| Matt Perrenod |
One encouraging aspect of the new Biden Administration’s response to the combined COVID/economic crisis is its unapologetic willingness to spend public funds, in sharp contrast to the Obama Administration’s response to the 2008 bank crash. There seems to be a solid understanding that any future initiatives depend upon a strong recovery over the next 12 months and that, in turn, depends on a sharp reversal of Trump Administration policies of bailing out corporations while leaving everyone else to fend for themselves.
Even if Biden is successful in pushing his immediate $1.9 trillion plan through Congress — and in getting a large infrastructure/stimulus package through later this year — there is an enormous challenge in actually delivering aid where, and to whom, it’s most badly needed. We saw this last summer with the rollout of the Payroll Protection Program (PPP), which achieved some of its goals of sustaining small business payrolls, but performed very poorly in terms of reaching community-based enterprises, especially BIPOC (Black, Indigenous and People of Color)-owned and operated businesses.
This speaks to how major financial investment channels are currently structured: well-designed to deliver capital to large corporations with substantial infrastructure to deal with complex capital structures; less adept, but somewhat adequate at reaching many white-owned businesses with established banking relationships; and utterly abysmal at reaching Black, Hispanic, and immigrant-led operations that, in the case of PPP, were often at a loss in negotiating large bank bureaucracies.
In response to public outcry, Congress and the Small Business Administration (SBA) made a minor course correction, setting aside a portion of remaining PPP funds for Community Development Finance Institutions (CDFIs) with strong community relationships. Tellingly, these funds were almost immediately pushed out the door where needed, as CDFIs did the painstaking work of helping borrowers understand the use of the funds and how to successfully apply. CDFIs were able to quickly double, triple, and quadruple their previous levels of SBA-backed lending.
For decades, CDFIs and other mission-based lenders have been minor players in the U.S. financial system, dwarfed in size and importance by both regulated depositories and the broader network of profit-driven financial institutions, including the largely un-regulated “shadow banking” sector. Now, however, they offer an opportunity to build robust channels for federally-driven investment in hard-hit communities nationwide.
What is a CDFI?
The term Community Development Financial Institution refers specifically to a certification by the CDFI Fund, a bureau of the U.S. Treasury and, more generally, to a class of mission-oriented lending and investment organizations. Under CDFI Fund guidelines, a CDFI may be either a non-profit or for-profit corporation, but must:
• Have a primary mission of promoting community development
• Provide both financial and educational services
• Serve to one or more defined target markets
• Maintain accountability to the defined target market
• Be a legal, non-governmental entity (with the exception of Tribal governmental entities)
For purposes of this discussion, however, I will refer to CDFIs in their more generic sense as mission investors and will focus on nonprofits (thus the reference to NGOs in the title).
There is about a 50-year history of CDFI activity in the U.S., originating in the community development movement that emerged from the civil rights and anti-war activities of the 50s, 60s and 70s. Today, there are hundreds of such organizations, some active nationally, but most regional or local in scope. They are generally much smaller than banks. A few of the larger CDFIs have assets in excess of $500 million, but most are under $50M. By comparison, the largest U.S. banks have assets in excess of $500 billion. (Note: both banks and CDFIs engage in off-balance sheet activity that magnifies their impact.)
Most CDFIs invest primarily through loan instruments, though a few also provide equity or equity-like capital. In general, CDFIs tend to engage in smaller transactions, and have a higher risk tolerance than banks. Affordable housing, charter schools and small business lending are the largest categories of CDFI investment. Nonprofit CDFIs raise equity through retained earnings, fundraising and from a set of grant programs operated by the federal CDFI Fund. They raise debt primarily by borrowing from banks, but the CDFI Bond Guarantee Program extends a federal guarantee to a limited amount of debt raised (more on this below). In general, the primary limitation to CDFI growth is not demand for their product; rather it is the difficulty of raising equity, since most CDFIs are held to a minimum 20% net worth requirement (equity/liabilities).
Current Status of the CDFI Sector
Starting from essentially zero in 1980 CDFIs have grown substantially in number, size and impact since then. Highly innovative, they have pioneered investment practices which have meaningfully resolved the inherent conflict in their double-bottom lines: their own private financial prosperity (and from that, growth) and a public social mission of supporting community development and collective prosperity.
Despite growth, however, CDFI capacity remains far too small, by perhaps two orders of magnitude, to have systemic impact on a national, much less global, scale. Their activities during the Great Recession bear this out. CDFIs, rather than retreating from community investment as the major banks did, expanded their activities from 2008 to 2011, including new efforts designed specifically to address the nature of the crisis. Several CDFIs, for example, began buying defaulted mortgage loans and instituted principal reductions (not just payment restructuring) that allowed homeowners to avoid foreclosure as their home values had fallen precipitously. This was in sharp contrast to the activities of the for-profit market, which competed to buy up defaulted loans for the purpose of foreclosing and claiming the underlying real estate at a bargain cost, and then turning those homes into rentals (and not the affordable kind). While nonprofit CDFIs were able to help tens of thousands avoid foreclosure, private equity ended up as landlords of millions of single-family structures previously owner-occupied.
