Southern New Hampshire University professor Michael Swack answers basic questions about capital markets and explains how community development lenders can raise their capacity by tapping into these markets.Community development ; Capital market ; Loans

Michael Swack

English

Research Papers in Economics

Spring 2004 10 A Q
by Michael Swack 
Southern New Hampshire University
and Q A A
Capital Markets 
for Community
Development Lenders:
Questions & AnswersC C
Q
&Banking Communities 11
How is this type of lending different from 
what conventional banks do? 
In the 1970s and 1980s, banks began packaging and selling
their residential mortgage loans to a secondary market, in a
process known as securitization.Banks no longer had to fund
each loan through their deposits. Instead, they could sell
their loans to investors and use the revenue to fund more
loans. The birth of securitization allowed banks to originate
more loans,generate more revenue off the fees from the orig-
inations, and sell off their risk of holding fixed rate loans in
their portfolios.1 With all of these benefits, this process of
originating loans and selling them, called capital markets
lending, is now the standard for banks. Today, securitization
accounts for trillions of dollars of transactions.2
So, banks are involved in capital markets lending,
not portfolio lending. Let’s take a step back.
What exactly are capital markets?
Capital markets are simply markets where individuals,
governments, and businesses trade money.Those with excess
funds transfer capital to those who need it. In return, the
investors expect to earn a rate of return on their money that
is consistent with the amount of risk they are taking. Capital
markets allow large amounts of money to be pooled, while
giving individual investors an opportunity to diversify their
risk. The stock and bond markets are two of the major 
capital markets.
Aren’t there also primary and secondary capital
markets–what’s the difference?
The primary market is where new securities are issued. A
corporation or government agency that needs funds issues
these rights of ownership, interest, or dividends to willing
buyers, most often in form of stock or bonds. The securities
are usually underwritten by investment banks to guarantee a
minimum price for the seller.
After the securities are issued, they are sold to the pub-
lic in the secondary capital market. Secondary markets are
where securities are traded. The vast majority of financial
transactions that occur through stock exchanges, bond mar-
kets, futures markets, or other mechanisms all happen in the
secondary market. Q
ommunity development financial institutions
(CDFIs) have grown significantly in size and scope in the
past 20 years. After two decades of lending where others are
often reluctant to lend, many CDFIs have demonstrated a
solid capability to manage risk in their markets and have
developed strong portfolios. As they continue to expand to
meet the ever-increasing housing, business, and facility
demands of their communities, their funding needs are
growing. At the same time, the traditional sources of com-
munity development capital, such as government and 
foundation funding, are diminishing, and many community
development lenders are looking for new strategies and tech-
niques to raise money. Some have turned their attention to
accessing funds through conventional capital markets. Can
this be done? How? Is it a good idea? In this article, I will
address a few of these questions.
What are community development financial
institutions (CDFIs)?
CDFIs are financial institutions that are committed to 
meeting the credit needs of low-income individuals and
communities. Typically, CDFIs are either community-based
nonprofit organizations or national intermediaries with local
community offices. They are sensitive to the community’s
financial needs, understand the local market, and are willing
to invest the time and resources needed to find and cultivate
sound lending opportunities in these neighborhoods. As
such, they are able to develop loan and investment products
that differ from conventional lenders’ offerings, providing
funding where traditional lenders may not. Community
development loan funds, community development credit
unions, community development corporation loan funds,
microenterprise funds, and community development 
banks are all considered CDFIs. With the exception of 
community development banks, all of these are private, non-
profit corporations.
Where do CDFIs get their funds, and how 
do they operate?
CDFIs are generally financed through a mix of public and
private funds that include loans, grants, and investments.
They lend this money to the communities in which they
work and typically oversee every aspect of the loan. Most
CDFIs review applications, originate loans, book the loans,
service them, and hold them in their portfolios until the
loans are completely repaid. This type of top to bottom
lending is known as portfolio lending.Spring 2004 12
This seems a little abstract. Can you give 
an example of how this works?
Sure. Let’s take a look at the residential mortgage system in
the United States. This system is made up of a primary mar-
ket and a secondary market. In the primary mortgage 
market, funds are provided directly to the new homeowner,
who in turn issues a security to his bank—his mortgage.
The secondary market is the market where this mort-
gage loan can be bought and sold by investors. The bank
that made the loan in the primary market wants to sell the
mortgage and use the money to originate more loans.
Because the mortgage is backed by the homeowner’s real
estate, it is an attractive security for investors. In most cases,
one of the two largest secondary mortgage market 
institutions—the Federal National Mortgage Association or
the Federal Home Loan Mortgage Corporation—will buy
the mortgage from the bank. “Fannie Mae” or “Freddie
Mac,” as they are commonly known, then bundles the loan
with others to form a large pool of similar mortgages.Fannie
Mae and Freddie Mac then sell mortgage-backed securities
to public investors in order to finance their future purchases.
You mean, my mortgage with my local bank is
being traded by investors around the country?
Yes. The idea behind this secondary market is that while
home loans are local loans, the system of finance for them
Wall Street Without Walls
