to focus on ar-

eas that are important to that investor.

Because the syndicator is typically on

the front line of negotiating with the

general partner, it is important that the

syndicator be experienced and knowl-

edgeable, but also that the organiza-

tion have competent tax counsel.

How do you choose the right

partner?

Whether banks are investing directly

or with syndicators, there are several

things to look for in a partner. First,

the partner should be generally knowl-

edgeable about real estate. Syndicators

should have depth of knowledge and

experience on their management teams

and in the staff working on transac-

tions. Syndicators should also have

solid underwriting processes and pro-

cedures that include checks and bal-

ances during the approval process.

The syndicator should be able to pro-

vide the investor with the information

necessary to approve a transaction in

an organized, accurate and timely fash-

ion. Most investors do a significant

amount of due diligence on syndica-

tors, particularly if they intend the rela-

tionship to last over a period of years,

and may review the syndicator’s exist-

ing portfolio, tax counsel, underwrit-

ing and asset management processes.

Over the past several years, the

Low-income Housing Tax Credit has

proven to be an excellent investment

for banks, both from a CRA and a fi-

nancial perspective. While relatively

more complicated than some forms of

real estate finance, with the right fi-

nancial partners the tax credit is not a

daunting investment and it allows

banks to participate in a meaningful

and financially rewarding way in their

community.

CATHERINE H. SUCH, vice president oforiginations and community develop-ment, is responsible for identifying andevaluating potential investment proper-ties and for the preparation of acquisitioncontracts and preliminary financial analy-sis. Ms. Such also spearheads Columbia’scommunity development function. In thiscapacity, she serves as Columbia’s liaisonto the political community.

Columbia Housing111 S.W. Fifth Avenue, Suite 3200Portland, Oregon 97204800-635-6556

CI

The Federal Reserve System’s updated Directory: Community Development Investments is agreat resource for bankers, community development groups and others interested in commu-nity development finance. It is currently available via the Federal Reserve Board of Governor’swebsite or by mail.

The directory contains profiles of community development investments made by bank hold-ing companies and state-chartered banks supervised by the Federal Reserve System. The pro-files highlight the activities of community development corporations, limited liability compa-nies and limited partnerships in which institutions have invested. Each profile describes theamount of initial capital invested by an institution and community development projects un-dertaken or planned. Also listed are contact persons who can provide additional informationon community development corporation organization and operations.

The directory can be downloaded from the Federal Reserve Board of Governor’s Web site:www.federalreserve.gov/community.htm

COMMUNITY DEVELOPMENT INVESTMENTS GUIDE AVAILABLE


http://www.federalreserve.com/community.htm

6

Definition: The Low-income Housing Tax Credit (LIHTC) is a credit against regular tax liability for invest-ments in affordable housing projects acquired and rehabilitated after 1986. Generally speak-ing, the credit is available annually over a ten-year period beginning with the tax year inwhich the project is “placed in service” or, at the owner’s election, the next tax year. A taxcredit project must meet one of the “minimum set-aside” requirements noted below. A quali-fied low-income housing project must comply continuously with these minimum set-asiderequirements for a full 15-year compliance period. A failure to meet this requirement willresult in a complete invalidation of a portion of the credit already taken. LIHTCs are carried asinvestments on the investing institution’s balance sheet in accordance with Generally Ac-cepted Accounting Principles (GAAP).

Minimum Set-Aside Requirements

1. 20/50 Test: Under this test, at least 20 percent of the residential rental units must be bothrent-restricted and occupied by individuals whose income is 50 percent or less of areamedian gross income, adjusted for family size.

2. 40/60 Test: Under this test, at least 40 percent of the residential rental units must be bothrent-restricted and occupied by individuals whose income is 60 percent of less of areamedian gross income, adjusted for family size.

➤ Special rules apply with respect to tenants who originally qualified under the govern-ing income levels and whose income subsequently rises above such levels.

➤ A unit is “rent-restricted” if gross rent does not exceed 30 percent of the qualifyingincome levels in either 1 or 2 above. Restricted rents are determined using 1.5 personsper bedroom rather than actual number of occupants. Rental assistance provided byfederal, state and local agencies is not considered rent paid by the tenant; utility allow-ances are, however, included.

➤ An election can be made to combine buildings and consider the project as a whole forpurposes of meeting the minimum set-aside tests, but all of the buildings in the projectmust meet the minimum set-aside requirements within twelve months after the firstbuilding is placed in service.

CRA Examples of qualified investments provided in the CRA regulation include lawful investments,grants, deposits or shares in projects eligible for low-income housing tax credits. If the projectcomplies with the above restrictions, CRA applies.

REGULATORY OVERVIEW

INVESTMENT TYPE: LOW-INCOME HOUSING TAX CREDITS (LIHTCS)


Applicability:

7

BACKGROUND

The Real Estate Investment Trust (REIT)was created in 1960 as a means of en-abling individual investors to invest inreal estate. REITs are basically mutualfunds that combine funds from indi-vidual investors and then invest thosefunds in real estate. There are REITsthat specialize in mortgage investmentsand there are REITs that invest solelyin real estate equity. Equity REITs haveshown the greatest growth in recentyears. In 1990 the total market capitali-zation of equity REITs was approxi-mately $9 billion; by 2000 that figure hadgrown to $140 billion. Within the equi-ty REIT market, there is additional mar-ket segmentation with REITs that spe-cialize in office buildings, retail, hotels,industrial and multifamily residential.

The Community Development Trust(CDT) is the only REIT created solelyfor the purpose of acquiring assets thatbenefit community development.CDT’s primary goal is to preserve andincrease the stock of affordable hous-ing both through long-term equityownership and by providing liquidityto lenders originating mortgages. CDTwill also provide debt and equity capi-tal to retail, commercial and otherprojects located in community devel-opment areas. CDT is a national com-pany that makes investments through-out the country. Since it provides bothequity and debt capital, it is consid-ered a hybrid REIT.

The CommunityDevelopment

CRA ELIGIBILITY

CDT’s charter requires it to purchaseonly assets that meet the requirementsof the Community Reinvestment Act(CRA). Because all of the assets CDTacquires are expected to be CRA eli-gible, banks may receive CRA creditby investing in CDT.

Bank investors have generally re-corded the CDT stock purchase ontheir books as an equity investment.CDT’s board of directors values thecommon stock on a quarterly basis bydetermining the net asset value (NAV)of its investments. The NAV is basi-cally the market value of all CDT’sassets less its liabilities. As a result, the

NAV changes from quarter to quarterreflecting changes in the level of interestrates as well as the individual perfor-mance of the underlying investments.

CDT SECONDARY MARKET

DEBT PROGRAM

CDT purchases multifamily mortgagesfrom both non-profit and for-profitcommunity development lenders.These secondary market purchasesgenerally involve loans that are notreadily acceptable to traditional second-ary markets. These loans, while credit-worthy, may not qualify for sale to oth-ers because of their small size (less than$3 million), location (inner city or ru

Growth in Market Capitalization of REITsJanuary 1980 – December 2000

Billions of dollars

160

140

120

100

80

60

40

180

20

01980 1985 1990 1995 2000

by Judd Levy, President and Chief Executive Officer, Community Development Trust

REIT


8

ral), configuration (scattered-site, ur-ban rehabs) or type (assisted living).

The development of the commer-cial mortgage-backed securities(CMBS) market has benefited manyreal estate markets by increasing li-quidity and lowering the cost of capi-tal. Because community developmentloans are generally under $3,000,000and may have complex structures in-cluding soft second mortgages, theyhave not been readily packaged asinvestments. Also, because of the na-ture of the asset being financed (anaffordable housing property), 5–10year adjustable rate mortgages, popu-lar in the CMBS market, entail too muchrefinancing and interest rate risk to beused to finance affordable housing.

Community development propertiesneed long-term, fixed-rate mortgageswhich are often not suitable for saleinto the traditional secondary markets.Banks and thrifts are equipped to origi-nate and service these loans but donot have the capital structure to holdthese assets in their portfolios. Life in-surance companies, pension funds andothers that are interested in investingin long-term, fixed-rate loans in com-munity development areas do not havethe expertise to underwrite these typesof loans. By acting as an intermedi-ary, CDT can use its experience incommunity development lending toacquire these loans from qualifiedoriginators and then securitize thesespecialized assets for subsequent saleto CRA-motivated and socially-respon-sible investors. CDT purchases loansas small as $250,000 and aggregatesthese loans for subsequent syndica-tion to institutional investors. CDT re-tains a subordinate interest in eachloan it acquires, thus providing creditenhancement to increase the market-ability of the senior securities.

EQUITY ACQUISITION PROGRAM

In the equity area, CDT provides taxadvantages to owners wishing to selltheir subsidized, affordable housingproperties. CDT is structured as anumbrella partnership REIT (UPREIT),which provides certain tax deferralsto owners that exchange ownershipinterests in their property for an inter-est in CDT. The tax deferral of theUPREIT structure has been used byowners of shopping centers and of-fice buildings, for example, as a meansof creating liquidity and diversificationin their real estate holdings. This fi-nancial engineering is available toowners of affordable housing whowant to sell their properties withoutincurring a taxable transaction.

When CDT acquires properties, itsmission requires it to preserve the unitsas affordable housing. CDT works withnon-profit and for-profit partners torestructure the properties to assureaffordability. The UPREIT acquisitioncan be combined with tax-exempt fi-nancing and tax credits to providecapital for rehabilitation and to in-crease the financial viability of theprojects while they are maintained asaffordable housing.

CONCLUSION

CDT was created to fill two gaps inthe community development financialmarkets: secondary market financingfor small loans and equity capital forhousing preservation. To date there areno other REITs dedicated to commu-nity development finance. As CDT’ssuccess grows others can be expectedto utilize the REIT structure as a meansof increasing the flow of capital to thecommunity development field.

ABOUT THE AUTHOR

JUDD S. LEVY is the president and chiefexecutive officer of the Community Devel-opment Trust. Mr. Levy was formerly presi-dent of LIMAC, a national nonprofit affili-ated with Local Initiatives Support Corpo-ration (LISC). Mr. Levy established CDT inJuly of 1998 with a background of over 25years in affordable housing and mortgagefinance.

Community Development Trust1350 Broadway, Suite 700New York, New York 10018-7702212-271-509

CI


REGULATORY OVERVIEW

INVESTMENT TYPE: COMMUNITY DEVELOPMENT REAL ESTATE INVESTMENT TRUSTS

9

Definition: A real estate investment trust (REIT) combines the capital of many investors to acquire orprovide financing for real estate. A REIT also permits real estate investors to obtain thebenefits of a diversified portfolio. A community development REIT (CD REIT) acquiresdebt and equity in projects that satisfy the definition of community development in theCRA regulation. CD REITs are carried as investments on the investing institution’s balancesheet in accordance with Generally Accepted Accounting Principles (GAAP)

CRA a. Community development, as defined in the CRA regulation, should be the investment’sprimary purpose.

b. The investment should address the needs of the institution’s assessment area(s) or abroader or regional area (not nationwide) that includes the institution’s assessmentarea(s).

c. The institution would receive credit for its investment only, not as a pro-rata share ofthe total.

Applicability:

The Federal Reserve Bank of San Francisco sponsors quarterly roundtable meetings throughout the 12th District to assist officers offinancial institutions in identifying local opportunities for improved CRA performance. If you would like to be included on a specificmailing list or update your mailing information, please contact Bruce Ito at (415) 974-2422 or contact us via e-mail [email protected].

