oversight

Community and Economic Development Loans: Securitization Faces Significant Barriers

Published by the Government Accountability Office on 2003-10-17.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               United States General Accounting Office

GAO            Report to Congressional Requesters




October 2003
               COMMUNITY AND
               ECONOMIC
               DEVELOPMENT
               LOANS
               Securitization Faces 

               Significant Barriers





GAO-04-21

               a

                                                October 2003


                                                COMMUNITY AND ECONOMIC
                                                DEVELOPMENT LOANS

Highlights of GAO-04-21, a report to            Securitization Faces Significant Barriers
congressional requesters




Community economic development                  CED lenders rely on multiple federal programs that offer grants, loans,
(CED) lenders serve the credit                  guarantees, and other support to help fund lending activities. Some of these
needs of nonconventional                        lenders have expressed an interest in finding alternative sources of funding,
borrowers and economically                      including securitizing the loans that they make. However, the volume of
distressed areas across the nation.             CED loans potentially available for securitization is not known. In addition,
However, little is known about this
industry, its ability to tap private
                                                the community economic development industry is characterized by
sources of capital, and loan                    nonstandard underwriting, loan documentation and loan performance
performance and volume in the                   information, and limited mechanisms for securitizing loans. Without greater
industry. To provide information                understanding of available loan volume, the capital markets have little
that would be helpful in                        interest in developing standards or mechanisms for securitizing CED loans.
considering the role that the
federal government might play in                CED lenders also face barriers to securitizing their loans. Some of these
facilitating the creation of a                  barriers are unique to CED lending, including: limited lender capacity to
secondary market for CED loans,                 manage a securitized portfolio of loans; the external legal and regulatory
GAO was asked among other items                 limitations and requirements governing the use of the funds that these
to (1) determine the barriers to                lenders receive; and the high cost of originating and servicing CED loans.
more widely securitizing CED loans
and (2) identify options for
overcoming these barriers and the               This report describes options that the federal government might exercise to
likely implications of these options.           address the identified barriers. This report also describes the implications
                                                that implementing each option might have, including the potential for
                                                increased federal costs and changes in lenders’ missions. Ultimately,
                                                securitization may not be a significant alternative for CED lenders until the
                                                volume of loans available for securitization is better known and lenders are
                                                convinced of the benefits of participating.

                                                Wall Street and Main Street Face Barriers to Securitizing Economic Development Loans




www.gao.gov/cgi-bin/getrpt?GAO-04-21.

To view the full product, including the scope
and methodology, click on the link above.
For more information, contact William Shear
at (202) 512-4325 or shearw@gao.gov.
Contents




Letter
                                                                                                1
                            Results in Brief 
                                                         2
                            Background                                                                 6

                            CED Lenders Share Similar Missions, but Markets Targeted and 

                              Loan Information Vary                                                    9
                            As with the Lenders They Serve, Federal Programs Share Similar
                              Missions, but Differ in How They Operate                                16
                            Selected Securitization Models for Small Business and CED Loans
                              Have Similarities and Differences                                       26
                            We Identified Barriers to Securitizing CED Loans                          35
                            Potential Options Exist to Overcome Barriers, but Most Imply Costs
                              or Changes to Federal Programs                                          43
                            Observations                                                              54
                            Agency Comments and Our Evaluation                                        56


Appendixes
             Appendix I:    Objectives, Scope, and Methodology                                        59
                            CED Lender Characteristics and the Performance of Their Loans             59
                            Selected Federal CED Programs                                             60
                            Selected Securitization Efforts for CED Loans                             62
                            Barriers to CED Loan Securitization                                       63
                            Options for Securitization and Their Implications                         63
             Appendix II:   Model Descriptions                                                        65


Tables	                     Table 1: Sources of Lender Funding                                        12

                            Table 2: Federal Programs and Type of Assistance Provided to CED 

                                     Lenders                                                          18

                            Table 3: Summary of Programs and Their Target Market Criteria             21

                            Table 4: Appropriations for CED Lending Have Declined in

                                     Selected Federal Programs (Fiscal Years 1998–2003)               22

                            Table 5: Number of Lenders and Dollar Volume of Federal Support 

                                     (Fiscal Years 1998–2002)                                         23

                            Table 6: Securitization Models and Lenders and Borrowers 

                                     Involved                                                         27

                            Table 7: Types of Loans Pooled Varies by Model                            28

                            Table 8: Credit Enhancements Used to Distribute Credit Risks Vary

                                     by Model                                                         32

                            Table 9: Federal CED Lending Programs, Lender Types, and 

                                     Sponsoring Agencies Included in Our Review                       61




                            Page i                     GAO-04-21 Community and Economic Development Loans
          Contents




Figures   Figure 1: Role of Participants in a Common Securitization Model                            7
          Figure 2: Business and CED Loan Performance Measures
                    Collected about Each Lender Type                                             14
          Figure 3: Levels of Outstanding Securitized Loans Have Not
                    Reached the Levels of More Well-Established Models                           34




          Abbreviations

          ARC      Appalachian Regional Commission

          BRV      bankruptcy-remote vehicle

          CED      Community and Economic Development

          CDA      Commonwealth Development Associates

          CDBG     Community Development Block Grant

          CDC      Community Development Corporation

          CDFI     Community Development Financial Institution

          Commerce U.S. Department of Commerce

          CRF      Community Reinvestment Fund

          CSBG     Community Services Block Grant

          EC/EZ    Enterprise Community/Empowerment Zone grant

          EDA      Economic Development Administration

          EDI      Economic Development Initiative

          HUD      U. S. Department of Housing and Urban Development

          HHS      U. S. Department of Health and Human Services

          IRP      Intermediary Relender or Intermediary Relending Program

          RBEG     Rural Business Enterprise Grant

          RLF      Revolving Loan Fund

          SBA      U.S. Small Business Administration

          SEC      U.S. Securities and Exchange Commission

          Treasury U.S. Department of the Treasury

          USDA     U.S. Department of Agriculture

          504 CDC Section 504 Certified Development Companies


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          Page ii                           GAO-04-21 Community and Economic Development Loans
A

United States General Accounting Office
Washington, D.C. 20548



                                    October 17, 2003

                                    Congressional Requesters:

                                    Community and economic development (CED) lenders make loans to
                                    qualified businesses that are generally unable to obtain suitable financing
                                    from conventional private-sector lenders. CED lenders rely on a variety of
                                    funding sources including the federal government, but tend not to rely on
                                    securitization as a funding source.1 If properly structured, securitization
                                    represents an option that could offer lenders increased liquidity for
                                    additional lending and offer borrowers greater availability of loanable
                                    funds.2 Some of the federal programs that support CED lending have
                                    considered using securitization to provide lenders greater access to capital.

                                    This report responds to your July 11, 2002, request for information on CED
                                    lending. Based on the potential benefits that securitization may offer
                                    lenders and borrowers, you asked us to describe the characteristics of (1)
                                    selected federally sponsored CED lenders, (2) the federal programs that
                                    sponsor them, and (3) selected existing and proposed models for
                                    securitizing CED loans. You also asked that we (4) determine the barriers
                                    to more widely securitizing CED loans, and (5) identify options for
                                    overcoming these barriers and the implications of these options.

                                    To address the first two objectives, we reviewed studies and other
                                    documents obtained from lender trade associations, program regulations,
                                    procedures, and guidance and spoke with program and industry officials
                                    representing seven federally sponsored CED lenders we were requested to
                                    review and the federal programs that support them.3 To describe efforts to
                                    securitize CED loans, we reviewed agency and trade association
                                    documents and spoke with representatives of organizations undertaking
                                    securitization efforts. To determine the barriers to securitizing CED loans


                                    1
                                     Broadly, securitization is a process whereby lenders and others create pools of loans and
                                    sell to investors securities that are backed by cash flows from these loan pools—thereby
                                    replenishing funds available for lending.
                                    2
                                     Lender liquidity is a measure of a lender’s ability to meet its current financial obligations. It
                                    implies that the quality of the lender’s assets are such that they can be readily converted into
                                    cash with minimal loss in market value.
                                    3
                                     Our review does not include lenders identified as Community Development Enterprises
                                    financed through the Department of Treasury’s New Markets Tax Credit because these
                                    entities were only recently established.




                                    Page 1                               GAO-04-21 Community and Economic Development Loans
                    and potential options for overcoming them, we synthesized information
                    from our literature search, as well as information gathered from interviews
                    with program officials, CED lender representatives, capital market
                    participants, researchers, and others knowledgeable about CED lending
                    and securitization. Finally, we developed additional options the federal
                    government might exercise for potentially overcoming identified barriers
                    and explored the implications of these options, as well as those proposed
                    by others. The options for overcoming the barriers often entail additional
                    federal costs and, given the scope of this review, we were unable to
                    determine whether the benefits would exceed the costs that could result
                    from such efforts. Therefore, we do not endorse these options. Also, our
                    work focused on access to capital through securitization, not through other
                    means. We conducted our work in Washington, D.C.; Philadelphia,
                    Pennsylvania; and Manchester, New Hampshire, between October 2002 and
                    July 2003 in accordance with generally accepted government auditing
                    standards.



Results in Brief	   While the seven groups of CED lenders we reviewed have similar missions,
                    available data show variation in the types of borrowers they serve, the
                    investments they make, and how they are capitalized.4 However, little is
                    known about the industry as a whole. CED lenders vary in the types of
                    loans they make. For example, some lenders tend to focus on operating
                    loans, while others may focus on real estate loans. Lenders are funded by
                    federal, as well as state, local, private, and philanthropic funding sources.
                    Federal funding sources, however, are important for all of the lenders
                    included in our review because they provide lenders engaged in high-risk
                    lending with low-cost funding. Data on the amounts the lenders invest in
                    communities were not current or complete for lenders in our review. In
                    addition, because data on lender activity are reported through multiple
                    channels, data on the total number of lenders and the amount they invest—
                    as a group—in communities are not available. Loan performance data
                    were not available or current on all lenders. Finally, because of the various




                    4
                     The seven groups of lenders reviewed are (1) Community Development Financial
                    Institutions (CDFIs); (2) Revolving Loan Funds (RLFs); (3) Intermediary Relenders funded
                    by the Department of Agriculture’s (USDA’s) Intermediary Relending Program (IRPs); (4)
                    Community Development Corporations (CDCs); (5) Small Business Administration (SBA)
                    504 Certified Development Companies (504 CDCs); (6) microlenders; and (7) lenders
                    supported by Community Development Block Grant (CDBG) entitlement and state grantees.




                    Page 2                           GAO-04-21 Community and Economic Development Loans
sources of data on CED lenders, loan performance is not consistently
defined. Therefore, it is difficult to describe the performance of CED loans.

The federal programs that support CED lenders have similar missions—to
improve economic conditions in communities considered to be distressed
or underserved. However, the type of federal support they provide and the
targeted lending criteria they use differ. These programs also differ in
terms of the number and type of lenders they support and awards made. In
fiscal years 1998—2002 these federal programs provided billions to support
CED lending in the form of grants, loans, loan guarantees, and equity
investments. However, federal funding for some of these programs has
declined in recent years. Some programs use securitization, or have
considered using securitization, to help lenders in accessing capital
markets to maintain or expand lending activity. Finally, these programs
collect and maintain data to oversee lender’s activities using various
methods and have different reporting requirements.

The five existing and three proposed securitization models that we
reviewed illustrate a variety of structures to securitize small business and
CED loans and vary in the amount of CED loans that they securitize.5 Each
of the existing and proposed models varies in terms of the types of loans
pooled and the method for pooling the loans. All of the models we
reviewed utilize or propose differing forms of credit enhancements, funded
by the federal government, participating lenders, or others to limit credit
risk to investors.6 Accordingly, each of the models distributes the risks and
benefits associated with securitization differently among participants—
borrowers, lenders, poolers, investors, and government(s). The structure
of these models can affect participants’ willingness to engage in
securitization and cost incurred by the federal government.


5
 The five existing models include those for securitizing SBA 504 program loans,
unguaranteed SBA 7(a) loans, guaranteed SBA 7(a) loans, and HUD Section 108 guaranteed
loans, and the securitization model used by the Community Reinvestment Fund—a
nonprofit secondary market maker for CED-based lenders nationwide. We also reviewed
three models proposed by various sources—Commonwealth Development Associates'
(CDA) model proposed under the EDA 2001 securitization demonstration, HUD’s proposed
CDBG /Section 108 model, and Capital Access Group's proposed Capital Access Program
securitization model.
6
 A credit enhancement is a payment support feature that covers defaults and losses up to a
specific amount, thereby reducing investor need for loan-specific information. It acts to
increase the likelihood that investors will receive interest and principal payments in the
event that full payment is not received on the underlying loans.




Page 3                            GAO-04-21 Community and Economic Development Loans
We identified six key barriers to securitization, all of which keep lenders
from working with capital markets.

•	 First, borrower demand is not known across targeted markets, and CED
   lenders generally lack incentives—both market-based and federally
   driven—to participate in securitization. As a result, the volume of loans
   that could be securitized is not well understood.

•	 Second, many CED lenders lack the capacity to securitize their loans.
   For instance, their reliance on small, less-diversified portfolios that
   require intensive servicing results in higher per loan costs. Also many
   lenders do not have financial information—such as their cost to
   originate and service these loans and the expected income from these
   loans—that is needed to assess whether securitization is a viable option.
   Nor can they readily obtain the staffing resources or skills needed to
   expand lending activity that might be required when securitizing their
   loans.

•	 Third, external requirements—statutory or programmatic—attached to
   funding sources may directly or indirectly inhibit the securitization of
   loans.

•	 Fourth, CED lenders believe that selling their below-market-rate loans
   would require them to absorb too high a discount to benefit from a
   securitization.

•	 Fifth, lack of lender standardization and performance information
   impedes securitization by increasing the cost of securitizing these loans.

•	 Finally, mechanisms available to support securitization for CED loans,
   such as information links between capital markets and lenders and loan
   pool assemblers, are limited in number and capacity.

We identified a range of options the federal government could use to
address each of the barriers to securitization. Undertaking any of these
options could have important implications in terms of cost to the federal
government, mission of CED lenders, and lender and program
management. For instance, to address lack of lender participation,
incentives could be built into existing federal programs for lenders who are
willing and capable of securitizing their loans. However, such incentives
might require federal funds, and the extent to which this might result in
sufficient loan volume to make securitization viable is not clear. To



Page 4                       GAO-04-21 Community and Economic Development Loans
improve lender capacity, the government could allow for set–asides within
existing programs for training and technical assistance to lenders designed
to help lenders improve portfolio management, staff skills, and their
financial information. This option, however, might reduce the funds
available to support lending. The government could also remove program
restrictions that inhibit or prohibit securitization such as restrictions on the
use of loan repayments, which could affect lender missions. To improve
standardization and performance information, the government could
provide incentives for lenders and capital market participants to develop a
useful level of standardization and performance information tailored to
CED loans—which could lower the cost of underwriting loans, but could
also result in lenders moving away from target markets. Such incentives
could include funding set-asides, changes in program award selection
criteria, or even increased program funding to those lenders—all of which
may entail added program costs that should be assessed. Improved
information on lending activity and loan performance could also help
managers make better program decisions. To overcome the limited
mechanisms to securitize CED loans, the federal government could provide
a variety of different credit enhancements that would improve the
investment quality of these securities and minimize standardization
requirements for lenders, but which might also have a negative financial
impact on the federal budget.

While we do describe the likely implications of many of the options we
identified, we did not measure the extent to which each may affect lenders’
mission, federal costs, program oversight, and other potential implications.
Likewise, we did not determine whether the benefits would exceed the
costs that could result from such efforts. We, therefore, did not endorse
these options, and this report contains no recommendations. The
information we present provides a framework for understanding the
challenges, benefits, and costs of securitization. Based on our findings and
this framework, the final section in this letter presents some observations
on the nature of barriers CED lenders face in securitizing loans.

We provided a draft of this report to the U.S. Department of Agriculture
(USDA); U.S. Department of Commerce (Commerce); U.S. Department of
Housing and Urban Development (HUD); U.S. Department of Treasury
(Treasury); U.S. Small Business Administration (SBA); U.S. Department of
Health and Human Services (HHS); and the Appalachian Regional
Commission (ARC). Officials in all agencies provided technical comments
that we incorporated into the report, where appropriate. The technical
comments from HHS were from officials in HHS’s Administration for



Page 5                        GAO-04-21 Community and Economic Development Loans
              Children and Families. Generally the agencies did not indicate whether
              they agreed or disagreed with the report’s findings.



Background	   The federal government funds CED lending through a variety of
              mechanisms, including grants, loans, loan guarantees, and tax
              expenditures. Many government officials, academics, CED lenders, and
              nonprofits have recognized the value of identifying ways to maximize the
              impact of CED dollars. These efforts have resulted in alternative
              mechanisms CED lenders can use to access private, rather than
              governmental, funding for CED purposes. For example, CED lenders have
              worked with local banks by providing subordinate financing.7 Lenders
              have also received equity-like investments from banks. In addition, lenders
              have sold CED loans to replenish loan funds. Many have studied
              securitization of CED loans as a potential option to access additional
              private capital.

              Securitization is a process that packages relatively illiquid individual
              financial assets, such as loans, leases, or receivables with common
              features, and converts them into interest-bearing, asset-backed securities
              with characteristics marketable to capital market investors.8 As outlined in
              figure 1, the participants in securitization—borrowers, originating lenders,
              pool assemblers, credit raters, investors, and sometimes third-party credit
              enhancers—each assume specific roles during the transaction.
              Additionally, each of these participants derives specific benefits from the
              transaction. For example, borrowers gain access to loanable funds with
              favorable terms—such as longer payment terms and fixed rates—that may
              otherwise be unavailable. Securitization offers originating lenders a tool to
              improve their risk and balance sheet management, as well as potential new
              fee or income streams and the ability to put existing capital to other
              purposes. Securitization also allows the cash flows from pools of assets to
              be structured to match the appetites of investors; thus, investors can
              diversify with access to new securities that satisfy their maturity, risk, and
              return preferences.