Several Federal Reserve Banks have teamed up with the Fannie Mae Foundation and Southern New Hampshire
University to support a unique initiative that addresses the financial needs of the community development
industry. Through the work of co-directors and founders Greg Stanton and John Nelson, Wall Street Without
Walls has established a volunteer core of financial experts and Wall Street executives that provide CDFI 
professionals with financial technical assistance and skills training.These specialists bring their expertise to the
nonprofit and community development fields, where the need for sophisticated financing is great, but access
remains low.
As part of its efforts, Wall Street Without Walls is developing a series of training sessions for community
lenders. The first,Orientation to the Capital Markets,is a one-day program that provides CDFIs with an overview
of financial markets and gives them information about raising capital in these markets. The program also offers
participants technical assistance to help them get started.
The first of these training sessions was held at the Federal Reserve Bank of Boston in May 2003. Community devel-
opment lenders from all over New England were invited to attend. A preliminary survey of the region’s 
community development organizations showed that most were heavily reliant on grants and donations for fund-
ing, and that many had recently seen a drop in their financial support. Sixty percent of the respondents had
recently searched for and found new sources of funding, but only a minority had successfully accessed the 
capital markets for this liquidity. Given these conditions, the Wall Street Without Walls training provided com-
munity lenders with a timely opportunity to learn how they could address their funding needs through capital
market investors.
The response from attendees of this first Orientation was positive. “The class provided relevant information 
for our changing times,” said one trainee, while another stated that the class provided her with “valuable 
information and ideas about potential opportunities to leverage new resources.”
Since May, Wall Street Without Walls has held training sessions at Federal Reserve Banks across the country,
assisting community development lenders in Baltimore, Atlanta, New York, and San Francisco. Recently, a two-
and-a-half-day follow-up course was developed, and the first Capital Markets Training Institute was held in March
at Southern New Hampshire University and co-hosted by the Boston Fed. These trainings and the volunteer
core are equipping local CDFIs with the financial knowledge and expertise they need to better serve their 
communities. For more information about the Wall Street Without Walls program and training opportunities,
visit www.wallstreetwithoutwalls.com.&Banking Communities 13
need not be. National capital markets provide funds for local
housing markets. With the proceeds from the sale of their
mortgages, primary lenders replenish their money supply
and use it to make more loans. Without this secondary mar-
ket, primary lenders would have to keep all of their loans in
their portfolios.They could make loans only from the money
they had in deposits, restricting their ability to serve the
needs of new homeowners.
O.K. I think I understand these primary and 
secondary capital markets. But aren’t CDCs 
and CDFIs already involved in them?
Yes, in a limited way they are. CDFIs are primary market
lenders.They receive money from foundations and govern-
ment agencies and lend it to individuals and communities
that need funds.
That seems to work in my community,
so what’s the problem?
Well, foundations and government have limited funds. You
probably have noticed this. You may also have noticed that
there is still demand for capital in your community. People
want to buy homes and start businesses. Organizations want
to develop housing and community facilities. CDFIs are
mostly portfolio lenders. And, while they have become good
at assessing risk and managing healthy portfolios, they are
limited by the amount of money they receive in grants and
donations. They cannot fill all of their lending needs. Many
CDFIs could expand their lending and better serve their
communities if they complemented their portfolio lending
with some capital markets lending. After all, there’s a lot of
money out there in the capital markets—and we could use it.
Remind me what you mean by capital 
markets lending.
A CDFI involved in capital market lending would employ
methods, such as securitization, that would distribute its
loans among a range of investors, instead of holding all of
the loans in its portfolio. By selling their loans on the 
secondary market, CDFIs can increase their liquidity.
We want Wall Street to buy our loans.What’s
the hitch?  What do we have to do to get them 
to buy?  Discount our loans? 
No,not necessarily. Sure,investors will want to pay less than
the face value of a loan if they think the loan won’t perform.
But CDFI loans perform and yield good returns. CDFIs
simply have to demonstrate this success in a way that
investors will understand.
How can CDFIs do that?  
First, the whole CDFI industry needs to change some 
collective behaviors in order to access these markets. In 
general, here’s what the capital markets are looking for:
Performance Data 
Capital markets like a lot of information and data. Investors
want to know how CDFIs perform over time. What are the
rates of delinquency, default, and recovery? Right now, most
CDFIs have weaker standards of data collection and meas-
urement than these markets want and often have different
definitions of what constitutes a delinquency or default. To
show the strength of their loans, CDFIs must illustrate per-
formance using standard industry data and definitions.
Standardization
This is a big one. Capital markets like vanilla. Not caramel,
not strawberry, not chocolate. Vanilla. Investors want
CDFIs to standardize things within the industry so that
they can better understand the products and appropriately
assess risk.The capital markets want not only standard data
collection but standardized performance tracking tools; uni-
form ways of servicing,underwriting,and assessing risk;and
a set method of collection.
The CDFI industry does not currently have any specif-
ic standards for these practices. However, trade associations
