At another crossroads: mission vs. market lending and risk assessment in Chicago community development loan funds

Prochaska, Natalie Karen

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https://hdl.handle.net/2142/117673 Copy

Description

Title

At another crossroads: mission vs. market lending and risk assessment in Chicago community development loan funds

Author(s)

Prochaska, Natalie Karen

Issue Date

2022-12-02

Director of Research (if dissertation) or Advisor (if thesis)

Greenlee, Andrew

Doctoral Committee Chair(s)

Greenlee, Andrew

Committee Member(s)

• Pendall, Rolf
• Doussard, Marc
• Layser, Michelle

Department of Study

Urban & Regional Planning

Discipline

Regional Planning

Degree Granting Institution

University of Illinois at Urbana-Champaign

Degree Name

Ph.D.

Degree Level

Dissertation

Keyword(s)

• community development
• affordable housing
• real estate
• real estate lending
• CDFI
• community development financial institution
• risk
• lending

Abstract

A massive gap exists between what community development financial institutions (CDFIs) do and what the larger community development industry imagines they do. What unites CDFIs is the centrality of improving economic conditions for low-income communities through the increased flow of capital (Caplan, 2014). Contrary to conventional understanding, CDFIs do not universally provide below market rate financing to community borrowers. Something appears to be restricting some CDFIs from low-interest lending to their social mission borrowers. This research lays out a framework for understanding why this is the case. This research theorizes why one type of CDFI, community development loan funds (CDLFs), may not always make low-interest loans to their mission borrowers. CDFIs have evolved since the mid-1990s into vital intermediaries between finance capital and community development actors. But they are an understudied link between capital markets and communities, despite having an outsized impact on the available real estate development financing in low- and moderate-income (LMI) communities (Benjamin, Rubin, & Zielenbach, 2004; Rubin, Caskey, Dickstein, & Zielenbach, 2008; Swack, Hangen, & Northrup, 2014). As unregulated mission lenders, limitations placed on profitability vary according to individual institutional mission lending goals (Bryson & Buttle, 2005). Although CDLFs play an outsized role in community and economic development financing, there are no studies documenting the details of their lending processes and how internal credit decisions are made. There is scarce procedural documentation of how CDLFs provide multifamily real estate financing. Generally, the CDFI industry provides credit access that market rate lenders do not provide. However, many community development practitioners think CDLFs exist to provide lower cost financing than conventional lenders. In this research I weigh in on this gap by understanding what structural limitations CDLFs have in making low-cost loans to borrowers, specifically focusing on their cost of capital and how they evaluate risk. The focus of this research is to understand how internal CDLF borrower risk assessment (underwriting) and CDLF bank lender risk assessment of CDLF portfolios (due diligence) may impact CDLF borrower loan pricing. To do this, I look at (1) how CDLFs lend, and (2) who CDLFs borrow from and on what terms. This research is a qualitative exploratory multiple-case study of a single type of CDFI – loan funds – used as a lens through which to assess real estate investment risk calculations in Chicago. Contemporary multifamily housing development finance results in uneven investments in local housing markets (Layser, 2019). Rather than looking at housing unit production and rehab “on the ground,” I focus on understanding how “upstream” activity within CDLFs, risk rating agencies, and other sources of capital shapes credit availability for investments in Chicago’s small and medium sized (SMMF) housing stock. I ask the questions: What business portfolios to multifamily lending Chicago CDLFs build and why; and what factors explain CDLF’s cost of capital? To answer these questions, I draw heavily on participant observation from working as an underwriter for the Federal Home Loan Bank of Chicago for five months in 2020. I combine that participant observation with qualitative interview data from 75 interviews (34 formal under IRB, 41 off-record conversations) between 2019-2021, including risk analysts across the FHLBC, rating analysts from S&P, Aeris and Moody’s, and staff from each of three Chicago CDLFs (CCLF, IFF and CIC). I combine this primary and secondary data triangulation with insights from interdisciplinary prior literatures on competitive strategy, macrocultural institutional theory and ‘soft’ information in bank lending credit assessment to build theory about risk assessment and risk management inside CDLFs. In my focus on CDLF lending practices, I observe that in Chicago, to effectively serve the needs of idiosyncratic markets, CDLF lending businesses have relatively narrow geographic scope and highly tailored product market strategies. The greater the proportion of loans involving dense interpersonal interactions, the narrower the businesses’ geographic scope, and vice versa. Inside Chicago CDLFs, risk is priced by a different set of institutional actors (credit committees) than the group assessing borrower default risk (loan officers). In evaluating CDLFs internally by specifically focusing on their processes for underwriting and portfolio management, I identify how financial ratios important for external legibility are managed discretionally by CDLF staff in ways that expand access to mission borrowers. In doing so I identify distinctions between loans to mission and to market borrowers in CDLF loan portfolios. Relative to market-driven loans, mission-driven loans are characterized by lower collateral requirements and greater underwriting flexibility to meet borrower needs, but also entail higher interest rates. While CDLFs exercise discretion in underwriting and portfolio management of mission loans, that discretion is limited by CDLF bank lenders through loan covenants. CDLFs’ internal contortions to maintain external legibility to their bank lenders lead to inferences about the impacts of these contortions: that absent particular externally imposed financial ratio thresholds, CDLFs might manage their businesses differently, serving more mission borrowers or serving them differently (e.g., through lower interest rates). Bank lenders’ loan covenants may limit CDLFs’ ability to facilitate the creation of affordable housing for historically marginalized groups. In my focus on CDLF borrowing practices, I interrogate what factors may explain CDLFs’ cost of capital. The cost of capital at the organizational level for lenders is an important driver of the cost of capital for their borrowers. I focus my inquiry on the source of the largest proportion of CDLFs’ cost of capital: commercial banks. In the absence of regulated loan portfolio reporting, the idiosyncratic business strategies of CDLFs require specialized expertise for banks to evaluate. Banks resolve their uncertainty about lending to CDLFs through internal due diligence processes and risk assessment outsourced to specialized rating agencies. Even though only 12% of all CDFIs nationally are rated, the processes and metrics used by rating agencies have indirect and direct effects that combine to drive up CDLF borrowing rates. Direct effects include the variation in emphasis and combination of subjective and objective rating criteria, and the tendency towards conservative assessments due to rating agency reputational risks. Indirect effects include CDLFs designing internal policies responsive to the metrics used by rating agencies to self-certify the risk of their portfolios for subsequent evaluation by banks. Overall, the combination of lack of required regulatory loan portfolio reporting and variation in rating agency methods drive up the costs of the specialized expertise banks require to evaluate CDLFs. I propose that CDLFs need a lower cost of capital to serve mission borrowers more effectively. This dissertation research provides an inside descriptive look at how CDLFs function, clarifying how CDLF lenders make decisions about allocating capital. In doing so it identifies the interrelated and discretionary nature of credit approval decisions made by bank risk analysts and CDLF lenders. I demonstrate that market and mission lending are different businesses. They require different policies, procedures and management strategies. Limits exist to scale efficiencies in CDLF mission lending because of the relationships and discretion required to be successful (in underwriting, portfolio management and borrower services). Identifying where CDLFs have discretion in mission loan risk assessment and mission loan portfolio risk management directs attention to how conventional risk assessment and risk management limits access to capital for CDLF mission borrowers. Conventional rules established by financial custom like LTVs, capital ratios, FICO scores, loan loss reserve ratios, charge-off ratios, delinquency ratios, etc. are used by lenders as shorthand representations of data useful for making decisions about future actions (Stuart, 2003). Financial risk evaluation frameworks like CAMELS are grounded in and designed for evaluating market lending. I demonstrate that CDLF mission lending is a distinct form of lending business categorically divergent from market lending businesses. Therefore, using a market lending business evaluation system (CAMELS) to evaluate mission lending is both a procedural and a substantive mismatch. It leaves out elements vital to mission lending and it over-emphasizes ratios calibrated to evaluate market lending. This research fills gaps in extant CDFI literature by delving into the weeds of CDLFs to illustrate the real limitations placed on what they can do resulting from structural constraints imposed by conventional financial practice. In doing so, my research challenges ideas about how finance in low- and moderate-income communities works and encourages a deeper understanding of what is needed to support and expand this industry without losing its original community mission.

Graduation Semester

2022-12

Type of Resource

Thesis

Copyright and License Information

Copyright 2022 Natalie Prochaska

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