LOCATION COMMUNITY AFFAIRS CONTACT DATES

Boise, ID Craig Nolte at (206) 343-3761 March 14, June 13, Sept. 12, Dec. 12

Las Vegas, NV John Olson at (415) 974-2989 March 12, June 11, Sept. 10, Dec. 10

Northern California John Olson at (415) 974-2989 Feb. 12, May 14, Aug. 13, Nov. 12

Phoenix, AZ Adria Graham Scott at (213) 683-2785 March 21, June 20, Sept. 19, Dec. 12

Portland, OR Craig Nolte at (206) 343-3761 Jan. 8, April 9, July 9, Oct. 8

Salt Lake City, UT John Olson at (415) 974-2989 April 18, July 18, Oct. 17

Southern California Adria Graham Scott at (213) 683-2785 Feb. 13, May 15, Aug. 14, Nov. 13

Seattle, WA Craig Nolte at (206) 343-3761 Feb. 7, May 9, Aug. 8, Nov. 7

2002 SCHEDULE OF CRA ROUNDTABLES


mailto:[email protected]

Equity EquivalentInvestments

E

10

THE NEED

A strong permanent capital base is criti-cal for community development finan-cial institutions (CDFIs) because it in-creases the organization’s risk toleranceand lending flexibility, lowers the costof capital, and protects lenders by pro-viding a cushion against losses in ex-cess of loan loss reserves. It allowsCDFIs to better meet the needs of theirmarkets by allowing them to engagein longer-term and riskier lending. Alarger permanent capital base also pro-vides more incentive for potential in-vestors to lend money to a CDFI. Allof these results help CDFIs grow theiroperations and solidify their positionsas permanent institutions. Unlike for-profit corporations, which can raiseequity by issuing stock, nonprofitsmust generally rely on grants to buildthis base. Traditionally, nonprofitCDFIs have raised the equity capitalthey need to support their lending andinvesting activities through capitalgrants from philanthropic sources, orin some instances, through retainedearnings. However, building a perma-nent capital base through grants is atime-consuming process, and one thatoften generates relatively little yield. Itis also a strategy that is constrained bythe limited availability of grant dollars.

DEVELOPING A SOLUTION

In 1995, National Community Capitalset out to create a new financial in-strument that would function like eq-uity for nonprofit CDFIs. To realizethis goal, National Community Capi-tal chose an experienced partner—Citibank—to help develop an equityequivalent that would serve as a modelfor replication by other nonprofitCDFIs and to make a lead investmentin National Community Capital. Theequity equivalent investment product,or EQ2, was developed through theCitibank/National Community Capitalcollaboration and provides a newsource and type of capital for CDFIs.

THE EQUITY EQUIVALENT –

WHAT IS IT?

The Equity Equivalent, or EQ2, is acapital product for community devel-opment financial institutions and theirinvestors. It is a financial tool that al-lows CDFIs to strengthen their capitalstructures, leverage additional debt capi-tal, and as a result, increase lending andinvesting in economically disadvantagedcommunities. Since its creation in 1996,banks and other investors have mademore than $70 million in EQ2 invest-ments and the EQ2 has become an in-creasingly popular investment productwith significant benefits for banks,CDFIs and economically disadvantagedcommunities.

The EQ2 is defined by the six at-tributes listed below. All six character-istics must be present; without them,this financial instrument would betreated under current bank regulatoryrequirements as simple subordinateddebt.

1. The equity equivalent is carried asan investment on the investor’sbalance sheet in accordance withGenerally Accepted AccountingPrinciples (GAAP)

2. It is a general obligation of theCDFI that is not secured by any ofthe CDFI’s assets

3. It is fully subordinated to the rightof repayment of all of the CDFI’sother creditors

4. It does not give the investor the rightto accelerate payment unless theCDFI ceases its normal operations(i.e., changes its line of business)

5. It carries an interest rate that is nottied to any income received by theCDFI

6. It has a rolling term and therefore,an indeterminate maturity

Like permanent capital, EQ2 en-hances a CDFI’s lending flexibility andincreases its debt capacity by protect-ing senior lenders from losses. Unlikepermanent capital, the investment musteventually be repaid and requires in-terest payments during its term, al-though at a rate that is often well be-low market. The equity equivalent isvery attractive because of its equity-like character, but it does not replacetrue equity or permanent capital as asource of financial strength and inde-pendence. In for-profit finance, a simi-lar investment might be structured asa form of convertible preferred stockwith a coupon.

1 This article is an adaptation of a NationalCommunity Capital technical assistancememo written by Laura Sparks.

2 Comptroller of the Currency, Adminis-trator of National Banks, in an opinionletter dated January 23, 1997, concern-ing Citibank’s Equity Equivalentinvestment in the National CommunityCapital Association.

Q2 1


11

This special debt

investment is a

precedent-setting

community

development debenture

that will permit

‘equity-like’ investments

in not-for-profit

corporations.

ACCOUNTING TREATMENT

An investor should treat the equityequivalent as an investment on its bal-ance sheet in accordance with GAAPand can reflect it as an “other asset.”The CDFI should account for the in-vestment as an “other liability” andinclude a description of the invest-ment’s unique characteristics in thenotes to its financial statements. SomeCDFIs have reflected it as “subordi-nated debt” or as “equity equivalent.”For a CDFI’s senior lenders, an EQ2investment functions like equity be-cause it is fully subordinate to theirloans and does not allow for accel-eration except in very limited circum-stances (i.e., material change in pri-mary business activity, bankruptcy,unapproved merger or consolidation).

CRA TREATMENT

On June 27, 1996, the OCC issued anopinion jointly with the Federal De-posit Insurance Corporation, Office ofThrift Supervision, and the FederalReserve Board that Citibank wouldreceive favorable consideration underCRA regulations for its equity equiva-lent investment in National Commu-nity Capital. The OCC further statedthat the equity equivalents would bea qualified investment that bank ex-aminers would consider under the in-vestment test, or alternatively, underthe lending test. In some circum-stances Citibank could receive consid-eration for part of the investment un-der the lending test and part underthe investment test.3

This ruling has significant implica-tions for banks interested in collabo-rating with nonprofit CDFIs becauseit entitles them to receive leveragedcredit under the more important CRAlending test. The investing bank isentitled to claim a pro rata share ofthe incremental community develop-ment loans made by the CDFI in whichthe bank has invested, provided theseloans benefit the bank’s assessment

area(s) or a broader statewide or re-gional area that includes the assess-ment area(s). The bank’s pro rata shareof loans originated is equal to the per-centage of “equity” capital (the sumof permanent capital and equityequivalent investments) provided bythe bank.

For example, assuming a nonprofitCDFI has “equity” of $2 million—$1million in the form of permanent capi-tal and $1 million in equity equiva-lents provided by a commercialbank—the bank’s portion of the CDFI’s“equity” is 50 percent. Now assumethat the CDFI uses this $2 million toborrow $8 million in senior debt. Withits $10 million in capital under man-agement, the CDFI makes $7 millionin community development loans overa two-year period. In this example, thebank is entitled to claim its pro ratashare of loans originated—50 percentor $3.5 million. Its $1 million invest-ment results in $3.5 million in lendingcredit over two years. This favorableCRA treatment provides another formof “return on investment” for a bank

3 See the Resources section of NationalCommunity Capital’s websitewww.communitycapital.org for acopy of the opinion letter.

in addition to the financial return. Thefavorable CRA treatment is a motivat-ing factor for many banks to make anEQ2 investment.

OUTCOMES AND BENEFITS

National Community Capital estimatesthat approximately $70 million in EQ2investments have been made by at leasttwenty banks, including national, re-gional and local banks. These transac-tions have resulted in the followingbenefits:

EQ2 capital has made it easier forCDFIs to offer more responsive financ-ing products.With longer-term capital in the mix,CDFIs are finding they can offer new,more responsive products. ChicagoCommunity Loan Fund, one of the firstCDFIs to utilize EQ2, once had diffi-culty making the ten-year mini-perma-nent loans its borrowers needed. In-stead, Chicago had to finance theseborrowers with seven-year loans. Withover 15% of its capital in the form ofEQ2, Chicago can now routinely maketen-year loans and has even started tooffer ten-year financing with automaticrollover clauses that effectively providefor a twenty-year term. Cascadia Re-volving Fund, a CDFI based in Seattle,finds EQ2 a good source of capital forits quasi-equity financing and long-term,real estate-based lending, and BostonCommunity Capital has used the EQ2to help capitalize its venture fund.

Very favorable cost of capital. WhenNational Community Capital first de-veloped the equity equivalent withCitibank, National Community Capitalwas uncertain about where the mar-ket would price this kind of capital.The market rate for EQ2 capital seemsto be between two to four percent.

Standardized documentation for EQ2investments. As EQ2 transactions be-come more common, CDFI’s and banks


http://www.communitycapital.org

12

BETH LIPSON is the manager of specialprojects in the financial services division atNational Community Capital. National Com-munity Capital provides financing, training,consulting and advocacy services to a na-tional network of private-sector CommunityDevelopment Financial Institutions (CDFIs).Beth manages National Community Capital’scollection and publication of CDFI industrydata and New Markets Tax Credit efforts. Shealso underwrites loans and investments toCDFIs. Beth has a BA from the University ofPennsylvania and an MBA from the WhartonSchool. For more information about NationalCommunity Capital, visit www.communitycapital.org.

ABOUT THE AUTHOR

4 The Bank Enterprise Award Program isa program of the CDFI Fund that pro-vides incentives for banks to make invest-ments in CDFIs.

have worked to standardize the docu-mentation, thereby lowering transac-tion costs, reducing complexity and ex-pediting closing procedures. There aregood examples of both short, conciseEQ2 agreements and longer, more de-tailed agreements. Of particular noteare the loan agreements crafted byBoston Community Capital and USBank. US Bank’s three-page agreement,which succinctly lays out the invest-ment terms and conditions, is a user-friendly document that has been usedwith approximately 25 CDFIs.

The Boston Community Capitaldocuments, with a 23-page loan agree-ment and a three-page promissory

note, are substantially longer and moredetailed, but include several statementsand provisions that may make a hesi-tant bank more likely to simply usethe CDFI’s standard documents. Forexample, the agreement specificallyreferences the OCC opinion letter rec-ognizing an EQ2 investment as a quali-fied investment and includes a formalcommitment from Boston CommunityCapital to assist a bank investor witha Bank Enterprise Award application.4

Non-bank investors are beginning toutilize EQ2 investments. Althoughbanks have a unique incentive underthe CRA to invest in equity equivalents,other investors can and are beginningto use the tool as well. Chicago Com-munity Loan Fund has secured an EQ2from a foundation, and Boston Com-munity Capital has secured an EQ2from a university. While the univer-sity and foundation do not have thesame CRA incentives, they are able todemonstrate leveraged impact in theircommunities by making an EQ2 in-vestment—rather than a loan—similarto how banks claim leveraged lend-ing test credit under CRA.

