Community Reinvestment Fund:
Securitization of EDA Loans

801 Nicollet Mall
Suite 1800 West
Minneapolis, MN 55402

Tel.: 800-475-3050
Fax: 612-338-3236
www.crfusa.com

Project Summary

By simply extending its current business practices, the leading economic development loan reseller was able to create a new secondary market for grants made from a government agency. By doing so, the grants were able to create economic development dollars well beyond their original value.

Community Reinvestment Fund (CRF) is a nonprofit corporation that provides capital to community development lenders across the country. It works with all type of lenders, from single person nonprofit organizations to giant state agencies. CRF provides a "secondary market" for these community development loans by buying loans secured by assets - including business loans, commercial and residential real-estate loans, and community facility loans. By selling loans at the fair market value to CRF, the lenders receive funds immediately and with minimal restrictions. To date, community-development lenders in 22 states have received more than $200 million in cash from CRF. Most of the loans that are purchased by CRF are "warehoused" until a sufficient quantity is acquired to pool together for a secondary debt offering (called Community Reinvestment Revenue Notes) issued by CRF to institutional investors, such as banks, insurance companies and pension funds. Since its inception in 1989, CRF has made 13 such Community Reinvestment Notes offerings totaling over $54 million.

In 1999, The Economic Development Administration (EDA), a division of the U.S. Department of Commerce that has long provided funds for the nation's economic developing lending organizations, announced a pilot project to test recapitalizing its lenders by encouraging them to sell loans made with the agency's dollars. CRF jumped at the opportunity and devised a program to satisfy the needs of EDA lenders.

CRF determined that the most efficient way to resell EDA loans was to bundle those loans with non-EDA loan pools and offer them as Community Reinvestment Notes. Thus far, CRF has made two offerings that have included loans bought as part of EDA's securitization project. These mark the first time that EDA funds have ever been made available for a secondary market transaction. Many organizations pursued the challenge set forth by EDA, but CRF was the only one in the country able to buy and securitize EDA-backed loans in 2000. This case will detail CRF's groundbreaking endeavor with the EDA.

Financial Challenge

Since no organization had ever attempted to securitize and sell EDA Revolving Loan Fund (RLF) grants, CRF had numerous challenges to bear. Not only did CRF need to educate potential participants, but it was also competing with other possible loan resellers. First, CRF needed to identify and contact associations that were receiving EDA grants and invite them to participate in the pilot program. In doing so, CRF found it necessary to lay out the goals for the project, it restrictions, and CRF's particular qualifications and advantages as a loan purchaser to each potential participant. This process was completed by individually phoning 425 organizations that had received EDA grants.

Of the 425 community developers, nine notified CRF that they intended to participate in the securitization project. In the end, however, only two actually followed through with the EDA program. It should be noted, though, that all but one organization did conduct business with CRF in other manners outside of the EDA pilot program. Furthermore, four organizations that initially declined participation, actually did sell EDA-funded loans to CRF.

CRF found that eligible organizations did not participate merely because they held EDA-funded loans. In conducting its marketing efforts, CRF identified three factors that influenced the loan-sale decision of the loan holders; (1) the size of the unmet demand for loans by potential borrowers, (2) the price received for the loans sold, and (3) the impact of a loan sale on the organization's operating revenue. It may seem to be a straightforward quantitative decision in which the lending organization's officers undertake a cost-benefit analysis of a loan sale verses other options for raising capital. However, several other factors enter into the equation that make a loan sale a less objective decision that it might appear. These factors include the political and organizational climate in which the officers are operating; the financial background and expertise of the officers themselves; the real or perceived quality of the loans themselves and the officers' willingness to have outside parties inspect them; and the personal motivation of the officers to increase the volume of the organization's business.

The participating lenders had several characteristics similar among them. First, most of the organizations that sold loans had an immediate need for funding. As one participant explained, "Our borrowers need the money now, they don't need it nine months from now," and further said that raising money through grants often takes too long. Second, some, but not all, of the lending officers had prior experience in the financial services industry and specifically commercial lending. In other words, those that were familiar with and saw the benefits of secondary financial markets did not need to be further educated.