              7
               In the case of a loan default, providers of subordinate financing have a claim to borrower
              assets that is junior, or secondary, to the claims of the provider of the senior financing.
              8
               Anand K. Bhattacharya and Frank J. Fabozzi, ed., Asset-Backed Securities, (New Hope,
              Pennsylvania: Frank J. Fabozzi Associates, 1996).




              Page 6                             GAO-04-21 Community and Economic Development Loans
Figure 1: Role of Participants in a Common Securitization Model

                                                  Investors purchase securities with cash flows that have desirable risk-return and maturity
                      Investors                   characteristics. A single pool can often contain multiple classes, or "tranches," of
                                                  securities.

                                                  The pool assembler legally sells the pool of assets to a "bankruptcy-remote vehicle
                                                  (BRV)," which holds the pool of assets in order to separate the performance and credit of
                                                  the pool from the assembler and originating lenders. The BRV sells securities to investors.
                     Bankruptcy-
                       remote                     Occasionally, external credit enhancements are secured from third parties. Third-party
                       vehiclea                   credit enhancers provide additional assurance to investors of payment of principal and
                                                  interest on the securities, or guarantee or insure some portion of individual loans, assuring
                                                  loan-holders (technically, the BRV), and ultimately investors, payment of principal and
                                                  interest on guaranteed or insured portions of loans.

                                                  Credit raters assess the performance and expected losses (credit quality) of the pool of
                                Third-party       assets, including internal and external credit enhancements, and provide a credit rating on
         Credit         Pool
                     assemblers    credit         the securities to be sold.
         raters
                                 enhancer
                                                  Loan pool assemblers assemble a pool of financial assets from participating lenders and
                                                  stratify the credit and payment positions of cash flows generated from the pool into
                                                  different classes of securities based on investor preferences; arrange for a credit rating;
                                                  and arrange for the sale of the securities to investors through the BRV.

                  Originating lenders             Originating lenders originate loans that conform to underwriting criteria acceptable to a
                                                  pool of loans and ultimately sell the loan into the pool. Lenders may fund credit
                                                  enhancements to support the credit quality of a pool of loans. The originating lender often
                                                  continues servicing the loan by collecting payments for distribution to the asset pool holder
                                                  (technically, the BRV) and managing impaired loans.

                      Borrowers                   Borrowers provide collateral and other documented assurances to the originating lender to
                                                  secure the loan, then provide specified payments of principal and interest.

Source: GAO.

                                              a
                                               Also known as a special purpose vehicle, a bankruptcy-remote vehicle is established to legally
                                              purchase the financial assets for the purposes of removing the assets from the credit risk associated
                                              with asset originators or the pool assembler.


                                              The degree to which participants receive these benefits depends largely on
                                              how well, or efficiently, the markets for securitized assets are functioning.
                                              With better current and historical performance data on financial assets,
                                              capital markets can more easily profile the risk of a pool of similar assets.
                                              This risk can be divided and sold to investors who are willing to purchase it
                                              at an acceptable risk-adjusted return (investor-required yield). As the
                                              markets for particular securitized assets grow more voluminous and liquid,
                                              and the performance of securitized assets as well as the risks associated
                                              with securitization become better understood, investor-required yields on
                                              particular asset-backed securities can decline. Additionally, the



                                              Page 7                                GAO-04-21 Community and Economic Development Loans
transaction costs of securitizing assets can also decline as the assets
become better understood. Declining investor-required yields and
transaction costs can lower the cost of financing for originating lenders and
ultimately borrowers. Conversely, with inadequate performance data, and
low volumes of similar financial assets, these benefits may not sufficiently
materialize for securitization to be a viable financing arrangement for
originating lenders and borrowers.

Home mortgages are the most well-established securitization market in the
United States. Private conduits, such as commercial banks, and
governmentally sponsored conduits such as the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac), have combined to securitize trillions of dollars
of home mortgages over the past three decades. According to the Federal
Reserve, as of the end of 2002, there were over $3 trillion dollars of
securitized home mortgages outstanding. With visible and voluminous
demand for home mortgage financings evident in the late 1960s and early
1970s, Congress restructured Fannie Mae and created Freddie Mac and the
Government National Mortgage Association (Ginnie Mae) to provide
secondary market outlets for home mortgage lenders using private capital.9
Ginnie Mae pioneered the securitization of the Federal Housing
Administration and the Veteran’s Administration home mortgages—which
already had standard underwriting and documentation guidelines, robust
secondary markets, and benefited from federal guarantees—in 1970.
Freddie Mac, and later Fannie Mae, did the same for nonfederally
guaranteed mortgages, developing uniform guidelines for mortgage
underwriting and documentation, and educating a diverse set of mortgage
lenders nationwide about the benefits of securitization.

In addition to home mortgages, financial assets such as commercial
mortgages, consumer credit receivables, and even small business and CED
loans have been securitized.10 Today, outstanding securitized commercial
mortgage and consumer credit receivable volume ranges in the hundreds of


9
 Congress established and chartered Fannie Mae and Freddie Mac as government-
sponsored, privately owned and operated corporations to enhance the availability of
mortgage credit across the nation during both good and bad economic times. Congress
established Ginnie Mae as a government-owned corporation within HUD responsible for
activities including guaranteeing mortgage-backed securities backed primarily by cash
flows from Federal Housing Administration and Department of Veterans Affairs mortgages.
10
     Consumer credit receivables include assets such as auto loans and credit card receivables.




Page 8                                GAO-04-21 Community and Economic Development Loans
                        billions of dollars. However, despite favorable regulatory treatment,
                        lending institutions have securitized less than $6.2 billion of nonfederally
                        guaranteed small business loans from 1994 through 2001. 11 During this
                        same time frame, lending institutions securitized approximately $22 billion
                        of SBA-guaranteed small business loans.12 As a rough point of comparison,
                        in June 2001 commercial banks held an estimated $450 billion in
                        outstanding small business loans.13 In a previous report, we attributed the
                        lack of securitized small business loans to the wide variety of small
                        business loan products, difficulty communicating the performance of small
                        business loans sufficiently and cost-effectively to capital markets, and
                        sporadic visible financial benefits for originating lenders and investors to
                        securitize these loans.14



CED Lenders Share       The seven types of federally sponsored CED lenders reviewed have similar
                        missions: to service the credit needs of small businesses and others that
Similar Missions, but   generally cannot access funding otherwise or are located in communities
Markets Targeted and    that are considered underserved. However, these lenders differ in the types
                        of borrowers they serve, the types of loans they make, and their sources of
Loan Information Vary   funding. Also, the total number of lenders and the amount they invest in
                        communities are not known. Finally, the performance of CED loans is
                        difficult to describe because consistent performance data are not available
                        for all lenders in our review.




                        11
                           Congress passed the Riegle Community Development and Regulatory Improvement Act
                        (Riegle Act) in 1994 to remove several legal and regulatory impediments to small business
                        and commercial mortgage securitizations, including favorable regulatory capital treatment
                        for depository institutions, and preemption of state securities registration and investment
                        restrictions. This data is from the Federal Reserve Board and includes pools of
                        nonguaranteed portions of SBA 7(a) loans and pools of other non-federally guaranteed
                        loans.
                        12
                             Federal Reserve Board. Includes pools of guaranteed portions of SBA 7(a) loans.
                        13
                           Federal Reserve Board. The board notes that their 1998 Survey of Small Business Finance
                        indicates that commercial bank small business loans outstanding represents roughly 65
                        percent of all small business lending.
                        14
                         U.S. General Accounting Office, Small Business Administration: Size of the SBA 7(a)
                        Secondary Markets Is Driven by Benefits Provided, GAO/GGD-99-64 (Washington, D.C.:
                        May 26, 1999).




                        Page 9                               GAO-04-21 Community and Economic Development Loans
Lenders Have Similar        All of the lenders we reviewed have similar missions to service CED credit
Missions in Financing       needs in low- and moderate-income communities or borrowers that are
                            considered to be underserved. Borrowers served by CED lenders are
Underserved Markets         perceived by traditional sectors as high risks—that is, they have difficulty
                            accessing credit either because they have poor or nonexistent credit
                            histories, insufficient collateral, or are start-up businesses with no track
                            record. Some lenders also help borrowers gain access to capital from
                            conventional sources (for example, banks) by providing a portion of what
                            the business needs and agreeing to let the bank recoup its losses first from
                            the business’ collateral in the event of default.

                            CED lenders employ several strategies to meet their missions. For
                            instance, they work extensively with their borrowers and target loans
                            rejected by banks. According to lenders with whom we talked and studies
                            we reviewed, lenders must work extensively with their borrowers,
                            providing loan servicing and technical assistance to help borrowers make
                            consistent loan payments and sound business decisions to ensure their
                            survival. In addition, lenders also devote more time to their borrowers than
                            that required for conventional loans to help borrowers qualify for CED
                            loans.



Lenders Target a Range of   While overall missions of CED lenders we reviewed are similar, they differ
Borrowers and Products      somewhat in terms of the types of borrowers they serve, products they
                            offer, and the targeted location of their investments. The lenders may
and Receive Funding from
                            support a range of borrowers, from poverty-level to moderate-income.
Various Sources             Many of the lenders focus on start-up businesses. Some lenders have more
                            specific targets. For example, microlenders serve businesses with five or
                            fewer employees and capital of $25,000 or less. Lenders may offer loans for
                            working capital, equipment, or real estate; however, some concentrate
                            more on one type of loan than others. For example, 504 Certified
                            Development Companies focus on commercial real estate and equipment
                            loans, while microlenders concentrate on working capital and equipment
                            loans. Some lenders service specific geographic areas. For instance, ARC
                            Business Development Revolving Loan Fund lenders service borrowers in
                            the Appalachian region.

                            As shown in table 1, lenders receive funding from various sources including
                            federal, state, local, private, and philanthropic sources of capital as well as
                            earned income. According to lenders, trade association representatives
                            and studies we reviewed, federal funding sources are important because



                            Page 10                       GAO-04-21 Community and Economic Development Loans
they provide low-cost capital for high-risk loans they finance. In addition,
federal funding makes up a significant portion of the capital available to
some lenders. We also found that the source of federal funding for these
lenders varies. For instance, federal funding for CDFIs comes from the
U.S. Department of Treasury. In addition, some CDFIs—particularly those
that finance microloans, and that are also classified as CDCs—also receive
funding from HUD, SBA, Commerce, USDA, and HHS.

Finally, lenders generate income from interest earned and administrative
fees they charge borrowers for services and loans. According to lenders
and other research, lenders rely on these earned-income sources to cover
their operating costs. Earned income also is important to many lenders
because other funding sources do not allow lenders to use a portion of the
funding to cover operating costs.




Page 11                      GAO-04-21 Community and Economic Development Loans
Table 1: Sources of Lender Funding

                                                      Nonfederal sources                                                  Federal sources
                                                           Earned
                                       State Local Private Income Othera                         Treasury Commerce              HUD      USDA SBA HHS ARC
Community Development
Financial Institutions                    X          X      X             X          X                X              X            X         X   X   X
(CDFI)
Microlenders
                                          X          X      X             X          X                X                                         X   X

Community Development
                                          X          X      X                        X                X              X            X         X   X   X
Corporations (CDC)
Revolving Loan Fund
                                          X          X      X             X          X                               X            X         X   X   X   X
lenders (RLF)b
Intermediary Relenders
                                          X          X      X             X                                                                 X
(IRP)
504 Certified
Development Companies                                       X             X          X                                                          X
(504 CDC)
Lenders supported by
HUD’s Section 108 and                                                     X                                                       X
CDBG programsc
Sources: Lender trade associations and federal programs.
                                                             a
                                                                 Other includes individual investors, philanthropic investors, and utilities.
                                                             b
                                                              Includes EDA- and ARC-sponsored RLFs. However, RLFs may receive funding from multiple federal
                                                             sources.
                                                             c
                                                              HUD Section 108 and CDBG lenders are local government agencies or nonprofit intermediaries.




Total Number of CED Loans                                    Data on the number and amount of CED loans invested in communities are
and Amount of CED                                            not current or complete for all lenders targeted by our review. For
                                                             example, data on the number and amount of loans these lenders make are
Lending Are Not Known
                                                             sometimes only collected for a sample of lenders. Data on the number and
                                                             amount of loans for microlenders were collected in September 2000, but
                                                             cover only 308 of the 554 identified microlenders. Similarly, the most
                                                             recent reporting time frame for 504 CDC data is fiscal year 2001 but covers
                                                             about 272 lenders. Data on the amount and number of CDFI loans covers
                                                             389 of the 800—1000 CDFIs identified. The latest survey on Community
                                                             Development Corporation lenders was completed in 1997 and indicated
                                                             that there were an estimated 3,600 CDCs nationwide—as many as 776




                                                             Page 12                                      GAO-04-21 Community and Economic Development Loans
                             reported making CED loans. 15 Data on loan numbers and amounts for
                             IRPs cover only 29 out of the 400 IRPs identified by the trade association
                             that represents them. 16 Data are reported on 422 Department of Commerce
                             RLFs and 1,012 lenders supported by Section 108 and CDBG programs.
                             However, the total universe of these lender types is unknown.17

                             In addition, it is impossible to aggregate available data to determine the
                             total number of CED lenders and the number or dollar volume of loans they
                             make because some lenders may be counted in more than one lender
                             group. For instance, as indicated previously, both microlenders and CDCs
                             may also be CDFIs. Many lender types can be supported by HUD’s Section
                             108 and CDBG grant programs. Given the data limitations, the total volume
                             of loans and dollars invested in communities through CED lending is also
                             unknown.



Loan Performance Data Are    Loan performance data, including data on loan delinquencies, defaults, and
Limited, but Attempts Have   loss rates were not available, complete or defined consistently for both
                             ongoing and one-time data collection efforts (see figure 2).18 For example,
Been Made to Improve Data
                             loan performance data are not available for CDCs at all. The CDFI Fund
                             and other ongoing sources of data on CDFIs do not track default rates at
                             all. Conversely, ongoing data collection on IRPs covers defaults and

                             15
                              The National Congress for Community Economic Development, a trade association for
                             Community Development Corporations conducts a survey on these lenders. The next
                             survey is not scheduled for completion until 2004.
                             16
                                While data on the number and amount of loans made by IRPs are limited, USDA, which
                             currently funds 400 IRPs is drafting a new template to be used by IRPs requiring lenders to
                             provide more detail on their lending activity.
                             17
                               Data on the total number of RLFs and HUD-supported lenders are unavailable. RLFs do
                             not have a central organization that maintains data on the RLF industry as a whole. While
                             an attempt to collect RLF data was made by the Corporation for Enterprise Development in
                             1997, it was not successful because reliable data were not available at that time on many of
                             the RLFs. Also, RLFs funded by HUD’s CDBG program were excluded from the count.
                             HUD’s recent attempt to identify its grantees using Section 108 and CDBG dollars for CED
                             lending resulted in the identification of 1,012 state and local entitlement grantees. However,
                             because these grantees make direct loans to businesses and to nonprofit intermediaries
                             (such as RLF lenders), identified grantees do not represent the universe of the lenders
                             supported by the programs.
                             18
                              Delinquency refers to a situation where an entity falls behind agreed payment dates in
                             making payments. Defaults occur when the lender no longer believes that the business will
                             make payments. Losses are the monetary losses to the loan holder in the event of borrower
                             default, less any monetary value recovered from the liquidation of loan collateral.




                             Page 13                            GAO-04-21 Community and Economic Development Loans
                                                                     delinquencies, but only at an aggregate level—not at a loan level. In fact,
                                                                     only EDA, SBA, and ARC collect loan-level performance information on an
                                                                     ongoing basis (for the RLF, 504 CDC, Microlenders, and ARC/RLF
                                                                     programs).



Figure 2: Business and CED Loan Performance Measures Collected about Each Lender Type

  Lenders                                                                        Performance measure status

                                                              Total
                                             Number           estimated
                                             of lenders       number                                                                                           Unpaid
  Data collection efforts                    reported         of lenders             Defaults           Delinquencies        Losses        Recovery      principal balances

  One-time data collection efforts
                    RLFs (EDA RLFs
                                                 422              546
                  Rutgers University)a
       Lenders supported by HUD's
                                                   51          unknownc
  Section 108 and CDBG programsb
 Community Development financial
                                                   54         800-1,000
      institutions (ABT Survey)d,e
  Ongoing data collection efforts
 Community Development financial
                                                 389          800-1,000
   institutions (CDFI data project)f,g

                         Microlendersh           174              554

             RLFs (EDA Commerce)i,j              450              546


                          RLFs (ARC)k              35               35


                                    IRPl           29             400

                       504 Certified
                                                 270              270
           Development Companiesm
                       Community
                                              Up to 776         3,600
         Development Corporationsn


                                                                     Legend

                                                                           Data collected at the loan level

                                                                           Data collected at the aggregate level

                                                                           Data are not collected


Sources: Reports maintained by lender trade associations and federal programs.