BANK ENTERPRISE AWARD

(BEA) CREDIT FOR EQ2INVESTMENTS

The CDFI Fund’s BEA program givesbanks the opportunity to apply for acash award for investing in CDFIs.Banks typically receive a higher cashaward (up to 15% of their investment)for equity-like loans in CDFIs than fortypical loans (up to 11% of invest-ment). To classify as an equity-like in-vestment for the BEA program, EQ2investments must meet certain char-acteristics, including having a mini-mum initial term of ten years, with a

five year automatic rolling feature (foran effective term of 15 years). The EQ2must also meet other criteria, whichare described in the Fund’s Equity-LikeLoan Guidance (available through theBEA page of the Fund’s website:www.treas.gov/cdfi). For more infor-mation on qualifying for equity-likeloans under the BEA program, visit theFund’s website or contact the CDFIFund at 202.622.8662.

CONCLUSION

For CDFIs to grow and prosper, theywill need to create more sophisticatedfinancial products that recognize thedifferent needs and motivations of theirinvestors. The EQ2 is one step in thisdirection. Unlike investors in conven-tional financial markets, CDFI inves-tors (and particularly investors in non-profit CDFIs) have few investmentproducts to choose from. The form ofinvestment is typically a grant or a be-low-market senior loan. This new in-vestment vehicle, the EQ2, is one stepin developing the financial markets in-frastructure for CDFIs by creating a newinnovative product which is particularlyresponsive to one class of investors—banks. Further development and inno-vation in CDFI financial markets willhelp increase access to and availabilityof capital for the industry.

ADDITIONAL RESOURCES

Please visit National CommunityCapital’s website www.community-capital.org for the following freedocuments:

➤ Sample Equity Equivalent Agreements

➤ Regulatory Opinions Letters regard-ing EQ2

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Definition: The equity equivalent investment product (EQ2) is a long-term deeply subordinated loan withfeatures that make it function like equity. These features include the six attributes listed belowwhich are characteristics that must be present under current bank regulatory restrictions. Withoutthem, this financial instrument would be treated as simple subordinated debt. Like permanentcapital, the equity equivalent investment enhances the non-profit’s lending flexibility and in-creases the organization’s debt capacity by protecting senior lenders from losses. Unlike perma-nent capital, investments must eventually be repaid and they require interest payments be madeduring their terms, although at rates that are usually below market. In for-profit finance, a similarinvestment might be structured as a form of “convertible preferred stock with a coupon.”

Attributes:

1. The equity equivalent is carried as an investment on the investing institution’s balance sheetin accordance with Generally Accepted Accounting Principles (GAAP),

2. It is a general obligation of the non-profit organization that is not secured by any of the non-profit organization’s assets,

3. It is fully subordinated to the right of repayment of all of the other non-profit organization’screditors,

4. It does not give the investing institution the right to accelerate payment unless the non-profitorganization ceases its normal operations (i.e., changes its line of business),

5. It carries an interest rate that is not tied to any income received by the non-profit organiza-tion, and

6. It has a rolling term and therefore, an indeterminate maturity.

CRA On June 27, 1996, and March 28, 1997, the four federal bank regulatory agencies issued jointinterpretive letters that financial institutions would receive favorable consideration under theCRA regulation for investments in equity equivalents. The June 27 letter stated that equity equiva-lents would be qualified investments under the investment test, or alternatively, under the lend-ing test (the pro rata share of loans originated equal to the percentage of “equity” capital pro-vided by the institution). In some circumstances a financial institution could receive consider-ation for part of the investment under the lending test and part under the investment test. (Seethe FFIEC interpretive letter issued June 14, 1996.)

REGULATORY OVERVIEW

INVESTMENT TYPE: LOW-INCOME HOUSING TAX CREDITS (LIHTCS)


Applicability:

I

14

Investment Companies

they represented the primary vehiclethrough which banks could invest inthe equity securities of private com-panies. Passage of Gramm-Leach-Bliley has removed this incentive fortheir formation.

The types of SBICs of most interestto investors are Debenture SBICs andParticipating Security SBICs. Deben-ture SBICs, which date back to theestablishment of the SBIC program,borrow money from SBA and in turnprovide it to small businesses, typi-cally in the form of fixed-income se-curities. The Participating Security pro-gram was established in 1994 to bet-ter accommodate the needs of themany small businesses that are not yetgenerating sufficient cash flow to ser-vice debt. Participating Security SBICs,which typically make equity invest-ments in small businesses, receivefunding from SBA on terms similar tothose of Debenture SBICs, but insteadof paying interest on a current basisto SBA, they remit to the SBA a por-tion of the profits they earn on theirinvestment portfolio.

SBICs enjoy a mandate to invest ina broad range of companies. As longas SBIC managers comply with SBAregulatory guidelines, they need con-sider only the financial merits of pro-spective investments. With a few in-dustry exceptions, SBICs may investin companies that have as much as$6 million in average net income forthe two preceding fiscal years and $18million in net worth.

SBIC’s have been quite profitablein recent years. In FY2000, for ex-ample, SBICs overall had a 39% re-turn on invested capital (ROI) and Par-ticipating Security SBICs had an ROI

of 99.4%. CRA Funding’s analysis ofdata reported by SBA suggests that Par-ticipating Security SBICs have realizedreturns of three times their cost basiswith nearly $4 billion of realized as-sets. As impressive as this performancehas been, those returns were notevenly distributed among SBICs andoccurred in a historically favorableinvestment climate.

CRA QUALIFICATION OF

SBICS

SBICs enjoy unusual clarity with re-spect to their qualification for consid-eration under the CRA. SBICs werespecifically identified as an exampleof a qualified investment in the pre-amble to the CRA regulation publishedin 1995. In 1997, SBICs were granteda special status with the initial publi-cation of the Federal Financial Institu-tions Examination Council’s (FFIEC)Questions and Answer document onthe CRA which serve as guidance byregulators to their field examiners andthe CRA community. In this guidance,regulators established a “purpose test”to determine whether an investmentby a bank constitutes “community de-velopment.” Despite their broader in-vestment mandate, SBICs were effec-tively exempted from the purpose testby the regulators who created a pre-sumption “that any loan to or invest-ment in a …Small Business InvestmentCompany promotes economic devel-opment” and is potentially a qualifiedCRA investment.

The CRA regulation requires thatcommunity development activitiesbenefit an institution’s assessment area“or a broader statewide or regionalarea that includes the bank’s assess

by Lawrence S. Mondschein, Managing Director, CRA Funding LLC

Small Business

Investing in Small Business InvestmentCompanies (SBICs) is a CRA qualifiedactivity that offers banks potential prof-its competitive with other lines of busi-ness. SBICs enjoy a special status withinthe CRA because they are recognizedas specifically CRA-eligible. And, as willbe mentioned in more detail a bit laterin this article, SBICs may also enjoy afavored position in the emergingGramm-Leach-Bliley regulatory frame-work relative to other permissible mer-chant banking activities. Nevertheless,SBICs pose certain challenges to thoseinstitutions seeking to participate inthem. Participation in SBICs through adiversified special purpose investmentvehicle may be an attractive alterna-tive for many institutions and may helpaddress these challenges.

THE SBIC PROGRAM

The SBIC program was established withpassage of the Small Business Invest-ment Act of 1958, which aimed to fos-ter economic development by facilitat-ing the flow of equity capital and long-term loans into small businesses. Pur-suant to the Act, the SBA, through theuse of public markets and a govern-ment guarantee, provides capital toSBICs at rates which are pegged to thecost of funds to the United States Gov-ernment. These low-cost funds expandthe financing capacity of SBICs and cansubstantially increase the financial re-turn to their private investors.

There are presently almost 500 li-censed SBICs with over $15 billion inprivate capital. SBICs that are whollyowned by banks represent about halfthe industry and receive no capital fromSBA. These SBICs were particularlyprevalent in the Glass-Steagel era when


15

ment area(s).” Pursuant to guidanceissued earlier this year, banks that havealready met the needs of their assess-ment area need not consider the inclu-sion of their assessment area in thebroader geographic investment activity.Regulators may also evaluate the pro-spective impact an investment has oncommunities within an assessment area.

SBICs are particularly well suited tooperate in a broad geography while,at the same time, benefiting a specificarea within the region. This is becausefor every dollar invested by a CRA-oriented institution, the SBA matchesthat investment exponentially. As aresult, even though the investing ac-tivity may be over a relatively broadgeography, this multiplier increases thelikelihood of a dollar-for-dollar, bonafide impact on a bank’s assessment area.

Investing in SBICs can be a chal-lenge for many institutions. Since SBICsprovide equity, they have a higher riskprofile than most other banking indus-try lines of business. Moreover, SBICsoffer limited current return and as ten-year private partnerships are generallynot liquid. Banking regulations recog-nize these risks and typically limit fi-nancial institution SBIC investments tofive percent of net capital.

Largely because of the CRA, SBICsseek out bank investors operating intheir geographies. Some banks havechosen to operate collectively in form-ing regionally focused SBICs or by par-ticipating with banks from other re-gions in professionally managed part-nerships that purchase diversified port-folios of SBICs.

While SBICs no longer enjoy a near-monopoly on bank private equity in-vestment activity, they may retain animportant advantage under theGramm-Leach-Bliley Act. Regulatorsimpose a special, higher reserve re-quirement on merchant banking

activities authorized by Gramm-Leach-Bliley. It is likely these requirementswill not be imposed on SBIC invest-ments. So, while the amount of capitala bank may deploy in an SBIC remainslimited, the associated “regulatory costof capital” may ultimately be less thanthe cost of non-SBIC investments.

FINANCIAL REPORTING AND

ACCOUNTING

Accounting and financial reporting ofSBICs is similar to that for other assetsheld for investment. When an institu-tion makes a commitment to an SBIC,it makes a small capital contributionthat is recorded on the balance sheetas an asset. The balance of the com-mitment shows up as a contingent li-ability in the institution’s call report.Once recorded in the bank’s financialreporting system, the full amount ofthe commitment is eligible for CRAconsideration. Fees and expenses ofthe SBIC that typically result in oper-ating losses in the early years are gen-erally capitalized on the balance sheetand not offset against operating earn-ings of the bank. They may, however,be deducted for tax purposes. Themost common practice is to continuerecording the investment on a costbasis until distributions are receivedor a demonstrable event occurs withrespect to the SBIC’s portfolio to jus-tify a change in valuation.

SUMMARY AND CONCLUSIONS

In summary, SBICs enjoy a uniqueposition within the CRA frameworkthat makes them ideally suited to thatportion of a CRA portfolio where profitgeneration is the paramount goal. In-stitutions that understand and can tol-erate the risks of private equity invest-ing can enjoy enhanced financial andregulatory benefits by investing inSBICs.

LAWRENCE MONDSCHEIN is the managingdirector of CRA Funding, LLC which is theManager and General Partner of the CRAFund of SBICs. The Fund, all of whose lim-ited partners are banks, invests in a diver-sified portfolio of Small Business Invest-ment Companies (SBICs) throughout theUnited States.

CRA Funding, LLC130 West 57th Street, Suite 1500New York, New York 10019212-459-1762

CI


16

REGULATORY OVERVIEW

INVESTMENT TYPE: SMALL BUSINESS INVESTMENT COMPANIES (SBICS)

Definition: SBICs are privately-owned venture capital funds licensed by the Small Business Administra-tion (SBA) to invest in the long-term debt and equity securities of small businesses. Thesebusinesses possess generally less than $18 million in net assets or $6 million in annual netincome and are represented in a variety of industries such as manufacturing, services andwholesale trade. Almost 75 percent of the small businesses funded by SBICs are non-tech-nology businesses. The SBA provides “financial assistance” to SBICs by purchasing securi-ties from them on terms which are related to the cost of funds to the U.S. Government.These low-cost funds, or “leverage,” augment the private capital invested in the SBIC andmay represent up to 66 percent of the capitalization of an SBIC. The amount and attractiveterms of this leverage have the potential to substantially increase the financial returns toprivate investors. As of March 1999, there were a total of 332 SBICs licensed to operate witha total of almost $10 billion in capital committed both from private sources and the SBA.

