More Positive Rating Actions Than Negative Since 2020 As Capital Adequacy Strengthens

Table 1

Rated CDFIs Work To Maintain Strong Loan Performance Through Changing Economic Landscapes

Chart 1

Rated CDFIs' loan portfolios have performed very well since the onset of COVID-19, with delinquencies and modifications in the low single-digits.   Through 2021, delinquencies represented less than 1.5% of rated CDFI loan balances, on average, with the highest reported figure reaching 4.3%. Even when nonperforming assets (NPAs) more than doubled as a percentage of total loans for some CDFIs, those ratios were still under 3% in 2021. At the same time, loan loss reserves were relatively in line with prior years at an average of 3.5% of total loans. Management teams set these reserves based on their view of risks within their loan portfolios, including loan type and other characteristics (e.g., riskier loans may require more reserves). The financing of fewer risky loans helps explain the slight average decrease in reserves in 2021. Loans with maturity extensions but no change in rate or other terms are not considered delinquent or troubled debt restructurings.

In our opinion, an average of 46% of CDFIs' real estate-secured multifamily housing loan exposure contained what we view as atypical credit risks, while an average of 25% of those loans carried atypical credit strengths.   As of our most recent loan analyses, on average, about 21% of multifamily loan balances carried atypically weak performance, 10% contained atypical loan provisions that we consider increase risk, and 8% were construction loans without sufficient risk mitigants. Conversely, about 12% of these balances, on average, had additional oversight at the loan level that could increase stability and performance, and 9% were for projects with atypically strong performance. We assumed a full loss on about 4% of loans that are either unsecured or lack certain risk mitigants, in our opinion. Based on our review of lending strategies, we expect this percentage to remain relatively in line or modestly decrease in the near term.

Rated CDFIs are mitigating risks of construction delays and rising costs amid inflationary pressure.   In mitigating effects from rising costs, some CDFIs are including higher reserves in their new loans this year and locking in construction budgets to the extent possible to reduce the likelihood of unexpected increases. Further, the "know-your-customer" approach to lending helps CDFIs understand borrowers' capacity for controlling costs and operating a project before they commit their capital. Another mitigation strategy is to offer maturity extensions, while maintaining the rate and other loan terms, to allow borrowers additional interest-paying months for their projects to generate cash flow and overcome labor shortages or supply-chain issues. We expect strong loan performance will continue, in part due to three defining characteristics of rated CDFIs: sound underwriting, strong portfolio oversight, and patient capital.

Rated CDFIs Continue Their Focus On Affordable Housing And Education Projects, While Increasing Lending To Small Businesses

Chart 2

The distribution of property types among CDFI loan portfolios has only slightly shifted since 2018, with a consistent focus on housing.   All rated CDFI loan portfolios contain multifamily housing loans, including four of 12 rated entities which strictly lend for housing projects. On average, housing loans were about 59% of portfolio balances in 2021, only modestly higher than in 2018; housing ranges in prevalence among these portfolios between 10% and 100% of outstanding balances. Education-related projects, most commonly charter schools, are the next-largest portion of CDFI portfolios at an average of 16% in 2021, a slight decrease from 2018 which may reflect more competition in charter school lending in some areas of the country, and the availability of financing earmarked for such projects.

Small business loans represent a minor but growing portion of average CDFI balance sheets, which we expect will not weaken our view of credit quality in the near term.   Between 2018 and 2021, a larger percentage of outstanding loan balances were for small businesses and retail projects, though this still averages less than 5% of portfolios, the largest percentage being 17%. Some of this increase reflects on-balance-sheet loans funded through the Paycheck Protection Program established from the CARES Act in 2020 and other loans through federal programs such as the Small Business Administration's 7(a) Loan Program, which carries a guarantee from the federal government. CDFIs' good stewardship of capital and long track record of achieving positive social outcomes set the stage for the sizable investments in recent years intended to expand CDFIs' lending capacity to small businesses. We consider the source of capital and presence of risk mitigants (including federal guarantees) in our assessment of loan repayment risk. Therefore, we do not expect the currently rated CDFIs' strategies for lending to small businesses to result in weakened credit quality in the near term.