                                                                     a
                                                                      Rutgers University, “EDA RLFs—Performance Evaluation,” 2002. These data do not include non-EDA
                                                                     RLFs.
                                                                     b
                                                                      Urban Institute, “Public-Sector Loans to Private-Sector Businesses: An Assessment of HUD-
                                                                     Supported Local Economic Development Lending Activities,” 2003.
                                                                     c
                                                                     While the total number of lenders is not known, loans covered by the 51 lenders in the Urban Institute
                                                                     Study account for over 50 percent of third-party lending for CED loans made, and up to 58 percent and




                                                                     Page 14                                        GAO-04-21 Community and Economic Development Loans
at least 96 percent respectively, of third-party CED loan dollars tracked in HUD’s CDBG and Section
108 state and local entitlement programs. Therefore, coverage is fairly high.
d
    Abt Associates, Inc., “CDFI Fund Secondary Market Survey of CDFIs,” 2002.
e
 Abt surveyed 108 CDFIs but received only 54 responses from the survey on loan-level performance
data. In addition, all measurements were not reported on all loans. For instance, recovery amounts
are available on fewer than 2 percent of the loans. Measurements for delinquencies reported 30 days
past due are available on 44 percent of the loans included.
f
    Corporation for Enterprise Development, CDFI Data Project FY 2001.
g
 The latest CDFI Data Project survey indicates all respondents surveyed did not report on each data
point requested. Therefore, these measures are available on only 389 of all 512 CDFIs surveyed.
CFED also disclosed that they could not guarantee the reliability of the data.
h
 SBA quarterly reports for the 174 microlenders participating in SBA’s microloan program; and Aspen
Institute, “ Directory of U.S. Microenterprise Programs,” 2002, for the estimated number of
microlenders, totaling 554.
i
    EDA program data as of May 2003.
j
Data are collected but are maintained in hard copy at various regional offices and, therefore, not
useable.
k
    ARC program data as of February 2003.
l
    National Association of Development Organizations Biennial Survey data as of March 2003.
m
    SBA 504 program data 2003.
n
    National Congress for Community and Economic Development 1999 Census.


EDA and HUD recently completed one-time studies on RLF lenders,
lenders funded by Section 108 and CDBG, respectively, that included
analysis of loan-level performance data (see figure 2). In addition, the
CDFI fund has received and consolidated loan-level data as part of its
ongoing Secondary Market Feasibility Study. We attempted to obtain
summary data from these sources on the dollar amount and number of
loans in default in order to estimate a cumulative default rate for each
program. Although CDFI Fund does not collect default data, they recently
began collecting loan-level data and tracked information on loan write-offs.
We, therefore, attempted to obtain CDFI write-off data as a proxy for
default measures. However, we found that loan-level data from the CDFI
Fund lacked data on the timing of write-offs. This information was
requested from the lenders in the study’s survey; however, only 10 percent
of the reported loans included the date of write-off. Without knowing the
timing of defaults, it is not possible to account for differences in default
rates attributed to the age of a loan. According to data provided by Rutgers
University, non-real estate, loans made by EDA/RLFs between 1988—1995




Page 15                                 GAO-04-21 Community and Economic Development Loans
                        have, on a weighted average basis, a 4-year cumulative default rate of 4
                        percent.19 The ultimate default rate cannot be calculated until loans have
                        had an opportunity to reach maturity. Comparable data on HUD loans
                        were not available at the time of this report.

                        Where loan performance measures did exist in aggregate form, they were
                        defined inconsistently across lenders. For instance, delinquencies for IRPs
                        are defined as loans up to 90 days past the due date, whereas delinquencies
                        are defined for CDFIs as failure to make a payment as early as 31 days and
                        up to 90 days or more past the due date. Defaults for EDA RLFs are defined
                        as 60 days past due, but not written off; whereas, the defaults for lenders
                        supported by HUD’s Section 108 and CDBG programs are defined as more
                        than 90 days delinquent with no further payments expected.



As with the Lenders     We reviewed 11 federal programs that fund the seven CED lenders included
                        in our study. These programs are administered by EDA, Treasury, HUD,
They Serve, Federal     USDA, SBA, ARC, and HHS.20 The programs have a similar purpose in that
Programs Share          each was established to improve economic conditions in communities
                        considered distressed or underserved. However, the programs differed in
Similar Missions, but   how they achieved their purposes and the size and level of activity. Some
Differ in How They      programs in our review have experienced budget reductions. We also found
Operate                 that several programs have considered securitization as an option to
                        increase access to capital. Finally, few programs regularly collect
                        information on the performance of lenders and the loans they make.
                        Consequently, little information is known about the dollar volume or
                        number of loans that some of these federal programs have funded to
                        support CED lending in communities across the country.




                        19
                           These data should be viewed carefully. Data on loan performance are derived from
                        semiannual reports prepared by RLFs. According to EDA officials, use of RLF grant money
                        may not be covered by RLF audits. We did not assess the reliability of these data.
                        20
                         HHS also administers the Community and Economic Development Discretionary Grant
                        Program. According to HHS officials, beginning in 2000, these grants may be used for
                        funding RLFs. In 2002, HHS made fewer than 10 grants to RLFs under this program.




                        Page 16                          GAO-04-21 Community and Economic Development Loans
Federal Programs Have        The 11 programs we reviewed were established to improve economic
Similar Purpose but          conditions in distressed or underserved communities. However, the
                             programs differed in the form of federal assistance offered to CED lenders,
Different Requirements and   and the targeting of assistance to specific geographic areas, borrowers, or
Forms of Support             businesses.

                             As noted in table 2, 6 of the 11 programs in our review helped fund CED
                             lending through grants only; one program used loans only; two used loan
                             guarantees only; one used a combination of loans and loan guarantees; and
                             another used a combination of grants, loans and equity investments. The
                             programs provide lenders with funds that may be loaned to borrowers and
                             the proceeds from repayments on the loans may be used to make additional
                             loans for community and economic development.21 All but one of the
                             programs allowed lenders to establish their own rates and terms.22 In
                             general, programs required that lenders’ applications include a discussion
                             of how they planned to use the funds, which might include lenders’
                             targeting criteria for borrowers, interest rates, and terms. Finally, all but
                             the 504 CDC program receive some level of government subsidy.




                             21
                                For the 504 CDC program, loan repayments go directly to investors and are, therefore,
                             unavailable for relending.
                             22
                                  SBA sets the interest rate on 504 CDC loans.




                             Page 17                               GAO-04-21 Community and Economic Development Loans
Table 2: Federal Programs and Type of Assistance Provided to CED Lenders

                                                                                      Loan
     Federal program                               Loan              Grant          guarantee
1    Intermediary Relending Program                  X
     (IRP)
2    Rural Business Enterprise Grant                                   X
     (RBEG)
3    Economic Adjustment Assistance                                    X
     Program (EDA RLF)
4    Business Development Program                                      X
     Revolving Loan Fund (ARC RLF)a
5    Community Development Block                                       X
     Grant (CDBG)
6    Section 108 loan guarantee                                                          X

7    Community Services Block Grant                                    X
     (CSBG)
8    Empowerment Zone/Enterprise                                       X
     Community Grant (EZ/EC)
9    Financial Assistance component                  X                 X
     of CDFI Fundb
10 504 Certified Development                                                             X
   Company (504 CDC)
11 Microloan Direct and Loan                         X                                   X
   Guarantee programs
Source: Federal program documents.
a
ARC is authorized to make loan guarantees but has not used this authority in the last 13 years.
b
Also offers equity investments, deposits, and credit union shares.


•	 The seven grant programs we reviewed permit grantees to use funds for
   operating RLFs, as well as for other economic development activity—
   for example, acquisition or development of land, or provision of public
   water and sewer facilities.23

•	 Two loan programs—USDA’s IRP, and SBA’s Microloan program—offer
   lenders loans with low rates and relatively long repayment terms. For

23
 HHS’s CSBG and EZ/EC programs are among these. According to HHS officials, Illinois is
the only state that uses HHS CSBG funds for the purpose of economic development
activities such as establishing RLFs.




Page 18                               GAO-04-21 Community and Economic Development Loans
     example, IRPs receive loans at 1 percent interest to be repaid within 30
     years. The low cost of the federal loan could enable the lender to pass
     on low loan payments to borrowers. SBA’s Microloan program makes
     loans to lenders that lenders then use to make microloans to eligible
     borrowers. Lenders may receive loans of up to $750,000 to be repaid
     within 10 years. Each lender is limited to a maximum of $3.5 million
     outstanding at any one time. SBA looks to the lending intermediary to
     pay its loans in full, regardless of the payment history of individual
     borrowers. Borrowers, unable to obtain credit from a traditional
     lending institution, also benefit from the technical assistance to improve
     their business’ chance of success.24

•	 The three loan guarantee programs—HUD’s Section 108 and SBA’s 504
   Certified Development Company (504 CDC) and Microloan programs—
   offset all or a part of the credit risk of loans by providing participating
   lenders with a loan guarantee on all or part of the loan payments in the
   event of a borrower default. In the Section 108 program, the principal
   security for the loan guarantee is a pledge by the applicant community
   or the state (for nonentitlement communities) of its current and future
   CDBG funds. Under the 504 CDC program, SBA guarantees loans made
   by 504 CDCs at market interest rates to be paid over 10 or 20 years.25
   The 504 CDCs provide small businesses with fixed-rate, long-term loans,
   primarily for buildings, land, equipment, and machinery (not to exceed
   40 percent of the total project cost). A private lender must provide at
   least 50 percent of the project cost. According to SBA officials, the
   lenders benefit from SBA’s guarantee because they are in a first lien
   position, which lessens their credit risk. Under the Microloan program,
   SBA guarantees loans that are made to intermediaries by private sector
   lenders.

•	 Finally, the Financial Assistance component of the CDFI Fund offers
   grants, loans, and equity investments to CDFI lenders. However, lenders


24
  SBA’s Microloan program allows grant funds to be used only for technical assistance and
training of microborrowers and potential microborrowers. According to SBA officials, such
technical assistance is sometimes viewed as a substitute for collateral and is intended to
help ensure repayment of Microloans.
25
  The 504 CDC makes its loans with proceeds from a guaranteed debenture. Loan payments
owed to the 504 CDC match the payments the 504 CDC owe investors under the debenture.
If the borrower defaults, SBA buys the debenture back from the investors. Lenders must
reimburse SBA for 10% of the loss it incurs in connection with the 504 CDCs’s default on the
debenture.




Page 19                            GAO-04-21 Community and Economic Development Loans
       must obtain nonfederal matching funds in a form and value similar to
       the CDFI Fund’s award. For instance, a lender receiving a grant award
       from the CDFI Fund must match the award dollar for dollar with other
       grant money. Likewise, lenders receiving loan and equity awards must
       match the loan dollar for dollar with other loan and equity money.

The programs also varied in whether and how they target geographic areas,
borrowers, or businesses. Table 3 illustrates the range of geographic areas
targeted by the programs in our review. For example, both USDA programs
target rural areas, the ARC program targets Appalachia, and other
programs target eligible areas that they define as economically distressed.26
Similarly, table 3 shows that many of the programs we reviewed require
that eligible borrowers create jobs or otherwise improve economic
conditions in the areas that the borrower’s business or project will
impact.27 Likewise, some programs have established target eligibility
criteria for borrowers that include credit qualifications. For example, in
EDA’s Economic Adjustment Assistance Program, borrowers are not
eligible unless they are unable to obtain a loan with acceptable terms and
conditions from a traditional lending institution. Finally, some programs
limit eligibility to specific types of borrowers. For instance, SBA’s
Microloan program requires that borrowers be small, for-profit
businesses.28




26
  Appalachia includes all of West Virginia and parts of 12 other states: Alabama, Georgia,
Kentucky, Maryland, Mississippi, New York, North Carolina, Ohio, Pennsylvania, South
Carolina, Tennessee, and Virginia. The term “economically distressed” is defined differently
among programs. For instance, EDA defines economically distressed as urban or rural
communities that are experiencing high unemployment, low per capita income, and other
conditions, including sudden economic dislocations due to industrial restructuring and
relocations or natural disasters. Other programs may use different terminology to indicate
targeted economically distressed areas.
27
   ARC’s Business Development program allows borrowers to be located outside of the
Appalachian region; however, the business or project to be funded must provide jobs or
other economic benefits within the region.
28
     A borrower may also use Microloan proceeds to establish a nonprofit child care business.




Page 20                              GAO-04-21 Community and Economic Development Loans
Table 3: Summary of Programs and Their Target Market Criteria


                                                                                 Targeting criteria
                                                                                 Job creation
                                                          Geographic Low income      and                      Borrower
Federal program                                             areas    populations preservation                  credit  Types of entities supported
Intermediary Relending Program (USDA                                                                                        Start-up, expansion of existing
                                                                     X                             X               X
IRP)                                                                                                                        businesses
Rural Business Enterprise Grant (USDA                                                                                       Start-up, expansion of existing
                                                                     X                             X
RBEG)                                                                                                                       businesses
Economic Adjustment Assistance                                                                                              Start-up, expansion of existing
                                                                     X                             X               X
Revolving Loan Fund (EDA RLF)                                                                                               businesses
Business Development Revolving Loan                                                                                         Start-up, expansion of existing
                                                                     X            X                X               X
Fund (ARC RLF)                                                                                                              businesses
Community Development Block Grant                                                                                           Various for-profit or nonprofit
                                                                                  X
(CDBG)                                                                                                                      businesses
Section 108 Loan Guarantee                                                                                                  Various for-profit or nonprofit
                                                                                  X
                                                                                                                            businesses
Community Services Block Grant                                                    X                Xa                       Start-up, expansion of existing
(CSBG)                                                                                                                      businesses
Enterprise Community/                                                X            X                X                        Various
Empowerment Zone Grant (EZ/EC)
Financial Assistance component of                                    X            X                                         Various
CDFI Fund
504 Certified Development Company                                    X                             X               X        Small, for-profit businesses
(504 CDC)
Microloan Direct and Loan Guarantee                                  X            X                                X        Small, for-profit businesses
programs
Sources: Federal program documents and Catalog of Federal Domestic Assistance.
                                                                 a
                                                                  Illinois CSBG program requires borrowers to hire at least one new full-time equivalent CSBG eligible
                                                                 employee for each $20,000, or any portion thereof, of CSBG monies borrowed.




Federal Programs Differ in                                       In general, as shown in table 4, programs ended fiscal years 1998—2003
Size, Level of Activity                                          with lower funding levels than they began. In the most recent three years,
                                                                 the Section 108 and 504 CDC loan guarantee programs, which securitize
                                                                 CED loans, have required less funding than most other CED programs. In
                                                                 these years, the 504 CDC had no appropriations because the present value
                                                                 of the estimated cash inflows from fees and recoveries equaled the
                                                                 estimated cash outflows from claims. Table 4 illustrates the levels of
                                                                 appropriations for those programs where data were available for fiscal
                                                                 years 1998—2003.




                                                                 Page 21                                GAO-04-21 Community and Economic Development Loans
Table 4: Appropriations for CED Lending Have Declined in Selected Federal
Programs (Fiscal Years 1998–2003)

Dollars in millions
                                                                                                        2003
Federal program                                    1998         1999         2000     2001    2002 (estimate)
EDA—RLF Granta                                    $29.9        $34.6        $34.6     $49.5   $40.9      40.6
Treasury—CDFI (FA) b                                43.0         75.8         66.8     47.1    34.3      31.8
HUD—Section 108 Loan
Guaranteec                                            9.0        10.0         29.0     29.0    14.0       6.0
SBA—504 CDC Loan
Guaranteec                                        166.0          34.0           5.0      0       0         0
USDA—IRP Loan                                       17.0         17.0         17.0     19.0    13.0      20.0
SBA—Microloan Direct Loand                              0          2.0          2.0     3.0     1.0       4.0
Sources: Federal Budget Appendixes for 1998 through 2004 and federal agency data.

Note: Six programs were unable to provide information on the dollar amount of annual appropriations
used to capitalize CED lenders. HUD CDBG (State-Administered and Entitlement Cities) and HHS
EZ/EC programs do not allocate appropriations by type of activity (that is CED lending) funded. The
USDA RBEG program does not receive an earmark in appropriations for RLF spending. RBEG
recipients may use the funds for a variety of purposes, including capitalization of an RLF.
Appropriations for the HHS CSBG program were not included because, as noted elsewhere in this
section, according to HHS officials, Illinois is the only state known to use CSBG funds for CED lending
purposes. ARC receives one appropriation to support all administrative and programmatic activity.
Hence, there is no budget specifically for the Business Development Revolving Loan Fund program.
The appropriation is allocated amongst the 13 states, and the commission decides to approve the
funding for individual plans submitted by states based upon how the proposed project meets the
agency’s mission strategy.
a
 Only includes funds for RLFs that help communities adjust to sudden and severe economic
dislocation (SSED/RLFs), and long term economic deterioration (LTED/RLFs). Does not include grant
funds used for defense and disaster assistance. Appropriated funds for these other types of economic
adjustment grants varies from year-to-year and has declined in recent years.
b
    Includes grants, loans, and equity investments made from the CDFI Fund.
c
 Appropriations for loan and loan guarantee programs are based on assumptions regarding the
performance of the loans. The ultimate cost to the government could be higher or lower if actual loan
performance differs from these assumptions.
d
 Appropriations for the SBA Microloan loan guarantees were zero for all fiscal years 1998–2002 and
the 2003 estimate, except in fiscal year 2000, when SBA did not report the budget authority for the
program. However, fiscal year 2000 outlays for the SBA Microloan loan guarantees were $1 million.