CRA The CRA regulation defines the term “community development” to include activities thatpromote economic development by financing small businesses or farms that meet the sizeeligibility standards of the Small Business Administration’s Development Company or SmallBusiness Investment Company programs (13 CFR 121.301) or have gross annual revenues of$1 million or less. According to the Federal Financial Institutions Examination Council (FFIEC),examiners “will now presume that any loan to or investment in an SBIC promotes economicdevelopment.”

Applicability:

ANNOUNCING . . . THE FEDERAL RESERVE BANK OF SAN FRANCISCO

IS PROUD TO ANNOUNCE

“BANKERS’ DIRECTORIES OF COMMUNITY ORGANIZATIONS”FOR THE FOLLOWING LOCATIONS:

The State of Alaska Phoenix, AZ Fresno, CALos Angeles, CA Oakland, CA Sacramento, CASan Diego, CA San Francisco, CA Santa Clara County, CAThe State of Hawaii The State of Idaho Las Vegas, NVThe State of Oregon The State of Utah Seattle, WASpokane, WA

A pdf version can be downloaded from www.frbsf.org/community/index.html, or call Bruce Ito at(415) 974-2422 to receive a hard copy.


http://www.frbsf.org/community/index.html

SecuritiesSecuritiesInvesting

17

BACKGROUND

The Community Reinvestment Act(CRA) requires regulated banks andthrifts to meet the credit needs of theircommunities. Large institutions—thosewith assets greater than $250 million—are subject to three performance tests:lending, service and investment. Smallinstitutions—those with total assetsunder $250 million or an affiliate withtotal banking and thrift assets of lessthan $1 billion at the end of the previ-ous two years—can opt to have ex-aminers review their performance un-der the investment test. For small in-stitutions, investment test performancemay be used to enhance a satisfactoryrating, but may not be used to lower arating.

While financial institutions are ex-perienced with the lending and ser-vice aspects of the performance tests,some banks are still grappling withwhat constitutes a qualified investment.Under CRA, a qualified investment hasas its primary purpose community de-velopment when it is designed for theexpress purpose of revitalizing or sta-bilizing low- or moderate-income ar-eas, or providing affordable housingfor or community services to low- tomoderate-income persons. This allowsbanks and thrifts the latitude to investin the communities that they servethrough creative means rather than dic-

tated measures. Performance under theinvestment test is based on:

➤ the dollar amount of qualifiedinvestments

➤ the innovativeness or complexityof qualified investments

➤ the responsiveness of qualified in-vestments to credit and commu-nity development need, and

➤ the degree to which qualified in-vestments are not routinely pro-vided by private investors

Finally, qualified investments mustbenefit the financial institution’s assess-ment area(s) or a broader statewideor regional area that includes the as-sessment area(s).

The Interagency CRA Q&A1 pro-vides some examples of qualified in-vestments. These include: state andmunicipal obligations, such as revenuebonds, that specifically support afford-able housing or other community de-velopment; projects eligible for low-income housing tax credits; and orga-nizations supporting the capacity oflow- and moderate-income people orgeographies to sustain economic de-velopment. The regulations also statethat “as a general rule, mortgage-backed securities and municipal bondsare not qualified investments becausethey do not have as their primary pur-

pose community development, as de-fined in the CRA regulations.” Thus, thekey to investing in municipal securitiesis in determining the primary purposeof the bond issue.

HOUSING BONDS

In order to qualify as a community de-velopment investment, housing-relatedsecurities must primarily address afford-able housing. Housing bond issues aregenerally either single-family or multi-family and can be local or statewideissues.

Single Family Issues: Single-familybond deals are usually targeted to geo-graphic areas, such as cities and coun-ties, or to a broader statewide area, andare often aimed at first-time borrowers.In analyzing single-family issues, finan-cial institutions should look closely atthe eligible participants for the bondprogram. Because housing authoritiesfrequently define low- to moderate-in-come under a broader definition thanthe CRA regulations allow, the bankshould research who ultimately benefitsfrom the programs.

For example, the Idaho Housing andFinance Association permits participantsin their residential lending program tohave annual gross incomes up to cer-tain limits, depending on which countythe borrower lives in and the number

1 http://www.ffiec.gov/cra/qnadoc.htm

Investing in

By Barbara Rose VanScoy, Principal, CRA Fund Advisors

CRA-Qualified Municipal


http://www.ffiec.gov/cra/qnadoc.htm

18

of people in the household. In 1999,some targeted counties allowed bor-rowers to have incomes in excess of140 percent of median family income.(To qualify as moderate-income underCRA, borrowers’ incomes cannot ex-ceed 80 percent of median family in-come.) Further research revealed thatthe average borrower in the IdahoHousing Program had an income of$32,681 in 2000. The statewide medianincome for Idaho for fiscal year 2000was $43,700. Therefore, on average, theborrowers participating in the IdahoHousing and Finance Association resi-dential lending program were moder-ate income.

Because of this confusion, some fi-nance agencies have taken further stepsto accommodate financial institutionqualified investing. The WashingtonState Housing Finance Commission is-sues CRA Taxable Single-Family Pro-gram Bonds and imposes an annualincome limitation of 80 percent or be-low of the Metropolitan StatisticalArea’s median income, which is in linewith the regulators’ definition. Pro-grams such as these help facilitate com-munity development investing by CRA-mandated institutions. Banks interestedin investing in these types of issuesshould ensure that the housingauthority’s residential lending programguidelines coincide with those cited inthe CRA regulations.

Multi-family Issues: Multi-family bondissues typically finance the construc-tion and rehabilitation of apartmentcomplexes. To be considered afford-able, there must be a low- to moder-ate-income set-aside or some otherincome restriction. Not all multi-fam-ily housing deals address affordablehousing. As with single-family issues,the bank should closely examine howthe housing authority or issuer defines‘qualifying’ or ‘eligible tenants.’

HEALTHCARE ISSUES

Some bond proceeds are used to sup-port healthcare facilities that serve acommunity development purpose.Community development includeshealth or social services targeted tolow- or moderate-income persons.Hospitals, nursing homes, assisted liv-ing facilities and homes for the devel-opmentally disadvantaged may qualifyunder CRA regulation if the patientsat these facilities are low- to moder-ate-income. Usually these facilitiesserve a large share of Medicaid pa-tients, whose incomes fall within theguidelines of CRA.

TAX ALLOCATION BONDS

Tax Allocation Bonds are bonds issuedin conjunction with a specific rede-velopment project—typically afford-able housing. The taxes pledged totheir repayment come from the in-creased assessed value over and abovea pre-established base. The redevel-opment creates this added value,known as the tax increment. Manystates use tax increment financing(TIF), which provides for the financ-ing of redevelopment projects thoughthe use of tax increment revenues. Ob-viously, since not all community de-velopment activities occur in low- ormoderate-income areas, it is impor-tant to explore beyond the projectdescription and establish the incomecomposition of the community.

ECONOMIC DEVELOPMENT

Many bond deals state their purpose aseconomic development. For regulatorypurposes, there must be some deter-mination of how the primary purposeis community development. Under CRA,an activity promotes economic devel-opment if it, “supports permanent jobcreation, retention, and/or improvementfor persons who are currently low- ormoderate-income; or supports perma-

nent job creation, retention, and/or im-provement either in low- or moderate-income geographies or in areas targetedfor redevelopment by federal, state, lo-cal or tribal governments.” Ultimately,the community development purposeshould be quantifiable in jobs createdor retained, affordable housing units orother economic development activities.

ELIGIBLE INVESTMENTS

Aside from looking at the primary pur-pose of the issue, financial institutionsmust also analyze certain attributesassociated with the bonds. Investmentpolicies may restrict purchases of eli-gible investments because of rating ormaturity constraints. Smaller deals maybe non-rated or below investmentgrade because of the costs associatedwith insuring the bonds and thus in-eligible investments for banks that canonly invest in grade BBB or highersecurities. Some investment policieslimit the purchase of securities to ma-turities inside of ten years, although itis not uncommon for multi-family se-curities to have maturities of 30 to 40years. Other banks are limited to tax-able or bank qualified municipal se-curities (i.e. issues under $10 million).Furthermore, bank qualified issues aregenerally limited to revenue bonds,which is only a fraction of the munici-pal market. This significantly reducesthe universe of available opportuni-ties. Taxable municipal securities of-fer a greater opportunity for investmentthan bank qualified issues, as issuanceis considerably larger, both in the fre-quency of issues and the overall dol-lar volume generated.

PURCHASING QUALIFIED

INVESTMENTS

Purchasing qualified investments usu-ally requires a concerted effort by dif-ferent divisions within the banking or-ganization. Bank investment officers


19

ABOUT THE AUTHOR

often have a negative perception ofqualified investments and choose topurchase only under duress from otherareas of the financial institution. It isvery important that the person respon-sible for monitoring CRA complianceestablishes a strong working relation-ship with the person responsible forinvesting on the bank’s behalf.

Unlike other investments, securitieswith a primary purpose of communitydevelopment are not common in themarket place. Because community de-velopment investments trade rapidly,especially in areas with a strong in-vestor demand, financial institutionsshould be poised to respond quicklyto qualified investment opportunities.This often requires establishing a net-work of investment professionals whoare familiar with qualified investments.This network is a valuable resource foridentifying projects currently trading inthe market place, as well as sourcesfor new origination. Given the limitedexpertise in CRA qualified investments,financial institutions should look forinvestment professionals with a proventrack record, who are committed toresearching and providing ample docu-

mentation to support the investment’scommunity development purpose.While a bank or thrift should not de-pend solely on an outside source forsupporting documentation, the finan-cial institution should request verifi-cation of the qualified investment be-fore undertaking any transaction.

CONCLUSION

Analyzing municipal securities as com-munity development investments re-quires banks to explore the purpose,the structure and the credit risk of theissue. Financial institutions should es-tablish a framework for examiningqualified investments. A plan of ac-tion should also be developed so thatcommunity development and invest-ment officers know what to look forand how much to invest. Examinersare often willing to suggest firms thatspecialize in qualified investmenttransactions if the institution is havingdifficulty finding or investing on theirown. Ultimately, it is up to the financialinstitution to clearly understand the pri-mary purpose of the issue and be ableto relate that to their examiner. CI

A BANKER’S QUICK REFERENCE GUIDE TO COMMUNITY DEVELOPMENT MUNICIPAL BONDS

Definition: Municipal bond is a general term referring to securities issued by states, cities, towns, counties and special districts. Aprimary feature of these securities is that interest on them is generally exempt from federal income taxation and, in some cases,state income taxation. Because of this feature, the interest rates on municipal bonds are lower than interest rates on other types ofbonds, but when taking into account one’s income taxes, often provide a comparable, or better rate of return. Revenue bonds aremunicipal bonds secured and repaid only from a specified stream of non-tax revenues. Examples of revenues include tolls, utilitycharges, or charges and use fees from a facility being constructed with the proceeds of a bond issue, such as a sports facility or ahousing project.