More generally, mission-driven CDFIs have been able to build great models of community investment, backed by sophisticated investment management operations, but as a whole have done little to change the overall landscape of American communities in terms of meeting the needs of the large portion of the market that is not well served by traditional profit-driven finance.
Not that CDFIs aren’t well-positioned for growth. Most are managerially quite strong, with staffs that rival much larger firms in terms of skill, experience and capacity. They have relationships among low- and moderate-income people, including communities of color, that go well beyond anything found in the profit-driven investment sector. They have struggled with, and resolved, many of the practical difficulties of reaching investees, whether individuals or businesses, who may lack personal wealth and financial literacy. Given access to larger pools of capital, they can grow exponentially.
The main limiting factor to CDFI growth is the amount of equity they possess. CDFIs are extremely good, as a class, at leveraging their own net worth, and have themselves excellent borrowing relationships. Successful borrowing, however, requires a solid equity base. Because of their (typically) nonprofit structure, however, CDFIs cannot raise equity by issuing ownership shares; nonprofits by definition are not privately owned. CDFIs have increased their net worth through engaging in profitable activities that generate retained earnings (less than if they were profit-maximizing) and from fundraising grants, mainly from the federal government.
Through grant-making programs administered by the CDFI Fund, the federal government has done a good job of making very small CDFIs less small. Many of the larger CDFIs have gotten where they are by consistently adding a few million in equity annually from federal programs established for that purpose. As they have grown, however, these limited grants are less effective at driving growth — $5 million in new equity can be transformational for an organization with only $5 million to start, but the incremental impact is considerably less when it’s grown to $100 million in net worth.
One of the most important things the federal government can do to support healthy communities would be to substantially increase its CDFI investment through the CDFI Fund. There is little, other than political will, that stands in the way of taking $1 billion of annual grant-making to $10 billion or even $100 billion, over a handful of years. But the feds can do even more than that.
For several years, beginning in the second Obama term, Treasury has operated a program called the CDFI Bond Guarantee Program. CDFIs are able to borrow, in $100 million chunks, with a full federal guarantee of the debt. This means that the CDFI’s cost of funds drops to the federal funds rate, allowing it to make community investments far below bank rates. Even more importantly, this activity can happen almost entirely off-balance-sheet, allowing CDFIs to leverage far more investment activity off a given equity base. This would allow CDFIs to grow not just 10X, but 100X over a small number of years. That’s not happening now, because the program remains small, at $500M to $1B annually. The federal government has the capacity to issue trillions in new debt instruments, however, and so it is again a question of political will.
A reasonable person might ask whether the federal government couldn’t just issue that debt for its own programs of direct investment – why act through another party?
The answer is that the federal government, even in the best of times, is not particularly good at retail investment. It is not customer-oriented, and really can’t be, given that all authority flows from the top down, from the authorizing and funding legislative branch through an administrative structure that is necessarily focused on approval from Congress, itself answering to voters and campaign contributors divorced from the consuming public. A voter may also be a consumer, but they think and act quite differently in those separate roles. Public sector agencies are necessarily rule-driven and bureaucratic, the opposite of the entrepreneurial innovation needed when old means have atrophied, and new investment channels have to be built anew or drastically widened.
CDFIs, however, have distinguished themselves in their outward customer focus. They have learned to reach out in their communities, to identify needs, and devise solutions to meet those needs. Working against the headwinds of a profit-maximizing capitalist system, they have nevertheless succeeded in delivering capital to millions unable to access it through any other channel. They are ideal vehicles for pursuing public goals through investment in private individuals and businesses.
Popular movements are forcing Congressional Democrats to consider real community investment, after years of much lip service, but precious little action. The challenges of scaling up in this area should not be underestimated. We have seen repeatedly that, even when the federal government generates the will, the paucity of existing investment channels hampers that investment, leading to a dragged-out, inefficient process lacking in urgency and ripe for criticism.
Fortunately, we have a class of NGOs already active in this space that are prepared to grow into a larger role in directing capital toward human needs at the community level. CDFIs have been doing this work at a small scale for decades, establishing community roots, and innovating new approaches geared toward today’s society and economy. Their dual character as private entrepreneurial innovators with a public mission makes them ideal targets to channel a renewal of public investment in our communities.
Matt Perrenod is a consultant to nonprofit community development and finance organizations working throughout the United States.