The federal programs we reviewed also differed in the number of lenders
participating in the program, ranging from as few as 35 lenders in ARC’s
Business Development program, to as many as 546 in EDA’s Economic
Adjustment Assistance RLF program. Most of the programs were able to
provide information on the number of lenders and the number and dollar
volume of program awards—whether loans or grants—made to CED
lenders. HUD CDBG and HHS EZ/EC and CED programs were the only



Page 22                                         GAO-04-21 Community and Economic Development Loans
exceptions. The two loan guarantee programs, 504 CDC and Section 108,
issue notes that are sold to investors. The volume of loan guarantee
commitments is noted in table 5. We found that there was a great deal of
variation in the level of program activity between these programs.



Table 5: Number of Lenders and Dollar Volume of Federal Support (Fiscal Years
1998–2002) a

                                                                  FY 1998–2002b
                                                                                    Dollar volume

                                                      Number of lenders                of support

Federal program (agency)                                    supported                (in millions)

Intermediary Relending Program (USDA)                                   273                  $167.5
Rural Business Enterprise Grant (USDA)                                  364                       45.6
Economic Adjustment Assistance (EDA)c                                   546                       24.4
Business development program (ARC)                                       35                       33.7
Section 108 loan guarantee (HUD) d                                      N/A                 1,800.7
Community Services Block Grant (CSBG-
Illinois)                                                                38                       49.0
Financial Assistance (FA) component of
CDFI Fund (Treasury)e                                                   N/A                   267.0
504 CDC program (SBA)                                                   272                11,524.0
Microloan program Direct Loans (SBA)f                                   174                   111.2
Source: Federal agency data.

Note: N/A data is not available.
a
 Federal support may consist of grants, loans, loan guarantee commitments, and other investments.
For loans and loan guarantees, the amount shown is the face value of the loan.
b
Business development program (ARC) covers FY 1977 through February 14, 2003, and the Illinois
CSBG program covers FY 1984–2002.
c
 Data on the number of lenders supported by EDA’s Economic Adjustment Assistance program covers
the period 1975-2002, and includes Disaster Assistance and Defense RLFs. However, dollar volume
amounts cover the period noted in the table (1998-2002), and reflect grants made to SSED and LTED
RLFs only.
d
 A Section 108 grantee may reloan the proceeds of a loan guarantee to fund loans to a third-party
borrower either directly or through a nonprofit intermediary (i.e., a RLF or CDC).
e
 CDFI’s Financial Assistance includes core and intermediary component programs. These amounts
include grants, loans, deposits, and equity investments.
f
Amounts for SBA’s Microloan program include support for direct loans only, not loan guarantees.




Page 23                               GAO-04-21 Community and Economic Development Loans
Several Programs Have       Several of the programs in our review have studied or are presently
Considered Securitization   undertaking securitization efforts. For example, Treasury’s CDFI Fund
                            recently commissioned a survey of its CDFIs to study the feasibility of
                            developing the secondary market for loans made by its members. In 1999,
                            EDA initiated a demonstration project that provided financial assistance to
                            support RLFs wishing to securitize a portion of their loan portfolio. The
                            pilot resulted in three RLFs successfully securitizing or selling loans. In
                            addition to the Section 108 loans HUD currently securitizes, HUD
                            sponsored a study to collect extensive information on the loans made by its
                            CDBG and Section 108 awardees to third-party businesses and nonprofit
                            organizations, in part to assess the potential for creating a secondary
                            market for these loans. Other programs have made some efforts to
                            determine the feasibility of securitizing loans made by their lenders. In
                            1999, the ARC program removed language from its guidance allowing its
                            RLFs to sell their loans. Officials noted that grantees were uninterested in
                            securitization for several reasons, including grantees’ easy access to
                            additional capital through the ARC grants. After a successful sale of IRP
                            loans made in Colorado, in November 1999, USDA piloted a first attempt to
                            sell IRP loans nationally. According to USDA officials, the pilot generated
                            little interest because of the strict requirements for lender participation. To
                            date, USDA has not established formal regulations to support
                            securitization. SBA securitizes 504 CDC loans. Finally, our review also
                            found that some programs have prohibitive or inhibitive program
                            requirements governing the use of the funds that limit lenders’ ability to
                            securitize their loans. We address this issue in more detail later in the
                            report.



Federal Programs Vary in    The programs differed in the type of information they collected on lender
Efforts to Collect and      activity, the performance of lenders’ loan portfolios, and how the
                            information was maintained. Information that lenders were required to
Maintain Information on
                            report also varied widely. For example, the CDFI Fund requires lenders to
Lender Activity and Loan    report on the amount, number, and type of loans that CDFI lenders make.
Performance                 In contrast SBA’s Microloan program required information on account
                            activity supported by bank statements, as well as an account of the status
                            of each loan in the portfolio. Other items that some programs required
                            lenders to report included the financial condition of the lender and impact
                            information—such as the number of jobs created and retained.

                            In addition, the frequency of reporting required by lenders differed by
                            program. Three programs—USDA’s IRP, RBEG and SBA’s Microloan—



                            Page 24                       GAO-04-21 Community and Economic Development Loans
required that lenders submit quarterly reports; two programs—EDA RLF29
and ARC’s Business Development—required semiannual reports; and six—
504 CDC, CDBG, EZ/EC, CSBG, CDFI, and Section 108—required annual
reports.

Further, our review found that regardless of how data are collected, there is
little information about the volume of lending activity supported by and
loan performance of some of the programs in our review. Programs in EDA,
ARC, and Treasury required that lenders provide ongoing information on
the loans in their portfolios, often including the loan amount, term, interest
rate, and losses.30 However, as mentioned earlier, they are not consistently
defined, and do not all contain information at the loan-level. Further, four
of the programs in HUD, EDA and Treasury only recently began collecting
loan-level information because they undertook one-time, loan-level data
collection efforts.31

Finally, these programs differed in whether they maintained performance
information on paper or in a database and whether the files were kept in a
central location or office. Only programs in Treasury maintained lender and
loan information in a database, and only programs in ARC and Treasury
maintained annual report information on lenders and their loans in a
central location.32




29
     However, grantees can graduate to annual reporting upon consent of the agency.
30
  The only exception to this is the CSBG program. According to HHS officials, Illinois is the
only state in the country that uses CSBG funds for economic development lending purposes.
The program has 38 local Community Action Agencies operating RLFs. The program
administrator told us that he is intimately familiar with the lenders and their loan portfolios.
As indicated in figure 2, performance data for CDFIs is currently collected at the aggregate
level. However, Treasury has recently proposed that CDFIs report performance information
annually at the loan level.
31
  In providing comments on the report, HUD officials informed us that while they do not get
information on loan performance data targeted in our report, HUD’s Integrated
Disbursement and Information System includes information on the type of assistance
provided and the terms of assistance including interest rates and amortization periods.
32
 The Illinois CSBG program also maintains data on lender activity in a database in a central
office. We were unable to document the extent to which SBA maintains data on loans made
by lenders supported in its 504 CDC program and Microloan programs.




Page 25                              GAO-04-21 Community and Economic Development Loans
Selected Securitization   We reviewed five existing and three proposed securitization models
                          designed to provide greater access to capital for small business and CED
Models for Small          lenders. Each of the eight models exhibit similarities and differences in
Business and CED          terms of (1) the types of lenders and borrowers served, (2) the types of
                          loans pooled and methods for pooling, (3) the distribution of financial
Loans Have Similarities   benefits and risks among participants, and (4) their outstanding securitized
and Differences           volumes. Less is known about the proposed securitization models since
                          they do not currently engage in market transactions.



Types of Lenders and      As shown in table 6, these models serve, or would serve, private, nonprofit,
Borrowers Served Vary     and governmental lenders. For example, the two models securitizing SBA’s
                          7(a) guaranteed and unguaranteed loans serve mostly depository lenders
                          such as commercial banks and some nondepository lenders such as finance
                          companies. The SBA 504 program serves only private nonprofit
                          corporations called CDCs, while the existing and proposed Section 108
                          models serve or would serve CDBG-funded state and local governments
                          and development agencies. The Community Reinvestment Fund (CRF)
                          may serve nonprofit, for-profit, and governmental community development
                          lenders eligible to sell loans. Similarly, the proposed CDA model would
                          serve those lenders eligible to sell loans.

                          Table 6 also shows a wide variety of borrowers served by these models. For
                          example, the SBA 504 model finances small businesses who have qualified
                          for conventional loans backed by commercial real estate loans with senior
                          bank participation, whereas the CRF model has provided financing to
                          businesses ranging from start-up microenterprises to marginal for-profit
                          and nonprofit borrowers. While all models generally loan to for-profit
                          businesses, some are restricted to small businesses (SBA models) and
                          others may also serve nonprofit borrowers (CRF and Capital Access
                          models).




                          Page 26                      GAO-04-21 Community and Economic Development Loans
                            Table 6: Securitization Models and Lenders and Borrowers Involved

                            Model                           Lenders                          Borrowers
                            SBA 504 Program                 Certified Development            For-profit small businesses that
                            guaranteed                      Companies                        have qualified for conventional
                                                                                             loans
                            SBA 7(a) guaranteed             Commercial banks, credit         For-profit small businesses that
                                                            unions, small business lending   have demonstrated they could
                                                            companies and other nonbank      not obtain financing without the
                                                            lenders                          7(a) program
                            SBA 7(a)                        Commercial banks, credit         For-profit small businesses that
                            unguaranteed	                   unions, small business lending   have demonstrated they could
                                                            companies and other nonbank      not obtain financing without the
                                                            lenders                          7(a) program
                            HUD Section 108                 CDBG grantees and their          For-profit or nonprofit borrower
                            guaranteed                      designated lenders
                            Community                       Nonprofit, for-profit, and       Local business, affordable
                            Reinvestment Fund               governmental CED lenders         housing, and community facility
                            (CRF)                                                            borrowers
                            Proposed                        Nonprofit, for-profit, and       Small business borrowers not
                            Commonwealth                    governmental CED lenders         served by local commercial
                            Development                                                      financial institutions
                            Associates (CDA)
                            Proposed                        CDBG grantees and their          For-profit or nonprofit borrower
                            CDBG / 108                      designated lenders
                            unguaranteed
                            Proposed                        CDFI lenders                     Minority businesses, nonprofits,
                            Capital Access                                                   commercial real estate
                            Program variation
                            Sources: SBA, HUD, CRF, CDA, Capital Access Group.




Types of Loans Pooled and   These models securitize a variety of loan products to serve the borrowers
Methods for Pooling Vary    and lenders described above. Table 7 details similarities and differences in
                            the type and characteristics of loans that may be pooled in each model,
                            including loan purpose, collateral positions, loan terms, and rates. For
                            example, while each of the models accepts commercial real estate and
                            business equipment loans into their loan pools, the models vary in their
                            acceptance of working capital and community facility loans. Additionally,
                            senior or subordinate collateral positions on these loans vary by model. For
                            instance, the two SBA 7(a) models prohibit subordinate loans, while the
                            SBA 504 and Capital Access models allow only subordinate loans. One
                            proposed model, CDA, would only purchase seasoned loans rather than
                            committing in advance to securitizing loans meeting certain underwriting



                            Page 27                                       GAO-04-21 Community and Economic Development Loans
                                           standards. Terms of the loans that each model may accept vary slightly; all
                                           of the models would purchase long-term loans between 10 and 20 years,
                                           but only one model—the SBA 504 model-–does not purchase loans with
                                           maturities less than 10 years. Variation in loan rates also exists. For
                                           instance, all of the models allow fixed-rate loans to be purchased, but three
                                           of the models prohibit variable-rate loans. Most of the loans securitized by
                                           the two SBA 7(a) models included variable-rate loans. Four of the models
                                           purchase or would purchase only market-rate loans. Two purchase or
                                           would purchase market and below-market-rate loans, and the remaining
                                           two models purchase below-market-rate loans only. While data on average
                                           loan size was not readily available for most models, the two models that
                                           provided this information demonstrated a wide divergence in average loan
                                           sizes: $165,000 for the SBA 7(a) loans in fiscal year 2003 compared with
                                           $1.5 million for the Section 108 Loan Guarantee program since 1995.



Table 7: Types of Loans Pooled Varies by Model

                                                                                               Proposed models
                                                                                                                  Capital
                                                           HUD         Community     Commonwealth     CDBG /      Access
                  SBA 504    SBA 7(a)      SBA 7(a)     Section 108   Reinvestment    Development     Section    program
                  Program   guaranteed   unguaranteed   guaranteed        Fund         Associates       108      variation
Types of loans
Commercial          Xa          X             X             X              X               X             X          X
real estate
Community                                                                  X
facilities
Business            Xb          X             X             X              X               X             X          X
equipment
Working capital                 X             X             X              X                             X          X
Loan position
Senior                          X             X             X              X               X             X
collateral
position
Junior              X                                       X              X               X             X          X
collateral
position




                                           Page 28                       GAO-04-21 Community and Economic Development Loans
(Continued From Previous Page)
                                                                                                                     Proposed models
                                                                                                                                        Capital
                                                                              HUD            Community     Commonwealth     CDBG /      Access
                       SBA 504          SBA 7(a)       SBA 7(a)            Section 108      Reinvestment    Development     Section    program
                       Program         guaranteed    unguaranteed          guaranteed           Fund         Associates       108      variation
Loan maturity
Less than 10                                  X                X                  X              X               X             X          X
years
10 to 20 years      Xc                        X                X                  X              X               X             X          X
Loan interest rates
Fixed                       X                 X                X                  X              X               X             X          X
                                                                                      d
Variable                                      X                X                  X              X
Market rate                 X                 X                X                                 X               X                        X
Below market                                                                      X              X               X             X
rate
Underwriting criteria
Advance loans               X                                                     X              X                          unknown       X
Seasoned                                      X                X                  X              X               X          unknown
loans
Sources: SBA, HUD, CRF, CDA, Capital Access Group.
                                                       a
                                                           90 percent of all loans.
                                                       b
                                                           10 percent of all loans.
                                                       c
                                                        90 percent of loans are 20 years.
                                                       d
                                                           For interim financing only.


                                                       Only SBA’s 7(a) models and CRF hold loans on balance sheets of the pool
                                                       assemblers until they assemble enough loans to pool and securitize. Other
                                                       models predetermine the timing of their securities issuances, and
                                                       sometimes their loan originations, in advance. For example, SBA’s 504
                                                       program anticipates regular and predictable monthly issuances of its 20-
                                                       year securities backed by CDC-originated, SBA-guaranteed loans. The
                                                       Section 108 Loan Guarantee model also issues notes to investors in a
                                                       regular and predictable manner—each year at the beginning of August. In
                                                       between these public offerings, HUD provides interim variable-rate
                                                       financing to CDBG grantees through a money market fund in Pittsburgh.
                                                       (Appendix II contains brief descriptions of the structures for each
                                                       securitization model.)



Distribution of Risks and                              As explained in the following sections, models distribute interest rate risk
Benefits Vary among Models                             (the risk of financial loss due to changes in market interest rates) and



                                                       Page 29                                 GAO-04-21 Community and Economic Development Loans
                               credit risks (the risk of financial loss due to borrower default) among
                               various participants differently. Benefits of various securitization models
                               also vary among participants.

Interest Rate Risks Are        The models distribute interest rate risk differently among participants,
Distributed Differently        depending on whether loans allowed in the loan pool are fixed-rate or
                               variable-rate, whether or not loans are held for extensive periods of time by
                               lenders and loan pool assemblers until they can be sold (warehousing) to
                               investors, and how these participants fund the loans they hold. Interest
                               rate risk for lenders, loan pool assemblers, and investors depends on the
                               terms to maturity of their own assets and liabilities, and their interest rates.
                               For example, an investor in a long-term, fixed-rate asset would not face
                               interest rate risk if this asset was funded with a long-term, fixed-rate
                               liability with the same term. Such asset funding would lock in an interest
                               spread (interest earned on the asset or interest paid on the liability) and
                               negate the impact of interest rate movements on earnings. However, an
                               investor that funds long-term, fixed-rate assets with short-term liabilities
                               would face interest rate risk because a future increase in interest rates
                               could require the investor to roll over the short-term liability when it came
                               due into a higher-rate, short-term liability and narrow or reverse the
                               interest rate spread. Similarly, a variable-rate asset if funded by a variable-
                               rate liability with a lower rate would curtail interest rate risk. However,
                               funding a variable-rate asset with a fixed-rate liability would create interest
                               rate risk. A future increase in the variable rate on the liability above the
                               fixed rate on the asset could create a negative spread. Borrowers of
                               variable-rate loans could find their cost of borrowing becoming less
                               affordable if interest rates increased, but could benefit from declines in
                               interest rates. Borrowers of fixed-rate loans benefit when interest rates
                               rise, but because business borrowers typically are penalized for prepaying
                               loans, they may not benefit from declines in interest rates.

Credit Risks Are Distributed   Credit risk is also distributed differently among participants in the models
Differently                    we reviewed. Investors assume limited or no risk relative to other
                               participants, depending upon the amount and type of credit enhancements
                               included in each model. As shown in table 8, all models use some form of
                               internal (assumed by the lender, borrower, or securitizer) or external
                               (third-party) credit enhancement to determine the credit risk assumed by
                               all participants. The three models where the federal government assumes
                               all credit risk require no additional internal or external credit
                               enhancement. The five models where the federal government takes little or
                               no credit risk result in other participants (usually lenders) assuming credit
                               risks through internal credit enhancements. CRF uses, and CDA proposed,



                               Page 30                       GAO-04-21 Community and Economic Development Loans
multiple internal and external credit enhancements. CRF, a nonprofit, uses
foundation grants and program-related investments to fund some of its
credit enhancements.33 The CDA model envisions a similar credit
enhancement structure using public or private funding. Finally, while the
Capital Access model does not specifically propose a publicly funded credit
enhancement, virtually all 20 states that currently have Capital Access
lending programs do provide state funding to loan loss reserve funds
assigned to each participating lender, which may be used as credit
enhancements if authorized by state law.