Next, the lending rates of those RLFs that sold to CRF varied widely, with interest rates as low as 4% and as high as 10.5%. Lenders had a variety of reasons for selling loans priced significantly below market. Some wanted to reposition their portfolios to higher rates. Others simply needed to raise funds and had few other options. Many of the loans sold, however, tended to be priced close to or at market rates. Finally, most of the organizations had other sources of funds that they could use to balance their revenue stream. They were not excessively reliant on the EDA for funding because they had significant other sources of lending resources.

Conversely, the organizations that did not participate also had common characteristics. By far, the most frequent reason given for not participating was, "No need for funding." However this can be broken down into several possible situations: (1) The organization recently received new grants that replenished its lending capital, (2) the organization has funded the bulk of its likely borrowers and is positioned to fund new borrowers incrementally as needed with its current sources of capital, (3) the organization lacks the marketing capacity to attract new borrowers or the administrative capacity to manage the loans, and (4) the current local supply of private capital can meet borrower demand.

However, there were several other reasons for not participating identified by CRF. First, a number of loan officers were simply not motivated to increase the volume of their business, even though that potential exists. In some cases, the idea of selling loans was viewed unfavorably by some members of boards that control the organizations. Other organizations declined to participate for fear of outside review of their loan portfolio and business operations. While some officers had strong financial backgrounds, others come from planning, grassroots organizing and social services and had no experience with secondary market techniques. Others may have made problematic loans and feared outside review would uncover poor lending practices and jeopardize future funding.

Another reason given for not selling EDA loans were fear of discounts on the sale of their loans. Some groups were convinced, sometimes wrongly, that the sale of loans priced at below market rates would mean very sizable discounts in the purchase price. However, CRF (in its original marketing materials) gave general estimates of what they might expect to receive for their loans, so there should have been little fear on behalf of the sellers. Conversely, CRF recognizes that those organizations lending at significantly below-market rates are not well-positioned for loan sales.

Although the loan purchase procedure may seem like a lengthy process, CRF believes that the purchase procedures required are minimal enough that there is no need for the lender to request professional assistance to comply. The speed with which these transactions can be closed is determined in part by the size of the loan and the ability of the lending organization to marshal its own resources. In the case of the pilot project, approvals of EDA loan sales were handled quickly and did not cause any delays in sales.

Transaction Summary

Loan Purchase Procedure

All loans purchased by CRF go through several phases. First, CRF provides a preliminary pricing to interested sellers to get an idea of what the loan is worth. If the RLF agrees to pursue a transaction, CRF then asks the lender for additional documentation, which is used to evaluate the quality of the individual loans and decides which loans can be purchased. Then, all loans must pass through a multi-layer approval process at CRF. Once approval is made, CRF provides a final price for the loans, which the RLF can accept or reject.

Description of Loan Assets for CRF's 12th Community Reinvestment Revenue Notes

• The pool is composed of 174 loans totaling $14.3 million of outstanding balances. Of this pool, 27 loans totaling $1.2 million are EDA loans.
• The loans were purchased from 27 sellers, of which 3 were of EDA loans (an additional 6 of these sellers operate EDA loan funds but did not sell EDA loans to CRF for this pool).
• The loans are located in 14 states, with EDA loans coming from 3 states.
• The weighted average interest rate on the loans in the pool is 8.5%, with rates on individual loans ranging from 2% to 14%. The weighted average interest rate on EDA loans is 8.65%.
• The typical loan amount of the loans in the pool is $57,800.

Security Characteristics of the 12th Series

• The total dollar amount of securities issued was $11,750,000.
• The securities were issued in three classes as follows:
  Class A Senior securities in the amount of $7,637,000

  Class B Junior securities in the amount of $3,525,000

  Class C Subordinate securities in the amount of $588,000

  The weighted average coupon on the securities was 7.73%

  The weighted average lives of the three security classes are as follows (assuming a 0% default rate)

  Class A - 35 months

  Class B - 71 months

  Class C - 94 months

  The securities were issued through a bankruptcy-remote special purpose entity (SPE). This SPE is a wholly-owned affiliate of CRF and is known as CRF-12, LLC.

  CRF is the holder of the Class C Subordinate securities and a portion of the Class A and Class B notes. In the event of defaults, the amounts that CRF would receive from future loan payments represented by these future interests would be reduced and would buffer both the Class A and Class B security holders from losses as a result of loan defaults.