Other recent strategic shifts have had little effect on our opinion of credit quality.   We're seeing nimble CDFI management teams explore off-balance-sheet securitizations and lending partnerships, as well as using different debt issuances to mitigate balance-sheet risk. Transferring or originating certain loans off-balance sheet could affect our loss assumptions depending on their characteristics, but we have not yet seen a material trend in either direction. We also see a growing use of publicly rated retail notes, which allow for smaller incremental debt issuances and mitigate negative arbitrage.

Rated CDFIs' Equity Grew Or Remained Stable In 2021, Fueled By Average Increases In Short-Term Investments And Loan Balances While Debt Obligations Decreased

Chart 3

Recent increases in capitalization reflect stronger capacity to absorb potential loan losses in the near term, but may not signal long-term credit strengths.   Generally, these increases have largely followed influxes of temporary grants and contributions. In assessing the stability and level of capital available to absorb loan losses and other charges, these improved ratios may not be sufficient to support long-term rating changes. Fluctuations in ratios may also result from strategic decisions. For example, as illustrated in the chart above, CCRC's business model includes building up its on-balance-sheet loan portfolio and then securitizing and selling the loans every two-to-three years. After the loan sell-off, capital adequacy ratios spike to new highs, and then drop again.

Chart 4

Balance-sheet equity grew by an average of 25% year over year in 2021, whereas outstanding debt fell by 4% on average.   This equity increase partly reflects rated CDFIs limiting their debt borrowings in recent years while assets have continued to grow. The receipt of additional funding since 2020 helped fuel a 7% average increase in short-term investments for rated CDFIs.

We expect near-term decreases in equity-to-assets ratios for some, though most ratings are likely to remain stable.   On average, rated CDFIs continued to grow their lending portfolios, with a 2% year-over-year increase in 2021, much slower than the 19% average annual increase between 2015 and 2018. This slower increase partly reflects increased competition from other lenders and prepayments exceeding loan originations. As they deploy their lending capital, we expect to see some decrease in equity without comparable increases in debt. For some entities, this reflects a deliberate strategy but also signals that higher equity ratios are temporary. We expect to see growth in loan portfolios by the end of 2022, particularly given the lending products and terms offered by CDFIs in times of need.

Low-Cost Lending Capital Helps Stabilize Or Grow Rated CDFIs' Profitability

Chart 5

CDFIs were as profitable in 2021 as they were before the pandemic.   Net interest margin (NIM) for loans increased an average of 30 basis points between 2019 and 2021, while the greater increase in return on average assets (ROA) is largely due to the influx of grants and contributions. While any slowdown in grant revenue may bring ROA lower in the near term, we expect rated CDFIs' NIM for loans to remain strong so long as they continue to prudently manage their costs of funds. As interest rates rise while reliance on debt obligations remain somewhat muted, and as CDFIs enter into agreements for low-cost lending capital, we're likely to see increases in CDFIs' interest margins on new loans. Similarly, rated CDFIs generally have limited variable-rate debt exposure and typically fixed-rate loans mitigating interest rate risks. Most rated CDFIs' loans have a weighted average interest rate of about 5.9%, varying with loan characteristics and portfolio composition. As of our latest reviews of their loan portfolios, about one-quarter of loan balances were maturing within one year, and three-quarters were set to mature by 2028.

Chart 6

While loans typically make up the majority of balance sheets, short-term investments have grown.   Rated CDFIs' loan balances decreased as a percentage of total assets between 2018 and 2021 (to an average of 63% from 71%) as investments increased to about 22% in 2021. As described previously, potential increases in lending volume or deployment of short-term assets could shift this asset composition in the near term, though we expect rated CDFIs' access to external liquidity facilities to generally remain strong. The availability of undrawn lines of credit grew for some entities during the pandemic, a trend we may not expect to see long term.