Credit enhancements can take a variety of forms. External credit
enhancements rely on third parties to provide additional assurance of
timely payment of principal and interest to investors. These enhancements
can be governmentally provided (for example, loan guarantees) or
privately provided (for example, loan guarantee insurance or letters of
credit). With external enhancements, the credit quality and expected
performance of the asset pool is often based on the credit quality of the
external enhancement provider. Internal credit enhancements are not
dependent on third parties and are often funded by lenders. These
enhancements include senior or subordinate positions, in which cash flows
from the pool of assets are structured so that the higher credit quality
“senior” securities would fail to receive timely cash flows only after lower
credit quality subordinated securities fail to receive their cash flows.
Internal enhancements also include over-collateralization, in which the
face value of the assets in the pool are greater than the face value of
securities issued; excess spread, in which the difference between the cash
flowing into an asset pool and the cash flowing out of a pool to security
holders is set aside in a reserve fund to cover future, unexpected payment
delays or losses; and loan loss reserves, in which monies are set aside to
cover future unexpected cash flow delays or losses. Occasionally, such as
with CRF, loan originators may be required to replace nonperforming loans
with performing loans according to loan substitution agreements. Lender
recourse are financial obligations of lenders to make a loan pool whole if
the portion of the loan pool provided by that lender fails to perform.



33
   Program-related investments include loans, loan guarantees, mortgage investments, and
equity investments that are made by foundations such as the Ford Foundation or MacArthur
Foundation for many CED purposes, to multiple CED entities. The foundation can receive
favorable tax treatment from the IRS if the Program-related investments receive below-
market-rates of return. Program-related investments can provide financial benefits to the
foundation, as well as further the mission of the foundation and the receiving CED entities.




Page 31                            GAO-04-21 Community and Economic Development Loans
Table 8: Credit Enhancements Used to Distribute Credit Risks Vary by Model

                                                                                                                                 Proposed models
                                                                                                         Common-                                         Capital
                                                                                  HUD       Community      wealth                         CDBG /         Access
     Credit      SBA 504  SBA 7(a)    SBA 7(a)                                 Section 108 Reinvestment Development                       Section       Program
enhancement type Program guaranteed unguaranteed                               guaranteed      Fund      Associates                         108         Variation
External
Governmental                       X                 X                                X                                     X
                                                                                                          a
Private                                                                                                 X                   X
Internal
Senior / subordinate                                                X                                   X                   X                 X
Overcollateralization                                                                                   X                   X
Excess spread                                                       X
Loan loss reserve                                                                                                           X                 X              X
Recourse to lender                                                                                      X
Loan substitution                                                                                       X                   X
Private or publicly             Public           Public       Public or            Public            Private             Private            Not           Private
placedb                                                        private                                                                    specified
Credit rating                     No                 No          Yes                 No                 No                 Yes               Yes            No
Sources: SBA, HUD, CRF, CDA, Capital Access Group.
                                                          a
                                                           In addition to external foundation monies, CRF may attempt a rated security that will include some
                                                          external guarantee insurance on the senior tranche securities.
                                                          b
                                                           Public offerings of securities must meet Securities and Exchange Commission (SEC) registration and
                                                          disclosure requirements. In a private placement, securities issuers can avoid the costs of the
                                                          registration and reporting process required of a public offering as long as there is no solicitation of the
                                                          public, the investors are sophisticated in business matters, and investors have access to certain
                                                          information.


Benefits Are Distributed                                  These securitization models distribute benefits differently among
Differently	                                              participants. Investors can diversify their portfolios with new securities
                                                          that have desirable risk, return, and maturity characteristics. For example,
                                                          a number of institutional investors, particularly state or local and religious
                                                          pension funds have been investing in “socially responsible” investments for
                                                          over two decades, provided they could achieve market-rate returns with
                                                          sufficient loss protection to satisfy their “prudent person” investment




                                                          Page 32                                 GAO-04-21 Community and Economic Development Loans
                             requirements.34 As noted earlier, pension funds hold longer-term, fixed-rate
                             investments for portfolio management purposes. These models provide
                             lenders opportunities to better manage their risk and financial positions by
                             selling certain loans they have originated from their portfolios and to
                             further their missions by replenishing capital available for new loans or
                             other purposes. For example, CRF’s ability to warehouse CED loans
                             improves CED lenders’ ability to sell loans on occasions when the benefits
                             of selling the CED loans are most clearly visible to CED lenders. SBA’s
                             attempts at regular and predictable monthly issuances of its securities
                             backed by SBA-guaranteed 504 loans allows a more consistent mechanism
                             for 504 CDCs to sell loans, rather than hold long-term loans in their
                             portfolios thereby freeing their capital for other purposes. Borrowers in
                             each of the models benefit from access to capital that would otherwise be
                             unavailable.



Volume of Outstanding        Figure 3 shows the total amount of outstanding securitized loans for well-
Securitized Loans Have Not   established securitization models versus models for securitizing CED
                             loans. Models with assets such as home mortgages, commercial
Reached the Volume of
                             mortgages, or consumer financings show the greatest amount of
More Well-Established        outstanding securitized loans. These models have been in existence for
Models                       many years. Conventional home mortgages, for example, have been
                             securitized for over 30 years. These industries have developed standards
                             for documents and underwriting that enable wider securitization. The
                             existing CED models we reviewed have not reached the level of
                             securitization of the more well-established models. Among the CED
                             models, the two SBA guaranteed models have a far greater amount of
                             outstanding securitized loans than the other three models—7(a)
                             unguaranteed, Section 108 guaranteed, and CRF.




                             34
                                Prudent person rules allow investment managers or fiduciary trustees the flexibility to
                             make financial decisions regarding asset-types and rates of return that an ordinary,
                             reasonably well-informed person would exercise. Prudent person rules tend to discourage
                             speculative transactions, placing the potential for higher incomes and capital gains in a
                             secondary position to preservation of capital.




                             Page 33                           GAO-04-21 Community and Economic Development Loans
Figure 3: Levels of Outstanding Securitized Loans Have Not Reached the Levels of
More Well-Established Models
Dollars in billions                                              Dollars in billions
3,500                                                            15
                                                                                     12.70
             3,064.74
                                                                 12
3,000
                                                                      10.20

                                                                  9
2,500

                                                                  6
2,000

                                                                  3                          2.10   2.12
1,500
                                                                                                           0.06
                                                                  0
1,000
                          694.80
                                                 621.41
     500
                                      266.78

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            Well-established models                              Less-established models
    Sources: Federal Reserve Board, SBA, CRF, and HUD.

a
 Federal Reserve Bulletin, Table A33, July 2003. Outstanding principal balances of Federal National
Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Association (Freddie Mac), and
Government National Mortgage Association (Ginnie Mae) guaranteed or insured mortgage-backed
securities. Includes one- to four-family mortgages.
b
 Federal Reserve Bulletin, Table A33, July 2003. Outstanding principal balances of mortgage-backed
securities issued through private mortgage conduits. Includes one- to four-family mortgages.
c
  Federal Reserve Bulletin, Table A33, July 2003. Outstanding principal balances of nonfarm,
nonresidential, mortgage-backed securities issued through private mortgage conduits.
d
 Federal Reserve Bulletin, Table A34, July 2003. Includes outstanding balances of all pools of
securitized credits, including revolving and nonrevolving credit.
e
    SBA reported data as of September 30, 2002.
f
    SBA reported data as of September 30, 2002.
g
 SBA reported data as of September 30, 2002. This number represents loan balances at the time of
securitization, not outstanding loan balances as of September 30, 2002.
h
    HUD reported data as of August 29, 2003.
i
CRF reported data as of December 31, 2002. This number represents loan balances at the time of
securitization, not outstanding loan balances as of December 31, 2002. This number excludes notes




Page 34                                           GAO-04-21 Community and Economic Development Loans
                                backed by roughly $41 million (loan balances at the time of securitization) of CED loans that were not
                                issued through a special purpose vehicle. As of December 2002, these notes had an outstanding
                                principal balance of about $1 million.




We Identified Barriers          We identified six categories of barriers for either lenders or capital markets
                                investors in securitizing CED loans. First, uncertain borrower demand
to Securitizing CED             exists across targeted markets, and CED lenders generally lack incentives
Loans                           to participate in securitization. Second, management capacity for
                                securitizing loans is limited. Third, external requirements attached to
                                funding sources may directly or indirectly inhibit the securitization of CED
                                loans. Fourth, CED lenders believe that selling below-market-rate loans
                                would require them to absorb too high a discount to profit from a
                                securitization. Fifth, lack of lender product standardization,
                                documentation, and loan performance information impedes securitization
                                by increasing transaction costs. Finally, mechanisms available to support
                                securitization for CED loans are limited.



Uncertain Borrower              According to studies, lenders, programs, and their associations, current
Demand and Limited Lender       and future borrower demand is not understood across target markets, and
                                CED lenders do not see the benefit of securitization. Borrower demand—
Interest Limit the Ability to
                                borrower’s need for capital in target markets served, given the risk levels
Securitize                      lenders can absorb—is not understood by lenders, programs, and capital
                                market participants across target markets because it can be volatile and is
                                not consistently measured. In some federal programs, for instance,
                                measurements of current borrower demand are assessed through lender
                                annual reports. Other programs and their lenders also use proxy
                                measurements of demand.35 In addition, there are no mechanisms or
                                standards for forecasting future borrower demand for such loans, making it
                                difficult to determine what borrower demand might be across markets.
                                Moreover, borrower demand is unpredictable, in part due to changes in
                                local conditions in some markets. For some targeted communities, the
                                favorable economic climate of the 1990s prompted conventional lenders to
                                move down market (that is, lend to more risky borrowers), thereby pushing
                                demand for CED loans into areas where CED lenders were less willing to
                                take on further risk.



                                35
                                   For example, CDFI ’s trade association noted a “deployment rate,” which is used as a proxy
                                for the percentage of loanable funds that are actually loaned out.




                                Page 35                                GAO-04-21 Community and Economic Development Loans
According to several CED lenders, securitization studies, and reviews of
federal agency securitizations, lenders lack incentive to participate in
securitizations. For instance, EDA’s securitization pilot study found that
the primary barrier to securitizing RLF loans stemmed from the fact the
lenders did not want to sell their loans.36 According to key officials
knowledgeable about one of the four demonstration projects, lenders did
not find the deal attractive because they had access to cheaper capital
through the EDA grant program. Additionally, lenders would not commit
loans for sale into the loan pool in advance because they were unsure
whether good borrowers would be available to whom they could relend the
sale proceeds. Also, the Department of Commerce’s Office of Inspector
General recently found that some RLFs funded by EDA were carrying
excessive capital reserves and required them to return these funds to the
program, and that EDA monitor the RLF to ensure continued compliance.
These lenders would not need the liquidity benefits from securitizing their
loans. According to program officials in ARC, lenders funded by ARC do
not wish to securitize their loans and are now prohibited from doing so.
Officials explained that there were a number of reasons why ARC grantees
did not want to securitize including loss of interest on loans they hold;
limited yields accrued from securitizing their loans; and limited need for
liquidity given readily available grant funding they receive through the ARC
program. Preliminary results from the Department of Treasury’s secondary
market feasibility study indicates that while about one-third of the
respondents have sold at least some loans they originated, CDFI
participation in the secondary market for loans remains small. Many of the
markets have not traditionally worked with CDFIs because of the small
typical size of the CDFI loans, their nonstandardized loan portfolios, and
concerns about the lenders’ ability to meet loan-servicing requirements.
About 23 percent of the respondents reported not knowing enough about
the secondary market to participate. USDA piloted an effort to securitize
IRP loans in 1998 but, according to program officials, it failed because the
requirements for participation were too restrictive for most of the lenders
to meet. For example, lenders who could not demonstrate an ability to
repay the entire principal balance on their loan to USDA were ineligible to
participate in any sale of the assets from their portfolios. HUD’s Section
108 loan guarantee program, one of our five existing securitization models,
is proposed for elimination in fiscal year 2004, according to the Office of



36
   Kelly Robinson, “Expanding Capital Resources for Economic Development: An RLF
Demonstration.” (Washington D.C.: Economic Development Administration, 2001).




Page 36                         GAO-04-21 Community and Economic Development Loans
                                Management and Budget.37 A recent HUD study cited the program’s
                                collateral requirements and lengthy approval process as the two major
                                reasons for declining program usage. 38 Senior HUD program officials cited
                                the elimination of the Economic Development Initiative (EDI) program as
                                the principal reason for the decline in use of the Section 108 program in
                                fiscal year 2001. Although the volume of lending has increased since that
                                time, it has not returned to the pre-2001 loan volume level.

                                We identified other reasons for the lack of lender interest in the
                                securitization efforts described above. First, the benefits of securitization
                                are not always clear to lenders. Second, as indicated earlier, some of the
                                lenders depend on income streams generated by their portfolios, making it
                                difficult for some of them to sell portions of their portfolios. CED lenders
                                that do not diversify their portfolios are particularly vulnerable to
                                interruptions in the stream of income coming from a smaller pool of loans.
                                During favorable economic times, the market in which CED lenders
                                operate is pressured by competition from conventional lenders, thereby
                                diminishing the demand for CED loans. While a number of securitization
                                efforts have been undertaken, given uncertain borrower demand for CED
                                loans and limited lender interest in securitizing loans, it is uncertain what
                                volume of CED loans might be available for securitization on a wide scale.
                                Without greater certainty, capital market participants do not have a reason
                                to invest in developing a market for securitizing CED loans.



Insufficient Capacity Limits    Limited lender capacity—constrained by factors such as reliance on small
Lenders’ Ability to             portfolios, insufficient financial information, and an insufficient number of
                                staff or inadequate staff skills—limits some lenders from being able to
Participate in Securitization
                                participate in securitization. Many CED lenders’ portfolios contain only or
                                mostly small loans. For instance, the average loan size for microlenders is
                                $11,600. In addition, lenders work extensively with their borrowers to help
                                them qualify for loans. This requires more time than required to make

                                37
                                 A review of trends in HUD’s unexpended balance report shows expiring balances in the
                                program going from $22.6 million in 1997 to $109.2 million in 2001. These were 1-year
                                appropriations that were not used at the end of the period. According to HUD, for the past
                                several years, the actual demand for the program has been substantially below the loan
                                guarantee level requested or provided in appropriations. HUD also recognized that grantees
                                have not utilized the program at higher levels in part because of their reluctance to pledge
                                future grant funds as collateral.
                                38
                                 These collateral requirements refer to the additional security Section 108 borrowers must
                                provide beyond the pledge of future CDBG program funds.




                                Page 37                            GAO-04-21 Community and Economic Development Loans
conventional loans and is often necessary to ensure borrower success.
Although lenders operate this way to meet their mission, one study
indicates it results in higher per loan costs, which in turn can increase the
subsidy required on each loan financed.

According to studies, lender trade associations, and private-sector officials,
lenders do not have sufficient financial information to determine how
much of a discount they could absorb. To ensure that an asset an investor
purchases provides market yields, capital market participants require
lenders to sell loans at a discount to at least cover the additional risk—
including interest rate risks and credit risks—they might incur from
securitizing loans. Lenders might benefit from securitization if they could
sell their loans at a price that best met their current financial needs.
However, according to trade and program officials, some lenders do not
have adequate financial information to determine whether a given price is
or is not in their best interest, given the discount they would have to absorb
in the sale. For instance, some may not know how much it was costing
them to originate and service these loans and the income they could expect
to earn from these loans. With better information, lenders would be better
able to determine whether the discount being requested was appropriate
and beneficial, given their knowledge of the performance and value of the
loans in their portfolios.

In addition, studies and lender trade associations indicate lenders lack
sufficient staff and staff with appropriate skills to manage the increased
activity they believe securitization would create. According to a Ford
Foundation study on CDFIs, many of these CED lenders offer salaries and
benefits that are significantly lower than those attached to jobs with similar
responsibilities and scope in the private sector.39 As a result, these lenders
may have a hard time competing for highly qualified and desirable
candidates. Further, lender trade associations with whom we spoke noted
that many CED lenders lack staff with the expertise to manage the
increased workload lenders might incur from portfolio sales. In addition,
some CED lenders experience difficulty originating and servicing loans,
including working out impaired loans, in a timely manner because staff
lack expertise and experience. The uncertainty about lender experience is
factored into the discounts charged by the markets. The Ford Foundation


39
  Brody, Weiser, Burns Business and Organizational Consulting, Strategies to Increase
Community Development Finance—a Ford Foundation CDFI, Study Phase II, January
2002.




Page 38                          GAO-04-21 Community and Economic Development Loans
                            study notes that while these impediments tend to be true across a range of
                            CDFI lenders, the extent of these impediments vary by lender. For
                            example, many of the larger loan funds have been able to increase salaries
                            enough to have significant success in attracting staff from banks and other
                            financial institutions, while the smaller loan funds have had much less
                            success in doing so.



External Requirements May   Lenders receive funds from various sources and must comply with the
Prevent or Serve as a       various requirements or laws governing how the funds must be spent.
                            These requirements may negatively impact CED lenders’ ability to sell their
Disincentive for
                            loans to third parties, ultimately preventing securitization. The impact
Securitization              could be direct or indirect. For example, some CED lenders receive funds
                            from more than one federal source and often underwrite loans to different
                            specifications, as determined by the various federal regulations governing
                            the funds. Disparate external requirements indirectly impact securitization
                            because they serve as a disincentive for CED lenders to develop standard
                            underwriting procedures, thus increasing the difficulty and costliness of
                            structuring a securitization.