of CDFIs like the National Community Capital
Association are becoming larger and more sophisticated.
They have begun to promote operating practices among
their members that enhance the industry’s ability to meet
the capital markets’ standards. It is the first step toward
standardizing CDFI processes and procedures.
Volume
Capital markets like to deal with big numbers. They want
pools of loans that are $50 million or more in value. By
comparison, CDFIs deal with very small numbers. Some
CDFIs are developing mechanisms for pooling their loans
in order to offer investors the big numbers they desire.
Pricing
The capital markets need products that are priced properly
to risk and offer an attractive return. Can CDFI loan prod-
ucts offer a rate of return that would satisfy the market?
The first response might be “no.” But, in fact, several CDFI
portfolios are offering competitive rates of return. Not all
CDFI products will meet the pricing criteria, but many can
and do. CDFIs must identify and market these products.
Credit Enhancements
To make CDFI products more attractive, investors may
want certain credit enhancements. Credit enhancements,
such as insurance or letters of credit, are tools that make
loans less risky to investors by ensuring that regular pay-
ments will be received. CDFIs could leverage some of theirSpring 2004 14
government and foundation money as credit enhancements
in, perhaps, a better use of these funds.
Where should we start?  How can CDFIs 
break into the capital markets?
Let’s look at two of these barriers:
Volume
To achieve larger volume,CDFIs can and have created coop-
erative mechanisms where a number of CDFIs pool their
loans and sell them to an institutional investor similar to
Fannie Mae. By enticing an investor with large volume and
low risk resulting from the geographic dispersion of the
loans, pooling can be a cost-effective way for smaller CDFIs
to increase their liquidity.3
Credit Enhancements
A common tool used to promote the sale of loans is financial
guarantee insurance. This insurance ensures that payments
are made to investors who buy pools of loans. CDFIs could
negotiate a financial guarantee through an established insur-
ance company and provide a credit enhancement on a pool
of community development loans. The enhancement would
help the pool achieve a good rating from one of the rating
agencies, which would signal that the pool was a sound
investment.4 The favorably rated security could now more
easily be sold in the financial markets, where many 
insurance companies and mutual funds buy only highly 
rated securities.
This all sounds good, but I still have concerns.
For example, I have developed and maintained
close working relationships with my borrowers.
Won’t I lose this when I sell my loans?
Not at all. In most instances, you will continue to directly
service your own loans. You will need to maintain a close
relationship with your borrowers, providing them technical
assistance and monitoring their performance, in order to
ensure a healthy return to your investors.
O.K. But won’t I have to adjust my portfolio 
to meet the specific “appetite” of the market,
as opposed to the needs of the borrowers and
communities I serve? 
Not necessarily. Many CDFIs will continue to do portfolio
lending even if they are able to sell some of their loans. That
is,they will still have loans that meet certain unique needs or
circumstances and require the CDFI to service and hold the
loan to maturity. In fact, a CDFI might have many of these.
But, many community development lenders have developed
certain pre-packaged loan products, such as housing or facil-
ity loans. These loans are underwritten in a consistent way
and are “standard” within the CDFI’s own portfolio. These
are the types of loans that would best be packaged and sold
to investors in the capital markets.
Will institutional investors really buy CDFI
loans? Has anyone actually done anything yet?
Yes, it can work, and it has. For example, both the
Community Reinvestment Fund (CRF) of Minneapolis,
Minnesota, and Self-Help of Durham, North Carolina,
have successfully accessed capital markets and are providing
increased liquidity to the community development field. To
attract institutional investors, CRF began pooling and
underwriting loans that had been originated by a range of
smaller community development lenders around the coun-
try.They have amassed over $300 million worth of loans and
sold them to the secondary markets, bringing in capital for
these small lenders. Self-Help developed and marketed a
standard home mortgage product to attract investors and
has underwritten over $1.5 billion in these mortgages for
low-income communities. Both organizations’ efforts have
attracted a number of institutional investors to invest in
these community development projects, including
Prudential Securities, MetLife, and Equitable Insurance.
It sounds like this might work! Where can I 
find additional information?
The Financial Innovations Roundtable at Southern New
Hampshire University’s School of Community Economic
Development is working on these issues and developing
concrete ways for CDFIs to access capital markets. If you
would like to learn more about current and future innova-
tions, visit the Financial Innovations Roundtable’s web site
at www.finir.org.If you are interested in participating direct-
ly in our ongoing initiatives, please contact me, Michael
Swack, at m.swack@snhu.edu.
End Notes
1 Securitization protects banks from interest rate volatility, reducing risk.
Before securitization, banks would make a loan at 6% for 30 years. Several
years later, they might suffer a loss, paying their depositors more than 6% if
interest rates went up.
2 Moy, Kirsten and Alan Okagaki. 2001. “Changing Capital Markets and
Their Implications for Community Development Finance,”The Brookings
Institution. Available at www.brookings.edu/urban.
3 Stanton, Gregory. 2003. “Unblocking Obstacles to Capital Markets for
Community Development Lenders,” Community Economic Development
Press, School of Community Economic Development, Southern New
Hampshire University. For reprints contact arc@snhu.edu.
4 Ibid.
Dr. Michael Swack is the director of the School of
Community Economic Development at Southern New
Hampshire University.

Capital markets for community development lenders: questions & answers

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