Investors in the Community Reinvestment Notes

The debt security was closed on September 28, 2000. Investor participation was strong and diverse. Indeed, the 12th Series was over subscribed by more than 10%. The investors in the Class A and Class B securities included two commercial banks, three life insurance companies, two pension funds and one foundation. These investors included Wells Fargo Bank, Firstar Bank, Equitable Life Insurance, Mennonite Mutual Aid Assoc., Catholic Order of Foresters, Evangelical Lutheran Church of America Board of Pensions, the John D. and Catherine T. MacArthur Foundation and Prudential Insurance Co. Investors in all of CRF's notes receive Community Reinvestment Act (CRA) credit.

The 13th Offering

The success of CRF's 12th offering encouraged the organization to include EDA loans in its next offering in June 2001. The 13th offering sold for $14 million, again offered in three classes. Twenty-two EDA loans were included in this offering totaling over $1.2 million in unpaid principal balance. The characteristics and experience of the 13th offering mirrored that of the 12th offering of CRF.

Lessons Learned

CRF was very pleased with the results of the EDA loans used for the 12th and 13th Series securitizations and made the following observations:

• The EDA loans caused no particular concern to investors and were accepted by investors on equal footing with other loans purchased by CRF as acceptable collateral.
• As stated above, investor participation was strong, with the 12th Series being oversubscribed by 10%. Participation was also diverse, including two commercial banks, three life insurance companies, two pension funds and one foundation.
• The weighted average yield on the securities was higher than CRF hoped for, but was within an acceptable range. However, this may have been due to volatile conditions and an inverted yield curve in the bond market at the time of the offering.
• The ability to aggregate a sufficient volume of loans for a cost-efficient securitization in a short time period is important. Lengthy aggregation periods expose CRF to market risks that may become increasingly difficult to manage.
• It will be necessary to aggregate larger pools of a more standardized product before it becomes possible to obtain a rating for securities backed by such loans. The advantage of a rating is that it potentially increases the total base of interested investors.

Transferability

The procedures for structuring and marketing a securitization are complex and require professional assistance. Further, they are cost effective only for those organizations of the very highest lending volume. The many costs associated with securitization, both out-of-pocket expenses and institutional capacity-building, suggest that it is not cost-effective for most RLFs to consider self-securitization. As such CRF believes RLFs should view securitization as a specialized field that is not cost-effective for most individual entities.

CRF has created organizational structures that situate it well to provide services in a cost-effective manner. CRF provides institutional investors a market rate of return, hence ensuring that its debt securities are attractive to a wider range of investors than if it offered "social investment" instruments paying below-market rates. However, as a nonprofit, CRF utilizes foundation resources to lower its cost of capital and purchase and warehouse loans to provide cash to RLFs more quickly, thus extending the reach of its services. CRF believes this elaborate balancing of the advantages of for-profit and non-profit strategies provides the best opportunity to allow securitization of economic development lending to continue for the foreseeable future.

Additionally, there are several legal considerations that need to be addressed. Many are the same as experienced with any securitization program, such as tax considerations (CRF qualifies as tax-exempt under Section 501(c)(3)), representation and warranties of the sellers and the issuer, true sale and other legal opinions of legal counsel, and SEC exemption from registration. However, CRF encountered an additional legal concern with respect to the EDA. Both EDA and CRF required that the sellers of EDA funded loans obtain any consent necessary to effectuate a loan sale. For the pilot program, EDA required CRF to obtain its prior approval on behalf of the EDA grantee considering a loan sale.

About the Authors

Christina Cannella is an MBA student at the McDonough School of Business at Georgetown University focusing on nonprofit organizations. Previously she was an Investor Communications Supervisor for Janus Funds.

Mark Ervin is pursuing an MBA at the McDonough School of Business at Georgetown University where he is concentrating his studies on finance. Prior to business school, he was a client group supervisor at Investors Bank and Trust in Boston, MA where he coordinated custody and mutual fund accounting activities for a leading mutual fund family.

A significant portion of the information for this case study was gathered from the Securitization Project Final Report, dated April 30, 2001 and prepared by Michael Blumfield, Director of Marketing for Community Reinvestment Fund. This report details CRF's experience and outcome of the EDA pilot program.