                            Several federal programs offer illustrations of how lending requirements
                            may inhibit securitization. Some CED lenders reject the idea of securitizing
                            loans made with federal funds because some federal programs, such as
                            EDA, require that lenders use the proceeds on the sale of a loan to make
                            subsequent loans with the same purpose. For example, an EDA RLF selling
                            a disaster assistance loan would have to use the proceeds on that loan sale
                            to make additional loans for disaster assistance. In addition, lenders in
                            HUD’s CDBG program that wish to sell their loans must ensure that the
                            buyer will uphold requirements to meet HUD national objectives.40 Some
                            requirements have a direct impact on lenders’ participation in
                            securitization. For example, ARC prohibits CED lenders in its program
                            from selling the loans they make with ARC funds.




                            40
                             These national objectives include benefiting low- and moderate-income persons,
                            preventing or eliminating slums or blight, and addressing conditions that pose a serious and
                            immediate threat to the heath and welfare of communities served.




                            Page 39                            GAO-04-21 Community and Economic Development Loans
Lenders Believe Below-        CED lenders’ missions, along with the purpose behind the supporting
Market-Rate Products Will     federal programs largely dictate the loan products and services lenders
                              offer. As such, CED lenders generally offer below-market interest rates or
Not Meet Market               other flexible, nonconforming loan terms to small businesses that are
Requirements without          generally unable to obtain reasonable credit terms from traditional lending
Substantial Discounts         institutions. Capital markets require discounts when securitizing below-
                              market-rate loans so that the effort will result in investments with market
                              yields, cover transaction costs associated with securitization, and offset the
                              uncertain performance of the underlying asset. To cover potential credit
                              concerns, capital markets may also require that lenders provide a credit
                              enhancement to offset the uncertainty of loan performance. Some lenders
                              believe that the discount or credit enhancement that investors would
                              require for securitizing their loans would be too great. Some report that
                              capital market investors would require higher discounts than they would
                              for securitizing other assets because CED loans are not well understood.
                              On the other hand, some federal program officials fear that should
                              securitization become an option for CED lenders to obtain additional
                              capital, lenders would shirk their mission in favor of lending to more
                              conventional borrowers.

                              Even if lenders were only required to accept a discount to offset the below-
                              market interest rate, they have a disincentive to sell their loans. When
                              holding loans, lenders account for the value of loans by using the unpaid
                              principal balance, less any allowance for loss—called net book value.
                              However, if a lender were to sell a loan, it would have to recognize as a loss
                              the difference between the sales price and net book value. When
                              purchasing below-market-rate loans, investors would require a sales price
                              below the unpaid principal balance to obtain a market yield—requiring
                              lenders to recognize a loss and creating a disincentive to sell loans. In
                              effect, selling loans would require a lender to recognize the market value,
                              rather than the higher book value of their loans.



Lack of Standardization and   CED lenders currently operate independently of each other, resulting in
Inadequate Performance        nonstandard loan underwriting, documentation, and servicing. CED
                              lenders also lack an infrastructure for consistently recording the
Information Inhibit           performance of lenders and loans. As mentioned previously, the sources of
Securitization                capital and the missions of CED lenders encourage CED lenders to
                              underwrite and service loans tailored to meet the unique needs of
                              borrowers in their communities. CED lenders also use varying definitions
                              and documents and utilize differing servicing policies. Additionally, CED



                              Page 40                      GAO-04-21 Community and Economic Development Loans
lenders have difficulty providing sufficient and consistent performance
information in a useable way. For example, few lender groups have a
facility for aggregating current loan-level performance information across
lenders. Lender reporting may or may not be automated, and the
performance data reported are not defined consistently across lenders.

Investors in securitized financial assets generally require reliable
assurances that the securities will pay interest and principal fully and in a
timely manner despite the performance of the overall economy. Credit
ratings from agencies such as Moody’s or Standard & Poor’s can often
provide these assurances. Additionally, securitizations require a credit
rating in order to be considered “investment-grade” and attractive to
institutional investors.41 Credit ratings play an important role in
determining how the securities should be structured and priced to appeal
to investors, including feedback on any levels of credit enhancement that
may be necessary to achieve a desired structure. Securities raters examine
certain characteristics of proposed securitizations in order to provide their
assessment of the performance of a pool of assets and ultimately their
credit rating as follows:

•	 Rating agencies examine current and historical loan and lender
   performance data such as delinquencies, defaults, and losses to assess
   the expected performance of a pool of similar loans over time.

•	 Rating agencies examine originator and servicer characteristics such as
   management and financial strength, servicing and collection practices,
   back-up servicing, workout and liquidation policies, and data processing
   and reporting to assess originators’ and servicers’ capability to execute
   their functions adequately and in a timely manner.

•	 Rating agencies examine the legal structure of the transaction to, for
   example, assure investors that the pooled assets have been properly
   sold to the bankruptcy-remote vehicle.

Generally, the larger the number of similar loans included in a loan pool
(that is, loans with more homogeneous loan underwriting, documentation,

41
  Many institutional investors, such as banks and pension funds are generally restricted to
“investment-grade” securities (nonspeculative securities with higher credit ratings). One
hundred percent governmental guarantees can also provide adequate assurance to
institutional investors without a credit rating on the pool of assets. Investors willing to take
on more risk can invest in lower-rated, or nonrated securities.




Page 41                             GAO-04-21 Community and Economic Development Loans
                         and servicing) the less costly securing a rating can be.42 Additionally, better
                         and consistent data can reduce the costs of securing a rating and allow for
                         more precise estimates of performance, also providing for accurate
                         assessments of any required internal credit enhancements.43 The variety of
                         CED lender practices and inadequate performance information prevent or
                         inhibit capital markets from satisfactorily understanding the performance
                         of CED loans and increase the transaction costs involved with assessing
                         performance. The benefits of securitization are greatly reduced for CED
                         lenders to the extent they must fund any extra transaction costs for these
                         services, as well as fund credit enhancements to cover unexpected losses
                         that capital markets cannot satisfactorily profile. Proposals to reduce
                         these costs through standardization are viewed by many CED lenders as
                         contrary to their missions.



Limited Mechanisms       According to trade association representatives and other interest groups, if
Available to Support     securitization is to become a viable alternative for lenders, information-
                         sharing and securitization mechanisms are needed to provide consistent
Securitization for CED
                         avenues for lenders to sell their loans, achieve the volume of loans needed
Loans                    for a securitization, and achieve quality control. That is, lenders have no
                         apparent and available network or facility from which to draw if and when
                         selling loans. Likewise, investors have no apparent facility or entity from
                         which to purchase securities backed by CED loans. In contrast to other
                         mortgage-backed and asset-backed securitizations, there is no
                         comprehensive mechanism for sharing information with interested lenders,
                         investors, and capital market intermediaries. Ad hoc networks, lender
                         trade associations, and investor organizations do exist, but they do not
                         provide updated and comprehensive data and information on a regular
                         basis regarding loan volume. Neither do they provide a list of interested
                         lenders, potential investors, securitization mechanisms, and credit
                         enhancement providers.

                         Existing securitization mechanisms are limited in two different ways. First,
                         there are few mechanisms available to securitize small business and CED


                         42
                           Securities raters have traditionally required at least several hundred similar loans or assets
                         in a pool in order to create a risk profile for the pool using statistical analysis. Statistical
                         analysis is generally more cost-effective for securities raters on a per loan basis than other
                         methods of analysis.
                         43
                            Many securitizations require originating lenders to assume first-loss positions or use other
                         internal credit enhancements to provide credit support to the investment-grade securities.




                         Page 42                             GAO-04-21 Community and Economic Development Loans
                          loans. Second, some of those that do exist have limitations. As noted
                          earlier, we could only find five existing models that securitize small
                          business or CED loans and three of them use 100-percent federal credit
                          enhancements. CRF is the only existing securitization mechanism that
                          actually purchases and securitizes CED loans without direct federal
                          government support. However, as we also noted earlier, CRF has several
                          important limitations. It is the only securitizer to provide a credit
                          enhancement and, as a nonprofit entity, depends on the availability of
                          foundation and other philanthropic sources to fund its credit
                          enhancements. Since CRF’s securities depend on private placements and
                          do not have credit ratings, the number of investors, particularly
                          institutional investors, that are able to purchase its senior tranche
                          securities is greatly limited too. The Section 108 model is limited by its
                          collateral requirements and the lengthy time needed for HUD’s approval of
                          each loan, according to a recent Urban Institute study. The study also
                          found that collateral requirements may have particular force in cases
                          where Section 108 is used to capitalize small business lending programs
                          and where borrowers may have little security to offer. In addition, since
                          2001, with the elimination of funding for the EDI grant program, grantees
                          can no longer use EDI funds to satisfy, in part, collateral requirements.
                          Finally, the administration is proposing to eliminate Section 108. Taken
                          together, the limited extent of information sharing and the limitations of
                          securitization mechanisms inhibit the CED lending industry’s willingness
                          and ability to efficiently sell their loans on a large scale.



Potential Options Exist   CED lenders, their organizations, some federal agencies, and others have
                          identified options the federal government could employ to potentially
to Overcome Barriers,     overcome securitization barriers. Generally, these options involve either
but Most Imply Costs      providing incentives or requiring or providing direct or indirect support to
                          resolve identified barriers. However, implementing these options singly or
or Changes to Federal     in combination would have ramifications—both positive and negative—for
Programs                  federal programs and the clientele served by these programs. For instance,
                          some options could require additional resources, while others could cause
                          lenders to focus less on CED lending. Some options could directly resolve
                          or address the barrier, while still others could improve program or lender
                          management. Furthermore, the options for overcoming the barriers often
                          entail federal costs. However, we did not determine whether the benefits
                          exceed the costs that could result from such efforts and, therefore, do not
                          endorse these options.




                          Page 43                      GAO-04-21 Community and Economic Development Loans
Potential Options for           As discussed previously, uncertain borrower demand and limited lender
Overcoming Uncertain            incentives for securitization could result in unpredictable or insufficient
                                loan volume necessary for securitization to work efficiently. We have
Borrower Demand and             identified options that could help to better define and measure borrower
Limited Lender Incentives       demand across markets and promote lender understanding of borrower
for Securitization and Their    demand and the cost and benefits of securitization. We also identified
Implications                    options for providing incentives to lenders to make loans available for
                                securitization. Ultimately, however, the market will largely determine what
                                the underlying demand for CED loans will be.

Overcoming Uncertain Borrower   Some of the specific options for addressing uncertain borrower demand
Demand Might Begin with         involve requiring or supporting research into how to measure borrower
Measuring Demand                demand, helping develop and ensure application of consistent definitions
                                and measures for periodically measuring borrower demand across lenders
                                and programs, and aggregating this information. These actions could
                                promote increased understanding of borrower demand and may have the
                                added benefit of improved lender and program management—provided
                                procedures and definitions are clearly defined and implemented, and that
                                measures are taken systematically and frequently to track ever-changing
                                markets. However, it is unclear whether increased understanding of
                                borrower demand, alone, would motivate lenders to participate in
                                securitization. In addition, as with any data collection effort of this
                                magnitude, it would likely be costly and time-consuming to put a system in
                                place. Therefore, it may be necessary to preface any efforts with a cost-
                                benefit analysis.

                                The federal government could promote lender understanding of borrower
                                demand through the use of forecasting tools, either across target markets
                                or as part of programs. Provided these tools were defined, applied, and
                                aggregated consistently, they could provide greater understanding of future
                                borrower demand across target markets. Again, given the potential costs, a
                                cost-benefit analysis might be warranted before pursuing such an effort.

                                The federal government could require or support efforts to increase
                                information exchange among lenders. For instance, incentives could be
                                implemented for CED lenders and local banks to refer potential clients to
                                one another. This option could help lenders gain access to better borrower
                                demand information in their local markets. Another option, a peer-to-peer
                                system, could inform CED lenders of potential loans available outside their
                                traditional markets. This process could help CED lenders anticipate
                                changes in borrower demand across target markets, perhaps nationwide.



                                Page 44                     GAO-04-21 Community and Economic Development Loans
                                   The costs of implementing either of these options are not well known.
                                   Without a mandate, marketing tools may be necessary to promote the use
                                   of either of these options. Either of these options could help to make more
                                   transparent the demand for CED loans, provided this sort of exchanged
                                   information could be aggregated and analyzed in a useful way.

Federal Government Could           As we discussed earlier in this report, while some lenders do securitize
Potentially Improve Lender         their loans, others lenders with securitizable loans could realize, but do not
Understanding of Securitization    perceive, the benefits to securitization. These lenders, for example, may
and Create Lender Incentives for   have existing low-cost sources of capital and rely on interest income to
Securitization                     support their operations and would have difficulty sustaining expanded
                                   lending operations that securitization would allow. We identified options
                                   for identifying those lenders that might benefit from securitization,
                                   informing those lenders about securitization and its benefits, and building
                                   incentives for lenders to securitize their loans.

                                   The federal government could help identify lenders that could benefit from
                                   or are ready for securitization by financing or supporting the development
                                   of a study designed to establish criteria, procedures, and practices for
                                   identifying such lenders, or requiring that such procedures be
                                   implemented. However, defining and identifying lenders that could benefit
                                   from securitization might not directly cause these lenders to consider
                                   securitization. To do so, the federal government could also promote better
                                   understanding of the benefits to lenders of securitization so that those
                                   lenders that were able and would benefit from securitization would use
                                   securitization as a means to expand community and economic
                                   development lending. Such efforts would require costs to the federal
                                   government.

                                   To provide greater encouragement, the federal government could also
                                   provide direct incentives for lenders to securitize their loans. For example,
                                   the government could build incentives for lenders (such as program set-
                                   asides, awards, or requirements) into existing federal programs. While
                                   built-in program incentives could have a direct impact on lenders’
                                   willingness to securitize their loans, the impact on lenders’ missions could
                                   vary depending on how support for these incentives is provided. For
                                   instance, unless additional funding was awarded specifically for such
                                   incentives, providing incentives through program set-asides, or program
                                   awards application processes, might give qualified lenders the ability to
                                   securitize, but decrease, the amount of available funding for all other
                                   lenders awarded grants or loans decreasing the federal support to meet
                                   their missions.



                                   Page 45                      GAO-04-21 Community and Economic Development Loans
                             Requiring lenders to use existing program dollars allocated to them for
                             securitization would not impact other lenders. However, if all lenders with
                             qualifying loans were required to use program dollars for securitization,
                             fewer dollars might go toward borrowers in the short-term until those
                             lenders gained access to capital from the sale of those loans. On the other
                             hand, the government could also eliminate disincentives to selling loans by,
                             for example, reducing the use of grant funds. Again, such an option would
                             have an immediate impact on lender behavior but also potentially motivate
                             lenders toward less risky lending.



Potential Options Exist to   Limited lender capacity is an underlying reason why lenders lack incentives
Overcome Limited Capacity,   to participate in securitization. To help lenders access or analyze
                             information on whether securitization would be useful, and to manage
but Each Has Implications    increased workload they would incur if they were to securitize their loans,
                             some lenders need to improve their staff skills and financial information
                             capabilities. Additionally, lenders’ long-term viability could be enhanced
                             through greater diversification of their portfolios.

                             Options the federal government could exercise include providing,
                             requiring, or supporting training and technical assistance to: (1) increase
                             skill levels of lenders in order to reduce the staff time spent on loans, (2)
                             improve financial and accounting information needed to make decisions on
                             whether benefits outweigh the costs of securitization, and (3) inform
                             lenders of the benefits of diversifying their portfolios. Possible options also
                             include supporting an increase in the number of lender staff needed to
                             manage any potential increases in workload they might incur by
                             securitizing their loans.

                             These options could not only move the industry closer to securitization by
                             improving lender knowledge and capacity needed to securitize their loans,
                             but could also have the added benefit of increasing lender capability and,
                             thus, more prudent use of federal program dollars. However, each of these
                             options also has other implications. For instance:

                             •	 Exercising options such as training and information sessions designed
                                to inform lenders of the benefits of diversifying their portfolios could
                                result in lenders investing in either larger loans or more collateralized
                                assets. However, altering lender portfolios in this way could result in
                                lenders making loans to less risky borrowers, moving them slightly “up-
                                market” (that is, to more creditworthy borrowers) and thus further away
                                from their mission. On the other hand, diversifying their portfolios with



                             Page 46                       GAO-04-21 Community and Economic Development Loans
                                more of a balance of larger and smaller loans and loans of varying risks
                                could help lenders’ long-term viability.

                             •	 Exercising options to increase staff skill levels through training or
                                providing tools to increase staff skills, improving financial and
                                accounting information, and for increasing the number of staff will have
                                added costs. Costs to the federal government will vary depending on
                                whether the government takes a direct or supportive role in developing
                                and implementing training courses or information sessions or funding
                                increased staff or tools for these lenders. However, improved lender
                                management and technical skills could increase lender efficiency.

                             •	 To ensure the effective use of limited federal resources, any support for
                                training, technical assistance, or staffing would require appropriate
                                federal oversight and evaluation.



Options Exist to Overcome    Our research identified a number of requirements that either directly or
Restrictive External         indirectly limit lenders’ ability to participate in securitization. To allow
                             lenders the ability to pool and sell loans, these requirements and others like
Requirements, but Each Has   them, would need to be identified and either modified or removed.
Implications
                             The federal government could exercise several options for identifying and
                             modifying or removing restrictive requirements, including requiring
                             programs to work collaboratively to identify and resolve conflicting
                             regulatory requirements that prohibit or inhibit securitization and develop
                             proposals for resolving conflicting statutory requirements. While these
                             options have the potential to expand the number of lenders that may
                             consider securitizing CED loans, each option has other implications such
                             as the following:

                             •	 Identification of conflicting federal, state, local, and private
                                requirements governing how CED funds must be spent could be costly
                                and time consuming because of the need to coordinate efforts on
                                several levels.