At one time, banks were permitted to deduct all the interest expense incurred to purchase or carry municipal securities. Taxlegislation subsequently limited the deduction first to 85 percent of the interest expense and then to 80 percent. The 1986 tax laweliminated the deductibility of interest expense for bonds acquired after August 6, 1986. The exception to this non-deductibilityof interest expense rule is for bank-qualified issues. An issue is bank-qualified if:

1. It is a tax-exempt issue (other than private activity bond) including any bonds issued by 501(c)(3) organizations, and

2. It is designated by the issuer as bank qualified and the issuer or its subordinate entities do not intend to issue more than $10million a year of such bonds

BARBARA ROSE VANSCOY is a principal atCRAFund Advisors, the registered investmentadvisor for the CRA Qualified InvestmentFund. Ms. VanScoy is responsible for research-ing and documenting qualified investmentson behalf of the CRA Qualified InvestmentFund’s shareholders. Prior to joining CRAFundAdvisors, Ms. VanScoy was the director of re-search at SunCoast Capital Group. While there,she also headed SunCoast’s Community De-velopment Initiative, in which she assistedtheir depository clients with community de-velopment investing. Ms. VanScoy was previ-ously employed with Raymond James TaxCredit Funds as the director of debt place-ment, and as a vice president in fixed incomeresearch. She is a graduate of the Universityof Florida with a BSBA in finance, and a spe-cialization in Latin American studies. She canbe reached through CRAFund Advisors at877/272-1977 or directly at 800/519-7065.


M

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Mortgage-backed securities (MBS) havebecome a popular vehicle for finan-cial institutions looking for investmentopportunities in their communities.CRA officers and bank investment of-ficers appreciate the return and safetythat MBSs provide and they are widelyavailable compared to other qualifiedinvestments.

Mortgage securities play a crucialrole in housing finance in the U.S.,making financing available to homebuyers at lower costs and ensuring thatfunds are available throughout thecountry. The MBS market is enormouswith the volume of outstanding MBSsexceeding $3.8 trillion. Investors in-clude corporations, banks and thrifts,insurance companies and pensionfunds. MBSs are popular because theyprovide a number of benefits to inves-tors including liquidity, yield and capi-tal management flexibility. CRA offic-ers should understand these benefitsto enable them to work with bank in-vestment officers.

UNDERSTANDING MBSS

An MBS is similar to a loan. When abank purchases an MBS, it effectivelylends money to the borrower/home-owner who promises to pay interestand to repay the principal. The pur-chase effectively enables the lender tomake more mortgage loans. MBSs areknown as “fixed-income” investmentsand represent an ownership interest inmortgage loans. Other types of bondsinclude U.S. government securities,municipal bonds, corporate bonds andfederal agency (debt) securities.

Here is how MBSs work. Lendersoriginate mortgages and providegroups of similar mortgage loans toorganizations like Freddie Mac andFannie Mae, which then securitizethem. Originators use the cash theyreceive to provide additional mort-gages in their communities. The re-sulting MBSs carry a guarantee oftimely payment of principal and inter-est to the investor and are furtherbacked by the mortgaged propertiesthemselves. Ginnie Mae securities arebacked by the full faith and credit ofthe U.S. Government. Some privateinstitutions issue MBSs, known as “pri-vate-label” mortgage securities in con-trast to “agency” mortgage securitiesissued and/or guaranteed by GinnieMae, Freddie Mac or Fannie Mae. In-vestors tend to favor agency MBSs

because of their stronger guarantees,better liquidity and more favorablecapital treatment. Accordingly, thisarticle will focus on agency MBSs.

The agency MBS issuer or servicercollects monthly payments fromhomeowners and “passes through” theprincipal and interest to investors.Thus, these pools are known as mort-gage pass-throughs or participationcertificates (PCs). Most MBSs arebacked by 30-year fixed-rate mort-gages, but they can also be backed byshorter-term fixed-rate mortgages oradjustable rate mortgages.

LIQUIDITY

Agency MBSs are extremely liquid. Be-cause there is a large amount of out-standing mortgage securities and inves-tors, there is a sizable and active sec

U.S. Fixed Income MarketOutstanding Bond Debt as of June 30, 2001*

Total = $17.7 Trillion

Money Market$2.6 – 15%

Corporate$3.6 – 20%

Municipal Securities$1.7 – 10%

U.S. GovernmentAgency

$2.0 – 11%

Mortgage-Backed Securities$3.8 – 21%

U.S. Treasury$2.8 – 16%

ABS$1.2 – 7%

Source: The Bond Market Association Estimates

by Andrew Kelman,Director, National Business DevelopmentSecurities Sales and Trading Group, Freddie Mac

Mortgage-backed Securities &Collateralized Mortgage Obligations:

Prudent CRA INVESTMENT Opportunities


21

ondary market. Investors can easily buy,sell or borrow against MBSs. The liquid-ity of MBSs is enhanced by the relativehomogeneity of the underlying as-sets, compared with corporate bonds(different issuers, industries and cre-dit) or municipal bonds (state issued,authority issued, revenue bond, etc.).

YIELD

Mortgage-backed securities offer attrac-tive risk/return profiles. There arehigher yielding fixed-income invest-ments in the marketplace, but theyhave greater credit risk. MBSs have tra-ditionally provided returns that exceedthose of most other fixed-income se-curities of comparable quality.1 MBSsare often priced at higher yields thanTreasury and corporate bonds of com-parable maturity and credit quality.

CAPITAL MANAGEMENT

For banks and thrifts, agency MBSs areconsidered bank-qualified assets. Theycan be held in higher concentrationthan other assets. In addition, the risk-based capital treatment of agencyMBSs is superior to that for corporateand many municipal bonds. For ex-ample, depositories holding GinnieMaes do not have to hold risk-basedcapital (RBC) against the assets andthey have to hold just 20% of the RBCrequirement for Freddie and FannieMBSs. This contrasts with a 100% RBCrequirement for corporate bonds andup to 50% for municipal bonds. Finally,there is an active repurchase (“repo”)market for MBSs that enables institu-tions to earn increased income fromtheir investments by lending in therepo market.

SUPPORTING CRA OBJECTIVES

WITH MBSS

The affordable housing goals that theU.S. Department of Housing and Ur-

ban Development (HUD) set forFreddie and Fannie (e.g., 50% of theirbusiness must be to low-and-moderateincome (LMI) borrowers) help deposi-tory institutions to achieve their LMIobjectives through MBS investments.

Usually, MBSs are comprised ofloans scattered throughout the coun-try to borrowers with varying incomes.To support CRA objectives, affordablehousing MBSs are created with loansto LMI borrowers in specified geogra-phies. As a “qualified investment,” theMBS should include loans in aninstitution’s assessment area or in a“statewide or regional area that in-cludes the assessment area.” At least51% of the dollars in the MBS shouldbe in loans to LMI borrowers, althoughmost total 100%. In addition, a finan-cial institution that, considering itsperformance context, has adequatelyaddressed the community develop-ment needs of its assessment area(s)will receive consideration for MBSswith loans located within a broaderstatewide or regional area. “Examin-ers will consider these activities evenif they will not benefit the institution’sassessment area(s).”2

The Federal Financial InstitutionsExamination Council (FFIEC) issuedan opinion letter (#794) indicating thattargeted MBSs may receive positiveCRA consideration. This has been re-inforced by scores of CRA examina-tions. Moreover, as lending-relatedqualified investments, CRA-qualifiedMBSs assist “small banks” with theirCRA performance by enabling an up-ward adjustment of their loan-to-de-posit ratio.

CRA-qualified MBSs increase thesupply of affordable housing. FreddieMac’s Securities Sales & Trading Group(SS&TG) pays a premium to origina-tors for the LMI loans that they pro-vide, giving originators an incentive

to create additional LMI lending op-portunities in communities, which isthe essence of the CRA. Bank pur-chases of MBS pools from Freddie Macsupport this affordable housing initia-tive. Since more than 2/3 of mortgagesare originated by companies whoseloan officers work on commission andhave an incentive to originate mort-gages on expensive homes. SS&TG cre-ates an incentive to originate LMI loans.

Here are reasons to consider MBSs aspart of a CRA strategy:

➤ Payment of principal and interestis guaranteed

➤ Market rate return

➤ No management fees

➤ Favorable capital treatment

➤ Liquid investment – can be sold orborrowed against

➤ Flexible – can be tailored to bank’sassessment area and sold in vary-ing amounts

➤ Low transaction costs

➤ Available everywhere—even inrural areas

EVALUATING AND PURCHASING

MBSS

Banks and other investors buy MBSsfrom securities dealers such as SS&TG,Freddie Mac’s in-house mortgage se-curities dealer operation. New MBSsusually sell at or close to their facevalue. However, MBSs traded in thesecondary market fluctuate in price asinterest rates change. When the priceof an MBS is above or below its facevalue, it is said to be selling at a pre

1 Source: The Bond Market Association 2 FFIEC Question and Answer Documenton CRA


22

mium or a discount, respectively. Theprice paid for an MBS is based on vari-ables including interest rates, the cou-pon rate, type of mortgage backing thesecurity, prepayment rates and supplyand demand.

MBSs issued in book-entry3 form ini-tially represent the unpaid principalamount of the mortgage loans. FreddieMac and Fannie Mae MBSs issued inbook-entry form are paid by wire trans-fer through the central paying agent,the Federal Reserve Bank of New York,which wires monthly payments to de-pository institutions. Depositories putthe MBS in “held to maturity” or “avail-able for sale” accounts, depending ontheir investment strategy. Some inves-tors hold bonds until they mature,while others sell them prior to matu-rity. Buy-and-hold investors worryabout inflation, which makes today’sdollars worth less in the future.

Bank investment officers analyze theeconomic value of MBSs using a num-ber of terms, including “weighted-av-erage coupon” (WAC), which is theweighted average of the mortgage noterates, and “weighted-average life”(WAL), which is the average amountof time a dollar of principal is investedin an MBS pool. The most importantmeasure used by investment officersto value investments is yield.

Yield is the return expressed as anannual percentage rate. Unlike otherfixed-income investments, MBS prin-cipal payments are made monthly andmay vary due to unscheduled prepay-ments (e.g., refinancing or sale of themortgaged home), which may also af-fect the amount and timing of MBSinterest payments and MBS yields. Pre-payment assumptions are factored intoprice and yield to compare the valueof a mortgage security with other fixed-income investments.

As fixed-income securities, MBSprices fluctuate with changing inter-est rates: when interest rates fall, pricesrise, and vice versa. Interest rate move-ments also affect prepayment rates ofMBSs. When interest rates fall,homeowners refinance mortgages,and prepayment speeds accelerate.Conversely, rising rates tend to de-crease the prepayment speed. An ear-lier-than-expected return of principalincreases the yield on securities pur-chased at a discount. However, whenan MBS is purchased at a premium,an earlier-than-expected return ofprincipal reduces yield.

Each MBS has a coupon, which isthe interest rate passed on to the in-vestor. The coupon is equal to the in-terest rate on the underlying mort-gages in the pool minus the guaran-tee fee paid to the agency and the feepaid to the servicer. The WAC is theweighted average of the mortgagenote rates and it is often used by in-vestment officers to compare MBSs.In analyzing a potential MBS invest-ment, the length of time until princi-pal is returned is important and theconcept of a weighted-average life(WAL) is used. Average life is the av-erage amount of time a dollar of prin-cipal is invested in an MBS pool. TheWAL is influenced by several factors,including the actual rate of principalpayments on the loans backing theMBS. When mortgage rates decline,homeowners often prepay mortgages,which may result in an earlier-than-expected return of principal to an in-vestor, reducing the average life of theinvestment. This can be thought of asan implied call risk. Investors are thenforced to reinvest the returned princi-pal at lower interest rates. Conversely,if mortgage rates rise, homeownersmay prepay slower and investors may

find their principal committed longerthan expected, which prevents themfrom reinvesting at the higher prevail-ing rates. This scenario can be thoughtof as extension risk.