Chart 7

Federal grant awards from the U.S. Treasury Department's CDFI Fund averaged slightly more than 10% of total revenues over the past three years for rated CDFIs.   Capital Magnet Fund (CMF) awards were typically the largest CDFI grants received over the past five years. CDFIs can use CMF grants to finance affordable housing activities as well as related economic development activities and community service facilities. The CDFI Rapid Response Program was funded in 2021 to help respond to economic challenges created by the COVID-19 pandemic, particularly in underserved communities. This program helped end a strong year in CDFI grant awards for rated CDFIs, excluding New Markets Tax Credit allocations which have averaged $229 million over the past five years. On average, CDFI Fund grants reached a high of 18% of total revenues in 2021.

The receipt and support of federal resources is another defining characteristic among most rated CDFIs, particularly when compared to banks or nonbank financial institutions.   CDFIs in our rated universe may have different strategies, capital sources, and lending portfolios, but there are several similarities. All are certified by the U.S. Treasury Department's CDFI Fund, with eligibility requirements that include, but are not limited to: a primary mission of promoting community development, providing both financial and educational services, and serving and maintaining accountability to one or more defined target markets. This differs from banks and other financial institutions that maintain lending businesses which may take deposits from customers, are regulated by federal entities such as the FDIC, and lack the level of federal support that certified CDFIs generally receive (e.g., grant awards and access to cheaper capital for lending). While loan losses are in the low single-digits for nonbank financial institutions, banks typically maintain lower capital and higher leverage ratios than CDFIs.

CDFIs Mitigate Environmental Risks In A Variety Of Ways

We analyze the environmental, social, and governance (ESG) factors relative to CDFIs' financial strength, management and legislative mandate, and local economy. We view social and governance risks as neutral considerations in our credit analysis. Some rated CDFIs' portfolios are exposed to environmental risks such as climate transition or physical risks of property damage (e.g., earthquakes, wildfires, flooding, or other severe storms). This exposure may grow for those lending in concentrated areas or regions. In addition to strong underwriting practices, sufficient reserves and liquidity, and diligent portfolio oversight, rated CDFIs partially mitigate such environmental risks through:

• Assessing potential collateral loss from climate events and requiring flood insurance and additional hazard-level insurance coverage on projects
• Prioritizing loans to projects with some component of renewable resources (e.g., water and energy efficiency), and
• Dedicating an internal team to assist communities nationwide in sustainability and resiliency efforts.

Table 2

Appendix: Recent CDFI Rating Actions

Low Income Investment Fund (LIIF)

One-notch upgrade in March 2021 on strong financial performance in fiscal 2020, with growing net equity, stabilized loan growth, improving leverage ratios, and strong profitability. LIIF's net equity (equity after S&P Global Ratings-applied loss assumptions) increased to 11.7% in fiscal 2020 compared with 7.9% and 2.5% in fiscal years 2019 and 2018, respectively. This increase was due to strong long performance and our view of its loan characteristics.

BlueHub Loan Fund (BHLF)

One-notch upgrade in September 2021 due to stronger capital adequacy in fiscal 2020 than in past years with a net equity-to-asset ratio of about 20%, up from 7.7% based on fiscal 2018 financials. Between fiscal years 2018 and 2020, the net equity-to-asset ratio averages about 13.7%. This results from BHLF controlling its capital costs, as well as support from grant sources and our view of loan portfolio risks.

Reinvestment Fund (RF)

Outlook revision to positive in November 2021 reflects the increase in RF's net equity in recent years, due partly to an influx of grants and contributions. Its net equity-to-assets ratio in fiscal 2020 reached about 21% and averaged 15% between fiscal years 2016 and 2020. As we tend to place the highest emphasis on net equity, we believe this five-year average ratio may remain near 15% in the next two years while RF's management remains strong.

Capital Impact Partners (CIP)

Outlook revision to positive in May 2022 reflects the increase in CIP's net equity in recent years, due partly to an influx of grants and contributions and an increase of net equity as a result of combining its operations with CDC Small Business Finance. Its net equity-to-assets ratio in fiscal 2021 reached about 20.3% and averaged 12% between fiscal years 2017 and 2021. We believe the ratio will remain over 17% over the next two years while the combined organization's management remains strong.