                             •	 Removing some requirements may impact lenders' ability to meet the
                                mission of the federal programs that support them. For example, if
                                requirements that lenders use loan sale proceeds to make loans with the
                                same purpose are eliminated, EDA has no assurance that the lenders it
                                supports would continue to meet program goals and objectives. Before




                             Page 47                      GAO-04-21 Community and Economic Development Loans
                                  removing such restrictions, their purpose and rationale should be
                                  weighed against the benefits of securitization.



Options Exist to Potentially   Some studies we reviewed, and lenders with whom we spoke, cite the very
Overcome Impact of Below-      nature of CED loans as a barrier to securitization because these loans often
                               have below-market-rates. Discounts on below-market-rate loans are a
Market-rate Loans on           consequence of the need to provide market yields on investments and to
Securitization, but Each Has   cover the transaction costs associated with carrying out any securitization.
Implications                   Securitization of CED loans may also require discounts to offset any
                               additional transaction costs due to the lack of performance information
                               and nonstandard loan underwriting. Loans made with limited collateral,
                               and with riskier borrowers, will continue to need either some type of
                               subsidized financing, such as the below-market-rate loans provided by
                               these lenders, or other mechanisms such as offering longer loan terms that
                               allow borrowers to make lower monthly payments.

                               The federal government could exercise several options to enhance lenders’
                               abilities to securitize below-market-rate loans. The federal government
                               could provide a direct subsidy or incentives for others to provide support
                               to lenders to offset the discount charged to lenders for securitizing below-
                               market-rate loans. The implementation of any one or all of the options
                               discussed in other parts of this section (from measuring borrower demand
                               to improving loan performance information) would diminish lender costs
                               and diminish, in part, the need for lender discounts. However, as explained
                               in those sections, these options have other implications as well. Provision
                               of a direct federal subsidy or incentives for others to provide support
                               would result in federal costs.



Options Exist to Overcome      The level of heterogeneity among community lenders and loans, and the
Lack of Standardization and    lack of adequate performance information regarding these lenders and
                               loans, results in disincentives to securitize. Capital markets cannot
Insufficient Performance
                               sufficiently, or cost-effectively assess the expected performance of a
Information, but Each Has      heterogeneous pool of loans and, thus, cannot accurately assure investors
Implications                   of the creditworthiness of a pool of CED loans. The benefits of
                               securitization are greatly reduced for community lenders as they fund any
                               extra transaction costs for these services and credit enhancements to cover
                               unexpected losses that capital markets cannot adequately profile.




                               Page 48                      GAO-04-21 Community and Economic Development Loans
Developing a Level of           The federal government could provide incentives (such as set-asides or
Standardization Would Involve   awards) for federal programs and/or capital markets (or other financial
Supporting Data and             institutions that securitize similar loans, such as commercial banks) to
Underwriting Standardization    collaborate in order to develop standardized performance information,
                                loan documentation, servicing, and underwriting criteria and procedures
                                that are useable for both capital markets and CED lenders. Developing
                                new criteria and procedures through this type of collaboration might
                                improve CED lenders’ ability to securitize or to develop innovative
                                financing arrangements other than securitization. Given the varied and
                                diverse nature of community lenders nationwide, providing outreach and
                                education on any information or procedural standardization could also
                                facilitate the timely implementation of any new criteria or procedures.

                                Developing and applying homogeneous loan and lender performance
                                information—key performance data points, definitions underlying those
                                data points, frequency for reporting data, and preferred format for
                                collecting the data for CED lenders—has several implications. The earlier
                                performance information could be developed and collected from CED
                                lenders, the sooner CED lenders could communicate a useable
                                performance profile to financial institutions and thus help to improve their
                                overall effectiveness as CED lenders. Aggregating and maintaining
                                performance information in a central facility—a “data-warehouse”—
                                accessible by CED lenders, loan pool assemblers, and federal programs,
                                may provide: (1) community lenders an easier way to report and monitor
                                their performance, thereby reducing any administrative burdens
                                accompanying repetitive federal reporting requirements; (2) loan pool
                                assemblers and rating agencies more cost-effective means to assess and
                                profile the risk of differing types of CED loans, helping to diminish the
                                securitization transaction costs lenders currently fund; and (3) federal
                                programs and Congress better data to make key programmatic decisions
                                within and across programs. Federal support for efforts to develop and
                                apply homogeneous loan and lender performance information would result
                                in costs to the federal government, but it may improve program
                                management in the long-term. Deciding where to develop, store, and
                                manage this data should take in account, privacy, access, and Freedom of
                                Information Act issues.

                                Developing homogeneous loan underwriting, servicing, and documentation
                                standards would likely require a balance between the level of
                                standardization necessary for cost-effective, reliable performance
                                estimates and a sufficient level of flexibility for CED lenders to meet the
                                needs of their communities. The tighter the standards, the less likely CED



                                Page 49                      GAO-04-21 Community and Economic Development Loans
                                lenders would be able to tailor their services to their communities, thus
                                potentially diminishing the effectiveness and benefits of CED lenders to
                                communities. Conversely, the looser the standards, the more costly
                                assessing the performance of CED loans becomes, thus diminishing the
                                benefits of securitization as a funding source for CED lenders. Developing
                                a range of underwriting and servicing standards for a variety of loan
                                products would limit lender flexibility for a particular loan product, but
                                these standards may be designed to accommodate the mission of
                                community lenders. Additionally, with enough available loan and lender
                                information, a range of standards may allow a pool assembler to assemble
                                a reasonably homogeneous pool of similar loans from a nationwide pool of
                                mission-oriented CED lender portfolios. Developing standards for
                                underwriting, servicing, and documentation can require substantial effort.
                                To the extent that these efforts are funded through federal programs, or
                                through incentives provided lenders and others, these efforts may impose
                                federal costs.

Credit Scoring Could Diminish   The federal government and CED lenders could examine the use of credit
Need for Other Information	     scoring as an indicator, for example, of the likelihood of borrower
                                repayment of principal and interest. Some commercial banks now
                                consider credit scores primary criteria for underwriting small business
                                credit decisions. Several studies and interviews have indicated that credit
                                scoring is a technique with the potential to reduce the need for
                                standardized underwriting procedures. Using credit scores to estimate the
                                likely performance of a pool of loans based upon borrowers with similar
                                creditworthiness might be more cost-effective than estimating the
                                performance of a pool of heterogeneous loans. If credit scores produce
                                performance probability estimates reliable enough for rating agencies,
                                investors and lenders can more accurately assess their financial incentives
                                and disincentives to securitize CED loans. Additionally, credit scores may
                                reduce the cost of loan origination. Whether credit scoring loans will affect
                                the missions of CED lenders is somewhat dependent on the lender. Credit
                                scoring may allow CED lenders to underwrite loans tailored to their target
                                markets and sell occasional loans to pools accepting certain credit score
                                ranges. Or, some CED lenders might only originate loans with credit scores
                                acceptable for resale into pools accepting certain credit score ranges,
                                thereby limiting the types of lending they would do in their communities.
                                Credit scoring might limit borrowers with little or no credit history from
                                accessing CED financings. Finally, questions still exist as to whether credit
                                scoring disadvantages minority or other segments of the population.




                                Page 50                      GAO-04-21 Community and Economic Development Loans
Use of Governmental Credit     Governmental credit enhancements could be applied in a number of ways,
Enhancements Could Minimize    but could result in increased costs to the federal government. However, the
the Need for Other Loan        level of the credit enhancement would determine the extent to which
Performance Data               standardization and performance data would be needed. A security issued
                               with a 100-percent federal credit enhancement could minimize the need for
                               standardization and loan performance data because it is backed by the full
                               faith and credit of the federal government and, therefore, would not need to
                               obtain an independent credit rating. However, such a federal credit
                               enhancement could expose the federal government to potentially greater
                               risk and cost and would also require a minimum degree of standardization
                               and review, depending upon the capabilities and loan performance record
                               of the lender. For example, in FHA’s Multifamily Insurance Risk-Sharing
                               Program, state and local housing finance agencies receive a 100-percent
                               federal credit enhancement, and the most experienced lenders are allowed
                               to use their own underwriting standards and documents in return for
                               assuming 50-90 percent of the credit risk. Compared with a 100 percent
                               credit enhancement, a partial federal credit enhancement reduces the
                               government’s risks and potential costs, but generally subjects the loans to
                               be securitized to an evaluation by the credit rating agencies or investors
                               (for unrated securities). Such an evaluation would necessarily include the
                               standardization and loan performance issues discussed earlier. Whether a
                               100 percent or a partial federal credit enhancement, federal agencies will
                               need sufficient loan performance data to estimate the credit subsidy cost of
                               the credit enhancement. Given the possible increased cost and risk the
                               government incurs, credit enhancements should be minimized and their
                               continuing need be assessed periodically. Such assessments would require
                               criteria for determining the continued need for credit enhancement.



Options Exist to Potentially   Lack of or limits in information sharing and securitization mechanisms are
Overcome Limited               seen by many as a barrier to securitization. Currently, there is no
                               comprehensive mechanism for lenders, investors, and capital market
Mechanisms for                 intermediaries to share information on loan volume with interested loan
Securitizing, but Each Has     buyers and sellers. There are also few mechanisms available to securitize
Cost and Other Implications    small business and CED loans, and there are limitations with some of the
                               existing mechanisms. We have identified several options for creating a
                               consistent mechanism for securitizing CED loans. These options are as
                               follows:

                               •	 The federal government could help establish formal networks for
                                  lenders and capital market participants to exchange information on
                                  loans available for sale and for interested loan purchasers to provide



                               Page 51                     GAO-04-21 Community and Economic Development Loans
   specialized origination and loan sale functions. Examples of networks
   could include a formalized group of lenders, investors, and capital
   market intermediaries or super-regional CED lenders who would be part
   of a voluntary regional network of local CED lenders. For the networks
   to be effective, they would need to provide tangible benefits to both
   lenders and capital market participants. For example, super-regional
   lenders could specialize in originating and selling larger, long-term loans
   referred to them by retail lenders, who could participate in the
   underwriting and loan servicing responsibilities and share in the loan
   fees. This may also allow local lenders more time to concentrate on
   smaller, short-term loans to be held in their portfolios. Implementing
   the networks may also require different degrees of federal funding.

•	 Two existing securitization mechanisms that could serve as a basis for
   greater securitization of CED loans are CRF and the Section 108
   guaranteed security programs. However, these structures have certain
   limitations that would first need to be addressed. CRF depends on the
   availability of foundation and other philanthropic sources to fund its
   credit enhancements, thereby limiting its capacity to sell more
   securitized loans to investors. Since CRF’s securities have only been
   privately placed and do not have credit ratings, the number of investors,
   particularly institutional investors, who are able to purchase its senior
   tranche securities is limited. Increasing CRF’s capacity to securitize
   more loans and providing it with a large enough credit enhancement
   would allow CRF to obtain a credit rating. Addressing CRF limitations
   could include providing direct federal funding for partial credit
   enhancements or match funding to attract other funding sources such as
   state and local government and program-related investors, as well as
   assistance in developing standardized loan products. However,
   providing partial federal credit enhancements could have both positive
   and negative effects depending upon the credit risks associated with the
   lenders and loans included in each loan pool to be securitized. Such
   credit enhancements would likely impose costs on the federal
   government. In addition, these options may have a negative impact on
   lender mission if standardization reduces lender flexibility to the point
   that loan terms no longer meet borrower needs or excludes targeted
   borrowers. However, lenders may be able to target greater resources to
   serving targeted markets if they can offer new loan products such as,
   long-term, fixed-rate real estate loans. In addition, the Urban Institute
   study found that the average loan size of Section 108 loans to third




Page 52                      GAO-04-21 Community and Economic Development Loans
     parties was about $1.5 million.44 Thus, the model securitizes much
     larger loans than many of those financed by many lenders covered in
     our review. For example, the average loan size for CDFIs is $66,000 for
     business loans and $11,600 for microenterprise loans. Finally, as
     indicated previously, the administration is proposing elimination of the
     Section 108 program. If the program remains or the model is adopted
     elsewhere, the model’s current limitations could be addressed. For
     example, the government could address the collateral concerns,
     particularly by communities that capitalize loan funds, while taking into
     account risks borne by the federal government. The government could
     also assess why the Section 108 model is not used more widely to
     securitize CED loan funds. This would require a better understanding of
     the extent to which Section 108 loan guarantees are used as a funding
     source for loan funds. Such efforts would involve costs for the federal
     government, but could lead to improvements in the program’s and the
     securitization mechanism’s usage.45

•	 The government could also opt to create new securitization mechanisms
   ranging from those with little or no credit enhancements to options with
   full credit enhancements. These structures could be supported by
   different entities such as the federal government or the private sector.
   For example, the government could create a new mechanism similar to
   the CDA securitization model with a partial federal credit enhancement.
   Another option might be a demonstration program with a 100-percent
   federal credit enhancement of the security plus sharing the credit risk of
   the underlying loans in a manner similar to the FHA Multifamily Risk-
   Sharing Program described earlier. For instance, if the risk-sharing
   demonstration with a 100-percent federal enhancement of the security
   were limited to CED lenders with high performing portfolios and high
   loan volume, standardization requirements would be minimized, thereby
   reducing lender mission impact. But this sort of federal credit
   enhancement might have negative cost consequences for the federal
   government, depending on the effectiveness of the risk-sharing
   mechanisms adopted and the quality of the lenders and loans included
   in the program. The implications for the proposed CDA model are less


44
  Some of the loans securitized under the Section 108 program are used to fund smaller
loans to individual businesses through RLFs and nonprofit intermediaries such as CDCs.
45
 In providing technical comments, HUD suggested that fees could be but are currently
prohibited from being charged to create a loan loss reserve for securitizing these loans.
However, we did not assess the implications of this option.




Page 53                            GAO-04-21 Community and Economic Development Loans
                   known since there are no current securitization models that use partial
                   federal credit enhancements to securitize any loans. Since CDA
                   proposes to purchase only seasoned loans and update their borrowers'
                   credit scores, the need for standardization may be minimized because
                   credit rating agencies would know the loans' short-term financial
                   performance and their borrowers' current creditworthiness. Since the
                   rating agencies would still not have the long-term loan performance data
                   they need to statistically predict loan delinquencies and defaults, they
                   would adjust the amount of credit enhancement upward, but by a
                   smaller amount than required for pools of new loans with outdated
                   credit scores. Overall, any options for providing enhancements to
                   create additional mechanisms for securitization will require
                   administrative effort and federal costs.

                •	 The government could also build upon existing structures that securitize
                   non-CED loans by providing incentives for private sector entities to
                   securitize CED loans. However, private sector securitization entities
                   may not agree to securitize CED loans or may “demand” too high a cost
                   to the federal government. In addition, because private securitization
                   mechanisms require standardized underwriting, lenders’ mission may be
                   negatively impacted. However, the impact standardization might have
                   on lender mission could be mitigated if securitization could provide
                   CED lenders with new kinds of loan products that they generally do not
                   now originate, that is, larger, long-term, fixed-rate loans. Overall,
                   providing incentives to private sector entities to securitize CED loans
                   would require federal costs. To ensure the effective use of federal
                   resources, any such program or incentives would also require
                   appropriate federal oversight and evaluation.



Observations	   Given the importance of volume in achieving efficiencies that could help
                securitization work effectively, uncertain borrower demand and limited
                lender incentives are critical barriers that would need to be addressed if
                CED loans are to be securitized widely. Therefore, securitization may not
                be a significant alternative for these lenders until the volume of loans
                available for securitization is known industrywide, and lenders are
                convinced of its benefits enough to participate. Further, limited lender
                management capacity, prohibitive external legal or regulatory limitations
                and requirements, and discounts due to below-market-rate financing are
                barriers consequent to the nature of CED lending. For varying reasons
                discussed in detail above, these barriers also combine to explain the lack of
                lender incentives to securitize their loans. Therefore, these barriers, along



                Page 54                      GAO-04-21 Community and Economic Development Loans
with the cost associated with their elimination, are factors to be addressed
if CED loans are to be securitized widely. In addition, eliminating these
barriers entail costs.

The remaining barriers—lender heterogeneity, insufficient performance
information, and limited mechanisms for securitizing loans—are traditional
barriers that have been experienced to some degree in the development of
other securitization models. Some of the actions we outline, such as
developing homogeneous documentation and performance information,
may help to improve lenders’ overall effectiveness in dealing with local and
national capital markets in a range of financing transactions, including
securitization, and could help improve program management. However,
the costs and benefits of these actions should be assessed before they
could be considered viable. Developing homogeneous underwriting and
servicing policies requires recognition of the tension between the flexible
underwriting these lenders employ to serve their communities versus the
standardization needed to cost-effectively securitize loans. Additionally,
any mechanisms developed to further CED loan securitizations will not
succeed without visible financial benefits for lenders and capital market
participants.

In addition, some of the options we have identified to improve lender
management practices, data on lenders and loans, and consistency in
assessing and documenting loans could not only move the industry closer
toward securitization, but could have the added benefit of improved
management and oversight for lenders and the federal programs that
support them. However, their costs and benefits need to be assessed. If
cost/benefit analyses prove them to be cost-effective, these are steps that
could help the industry regardless of whether securitization becomes a
viable option.