COLLATERALIZED MORTGAGE

OBLIGATION (CMO)The prepayment uncertainty of MBSsled to Freddie Mac’s development ofthe collateralized mortgage obligation(CMO) in 1983. This more complextype of mortgage security helps com-partmentalize prepayment risk andbetter addresses investment timeframes and cash-flow needs. Since 1986,most CMOs have been issued in realestate mortgage investment conduit(REMIC) form for tax purposes. Theterms are now used interchangeably.

MBSs are pooled to create CMOs.In structuring a CMO, an issuer dis-tributes cash flow from the underly-ing collateral over a series of classescalled tranches, each having averagelives designed to meet specific invest-ment objectives. As the payments onthe underlying mortgage loans are col-lected, the CMO issuer usually firstpays the coupon rate of interest to thebondholders in each tranche. Allscheduled and unscheduled principalpayments go first to investors in thefirst tranches. Investors in later tranchesdo not start receiving principal pay-ments until the prior tranches are paidoff. This basic type of CMO is knownas a sequential CMO.

Almost all CRA MBSs are comprisedof 30-year fixed-rate mortgages. Somebank investment officers find the av-erage life of 30-year MBSs too long(since bank funding sources tend tobe shorter). These investors can sup-port affordable housing by purchas-ing a CRA CMO tranche, which is struc-tured with CRA MBS pools to provide

3 An electronic issuance and transfersystem for securities transactions


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shorter cash flows than the CRA MBSpools would normally provide. Thisenables many banks to invest more inCRA CMOs than they would be ableto in CRA MBSs. Additionally, the in-novative and complex CMO structureenables banks to leverage investmentin affordable housing from non-CRAregulated institutions, since the longcash flows are sold to pension fundsand insurance companies. This ap-proach is not routinely provided byprivate investors. Additionally, CRACMOs provide all the previously men-tioned compliance and investmentbenefits of CRA MBSs. While the eco-nomics of developing complex secu-rities like CMOs generally require de-velopment of tranches usually exceed-

ANDREW KELMAN is director of nationalbusiness development at Freddie Mac’sSecurities Sales and Trading Group, wherehe assists financial institutions in achiev-ing CRA and investment objectives.

Freddie Mac575 Lexington Avenue, 18th FloorNew York, New York 10022-6102212-418-8931

ing $20 million, pieces of tranches maybe sold. Nevertheless, CRA CMOs arenot as readily available as CRA MBSs.

SUMMARY AND CONCLUSION

Both CRA MBSs and CRA CMOs meetthe investment objectives of CRA of-ficers while providing a safe andsound strategy with market rate re-turns. Investors increase the supply offinancing for affordable housingthrough these products by leveraginginvestment in affordable housing fromnon-depositories and by incentingloan originators. As with all CRA prod-ucts, institutions should discuss theirunique circumstances with their regu-lator to determine suitability.

ABOUT THE AUTHOR

Definition: Mortgage originators can either (1) hold a new mortgage in their portfolio, (2) sell the mort-gage to an investor or conduit, or (3) use the mortgage as collateral for the issuance of asecurity. A mortgage-backed security (MBS) is a pool of mortgages that represent the collat-eral for a security. The cash flow pattern associated with an MBS is based on the payment ofthe individual mortgage loans underlying the security. The ability of borrowers/homeownersto prepay part or all of the mortgage at any time creates uncertainty regarding cash flow(above and beyond possible delinquencies), so investors usually wish to be compensated foraccepting the risk of unscheduled payments. A targeted MBS is a security collateralized by apool of mortgages originated to borrowers/homeowners whose incomes are 80 percent orbelow area median income.

CRA As a general rule, mortgage-backed securities are not qualified investments under the CRAbecause they do not have as their primary purpose community development as defined in theCRA regulation. Nonetheless, mortgage-backed securities designed primarily to finance com-munity development are qualified investments. These housing-related securities must prima-rily address affordable housing needs (including multifamily rental housing needs) in order toqualify. In addition, an institution may receive investment test consideration for purchases ofthese targeted mortgage-backed securities as long as they are not backed primarily or exclu-sively by loans that the same institution originated or purchased.

REGULATORY OVERVIEW

INVESTMENT TYPE: MORTGAGE-BACKED SECURITIES

CI

Applicability:


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Community development venture capi-tal (CDVC) is one of the fastest grow-ing sectors in the field of communitydevelopment finance. From a handfulof funds in 1990, the industry hasgrown to more than sixty funds in theUnited States, and at least anothertwenty funds operating or in forma-tion in other parts of the world. In thelast year alone, CDVC under manage-ment in the U.S. has grown to $400million, up $100 million dollars fromthe end of 2000. Almost $40 million ofthis increase was raised by three es-tablished managers that have success-fully closed on second funds.1

THE DOUBLE BOTTOM LINE

CDVC funds use the tools of venturecapital to create jobs, wealth and en-trepreneurial capacity to benefit low-income people and distressed commu-nities. They are mission-driven fundsthat invest in businesses that promiserapid growth. This growth creates notonly financial returns for the fund andits investors but also social returns inthe form of good jobs for low-incomepeople—a double bottom line.

CDVC funds apply disciplined eq-uity investment practices in placeswhere other venture capitalists do notgo: inner cities and distressed ruralcommunities. They offer financing tominority- and women-owned firms and

for Communitiesthose that are environmentally fo-cused. They invest in such businessesas new-economy manufacturing com-panies and promising new service-sec-tor firms, which can offer good em-ployment to large numbers of low-in-come people. They seek to apply prin-ciples that have helped create unprec-edented economic growth in placesfrom Silicon Valley to areas often leftbehind such as rural Appalachia, in-ner-city Baltimore and NizhnyNovgorod, Russia.

THE IMPORTANCE OF EQUITY

CAPITAL

Equity capital is vital to all businesses.It provides a cushion against slowbusiness climates and is relatively pa-tient and flexible. As any banker ana-lyzing debt/equity ratios can tell you,without sufficient equity, companiescannot borrow additional funds. Mostimportant for economic development,equity provides the seed funding tostart new companies and allows es-tablished companies to develop newproducts or build new plants—activi-ties that create signifi-cant new em-ployment and economic opportunity.

Equity capital is difficult for anycompany to raise. Most entrepreneursraise initial equity capital from theirown savings and those of family andfriends, but this is particularly hard tocome by in low-wealth communities.A ready source of equity capital canthus be an extraordinarily effective toolfor fueling the creation of new wealthin economically distressed areas andalso new job opportunities for peoplewho need them.

CDVC funds seek to create good

jobs that pay a living wage. To pro-duce the financial portion of the doublebottom line, CDVC funds must seekout companies that hold the promiseof rapid growth. Companies that aregrowing and successful can afford topay higher wages than companies thatare just scraping by. Successful com-panies tend to offer better benefits totheir employees, as well as job train-ing and opportunities for advancement,and to attract and retain the workforcethey need for expansion.

By providing equity and near-equityinvestments to businesses that other-wise would not have access to them,CDVC funds create a powerful engineof economic growth. Equity invest-ments are made through the purchaseof common or preferred stock, whilenear-equity investments might be madethrough a subordinated loan that car-ries an “equity kicker,” such as royal-ties or warrants to purchase stock.These investments each carry signifi-cant risk of loss but are structured sothat the fund will share the “upside” ofthe business if the business does well.

MORE THAN MONEY:

ENTREPRENEURIAL AND

MANAGERIAL ASSISTANCE

CDVC funds become part-owners ofthe companies in which they invest,tying their own success directly to thesuccess of their portfolio businesses.As a result, CDVC funds invest not justmoney but a great deal of time andeffort in helping the companies inwhich they invest succeed. They typi-cally take seats or observer rights onthe boards of their portfolio compa

1 This includes Silicon Valley CommunityVentures of San Francisco, California,which closed its second fund with a $10million commitment from the Califor-nia Public Employees’ RetirementSystem—the first capital ever committedto a CDVC fund by a retirement fund.

by Kerwin Tesdell, President, Community Development Venture Capital Alliance

Venture Capital

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nies. Fund staff may help with suchactivities as raising additional capitalor marketing a new product. Fund staffmay even fill the chief financial officerfunction for a company for a periodof time, then help recruit a new headof finance. Extensive entrepreneurialand managerial assistance is central tothe economic development functionof CDVC funds and often proves asimportant to the success of portfoliocompanies as the financing itself.

Taking this assistance a step further,several funds have learned to act asintermediaries between localworkforce development programs andthe businesses in which they invest.Adding value to portfolio companiesby helping to recruit trained employ-ees from distressed areas and disad-vantaged populations augments afund’s social and financial bottomlines. Likewise, some funds havelearned how to help their portfoliocompanies use government tax incen-tives and other programs in empow-erment zones and other economicallydistressed communities. In this way,the funds make it not only financiallypossible but also attractive for a busi-ness to locate in a low-income areaand hire area workers.

FACTS AND FIGURES

While CDVC funds share a commonmission, they take a number of legalforms, including: limited liability com-panies; limited partnerships; regular“C” corporations; and not-for-profit tax-exempt corporations. Their capitalcomes from sources that share theirinterest in a double bottom line re-turn, including foundations, banks ful-filling their Community ReinvestmentAct obligations, other corporations,government and wealthy individuals.

Although foundations and othersocially motivated investors led theway in the development of the indus-try, banks have now supplanted theseinvestors as the leading source of capi-tal for the industry. While they pro-

vided a little over a third of the eq-uity capital to CDVC funds startedbefore 1998, banks provided abouttwo-thirds of the equity capital raisedby funds formed after that year. Andthe range of legal structures used byCDVC funds offer banks a variety ofinvestment options including the pur-chase of interests in a limited part-nership or limited liability company,the purchase of stock in a corpora-tion, straight debt, equity equivalentinvestments2 and capital grants.

Based on a survey of 25 CDVCfunds, the average capitalization perfund was $12.7 million at the end of2000 and the median for these fundswas $6.2 million. However, newerCDVC funds are starting out larger.The three funds that raised capital in2001 each began life in the $12 to$13 million range.

Because most CDVC funds are rela-tively young, it is impossible to quan-tify precise financial or social returns.However, a sample of the older fundsindicates that they have created ap-proximately one job for every $10,000invested. These job creation numbersare particularly impressive in light ofthe fact that the funds surveyed wereall operating in very depressed ruralareas. And, of course, the money in-vested is not spent, but returned toinvestors or recycled to invest in othercompanies to create more jobs in thefuture.

OPPORTUNITIES

AND CHALLENGES AHEAD

The environment in which CDVCfunds and their investors operate haschanged significantly during the pastyear. New funds are forming at a rapidpace, mature funds are successfully

raising money to start second funds andtwo new federal programs have beenintroduced that will further boost thefield: the New Markets Venture Capital(NMVC) and New Markets Tax Credit(NMTC) programs, both enacted inDecember of 2000.

In July of 2001, the Small BusinessAdministration conditionally designatedseven new NMVC companies. TheNMVC program provides capital in theform of zero coupon debentures3 andoperating assistance grants to NMVCfunds that invest in small businesses inlow-income areas. NMVC companiesmust raise matching funds from theprivate sector for both the capital andthe technical assistance grant. The sevenfunds aim to raise between $5 millionand $12.5 million in private capital andan additional $1.5 to $3 million in pri-vate operating assistance grants. Thetarget date for a second round of NMVCselection is the fall of 2002.

The New Markets Tax Credit providesa dollar-for-dollar credit of 39% of theamount invested in a community de-velopment venture capital fund, spreadout over a period of seven years. A com-munity development venture capitalfund that wishes to participate in theprogram would apply to the Commu-nity Development Financial Institutions(CDFI) Fund for an allocation of taxcredits. If such an allocation is awarded,the fund can go to the market to raisecapital with the tax credit as a strong in-ducement to investors. The NMTC pro-gram will pump $15 billion into com-munity development venture capitalfunds and other investments in low-in-come urban and rural areas of the coun-try with $2.5 billion available in 2002.

These two programs together offerunprecedented opportunities to the

2 For more information on equity-equivalents (or EQ2s), please refer toMark Pinksy’s article on page 10.

3 Unsecured debt backed only by theintegrity of the borrower, not bycollateral, and documented by anagreement called an indenture. Oneexample is an unsecured bond.


Join Us

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community development venturecapital industry. At the same time, theyoffer some challenges. The industrymust be careful that the regulatorydefinition of New Markets investing—based on geography—does not re-place the more nuanced and power-ful methods that mission-driven CDVCfunds use to produce their social re-turns. These methods take into ac-count not only the area in which abusiness is located but also a com-plex mix of factors including the typesof jobs the business is likely to createand the types of people who are likelyto take those jobs.

Perhaps more important than anylegislation is the fact that communitydevelopment venture capital is be-coming an established and recognizedindustry. Someone raising a CDVCfund six or seven years ago faced a

difficult task of trying to define for in-vestors this unusual activity with fewpoints of reference; now those raisingfunds have an entire industry to pointto. Investing in CDVC funds is an es-tablished activity and a number oflarger institutional investors have staffsof people with expertise and budgetsdedicated to that purpose. People arebuilding careers in CDVC funds, de-veloping a unique set of skills thatcombine those of venture capital fi-nance and economic development. Atthe same time, the CDVC field ischanging rapidly, with an unusualspirit of experimentation and learningthat will serve it well in the search forinnovative ways to produce doublebottom line results.

KERWIN TESDELL is president of the CommunityDevelopment Venture Capital Al l iance(www.cdvca.org), the trade association of com-munity development venture capital (CDVC)funds. It provides training, technical assistanceand consulting services to the field; operates aCentral Fund that invests in and co-invests withCDVC funds; performs and publishes research;and advocates for the field.Community Development VentureCapital Alliance330 Seventh Avenue, 19th FloorNew York, New York 10001212-594-6747

THE FEDERAL RESERVE BANK OF SAN FRANCISCO

IN PARTNERSHIP WITH

THE UNIVERSITY OF SOUTHERN CALIFORNIA

PRESENT THE

NATIONAL COMMUNITY DEVELOPMENT LENDING SCHOOL

JULY 21–25, 2002

for five days of intensive training on the key issues and current industry trends relevant to community development lending in today’s businessenvironment. Training in five core areas—single-family and multi-family housing, small business, commercial real estate and community-basedfacilities lending—stresses the day-to-day mechanics of underwriting community development loans and ensuring their long-term profitability.

A redesigned and challenging curriculum has been developed by an advisory committee of community development bankers, trainingprofessionals and representatives of bank regulatory agencies to focus on structuring and underwriting community development loans. Eachcourse is developed to ensure that students receive the most current, relevant, challenging and applicable instruction available. In addition,students will have the opportunity to participate in evening roundtables and seminars that focus specifically on issues that have been raisedduring the day’s courses.

WATCH YOUR MAIL . . .A brochure and registration application will arrive soon.

FOR PROGRAM AND REGISTRATION INFORMATION

Check our website at http://www.frbsf.org/frbsf/events/index.html

CI

ABOUT THE AUTHOR

LOS ANGELES BRANCH

http://www.frbsf.org/news/events/index.html

REGULATORY OVERVIEW

INVESTMENT TYPE: COMMUNITY DEVELOPMENT VENTURE CAPITAL

Definition: Community development venture capital organizations (CDVC) use the tools of venture capi-tal to conduct community and economic development activities as defined in the CRA regu-lation. CDVC funds make equity and equity-like investments in small businesses that hold thepromise of rapid growth and a “double bottom line” of not only financial returns, but alsocommunity and economic development benefits. CDVC funds come in many different forms,including not-for-profit, for-profit, and quasi-public organizations. Their structures encom-pass for-profit “C” corporations, limited partnerships, limited liability companies, communitydevelopment corporations (CDCs) and Small Business Investment Companies (SBICs). CDVCsfund investments ranging from the purchase of preferred and common stock to the provisionof subordinated debt with equity “kickers” such as warrants or royalties. Investments inCDVCs should be carried as investments on the investing institution’s balance sheet in accor-dance with Generally Accepted Accounting Principles (GAAP).

CRA A lawful investment, deposit, membership share or grant to a community development ven-ture capital fund that has as its primary purpose community development will be considereda qualified investment/community development investment under the CRA regulation.

27

Applicability:

FEDERAL RESERVE SYSTEM CONFERENCE

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A national conference to encourage initiatives and partnershipsthat increase access to credit and capital and strengthen local economies

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28

REGULATORY RESOURCE

§§ __.12(i) & 563e.12(h) – 5:Must there be some immediate or di-rect benefit to the institution’s assess-ment area(s) to satisfy the regulation’srequirement that qualified investmentsand community development loans orservices benefit an institution’s assess-ment area(s) or a broader statewide orregional area that includes theinstitution’s assessment area(s)?

A5. No. The regulation recognizes thatcommunity development organizationsand programs are efficient and effec-tive ways for institutions to promotecommunity development. These orga-nizations and programs often operateon a statewide or even multi-state ba-sis. Therefore, an institution’s activityis considered a community develop-ment loan or service or a qualified in-vestment if it supports an organizationor activity that covers an area that islarger than, but includes, the insti-tution’s assessment area(s). The insti-tution’s assessment area(s) need notreceive an immediate or direct benefitfrom the institution’s specific partici-pation in the broader organization oractivity, provided that the purpose,mandate, or function of the organiza-tion or activity includes serving geog-raphies or individuals located withinthe institution’s assessment area(s).

In addition, a retail institution that,considering its performance context,

has adequately addressed the commu-nity development needs of its assess-ment area(s) will receive considerationfor certain other community develop-ment activities. These community de-velopment activities must benefit ge-ographies or individuals located some-where within a broader statewide orregional area that includes theinstitution’s assessment area(s). Exam-iners will consider these activities evenif they will not benefit the institution’sassessment area(s).

§§ __.12(i) & 563e.12(h) – 6:What is meant by the term “regionalarea”?

A6. A “regional area” may be as smallas a city or county or as large as amulti state area. For example, the“mid-Atlantic states” may comprise aregional area. Community develop-ment loans and services and qualifiedinvestments to statewide or regionalorganizations that have a bona fidepurpose, mandate or function thatincludes serving the geographies orindividuals within the institution’s as-sessment area(s) will be consideredas addressing assessment area needs.When examiners evaluate communitydevelopment loans and services andqualified investments that benefit a re-gional area that includes the insti-tution’s assessment area(s), they will

consider the institution’s performancecontext as well as the size of the regionalarea and the actual or potential benefitto the institution’s assessment area(s).With larger regional areas, benefit to theinstitution’s assessment area(s) may bediffused and, thus less responsive toassessment area needs.

In addition, as long as an institutionhas adequately addressed the commu-nity development needs of its assess-ment area(s), it will also receive con-sideration for community developmentactivities that benefit geographies orindividuals located somewhere withinthe broader statewide or regional areathat includes the institution’s assess-ment area(s), even if those activities donot benefit its assessment area(s).

§§ __.12(i) & 563e.12(h) – 7:What is meant by the term “primarypurpose” as that term is used to definewhat constitutes a community develop-ment loan, a qualified investment or acommunity development service?

A7. A loan, investment or service hasas its primary purpose community de-velopment when it is designed for theexpress purpose of revitalizing or sta-bilizing low- or moderate-income ar-eas, providing affordable housing for,or community services targeted to, low-or moderate-income persons, or pro-moting economic development by fi

QUALIFIED INVESTMENT means a lawful investment, deposit, membership share or grant that has as its primary purposecommunity development

COMMUNITY DEVELOPMENT means:

1. Affordable housing (including multifamily rental housing) for low- or moderate- income individuals

2. Community services targeted to low- or moderate-income individuals

3. Activities that promote economic development by financing businesses or farms that meet the size eligibilitystandards of 13CFR121.301 or have gross annual revenues of $1 million or less

4. Activities that revitalize or stabilize low- or moderate-income geographies

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nancing small businesses and farmsthat meet the requirements set forth in§§ __.12(h) or 563e.12(g). To determinewhether an activity is designed for anexpress community development pur-pose, the agencies apply one of twoapproaches. First, if a majority of thedollars or beneficiaries of the activityare identifiable to one or more of theenumerated community developmentpurposes, then the activity will be con-sidered to possess the requisite primarypurpose. Alternatively, where the mea-surable portion of any benefit be-stowed or dollars applied to the com-munity development purpose is lessthan a majority of the entire activity’sbenefits or dollar value, then the activ-ity may still be considered to possessthe requisite primary purpose if (1) theexpress, bona fide intent of the activ-ity, as stated, for example, in a pro-spectus, loan proposal, or communityaction plan, is primarily one or moreof the enumerated community devel-opment purposes; (2) the activity isspecifically structured (given any rel-evant market or legal constraints orperformance context factors) to achievethe expressed community developmentpurpose; and (3) the activity accom-plishes, or is reasonably certain to ac-complish, the community developmentpurpose involved. The fact that an ac-tivity provides indirect or short-termbenefits to low- or moderate-incomepersons does not make the activitycommunity development, nor does themere presence of such indirect or short-term benefits constitute a primary pur-pose of community development. Finan-cial institutions that want examiners toconsider certain activities under eitherapproach should be prepared to dem-onstrate the activities’ qualifications.

§§ __.12(s) & 563e.12(r) – 2:Are mortgage-backed securities or mu-nicipal bonds “qualified investments”?

A2. As a general rule, mortgage-backedsecurities and municipal bonds are not

qualified investments because they donot have as their primary purposecommunity development, as definedin the CRA regulations. Nonetheless,mortgage-backed securities or munici-pal bonds designed primarily to fi-nance community development gen-erally are qualified investments.

Municipal bonds or other securitieswith a primary purpose of commu-nity development need not be hous-ing-related. For example, a bond tofund a community facility or park orto provide sewage services as part ofa plan to redevelop a low-incomeneighborhood is a qualified invest-ment. Housing-related bonds or secu-rities must primarily address afford-able housing (including multifamilyrental housing) needs in order toqualify. See also § __.23(b) – 2.

§§ __.12(s) & 563e.12(r) – 3:Are Federal Home Loan Bank stocksand membership reserves with the Fed-eral Reserve Banks “qualified invest-ments”?