While the options we identify have many likely implications, we did not
measure the extent to which each may affect lenders’ mission, federal
costs, program oversight, and other potential implications. Likewise, we
did not determine whether the potential benefits exceed the costs that
could result from such efforts. We, therefore, do not endorse these options.
Nonetheless, the information we present provides a framework for
understanding the challenges when considering the federal role in
facilitating securitization.




Page 55                      GAO-04-21 Community and Economic Development Loans
Agency Comments and 	   Officials in all agencies provided technical comments that we incorporated
                        into the report, where appropriate. The technical comments from HHS
Our Evaluation	         were from officials in HHS’s Administration for Children and Families.
                        Generally, the agencies did not indicate whether they agreed or disagreed
                        with the report’s findings.


                        We are sending copies of this report to interested congressional parties and 

                        to the Secretaries of Agriculture, Commerce, Health and Human Services, 

                        Housing and Urban Development, and Treasury, the SBA Administrator,

                        and the Federal Co-Chair of the Appalachian Regional Commission. Copies

                        will be made available to others upon request. In addition, the report will 

                        be available at no charge on the GAO Web site at http://www.gao.gov.


                        Please contact Mathew J. Scirè, Assistant Director, or me at (202) 512-8678, 

                        or by e-mail (sciremj@gao.gov or shearw@gao.gov ) if you or your staff 

                        have any questions concerning the report. Key contributors to this report 

                        were Diane T. Brooks, Tiffani L. Green, Mitchell B. Rachlis, Barbara M.

                        Roesmann, Keith A. Slade, and James D. Vitarello.





                        William B. Shear

                        Director, Financial Markets

                         and Community Investment




                        Page 56                      GAO-04-21 Community and Economic Development Loans
List of Congressional Requesters

The Honorable Hillary Rodham Clinton
United States Senate

The Honorable Susan Collins
United States Senate

The Honorable Christopher J. Dodd
United States Senate

The Honorable Tom Harkin
United States Senate

The Honorable James M. Jeffords
United States Senate

The Honorable Edward M. Kennedy
United States Senate

The Honorable John F. Kerry
United States Senate

The Honorable Patrick J. Leahy
United States Senate

The Honorable Carl Levin
United States Senate

The Honorable Jack Reed
United States Senate

The Honorable Paul E. Kanjorski
House of Representatives

The Honorable James A. Leach
House of Representatives

The Honorable John M. McHugh
House of Representatives




Page 57                    GAO-04-21 Community and Economic Development Loans
The Honorable Jack Quinn
House of Representatives




Page 58                    GAO-04-21 Community and Economic Development Loans
Appendix I

Objectives, Scope, and Methodology



                          Our objectives were to: (1) describe the characteristics of selected
                          federally sponsored Community and Economic Development CED lenders;
                          (2) describe the characteristics of selected federal programs that support
                          CED lenders; (3) describe selected efforts to securitize economic
                          development loans; (4) determine the barriers to securitizing economic
                          development loans; and (5) identify options for overcoming these barriers,
                          as well as the implications of the identified options. We limited the scope
                          of our work to securitization and did not include alternative means for
                          lenders to access private capital.



CED Lender                Our review focused on the seven types of federally sponsored CED lenders
                          that we were specifically requested to include and identified as key CED
Characteristics and the   lenders.1 They are the following:
Performance of Their
                          • Community Development Financial Institutions (CDFIs),
Loans
                          • Revolving Loan Funds (RLFs),

                          • Intermediary Relenders (IRPs),

                          • Community Development Corporations (CDCs),

                          •	 Small Business Administration’s (SBA) 504 Certified Development
                             Companies (504 CDCs),

                          •	 lenders supported by entitlement city and state grantees under the U.S.
                             Department of Housing and Urban Development’s (HUD) Community
                             Development Block Grant Program and lenders supported by the
                             Section 108 Loan Guarantee program, and

                          • microlenders.

                          To describe the characteristics of selected federally sponsored CED
                          lenders, we reviewed and synthesized studies, reports, data, and
                          information from industry nonprofits, trade associations, and federal


                          1
                           Although we identified one other lender group--Community Development Entities under
                          Treasury’s New Markets Tax Credit—we did not review these lenders because Treasury just
                          recently (2002) established Community Development Entities, and limited information was
                          available on them.




                          Page 59                          GAO-04-21 Community and Economic Development Loans
                       Appendix I

                       Objectives, Scope, and Methodology





                       program data on selected CED lenders and lending programs. We also
                       interviewed CED lenders, their trade associations, and other industry
                       groups. We then used the information collected from the identified
                       sources to document and describe, where available, the following:

                       • purpose of (mission) and target markets served by the lender group;

                       • lender’s sources of capital;

                       •	 characteristics of the lender group (for example, number of loans,
                          amount of loans);

                       • reported impacts on target markets served; and

                       • attempts to measure and define demand for liquidity and capital.

                       Finally, we documented the availability of data describing the
                       characteristics and performance of the loans that CED lenders make. Loan
                       performance data were inconsistently available for all lender groups;
                       therefore, we were unable to assess the performance of CED loans in
                       general. However, we were able to document differences in how loan
                       performance was measured. We also identified three current efforts to
                       collect loan-level data on CED loans made by select CED lenders in EDA,
                       HUD, and Treasury’s CDFI Fund. We attempted to obtain summary data
                       from these sources on the dollar amount and number of loans in default in
                       order to estimate a cumulative default rate for each program. However,
                       Treasury’s CDFI Fund data were inconsistent and incomplete for our
                       analysis. Comparable data on HUD loans were not available at the time of
                       this report. We did not independently verify the data, but we corroborated
                       it against various sources.



Selected Federal CED   Our review focused on 11 federal programs that support the seven types of
                       CED lenders targeted. 2 Programs selected for review, the lenders they
Programs               fund, and the agencies that administer them are listed in table 9.


                       2
                        While there are other federal programs that support economic development activity, we
                       focused on those within the seven federal agencies we were requested to review that
                       support seven types of CED lenders targeted. For example, HHS administers the
                       Community and Economic Development Discretionary Grant program. However, the
                       program could only recently be used to fund RLFs. Also, see previous footnote.




                       Page 60                          GAO-04-21 Community and Economic Development Loans
                                              Appendix I

                                              Objectives, Scope, and Methodology





Table 9: Federal CED Lending Programs, Lender Types, and Sponsoring Agencies Included in Our Review

Federal program                                            Lender type                        Sponsoring agency
Intermediary Relending program (IRP)                       IRPs                               U.S. Department of Agriculture
                                                                                              (USDA)
Rural Business Enterprise Grant program (RBEG)             RLFs                               USDA
Economic Adjustment Assistance Program                     RLFs                               U.S. Department of Commerce
                                                                                              Economic Development
                                                                                              Administration (EDA)
Business Development Revolving Loan Fund program           RLFs                               Appalachian Regional Commission
                                                                                              (ARC)
Community Development Block Grant (CDBG) (entitlement Local lenders                           U.S. Department of Housing and
cities and state-administered)                                                                Urban Development (HUD)
Section 108 loan guarantee                                 Local lenders                      HUD
Community Services Block Grant (CSBG)                      Local lenders                      U.S. Department of Health and
                                                                                              Human Services (HHS)
Enterprise Community/Empowerment Zone Grant (EZ/EC) RLFs                                      USDA, HHS, and HUD
Financial Assistance component of CDFI Fund                CDFIs                              U.S. Department of Treasury
                                                                                              (Treasury) CDFI Fund
504 Certified Development Company (504 CDC)                Certified Development Companies    Small Business Administration (SBA)
                                                           (CDCs)
Microloan Program                                          Microlenders                       SBA
Source: GAO.


                                              For each program we analyzed the following:

                                              • purpose and target markets served by the program,

                                              • how the federal government supports the CED lending program,

                                              • restrictions on the use of the federal funds,

                                              •	 types of performance and lender activity information that the program
                                                 collects,

                                              • volume of program activity, and

                                              • budgetary costs of funding the program’s CED lending activity.




                                              Page 61                          GAO-04-21 Community and Economic Development Loans
                            Appendix I

                            Objectives, Scope, and Methodology





Selected Securitization 
   Our review focused on eight models—five existing and three proposed—
                            that are intended to serve small business and CED lenders. SBA’s 7(a)
Efforts for CED Loans
      guaranteed and unguaranteed models and the two HUD Section 108 models
                            were specifically requested. The remaining four models were identified
                            through our contacts with agency officials and other parties.

                            The five existing models are:

                            1. SBA’s 7(a) guaranteed model,

                            2. SBA’s 7(a) unguaranteed model,

                            3. SBA’s 504 model,

                            4. HUD’s Section 108 model,

                            5. The Community Reinvestment Fund’s (CRF) model

                            The three proposed models are:

                            1.	 HUD’s proposed CDBG/Section 108 unguaranteed model for
                                securitizing CED loans,

                            2.	 Commonwealth Development Associates’ (CDA) proposed model for
                                securitizing CED loans,

                            3.	 Capital Access Group’s proposed securitization model, building on
                                existing state-level Capital Access lending programs

                            For each of the models, we then collected and summarized information
                            about the following:

                            • models’ structure, including lenders and borrowers served;

                            • securitized volume of each model;

                            • loan types included in the models’ loan pools;

                            • financial benefits and risks to the participants in the models; and

                            • barriers to securitization the models faced.



                            Page 62                          GAO-04-21 Community and Economic Development Loans
                       Appendix I

                       Objectives, Scope, and Methodology





Barriers to CED Loan   To identify barriers to securitization, their causes and proposed solutions,
                       we (1) reviewed and synthesized studies and reports obtained from
Securitization         literature searches completed on securitization of economic development
                       loans and selected sources we thought were most relevant to our review;
                       (2) relied on relevant documents and studies identified in interviews with
                       program officials, lenders, and their trade associations referred to
                       previously; and (3) pinpointed barriers faced in the eight securitization
                       models reviewed and the extent to which the barriers have been
                       overcome. We limited our review to those documents that identified
                       barriers to CED loan securitization and did not include those that discussed
                       barriers to accessing capital through other means. We synthesized
                       information on barriers in these documents into a single matrix uncovering
                       over 264 citations of barriers to securitization, their causes, and any
                       proposed solutions. We then developed logical groupings that
                       characterized the barriers and assessed the reliability of these groupings by
                       having teams of two independently code them and reach consensus on
                       areas where original coding did not agree. The six categories that appear in
                       this report are as follows:

                       • uncertain borrower demand and limited lender interest,

                       • insufficient lender capacity,

                       • external requirements attached to capital sources,

                       •	 below-market-rate loan products will not meet market requirements
                          without a discount or subsidy,

                       • lack of standardization and inadequate performance information, and

                       • limited mechanisms available to support securitization for CED loans.



Options for            We relied upon the proposed solutions identified in the barrier analysis
                       described above and our professional judgment to identify strategies for
Securitization and     overcoming barriers to securitizing economic development loans. We
Their Implications     considered a range of options available to the federal government to
                       address the barriers developed in our analysis. Federal options generally
                       include the following:

                       • potential modification(s) of legal or program requirements,



                       Page 63                          GAO-04-21 Community and Economic Development Loans
Appendix I

Objectives, Scope, and Methodology





•	 potential incentives within existing programs to promote participant
   interest and/or the ability to securitize, and

• potential actions to help improve lender capacity.

We do not endorse the options we identified and, given the scope of this
report, note that these options are designed to address barriers to
securitization, rather than improving access to capital through other
means.

We also used our professional judgment and that of experts in the field to
determine the potential implications of each option. We developed a range
of implications based upon our research and discussions with program and
industry experts. The potential implications of the options generally
considered whether the option could result in

• conflicts with lenders’ mission,

• need for new federal funding or resources,

• direct and/or immediate impact on the barrier being targeted, and/or

• improved lender or program management.

While we recognize that options could entail additional federal costs, we do
not determine whether the benefits exceed the costs that could result from
such efforts.

Our work was conducted in Manchester, New Hampshire; Philadelphia,
Pennsylvania; and Washington, D.C., between October 2002 and July 2003
in accordance with generally accepted government auditing standards. We
obtained comments on a draft of this report from U.S. Department of
Agriculture; U.S. Department of Commerce; U.S. Department of Housing
and Urban Development; U.S. Department of Treasury; U.S. Small Business
Administration; U.S. Department of Health and Human Services; and the
Appalachian Regional Commission which we incorporated into the report,
where appropriate.




Page 64                          GAO-04-21 Community and Economic Development Loans
Appendix II

Model Descriptions





Model               Lenders            Borrowers            Model structures
SBA 504 program     Certified          Creditworthy, for-   In existence since 1986, the SBA 504 program provides creditworthy small
                    Development        profit small         businesses with fixed-rate, long-term subordinate loans, primarily for
                    Companies          businesses who       commercial real estate (not to exceed 40 percent of the total loan amount).
                                       have qualified for   A third-party lender must provide at least 50 percent of the project amount.
                                       conventional         Each 504 CDC loan is funded by a guaranteed debenture and sold by SBA’s
                                       loans                designated trust agent, who pools them and issues U.S. Government
                                                            Guaranteed Development Company Participation Certificates. These
                                                            certificates are sold to investors through underwriters with timely payment of
                                                            principal and interest guaranteed by SBA.
SBA 7(a)            Commercial         For-profit small     SBA has been authorized to securitize 7(a) guaranteed loans since 1984.
guaranteed          banks, credit      businesses that      The program provides a guarantee on a portion of a small business loan
                    unions, small      could not obtain     ranging from 50 percent to 85 percent, following SBA’s review and approval
                    business lending   financing            of each loan unless originated by a preferred lender. The lender may elect to
                    companies and      elsewhere            sell the guaranteed portion of each loan to an SBA-approved loan pool
                    other nonbank                           assembler, which issues SBA-guaranteed securities to investors. Working
                    lenders                                 capital, equipment, and real estate loans may be included in these loan
                                                            pools, which normally carry a variable interest rate.
SBA 7(a)            Commercial         For-profit small     SBA first authorized the sale of unguaranteed portions of 7(a) loans on the
unguaranteed        banks, credit      businesses that      secondary market in 1992. On February 10, 1999, SBA issued a Final Rule
                    unions, small      could not obtain     that created a new regulatory regime for all participating lenders in this
                    business lending   financing            program. Lenders pool their loans and issue securities to investors that
                    companies and      elsewhere            include internal credit enhancements provided by the lender. To date, each
                    other nonbank                           security has been rated as investment-grade by credit rating agencies.
                    lenders
HUD Section 108     CDBG grantees      For-profit or        Operating since 1978, the Section 108 permanent financing program
guaranteed          and their          nonprofit            provides both the actual financing for the securities and a 100 percent
                    designated         borrower             federal credit enhancement. Payments on the loans are passed through to
                    lenders                                 the Section 108 note holders. The principal security for the loan guarantee
                                                            is a pledge by the applicant community or the state (for nonentitlement
                                                            communities) of its current and future CDBG funds. Additional security will
                                                            also be required by CDBG grantees to assure repayment of the guaranteed
                                                            obligations.
Community           Nonprofit, for-    Local business,      CRF is a nonprofit secondary market maker for CED-based lenders
Reinvestment Fund   profit, and        affordable           nationwide. It purchases and warehouses loans from community lenders
(CRF)               governmental       housing, and         and uses the loans to back securities issued to private investors through
                    community          community            private placements. These securities include a variety of credit
                    development        facility borrowers   enhancements, including subordinated tranches that are typically financed
                    lenders.                                with loans and grants from private foundations.
Proposed            Nonprofit, for-    Small business       CDA was part of the Economic Development Administration’s securitization
Commonwealth        profit, and        borrowers not        pilot in 1999. CDA proposed to pool economic development loans and
Development         governmental       served by local      acquire a rating using a credit-scoring model. Under the CDA model, loan
Associates (CDA)    community          commercial           originators were to hold the loans until enough loans became available for a
                    development        financial            rating and sale as a private placement, with partial internal credit
                    lenders.           institutions         enhancements funded by each participating lender, as well as external
                                                            enhancements funded with public or private monies. Since CDA was unable
                                                            to achieve the minimum loan volume required by the credit rating agency,
                                                            the model was never implemented.




                                            Page 65                              GAO-04-21 Community and Economic Development Loans
                                                          Appendix II

                                                          Model Descriptions





(Continued From Previous Page)
Model                         Lenders                Borrowers           Model structures
Proposed                     CDBG-grantees           For-profit or       Under contract with HUD, the Urban Institute has proposed a structured
CDBG / 108                   and their               nonprofit           finance securitization model that includes a small senior tranche, a large
unguaranteed                 designated              borrower            subordinated tranche, and a residual retained by the loan seller equal to
                             lenders                                     about 20 percent. This assumes that a bank has provided 35 percent of the
                                                                         project cost with a senior collateral position. The remaining 55 percent has
                                                                         been provided by the community with either Section 108 or CDBG funds in a
                                                                         junior collateral position. The senior tranche would be sold to investors as
                                                                         an investment-grade security. An alternative is to include the senior bank
                                                                         loan portion in the loan pool, thereby also increasing the size of the senior
                                                                         tranche.
Proposed                     CDFI lenders            Minority            Proposes to purchase subordinated loans to small businesses and nonprofit
Capital Access                                       businesses,         organizations (25–40 percent of total loan amount), that would require 100
Program variation                                    nonprofits, and     percent financing, assuming a commercial bank agrees to provide the
                                                     commercial real     remaining 60–75 percent as a senior collateral position. Only the
                                                     estate properties   subordinate loan would be sold as securities, with primarily the borrower
                                                                         and possibly the lender, the state, or the federal government providing the
                                                                         necessary credit enhancements to investors.
Sources: SBA, HUD, CRF, CDA, Capital Access Croup.




(250103)                                                  Page 66                             GAO-04-21 Community and Economic Development Loans
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