A3. No. Federal Home Loan Bank(FHLB) stock and membership re-serves with the Federal Reserve Banksdo not have a sufficient connectionto community development to bequalified investments. However, FHLBmember institutions may receive CRAconsideration for technical assistancethey provide on behalf of applicantsand recipients of funding from theFHLB’s Affordable Housing Program.See §§ __.12(j) & 563e.12(i) – 3.

§§ __.12(s) & 563e.12(r) – 4:What are examples of qualifiedinvestments?

A4. Examples of qualified investmentsinclude, but are not limited to, investments,grants, deposits or shares in or to:➤ Financial intermediaries (includ-ing, Community Development Finan-cial Institutions (CDFIs), CommunityDevelopment Corporations (CDCs),

minority- and women-owned financialinstitutions, community loan funds, andlow-income or community develop-ment credit unions) that primarily lendor facilitate lending in low- and mod-erate-income areas or to low- andmoderate-income individuals in orderto promote community development,such as a CDFI that promotes economicdevelopment on an Indian reservation➤ Organizations engaged in afford-able housing rehabilitation and con-struction, including multifamily rentalhousing➤ Organizations, including, for ex-ample, Small Business InvestmentCompanies (SBICs) and specializedSBICs, that promote economic devel-opment by financing small businesses➤ Facilities that promote communitydevelopment in low- and moderate-income areas for low- and moderate-income individuals, such as youth pro-grams, homeless centers, soup kitch-ens, health care facilities, batteredwomen’s centers, and alcohol and drugrecovery centers➤ Projects eligible for low-incomehousing tax credits➤ State and municipal obligations,such as revenue bonds, that specifi-cally support affordable housing orother community development➤ Not-for-profit organizations servinglow- and moderate-income housing orother community development needs,such as counseling for credit, home-ownership, home maintenance, andother financial services education➤ Organizations supporting activitiesessential to the capacity of low- andmoderate-income individuals or geog-raphies to utilize credit or to sustaineconomic development, such as, forexample, day care operations and jobtraining programs that enable peopleto work

§§ __.12(s) & 563e.12(r) – 5:Will an institution receive consider-ation for charitable contributions as“qualified investments”?

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A5. Yes, provided they have as theirprimary purpose community develop-ment as defined in the regulations. Acharitable contribution, whether in cashor an in-kind contribution of property,is included in the term “grant.” A quali-fied investment is not disqualified be-cause an institution receives favorabletreatment for it (for example, as a taxdeduction or credit) under the Inter-nal Revenue Code.

§§ __.12(s) & 563e.12(r) – 6:An institution makes or participates ina community development loan. Theinstitution provided the loan at below-market interest rates or “bought down”the interest rate to the borrower. Is thelost income resulting from the lowerinterest rate or buy-down a qualifiedinvestment?

A6. No. The agencies will however,consider the innovativeness and com-plexity of the community developmentloan within the bounds of safe andsound banking practices.

§§ __.12(s) & 563e.12(r) – 7:Will the agencies consider as a quali-fied investment the wages or other com-pensation of an employee or directorwho provides assistance to a commu-nity development organization on be-half of the institution?

A7. No. However, the agencies willconsider donated labor of employeesor directors of a financial institution inthe service test if the activity is a com-munity development service.

§ __.23(b) Exclusion§ __.23(b) – 1:Even though the regulations state thatan activity that is considered under thelending or service tests cannot also beconsidered under the investment test,may parts of an activity be consideredunder one test and other parts be con-sidered under another test?

A1. Yes, in some instances the natureof an activity may make it eligible forconsideration under more than one ofthe performance tests. For example,certain investments and related sup-port provided by a large retail institu-tion to a CDC may be evaluated un-der the lending, investment, and ser-vice tests. Under the service test, theinstitution may receive considerationfor any community development ser-vices that it provides to the CDC, suchas service by an executive of the in-stitution on the CDC’s board of direc-tors. If the institution makes an invest-ment in the CDC that the CDC uses tomake community development loans,the institution may receive consider-ation under the lending test for its pro-rata share of community developmentloans made by the CDC. Alternatively,the institution’s investment may beconsidered under the investment test,assuming it is a qualified investment.In addition, an institution may electto have a part of its investment con-sidered under the lending test and theremaining part considered under theinvestment test. If the investing insti-tution opts to have a portion of itsinvestment evaluated under the lend-ing test by claiming a share of theCDC’s community development loans,the amount of investment consideredunder the investment test will be off-set by that portion. Thus, the institu-tion would only receive considerationunder the investment test for theamount of its investment multipliedby the percentage of the CDC’s assetsthat meet the definition of a qualifiedinvestment.

§ __.23(b) – 2:If home mortgage loans to low- andmoderate-income borrowers have beenconsidered under an institution’slending test, may the institution thatoriginated or purchased them also re-ceive consideration under the invest-ment test if it subsequently purchasesmortgage-backed securities that are

primarily or exclusively backed by suchloans?

A2. No. Because the institution receivedlending test consideration for the loansthat underlie the securities, the institu-tion may not also receive considerationunder the investment test for its pur-chase of the securities. Of course, aninstitution may receive investment testconsideration for purchases of mort-gage-backed securities that are backedby loans to low- and moderate-incomeindividuals as long as the securities arenot backed primarily or exclusively byloans that the same institution origi-nated or purchased.

§ __.23(e) Performance criteria§ __.23(e) – 1:When applying the performance crite-ria of § __.23(e), may an examiner dis-tinguish among qualified investmentsbased on how much of the investmentactually supports the underlying com-munity development purpose?

A1. Yes. Although § __.23(e)(1) speaksin terms of the dollar amount of quali-fied investments, the criterion permitsan examiner to weight certain invest-ments differently or to make other ap-propriate distinctions when evaluatingan institution’s record of making quali-fied investments. For instance, an ex-aminer should take into account that atargeted mortgage-backed security thatqualifies as an affordable housing is-sue that has only 60 percent of its facevalue supported by loans to low- ormoderate-income borrowers would notprovide as much affordable housing forlow- and moderate-income individu-als as a targeted mortgage-backed se-curity with 100 percent of its face valuesupported by affordable housing loansto low- and moderate-income borrow-ers. The examiner should describe anydifferential weighting (or other adjust-ment), and its basis in the Public Evalu-ation. However, no matter how a quali-fied investment is handled for purposes

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of § __.23(e)(1), it will also be evalu-ated with respect to the qualitativeperformance criteria set forth in §__.23(e)(2), (3) and (4) . By applyingall criteria, a qualified investment of alower dollar amount may be weighedmore heavily under the Investment Testthan a qualified investment with ahigher dollar amount, but with fewerqualitative enhancements.

§ __.23(e) – 2:How do examiners evaluate aninstitution’s qualified investment in afund, the primary purpose of which iscommunity development, as that is de-fined in the CRA regulations?

A2. When evaluating qualified invest-ments that benefit an institution’s assess-ment area(s) or a broader statewide orregional area that includes its assessmentarea(s), examiners will look at the fol-lowing four performance criteria:1. The dollar amount of qualified

investments;2. The innovativeness or complexity of

qualified investments;3. The responsiveness of qualified in-

vestments to credit and communitydevelopment needs; and

4. The degree to which the qualifiedinvestments are not routinely pro-vided by private investors.

With respect to the first criterion, ex-aminers will determine the dollaramount of qualified investments byrelying on the figures recorded by theinstitution according to generally ac-cepted accounting principles (GAAP).Although institutions may exercise arange of investment strategies, includ-ing short-term investments, long-terminvestments, investments that are im-mediately funded, and investmentswith a binding, up-front commitmentthat are funded over a period of time,institutions making the same dollaramount of investments over the samenumber of years, all other performancecriteria being equal, would receive the

same level of consideration. Examin-ers will include both new and out-standing investments in this determi-nation. The dollar amount of quali-fied investments also will include thedollar amount of legally binding com-mitments recorded by the institutionaccording to GAAP.

The extent to which qualified in-vestments receive consideration, how-ever, depends on how examinersevaluate the investments under theremaining three performance criteria—innovativeness and complexity, re-sponsiveness, and degree to which theinvestment is not routinely providedby private investors. Examiners alsowill consider factors relevant to theinstitution’s CRA performance context,such as the effect of outstanding long-term qualified investments, the pay-in schedule, and the amount of anycash call, on the capacity of the insti-tution to make new investments.

§ __.25(d) Indirect activities§ __.25(d) – 1:How are investments in third partycommunity development organiza-tions considered under the communitydevelopment test?

A1. Similar to the lending test for re-tail institutions, investments in thirdparty community development orga-nizations may be considered as quali-fied investments or as community de-velopment loans or both (providedthere is no double counting), at theinstitution’s option, as described abovein the discussion regarding §§ __.22(d)and __.23(b).

§ __.26(a) Performance criteria§ __.26(a) – 1:May examiners consider, under one ormore of the performance criteria of thesmall institution performance stan-dards, lending-related activities, such ascommunity development loans andlending-related qualified investments,when evaluating a small institution?

A1. Yes. Examiners can consider “lend-ing-related activities,” including com-munity development loans and lend-ing-related qualified investments, whenevaluating the first four performancecriteria of the small institution perfor-mance test. Although lending-relatedactivities are specifically mentioned inthe regulation in connection with onlythe first three criteria (i.e., loan-to-de-posit ratio, percentage of loans in theinstitution’s assessment area, and lend-ing to borrowers of different incomesand businesses of different sizes), ex-aminers can also consider these activi-ties when they evaluate the fourth cri-teria—geographic distribution of theinstitution’s loans.

§ __.26(a) – 5:Under the small institution performancestandards, how will qualified invest-ments be considered for purposes of de-termining whether a small institutionreceives a satisfactory CRA rating?

A5. The small institution performancestandards focus on lending and otherlending-related activities. Therefore,examiners will consider only lending-related qualified investments for thepurposes of determining whether thesmall institution receives a satisfactoryCRA rating.

§ __.26(b) – 2:Will a small institution’s qualified in-vestments, community developmentloans, and community developmentservices be considered if they do notdirectly benefit its assessment area(s)?

A2. Yes. These activities are eligiblefor consideration if they benefit abroader statewide or regional area thatincludes a small institution’s assess-ment area(s), as discussed more fullyin §§ __.12(i) & 563e.12(h) – 6.

REGULATORY RESOURCE

CI


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NATIONAL COMMUNITY CAPITAL’S 18TH ANNUAL TRAINING CONFERENCE

October 30 through November 2, 2002, in Oakland, California. Community Development Financial Institution staff andboard members, groups interested in starting a CDFI, funders, investors and policymakers should attend. More informa-tion can be found at www.communitycapital.org.

CALIFORNIA REINVESTMENT COMMITTEE STUDY ON SUB-PRIME LENDING

On November 29, 2001, the California Reinvestment Committee (CRC) released a statewide study, “Stolen Wealth: Inequi-ties in California’s Subprime Mortgage Market.” The study indicates that one-third of subprime mortgage borrowers in thestate could be victims of predatory lending and represents the first effort to statistically reflect California’s subprime mort-gage lending market. For a copy of the study, contact Kevin Stein, CRC Associate Director, at (415) 864-3980 or visit the CRCwebsite at www.calreinvest.org.

http://www.calreinvest.org


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Community Investments Magazine · 2014-02-13 · If you have an interesting community development program or idea, we would like to consider publish-ing an article by or about you